Posts Tagged Economists

The Crisis & Economics, Part 4: Masters of the Universe?

This is part 4 in my series on economics and the crisis, which asks whether economics is really responsible for policy, and if so, how these policies may have contributed to the financial crisis. Here are parts 1, 2 & 3.

Argument #4: “Mainstream economics cannot be blamed for politicians inflating housing bubbles/pursuing austerity/deregulating the financial sector; our models generally go against this. Clearly, we do not have that much influence over policy.”

This defence really raises two questions. The first is whether or not economic theory has had a major influence on policy. The second is whether or not this influence, if it exists, is culpable in creating the financial crisis.

The first is, in my opinion, easily answered in the affirmative. While it’s entirely understandable that the majority of academic economists would scoff at the idea that they effect policy, this doesn’t have to be the case for economic theory itself to hold sway among governments. After all, economics graduates are highly sought after and employed in policymaking positions. Famous economists lunch with the president; textbooks and macroeconomic papers are full of policy discussions; prize-winning economists such as Bob Shiller acknowledge that a “problem with economics is that it is necessarily focused on policy, rather than discovery of fundamentals.” It’s hard to imagine powerful institutions such as Central Banks, the World Bank or the IMF functioning with advice from any but economists, and government organisations are even set up based on new ideas coming out of economics. Economics is the language in which the media discuss policy: demand, stimulus, markets, etcetera. I could go on.

However, as economists like to remind us, there’s no reason to believe that advice based on mainstream economic theory should have led to the types of ‘free market’ policies typically implicated in the financial crisis and its aftermath. Even a basic economics education will leave you with an awareness of things like information asymmetry, moral hazard and externalities, and few economists support wanton deregulation of the financial sector. Modern macroeconomics is loosely pro-stimulus,  not pro-austerity. So what’s going on?

First, it should be noted that not only ‘free market’ thinking was implicated in the crisis. Central Banks around the world used inflation targeting, based on the New Keynesian idea that this would be sufficient to achieve macroeconomic stability, which blinded them to problems brewing in the financial sector. What’s more, the approach to regulation favoured by economics was, not atypically, quite narrow and didn’t favour systemic thinking. For example, I have previously spoken about Value at Risk (VaR) regulation, which forces firms to sell off assets when markets are volatile and hence increase their insurance against risk. However, while this looks good from the perspective of individual firms, it worsens systemic risk because the asset sell-offs result in increased volatility. Overall, the reductionist nature of economic theory tended to blind policymakers to systemic problems and made them focus on the wrong variables, things they might not have done if they’d been familiar with more holistic viewpoints.

Having said this, it’s clear that at the heart of the financial crisis were lax regulatory policies, justified by a belief in the self-stabilising power of financial markets. And while a majority of individual economists may not endorse such a view, theoretical frameworks or ‘ways of thinking‘ came out of economics which were used to justify this deregulation. Whether or not efficient markets, perfect competition, rational expectations and other theories which imply financial markets will run smoothly are endorsed by most economists, the fact that they are common knowledge in economics (and usually the benchmark for more complex analysis) is significant. As I’ve argued before, familiarity with economic theory lends itself to a pro-market view, even if a lot of modern work is done pushing the core framework away from this. And as I’ve argued before, the nuances of this work are often lost in popular translation, as the elegance of the most Panglossian theories proves too tempting when economists speak to the public. Alternative theories which use different starting points for analysis, such as input-output matrices, sectoral balances, or class struggle, would help to combat the deeply ingrained nature of the neoclassical theories.

This issue does not necessarily fit into a narrow ‘government versus market’ policy perspective. Instead, the point is that acknowledging different approaches in economic theory can give us a different way of thinking about policy, illuminating rather than obfuscating debates. A key complaint about economics graduates is that they have overly narrow, abstract tools, so the enemy is not so much any particular approach as it is one sided thinking. Providing both economics students and professional economists with an awareness of  different theories, as well as making economics more politically, historically and ethically engaged, would hopefully at least temper the zeal and enthusiasm with which pet policies are recommended, and partially dislodge whatever pedestal economics currently sits on as a rationale for policy.

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The Crisis & Economics, Part 2: The EMH-Twist

This is part 2 in my series on why and how the 2008 financial crisis is relevant to economics. The first instalment discussed why the good times during the boom are no excuse for the bad times during the bust. This instalment discusses the use of the Efficient Markets Hypothesis (EMH) to defend economists’ inability to forecast the movements of financial markets, hereafter referred to as the ‘EMH-twist’.

Argument #2: ““The EMH claims that crises are unpredictable, so the fact that economists didn’t predict the crisis is not a problem for economics at all.”

As far as I’m aware, this argument was first used by John Cochrane, and it has reappeared multiple times since then: for example, it was more recently referenced by Andrew Lilco, who was sadly echoed by the generally infallible Chris Dillow. The idea is that financial markets process new information faster than any one individual, government or institution could, and so for most people they may seem to behave unpredictably. However, economists can not be expected to understand these sudden movements better than anyone else, so expecting them to foresee market crashes is absurd. As Cochrane puts it, “it makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn’t see the crash coming”.

However, this logic is completely circular. The mere fact that a theory exists which claims crises are unpredictable does not mean that, if a crisis is not predicted – particularly by the proponents of said theory – this shows the theory is correct. If the EMH had, to the best of our knowledge, been shown to be correct, then the EMH-twist might hold some water, but we must establish this truth separately from the the fact its proponents didn’t predict the crisis (David Glasner recently made a similar point about the ubiquitous use of rational expectations in macroeconomics). While Cochrane does claim that the central tenet of the EMH “is probably the best-tested proposition in all the social sciences”, he fails to reference supporting evidence, and in fact goes on to add substantial qualifications to the empirical record of the EMH, admitting that market volatility might happen “because people are prey to bursts of irrational optimism and pessimism”.

It is not necessarily my aim to establish the truth or falsity of the EMH here: it has been discussed extensively elsewhere. However, there are a couple of key tests for whether or not it applies to 2008. The first is whether or not anybody - both adherents and detractors of the theory – foresaw the crisis. While the EMH claims nobody could, this is clearly wrong: some people in finance made a lot of money; some economists not only called it but had frameworks that explained it well once it happened; quite a few people (even mainstream economists) at least noted the existence of a housing bubble. The EMH can attribute these predictions to simple luck, but now we’re back to circularity: assume the EMH is true, then appeal to it to rationalise any possible market movement. The second test of the EMH, since it depends on new information to trigger volatility, is to ask exactly what new information became available just before the crash. However, the financial instruments key to 2008 were used by investment banks for a good few years prior to the crash, so it’s quite difficult to claim that new information about these suddenly became available in 2007-8. Instead, what happened was a collective realisation that everyone knew very little about the products they’d been trading, resulting in a classic panic.

In fairness, there is an element of truth to the EMH-twist. Financial markets are incredibly difficult to understand, and the argument that economists don’t yet understand them, along with a mea culpa, might be acceptable – there are many things natural scientists still don’t understand, such as dark matter, or what happened ‘before’ the big bang. However, the EMH-twist as used by Cochrane et al is phrased more strongly: it is the assertion that economists can’t and shouldn’t understand the movements of financial markets, simply because the EMH allows them to wash their hands of the task. We wouldn’t accept this kind of attitude from any other field, so I can’t help but feel Cochrane’s claim that “the economist’s job is not to ‘explain’ market fluctuations after the fact” can only be met with: “then what is the economists’ job, exactly?”

The next instalment in the series will be part 3: econoracles.

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The Crisis & Economics, Part 1: The Boom & The Bust

For critics of mainstream economics, the 2008 financial crisis represents the final nail in the coffin for a paradigm that should have died decades ago. Not only did economists fail to see it coming, they can’t agree on how to get past it and they have yet to produce a model that can understand it fully. On the other hand, economists tend to see things quite differently – in my experience, your average economist will concede that although the crisis is a challenge, it’s a challenge that has limited implications for the field as a whole. Some go even further and argue that it is all but irrelevant, whether due to progress being made in the field or because the crisis represents a fundamentally unforeseeable event in a complex world.

I have been compiling the most common lines used to defend economic theory after the crisis, and will consider each of them in turn in a series of 7 short posts (it was originally going to be one long post, but it got too long).  I’ve started with what I consider the weakest argument, with the quality increasing as the series goes on. Hopefully this will be a useful resource to further debate and prevent heterodox and mainstream economists (and the public) talking past each other. Let me note that I do not intend these arguments as simple ‘rebuttals’ of every point (though it is of some, especially the weaker ones), but as a cumulative critique. Neither am I accusing all economists of endorsing all of the arguments presented here (especially the weaker ones).

Argument #1: “We did a great job in the boom!”

I’ve seen this argument floating around, and it actually takes two forms. The first, most infamously used by Alan Greenspan – and subsequently mocked by bloggers – is a political defense of boom-bust, or even capitalism itself: the crisis, and others like it, are just noise around a general trend of progression, and we should be thankful for this progression instead of focusing on such minor hiccups. The second form is more of a defence of economic theory: since the theory does a good job of explaining/predicting the boom periods, which apply most of the time, it’s at least partially absolved of failing to ‘predict’ the behaviour of the economy. Both forms of the argument suffer from the same problems.

First, something which is expected to do a certain job – whether it’s an economic system or the economists who study it – is expected to do this job all the time. If an engineer designs a bridge, you don’t expect it to stand up most of the time. If your partner promises to be faithful, you don’t expect them to do so most of the time. If your stock broker promises to make money but loses it after an asset bubble bursts, you won’t be comforted by the fact that they were making money before the bubble burst. And if an economic system, or set of policies, promise to deliver stability, employment and growth, then the fact that it fails to do so every 7 years means that it is not achieving its stated objectives. In other words, the “invisible hand” cannot be acquitted of the charge of failing to do its job by arguing it only fails to do its job every so often.

Second, the argument implies there was no causal link between the boom and the bust, so the stable period can be understood as separate from the unstable period. Yet if the boom and the bust are caused by the same process, then understanding one entails understanding the other. In this case, the same webs of credit which fuelled the boom created enormous problems once the bubble burst and people found their incomes scarce relative to their accumulated debts. Models which failed to spot this process in its first phase inevitably missed (and misdiagnosed) the second phase. As above, the job of macroeconomic models is to understand the economy, which entails understanding it at all times, not just when nothing is going wrong – which is when we need them least.

As a final note, I can’t help but wonder if this argument, even in its general political form, has roots in economic theory. Economic models (such as the Solow Growth Model) often treat the boom as the ‘underlying’ trend, buffeted only by exogenous shocks or slowed/stopped by frictions. A lot of the major macroeconomic frameworks (such as Infinite Horizons or Overlapping Generations models) have two main possibilities: a steady-state equilibrium path, or complete breakdown. In other words, either things are going well or they aren’t – and if they aren’t, it’s usually because of an easily identifiable mechanism, one which constitutes a “notably rare exception” to the underlying mechanics of the model. Such a mentality implies problems, including recessions, are not of major analytical interest, or are at least easily diagnosed and remedied by a well-targeted policy. Subsequently, those versed in economic theory may have trouble envisaging a more complex process, whereby a seemingly tranquil period can contain the seeds of its own demise. This causes a mental separation of the boom and the bust periods, resulting in a failure to deal with either.

The next instalment in the series will be part 2: the EMH-twist

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18 Signs Economists Haven’t the Foggiest

I’d like to thank Chris Auld for giving me a format for outlining the major reasons why economists can be completely out of touch with their public image, as well as how they should do “science”, and why their discipline is so ripe for criticism (most of which they are unaware of). So, here are 18 common failings I encounter time and time again in my discussions with mainstream economists:

1. They defer to the idea that “all models are simplifications” as if this somehow creates a fireguard against any criticism of methodology, internal inconsistency or empirical relevance.

2. They argue that the financial crisis is irrelevant to their discipline (bonus: also that predicting such events is impossible).

3. They think that behavioural, new institutional and even ‘Keynesian’ economics show the discipline is pluralistic, not neoclassical.

4. They think that the fact most economic papers are “empirical” shows economists are engaging in the scientific method.

5. They think ‘neoclassical economics‘ doesn’t exist and is just a swear word used by their opponents.

6. When pushed, they collapse their theories and assumptions into ridiculously weak, virtually unfalsifiable claims (such as revealed preference, the Efficient Markets Hypothesis, or rationality).

7. They dismiss ideas from the past or comprehensive study of previous thinkers and texts as “not science”.

8. They think positive and normative economics are 100% separable, and their discipline is “value free“.

9. They simply cannot think of any other approach to ‘economics’ than theirs.

10. They believe in an erroneous history that sits well with their pet theories, such as the myths of barter and free trade.

11. They think that microfoundations are a necessary and sufficient modelling technique for dealing with the Lucas Critique.

12. They think economics is separable from politics, and that the political role and application of economic ideas in the real world is irrelevant for academic discussion (examples: Friedman and Pinochet, central bank independence).

13. They think their discipline is going through a calm, fruitful period (based on their self-absorbed bubble).

14. They think that endorsing cap & trade or carbon taxes is “dealing with the environment”.

15. They think making an unrealistic model consistent with one or two observed phenomena makes it sound or worthwhile (DSGE and other models are characterised by this “frictions” approach).

16. They think their discipline is an adequate, even superior, method for analysing problems in other social sciences such as politics, history and sociology.

17. They think that the world behaves as if their assumptions are true (or close enough).

18. They think that their discipline’s use of mathematics shows that it is “rigorous” and scientific.

Every above link that is not written by an economist is recommended. Furthermore, here are some related recommendations: seven principles for arguing with economists; my FAQ for mainstream economists; I Could Be Arguing In My Spare Time (footnotes!); What’s Wrong With Economics? Also try both mine and Matthjus Krul’s posts on how not to criticise neoclassical economics. As I say to Auld in the comments, I actually agree with some of his points about the mistakes critics make. But I think these critics are still criticising economics for good reasons, and that economists need to improve on the above if they want anyone other than each other to continue taking them seriously.

PS If you think I haven’t backed up any of my claims about what economists say, try cross referencing, as some of the links fall into more than one trap. Also follow through to who I’m criticising in the links to my previous posts. And no, I don’t think all economists believe everything here. However, I do think many economists believe some combination of these things.

Addendum: I have received predictable complaints that my examples are straw men, or at least uncommon. Obviously I provided links for each specific claim – if you’d like to charge that said link is not relevant, please explain why, and if you want more, I’m happy to provide them. However, my general claim is simply that a given article trying to expound or defend mainstream economics will commit a handful of these errors, perhaps excluding the more specific ones such as history or carbon taxes. Here are some examples to show how pervasive this mindset is:

Auld’s original article commits 2, 3, 4, 5 & 12.

This recent, popular defense of economics as a science in the NYT commits 2, 4, 8 & 13 (NB: I forgot “makes annoying and inappropriate comparisons to other sciences”, although both sides do this).

Greg Mankiw’s response to the econ101 walkout commits 8, 9, 12 & 13.

This recent ‘critique‘ of Debunking Economics commits 9, 11, 15 (though, to its credit, it avoids 2).

Stephen Williamson manages 2, 6, 7, 8, 9, 11, 12, 13, 15 & 16 in his reviews of John Quiggin’s Zombie Economics (in fact, Williamson is a fantastic source of this stuff in general).

Paul Krugman committed 1, 7, 9 & 15 in his debate with Steve Keen

Dani Rodrik, who is probably the most reasonable mainstream economist in the world, committed 3, 4, 13 & 15 in his discussion of economics.

and so on…

(Note that, in the interest of fairness, I have left out the most ridiculous things I’ve seen since the crisis.)

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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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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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My Favourite Quotes

I’m feeling a bit lazy today, so instead of contributing some original content I’m going to offer up some of my favourite quotes. They get progressively leftier, which wasn’t intended but is of course welcome. Enjoy!

Science

It doesn’t make any difference how beautiful the hypothesis (conclusion) is, how smart the author is, or what the author’s name is, if it disagrees with data or observations, it is wrong.

Richard Feynman

…when two opposite points of view are expressed with equal intensity, the truth does not necessarily lie exactly halfway between them. It is possible for one side to be simply wrong.

- Richard Dawkins

Economics

I have found out what economics is; it is the science of confusing stocks with flows

- Michael Kalecki, quoted by Joan Robinson in Shedding Darkness

By applying V, velocity of circulation, that is turnover say per week or per year, to M, the stock of money used in transactions in a given market, we arrive at the flow of transactions in the market concerned.

So what? Neither M nor V is an independent causal factor determining or limiting the level of prices or of output but merely an element in the mechanism that relates one to another.

- Joan Robinson on the Quantity Theory of Money, ibid

Economists have a singular method of procedure. There are only two kinds of institutions for them, artificial and natural. The institutions of feudalism are artificial institutions, those of the bourgeoisie are natural institutions. In this, they resemble the theologians, who likewise establish two kinds of religion. Every religion which is not theirs is an invention of men, while their own is an emanation from God. When the economists say that present-day relations — the relations of bourgeois production — are natural, they imply that these are the relations in which wealth is created and productive forces developed in conformity with the laws of nature. These relations therefore are themselves natural laws independent of the influence of time. They are eternal laws which must always govern society. Thus, there has been history, but there is no longer any. There has been history, since there were the institutions of feudalism, and in these institutions of feudalism we find quite different relations of production from those of bourgeois society, which the economists try to pass off as natural and as such, eternal.

- Karl Marx, The Poverty of Philosophy

Milton Friedman’s misfortune is that his economic policies have been tried.

- John Kenneth Galbraith

Capitalism

People who dismiss the unemployed and dependent as ‘parasites’ fail to understand economics and parasitism. A successful parasite is one that is not recognized by its host, one that can make its host work for it without appearing as a burden. Such is the ruling class in a capitalist society.

- Jason Read

People are taking the piss out of you everyday. They butt into your life, take a cheap shot at you and then disappear. They leer at you from tall buildings and make you feel small. They make flippant comments from buses that imply you’re not sexy enough and that all the fun is happening somewhere else. They are on TV making your girlfriend feel inadequate. They have access to the most sophisticated technology the world has ever seen and they bully you with it. They are The Advertisers and they are laughing at you. You, however, are forbidden to touch them. Trademarks, intellectual property rights and copyright law mean advertisers can say what they like wherever they like with total impunity. FUCK THAT. Any advert in a public space that gives you no choice whether you see it or not is yours. It’s yours to take, re-arrange and re-use. You can do whatever you like with it. Asking for permission is like asking to keep a rock someone just threw at your head. You owe the companies nothing. Less than nothing, you especially don’t owe then any courtesy. They owe you. They have re-arranged the world to put themselves in front of you. They never asked for your permission, don’t even start asking for theirs.

- Graffiti artist Banksy on advertising

We should do away with the absolutely specious notion that everybody has to earn a living. It is a fact today that one in ten thousand of us can make a technological breakthrough capable of supporting all the rest. The youth of today are absolutely right in recognizing this nonsense of earning a living. We keep inventing jobs because of this false idea that everybody has to be employed at some kind of drudgery because, according to Malthusian Darwinian theory he must justify his right to exist. So we have inspectors of inspectors and people making instruments for inspectors to inspect inspectors. The true business of people should be to go back to school and think about whatever it was they were thinking about before somebody came along and told them they had to earn a living.

- Richard Buckminster Fuller

The mine owners did not find the gold, they did not mine the gold, they did not mill the gold, but by some weird alchemy all the gold belonged to them!

- “Big Bill” Haywood, Union Leader

Revolutions

….you can’t prevent me from believing that these notions of human nature, of justice, of the realisation of the essence of human beings, are all notions and concepts which have been formed within our civilisation, within our type of knowledge and our form of philosophy, and that as a result form part of our class system; and one can’t, however regrettable it may be, put forward these notions to describe or justify a fight which should – and shall in principle – overthrow the very fundaments of our society.

- Michel Foucault in the Chomsky-Foucault debate

History does not tell us what a Soviet Union, allowed to develop in a “normal” way of its own choosing, would look like today. We do know, however, the nature of a Soviet Union attacked in its cradle, raised alone in an extremely hostile world, and, when it managed to survive to adulthood, overrun by the Nazi war machine with the blessings of the Western powers. The resulting insecurities and fears have inevitably led to deformities of character not unlike that found in an individual raised in a similar life-threatening manner.

- William Blum, author of Killing Hope

There were two ‘Reigns of Terror’, if we could but remember and consider it; the one wrought murder in hot passions, the other in heartless cold blood; the one lasted mere months, the other had lasted a thousand years; the one inflicted death upon a thousand persons, the other upon a hundred million; but our shudders are all for the “horrors” of the minor Terror, the momentary Terror, so to speak; whereas, what is the horror of swift death by the axe compared with lifelong death from hunger, cold, insult, cruelty and heartbreak? A city cemetery could contain the coffins filled by that brief terror that we have all been so diligently taught to shiver at and mourn over; but all France could hardly contain the coffins filled by that older and real Terror – that unspeakable bitter and awful Terror which none of us has been taught to see in its vastness or pity as it deserves.

- Mark Twain on the French Revolution

Atheism/Religion

In the way that scepticism is sometimes applied to issues of public concern, there is a tendency to belittle, to condescend, to ignore the fact that, deluded or not, supporters of superstition and pseudoscience are human beings with real feelings, who, like the sceptics, are trying to figure out how the world works and what our role in it might be. Their motives are in many cases consonant with science. If their culture has not given them all the tools they need to pursue this great quest, let us temper our criticism with kindness. None of us comes fully equipped.

- Carl Sagan, The Burden of Skepticism

PS I also started to look through Robert Solow and John Maynard Keynes quotes, but decided that one should really just read all of them.

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67 Comments

Mankiw to the Rescue (of the 1%)

Apparently, when Greg Mankiw isn’t smugly referencing his own textbook on his blog, where criticism comments are banned, he finds time to write papers on the most important political issues of our time. In his most recent offering, he is defending the poor old 1%, who are just so upset with the various criticisms directed at them by the plebs that they simply can’t take it anymore. If we are not careful they will stop creating wealth and we’ll all be doomed.

OK, enough snark for now. What Mankiw has done is written a paper literally titled ‘Defending the One Percent’, where he takes a pot shot at the Occupy Wall Street movement, and everyone else who – unjustifiably, it seems – directs their anger at the wealthiest people in society. Mankiw uses a Cold Hard Dose of Economic Logic to show us lefties how the real world works.

Typically, Mankiw starts with a quasi-perfectly competitive story about income distribution:

Imagine a society with perfect economic equality. Perhaps out of sheer coincidence, the supply and demand for different types of labor happen to produce an equilibrium in which everyone earns exactly the same income. As a result, no one worries about the gap between the rich and poor….

…[t]hen, one day, this egalitarian utopia is disturbed by an entrepreneur with an idea for a new product…everyone in society wants to buy it…The new product makes the entrepreneur much richer than everyone else.

Let’s for now ignore that we’ve gone from the impossible world of perfect competition into a Schumpeterian/Randian vision of dynamic entrepreneurs, two worlds which are surely fundamentally incompatible. Let’s even ignore the fact that, far from originating in the minds of heroic entrepreneurs, an overwhelming number of innovations come from, or have their roots in, public funding, including the iPhone Mankiw references.

The main problem is that, contrary to Mankiw’s claim that:

…this thought experiment captures, in an extreme and stylized way, what has happened to US society over the past several decades.

This is nothing like what has happened, and is not at all what OWS and those like them are complaining about. The majority of the 1% are “managers, executives, and people who work in finance”, while the rest is composed of a mixture of people who are by no means Randian superheroes: for example, there are twice as many ‘not working or deceased’ (read: living off daddy’s wealth) as there are in “arts, media, sports” (celebrities) – the latter could, I suppose, be said to contribute something worthwhile, and have some talent.

Mankiw goes on to admit that it would indeed be a problem if the picture painted by the facts were true:

On the other hand, some of what occurs in financial firms does smack of rent seeking: when a high-frequency trader figures out a way to respond to news a fraction of a second faster than his competitor, his vast personal reward may well exceed the social value of what he is producing.

But here he completely ignores whether or not this is actually what’s happening, instead focusing on what really matters:

For example, if domestic firms are enriching themselves at the expense of consumers through quotas on imports (as is the case with some agribusinesses).

It’s the bloody farm subsidies! Evidently OWS should take their protests to Iowa, the morons. Alternatively, Mankiw would have done well to reference the fraud, publicly funded bailouts and general corruption that got the 1% where they are today.

The American Dream

Mankiw now repeats some standard blatherings about The Land Of Opportunity And All That. He notes that income persistence may be partly genetic: that is, the 1% are just a superior breed and we really shouldn’t worry too much. He references a paper that studies adopted children, and sums it up:

Indeed, Sacerdote estimates (in his Table 5) that while 33 percent of the variance of family income is explained by genetic heritability, only 11 percent is explained by the family environment. The remaining 56 percent includes environmental factors unrelated to family.

I’ll ignore the question of whether it is ‘unfair’ or ‘lucky’ to inherit good genes, various problems with IQ and so forth (for those interested, Ben Bernanke spoke about this eloquently in a recent speech). For the real issue here is that leaving the majority of the data unexplained and then throwing your hands up in the air is no conclusion at all.

Mankiw has deliberately narrowed his focus of social immobility to the effects of the family, but this is not necessarily the problem: it is that those who are poor will be born in bad neighbourhoods; will go to worse schools; will not move in the right circles; will not inherit money. It takes some real obfuscation to deny that social mobility is low in the US, where one’s income bracket is undoubtedly largely determined by that of one’s parents. Does Mankiw know, for example, that being born rich but not going to college is 2.5x more likely to make you rich later in life than if you are born poor but go to college?

He finishes the topic with this gem:

My view here is shaped by personal experience. I was raised in a middle-class family; neither of my parents were college graduates. My own children are being raised by parents with both more money and more education. Yet I do not see my children as having significantly better opportunities than I had at their age.

Well, that’s the matter settled then, folks. Mankiw doesn’t really feel like social immobility is a problem, based on some vague observations about his own life. This is after he previously castigated Joseph Stiglitz’ book for relying on anecdotes, by the way.

Mankiw then gives the verdict, based on his conclusions that neither rent-seeking nor social immobility are a major problem:

If the growing incomes of the rich are to be a focus of public policy, it must be because income inequality is a problem in and of itself.

Let’s forget how wrong Mankiw is about everything, and assume income inequality is a result of ‘natural’ forces of whatever he wants us to believe. If Mankiw is driven by the evidence, this sentence alone should make him want to reduce inequality: the authors of The Spirit Level showed that income inequality is associated with a wide range of social ills (if you tell me they confused correlation with causation then I’ll assume you have’t read the book). These observations hold true no matter how countries gain their equality: for example, in Scandinavian countries the equality is achieved through progressive taxation, whereas in Japan pre-tax income is already quite equal and progressive taxation is not as necessary. Equality is beneficial for people in every income bracket, across a wide range of societies.

As if that wasn’t enough…

Mankiw now takes us to neoclassical fairy-land, introducing us to a model whose assumptions essentially assume its conclusions. In this model:

redistribution is hard to accomplish, because the government is assumed to be unable to observe productivity W; instead, it observes only income WL, the product of productivity and effort. If it redistributes income too much, high productivity individuals will start to act as if they are low productivity individuals.

In other words: we assume the rich are productive and the poor aren’t, and that redistribution will make the rich less productive. We then conclude that redistribution could be risky because it would mean society produces less! It’s not really worth going into the specifics here, because the best bit of this section is that Mankiw then pokes a couple of holes in the model – with the goal of finding reasons to doubt the efficacy of redistribution – before concluding that:

I believe there are good reasons to doubt this model from the get-go.

Me too. Let’s forget about it.

Mankiw then chronicles the various problems with comparing the level of satisfaction different people with different tastes get from having more income, and implies that because of this we can’t really know whether or not to ‘redistribute’ money:

as of now, there is no scientific way to establish whether the marginal dollar consumed by one person produces more or less utility than the marginal dollar consumed by a neighbor.

Well, yes: utility is imaginary, we all know that. But really this isn’t the point. All people want is enough to have a decent standard of living, healthcare, education and so forth. Really, the idea that we need to do some sort of Benthamite calculation of society-wide pleasure is a construct of Mankiw’s; something only an economist could infer from looking at OWS.

Mankiw’s final word

Mankiw now sums up – yes, we’re almost there:

It is, I believe, hard to square the rhetoric of the left with the economist’s standard framework.

Yes, it is. But then, if you bothered listening to your political opponents beyond a few placards and caricatures, you’d learn that the left – and the general public – have many reasons to doubt this framework. Perfectly competitive models that don’t even have banks in them are hardly relevant when we are discussing animosity towards the finance industry and the clear impact it has had on real people.

Mankiw finishes with three points: number one is that the left argue the current tax system is regressive. This is something I have not heard before and it seems largely irrelevant – the real question is whether it is progressive enough. The second point is a restatement, with scant evidence, that the 1% aren’t the 1% because of rent-seeking, something I rebutted above. He offers some stylised facts about shareholders and CEOs which are really besides the point when we are talking about the entire finance industry.

The third and final point is based on the idea that the wealthy benefit from being in society, so should pay their fair share. Mankiw’s ‘rebuttal’ to this point is essentially to assert incredulously that the top already pay enough for some reason:

As I pointed out earlier, the average person in the top 1 percent pays more than a quarter of income in federal taxes, and about a third if state and local taxes are included. Why isn’t that enough to compensate for the value of government infrastructure?

Well, there are a few reasons we may want to tax the wealthy more: if their incomes are acquired unjustly; if inequality has pernicious effects; if the money is needed to reduce the deficit. All of these things are true based on the evidence I and others have presented. Ethically speaking, we might even make the stronger point that no income distribution is neutral in terms of policy, and taxation is really just one prong among a wealth of government-backed institutions that affect how incomes and wealth are distributed. Hence, the moral question of ‘redistribution‘ becomes something of a moot point, and Mankiw’s implicit notion of ‘just deserts’ is revealed to be spurious.

Mankiw and those who agree with him need to learn that the animosity toward the 1% does not rest on interpersonal utility comparisons, envy or whatever else. It is an expression of the dissatisfaction and outrage ordinary people feel when those at the top not only commit crimes but seem to flaunt their lawlessness; when they suck vast sums of public money out of the government, only to tell those in need that there’s not enough left for them; when they create massive, global economic problems through their incompetence/arrogance/selfishness; and when they have the political and economic power to make sure that nothing is done to remedy the situation they have created. It is a problem economists like Mankiw, with their largely irrelevant models, are ill equipped to solve and may even be blind to. Unfortunately for them, everyone else can see the problem clear as day, and will hopefully view out-of-touch articles like Mankiw’s as the snake oil that they are.

Update: the paper is chock full of gems, and naturally many other rebuttals have sprung up, covering areas I did not:

A write for The Economist takes issue with Mankiw’s Randian superhero story, and highlights his absurd ‘progressive taxation = compulsory organ donation’ analogy.

Tomas Hirst focuses on Mankiw’s ‘education education education’ argument, and finds it wanting.

Matt Bruenig gives Mankiw a lesson in political philosophy, exposing his implicit ‘just deserts’ hypothesis’

Commenter Magpie notes the reality of wealth and power, showing how selective Mankiw was with his list of ‘entrepreneurs’.

Commenter Luis Enrique says Mankiw is ‘embarrassing the economics profession’, offering some examples of economists who are not shills.

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Helping Economists Escape Economics

There are plenty of economists who will happily admit the limits of their discipline, and be nominally open to the idea of other theories. However, I find that when pushed on this, they reveal that they simply cannot think any other way than roughly along the lines of neoclassical economics. My hypothesis is that this is because economist’s approach has a ‘neat and tidy’ feel to it: people are ‘well-behaved'; markets tend to clear, people are, on average, right about things, and so forth. Therefore, economist’s immediate reaction to criticisms is “if not our approach, then what? It would be modelling anarchy!”

One such example of this argument is Chris Dillow, in his discussion of rationality in economics:

Now, economists have conventionally assumed rational behaviour. There’s a reason for this.Such an assumption generates testable predictions, whereas if we assume people are mad then anything goes.

However, as I and others have pointed out, people do not have two mindsets: ‘rational’, where they maximise utility, and ‘irrational’, where they go completely insane and chuck cats at people. People can behave somewhat predictably without being strictly ‘rational’, in economists sense of the word, and falsifiable predictions and clear policy prescriptions can be made based on this behaviour.

One example of this is Daniel Kahneman’s ‘Type 1′ versus ‘Type 2′ thinking. Type 1 thinking is basically the things you do without thinking: making a cup of tea, walking, breathing. People use a lot of mental shortcuts and heuristics with Type 1 thinking, helping to avoid lengthy calculations for everyday actions. Type 2 thinking, on the other hand, is the type of thinking one does when learning something new or solving a problem. It is far slower and more careful, and time consuming. Hence, it is saved only for things that are new and/or important.

So what are the implications of this? Well, there are many, but a major thing it helps to explain are implied contracts. Most purchases do not require one to sign a contract, and even when one is signed, who really has the time or expertise to read through the whole thing? So studying how people think – or don’t – when engaging in everyday transactions can help courts decide what exactly they have agreed to. In fact, the Type 1/Type 2 disparity highlights an opportunity for exploitation: a company with a large legal department who can draft the terms of doing business with them, using ‘Type 2′ thinking, has an obvious advantage over a customer who wants to get in and out and has many other things to think about. Such considerations could be highly relevant when deciding whether or not someone ‘agreed’ to certain addons when buying a credit card.

So the discussion of rationality versus irrationality is something of a red herring. Yet I expect economists will still question how we can model people’s economic behaviour if we don’t appeal to some semi-rational ordering of preferences. This mentality was reflected in my comments by an occasional sparring partner of mine, Luis Enrique:

Even if you tried to discard utility…you would end up implicitly appealing to some thing very similar to utility (which is just a convenient means of representing preferences) if you want to say anything about what people buy at what prices.

The issue here is that economists are predisposed to believe that we need to appeal to individual preferences to understand consumption. They will then assert that all utility really requires is that people have preferences and that they don’t order them nonsensically, and ask what exactly the problem with utility is.

However, as I have previously argued, utility does not only require that preferences are complete, transitive and so forth, but also that they are fixed: that is, individuals have a set of preferences that remain the same for at least long enough to be useful for analysis (and in some neoclassical models, preferences are the same for an agent’s entire lifespan). However, evidence suggests that individual preferences are highly volatile, differing across time and being highly dependent on situation. How exactly could something so hard to pin down be useful?

The truth is that most preferences are shaped by social conventions, by situations and by how they are presented to the consumer. What’s more, these things tend to stick around longer than individual preferences. Fashion is the most obvious example here: ultimately, this season’s trends are determined by a relatively small group of people in key companies, and consumers simply copy everyone else. In many ways the individual preference does not exist; it is created by circumstance and copied. If we want to understand fashion choices there is little to be gained from building a model around a utility maximising individual in a vacuum: we can simply look at trends and assume a certain proportion of people will follow them. In other words, like all of economics, the micro level needs macrofoundations.

The economist’s mentality extends up to the highest echelons of economics modelling, and culminates in the ‘DSGE or die’ approach, described well on Noah Smith’s blog by Roger Farmer:

If one takes the more normal use of disequilibrium to mean agents trading at non-Walrasian prices, … I do not think we should revisit that agenda. Just as in classical and new-Keynesian models where there is a unique equilibrium, the concept of disequilibrium in multiple equilibrium models is an irrelevant distraction.

This spurred a puzzled rebuttal from J W Mason:

The thing about the equilibrium approach, as Farmer presents it, isn’t just that it rules out the possibility of people being systematically wrong; it rules out the possibility that they disagree. This strikes me as a strong and importantly empirically false proposition.

When questioned about his approach, Farmer would probably suggest that if we do not assume markets tend to clear, and that agents are, on average, correct, then what exactly do we assume? A harsh evaluation would be to suggest this is really an argument from personal incredulity. There is simply no need to assume markets tend to clear to build a theory – John Maynard Keynes showed us as much in The General Theory, a book economists seem to have a hard time understanding precisely because it doesn’t fit their approach. Furthermore, the physical sciences have shown us that systems can be chaotic but model-able, and even follow recognisable paths.

A great, simple and testable disequilbirium theory was given to us by Hyman Minsky with his Financial Instability Hypothesis. His idea was that in relatively stable times, investors and firms will make good returns on their various ventures. Seeing these good returns, they will decide that in the next period, they will invest a little more; take a little more risk; borrow a little more money. As long as they generate returns, this process will continue and the average risk-taking will increase. Eventually – and inevitably – some investors will overextend themselves into debt-fuelled speculation, creating bubbles and crashes. Once this has settled everyone will be far more cautious and the whole thing will start again. Clearly, constructing a disequilibrium scenario is not intellectual anarchy: in fact, the actors in this scenario are behaving pretty rationally.

Ultimately, the only thing stopping economists exploring new ideas is economists. There is a wide breadth of non-equilibrium, non-market clearing and non-rational modelling going on. Economists have a stock of reasons that these are wrong: the Lucas Critique, Milton Friedman’s methodology, the ‘as if‘ argument and so forth. Yet they often fail to listen to the counterarguments to these points and simply use them to defer to their preferred approach. If economists really want to broaden the scope of the discipline rather than merely tweaking it around the edges, they must be prepared to understand how alternative approaches work, and why they can be valid. Otherwise they will continue to give the impression – right or wrong – of ivory tower intellectuals, completely out of touch with reality and closed off from new ideas.

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Is Economics A Gun That Only Fires Left?

Sometimes it seems like economist’s pet principles are applied selectively, in such a way that they attack ideas generally endorsed by the left end of the political spectrum. This isn’t to say economists themselves are ideologically inclined toward any opinion; merely, that key aspects of their own framework, and the way they present these aspects, lends itself to a more ‘right-friendly’ way of thinking.

In part, the issue is merely one of a disparity between how economists present issues to the public and how they speak to others in academia. Dani Rodrik noted this issue in his book The Globalisation Paradox. Here he describes a situation where a reporter asks an economist whether free trade is beneficial:

We can be fairly certain about the kind of response [the reporter] will get: “Oh yes, free trade is a great idea,” the economist will immediately say, possibly adding: “And those who are opposed to it either do not understand the principle of comparative advantage, or they represent the selfish interests of certain lobbies (such as labor unions).”

Rodrik then contrasts this with how such a question would be answered in the classroom:

Let [the student] pose the same question to the instructor: Is free trade good? I doubt that the question will be answered as quickly and succinctly this time around. The professor is in fact likely to be stymied and confused by the question. “What do you mean by ‘good’?” she may ask. “Good for whom?… As we will see later in this course, in most of our models free trade makes some groups better off and others worse off… But under certain conditions, and assuming we can tax the beneficiaries and compensate the losers, freer trade has the potential to increase everyone’s well-being…”

This adherence to basic, market-friendly principles over nuance can be found often in ‘pop’ economics: for example, economist Paul Krugman does it in his book Peddling Prosperity. The book is intended as an survey of nonsensical ideas from both the left and the right, remedying them both with a cold hard dose of facts, plus some basic economics. However, Krugman treats the left and right somewhat asymmetrically: with the right, he primarily opts for facts, whereas with the left, he uses economic principles

This is quite possibly because the right’s arguments, though they are taken to an extreme, have economic principles on their side, while the left’s do not. The ‘supply side’ economics that Krugman takes issue with is really just an extreme statement of the well known principle of deadweight loss, which suggests that taxes decrease output. If taxes reduce output by enough, then it logically follows that not only output, but overall revenues might fall if we raise taxes. Krugman would not question the principle, so he spends several chapters documenting evidence against the idea*.

Krugman then follows this up with a section berating the ‘strategic traders’, endorsed by Bill Clinton and others on the centre-left. Strategic trade suggested a role for government policy in promoting industry, because various clustering effects, economies of scale and positive feedback loops could mean that the initial wave of government investment could kick start an industry. As Krugman himself notes, such dynamic effects and ‘historical path dependence’ could render comparative advantage obsolete, since comparative advantage posits a more fundamental, innate reason a country produces a particular good, one that cannot be changed with policy (one that may be more applicable to agriculture).

Yet, in contrast with his section aimed at refuting the right, Krugman offers scant evidence suggesting government intervention doesn’t work. Instead, he effectively restates the theory of comparative advantage, coupled with a typical story to illustrate it. This is despite explicitly suggesting it might not be applicable in the previous chapter. When pushed, Krugman is prepared to fall back on his pro-market principles, even in areas where he knows they may not apply.

William Easterly does something similar in his book The Elusive Quest for Growth. The book is a survey of various policies than have purported to be panaceas for development, such as education, investment and population control. (As you can see, economists really love writing their “I’m an economist, here’s how it is” manifestos). Easterly finds every supposed development panacea wanting based on the available evidence, which is fine. However, occasionally he supplements his arguments with an excruciating example of ‘economic logic’ that always looks out of place.

For example, in the section on increasing availability of condoms, Easterly essentially makes the argument ‘how could people be lacking condoms? If they were, the free market would provide them!’ I am reminded of the joke about the economist who does not pick up a £10 note from the ground, because, if it were really there, somebody would already have picked it up. Easterly is a smart guy with a lot of concern for the poor, and I have a hard time believing he wouldn’t agree that a country might lack the institutions to deliver condoms, that people might lack the education to know why they’d need them, that it might conflict with their beliefs, etc. But the ease with which he can apply a pet economic principle is just too tempting, so he ignores these factors.

Another example is where Easterly asserts that population growth cannot be a problem, because “an additional person is a potential profit opportunity for a person that hires him or her” and as a result “the real wage will adjust until the demand for workers equals the supply.” It’s quite clear things don’t function this smoothly in labour markets even in developed countries; for theoretical reasons as to why, Easterly need look no further than John Maynard Keynes; failing that, modern work on labour market frictions might prove sufficient. Again we see a neat but overly simplistic principle applied when even the economist themselves surely knows better.

So it is not uncommon for economists to prefer their more ‘free market’ principles over nuance when writing for a popular audience**. But is this problem only limited to popular economics? Economists seem to think so; to them, the issue is primarily one of communication, and knowing the limits of your models. This is fine as it goes. However, there are reasons to believe this bias extends into the murky depths of academia.

In my opinion, there is one major culprit of selective application in economics, and it is one that cannot be explained by economists simplifying their work for public consumption: the Lucas Critique. The Lucas Critique suggests that adjusting policy based on observed empirical relationships from the past will alter the conditions under which these observations were generated, hence rendering the relationship obsolete.

Unfortunately, in practice, Lucas’ version of the critique seems to have been used to beat ‘Keynesians’ over the head, rather than being universally applied as a tool to further understanding. To illustrate this, here are some areas I think Lucas critique-style thinking could be applied, but hasn’t:

  • Milton Friedman’s methodology. If a ‘black box’ theory corroborates well with past evidence but we aren’t entirely sure the internal mechanics are accurate, there’s no reason to believe the corroboration will hold, or to know how the mechanics of the system will change, if we change policy.
  • Nominal GDP Targeting (NGDPT). This hasn’t caught on much on the left (in my opinion, for primarily ideological reasons: it’s anti-Keynesian, it partly absolves the private sector of responsibility for recessions). But it doesn’t seem to have occurred to proponents of NGDPT that we must ask if the relationship between inflation, RGDP and NGDP will break down if we try to exploit it for policy purposes. This is despite the fact that we are talking about precisely the same variables as  the Phillips Curve, the primary theory to which the Lucas Critique was initially applied.
  • The supposed “deep parameters” of human behaviour on which Lucas suggests we construct economic models, such as technology and preferences. For a neoclassical economist, you are born with a set of preferences and you die with them, while in many models technology is a vaguely defined exogenous parameter. Yet a single example can show that both of these things can change with policy: government investment, which is at the root of a large number of technological break throughs. These break throughs have often resulted in new products, creating preferences that otherwise wouldn’t have existed. A model with fixed, exogenous parameters for technology and preferences is therefore hugely fallible to policy changes.

The fact that the critique hasn’t been applied to these examples leads me to believe it’s often only used to preserve existing economic theory.  In fact, the critique itself is really just a narrow version of the more general principle of reflexivity, noted by many before. Reflexivity is an ever-present problem that suggests an evolving relationship between policy and theory, not a principle that means we can fall back on economist’s preferred methods.

Is the Lucas Critique the only culprit? Well, I’ve found economists are generally critical of the assumptions and mechanics of heterodox models, despite appealing to Friedmanite arguments when questioned about their own. I’ve also found economists (okay, one) appeal to how businessmen really behave when defending their theories despite not paying much credence to alternative theories based on the same principle, such as cost-plus pricing. So maybe economists need to air out their theories and principles a bit, rather than simply applying them where it suits them.

Economist’s simple stories often capture some truths, which is why they will defend them to the death. But too often this becomes a matter of protecting a core set of beliefs, and being unwilling to apply them in new ways or even abandon them altogether. So economists end up deferring to their framework when it isn’t appropriate, or only interpreting it in their preferred way, particularly when they communicate their ideas to the public. The result can be that misleading conclusions about the economy remain prominent, even when economist’s own frameworks, interpreted completely, don’t necessarily imply them. Perhaps if economists were more willing to open up their theories, which can sometimes feel like something of a black box, these misinterpretations would be exposed.

*I won’t delve into the evidence here because it’s not the point, but you can easily find Krugman making the same arguments on his blog if you’re curious.

**In fairness to Krugman and Easterly, these books were written a while ago, and I’m sure they have updated their positions since then. I only wish to show that economists use this tactic, not that any one economist endorses any particular position.

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