The Econometrician and the Entrepreneur

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Don Boudreaux writes,

The market itself is a vast and on-going laboratory of experiments – experiments that are relevant, real, and revealing. These experiments are valuable not least because they are made under real-world circumstances and by people with strong personal incentives to discover and comprehend the ‘truth’ better than their rival experimenters. . .

While I sincerely believe that much useful information can be gathered by academics doing empirical studies (both quantitative and non-quantitative), it is an unwarranted conceit of academics to suppose themselves and their empirical studies to be the only, or even the chief, source of empirical knowledge of social reality.

The notion that markets generate and process information must be very non-intuitive. It strikes me as under-appreciated by many people, including economists. Of course, markets lack perfect information–otherwise there would be no flawed products, no business failures, and no financial crises. But I am not arguing that the market process has generated perfect information. I am simply suggesting that it is hard for someone–even someone armed with a lot of data and a computer–to be more informed than the market.

The Null Hypothesis Strikes Again

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Jason Richwine writes,

Now a new report from the Institute of Education Sciences (IES), a research division of the Education Department, has poured more cold water on the idea that pursuing better teachers automatically translates to better student performance. The Chicago public-school system implemented a “whole-school” intervention called the Teacher Advancement Program (TAP), which was supposed to raise the quality of its teacher workforce. Teachers were given the opportunity to earn performance pay and promotions through a special system of mentoring and observation. Although the literature on TAP is extensive, IES focused on the most reliable study — an experimental evaluation conducted by Mathematica a few years ago. There are questions about how faithfully TAP was implemented in Chicago, and the control group was small, but here is the study’s bottom line: There were no significant gains in student test scores, regardless of grade level or subject area.

Incidentally, I hate the way that the National Review Corner page loads (or doesn’t). Is there some plug-in I should be using that can refuse to download all the junk that they are trying to send me?

Tyler Cowen Interviewed

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The transcript is interesting. I could have annotated almost any one of his answers with comments of my own. One example:

the best way to “educate yourself,” for most people at most stages in your life, is to make marginal adjustments in your peer group. That means more mobility along particular dimensions, including geographic. Yet in most ways our current mobility is going down.

Recall that my suggested way to speed the formation of new patterns of specialization and trade is to increase social mixing.

The State of the Phillips Curve

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John Cochrane writes,

There is supposed to be a stable negatively sloped curve here by which higher inflation comes with lower unemployment. Beyond that correlation, most policy economists read it as cause and effect, higher unemployment begets lower inflation and vice versa. The point of the article is how little reality conforms to that bedrock belief.

He refers to a WSJ article with an amusing chart in accompaniment.

The Phillips Curve famously began as an empirical finding in search of a theory. For several decades, it has been a theoretical relationship in search of empirical support.

In the Book of Arnold, I write,

In normal times, most prices remain stable, with some prices rising and some prices falling. Changes in relative prices (prices of computers falling, college tuition rising) are much more dramatic than changes in the overall rate of inflation.

Over the past 70 years, inflation in the United States has typically stayed in a range of 1 to 5 percent. However, inflation broke out of that range significantly in the 1970s, reaching highs of close to 15 percent. In the early 1980s, inflation began to ebb, receding to its normal range by the end of the decade.

The orthodox view of the 1970s inflation is that the acceleration was caused by excessive monetary growth and it was ended by a change in Federal Reserve policy that reduced the rate of money creation. My unorthodox view is not as well positioned to explain these movements. One possible alternative explanation is that the habitual behavior of people changed. They began to expect high inflation, and they factored such expectations into labor contracts and other long-term arrangements.

In my view, the 1970s through the mid 1980s are the only important inflation event in post-war American macro history. Whatever explains the behavior of inflation in that period, the Phillips Curve is not the story. An “expectations-augmented Phillips Curve” will fit, but primarily because of the expectations term. The idea that inflation develops momentum because of expectations strikes me as sound. The empirical support for other factors is mostly of the form of confirmation bias.

A Philosophy of Markets

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from Jason Brennan:

Peter Jaworski and I have a book on commodification, Markets without Limits, coming out next month. Our thesis is that any service or good that you may give away for free, you may sell for money.

Pointer from Bryan Caplan.

If it’s worth doing, it’s worth doing for a profit. That sounds like what I said about Planned Parenthood controversy. If harvesting body parts from aborted babies is ok, then they should be allowed to profit from it. But if it’s not ok, then doing it for free would not make it better.

Is This True of Progressive Education?

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Peter Berkowitz writes,

Progressives also abandon the idea of liberal education. Rather than transmitting the basics of the humanities and sciences, teaching the principles of freedom, and cultivating the capacity of students to think for themselves, progressivism supposes that the purpose of education is to mold students who think and act like progressives. They embrace the pedagogical creed of John Dewey, who held that “education is a regulation of the process of coming to share in the social consciousness”; that “every teacher” is properly “a social servant set apart for the maintenance of proper social order and the securing of the right social growth”; and that in instilling a democratic faith, the true teacher serves as “the prophet of the true God and the usherer in of the true kingdom of God.”

I think that the goal should be for students to know how to learn and how to search for truth. Am I so out of step with the times?

A Case of Over-Supply

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Steven J. Harper writes,

Amazingly (and perversely), law schools have been able to continue to raise tuition while producing nearly twice as many graduates as the job market has been able to absorb. How is this possible? Why hasn’t the market corrected itself? The answer is that, for a given school, the availability of federal loans for law students has no connection to their poor post-graduation employment outcomes.

Of course, outcomes do not matter when it comes to government support for higher education, or for home ownership. Intentions matter (“everyone needs access to higher education and to home ownership”). And what really matters is rent-seeking.

Markets and Trust

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Liran Einav, Chiara Farronato, and Jonathan Levin write,

Businesses that hope to create successful marketplaces or platforms for matching buyers and sellers have to solve several problems. They need to help buyers and sellers Önd each other, either by developing a centralized assignment mechanism or by allowing for e§ective search. They need to set prices that balance demand and supply, or alternatively ensure that prices are set competitively in a decentralized fashion. And importantly, they have to maintain an adequate level of trust in the market, by developing mechanisms to guard against low quality, misbehavior and outright fraud.

In The Book of Arnold, I write,

In the 21st century, many of us shop on the Internet. How do I know that the biking gloves I order really have the padding that I want? How do I know that the retailer will send me the gloves that I order? How do I know that the gloves will not be stolen before they reach me?

When you consider these sorts of questions, you realize that our modern market economy is built on layers of trust. In order for trade to take place, individual beliefs, cultural norms, and formal institutions must be aligned to reinforce such trust.

The catch is that almost every mechanism for promoting trust has flaws and can be abused.

Ray Fair on Macroeconometrics

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He writes,

Take a typical consumption function where consumption depends on current income and other things. Income is endogenous. In CC models using 2SLS, first stage regressors might include variables like government spending and tax rates, possibly lagged one quarter. Also, lagged endogenous variables might be used like lagged investment. If the error term in the consumption equation is serially correlated, it is easy to get rid of the serial correlation by estimating the serial correlation coefficients along with the structural coefficients in the equation. So assume that the remaining error term is iid. This error term is correlated with current income, but not with the first stage regressors, so consistent estimates can be obtained. This would not work and the equation would not be identified if all the first stage regressors were also explanatory variables in the equation, which is the identification criticism. However, it seems unlikely that all these variables are in the equation. Given that income is in the equation, why would government spending or tax rates or lagged investment also be in? In the CC framework, there are many zero restrictions for each structural equation, and so identification is rarely a problem. Theory rules out many variables per equation.

Pointer from Mark Thoma.

I am afraid that Ray Fair leaves out the main reason that I dismiss macroeconometric models, namely the “specification search” problem. As you can gather from the quoted paragraph, there are many ways to specify a macroeconometric model. Fair and other practitioners of his methods will try dozens of specifications before settling on an equation. As Edward Leamer pointed out in his book on specification searches, this process destroys the scientific/statistical basis of the model.

I have much more to say on this issue, both in my Science of Hubris paper and in my Memoirs of a Would-be Macroeconomist. In the latter, I recount the course that I took with Fair when he was a visiting professor at MIT.

Other remarks:

1. On DSGE, I think that the main vice is the “representative agent” consolidation. It completely goes against the specialization and trade way of thinking. Fighting the whole “representative agent” modeling approach is a major point of the Book of Arnold, or at least it is supposed to be. (I may have been too terse in the macro section of my first draft.)

2. VAR models are just a stupid waste of time. As I said in a previous post, we do not have the luxury of saying that we construct models that correspond with reality. What models do is allow us to describe what a possible world would look like, given the assumptions that are built into it. VAR models do not build in assumptions in any interesting way. That is claimed to be a feature, but in fact it is a huge bug.

I think that the project of building a model of the entire economy is unworkable, because the economy as whole consists of patterns of specialization and trade that are too complex to be captures in a model. But if you forced me to choose between VAR, DSGE, and the old-fashioned stuff Fair does, I would actually use that. At least his model can be used to make interesting statements about the relationship of assumptions to predicted outcomes. But that is all it is good for, and for my money you are just as well off making up something on the back of an envelope.

Double Liability for Bank Shareholders

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Howard Bodenhorn writes,

Beginning in the 1810s, several states imposed double liability on chartered commercial
banks. . .

Relying on cross-sectional data Macey and Miller (1992) and Grossman (2001) find that double liability actually increased measured bank leverage, an apparently counterintuitive result they attribute to double liability serving to reassure creditors that they would be made whole in the event of bank failure. To the extent that double liability served as an implicit, off-balance-sheet increase in the bank’s capital account, the increase in measured leverage overstates creditor risk and explains the counterintuitive result.

Remarks:

1. Double liability for shareholders is not as strong as a proposal that I have made, which is that bank managers serve prison terms in the event of bank failure.

2. I think that double liability works well only if the bank’s ownership is highly concentrated. In that case, I assume that the shareholders would be able to exert strong influence on the bank’s practices.

3. There are two forms of leverage: financial leverage, which is the ratio of debt to equity; and operating leverage, which is the risk of the firm’s assets. Assuming that bank creditors were rational, they must have believed that the double-liability firms were employing less operating leverage than their peers.