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Empirical and Normative Economics: a Game Theoretic Approach

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Empirical and Normative Economics: a Game Theoretic Approach Theoretical Economics Letters, 2020, 10, 655-695 https://www.scirp.org/journal/tel ISSN Online: 2162-2086 ISSN Print: 2162-2078 Empirical and Normative Economics: A Game Theoretic Approach Frederick Betz Institute for Policy Models, Enumclaw, WA, USA How to cite this paper: Betz, F. (2020). Abstract Empirical and Normative Economics: A Game Theoretic Approach. Theoretical Eco- An important problem in public finance is the interaction of public finance with nomics Letters, 10, 655-695. private finance—particularly when private financial markets crash, then bank https://doi.org/10.4236/tel.2020.103042 runs occur, and a central bank needs to bail out the banks to prevent an eco- Received: March 2, 2020 nomic depression. Historically, private financial markets have periodically Accepted: June 25, 2020 crashed (financial bubbles); and then public finance (central bank reserves) have Published: June 28, 2020 sometimes bailed out banks, to prevent a depression. The reason this pattern (of Copyright © 2020 by author(s) and a lack of regulation to prevent financial bubbles, but then bailing out banks) Scientific Research Publishing Inc. has historically recurred has been the use of an idealized economic theory of This work is licensed under the Creative “perfect market”—used in economic policy to avoid appropriate regulation of Commons Attribution International License (CC BY 4.0). a financial market. In this research, we formulate a “game-theoretic ap- http://creativecommons.org/licenses/by/4.0/ proach” to include financial regulation as an explicit part of the model of a Open Access financial market. Future research direction from this game approach can ex- tend the traditional “endogenous economic theory of markets” into an em- pirical modeling technique—which can ground economic theory in the real history of market instabilities. Keywords Public Finance, Political Economy, Government Regulation, Financial Bubbles, Market Imperfections 1. Introduction We will extend the Keynes-Minsky theory of a financial market as institutionally based—through analyzing the strategies of agents (market players) in a “game- theoretic form”. The advantage of a game-theory approach is to enable the ex- plicit inclusion of government regulation as one institutional aspect of economic market theory. DOI: 10.4236/tel.2020.103042 Jun. 28, 2020 655 Theoretical Economics Letters F. Betz In a game-theory view, financial markets operate, not just simply under fi- nancial-agent logic but also under the rules of government regulation. In gaming terms, the economic theory problem is how should government regulation operate in order to facilitate real markets operating efficiently (toward a perfection). 2. Background: Market Imperfections First, we review the two schools of economics which have divided upon this is- sue of: whether the economic theory of a perfect market is empirically true or an ideal to which to aspire: Empirical or Normative Theory. When is an economic theory empirically true? Economic history can provide the answer. For example: is the economic theory of the “perfect market” always empirically true? The historical answer is no. In the United States economic his- tory, the empirically series of market failures and economic recessions/depressions (from 1857 to 2007) provide this negative answer (Kindelberger and Aliber, 2011). • Panic of 1857—This was triggered by an excessive railroad investment, lead- ing up to a stock market collapse, which triggered a bank panic and created an economic recession. • Panic of 1873—Again, excessive investment created a stock bubble, whose collapse triggered a bank panic and subsequent economic recession. • Panic of 1893—Again excessive investments in railroads, resulted in tempo- rary overbuilding, triggering again a bank panic and recession—financial excess, market crash, bank panic, recession. • Panic of 1896—Monetary policy about US currency began to be based both upon silver and gold, which, as monetary policy, created an economic de- pression when silver reserves declined. • Panic of 1907—This was again a stock market failure, which began to trigger bank runs; but this was halted by JP Morgan Bank. Stopping the bank panics prevented a recession. Six years later, this event had encouraged the estab- lishment of the U.S. central bank system (Federal Reserve System). • Panic of 1929—A New York stock market bubble triggered three years of bank panics, resulting in the U.S. Great Depression, which lasted a decade. • Panic of 2007—A U.S. real estate bubble was followed by the crash of a Wall Street financial derivatives market, and a global bank panic, creating a reces- sion in the U.S. Also, financial panics have been international. In Asia in 1997, there was an Asian fiscal crisis, triggered first by real estate and stock bubbles in Thailand, and then by a sharp decline in exchange-rate and out-flow of foreign capital. The market failure in 2007 required the U.S. government to bail out U.S. banks with 3/4th of a trillion dollars. In Europe in 2011, there were bank panics in Euro coun- tries, due to excessive sovereign debts, which triggered bank panics, and resulting depressions, particularly in Southern Europe, in Greece, Portugal, and Spain. DOI: 10.4236/tel.2020.103042 656 Theoretical Economics Letters F. Betz A key issue in any social science discipline is this. Whether a proposed theory is empirically true or normatively true—true in fact or true in ideal? An empiri- cally true theory is “Real” in an actual social situation; a normatively true theory is “Ideal” in an actual social situation. “Real” is what actually exists; and “Ideal” is what should exist, what is desired. Real theory is objectively true (existent); whereas Ideal theory is subjectively true (value). Why is it important whether an economic theory is empirically real or ideally true? It is important because economic theory has often been used to guide and justify government policy decisions on economic policy. For example, as we have just seen from the list of the empirical instances of market failure (eco- nomic history), the economic theory of a perfect market can only be an Ideal theory—a state of the market to be desired. Yes, it is to be desired; but some- times it is not actual. Yet some government regulators have argued it was a Real theory (an empiri- cal theory)—that financial markets are actually and always perfect. A historically recent example of this occurred in 2000 in U.S. economic history, when the Chair of the Federal Reserve System, Allen Greenspan, argued to the U.S. Con- gress that the relatively new financial market of “derivatives” should not be re- gulated because all markets were perfect. Yet only seven years later in 2007, that mortgage-derivatives market went bust; and it almost brought down the U.S. whole financial system (while also creating chaos in the world financial system). Why had Allen Greenspan argued that the economic theory was an empirically Real theory rather than an Ideal theory? Because he believed in the Exogenous school of economics, which we will next review. 3. Background: Two Economic Schools about the Theory of Financial Markets It is important to avoid the kind of “Greenspan-Theory-Confusion” in formu- lating economic policy—the confusion which led to disastrous consequences in the world financial system in 2007-2008. This paper is a little long because we must first review how to “model” the Endogenous theoretical approach (Keynes- Minsky) to a financial market, before we can extend the modeling analysis with a game-theoretic model. This issue of Idealism or Realism about financial markets has been a central methodological issue in the history of economics in the United States (from 1937 to 2007) dividing economic theory in Exogenous and Endogenous Schools (This is a well-known story, but it is useful to see it again—to appreciate how “metho- dology” can divide academic schools in the social sciences, including econom- ics). The “Classical-Synthesis” economic school was called the “Exogenous scho- ol”—meaning the imperfections in a market were external to the functioning of the market. The opposing Neo-Keynesian economic school was called the En- dogenous school—meaning that the imperfections in a market were internal to DOI: 10.4236/tel.2020.103042 657 Theoretical Economics Letters F. Betz market operations. The Exogenous school argued that perfect market theory is Real, with any imperfections in a market as “external” to the market. In contrast, the Endogenous school argued that perfect market theory is Ideal, as empirically markets always contain imperfections “within” the market. (Greenspan belonged to the Exogenous school; but our focus here is on the Endogenous school). In 2012 after the “Great Recession” in the U.S. due to the mortgage-derivatives market failure, some economists, such as Charles J. Whalen, saw these two foci about financial systems as converging: “In the mid-1970s, Wallace C. Peter- son … argued that institutionalism and the economics of John Maynard Keynes can be viewed as ‘two trains on parallel tracks toward a common destination’. Today, in the wake of the Great Recession (2007)—the worst global economic downturn since the 1930s—those trains have finally reached the station. Their arrival is none too soon for economics and the world economy. The common destination of institutionalism and the economics of Keynes, the latter of which is currently called Post-Keynesian economics, is also called Post-Keynesian In- stitutionalism” (Whalen, 2012). The Post-Keynesian Institutionalism school has emphasized that the institu- tional relation of Credit-to-Debt is an essential process (Endogenous) aspect of a financial market. This points to the essential role of banking in financial mar- kets. Hyman Minsky wrote: “…the dynamics of contemporary capitalism … characterizes all economic units by their financial portfolios. In all sectors, people and organizations constantly face the need to decide what assets to ac- quire and how to finance them.
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