Pieria: Straw Men and Marxism

I’m in Pieria again, with a post that tries to outline Marxist theories and defend them from some common but clearly misplaced criticisms:

For many, Marxist theories should be laid to rest. His labour theory of value is often referred to as “discredited”, superseded by the subjective theory of value, while historical materialism and its lofty ideals about changing human nature are held to be equally fallacious. His purported views on colonialism (and their Leninist children), while not entirely wrong, are held to be incomplete as they fail to include non-capitalist instances of these phenomena. Finally, his historical ideas about the ‘inevitable’ overthrow of class war and victory of socialism are seen as naive and deterministic, and, to a degree, ethnocentric.

However, as I will show, such crude caricatures have been around for over a century, and were often repudiated by Marx (and his collaborator, Friedrich Engels) themselves.

I talk about the Labour Theory of Value (not price!), which I’ve defended before, as well as the Marxist view of colonialism and imperialism; finally, I refute the absurd idea that Marx supported a strong form of historical materialism.

As a brief conjecture, I think one of the main problems people have with accepting Marxism – aside from the difficult political implications – is that it is such a comprehensive ‘theory of everything’. While, as I argue, Marxism gives birth to many falsifiable hypotheses, it also acts as a lens through which to view the world. Hence, embracing it fully is a big step for a most people, because they (a) lose the ‘individuality’ of their views and (b) have to master an entirely different method of communication. (To this end, I would advise Marxists to refrain from using terminology quite as much as they do – it alienates (!) people).

Anyway, ‘read the whole thing’, as they say.

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A Question for Economists

Sincerely: do you believe your discipline has earned a status as a decider of policy? Which successes would you point to in order to highlight this? And how have non-economists fared in the policy arena compared to you?

Justin Wolfers recently tweeted to the effect that although economics is not perfect, it is the best existing way to formulate policy. Yichuan Wang has also defended economists’ record in the real world. Bryan Caplan has notoriously argued that voters do not know enough economics and therefore cannot be trusted with policy. In general, economists are always willing to trot out policy prescriptions – often at the end of mathematical papers that are largely incomprehensible to the public – on the grounds that they are scientifically determined solutions to social and economic problems. But does economists’ record formulating policies justify this? I’m skeptical: as far as I’m aware, economists’ record shows few successes, many failures, and a lot of ambiguity.

Generally, economists favourite policies actually don’t have much evidence behind them. ‘Free trade’ deals have ambiguous effects on growth. The issue of whether the minimum wage produces unemployment is famously controversial, with any of the effects predicted being undeniably small. Estimates of the Keynesian multiplier also vary widely, and are generally easy to predict based on the political biases of who is doing the estimation. There is also a surprising lack of evidence to support the contention that fiscal stimulus alone can ‘kick start’ a flailing economy. Sure: the New Deal created growth, but it didn’t end the Great Depression. Japan has had a lot of monetary and fiscal stimulus but has remained in a ‘lost decade‘. Countries that have used stimulus and done well in the recent crisis generally had strong institutions and financial sectors (Sweden, Germany) or are simply at an earlier stage of development and therefore their growth is far more resilient (China). What’s more, you get as many arguments against stimulus coming from economists as you do for it, so even if it were the case that stimulus were the ‘right’ policy, the discipline hasn’t been a beacon of scientific truth concerning the matter.

What’s more, there are many examples of economists chosen policies clearly failing when applied to the real world. Milton Friedman’s quantity-targeting monetarism failed in 3 different countries in the 1980s. The Black-Scholes formula for pricing financial assets is infamous for its complete inability to do its job properly, and has caused chaos wherever it has been used. The ‘Great Moderation’ was built on inflation targeting and financial deregulation, both of which were pushed by vocal economists, and it culminated in the 2008 financial crisis (no, the two were not unrelated). The IMF’s ‘structural adjustment programs’ – such as those used in the ‘transition’ of the former communist countries, and in sub-Saharan Africa, engineered largely by well known economists like Jeffrey Sachs – were notorious disasters. It’s true that Africa’s economic performance has been better in recent years, but this has less to do with the influence of economists and more to do with commodity booms and a decrease in conflict.

The one major example of macroeconomic success was in the post-World War 2, Bretton-Woods era. The ideas put in place – pioneered by economists John Maynard Keynes and Harry Dexter White – revolved around trade management and stable exchange rates. However, these ideas were quite far from the mainstream and are endorsed by few today; the discipline believes it has moved past them. What’s more, these ‘social democratic’ policies were erected largely because of popular support after the devastation of the depression-war period. In fact, the major aim of Bretton-Woods was to prevent another world war from happening. The whole thing was a more of a social movement based on political dynamics than an example of technocratic economists coming along and working their magic.

However, perhaps there are a few examples of this occurring elsewhere. One of economists’ go-to examples is auctioning off wireless spectrums. However, the evidence on this is actually somewhat mixed. In the UK and US, many of firms who’ve won the auctions have been incapable of utilising the spectrums they have bought and have had to sell them back to the regulatory bodies. Furthermore, since different companies often have to cooperate to prevent disturbances, fierce competition can undermine this process and engineers can be necessary to plan and coordinate things. To be sure, I don’t claim to have a definitive answer to this problem, as it is complex, but it seems that economists don’t have such an answer, either.

Now, there is one clear example of economists toolkit resulting in real world success: recent Nobel Memorial Prize winner Al Roth, whose work on ‘matching’ in kidney markets, schools and more has produced admirable results. It makes sense that this kind of thing would be an example where economics ‘works’: after all, in such situations choices are clear, there are not too many actors and institutional variables, and people have access to all of the information they need. However, this is the only obvious example I can think of.

What about non-economists record with policy? Well, developed countries rose to prominence before economics as a separate discipline really existed. And, as Ha-Joon Chang has pointed out, recently industrialised/industrialising countries such as South Korea, Japan and China have largely relied on bureaucrats and lawyers to form policy (and my sources tell me that the economists in China are inclined towards Sraffian economics). Different countries have benefited from highly disparate approaches to policy: in keeping with their history, culture and existing institutions, but without much consideration of ‘economic logic’. To be sure, there are examples of both good and bad policies coming out of the democratic process, but the bad is certainly not worse than economists’ record, and it least it’s accountable to the people it affects. (Incidentally, public choice theory is not a sound argument against democracy, and even if it were, it would also be an argument against economists).

This is only a brief, cursory overview, but even so we should have expected better examples of economists’ successes, and far fewer, less catastrophic failures. In my opinion, if there is a role for economists in advising policy, it’s on small, micro-issues like Al Roth’s auctions, or on specific empirical matters. However, once we get more complex, economists’ pet policies seem to be at best neutral, and they have no empirical reason to prefer their choices to those of the electorate.

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Pieria: Introducing Post-Keynesian Economics

My newest article at Pieria provides an overview of the post-Keynesian theories of consumers, producers, money/banking and trade:

A common charge directed at heterodox economics is that it is defined as a negative and has little to offer in the way of an alternative to mainstream economics (at least, if we ignore the ‘extremes’ of Austrianism and Marxism). It’s true that heterodox economists, including myself, often spend more time criticising mainstream economics than we do offering alternative theories. Yet there is in fact a large amount of work on alternative theories of pricing, distribution, finance and trade. Below I will sketch out what is known as the ‘Post-Keynesian’ (PK) approach to economic theory….

The summary echoes what I’ve said before about the difference between mainstream and heterodox economics:

First, post-Keynesians tend to emphasise that key variables (wages, the rate of interest) are monetary, not real phenomena. This doesn’t mean the notion of the real is unimportant – far from it – but it does mean that it is often a poor starting point for analysis. Second, there is generally no special status accorded to particular variables. Consumers and producers are not ‘optimising’; trade between countries can be imbalanced for long periods of time; the economy can remain in a state of depressed demand and no adjustment of prices will save it. Third, there is a lot of emphasis on institutional considerations. Since prices, demand and trade depend somewhat on social norms and agreements, and since agents tend to fix their decisions for long periods of time to maintain a degree of certainty, different economic trends can persist based on historical path dependence, and there is no ‘one size fits all’ model.

I have to say that I’m not sure why post-Keynesians don’t spend more time on this stuff. I find the theories pretty comprehensive and quite obviously more grounded in reality than the neoclassical approach.

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Whig Theories of the History of Thought

Yesterday, Paul Krugman had a post in which he pontificated on the Stock Flow Consistent (SFC) models of the economy used by Wynne Godley (and generally by post-Keynesians). These models focus on simple flows of funds between sectors, use endogenous money mechanics and are consistent with accounting identities, making them highly suitable for modelling financial crises. Krugman, however, is not impressed. He seems to see these simple mechanics – with relationships between sectors determined by coefficients – as not quite ‘rigorous’ in the same way as the type of optimising, equilibrium model he favours. He believes that “Hydraulic” approaches like Godley’s have been supplanted by superior models, and so it would be a step backward to take another look at them.

It is worth noting that Krugman’s dismissal of these “hydraulic” models is strange given his zealous promotion of IS/LM, which is surely a hydraulic model if there ever was one: variables are simply determined by coefficients and left largely unexplained in terms of typical ‘optimising’ behaviour. More importantly, though, I think Krugman has quite an ignorant conception of how economic theory has developed. He tries to paint picture of economics as continually discovering new and interesting insights, but the reality is far more complex. In fact, many of the ‘insights’ mainstream economics claims to have discovered were already known; what’s more, their solutions to the purported problems with “hydraulic” models leave a lot to be desired. Often the only problems with a theory resulted from misinterpretations of particular thinkers, and, properly interpreted, the model offered a credible alternative to the neoclassical approach. Overall the history of economic thought is not really a clear cut story of scientific progression.

Yet Krugman sees things through a ‘Whig‘ perception of the history (of thought), where everything has progressed over time and culminated naturally in what we have now. He thinks that macroeconomics in the 1950s and 60s was similar to Godley’s work, but that it was abandoned for good reasons:

What you might not realize from this passage is that Godley’s notion that we should represent behavior by rules of thumb isn’t something new — it’s something old, which got driven out of macroeconomics. The “hydraulic Keynesianism” of the 1950s was all about viewing the economy as a kind of mechanism in which consumer behavior could be represented by an ad hoc consumption function, investment behavior by an ad hoc investment function, and so on. This produced a more or less mechanistic view of the economy, and AW Phillips famously represented hydraulic macro with a literal hydraulic mechanism.

I’m glad Krugman knows about Phillips’ wonderful MONIAC model. However, economists really misinterpreted Phillips, as this is clear in Krugman’s discussion of his work. His ‘curve‘ – which Krugman goes on to reference – was supposed to be a dynamic model of how unemployment and inflation change over the business cycle, not a static trade off between the two. Furthermore, Phillips’ models also included expectations, one of the supposed strengths of the models that displaced his. What’s more, Phillips was well aware of the problem of how the economy may evolve and change over time or with policy – as he put it:

In my view it cannot be too strongly stated that in attempting to control economic fluctuations we do not have two separate problems of estimating the system and controlling it, we have a single problem of jointly controlling and learning about the system, that is, a problem of learning control or adaptive control.

Krugman doesn’t reference this point – known by the mainstream as the Lucas Critique – explicitly, but this is the major reason “hydraulic” models were abandoned in favour of the ‘microfounded’ models Krugman endorses: it was thought that the latter would not be as susceptible to change with policy. However, this insight had been stated by many long before Lucas – not only Phillips above, but also Keynes – and it is a continual problem, so we cannot ‘immunise’ ourselves from it with microfoundations or anything else. The heterodox economists Krugman dismisses so blithely were actually more alert to the problem than he was, because they didn’t think they had – or could – supersede it.

Krugman now discusses why his favoured ‘optimising’ approach took centre stage in the 1970s and 80s:

So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers — it’s at the core of what we’re supposed to know — so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb.

I’m not sure this even counts as a defense of economist’s approach, because it is hopelessly question-begging. Economists shouldn’t model a certain way “because [they] like to”; they should do it because it is more consistent with observed phenomenon. Rational behaviour doesn’t really “trump” anything, as it is largely unobserved in the real world, whether on the part of firms, consumers, governments or what have you. All this point actually demonstrates is how economists can be predisposed toward a certain framework, regardless of predictive success or failure.

However, Krugman thinks that the neoclassical approach has been largely a predictive success when compared with its “hydraulic” counterpart, and puts forward two major points to show this:

First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim….In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.

First, as Ramanan quickly noted, Wynne Godley’s model did not suggest the savings rate would rise as incomes rose; in fact, it was the opposite. So his model was perfectly consistent with observed behaviour, and there was no need to invoke optimising agents to ‘explain’ anything.

Second, if we were looking for a model of consumption based on human behaviour, Friedman’s permanent income hypothesis – where people spent money as a function of their total lifetime, rather than current income – was not the first or best theory for the job. In fact, it actually displaced a better theory, the relative income hypothesis. This suggested that people’s expenditure was a function of what people around them were spending, or the norms in a society. Poor people’s consumption would be a higher percentage of their income because they were trying to “keep up with the Joneses”; however, as incomes as a whole rose, so would the socially acceptable level of income, so savings rates would not rise with total income. This kind of airy-fairy explanation is like nails on a blackboard for many mainstream economists, but it is more consistent with both the statistical evidence and observed human behaviour.

Krugman’s second point in favour of neoclassical economics is the role of the 1970s stagflation as a vindication of the ‘rational agent’ approach:

In came Friedman and Phelps to argue that rational price-setters would build expected inflation into their choices, so that sustained low unemployment would produce accelerating inflation. And the stagflation of the 70s seemed to vindicate their argument.

Friedman and Phelps’ model may “seem” consistent with stagflation, but there are alternative explanations for stagflation, too, and the question is which one is most closely consistent with the mechanics of the phenomenon. In fact, Friedman and Phelps’ NAIRU theory’s major prediction – that past a certain level of unemployment, inflation will start to increase dramatically – actually has little evidence behind it. On the other hand, Andrew Lainton has pointed out that in Wynne Godley’s Magnum Opus, Monetary Economics, he developed a full model of stagflation that dealt with the 1970s quite competently. On top this this, Godley’s model, as well as similar ones like Steve Keen’s, are also well equipped to explain the recent financial crisis. As Noah Smith once argued, the best theories are those which can explain all phenomena within their domain, and models like Godley’s simply fit this description more closely. But Krugman doesn’t realise this, because he knows very little about the work of Godley and people like him – after all, why bother when they’ve been relegated to the dustbin of progress?

The only problems with economist’s 1950s view of inflation and unemployment stemmed from the ‘bastard Keynesianism’ of the 1950s and 60s, which resulted from misinterpreting Keynes and Phillips and trying to shoehorn them into the neoclassical approach. However, even if we accept ‘bastard Keynesianism’, Krugman’s point is questionable, as the prominent post-war economists Robert Solow and Paul Samuleson were also aware of the potential for the relationship between inflation and unemployment to become unstable. Therefore, claiming that Friedman and Phelps swept in with new, largely successful insights is a stretch to say the least.

Essentially, Krugman believes in a Whiggish conception of the history of thought, where good ideas have driven out the bad, and economics has slowly made better and better predictions. But like all Whig history, Krugman’s opinion rests on arbitrarily placing current theory as the inevitable goal of complex and fractured processes, ignorance of things that don’t seem immediately relevant to these theories, and above all, a good old bit of self-aggrandisation. While I don’t want to tar too many with this brush, judging from the way I was taught, and what I’ve seen elsewhere, it seems that a large part of the discipline thinks this way. But the development of economics has been far more complex, and alternative theories are far more credible, than such a narrative would have you believe.

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On Pieria: Defending Lefty Books

I’m in Pieria, taking a brief look at the (often contentious) debate surrounding three books: The Spirit Level, Chavs, and The Shock Doctrine. It’s split into 3 parts, and you can start here:

Over the past few years, there have been some big hitting books from the left criticising inequality, capitalism and ‘free market’ economics or neoliberalism. Naturally, these books have received a lot of criticism from the right. However, sometimes it seems that this criticism is overzealous: an attempt not merely to question the book, but discredit it entirely, and accuse the authors of various misrepresentations of facts and people along the way. Now, while it’s true that some arguments or ideas are essentially ‘just wrong’, and that some proponents of certain ideas can be intellectually dishonest, the frequency with which these accusations are made is alarming, and I believe they are often mistaken.

These books definitely have their flaws. Jones and Klein are both journalistic accounts, which means that they tend to spin things a certain way (Jones refer to TSL‘s thesis as “irrefutable”, which is obviously an exaggeration’). Wilkinson & Pickett’s case is actually stronger than reading their book would have you believe, and they miss some opportunities to really slam dunk the point home, which I found frustrating. In any case, all 3 books are worth your time and are much better than most of the material dedicated to refuting them.

PS I am now going on holiday for a week, so expect little to no activity.

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Economists Say The Funniest Things

A short while ago, I tweeted that a show entitled “Economists Say the Funniest Things” – where economists opine on issues outside their domain – would make for good watching by those of us who inhabit the real world. Unfortunately, I can’t afford a show, so I’ll settle for a blog post.

I have previously posted on ‘economic imperialism’, but the examples in this post are, to put it bluntly, less serious, often crossing the line into simply silly.  Economists sometimes like to transpose their incentive-driven, utility-maximising agents onto complex social problems, and claim that they have discovered the elegant, underlying mechanics underneath all the noise that the other social sciences study. They will also argue that those who object to their framework do it simply because they don’t like or understand maths, or because they can’t stomach the often unpalatable conclusions of the model. In fact, it is these economists who are seemingly unable to comprehend the phenomena they purport to study, preferring instead to solve equations, which they label ‘models’, but which do not actually ‘model’ the world at all, and which often seem to lead the economist to ridiculous conclusions.

I will put a standard disclaimer out there: I’m not so much attacking the entire economics profession as the ‘pop’ economics that you find in books, on the internet and, sadly, sometimes in policy circles. I hope many economists – those who are able to comprehend history, the complexity of human behaviour and above all the difference between models and reality – will find these examples equally absurd.

Economists do psychology

Naturally, the sometimes infuriating Freakeconomics craze could warrant an entire post, as their ‘antics’ have angered many, including other economists. However, I am going to focus here on one of their less covered arguments: a story about incentives, which is at the beginning of their first book. It provides a nice introduction to wrongheaded economic imperialism, as this wooden insistence on how, underneath everything, people are essentially driven by clear incentives, underlies many of economist’s attempts to try their hand at other disciplines.

The story goes like this: an Israeli day care centre found that parents were picking up their children too late, so they introduced a small charge of $3 to try and disincentivise lateness. However, instead of discouraging this behaviour, the payment served to legitimise it and buy the parents piece of mind. The result was that lateness actually increased. Bizarrely, the Freakonomics duo decided that this story is consistent with economist’s way of thinking, and used it as an introduction to the idea that “incentives matter”. They argue that people actually face three different types of incentives: economic, moral and social. The idea is that the charges “substituted an economic incentive for a moral incentive (the guilt)”, with the implication that the daycare centre simply didn’t get the amount right. However, if this were true, treating guilt would be as simple as paying somebody that you had wronged.

The way people respond to incentives is in fact highly complex and unpredictable. Incentives that are too big or too small can have perverse effects. What’s more, how people will respond to any incentive depends on the perceived motives of the person offering it, and the implied motives of the person receiving it. Studies show that incentives can easily backfire if these motives are questionable, something that has had an impact on the field of organ donation: when people were offered money for donating, donations decreased. People simply no longer felt that they were helping people, only that they were making a bit of money. The Freakonomics guys do not engage with any of these well established psychological tendencies; they simply select three arbitrary and incommensurable concepts and proceed as if their analysis were obviously true. But it’s clear that, contrary to their mantra, claiming to be able to predict people’s response to incentives with certainty is simply a fool’s game.

Economists do history

Historians – at least, those who aren’t Niall Ferguson – try to emphasise context, combat euro-centric (and therefore usually capitalism-centric) narratives, and endlessly struggle against ‘Whig’ history, which suggests that history has naturally culminated in contemporary societies. History is therefore a prime stumbling ground for economists, whose models generally take place in a theoretical ‘vacuum’, take capitalist institutions and social relations as a given, and often model the economy as a deterministic time path or as in equilibrium. It seems that economists tend to see the ‘people respond to incentives’ behaviour outlined above as underlying history, and therefore believe that events naturally culminated in capitalistic behaviour; of course, the corollary is that deviations from this were caused by bad policy, externally imposed by governments.

This type of thinking is clear in Evsey Domar’s serfdom model, which attempted to explain the end of serfdom through notions of its profitability to the landowner. The model argues that if land is too plentiful relative to labour, this results in competition among landlords for workers, which drives wages up, and subsequently it becomes more profitable for landlords to use the institutions of serfdom and slavery to ‘put down’ labourers, rather than employ them for wages. Conversely, if land is scarce relative to labour, wages will remain low enough for wage labour to be profitable, and serfdom and slavery will disappear. Domar suggested that this explained the end of serfdom in Russia in the late 19th Century.

To be fair to Domar, he was more than ready to acknowledge the limitations of this model. One person who was less so, however, was Paul Krugman, who has used it as an illustration of why he considers economics the superior framework for social science. According to Krugman, models like Domar’s are an indication of how economics is “rigorous” and makes “generally correct predictions”. This latter characterisation is especially bizarre, because Krugman goes on to acknowledge that there are large areas of history the Domar model doesn’t explain, such as why serfdom was not reinstituted in Europe after the Black Death wiped out a large amount of the labour force, pushing up wages. According to Krugman, events such as these are “puzzles”. Surely they are just an indication that economist’s framework isn’t so great?

In fact, the Domar model actually doesn’t do a great job of explaining its prime example of 19th century Russia. The serf agreement was not simply forced onto peasants, but was a three way deal between the state, landlords and peasants: peasants had rights and were in many ways ‘free’, as long as they produced enough for the gentry, who were subsequently available for the military. What’s more, the 1861 ‘emancipation’ from serfdom was not instituted by the landlords based on considerations of profitability; the move was centrally directed by the state, based mostly on imperialist/defensive considerations after the Russian defeat in the Crimean War. Many landlords were resistant to the change, and though the legislation was passed a large number of restrictions remained, some effectively extending serfdom.1 Overall, the incentive-based behaviour outlined by Domar is irrelevant to the broader story of social and political change.

The root of the issue is the assumption is one that is not atypical in economics: the idea that the capitalist institution – in this case wage labour – is the ‘natural‘, underlying tendency, upon which artificial institutions like slavery and serfdom are ‘forced’. Indeed, Domar repeatedly refers to the wage labourer as the “free man”. But history shows us there are no natural, underlying institutions: capitalist, feudalist and slave(ist?) institutions are all complex, and their introduction is fragmented. Therefore, at worst, the Domar model is trivial: it suggests that if wage labour, serfdom and slavery are all easily available to landlords, they will choose the one most beneficial to them (in fairness, Domar acknowledges in one place that we might “question the need for [his model]“). However, you don’t need an economist to tell you this, and neither would they be able to tell you how such a situation arose in the first place. A historian would.

The next example continues our journey through Russian history, though perhaps that is stretching the definition of the word ‘history’. This one reminds me of a story – probably an urban myth – about a student at the University of Chicago, who fell asleep in one of Milton Friedman’s lectures. Friedman was furious, and demanded the student answer whichever question he had just asked. The student responded “I don’t know the question Professor Friedman, but the answer is a change in the money supply”. It’s a funny joke, until you realise that economists (in this case Irving Fisher*) actually write things like this:

Economistslol

There you have it, folks: belief in socialism is a monetary phenomenon. This is despite the fact that Russia, the centre of Bolshevism, wasn’t really capitalist at the time of its revolution but mostly feudalist, making Fisher’s discussion of workers and employers bargaining largely irrelevant. It was actually the increasing scarcity of land and food – not the instability of money – which robbed peasants of their lot. Fisher’s account also ignores the undeniable role of World War 1 (elsewhere as well as in Russia), which devastated large areas of the country and created an armed, disenchanted underclass accustomed to conflict. Contrary to what Fisher implies, I’m pretty sure that an oppressive regime drafting you for a largely pointless war, or taking away what little you have, does not only “appear to be social injustice”, but is social injustice, and is peripheral to “changes in the buying power of money”, itself usually symptomatic of broader instability – economic or otherwise.

An economist does sociology (and more)

Perhaps nobody better characterises the term ‘Economic Imperialism’ than University of Chicago economist Gary Becker. Becker has used economist’s toolkit to craft theories for everything from crime to addiction to the family, and in fact he won the Sveridges Riksbank Prize for his efforts (yes, it’s a fake Nobel yada yada). Naturally, Becker’s models were praised because they were rigorous and mathematical (a quick google search will reveal multiple people fawning over him for god knows what reason). While Becker himself is quite modest and seemingly well intentioned, his theories about human behaviour are so far from the truth it’s a wonder they have garnered any respect at all.

The first of these, Becker’s theory of ‘Rational Addiction‘ (amusingly parodied in this video), suggests that those who are addicted to drugs are just following a rational long term utility-maximisation plan. This is the sort of thing that a normal person looks at and goes “erm, no”, as it is completely at odds with the internal and external struggles that addicts commonly face. “I’m just maximising my satisfaction” sounds like something an addict will tell you, but analysis of addiction generally has to go beyond that to be of any use.

It almost goes without saying that do not plan their addiction because they think it will maximise their future satisfaction, and is well established people in general do not behave this way. Some economists have tried to use vague data points – such as the evidence that smokers adjust their habits due to expected tax increases – to ‘show’ people are rational and forward looking. However, it is obviously a leap from this highly stylised behaviour to suggest that smokers are perfectly rational and informed forward looking utility maximisers. In fact, the observed behaviour of addicts suggest that addiction is generally involuntary, and people become addicted because they are unaware of, or underestimate, the risks of addiction. Often it is not clear why people are addicted, even (or especially) to themselves.2

On top of this, the actual mechanics of addiction used in the theory are questionable. ‘Rational addiction’ occurs because past consumption of something builds up a ‘stock’ (with typically undefined units), increasing the pleasure you get from consuming it now. However, in the real world addiction is far more complex than this, and is associated with numerous, sometimes conflicting effects. For example, the theory of rational addiction cannot explain the ‘empty compulsion’ addicts feel once the brain has adapted or become satiated, resulting in a disappearance of the ‘high’, but not of the desire to continue, even if the addict’s conscious brain conflicts with this desire. What’s more, different drugs create different reactions inside the brain (not to mention psychological reactions): opiates like heroin tend to mimic certain neurons, whereas alcohol inhibits the brain’s ability to release (and coordinate the release of) neurons. These are disparate processes that cannot be captured by economist’s utility. Conversely, neurologists, psychologists and social workers have models that can explain such nuances, which are certainly the ones I’d turn to if I wanted to understand and deal with addiction.**

Becker’s second major theory of human behaviour is New Home Economics, or the theory of the family, which started with Becker’s 1965 paper on the allocation of time and culminated in his 1981 Treatise on the Family. As would be expected, the theory models families as a collection of rational agents optimising various preferences and operating according to their respective specialisations, and so it can easily be criticised along previously mentioned lines. However, I will not go over these arguments again.

Instead, the critiques I find of interest here are those by feminist economists, who generally take issue with Becker’s almost hilariously stereotypical depiction of the family. The head of the household – implied to be a man – is modeled as an ‘altruistic’, breadwinning agent who coordinates everything and makes sure it is OK, while the rest of the family accept his judgment as in their best interests (in other words, he is a benevolent dictator). Housework is done by the woman (as women have a ‘comparative advantage’ in housework), and is not counted as a contribution to the family pot, implying that said work is not similarly ‘altruistic’. One is forced to wonder whether the theory would be more suited to the 18th or 19th centuries – clearly, it precludes the study of non-traditional families. A real household that looked like this would probably be classed as abusive.

The theory has many other conceptual and explanatory problems. It could be viewed as an attempt to deal with the troublesome existence of the family unit by arguing it can be represented by a single optimising agent, similar to the way some perfectly competitive models deal with the firm. Economist Barbara Bergmann noted that the theory seems to lead to the “conclusion that the institutions depicted are benign, and that government intervention would be useless at best and probably harmful.” Yet this depiction is completely at odds with the obvious fact that families often exhibit conflicting or self destructive behaviour. Bergmann goes further, arguing that Becker’s theory more generally leads to “preposterous conclusions”, among which is the ‘economic argument’ that women should embrace polygamy, and the idea that the decision to have children is only a function of parent’s ‘altruism’ and of the rate of interest. While the theory may be vaguely consistent with a few stylised facts about how income affects families, these are largely trivial and do not need Becker’s theory to explain them.

The third and final theory is Becker’s theory of crime, which unsurprisingly argues that criminals simply perform crimes because the benefits outweigh the costs. Criminals were said to calculate the ‘expected utility’ of a crime, which multiplies the probability of being caught times the price for being caught. Becker’s cost-saving solution was to increase penalties but reduce enforcement, and also to increase enforcement of more costly crimes (which, in practice, means increasing enforcement in wealthy areas and decreasing it in poor areas).

To be fair, Becker always warned against implementing an extreme version of his view, but as is often the case the caveats were not taken on board and ideas like his seemed to have a substantial (negative) impact on law enforcement (the fact that Becker has a blog with notable judge Richard Posner should be a clue that he has an influence on the legal profession). Over the 1970s and 80s, law enforcement seemed to follow the Chicago-style prescriptions: punishments were increased, with mandatory sentencing introduced and incarceration rates rising. Meanwhile, particularly in cities, the number of police officers was reduced, as was general enforcement and surveillance. The well-documented wave of crime that followed/coincided with this, culminating in the late 1980s, led to the realisation that this approach was flawed, at which point different approaches to law enforcement were taken and crime started to go down. (I’m not going to go over the Freakonomics abortion explanation for this, though this paper has been acknowledged to show that at the very least the effect was smaller than they thought).

Criminologists generally find that combating crime requires the opposite approach to the one Becker had in mind: frequent enforcement, modest penalties (note: commenter ‘TheHobbesian’ helpfully provides a link to ‘situational crime prevention‘, which is apparently gaining followers). It turns out that real criminals are not so bothered by the punishment for a crime, within reason, but by the likelihood of being caught. Most criminals do not even consider the punishment at all when committing a crime, particularly because many of them are under the influence of drugs when they do it. What’s more, punishments that are too severe can backfire, either because they end up being impossible to enforce or because, if a punishment is severe enough, a criminal may as well commit a more heinous crime. I expect an economist like Becker might respond that this just shows that criminals have ‘interesting utility functions’. I would respond that they need to get a grip on reality.

Conclusion

Economists are prone to thinking their framework is neat, useful and even universal, but actually it is just quite a naive and one-dimensional view of human behaviour. When economists take their toolkit to other social sciences, they’d like to believe that they ‘simplify’ in such a manner that they get to the ‘underlying’ mechanics of issues; but they actually ‘simplify’ in such a manner that they often assume everything relevant away. This may make for compelling mathematics and entertaining books, but when we actually venture out into the real world these theories at best only to touch on the surface of the story; at worst, they simply become absurd.

Footnotes

*This is from Fisher’s book The Money Illusion. The chapter in question is fully available online here, and no, it doesn’t look any better in context.

**A part of me says that someone like Becker probably wouldn’t rely on his theory, either. There is a joke about an academic economist who was offered a position at another university, and was conflicted about the choice. One of his students asked him why he didn’t simply choose the rational option. Puzzled, the professor responded “come on, this is serious”.

References

1. Crime, Cultural Conflict, and Justice in Rural Russia, 1856-1914 by Robert Frank, pp. 6-7

2. The Theory of Addiction by Robert West, pp. 32-36, 75

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On Pieria: What’s Wrong With Economics?

My latest article, trying to sum up the problems with economist’s approach – in 3 words, “it’s too narrow”:

The question of whether mainstream (neoclassical) economics as a discipline is fit for purpose is well-trodden ground…

….[I think] economic theory is flawed, not necessarily because it is simply ‘wrong’, but because it is based on quite a rigid core framework that can restrict economists and blind them to certain problems. In my opinion, neoclassical economics has useful insights and appropriate applications, but it is not the only worthwhile framework out there, and economist’s toolkit is massively incomplete as long as they shy away from alternative economic theories, as well as relevant political and moral questions.

As Yanis Varoufakis noted, it is strange how remarkably resilient the neoclassical framework is in the presence of many coherent alternatives and a large number of empirical/logical problems. However, I actually think this is quite normal in science – after all, it is done by humans, not robots. Hopefully things will change eventually and economics will become more comprehensive/pluralistic, as I call for in the article.

It’s good to sum up my overall position, but I think I’ll probably lean more (though not entirely) towards positive approaches from now on, some of which I mention in the article. Though I strongly disagree with Jonathan Catalan that heterodox economists are “more often wrong than right”, I agree with his sentiment that it’s probably better to “sell [one's] ideas” that to endlessly repeat oneself about methodology and so forth. So maybe expect a shift from general criticisms of economics to more positive and targeted approaches!

PS Having said that, my next post definitely doesn’t fit this description.

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Market Monetarism Jumps the Shark

Seriously, what does this mean?

The US economy is currently in equilibrium. It’s not a market-clearing equilibrium. It’s not a very good equilibrium. But it is an equilibrium. If it wasn’t an equilibrium, it would be somewhere else. But it isn’t somewhere else, so it must be.

- Nick Rowe

I find this incomprehensibly circular. The beetle is red because if it weren’t red it would be something else, but it isn’t something else, so it’s red. Nick, we must first prove that the bloody beetle is red! Furthermore, ‘proving’ something does not entail making analogies to driving rules or how we manage time, which are both 100% arbitrary, maneuverable human constructs.

Also note that the entire post is about how people who want to know what market monetarists are talking about are somehow crazy for asking. Imagine if engineers had this type of attitude: “heh, so you want to know what we’re making the bridge out of? Doesn’t matter, just believe that it will stand up. God, stop being so concrete! (No pun intended)”.

I’ll give some credit to Rowe – he goes on to try and list some transmission mechanisms, but doesn’t get very far:

1. The Fed clearly announces its target path for NGDP. That’s by far the most important bit. Everything else is secondary. And if the Fed had credibility, that would be enough.

Irrelevant, as credibility depends on transmission mechanisms; expectations can only ever work if there is something to anchor them to. So this one is a no-go, as it depends on the actual transmission mechanisms below:

2. The Fed makes a threat. On the first day the Fed will print $1 billion and use it to buy assets. On the second day the Fed will print $2 billion and use it to buy assets. On the third day the Fed will print $4 billion and use it to buy assets. And the Fed will keep on doubling the amount it prints and buys daily, forever and ever, until E(NGDP) rises to the target path. (And will go into reverse and sells assets if E(NGDP) rises above the target path).

And, if my calculations are correct, just over half way through the month the fed will own every asset in the US economy. Then what? But don’t worry, this won’t materialise because:

3. The Fed puts on its best James Dean (oops, Marlon Brando, thanks Andy) voice and replies: “What have you got?”

There are two rooms at a party. The first room is nearly empty. The second room is nearly full. Because everyone wants to be where everyone else is. Then Chuck Norris enters the second room. He threatens to beat up 1 person at random in the first minute, 2 people in the second minute, 4 people in the third minute, and so on, until the room is empty. This is no longer an equilibrium.

More analogies. But as somebody, somewhere in the blogosphere, once said: if Chuck Norris has no arms or legs, nobody will listen to him.

Why will buying assets actually have an effect on the economy? What if people just hold the money, or put it into banks? What if they don’t want to sell their assets? Do you wonder if people/banks/firms are not spending right now because of the the fact that they are in bad financial positions and facing a lack of demand, and buying their assets (presumably at market prices) wouldn’t change this? Finally, are there any examples of this ever working, on the scale and in the ‘rule-based’ way you outline, in similar conditions to the one the US/UK/EZ economies are in now?

Market monetarists: please tell everyone what you mean, and without using any analogies, either. Because right now your school of thought doesn’t sound like a serious attempt at economics, but an article of faith.

Edit: I’m aware I used analogies here, but there’s a difference. Think of analogies as a First, analogies where you only replace one or two words are more useful than those that attempt to model complex systems by another complex system. Second, I regard my analogies as tools of communication, rather than a means of proof.

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The Ideology of Doing Business

What is the role of ideology in shaping how businesses go about their everyday operations?

Generally, economic theories of the firm - particularly at undergraduate level –  imply that businesses have clear aims and a clear way to go about those aims. This might be the basic profit maximisation; it could be growth; it could be market share. In some models it’s not quite as clear for the firm as a whole – the objectives of managers and shareholders can conflict, for example – but it is at least the case that each agent has clear objectives, subject to some constraints.

However, the real world is rarely so certain. While it is obvious that capitalist firms throughout history have the overarching aim of making money, the way to achieve this is not always clear, particularly if we are talking about long term strategies. For example, could it be that being a “socially responsible” firm will increase business from sympathetic customers? Or that higher wages, better working conditions and so forth, which seem costly, will actually increase employee productivity? The history of how firms have worked seems to suggest that firms as a whole – or capitalism, if you like – is susceptible to waves of ideology about the ‘right’ way to do business.

Consider the American School of Economics, which was the chief ideology and policy of the USA during its industrialisation period. This was a highly protectionist school, which focused around maintaining domestic competitiveness and employment. High wages, good education and healthcare for the workers were encouraged, both for humanitarian reasons and as a way to increase productivity and make business more profitable. It was not only required that government policies were set up in a certain way – tariffs, public services, employment rights – but also that these policies had popular support. Business generally shared in the idea that well paid employees would be more productive, something epitomised by Henry Ford’s famous doubling of his worker’s wages.

The result of this policy was a large, profitable domestic sector and consistent increases in real wages, allowing the USA to outperform the UK. This isn’t to romanticise the period: I’d have plenty to say about anti-labour violence and US foreign policy at the time (that is, if anyone were interested). However, the American School of Thought demonstrates how a certain way of thinking can permeate society and business as a whole, and massively affect how the economy functions. Can you imagine such policies working these days, when the popular mentality is so against them? Surely, firms would lobby against – or find ways around – attempts to reestablish such a system.

Another example is in Japan, where they had different ideas. The Japanese firm is a highly collective organisation, one which is loyal to its employees, and in turn has this loyalty reciprocated. Firms generally offer workers ‘lifetime employment’, coupled with numerous benefits such as insurance, pensions and promises of progression, based mostly on seniority. Achievements are shared collectively, and many companies even require employees to sing a ‘company song’. Getting a job at a major firm requires that one goes through a rigorous army-esque training program, and is a major lifetime achievement, to the extent that it is not uncommon for those who accomplish the feat (or don’t) to be reduced to tears. From a certain perspective, this approach might seem quite rigid and inflexible for both workers and firms, but it has certainly produced results: successful firms like Sony and Nintendo; low unemployment despite macroeconomic weakness, security for a large amount of the population, even with relatively low government spending.

There are numerous – indeed, surely countless – other ways to organise a firm based on a people’s worldview, national identity and so forth. Germany has its stakeholder model, where union leaders sit on board meetings and have a say in how the company is run; in turn, however, they are willing to go against their immediate interests by holding wages down to maintain national competitiveness. In countries such as India, the nature of the workplace is intertwined with religious ritual, something firms must consider in how they run their businesses. The rise in worker owned coops in Argentina and across the western world, with 48,000 in the US alone, indicates a growing number of people who share their own, democracy based ideas about the best way to organise business and treat employees.

One implication of the ideology theory is that, contrary to the Reaganite idea that 1980s ‘neoliberal’ reforms simply unleashed business to its true calling, it could be that the decade just instilled them with a certain mentality, one no more special than any other. This ideology was a more ruthless, ‘profit (shareholders) first’ mantra: firms merged, outsourced and became less tolerant of unions. While it is true that these things were accompanied and enabled by changes in the law and technology, the decade as a whole it also seemed put a lot of things, particularly mergers, in vogue: evidence is quite consistent with the idea that mergers were mostly driven by hubris. Similarly, outsourcing has come under fire after it has emerged that there are many hidden communication, management and transaction costs that were not first realised, and hence it may not be as profitable as first thought. Is this uncertainty the mark of firms which have a clear aim and know how to go about it, or which seem largely motivated by fads and unaware of the exact results of the actions?

One last example of how people’s perceptions can have a large influence on the economy may come from the UK. Here, the government’s recent policy of austerity has meant that public sector workers have faced massive cuts. Naturally, the government and press have justified this by appealing to the idea that there is a lot of excess waste in the public sector: pointless, lazy bureaucrats and so forth. Meanwhile, the private sector has failed to step up and fill the gap in employment. Interestingly, a survey provided some insight into why – aside from general macroeconomic weakness – this may be the case: 57% of private sector employers said they were not interested in former public sector employees because they were “not equipped” for the job, based simply on the fact that they were employed by the public sector. In other words, the general impression, fostered by the political class, that public sector workers are useless – false though it may be – has backfired by changing business’ impression of them, reducing hires.

In sum,  it seems how businesses are run is substantially dependent on ideas, and hence can be a political choice. Cries that businesses should be more “socially responsible” may sometimes seem repetitive and empty, but history shows us that it is possible to manoeuvre the way businesses operate as a whole. Business’ ideology is also an interesting area of exploration for economic theory: instead of having businesses driven by maximising some goal, they could be driven by a certain set of principles (I expect there are some papers that deal with this, though perhaps not in the way I’d like). In any case, anyone trying to legitimise whatever way business happens to be behaving right now as ‘natural’ should take another look at the history of the firm.

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Monetarists Versus Money

In my article on NGDP Targeting, I  argued  - among other things – that traditional monetary policy transmission mechanisms are now ineffective, and the banking system stops any ‘hot potato’ effect in its tracks. I felt the nature of which alternative monetary transmission mechanisms we might use to target NGDP was not always made clear by market monetarists; however, they proved me wrong with responses that discussed just that.

But I am still not satisfied.

The problem here is that their suggestions, which imply transcending ‘traditional’ monetary policy, may simply undermine the role of money in the economy. Market monetarists sometimes display a tendency to believe that those who conduct monetary policy simply don’t ‘get it‘, or are just constrained by petty politics. I’d instead suggest that policymakers just realise they’ve come up against some fundamental, inescapable constraints, implied by the nature of monetary policy itself.

One unconventional monetary policy tool was suggested by commenter J P Koning: negative interest rates on reserves. When I said that this would simply induce people to hold cash, he suggested that the central bank could stop 1:1 conversion of cash to deposits, making cash just as unattractive as deposits as the ‘price’ between cash and deposits adjusted to reflect the negative rates. Yet one of money’s fundamental roles is a store of value, and you undermine that by charging people to hold it. If you charge people to hold money, they will no longer see it as a desirable asset and will simply reject it. It is also worth noting that ‘floating’ deposit conversion rates could potentially play havoc with the value of bank’s balance sheets (bubble in deposits anyone?), as if these didn’t need more disruption.

Another suggestion, which I’ve seen before, is that the central bank could buy other assets than government bonds. First, I don’t really see why this would result in actual spending rather than people simply depositing or (assuming J P’s idea is not in play) holding cash. Second, this seems to undermine what it means to have somebody invest in your business – why bother having a business plan if the central bank will just buy up your bonds? I could set up ‘Unlearning Economics PLC’ and sell millions of pounds worth of bonds to the central bank – free money! Obviously this would quickly undermine the scarcity of, and trust in, money.

I suppose the central bank could screen who it invests in, but that just makes it another bank. This might help somewhat if the central bank were more willing to lend than private banks, but it doesn’t change the fact that banks aren’t lending for a reason: there’s just not much demand for goods and services in the economy, and businesses will have limited success.

Obviously, even the proposed introduction of such changes would likely meet widespread political opposition. However, if they were implemented I simply see it undermining the value of money and the workings of the financial sector, possibly resulting in widespread instability. I’m not talking about ‘the money is coming!!!’ gold bug style instability; more ‘what is going on, why is the central bank buying my house and the local branch of KFC?’ or ‘why am I not allowed to save money safely any more?’ type instability.

My basic view is that that monetary policy can primarily alter the costs in the economy, but not the demand conditions. This is why it can often effect changes in NGDP and other variables, albeit indirectly. However, when those costs go as low as they can go (0), beginning to tamper with the fundamentals only risks completely undermining the term ‘monetary policy’ and how it should ensure that money retains its traditional roles, including that as a reliable store of value.

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