Proper Critiques of Economics

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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.

Grumpy Monetary Economics

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John Cochrane writes,

I don’t think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt.

Read the whole post.

John Taylor, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was loose monetary policy prior to the financial crisis and the Fed is too loose now.

Scott Sumner, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was too tight monetary policy during the financial crisis and that the Fed is too tight now.

John Cochrane, who claims to be the intellectual heir of Milton Friedman, seems to be saying that these days the Fed is impotent.

I do not claim to be the intellectual heir of Milton Friedman. My views happen to be closest to Cochrane’s.

Clay Shirky’s Little Rice

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The book is centered on Xiaomi, a Chinese cell phone firm. I found the writing rather jumpy, almost ADD. Here are some random excerpts (each of these is from different parts of the book):

This focus on a handful of individual product lines in turn allows the company to stay small. Employees who have been through Xiaomi’s hiring process are told that the company’s goal is to hire as few people as possible, by concentrating on attracting and retaining talented employees.

China, remarkably, has managed to create an alternate path, building a country where information moves like people,, in highly identified and constrained ways

the usual modes of censorship and surveillance are no longer enough to keep control of public opinion, and the government is expanding its online propaganda efforts. The people who flood online conversations with pro-Beijing sentiment are . . .paid half a yuan for every post.

the People’s Liberation Army paper published one saying, “The Internet has grown into an ideological battlefield, and whoever controls the tool will win the war.”

Of course, the idea of trying to operate a firm with a relatively small cadre of talented employees sounds very reasonable to someone in the tech business. But note that it is quite different from old-fashioned economic models, in which you hire “labor” until marginal revenue equals marginal cost.

But the issue that I am still mulling is the role of social media in affecting the evolution of beliefs and behavior. My sense is that people’s dislike of “the other” has gone up quite a bit during the relatively short period in which social media went from a small niche phenomenon to a mass-market phenomenon.

Contrarian Betting/Forecasting

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Bryan Caplan writes,

I doggedly take the outside view. When long-run trends say X, and the “latest news” says Y, I go with X. When Democrats won big in 2008, I saw good luck, not a new political regime. That’s why, in 2009, I bet my former co-blogger Arnold Kling that the Republicans would regain control of one branch of the federal government by 2017. I won in 2010.

I sometimes think that there are two major types of investors. Momentum investors say that “the trend is your friend.” Contrarian investors say, “if something cannot go on forever, it will stop.” The former investors look at short-term developments. The latter investors look at long-term averages. If the long-term average in U.S. politics is that no party dominates for extended periods, then I was making a momentum bet, which is not what a good economist should do.

Read Bryan’s post, which talks about superforecasters looking first to general statistics (what proportion of households own pets) and then to specific factors (what about this family suggests pet ownership?). Momentum investors probably are more likely to look at specific factors.

Paul Romer on Growth

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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

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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.

Heterogeneity of Firms and Workers, Scarcity of Management Talent

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Jason Furman and Peter Orszag write,

Longstanding evidence (e.g. Krueger and Summers 1988) has documented substantial inter-industry differentials in pay—a mid-level analyst may have the same marginal product wherever he or she works but is paid more at a high-return company than at a low-return company. Newer evidence (Barth et al. 2014 and Song et al. 2015) suggests that much of the rise in earnings inequality represents the increased dispersion of earnings between firms rather than within firms. This is consistent with the combination of a rising dispersion of returns at the firm level and the inter-industry pay differential model, as well as with the notion that firms are wage setters rather than wage takers in a less-than-perfectly-competitive marketplace.

Pointer from Tyler Cowen.

I bristle at the phrase “same marginal product.” Modern workers are not widget-makers, and their value inside an organization is not visible to people outside the organization. Indeed, even within the organization, the value contributed by individual workers cannot be calculated with any precision.

I know someone, call him A, who works in information technology at a firm in a buggy-whip industry. One of his friends, call him B, just took a job at Google. Assume, probably correctly, that the difference between their two compensation packages is a lot wider than the difference in their skills. Some possibilities:

1. This is a disequilibrium situation. Information technology workers currently produce more value at Google than in the buggy-whip industry. In equilibrium, A will move out of the buggy-whip industry and go to work for Google.

2. This is an “efficiency-wage” equilibrium, in which Google pays B slightly more than B’s opportunity cost. This enables Google to be highly selective in who it hires and also to give B an incentive to provide top performance.

I am inclined toward (2). But in either case, the value of B’s work is high relative to B’s wage, which raises the question of why Google does not hire more engineers. Perhaps the value of the next engineer would be lower, because of management limitations at Google.

I think that the key factor here is that the collective management talent assembled at Google is scarce. It generates more value that the collective management talent at the firm in the buggy-whip industry.

What I am suggesting is that the value of a firm depends a great deal on collective management talent. This includes the skills of individual key executives as well as the team chemistry among them.

One of the challenges of maintaining a high-functioning management team is that the “tournament” to get to the top can become corrupt. That is, managers can start to get ahead by undermining other managers rather than by exercising better judgment. As this sort of corruption becomes widespread, a firm can rapidly deteriorate. For me, this is one of the most interesting phenomena in the sociology of organizations.

Mishkin Before vs. Bernanke After

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In Greg Ip’s new book, Foolproof, he writes,

Frederic Mishkin, an expert on banking who had studied the Great Depression, examined what would happen if housing prices fell 20 percent. The Fed, he argued in a lengthy presentation to other central bankers, would lower interest rates quite quickly, the economy would shrink only 0.5 percent, and unemployment would barely rise.

I have not yet read Bernanke’s new book, but I gather that he thinks that without the bailouts the economy was headed toward another Great Depression. So my point is that there is quite a gap between what Mishkin thought would happen if housing prices fell and what Bernanke was afraid was going to happen. Some possibilities.

1. Mishkin actually was right. The economy easily could have withstood the housing price crash. The problem must have been something else. (Scott Sumner would say that it was tight money.)

2. Mishkin was working with a simplistic model of the economy, which did not include the fragility of the financial sector or the feedback from loss of confidence in banks to the rest of the economy. There are two variations on this view

a) the bailouts helped, just as Bernanke says they did.
b) the bailouts made no macroeconomic difference. They simply served to redistribute losses away from the some of the stakeholders in the bailed out firms.

3. Mishkin actually was right. The economy would have recovered quickly with only a small recession. However, Bernanke and other policy makers did the wrong thing and turned what would have been a short-term crisis and the failure of a few firms into a long, drawn-out period of slow growth.

I think that (2a) is the most generally accepted view. My own view is 2b. I could also make a case for (3). Note that in the Great Depression, both Hoover and Roosevelt thought that destructive competition was a major problem. Both tried to discourage businesses from competing, Hoover through exhortation and Roosevelt through the National Industrial Recovery Act. In hindsight, reducing competition was a counterproductive idea. Perhaps in hindsight TARP and the other bailouts will not look so good, either.

By the way, I can offer a lot of praise for Ip’s economic judgment. However, I think I will end up putting Foolproof in the “very good but could have been even better if. . .” category.

Many Margins

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Don Boudreaux writes,

Statists, in contrast, seem me to suppose both that the number of margins on which private people can adjust their actions is relatively small, and that these margins are mostly detectable by outside observers.

The contrast is with what Boudreaux calls marketists, who believe that private actors can adjust along many margins, including some that are not visible to outsiders.

the large number of such margins and the invisibility of their details to everyone who is not ‘on the spot’ combine with the subjectivity of each person’s preferences to make it practically impossible for government officials to assess how well or how poorly markets are working. Too much is unseen – indeed, too much is unseeable – to render imposed collective decisions likely to improve the general welfare.

I think that it may help to consider examples. Consider a doctor, a set of patients, and an outsider, such as an insurance company or the government. The outsider has to choose a method of compensating the doctor. If the compensation is for procedures, then the margin along which the doctor will adjust is likely to be to order excessive procedures. If the compensation is per patient, then the margin of adjustment is likely to be to order insufficient procedures, in order to have time to see more patients. If the compensation is for outcomes, then the margin of adjustment is likely to select for patients who the doctor expects to have good outcomes.

A standard trope among statist economists is that patients cannot know enough to second-guess their doctors, so that there is likely to be a “market failure” with doctors exploiting the patient’s lack of knowledge. But this ignores the margin of adjustment whereby the patient can affect and be affected by the doctor’s reputation. It ignores the margin of adjustment whereby a patient can get a second opinion. It ignores the margin of adjustment whereby a patient, while not acquiring the full range of knowledge as a doctor, can read intensively about the patient’s particular condition. etc.

Other Countries Matter

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Timothy Taylor writes,

the number of cars sold in China has exceeded the number sold in the U.S. market for several years now.

…in 2001 the US was about half of the global market for movies. Now the US/Canada share of the global market for movies is just over one-quarter, and falling.

…more and more, Americans are going to be seeing brands and titles and products where the US market is just one among several–and not necessarily the most important one.

Read the whole post.