Goldilocks Economics

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It occurs to me now that this might have been a good title for my latest book. Here is my thought process.

1. Economic thinking can be too simple or too abstract. What I call Goldilocks economics involves thinking about specialization and trade, and in particular the implications of the extremely complex patterns of specialization and trade in the modern world.

2. Too-simple thinking tries to generalize from what you see in your immediate world as a consumer or in the workplace or in a small segment of society. It comes from not having absorbed enough economics to understand Goldilocks economics. In the book, examples of too-simple thinking include using a camping trip as a model economy or thinking that “sustainability” means conserving a particular resource.

3. Too-abstract thinking is what academic economists undertake and force their grad students to undertake. The exercise of “modeling” creates a false impression of scientific endeavor. Mathematical and statistical models look like the sorts of things that engineers use to design machines, but that appearance is deceptive. The economic world is not as straightforward to manage as a machine.

4. Interestingly, macroeconomics manages to straddle both too-simple and too-abstract thinking. Keynesianism in its popular form uses the too-simple notion that spending creates jobs and jobs create spending. That is how most economic journalism treats it, and that is how many freshman macro classes treat it. What gets taught in grad school as macro is something completely different–very abstract.

5. Economists have never found it easy to reconcile the too-simple version of Keynesianism with standard microeconomics. So what can be done?

a. Say that macro is true in its own way, and micro is true in its own way, and don’t bother trying to reconcile them. That was the state of things around 1965, and much of the profession seems to have reverted to it since 2008. But choosing to ignore the discrepancy does not make it go away.

b. Say that macro is just dynamic stochastic general equilibrium theory. Try to explain macro fluctuations in terms of people time-shifting their decisions to work and consume. Maybe there is a more charitable way of putting it. This approach dominated the profession for thirty years–right up to the point in 2008 when Olivier Blanchard was telling us that “the state of macro is good.” Although it still has some adherents, I have always thought that it was garbage.

6. As of 1965, the too-abstract approach to Keynesian economics was the large-scale macroeconometric model. As of 1980, it was the rational expectations mathematical model, eventually becoming the DSGE model. Today, you show your Keynesian colors by uttering magical phrases like “zero bound.”

7. In either the too-simple or too-abstract formulation, Keynesianism treats the economy as a GDP factory. Specialization is assumed away.

8. The Goldilocks approach is PSST. Instead of thinking of jobs as created by spending, think of them as created by the discovery of sustainable patterns of specialization and trade.

Another Minsky Moment?

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That was my reaction to reading this.

Brian Lockhart says, “The payout ratio for S&P companies was $200 billion more than GAAP earnings. Companies are borrowing money to buy back stock to drive up earnings-per-share. How do they pay that back? They have to take future earnings in order to pay back the debt they’re using.”

In my talk in Oslo on bubbles, I said that whenever asset prices are high relative to some historical pattern, there are always two narratives available. One narrative says “Bubble.” The other narrative says that historical norms have been superceded by new patterns. In other words, “This time is different.”

I do not have a strong view about which narrative best fits the current stock market.* I do take it as given that the ratio of share prices to earnings is on the high side relative to historical norms.

*My portfolio has for quite some time been relatively light on stocks, but I have not bailed completely and not gone short.

Un-taxed Owners of Corporate Shares

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Steven M. Rosenthal writes,

In a report published today in the journal Tax Notes, my Tax Policy Center colleague Lydia Austin and I found the other three-quarters of shares now are held in tax-exempt accounts such as IRAs or defined benefit/contribution plans, or by foreigners, nonprofits or others.

Pointer from Tyler Cowen. Other things equal, this should lead corporations to pay higher dividends. What other implications are there?

Timothy Taylor has thoughts.

Market Entrepreneurs and Policy Entrepreneurs

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One way to look at the issue of markets vs. government is to compare the relative strengths of entrepreneurs operating in the market with that of entrepreneurs operating through government. I think that this issue can be addressed along several dimensions:

1. Ability to resolve Coasian bargaining problems

Consider an entrepreneur wishing to solve an urban transportation problem. If the solution involves reconfiguring a lot of land, by building a new highway or rail system, then a market entrepreneur is likely to face a huge Coasian bargaining problem in trying to get all affected parties to come to terms that allow the project to be built. A policy entrepreneur, backed by the coercive power of government, can implement the solution by fiat.

2. Knowledge

I think that a lot of pro-government, anti-market bias comes from implicitly assuming that the policy entrepreneur knows everything about a problem. This is a troublesome implicit assumption, for a number of reasons. First, some problems are simply too complex to be fully understood. In James Manzi’s terminology, causal density is just too high. You cannot isolate the causes of phenomena, and so you cannot reliably predict the consequences of new actions.

Once we accept that knowledge is going to be imperfect, then the issue becomes comparing what a market entrepreneur is likely to know with what a policy entrepreneur is likely to know. As Hayek pointed out, the market entrepreneur works within a price system that coordinates local knowledge. In contrast, the policy entrepreneur relies on centralized knowledge. For opening, operating, and closing restaurants, local knowledge is likely to be more robust. For regulating nuclear power, centralized knowledge probably is more reliable.

3. Incentive to innovate

Large organizations are not well suited to innovation. The problem is that for an individual operating within a large organization, the risks and the rewards are both too small. If your project does really well, you get at most a trivial personal reward. If it costs a lot of money and flops, you personally suffer very little. The type of project that is optimal for a middle manager to launch is one that has a high probability of a small upside, even if it has a nearly unlimited downside. To prevent such projects from being launched, organizations set up procedures that make it difficult to undertake new projects.

(Note that a typical venture capitalist prefers a project with a nearly unlimited upside even if it has a high probability of a small downside. And self-funded entrepreneurs prefer projects where both the probability and magnitude of the potential upside are high enough to offset the downside risks.)

4. Incentive to evolve

Government has no reliable mechanism for discarding bad programs. The market has the profit-and-loss system. Thus, the market is better suited to evolution.

To me, the evolution issue is particularly important. Only a policy entrepreneur could undertake the DC Metro subway system. But once that works out badly, it does not fall by the wayside as would a market entrepreneur’s failed project.

Carlos Lozada Reviews Yuval Levin

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Lozada writes,

So how do we go about strengthening families, religious organizations, schools and all those mediating institutions? Levin’s recommendations are aggressively vague, and where they get specific they seldom surprise. He calls for a “mobility agenda,” with economic growth spurred by tax and regulatory reform, a more competitive and low-cost health-care system, lower budget deficits — all part of a standard conservative recipe. He proposes education reform that includes more professional certificates, apprenticeships “and other ways of gaining the skills for well-paid employment that do not require a college degree.” He prefers to untether employees’ retirement accounts and health insurance from any particular workplace, but acknowledges that this would require “more fundamental policy innovations, and it is not yet evident just what those will be.” Okay, then. It’s nice if the things you want are all bottom-up and empowering and networked and diverse and flexible, but adjectives are not policies.

The review is more sympathetic than what I expected. In my view, Lozada makes too much of the contrast between Levin and Trump. Of course, that contrast is quite strong, but dwelling on it does not help the reader of the review understand what is distinctive about Levin’s thought. For that, you should go back to my review. And read the book when it comes out, which will be in a few days.

Four Forces and Urbanism

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Justin Fox writes,

Basically, urban life is becoming a luxury good in much of the U.S., in part because there isn’t enough of it to go around.

Pointer from Mark Thoma.

I think of this in terms of the four forces. The New Commanding Heights of education and health care tend to concentrate in inner cities. This helps draw affluent professionals to cities, leading to gentrification. Then you get the sorts of amenities that affluent professionals like–bike lanes, sushi restaurants, yoga studios. The urban-suburban demographics becomes sorted by taste as well as by occupation.

Martin Gurri on Elites vs. Democracy

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He writes,

The elites’ loss of faith in democracy is directly proportional to their heightened loathing of the public. According to Cohen, the public is susceptible to “greed, prejudice, ignorance, domination, subservience and fear.” It worships political thugs like Donald Trump in the US and Jeremy Corbyn in the UK. It erupts into Tea Parties and Occupations that upset the steady progress of history. The elites, in brief, have come to doubt that their pet projects can be implemented democratically. They are shopping for alternatives.

Gurri ends up suggesting that Estonia and Iceland’s Pirate Party might offer workable models for the future. I think that it is fair to say that you won’t find that view widely expressed.

Idiosyncratic Housing Market Perspective

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Kevin Erdmann, whose comments on this blog are much appreciated, wrote

There wasn’t even a housing boom. We all just decided to freak out about the one type of homebuilding that was growing – single family units for sale – and ignore every single other category of housing supply, which included homes built by owner, multi-unit homes, and manufactured homes. All of those categories had been in decline. Of course, it was the decline that created the illusion of a boom, because it was precisely those cities where we can’t build, yet where income opportunities are available, where home prices were skyrocketing, because households were bidding up the stagnant pool of homes in those cities in an attempt at economic opportunity in a country that has become inflexible.

What I think he is saying is this (and I could be wrong in my characterization):

1. Because of natural and artificial constraints on supply in cities like SF, the housing stock stays just about fixed, so any increase in demand shows up in price.

2. People have to live somewhere. When supply is fixed in some places, some households get pushed to other places. However, the rise in supply in those other places was never much ahead of demand.

3. If there were excess supply, we would expect rents to fall, and they have not.

4. The sharp fall in house prices came from tightening mortgage credit by much more than was necessary.

My own thoughts:

1. A fact that is salient to me is that the share of mortgages for non-owner-occupied homes went from about 5 percent before 2004 to at least 15 percent in 2006. To me, this says that at the margin there was some demand that was not driven by housing needs. Also, I believe that in housing the marginal supplies and demands exert big effects on prices, even though those marginal Q’s are small relative to the stock of housing and the total number of household.

2. Another salient fact is that the average price-to-rent ratio also shot up over this period.

3. This suggests to me that something other than “pure” supply and demand was at work in driving up house prices. I am inclined to see some combination of looser credit and (unrealistic) expectations for house price increases.

4. I think that Kevin is right to stress that the characteristics of housing markets differ in different locations. In SF or DC, rapid gentrification combined with restricted supply gives you one dynamic. (I don’t think I would pin it all on people bidding for “an attempt at economic opportunity,” as if these cities offer better jobs to people of every skill, which is what Enrico Moretti has claimed. Instead, I see a shift in economic opportunity inside cities away from low-skilled workers and toward professionals in the New Commanding Heights sectors.) In rural Ohio, a long decline in economic opportunity gives you another dynamic. In Texas, a big population inflow with more elastic supply gives you yet another dynamic. I could imagine that national averages, including the national averages I tout as “salient facts,” could be quite deceiving. Perhaps to understand the whole you need to study the parts.

The Problem of Ignorance

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Two recent discussions.

1. David Harsanyi wrote,

by weeding out millions of irresponsible voters who can’t be bothered to learn the rudimentary workings of the Constitution, or their preferred candidate’s proposals or even their history, we may be able to mitigate the recklessness of the electorate.

2. John Cochrane wrote,

Like most economists, I was a bit baffled by the Administration’s announcement of stricter overtime rules. The Jonathan Hartley and many others cover the obvious consequences on jobs, business formation and destruction, and so forth. A bit less mentioned, it reduces employee flexibility. If you like working more hours one week and less the next — perhaps you have child or parent care responsibilities — you’re going to be stuck working an 8 hour day. It’s part of the general regulated ossification of American employment. Or, it could be one more inducement to substitute machines for people or make people independent contractors.”>WSJ, and Jonathan Hartley and many others cover the obvious consequences on jobs, business formation and destruction, and so forth. A bit less mentioned, it reduces employee flexibility. If you like working more hours one week and less the next — perhaps you have child or parent care responsibilities — you’re going to be stuck working an 8 hour day. It’s part of the general regulated ossification of American employment. Or, it could be one more inducement to substitute machines for people or make people independent contractors.

As far as I know, the economically ignorant rules that Cochrane complains about were not demanded by the economically ignorant voters that Harsanyi complains about. So I think that the problem of ignorance is more complex than Harsanyi implies. Perhaps the elites are a bit less ignorant than the masses. Perhaps if the ignorant masses did not vote, elites would lean toward better better policies. Perhaps, but I doubt it.

My own view is that at the very highest academic levels, economics is a mess. At elite colleges, inane “sustainability initiatives” are launched without a peep of protest from the economics department. Macroeconomists still fill the air with the mumbo-jumbo of aggregate demand. There is much talk of market failure and hardly any talk of market self-repair or political failure.

I am most troubled by the bad intellectual habits of economists and other academics. My hope is that the ideas in my forthcoming book will eventually be re-discovered. Although hardly anyone is going to read the book, other authors with similar ideas may at some point prove successful. Restore sanity in the academy, and then see if the ignorance of the general public is still a large concern.

Scott Alexander Puts Me in His Corner

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On the subject of poverty, he offers a two-by-two matrix to classify viewpoints.

On one axis, you can think that the capitalist system is basically competitive or basically cooperative. The former view is that it creates winners and losers. The latter view is that it is a rising tide that lifts all boats.

On the other axis, you can be optimistic or pessimistic. If you are optimistic, you think that a bit of social change can take care of poverty. If you are pessimistic, then if you think of the system as competitive you want revolution. If you think of the system as cooperative, you end up like this:

we’re all in this together, but that helping the poor is really hard. . .capitalism is more the solution than the problem, and that we should think of this in terms of complicated impersonal social and educational factors preventing poor people from fitting into the economy. . .worry school lunches won’t be enough. Maybe even hiring great teachers, giving everybody free health care, ending racism, and giving generous vocational training to people in need wouldn’t be enough. If we held a communist revolution, it wouldn’t do a thing: you can’t hold a revolution against skill mismatch. This is a very gloomy quadrant, and I don’t blame people for not wanting to be in it. But it’s where I spend most of my time.

Me, too. Except note that over the past two hundred years the tide has lifted more and more boats, quite dramatically. It is still lifting more and more boats, but those boats are more likely to be in China, India, or Africa than in the rural United States. And places like St. Louis.