Justin Fox Inadvertently Makes the Case Against Empiricism

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On the question of whether Federal workers are overpaid relative to private sector workers, He writes,

The Federal Salary Council, a government advisory body composed of labor experts and government-employee representatives, regularly finds that federal employees make about a third less than people doing similar work in the private sector. The conservative American Enterprise Institute and Heritage Foundation, on the other hand, have estimated that federal employees make 14 percent and 22 percent more, respectively, than comparable private-sector workers.

Pointer from Mark Thoma. My comments:

1. The empirical estimates are supposed to “control for” the many factors that could affect salaries: benefit packages, education level of workers, other measures of skill, etc. But obviously, there is no clear and unambiguous choice of how to control for these factors, or else everyone would get the same estimate. Ed Leamer hit the profession over the head with this 35 years ago.

2. Could you have predicted ahead of time which organization’s “research” would find a result favorable to Federal workers and which organization would find unfavorable results? Of course you could. So how do you sustain the belief that normative economics and positive economics are distinct from one another, that economic research cleanly separates facts from values?

3. A number of us have observed that the rate of exit from the public sector to the private sector is not terribly high, and that the ratio of applicants to vacancies in public sector jobs is not terribly low. If public sector pay were too low, you would expect government agencies to be rife with unfilled positions, due to high exit and low entry.

4. Point (3) is an example of what Noah Smith would dismiss as “casual intuition.” But in this instance, I would argue that casual intuition has a higher signal-to-noise ratio than does formal empiricism.

Malcolm Gladwell on Race

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He says,

So, if your problem is that you’re facing a series of stereotypes about how you are intellectually inferior, how you have a broken culture, how you have . . . I could go on and on and on with all of the stereotypes that exist. Then how does playing brutally violent sports help you? How is an association, almost an overrepresentation in these various kinds of public entertainments advance your cause? I’m for those things when they’re transitional, and I’m against them when they seem like dead ends.

His point is that while other minorities were over-represented in sports and entertainment for short periods of time, African-Americans have been over-represented for a long time, which is a sign of an inability to penetrate into other fields. This thought had never occurred to me.

From a conversation with Tyler Cowen. There is much more that is worth either listening to or reading (I prefer the latter), including an amusing analogy between Harvard and Luis Vuitton.

A Reader’s Questions About Health Insurance

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She writes,

how do you define ‘extreme circumstances’? By the cost of the treatment? By the severity of the disease? How and who defines ‘extreme circumstances’?

…Let’s say I get pneumonia. Doctor prescribes antibiotics that cost $100. I decide that the cost of the antibiotics are too high compared to the possible benefit (50/50 chance the antibiotics help) so I hope that enough rest and fluids cure me. Pneumonia gets worse. Now I’m hospitalized and it cost $10,000 a day to be in the hospital. Now my insurance company decides that $10,000 a day is an ‘extreme circumstance.’ How is this scenario more cost effective?

To answer these questions, use some standard insurance company terminology.

1. An insurable event is a rare, unpredictable, costly occurrence. A fire burns down your house. Someone runs into your new car and totals it. What I mean by an “extreme circumstance” is something that constitutes an insurable event. Let me come back to that in a moment.

2. Moral hazard is the failure of an insured person to undertake reasonable steps to reduce risk. Insurance companies address moral hazard through a combination of carrots and sticks. For example, a fire insurance company could offer you a discount on premiums if you have a working smoke alarm. Or they might provide you with a free smoke alarm. Also, because your behavior affects their risk, they might have a rule that says that if your house burns because of negligence (smoking in bed) then they are not liable to pay claims.

The pneumonia patient who decides not to take antibiotics is an illustration of the moral hazard problem. In theory, real health insurance would try to address this. The insurance company might offer a discount to people who obey doctor’s orders. It might offer to pay for the antibiotics. Or it might issue rules warning that it will not pay for hospitalizations that could have been prevented by following a doctor’s reasonable advice.

In any field of insurance, including health insurance, moral hazard is challenging to address. It is hard to list all of the things that insured individuals can do to reduce risk and to specify appropriate carrots and sticks to incent individuals to do those things. So moral hazard will never go away completely, but with well designed insurance contracts it may be reduced to a manageable level.

Now, back to the definition of the “insurable event” in health care. Consider long term care insurance, which pays for a nursing home if you need it. Let us say that a policy covers 10 years, meaning that if the event happens in the next 10 years, the coverage kicks in. If I get this long-term care insurance when I am 50, and I become decrepit at age 59, then the insurance will pay for my long care for the rest of my life. But if I am still independent at age 60, my policy has expired and I would have to get a new one if I want to remain insured. [I am not saying that actual long-term care policies are structured this way. Things are more complicated.]

If you are 40 years old, becoming decrepit any time in the next 10 years is an insurable event, because it occurs so rarely. If you are 70 years old, the chance of having to check into a nursing home some time in the next 10 years is so high that it is not an insurable event. The premiums would have to cost you nearly as much as the nursing home bills.

In dollar terms, I think that the threshold for an event to be insurable needs to be much higher than it is currently in health insurance. People need to get used to saving a lot of money in health savings accounts to deal with short hospitalizations, pregnancies, and the high medical costs of old age, including long term care. It is fair to wonder how practical it is to assign households the responsibility for accumulating this saving. The alternative is to use a government tax-and-transfer scheme. Some combination of both is inevitable, but the relative mix is a subject for discussion. You can think of this is the problem of where to draw the line between health insurance and health charity. How high should a household’s health care spending be as a percentage of income before you give them charity? Keep in mind that in the U.S. average health care spending is 15 percent of income (not nearly that much out of pocket, obviously), so it is mathematically impossible to draw the charity line below 15 percent for everyone.

In health insurance as it is currently designed, the “insurable event” is any expenditure that takes you over the deductible. That is very problematic.

Suppose that you have a chronic illness that is expensive to treat, with an average expense of $25,000 a year. As you apply for health insurance, having high medical expenses next year is not an insurable event. You know that you will have high expenses, and so does the insurance company. Fair premiums would be $25,000 or more, so you would not really benefit by obtaining insurance.

Or suppose that a week before your insurance policy comes up for renewal you get injured in a way that is going to require a sequence of expensive surgeries to fix. Those expensive surgeries are not an insurable event, so your insurance company is not going to renew your policy, and other insurance companies either will not cover you or will charge exorbitant premiums.

We need to change the way we think about insurable events in health care. For the case of the injury, the “insurable event” would be getting into the accident. An insurance adjuster should determine your compensation based on the estimated cost of fixing your body, just as with a car accident an insurance adjuster will determine compensation based on the expected cost of fixing the damage to your car.

It is possible that this “insurance adjuster” model also could be applied to a chronic illness. The “insurable event” would be the point at which you are diagnosed with the illness, and the adjuster would set compensation based on expectations of future treatment costs. However, because chronic illnesses require many years of treatment and the course is unpredictable, this may not be the most workable approach.

Another approach, suggested by John Cochrane (“the Grumpy economist”), is to make the insurable event an increase in your health insurance premiums. Suppose, for example, that you were cruising along paying $1,000 a year in health insurance premiums, and then you get diagnosed with a chronic illness that is expected to cost $25,000 a year. Your current health insurance company, ABC Insurance, is ready to drop you like a hot potato, so you shop for a new policy and you find that the best deal you can get is from XYZ insurance and costs $26,000 a year. If you end up with that policy, you pay $1000 a year, while ABC pays the extra $25,000 a year. That is, your original policy with ABC includes protection against becoming uninsurable!

There is more to this complex topic. I hope this helps.

Empirical Public Policy

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James R. Barth and Stephen Matteo Miller write,

Testing whether it is good policy to increase bank capital requirements from 4 percent to 15 percent requires calculating and comparing the benefits and costs of such a change. Across all tested cases, it becomes clear that the benefits of increasing the capital ratio from 4 percent to 15 percent equal or exceed the costs.

This is an interesting example to discuss.

1. I am very confident that I could find problems with their methodology. This is an area in which empirical analysis is much less definitive than the authors suggest. I would say that their abstract is an example of lack of humility.

2. Nonetheless, I am very sympathetic to their conclusion.

3. In fact, many economists, left and right, are sympathetic to their conclusion. It would be hard to find a prestigious academic economist who is opposed to higher capital requirements for banks than what we have now. Unless these guys count.

4. But I bet that in fact capital requirements for banks will remain low, almost surely with obscure loopholes that make them even lower than the stated levels. It would not surprise me to find that capital requirements are so low that they are not binding, meaning that many banks will maintain capital ratios well above the minimum.

5. Speaking of my opinions, in Specialization and Trade I claim that government intervention in markets generally consists of subsidizing demand and restricting supply. This is inconsistent with any optimal intervention to address market failure.

6. Another presumption of mine is that housing policy will be dysfunctional. In addition to subsidizing demand and restricting supply, it will discourage saving and instead encourage indebtedness.

My claims in (4) -(6) might fall under the heading of “empirical public policy.” That is, what sorts of public policies can we expect? These questions are under-researched. On the other hand, economists over-research the topics of market failure and optimal policy solutions.

Implicit in this research imbalance is a very optimistic view of government intervention. It helps ingratiate economists with people in power. In effect, the economist says to the politician, “You are a wonderful public servant. I, the wise technocrat, am here to help you in your benevolent endeavors.”

Thus, the empirical policy economist is both obsequious and self-flattering. What gets lost is the opportunity to provide the public with a realistic comparison between the political process and the market process.

Economists, Empiricism, Humility, etc.

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Peter Dorman writes,

what passes for empiricism in economics at present is often deficient in an empiricist, self-critical spirit and methodology. At the same time, the debates over topics like the minimum wage, the effects of charter schools on educational outcomes and the like are on a vastly higher plane when they are about data sets and analytical assumptions than the certitude of my unquestioned beliefs against the certitude of yours. It’s also a cheap and not altogether forthcoming dodge to respond to econometric disputes with a flip “There is never a clean empirical test that ultimately settles these issues.” (Roberts) That’s a epistemology.

Pointer from Mark Thoma.

Adam Ozimek writes,

Calls for skepticism of empirical economists also need to be matched with “compared to what?” Often those arguing for more humility about empiricism aren’t actually embracing humility, but instead are making space for their own narratives that are no less humble. For example, Russ says he doesn’t know how many jobs NAFTA has created or destroyed because “thousands and thousands of jobs are created every month and it is very difficult, perhaps impossible to know which ones are related to NAFTA.” Certainly, humility with regard to this question is useful. But then at the end of that paragraph Russ tells us he believes “trade neither destroyed nor created jobs on net.” Zero is not the same as “I don’t know,” nor is it necessarily any more humble than some specific estimate with wide confidence intervals.

…Economists do disagree on whether the direct effect of immigrants on native wages is a small positive or small negative. But they agree it is small. It’s easy to take this conclusion for granted as somehow common sense. But the truth is that, in the absence of the empiricism, the claim that immigration has held back wages by 20% for everyone would be much harder to argue against.

Noah Smith adds,

Theories can be wrong, stylized facts can be illusions, and empirical studies can lack external validity. But where does casual intuition even come from? It comes from a mix of half-remembered theory, half-remembered stylized facts, received wisdom, personal anecdotal experience, and political ideology. In other words, it’s a combination of A) low-quality, adulterated versions of the other approaches, and B) motivated reasoning.

If we care about accurate predictions, motivated reasoning is our enemy. And why use low-quality, adulterated versions of theory and empirics when you can use the real things?

Pointers from Tyler Cowen, who adds

A lot of the bias in empirical methods comes simply from which questions are asked/answered.

I say “amen” to that. For example, in the health care policy debate, the empiricists at CBO are telling us how many people would “lose” their health insurance under the GOP proposal. If you want to, you can question the CBO’s empirical estimates (their forecasts for Obamacare were, in the words of Avik Roy, “way off”). But that is not where I think the debate should go.

Instead, I think we ought to be talking about the real meaning of “insurance” in the context of health care. I think we ought to talk about the pros and cons of individuals having less “coverage” and making their own decisions about medical procedures with high costs and low benefits vs. having more “coverage” but subject to restrictions placed on them by bureaucrats. I think we ought to be talking about the issue that Timothy Taylor raised the other day, namely, should we be spending less on medical services and more on other things that are conducive to better health. (Note that Taylor’s post is grounded in formal empiricism.)

Perhaps we ought to be listening to Dierdre McCloskey’s view that economics is a discipline that uses rhetoric. I think that Russ Roberts and I would complain about the pseudo-scientific rhetoric that gets used.

Noah Smith’s use of the rhetorical phrase “the real things” is an example of the sort of language that lacks humility. It implies that there is a great distance between casual observation combined with theoretical introspection on the one hand and formal empirical work on the other, with the implication that the latter dominates the former. I would say that in some cases it is the former that is unreliable and in other cases it is the latter.

I hope that we can all agree that a lack of humility consists of pretending to know something for certain when it is in fact doubtful. We can then argue about what sort of approaches to economics are conducive to humility or a lack thereof.

Again, I have a longer essay on this topic, but it will not appear until this summer.

The Many Enemies of Liberty

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Kevin Williamson writes,

The old robber barons were far from being free-enterprise men: J. P. Morgan and Andrew Carnegie, like many businessmen of their generation, believed strongly in state-directed collusion among firms (they’d have said “coordination”) to avoid “destructive competition.” You can draw a straight intellectual line from their thinking to Barack Obama’s views about state-directed “investments” in alternative energy or medical research.

…the capitalists are not prepared to offer an intellectual defense of capitalism or of classical liberalism. They believe in something else: the managers’ dream of command and control.

His claim is that many top corporate executives are naturally inclined toward progressivism.

Of course, we have known since Adam Smith that business leaders do not like markets and competition. What they like is protection and cronyism.

Progressives will engage in rhetoric against protected large businesses and cronyism, but that is not because they believe in markets and competition. What they believe in is industries that are organized and directed by government (e.g., Obamacare), which in practice devolves to. . .protected large businesses and cronyism.

I am skeptical of attempts, such as the Niskanen Center or ProMarket.org, to reach out to progressives. I would say to those who are trying this: don’t hold your breath waiting for progressives to reciprocate. They may favor you with a few status points, but their antipathy toward economic liberty will not abate.

I am not suggesting that an alliance with conservatives is the answer. There are many enemies of liberty among them, also. Moreover, reaching out to them will cost you status points with progressives.

Populism? I don’t think that the “keep your hands off of my Medicare” crowd is going to be our salvation.

All I can think of is to keep trying to explain the rationale for economic liberty, and hope that somehow amidst the din of all the outrage politics that the message gets through to some people and that they grasp it.

File this post under “being frustrated with those who disagree.”

Tyler Cowen’s Complacency Quiz

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It sorts you into four categories:

Trailblazer

Striver

Comfortable

Complacent

I was rated as a striver. I don’t think of myself that way. I might feel better if there were a category called “contrarian.” It would describe me, and I think it also would describe Tyler.

In terms of the categories as given, I would self-identify as comfortable now and a trailblazer when I was younger. I was very entrepreneurial in my 30s and 40s. Now, I just blog. My wife and I have visited many countries, but lately we would rather travel to visit relatives than to see new places. I would much rather go folk dancing than go to a party or have a new experience.

It could be that my score was affected by questions that were impossible to answer, forcing me to almost randomize. For example, dancing is the source of suggestions for music to which I like to listen. That was not one of the choices in the quiz.

Other comments:

1. The introduction to the quiz says that

Complacency is defined as self-satisfaction accompanied by unawareness of possible deficiencies or dangers

This differs from the definition that is offered in The Complacent Class, but I think it gets much closer to what Tyler means.

2. Making up a quiz is fun, but I wonder if it was made up with complacency (as defined above). In theory you ought to test your quiz to see how well it works. You would ask a bunch of beta testers to both self-identify in terms of categories and to take the quiz. If the quiz puts them in their self-identified categories, then it works. Otherwise, it needs to be tweaked.

In the first edition of The Three Languages of Politics, I used a made-up quiz. I only tested it out on a few friends beforehand. They said that it worked ok. I imagine that it was easier for people to self-identify as libertarians progressives, or conservatives than to self-identify into Tyler’s idiosyncratic categories. But in the new edition that is about to come out, I dropped the pretense of a quiz, and instead I just used the examples as illustrations of the three-axes model.

The Overton Window and Health Insurance

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Liz Sheld writes,

The implicit standard in analysis of the health insurance system is that every consumer must have government-selected coverage. But why? This chosen paradigm doesn’t take into consideration the most forceful motivation of human behavior, namely, whether a large expenditure of limited resources is in one’s economic interest. This standard of “universal coverage” is as artificial as the government’s bloated health care costs.

This is the debate that the Congressional Republicans are ducking. As a result, the Overton Window has moved to the point where Obamacare will not be replaced until the Democrats replace it with full-on single payer.

The points that I would make are:

1. What we call health “insurance” is not real insurance. It is instead a layer of insulation between the recipients of medical services and the providers of those services.

2. It seems that hardly anybody wants real health insurance, meaning a policy that pays benefits rarely and only under extreme circumstances. Instead, what people want as individuals is unlimited access to medical services without having to pay for them. If that is the definition of health insurance in the popular mind, then we are all going to lose our health insurance. Unlimited access to medical services without having to pay for them is an unsustainable approach.

3. There are two alternatives to the unsustainable approach. One alternative is to have people face more of the cost of medical services, in which case they ration their own use of those services. The other alternative is to have the government pay for medical services, in which case it will be the government that rations the use of those services.

4. Much of health care spending is on medical procedures that have high costs and low benefits. Socializing the cost of those procedures means that people will undertake more of them, until the government starts to get serious about health care rationing.

5. Health spending is approaching one fifth of all spending in the economy. If we become culturally committed to socialized medicine, then we can expect the usual consequences of socialism: productivity stagnation; the emergence of an underground economy; corruption; and government repression.