Category Archives: Mark Thoma is Indispensable

How Bad is Financialization?

Posted on by

Noah Smith writes,

For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.

Pointer from Mark Thoma.

1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.

2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”

What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.

Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.

Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.

Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.

Proper Critiques of Economics

Posted on by

Noah Smith writes,

some econ literatures are still crammed with mutually contradictory models for which the scope conditions are neither known nor specified. And the stock of existing theories is still enormous. In some areas, especially in macro, economists really do have theories that make almost any prediction, with no real way to choose between them except priors and politics. And many economists still have very little problem using modeling assumptions that have already been taken to the data with discouraging results.

Pointer from Mark Thoma. In his post, Smith tries to “score” various criticisms of economists. His post made me want to recycle a quote from Herbert Stein:

1. Economists do not know very much.

2. Other people, including politicians who make economic policy, know even less about economics than economists do.

[typo corrected]
Non-economists are responsible for many of the critiques of economists to which Smith gives a low score.

I have come to believe that economics is epistemologically difficult. That is, it is difficult to answer the question, “How do you know that?” Non-economists do not have much insight into this issue. Unfortunately, many economists lack insight as well.

The appeal of the mathematical approach is that it provides rigorous connections between assumptions and conclusions. The weakness of the mathematical approach is that it places tremendous pressure on one’s choice of assumptions. And, as Smith has pointed out, these choices are more arbitrary than they are in the hard sciences.

Economists can almost never directly test their assumptions. Milton Friedman famously suggested not worrying about direct testing. Instead, he proposed the indirect approach of testing predictions. In practice, however, this does not work, or at least it does not work cleanly.

One problem is that you can have two interpretive frameworks that both “predict” one observed phenomenon yet have different predictions about other phenomena about which we do not have precise observations. Consider the vast array of candidate explanations for the financial crisis, with widely varying implications about how one might try to prevent a recurrence.

Another problem is that when an anomalous observation appears to confound an interpretive framework, this fails to result in a decisive rejection of that framework. Instead, the framework is tweaked in order to accommodate the observation. So, when the huge fiscal contraction in the United States at the end of World War II did not lead to another Great Depression, the explanation might be “pent-up consumer demand.” When the inflation rate failed to obey the Phillips Curve in the 1970s, the explanation might be “supply shocks” and/or “higher expectations of inflation.”

If assumptions cannot be tested directly, and Friedman’s proposal to test predictions does not work, how will assumptions be chosen? The answer, all too often, is a combination of mathematical tractability and faddism. Economists will jump all over a model because it is fun to play with, regardless of how silly or irrelevant the set of assumptions may be. The overlapping-generations model of money would be a prime example.

My main concerns with mainstream economics include:

1. A bias toward “engineers” rather than “ecologists.” That distinction comes from Greg Ip’s new book, Foolproof. The engineer is like Adam Smith’s man of system, who ignores evolution, both as a factor that may permit markets to over come their own failures and as a factor that may cause government “solutions” to become obsolete.

2. A bias toward simplifying the phenomenon of specialization. Macroeconomists live in a world with one producer and one consumer (the “representative agent.”) Microeconomists live in a 2x2x2 world, with two factors of production, two goods, and two producers. They miss important differences between those worlds and the real world of millions of tasks being performed to lead to a final product.

Paul Romer on Growth

Posted on by

He writes,

It is not enough to say “_________ explains why Malthus was wrong,” and to fill in the blank with such words as “technological change” or “discovery” or “the Enlightenment” or “science” or “the industrial revolution.” To answer the question, we have to understand what those words mean. As I’ll argue, there is no way to understand those words without understanding the more fundamental words “nonrival” and “excludable.”

…The second question, about missed opportunities, asks what that other variable might be. Once again, it is not enough to say that “many poor countries fail to take advantage of rapid catch-up growth because they ____________” and then fill in the blank with such words as “have bad institutions” or “are corrupt” or “lack social capital” or “are held back by culture.”

Pointer from Mark Thoma. I plead guilty to the second.

Oh, Barf

Posted on by

I am afraid that was my reaction to Luigi Zingales,

Inquisitive, daring and influential media outlets willing to take a strong stand against economic power are essential in a competitive capitalist society. They are our defence against crony capitalism.

Pointer from Mark Thoma. Our media outlets dismiss the opponents of the Ex-Im bank or people who want to wind down Freddie and Fannie as Tea Party nut cases. If you want to stop crony capitalism, what we need are fewer influential media outlets and more Tea Party nut cases.

Market Denialism

Posted on by

Jayson Lusk and Pierre Desrochers write,

In a recent paper, Andrew Zumkehr and Elliott Campbell (2015; Front Ecol Environ 13[5]: 244–248) present a simulation study that assesses the technological feasibility of providing enough local calories to feed every American. In so doing, they suggest turning back the clock on one of Homo sapiens sapiens’ greatest evolutionary achievements: the ability to trade physical goods over increasingly longer distances, producing an attending ever-widening division of labor (Horan et al. 2005). The main benefit of this process is that one hundred people who specialize and engage in trade end up producing and consuming far more than one hundred times what any one individual would achieve on his or her own. By spontaneously relocating food production to regions with higher biotic potential for specific types of crops and livestock in order to optimize the overall use of resources, trade and the division of labor have delivered more output at lower costs.

Pointer from Mark Thoma.

I am stunned by the casual way in which environmentalists dismiss the information that markets provide concerning costs. They instead substitute their own cost estimates.

Some further thoughts:

1. If you really have a better estimate of costs than the market, then there should be profit opportunity. In the case of locavorism, you should be able to offer local food for lower prices. Do any locavorists stop to wonder why food that comes from far away cost less? Do they suppose it is some perverse conspiracy on the part of “big food” to subsidize the transportation industry (or perhaps the other way around)?

2. Consider recycling. At a local elementary school, I saw the winning poster in a county contest to promote recycling. The poster pictured a barren, brown earth, and said that this is what would happen if we did not recycle. And yet, economically, government-forced recycling is unsustainable, and it probably results in a net cost to environmental desiderata. (I wonder if people on the left would be so attached to government-run schools if the propaganda coming from those schools offended them.)

3. Consider two extremes: “free-market fundamentalism,” which says that markets always lead to optimal outcomes; and “market denialism,” which I will define as the belief that the information found in markets is of so little importance that one’s personal opinions should take precedence. I think that in practice market denialism is much more prevalent than free-market fundamentalism. In fact, it is so prevalent that no one refers to it as “market denialism.” They just presume that it is the appropriate point of view.

Related: Clive Crook cites Dani Rodrik‘s 10 commandments for economists.

“Substituting your values for the public’s is an abuse of your expertise.”

Pointer from Tyler Cowen. And how can Rodrik be immune from “abuse of your expertise”?

What Else Would be True?

Posted on by

Chris Dillow writes,

we should remember the Big Facts. For example, one the Big Facts in finance is that active equity fund managers rarely beat the market for very long, at least after fees. This, as much as Campbell Harvey’s statistical work reminds us to be wary of the hundreds of papers claiming to find factors that beat the market.

Pointer from Mark Thoma

This is a good example of asking, “What else would be true?” When you are inclined to believe that a study shows X, consider all of the implications of X. In the example above, Dillow is suggesting that if one finds that there is some factor that allows one to earn above-market returns, how do we reconcile that with the fact that we do not observe active fund managers earning above-market returns?

Recall that I raised a similar question about the purported finding that in the United States worker earnings have gone nowhere as productivity increased. This should greatly increase the demand for labor. It should greatly increase international competitiveness, turning us into an export powerhouse. Since I do not see either of those taking place, and since many economists have pointed to flaws in the construction of the comparison of earnings and productivity, I think this makes the purported finding highly suspect.

In contrast, consider the view that assortative mating has increased and plays an important role in inequality. I have not seen anyone say, “IF that were true, then we would expect to observe Y, and Y has not happened.”

I think that this is the way to evaluate interpretive frameworks in economics. Consider many possible implications of an interpretive framework. Relative to those implications, do we observe anomalies? When you have several anomalies, you may choose to overlook them or to explain them away, but you should at least treat the anomalies as caution flags. If instead you keep finding other phenomena that are consistent with the interpretive framework, then that should make you more comfortable with using that framework.

The Puzzle of Low Real Interest Rates and Low Investment

Posted on by

Antonio Fatas writes,

What the world is missing is investment demand. The real tragedy is that investment in physical capital has been weak at the time when financial conditions have been so favorable. Why is that? Jason Furman (and early the IMF) argues that the best explanation is that this the outcome of a a low growth environment that does not create the necessary demand to foster investment. And this starts sounding like a story of confidence and possibly self-fulfilling crises and multiple equibria. But that is another difficult topic in economics so we will leave that for a future post.

Pointer from Mark Thoma.

The puzzle in macroeconomic data is that the real interest rate is low and investment is low. There are a number of stories, none of them fully convincing.

In the Keynesian category, we have:

1. Low “animal spirits.” As far as I know, no one has actually propounded this.

2. Accelerator model. That is, when other forms of spending are high, investment is high. So when spending by households goes down, investment goes down. I put Furman (and most Keynesians) in this camp.

In the non-Keynesian category, we have:

3. Real interest rates are actually high, because prices are falling. This is perhaps more plausible if you think about sectoral price movements. If the price indexes go up because of college tuition and health insurance, then prices elsewhere may be falling.

4. Real interest rates are actually high for risky investment. Interest rates on government debt and on high-grade private bonds are a misleading indicator of the marginal cost of capital.

5. Crowding-out can occur at low interest rates. That is, if financial intermediaries are gorging on government debt, they may not seek out private-sector borrowers.

These explnations are not mutually exclusive.

Free Trade and Trade Treaties

Posted on by

Noah Smith writes,

As for the Trans-Pacific Partnership — the most important trade deal in years — support from the economics profession has been muted. However, some of that might be because of the intellectual-property protections in the treaty, which many consider a trade restriction rather than a liberalization.

Pointer from Mark Thoma.

On the other hand, Greg Mankiw writes,

I would guess that TPP would also poll well among economists. FYI, here is CEA chair Jason Furman singing the praises of TPP, and here is an open letter from a sizeable group of past CEA chairs.

Apart from mood affiliation, economists should not feel compelled to support every trade agreement. In fact, there is no reason to presume that a trade agreement actually promotes free trade. One country can do its part to promote free trade without having to negotiate an agreement with anyone. Just eliminate trade barriers, regardless of what other countries do.

It is likely that every trade agreement includes at least some measures that are protectionist. Maybe you can say something good about an agreement “on net, relative to the status quo.” But in a better world, there would be no trade treaties–just free trade.

UPDATE: Jeff Frankel gives the upbeat view of the TPP.

Poor Replication in Economics

Posted on by

Andrew C. Chang and Phillip Li write,

we replicate 29 of 59 papers (49%) with assistance from the authors. Because we are able to replicate less than half of the papers in our sample even with help from the authors, we assert that economics research is usually not replicable.

Pointer from Mark Thoma.

As an undergraduate at Swarthmore, I took Bernie Saffran’s econometrics course. The assignment was to find a paper, replicate the findings, and then try some alternative specifications. The paper I chose to replicate was a classic article by Marc Nerlove, using adaptive expectations. The data he used were from a Department of Agriculture publication. There was a copy of that publication at the University of Pennsylvania, so I went to their library and photocopied the relevant pages. I typed the data, put into the computer at Swarthmore–and got results that were nowhere close to Nerlove’s.

Noah Smith on Natural Experiments

Posted on by

He writes,

With lab experiments you can retest and retest a hypothesis over a wide set of different conditions. This allows you to effectively test whole theories. Of course, at some point your ability to build ever bigger particle colliders will fail, so you can never verify that you have The Final Theory of Everything. But you can get a really good sense of whether a theory is reliable for any practical application.

Not so in econ. You have to take natural experiments as they come. You can test hypotheses locally, but you usually can’t test whole theories. There are exceptions, especially in micro, where for example you can test out auction theories over a huge range of auction situations. But in terms of policy-relevant theories, you’re usually stuck with only a small epsilon-sized ball of knowledge, and no one tells you how large epsilon is.

Pointer from Mark Thoma. Read the whole post.