Monday, April 25, 2016

Life Update: Leaving Stony Brook, joining Bloomberg View


Short version: I've joined Bloomberg View as a full-time writer. I'm leaving Stony Brook, and leaving academia, effective August 15, 2016. Bloomberg View had approached me a year ago about possibly working for them full-time. So I took a 1-year leave from Stony Brook, partially to finish some research stuff I had to do, and partially to decide whether I should switch jobs (I retained my Stony Brook affiliation during that time, and kept advising students and working with Stony Brook professors, but didn't teach classes). Early this year, Bloomberg made me a very nice offer for a full-time position, and I decided to take it. The offer included the chance to live in the San Francisco Bay Area, where I've long wanted to live, so I've moved to SF.

Longer version: Back in 2006, the original reason I thought of getting an econ PhD was actually to become an econ pundit and writer. I saw the quality of the econ commentary out there, and decided that it could be much improved - that there was a huge breakdown in the pipeline of good and useful ideas between academia and the public debate. I admired economists like Brad DeLong and Paul Krugman, and writers like Matt Yglesias, who took some steps to bridge that gap, but I thought that much more needed to be done. I wanted to make sure that good ideas, rather than politically motivated propaganda or silly oversimplifications, made it out of the ivory tower and into the public consciousness.

As soon as I started grad school, I essentially forgot that dream entirely. I got absorbed in the grad school stuff, first in macroeconomics, then later in my dissertation and behavioral finance (which was much more fun and satisfying than macro). And I enjoyed the academic life at Stony Brook, especially the people there. Now, with this Bloomberg job, I'll sadly be leaving that behind - but in the end, I came right back around to where I started. In terms of bringing good ideas from academia into the public consciousness, progress has been made, but much remains to be done. Fortunately, Bloomberg is a great platform to do this, and I'll be working with some great econ writers like Narayana Kocherlakota, Justin Fox, and many others.

As for Stony Brook, I will miss everyone there. It's a good, fast-growing department. The behavioral finance group there is strong and growing, with Danling Jiang, Stefan Zeisberger, and others. The people in charge of the College of Business, including the dean, Manuel London, are really excellent leaders, and the department is much friendlier and less politics-ridden than basically any other I've seen. They'll be hiring my replacement soon, so if you're a job candidate in behavioral finance, and you'd like to live in New York, I'd recommend Stony Brook.

Anyway, to you grad students out there, I certainly wouldn't regard me as a role model - my career is weird and unusual, and was probably always destined to be that way. I'd still recommend the economics PhD, and the life of an economist, to a whole lot of people out there.

That's all that's changed. I'll still be blogging here, and I'll still be around on Twitter!

Sunday, April 24, 2016

Baseline models


Your macro diss of the day comes via Kevin Grier. Grier is responding to a blog post where David Andolfatto uses a simple macro model to think about interest rates and aggregate demand. Kevin, employing a somewhat tongue-in-cheek tone, criticized David's choice of model:
OK, everybody got that. Representative agent? check. Perfect capital markets? check, lifetime income fixed and known with certainty? check. Time-separable preferences? check. 
AAARRRRGGGGHHHHH!! 
People, it would be one thing if models like this fit the data, but they don't. 
The consumption CAPM is not an accurate predictor of asset prices, The degree of risk aversion required to make the numbers work in the equity premium puzzle is something on the order of 25 or above, the literature is littered with papers rejecting [the Permanent Income Hypothesis]. 
So we are being harangued by a model that is unrealistic in the theory and inaccurate to the extreme in its predictions. 
And that's pretty much modern macro in a freakin' nutshell.
Mamba out. 
Kevin is saying that if simple models of this type - models with representative agents, perfect capital markets, deterministic income, and time-separable preferences - haven't performed well empirically, we shouldn't use them to think about macro questions, even in a casual setting like a blog post.

I think Kevin is basically right about the GIGO part. Bad models lead to bad thinking.

A defender of David's approach might say that this model is just a first-pass approximation, good for a first-pass analysis. That even if simple models like this can't solve the Equity Premium Puzzle or predict all of people's consumption behavior, they're good enough for thinking about monetary policy in a casual way.

But I don't think I'd buy that argument. We know that heterogeneity can change the results of monetary policy models a lot. We know incomplete markets can also change things a lot, in different ways. And I think it's pretty well-established that stochasticity and aggregate risk can change monetary policy a lot.

So by using a representative-agent, perfect-foresight, complete-markets model, David is ignoring a bunch of things that we know can totally change the answers to the exact policy questions David is thinking about.

So what should we do instead? One problem is that models with things like heterogeneity, stochasticity, and imperfect markets are a lot more complicated, and therefore harder to apply in quick or casual way. If we insist on using models with those elements, then it's going to be very hard to write blog posts thinking through monetary policy issues in a formal way. Maybe that's just the sad truth.

Another problem is that we don't really know that models with things like heterogeneity, stochasticity, and imperfect markets are going to be much better. Most of these models can match a couple features of the data, but as of right now there's no macro model in existence that matches most or all of the stylized facts about business cycles, finance, consumption, etc. 

So it might be a choice between using A) a simple model that we know doesn't work very well, and B) a complicated model that we know doesn't work very well. Again, the best choice might be just to throw up our hands and stop using formal models to think casually about monetary policy.

Kevin also says that "being harangued by a model that is unrealistic in the theory and inaccurate to the extreme in its predictions" is "pretty much modern macro in a freakin' nutshell." Is that true? 

Actually, I'd say it's more of a problem in fields like international finance, asset pricing, and labor that try to incorporate macro models into their own papers. Usually, in my experience, they pick a basic RBC-type model, because it's easy to use. They then add their own elements, like labor search, financial assets, or multiple countries. But since the basic foundation is a macro model that doesn't even work well for the purpose it was originally conceived for (explaining the business cycle), the whole enterprise is probably doomed from the start.

In the core macro field, though, I think there's a recognition that simple models don't work, and an active search for better ones. From what I've personally seen, most leading macroeconomists are also pretty cautious and circumspect when they give advice to policymakers directly, and don't rely too strongly on any one model. 

Saturday, April 23, 2016

Policy recommendations and wishful thinking


There was a bit of a blow-up earlier this year over Gerald Friedman's analysis of Bernie Sanders' economic plans. Paul Krugman, Christina and David Romer, Brad DeLong and others (including yours truly) said that Friedman was being overly optimistic about the effects of stimulus - some said he had overestimated the remaining output gap, others questioned the use of "Verdoorn's Law" to predict that stimulus can increase productivity growth to very high levels. Others, like JW Mason and Dean Baker, defended Sanders.

To me, it seemed that the coup-de-grace was delivered by Justin Wolfers:
When I pointed Mr. Friedman to this critique of his analysis, he simultaneously accepted and rejected it 
He accepted it, telling me that “I may have made a mistake.” 
But he also rejected this critique, arguing that his figures are based on an alternative view of the world, stating: “To me, when the government spends money, stimulates the economy, hires people who spend, that stimulates more private investment. That remains, and at the next year, you’re starting at the higher level.” He admits that this “is not standard macro,” and described it as the understanding of an earlier generation of economists — a sub-tribe of Keynesians he called “Joan Robinson Keynesians.”
When you get someone to admit they made a mistake in their analysis, it seems like it's over. Friedman admits he made a mistake and then says that his conclusion was right anyway, because we can go find some alternative assumptions that make his original conclusion hold. To me this is transparently assuming the conclusion. That's a big no-no, and while a lot of macroeconomists probably do this, it looks really bad to admit to it!

(I'm also starting to realize that "Joan Robinson" is a sort of an invincible rhetorical refuge for lefty macro types, the way "Friedrich Hayek" is for righty macro types.)

But anyway, the fracas quieted down, but now it's back. Friedman and allies are no longer saying that their analysis is "just standard economics", since they had to switch to non-standard economics to make the conclusions come out the way they wanted. The line now is that Krugman, the Romers, et al. are just a bunch of pessimists, who are unintentionally playing into the hands of conservatives.

Here's Friedman, writing at the INET website:
Professional economists tend to embrace an economic theory that government can do little more than fuss around the edges. From that stance, what do they have to offer ordinary people for whom the economy is not working? Not a whole lot...The angry reaction to my report revealed that by some combination of rationalization and the dominance of neoclassical microeconomics since the 1970s, liberal economists have virtually abandoned Keynesian economics.. 
There is, of course, a politics as well as a psychology to this economic theory...The role of economists and other policy elites (Paul Krugman is fond of the term “wonks”) is to explain to the general public why they should be reconciled with stagnant incomes, and to rebuke those, like myself, who say otherwise[.]
And here's Mason, being interviewed in Jacobin:
The position on the other side, the CEA chairs and various other people who’ve been the most vocal critics of [Friedman's] estimates, has been implicitly or explicitly: “This is as good as we can do.”...“No you can’t.” That’s the other side here: all the reasons for why you can’t do anything. Just give up! Then this notion that Republicans make everything impossible is just another bit of ammunition for “No you can’t.”... 
Right now, we have a system that says as soon as wages start rising, you have to throttle back demand. In many ways, the people running the show don’t necessarily want very fast growth. They prefer an economy that’s sort of sputtering along because it’s one that involves a lot of insecurity and a lot of weakness for working people. When there’s a chronic oversupply of labor people can’t rock the boat.
On Twitter, Mason clarified that when he talks about "the people running the show," he meant the Republicans, not Krugman, the Romers, et al. Basically, he's accusing mainstream liberal economists of unintentionally playing into the hands of conservatives.

Krugman was not happy about this, and blogger ProGrowthLiberal was pretty mad:
The claim that economists like Christina and David Romer bought into the New Classical revolution is both absurd and dishonest...[W]e critics do admit we are below full employment and we have been calling for fiscal stimulus. On this score, the latest from J.W. Mason is even more dishonest than the latest from Gerald Friedman. Guys – you do not win a debate by lying about the other side’s position.
I think PGL is going a little far here - Friedman and Mason aren't lying about their liberal opponents' positions. They aren't claiming Krugman, et al. are New Classicals, only that in the current political and economic situation, they might as well be. Also, Jacobin appeared to put words in Mason's mouth.

But anyway, I don't like what Friedman and Mason are doing. I think economists have a duty to look at the facts as objectively as they can, regardless of their emotions and desires. You shouldn't prefer Model B over Model A just because one leads to "hope" and the other to "hopelessness". 

Suppose you're a doctor, and your patient has knee pain, so you prescribe some anti-inflammatories. The inflammation goes away and the knee pain gets somewhat better, but doesn't go away entirely, and you conclude that inflammation wasn't the only thing that was causing pain. You don't prescribe a 10x dose of the original anti-inflammatory just because doing otherwise would mean abandoning hope. That would be silly! Even if the patient has an evil boss who doesn't want him to recover, you still don't recommend the 10x dose of anti-inflammatories.

Friedman and Mason seem to be arguing that our belief about the facts should be driven, at least in part, by our desire to avoid a feeling of powerlessness. They also seem to be saying that if the facts seem to support conservative policies, even a tiny bit, we should reinterpret the facts.

I don't like this approach. It seems anti-rationalist to me, and I think that if wonks behave this way, they'll end up recommending lots of bad policies. 

Monday, April 11, 2016

Astrologers and macroeconomists


I like to keep track of "econ diss" articles, since that's what this blog was mostly about for its first few years of existence. Most of them leave a lot to be desired. But here's one I really like, in Aeon magazine, by philosophy prof Alan Levinovitz.

Levinovitz likens modern-day macroeconomics to mathematical astrology in the early Chinese empire. And in fact, the parallel sounds pretty accurate. The article is worth reading just to learn about classical Chinese astrology, actually.

But anyway, Levinovitz draws heavily on the econ disses of Paul Romer:

‘I’ve come to the position that there should be a stronger bias against the use of math,’ Romer explained to me. ‘If somebody came and said: “Look, I have this Earth-changing insight about economics, but the only way I can express it is by making use of the quirks of the Latin language”, we’d say go to hell, unless they could convince us it was really essential. The burden of proof is on them.’
 ...and Paul Pfleiderer:
Pfleiderer called attention to the prevalence of ‘chameleons’ – economic models ‘with dubious connections to the real world’...Like Romer, Pfleiderer wants economists to be transparent about this sleight of hand. ‘Modelling,’ he told me, ‘is now elevated to the point where things have validity just because you can come up with a model.’
He also rightly (in my opinion) identifies Robert Lucas as a key figure in the turn away from empiricism in macro:
Lucas’s veneration of mathematics leads him to adopt a method that can only be described as a subversion of empirical science:
"The construction of theoretical models is our way to bring order to the way we think about the world, but the process necessarily involves ignoring some evidence or alternative theories – setting them aside. That can be hard to do – facts are facts – and sometimes my unconscious mind carries out the abstraction for me: I simply fail to see some of the data or some alternative theory."
A lot of what Levinovitz is writing is just a synthesis of things that smart economists have been complaining about in private for decades, and in public since the 2008 crisis. I think econ needs more critics like this, who are willing and able to go talk to the smart dissidents within the econ mainstream, rather than just accepting at face value the arguments of "heterodox" outsiders due to political affinity (as some econ critics sadly do).

Levinovitz, however, leaves out what I think is the most important development: the empirical revolution in econ. This has been most important in micro fields, since data is much more abundant, but it's also starting to influence macro. "Micro-focused macro" - using firm-level or area-level data to test the assumptions of macro models directly, rather than just throwing in a bunch of obviously wrong assumptions and hoping they yield aggregate results you like - is a big deal these days, and getting bigger. Soon, we may even see people insisting in seminars that DSGE models only use assumptions that have been rigorously tested on high-quality micro data! That dream is still far off, but it seems to be getting closer.

I also think Levinovitz should have given a shout-out to the successes of applied micro theory - auction theory, matching theory, discrete choice models, and the rest. He writes:
Unlike engineers and chemists, economists cannot point to concrete objects – cell phones, plastic – to justify the high valuation of their discipline.
But that's actually not right. Econ theory powers lots of useful technology, from Google's ad auctions to kidney transplant allocation systems. Economic engineering isn't a term people use, but it's a real thing, and mathematical econ theories sometimes do an excellent job of describing human behavior in ways that can be consistently applied.

But anyway, Levinovitz' article is very good (and very well-written), and is worth a read. Just remember that econ is a lot more than macro, that it has become much more data-centric, and that it has produced a number of useful engineering applications.

Saturday, April 09, 2016

101ism in action: minimum wage edition


A while ago I went on a rant about the dangers of "101ism", which is a word I made up for when people use an oversimplified or just plain wrong version of Econ 101 in policy discussions. Well, here I have a perfect example for you. And among the culprits was me.

It started when American Enterprise Institute scholar Mark J. Perry tweeted the following graph about minimum wage:


I was annoyed by the word "actually". My current pet peeve is people not paying attention to empirical evidence - I think if you say "actually", there should be more than just a theory backing you up, especially if evidence is actually available. So I started giving Mark a hard time about ignoring the empirical evidence on the minimum wage question. 

That's when Alex Tabarrok jumped in and defended the cartoon, saying that it's just a basic supply-and-demand model:


But that's not right. This cartoon actually doesn't show the basic D-S model at all. Let's look at it again:


The basic, Econ 101 D-S model is a model of a market for a single homogeneous good. In the case of the labor market, that good is labor. There's one kind of labor, and everyone who does it gets paid the same wage. Since the wage in that model is equal to the marginal revenue product of labor, this means everyone's labor generates the same amount of revenue (this is also obvious just from the assumption that labor is homogeneous; if everyone's doing the exact same work, they can't each be generating different amounts of revenue). A wage floor in the basic D-S model will put some people out of work, and will raise the amount of revenue generated by each person who keeps her job, thus raising wages as well.

In the cartoon, however, different jobs are stated to generate different amounts of revenue. Also, the last panel implies that a wage floor leaves the revenue generated by workers unchanged. So while the cartoon and the D-S model both predict that minimum wage causes job loss, it's only a coincidence - they're not the same model at all. 

The cartoon could be trying to portray a sophisticated model of heterogeneous labor in a highly segmented market. Or, far more likely, it could just be some sloppy political crap made by a cartoonist who doesn't remember his intro econ class very well. Either way, Econ 101 it ain't.

When Alex claimed that the cartoon is an "accurate portrayal" of the D-S model, I waved away his protest, basically saying "Who cares, evidence comes first." But (possibly because I had a nasty virus...excuses, excuses), I failed to notice until this morning that the cartoon is not the D-S model at all! I gave it the benefit of the doubt and assumed Alex was right. But Alex must not have been paying close attention - since he teaches the D-S model in online videos, he obviously does know how that model works.

So the cartoonist, and Mark J. Perry as well, are peddling bad economics. But they managed to momentarily convince both me and Alex that they're just peddling good' ol simple Econ 101. How did they do that?

In my case, it was because I committed the fallacy of the converse. I assumed that because the basic Econ 101 model says minimum wages cause job loss, and the cartoon says the same, the latter must be equal to the former. That's like saying "Horses have legs, I have legs, therefore I must be a horse." I suspect that Alex made the same mistake. And so we both gave a stupid cartoon far more credit than it deserved.

This is 101ism at its worst. It got me too, people. It's a plague, I tell you! A plague!


Updates

This post has stimulated a lot of interesting discussion about what the basic Econ 101 supply-and-demand model actually says (see comments, also Twitter).

One point has been that the definition of "the amount of revenue a job generates" - the language in the cartoon - is not clear. I took it to mean "marginal product of labor", but some people take it to mean "average product of labor". Either way, though, the APL generally changes as total labor consumed changes, so the cartoon still doesn't make sense if we define "revenue generated" as APL.

Alex Tabarrok, in the comments, seems to suggest a model in which one "job" is not equal to one differential unit of undifferentiated labor, but actually represents several units. If this is the case, each job will have a different total revenue benefit to employers, and the MPL of a job can't even be well-defined (since it's a discrete unit rather than a differential). So with these definitions, you can definitely say that "each job generates a different amount of revenue". 

But the point is, no matter how you define a job, or the revenue generated by a job, that amount will in general change for each job under a wage floor. The amount of revenue one person's job generates depends on who else is working. That's what Econ 101 teaches - or ought to teach, anyway. And that's what the cartoon gets wrong. It shows a wage floor eliminating every job whose "revenue generated" is lower than the wage floor before the implementation of the wage floor. Actually, basic Econ 101 D-S teaches that a wage floor eliminates every job whose total revenue benefit to employers (the integral of marginal revenue product over some range represented by the "job") is less than the wage floor (representing the cost of hiring the worker) after the introduction of the wage floor. Since the wage floor changes the quantity of labor consumed, and since the marginal revenue product of labor is in general not constant, those things are not the same. 

And that is why the cartoon is a bad representation of Econ 101. Good Econ 101, in my opinion (and probably in most people's opinions), should teach how marginal benefits and costs change according to the quantity consumed. The cartoon shows them not changing. That's not good Econ 101.

Tuesday, April 05, 2016

A new age of econ imperialism is coming


Much of the discussion about econ methods these days revolves around the "credibility revolution", and the broader rise of empirics in general. Despite scattered protests from various quarters of the discipline, there looks to be no stopping the transformation of econ into an empirical, evidence-based field.

But the shift isn't just healthy - it's also a golden opportunity for economists to do what social scientists love best, which is to go on a giant raid and conquer the other social sciences! The new empiricism is the amphibious assault ship that will carry hordes of Econquerors (heh) to the vulnerable shores of sociology. 

The first big econ raid on sociology came from Gary Becker and other theorists in the 70s and 80s, who applied rational choice theory (partial equilibrium optimization, game theory, etc.) to issues like crime and marriage that had traditionally been the domain of sociology. By the turn of the century, economists were brashly trumpeting their dominion over their sister field. This earned the undying animosity of sociologists, of course, since social scientists tend to guard their intellectual "territory" quite jealously.

But the attack on soc-land was ultimately repulsed. Sociologists were basically free to ignore the incursion by A) not learning anything about econ models, and B) not publishing econ models in their journals. That was quite an effective tactic. Since university administrators and other dark overlords of academia (not to mention the general public) also don't understand optimization models, economic imperialists found themselves mostly talking to each other. 

The conquest was also a lot more difficult than economists predicted, since the defenders got an assist from Extant Reality. A lot of the imperialists' models were just flat-out wrong. A spectacular (and spectacularly tragic) example was Gary Becker's prediction that harsh sentencing could substitute for consistent law enforcement. Oops.

And in the end, economists had to pull back their occupying troops to fight battles closer to home. The financial crisis and Great Recession showed that economists didn't really understand the economy, which made a lot of people wonder why they were going off and trying to explain the division of household chores. (Of course, there's a good reason for this; it's a lot easier to test theories about household chores than it is to understand the business cycle...but hey!) By the 2010s, economic imperialism was kind of a joke.

But now the empirical revolution, especially the Credibility Revolution, is giving econ a second chance to conquer the neighbors. The new techniques - regression discontinuity, difference-in-difference, synthetic controls - are mostly pretty easy and quick for any smart person to grasp. The results of these sorts of studies are also usually very easy to interpret, unlike the output of many optimization models. And most importantly, the techniques can be applied to any social science subject.

That means that if empirical economists feel like writing a paper, it's really easy to go pick a soc topic. Want to study education policy? Just pull out your empirical econ toolkit! The relationship between crime and poverty? Go for it! 

The new econ imperialists will succeed where the first wave mostly failed, because they're armed with better weapons. Back then, it was basically a war of theory against theory, and the fights looked like:
Economist: [optimization model no one except economists understands] 
Sociologist: [slew of jargon no one except (possibly) sociologists understands] 
Public: Hmm, let me go with my political priors on thi - Hey, look, CNN is talking about Monica Lewinski! Sorry guys, gotta go.

Now, when empirical economists come with actual evidence, sociologists will be in a bind. See, the public doesn't get theory, but it gets empirical results. "X causes Y" is easy to understand, even for the most distracted of university administrators or Quartz columnists. That means empirical economists will soon be treated as experts on sociological topics.

In order to rebut economists, both in the public sphere and in the court of their own intellectual consciences, they will either need A) empirics of their own, or B) a good understanding of empirics AND the ability to clearly explain their own theories in order to use theory to question economists' interpretations of their results. 

Sociologists will have at least two barriers to doing this. First, many sociologists aren't nearly as proficient at stats and math as economists. That's not a huge problem, because Credibility Revolution techniques are actually not nearly as hard to learn as stuff like structural econometrics or Bayesian time-series methods. So sociology will have to beef up its grad students' quant skills, but it's hardly an insurmountable task.

Second, sociology is much more closed-off than econ, since few sociologists publish working papers. Soc is going to have to become a lot more open if it's going to hold off against the coming econ onslaught, both in the court of public opinion and in the general intellectual world.

Even if sociology does this, it's going to have another problem - many sociology theories will be found to be "not even wrong". As empirical evidence becomes the gold standard for social science arguments, jargon-heavy non-mathematical theories will just be less and less useful. That's probably going to make some soc theorists even angrier than it made econ theorists - at least econ theories, being quantitative, can often be tested with data. 

(Political scientists, meanwhile, will just keep doing what they always do, which is to cheerfully copy techniques from anyone and everyone.)

Anyway, in the end, I expect the new age of econ imperialism to be a good thing, for the world and for social science in general. It's time for the siloes to come down, for the borders between the arbitrary domains to be erased. Econ hordes: Conquer, pillage, burn!!

Wednesday, March 23, 2016

How to actually redistribute respect


A while ago, I wrote a blog post called "Redistribute wealth? No, redistribute respect." That could have been the title of a speech Paul Ryan gave recently. I especially liked this part:
There was a time when I would talk about a difference between “makers” and “takers” in our country, referring to people who accepted government benefits. But as I spent more time listening, and really learning the root causes of poverty, I realized I was wrong. “Takers” wasn’t how to refer to a single mom stuck in a poverty trap, just trying to take care of her family. Most people don't want to be dependent. And to label a whole group of Americans that way was wrong. I shouldn’t castigate a large group of Americans to make a point. So I stopped thinking about it that way—and talking about it that way.
This is a hugely important step toward increasing American society's respect for the poor and the working class. Language matters, of course - Ryan's speech is almost certainly a rebuke to Kevin Williamson's disgustingly elitist article in National Review. But much more importantly, Ryan is actually starting to go and look up close at poor and working class people, talk to them, see how they live, and understand their problems. Good for Ryan.

But that is only a first step toward really respecting the poor and the working class. What are the next steps toward a respectful society?

Words are important, but they need to be backed up with beliefs. Truly respecting poor and working class people means believing that they are mostly taking government assistance for reasons that most of us would find respectable - to support their kids and parents, to help themselves through what they think are temporary difficulties, to keep up their health, to get an education and a good job, etc. It also means believing that poor people are basically rational - not totally rational, because no one is, but not substantially less rational than middle-class and rich people.

If you believe these things, you will be more likely to support a social safety net. That doesn't mean we should stop worrying about the work disincentives created by high implicit rates of income taxation for poor people. But it does mean we should drop any and all attempts to paint the poor as undeserving due to bad morals, laziness, or stupidity. And all else equal, it should make us more likely to support things like food stamps, child care tax credits, public housing, health assistance, etc. - and the taxes to pay for them. In other words, the opposite of the economic plans that Paul Ryan is pushing right now.

Beyond the social safety net, there are many important ways that Americans could turn our country into a more respectful one.

For one thing, upper class people could stop trying to segregate themselves from the working class. Gated communities? Development restrictions that stop cheap housing from being built in high-income areas? Private schools? How about less of that stuff.

Even more importantly (in my opinion), we could start respecting people of different races, genders, sexualities, etc. Institutional unfairness, bigotry, stereotypes and harassment are all manifestations of deep disrespect for whole swathes of Americans.

Racist jokes at the Oscars? Cut that out. Hiring people based on having white-looking resumes? Make a conscious effort not to do that. Sexual harassment of women in science? No more of that. Aggressive online harassment of women? Just hit yourself in the head with a brick every time you get the urge to do that. Etc. etc. To say nothing of the racism of the police and the justice system, which is a huge manifestation of deep societal disrespect for black Americans.

Donald Trump and Ted Cruz? No American who is genuinely respectful of other Americans has any business voting for those jerks.

The above is mostly aimed at people on the right, but the left could do some things as well. How about not writing posts about "America's white male problem"? How about respecting freedom of speech on campus, even the views of Trump supporters? How about not echoing Kevin Williamson's elitist tripe in the pages of Salon? I'm not trying to draw an equivalence here between the left and the right, but everyone should do their part in creating a more respectful society.

See? There are lots of things we can do. I stand by my statement that respect is a bigger problem in America than raw economic inequality. Imagine a country where the rich are willing to send their kids to school with the kids of the poor, where poor people can walk past the houses of the rich without being escorted out by a security guard, where the wealthy are happy to have the government use some of their income to buy food for the poor. A country where black people can get a job as easily as white people of the same qualifications, where women don't get harassed by men all day, where black people don't get persecuted by police or treated unfairly by juries, where Asians get promoted just as easily as whites. A country where income, wealth, race, gender, education level, etc. don't affect your social status one bit.

Let's create that country, and then let's have a debate about redistributing wealth. I bet if we lived in that classless, fair society, pressure for socialism would essentially vanish. But there's only one way to find out.

Saturday, March 19, 2016

New paradigms in economic theory? Not so fast.


I've recently read two big-think piece about new paradigms for economic theory - this one by evolutionary biologist David Sloan Wilson, and this one by venture capitalist and activist Nick Hanauer and speechwriter Eric Liu. Is economic theory due for a paradigm shift? Maybe, but I don't think we know what the new paradigm will be yet.

Wilson's piece - grandiosely titled "Economic Theory Is Dead. Here’s What Will Replace It." - claims that evolutionary theory will be the magic bullet that will breathe life into econ. The piece doesn't explain how to incorporate evolutionary thinking into econ, but it does link to a 2013 special issue of JEBO that Wilson edited along with Barkley Rosser about incorporating evolution into economics. In a paper in that volume, Wilson lays out his ideas slightly more explicitly.

But only slightly. Wilson's paper does three things: 1) it references economists who have suggested making use of evolutionary ideas in the past, 2) it discusses some arguments against using evolutionary theory in econ, and 3) it lays out some broad general principles of evolutionary theory. Concrete examples are left to the other papers in the volume (which are all sadly paywalled).

In principle I think evolutionary theory might add a lot to economics, because economies obviously involve things like birth and death of firms, competition, predation, and other features similar to natural ecosystems. 

But the case for using evolutionary theory in econ is not yet a slam-dunk. The big reason is that we don't have much evidence that inheritance of traits occurs in economies. In biological evolution, we have many clear examples of heredity. In econ, to my knowledge, we have none. Evolution needs heredity, so evolutionary theorists who want to change the econ world should focus on demonstrating the existence of traits that are passed from company to company, or person to person, or industry to industry, within economies. Or, alternatively, they should show that companies and/or individuals have traits that change over time in a way similar to the way that biological traits change between generations. They should be very concrete and consistent about how to measure these traits. Then we can start talking about using evolution to create a new economics. 

Would-be evolutionary economists should realize that the measure of their success will be quantitative prediction. Get some numbers right out of sample, and they will win. What won't be useful is for them to simply point at various economic phenomena and say "Hey, this looks kind of like it conforms qualitatively to one or more general principles of evolution!" That sort of vague hand-waving does not really generate any progress in humanity's understanding of our world - it merely creates a feel-good sense of "truthiness" that makes for some good hypey media articles but little else. Evolutionary theorists, like all other researchers in all fields, should focus on predictive power and leave the hand-wavey just-so stories to a minimum.

Hanauer and Liu's piece - similarly titled "Traditional Economics Failed. Here’s a New Blueprint." - is, in my opinion, much more promising, if also pretty vague. It is also much more diverse, specifying many different sweeping changes that they believe need to be made in economic theory. Among these are:

1) The replacement of reductionist models with ones based on "complex adaptive systems"

2) The use of network models

3) The use of disequilibrium models

4) The use of nonlinear models

5) The replacement of "mechanistic" theories with "behavioral" ones

6) The replacement of optimization with something resembling "satisficing"

7) The replacement of forward-looking agents with adaptive agents in econ theories

8) Modeling people as interdependent instead of independent

9) Modeling people as irrational approximators instead of rational calculators

10) Modeling people as caring about reciprocity

11) Modeling win-win situations instead of environments characterized by rivalry

12) Replacing models of competition with models of cooperation


There is a lot to digest here. I'd split these points into three categories:

Category 1: Good points. These include (2), (4), (6), (7), (8), (9), (10), and (12). Hanauer and Liu identify networks, nonlinearity, incomplete optimization, incomplete forward-looking-ness, externalities, behavioral heuristics, social preferences, and cooperative games as areas needing more attention in economics. I agree with all of this. Good job, guys!

Category 2: Points that misunderstand the current state of economics research. These include (3) and (11). Regarding "equilibrium", economists don't use it in the physics sense that Hanauer and Liu cite. Instead, they have redefined the word "equilibrium" to mean "any solution to a system of equations in any model." The term is thus now meaningless. Many, many mainstream economic models include "transition dynamics" or "short-run equilibrium" that is exactly the same as what Hanauer and Liu call "disequilibrium".

As for "win-win" models, most existing mainstream econ models are all about win-win situations. This is the concept of Pareto Efficiency

Category 3: Points that are not very well-defined. These include (1) and (5). "Complex adaptive systems" is a term that gets thrown around a lot but rarely gets a concrete definition. In computer science research, "complexity" basically just means "displaying emergent properties", and progress in that field has been rather halting. I'm still not sure what the term "complex adaptive systems" means in terms of economics. 

Hanauer and Liu assert that "We understand now how whirlpools arise from turbulence, or how bubbles emerge from economic activity." The latter is not the case; we do not actually know what bubbles are, or even whether they are a single phenomenon or several similar-looking phenomena. Are bubbles based on "greater fool" speculation? Rational mispricing? Emotion-based irrational mispricing? Information cascades? Other forms of herd behavior? Bayesian "information overshoot"? Some combination of these? None of these? We just don't know.

As for making economics less "mechanistic" and more "behavioral", Hanauer and Liu do not explain what this means, and merely reference a David Brooks book (which is not encouraging). 


So I agree with about two-thirds of Hanauer and Liu's points. The others need tightening up, but not bad overall. The question is whether these ideas, together, represent a new paradigm in economic theory. Hanauer and Liu argue that they do, but I am not so sure. There seem to be three mini-paradigms here: bounded rationality, interdependence, and holistic analysis. The first two have already been making inroads in economics, though I think they should make more inroads. The latter is kind of an older idea that doesn't seem to have panned out as well as many hoped - there isn't actually going to be a Second Enlightenment replacing reductionist science with holism.  

But I think that more important than any of these theoretical changes - or the evolutionary theory suggested by Wilson - is the empirical revolution in econ. Ten million cool theories are of little use beyond the "gee whiz" factor if you can't pick between them. Until recently, econ was fairly bad about agreeing on rigorous ways to test theories against reality, so paradigms came and went like fashions and fads. Now that's changing. To me, that seems like a much bigger deal than any new theory fad, because it offers us a chance to find enduringly reliable theories that won't simply disappear when people get bored or political ideologies change.

So the shift to empiricism away from philosophy supersedes all other real and potential shifts in economic theory. Would-be econ revolutionaries absolutely need to get on board with the new empiricism, or else risk being left behind.


Updates

David Sloan Wilson replies. He laughs at economics for being very very late to embrace empiricism. While the rebuke is very deserved, it's also true that good data is a lot harder to gather in econ, and that technology has made this a lot easier in recent decades.

Wilson also writes:
But there is more to Science 101 than the need to test theories. Let’s imagine that there were ten million cool theories out there. How long would it take to test them? Hundreds of millions of years. ...Does Smith really believe that any old idea that comes into the head of an economist is equally worthy of attention?
Answer: Of course not, but this is another reason empirical results are important. They typically leave a trail of clues that help guide scientists toward good theories. You see electrons making a sort of wavey pattern, and you invent quantum mechanics to explain that - and luckily it turns out to explain a lot of other stuff too. That's a typical progression - you start out with some fact or phenomenon, then you make a theory to fit it, then you test that theory on different phenomena to see if you've got something structural. Of course, sometimes pure intuition gets things right the first time around - general relativity and auction theory are examples of this - but usually we're not that smart, and theorists have to follow the empirical bread crumbs.

Wilson also writes:
The main reason that the so-called orthodox school of economics achieved its dominance is because it seemed to offer a grand unifying theoretical framework. Too bad that its assumptions were absurd and little effort was made to test its empirical predictions.
Well, there has definitely been some of that going on. But "orthodox" econ has achieved a lot of solid results, like auction theory, random utility discrete choice models, and a number of other models in tax, labor, and other areas. Nor are orthodox assumptions always absurd, since some of them hold up well in lab experiments and other micro-level studies. I think Wilson would enjoy learning about these successes, in addition to the well-publicized failures.

Thursday, March 17, 2016

Russ Roberts and the new empirical world


My last post, about Russ Roberts' EconTalk interview with David Autor, was requested by Russ as part of a general symposium on the topic. But it also reminded me that I had wanted to blog about two earlier EconTalk episodes - Russ' interviews with Joshua Angrist and Adam Ozimek.

These interviews, along with my own and Autor's, are basically part of a series. In this series, a bunch of people basically try to convince Russ that empirical economics matters a lot. Russ plays the part of the econ public - the average older academic, plus the econ-literate community of policy wonks, blog readers, and the like. He starts off basically thinking that econ is about theory (as it really was back when he was learning his chops). Then, through a successive series of conversations, he becomes convinced that not only have things changed, but that this is as it should be.

First, he talks to Angrist. Angrist is the chief academic evangelist for the "credibility revolution," the methodology at the heart of the new empirical revolution. Angrist tells him about a whole raft of exciting results that have come out of this methodological shift. Russ doesn't really know these methods very well, since only recently have they been codified, systematized, and popularized. So he doesn't quite know how to respond to Angrist's assertion that a revolution is underway. He keeps asking things like "But your new methods aren't convincing everybody...right?" And Angrist gets a little frustrated, basically responding that it's impossible to convince someone with evidence if they don't take a careful look at said evidence. If Russ were more up on this debate, he could have given Angrist a stiffer challenge, bringing up external validity concerns, or the fact that the new methods don't really work in macroeconomics. But remember, the whole point of this series of interviews is to introduce Russ into the new world! There will be time for pointed criticism later.

Second, Russ talks to me. I am a snarky, combative blogger who has trumpeted econ's empirical turn as something to be celebrated - something that will make the whole field more scientific. Russ and I have a great discussion and debate. Unlike Angrist, who focuses on research methodology and doesn't really bother going around asking people if they've changed their minds, I can offer a few concrete examples of economists who have shifted their views in response to empirical results, both of the "credibility revolution" type and other types like structural models and time-series macroeconometrics. I also rant about my favorite hobbyhorse, i.e. the value of empiricism. Russ is more convinced, but my combative nature probably leaves him uneasy with simply accepting my assertions.

Next, he talks to Adam. Adam makes basically the same points I do, but more eloquently and in a gentler fashion. Adam has been involved in an extensive debate with Russ over the value of convictions vs. evidence in economics. In his interview, Adam declares that although empirical results should be interpreted with humility, "stories and our own narratives about the world need even more humility," and we need more skepticism of our basic lenses [i.e. worldviews and ideologies] than we do of empiricism." Those are beautiful lines. Adam also cites empirical literatures that have convinced large numbers of economists to change their minds (to varying degrees) about big questions. Some are the same examples I cite, but he adds the example of trade, and cites Autor's work.

Russ is no longer nearly as dismissive of empirical econ, but he is still firmly in the role of the skeptic. He consistently refers to "sophisticated" econometric techniques, as opposed to "casual" evidence that he finds generally more convincing (he is not alone). The first few dozen times I heard Russ use the term "sophisticated" to refer to things like credibility-revolution econ, I was flummoxed, since many of these methods are simple comparisons of means. Suppose I tell my dog to bite your leg,* and I compare the number of bite marks after the attack to the number before - how sophisticated is that? But eventually I realize that by "sophisticated", Russ just means "systematic". He's saying that he trusts the evidence of his own eyes more than the opaque systematic data collection and analysis methods of empirical economists.

If I had realized that during my own interview, I would have pointed out that this is how science always works. Most people don't know how scientists know the distance from the Earth to Mars, or the mass of the electron, or that bacteria cause the plague. The scientific consensus on these topics was created by insiders - people with knowledge of both the theories and the empirical methods - convincing other insiders. Educated outsiders don't understand the theories and the methods, but they trust the scientists to get things right (and once in a while they even trust the scientists too much). Uneducated outsiders don't even trust the scientists - they believe vaccines cause autism, or that the world is flat, or that diseases are caused by demon possession, or whatever.

Russ isn't an uneducated outsider - he's an educated outsider in a field where the scientists (or whatever you want to call them, empirical researchers) haven't yet built up the trust and credibility to have their results gain instant acceptance by educated outsiders. Scientists cured the plague and put humans on the moon, but economists have a much harder job applying most of their results, since the results are usually about policy, and policy is ponderous, slow, clumsy, and subject to lots of random shocks. So Russ has not yet been shown the money, so to speak, and he's understandably wary.

But like most economists, Russ is smart, open-minded, and intellectually honest. In his interview with Adam, you can see that he is warming to the idea of the empirical revolution. Russ has been deeply disturbed by the ideological tone of the macroeconomic debates since 2008, and he recognizes that people might interpret casual evidence in ways that confirm their own worldview. He talks about psychological rigidity and people's tendency to defend their previous statements and positions. He worries that sloppy empirical work might be used by tendentious researchers as a front for their preferred policy positions (and this is a real worry), but he seems to realize that casual or anecdotal evidence is far more subject to this sort of misuse. Adam's contention that we need to be even more skeptical of our ideologies than of our evidence hits home.

So Russ is getting more into the empirical world here. In his interview with Autor, he doesn't question the validity of empiricism as a research method, but focuses on understanding the results in the context of theory. He does not ask many pointed questions about the research methodologies Autor uses, but he is not dismissive of the idea that empirical econ could poke holes in a hallowed policy consensus.

This is great to see. Though Russ is considerably more libertarian than the average economist, I think of EconTalk as a sort of a barometer for the wider econ world. The things Russ thinks out loud on the air must be things that thousands of older econ profs are thinking silently in their seminars, and that thousands of policy wonks are thinking silently while reading blog debates. The older generation came of age in a time where theory was king, and it's going to take some time to adjust to the new world. But that adjustment is happening.

So who should Russ have on EconTalk next? How should this series continue? I'd like to see some more top empirical researchers get a chance to strut their stuff. For example, he could get John Haltiwanger on to talk about declining dynamism in the American economy. He could get Raj Chetty to talk about mobility, education, and inequality. He could get Susan Athey to talk about machine learning techniques. Guests like this will continue to convince him that empirical econ is making lots of useful and reliable discoveries, as well as publicizing these discoveries to his many listeners!


Updates

Looks like I missed a couple of "episodes" in this "series". Here's Russ talking to Ed Leamer way back in 2010, and to James Heckman more recently.

Wednesday, March 16, 2016

Autor on EconTalk


David Autor recently went on Russ Roberts' EconTalk podcast to talk about his new paper about China trade. The Autor paper, co-authored with Dorn and Hanson, has been a real bombshell in the econ world, since it seems to challenge the "consensus" on free trade. Economists have long asserted confidently - in public, though not always in private - that free trade is always good, and now some top economists have shown that maybe it's not always good. That's a big deal.

Roberts and Autor do a very good job of zeroing in on why free trade might not be good, and why it might not have been good in the case of China. The reason is distribution - trade can hurt some people, especially if the government is not perfectly efficient in using redistribution to cancel out the distributional effects of trade (which of course it never is). This has been known for a long time, but economists often wave their hands and ignore distribution. 

Autor et al. have basically made a splash by failing to ignore this very important thing. They treat distribution as important by assumption, and then they check that assumption by showing that govt efforts to cancel out the distributionary effects of trade have been woefully inadequate. Roberts, to his great credit, does not do the "annoying online libertarian" thing, and simply wave away distributionary concerns (as, say, Bryan Caplan might do if he were doing podcasts). In fact, Russ once again comes off as a very pragmatic, situationalist, intuition-driven sort of fellow - the kind of thinker I believe we need more of (and that Brad DeLong says have made America great). 

One very interesting point in the discussion is when Autor says that trade between rich countries is basically all upside. I think that this is a hugely important point that gets completely ignored in today's trade policy discussions, including by some of my favorite writers like Paul Krugman. Unfortunately, Russ doesn't follow up on this point, but it matters a lot, since the trade agreements we're now considering - the TPP and TTIP - are almost entirely agreements with rich countries. Some people seem to be treating the Autor paper like it applies to TPP and TTIP, but it just doesn't, and I wish this were talked about more.

Autor also mentions a couple of other potential downsides of trade. He mentions trade diversion from multilateral agreements - unfortunately this doesn't get followed up on. He also mentions trade deficits, correctly pointing out that in real terms, trade deficits are a loan, not a gift. This means that running trade deficits today is, at the country level, an impatient thing to do - it sacrifices the consumption of future generations to allow our current generation to consume more. Sadly, this point is not pursued much, but I guess podcasts have time constraints, and this one was already a bit long.

Anyway, a very good episode. I think I will do more reviews of EconTalk episodes! One thing I think Russ needs to get better at is critiquing empirical papers. In this episode, he brings up the possibility of multiple comparisons (which of course Autor accounted for, Autor being Autor). A better critique might have been to question the structural assumptions of the linkage model that allowed Autor et al. to conclude that the China trade shock reduced employment in aggregate. Now that econ is becoming more empirical, being able to get into the empirical weeds like that is going to be more and more important.

Update: Others have responded to the episode, as requested by Russ. This is great, since Autor's work, and the new controversy over trade, needs to be publicized a lot more!

Monday, March 14, 2016

Grading King Yudkowsky


Scott Sumner, diabolical sentient alien virus renowned monetary policy guru, has endorsed Eliezer Yudkowsky, professional Reasonable Dude, for King of the World. This is based on an interview of Yudkowsky by John Horgan for Scientific American. In that interview, the future King Yudkowsky makes some economic policy suggestions. However, as Emperor of the Local Group of Galaxies, I feel that I should grade the planetary monarch's ideas.

First, King Yudkowsky holds forth on the value of college:
Horgan: Is college overrated? 
Yudkowsky: It'd be very surprising if college were underrated, given the social desirability bias of endorsing college. So far as I know, there's no reason to disbelieve the economists who say that college has mostly become a positional good, and that previous efforts to increase the volume of student loans just increased the cost of college and the burden of graduate debt.
As far as I know, there is no quantitative or systematic evidence for social desirability bias regarding the value of college, so I assume that King Yudkowsky is leaning heavily on his priors here. As for student loans increasing the cost of college and the burden of debt, that does appear to be true, but says very little about college actual value, or whether college is mostly a positional good.

Next, King Yudkowsky offers a raft of economic policy suggestions:
Horgan: If you were King of the World, what would top your “To Do” list? 
Yudkowsky: I once observed, "The libertarian test is whether, imagining that you've gained power, your first thought is of the laws you would pass, or the laws you would repeal."  I'm not an absolute libertarian, since not everything I want would be about repealing laws and softening constraints.  But when I think of a case like this, I imagine trying to get the world to a condition where some unemployed person can offer to drive you to work for 20 minutes, be paid five dollars, and then nothing else bad happens to them.  They don't have their unemployment insurance phased out, have to register for a business license, lose their Medicare, be audited, have their lawyer certify compliance with OSHA rules, or whatever.  They just have an added $5. 
I'd try to get to the point where employing somebody was once again as easy as it was in 1900.  I think it can make sense nowadays to have some safety nets, but I'd try to construct every safety net such that it didn't disincent or add paperwork to that simple event where a person becomes part of the economy again. 
I'd try to do all the things smart economists have been yelling about for a while but that almost no country ever does.  Replace investment taxes and income taxes with consumption taxes and land value tax.  Replace minimum wages with negative wage taxes.  Institute NGDP level targeting regimes at central banks and let the too-big-to-fails go hang.  Require loser-pays in patent law and put copyright back to 28 years.  Eliminate obstacles to housing construction.  Copy and paste from Singapore's healthcare setup.  Copy and paste from Estonia's e-government setup.  Try to replace committees and elaborate process regulations with specific, individual decision-makers whose decisions would be publicly documented and accountable.  Run controlled trials of different government setups and actually pay attention to the results.  I could go on for literally hours.
Fortunately, King Yudkowsky does not go on for literally hours, because we Pan-Galactic Emperors have a great number of duties, and thus have limited time to spend grading the policies of mere planetary monarchs. So let's take a look at what we have.

King Y. believes that the year 1900 was a good year for the regulatory environment. Of course, the world of 1900 was much poorer than the world of 2016, but most of that can probably be chalked up to technological progress, so we shouldn't go assuming that regulation is what has made us fabulously wealthy compared to our forebears. But given the potential existence of asymmetric information, there are theoretical justifications (which you may or may not believe) for a large number of regulations, on economic efficiency grounds alone. Use regulation to make the world safer from adverse selection, moral hazard, and the like, and incomplete markets become complete, and everyone gets a lot richer - or so the theory goes. King Yudkowsky would reverse all this, but refers to no evidence for why that would be efficiency-enhancing.

As for "smart" economists advocating for his remaining policies, I am flattered that King Yudkowsky sees fit to include Land Value Taxes among these, for I myself am quite a strong advocate of these. However, on the matter of income versus consumption taxes, I must defer to a far, far smarter economist, Stanford University's Robert Hall (who could easily do my job of Pan-Galactic Emperor if he didn't have more valuable things to do with his time). Robert Hall, having analyzed the question of consumption vs. income taxes from a theoretical standpoint, concludes that "the argument from economic efficiency for a consumption tax is weak indeed."

On the matter of replacing minimum wages with negative wage taxes, I am again flattered that the King has taken a position I myself have long favored. However, on the matter of abolishing the minimum wage, even Kings and Emperors err, and the empirical evidence is only now coming in. Perhaps we should wait for the data before throwing away an important policy tool.

Regarding the suggestion of NGDP-level targeting, it frankly sounds like a...oh wait, hold on, Scott Sumner is on the line...(long pause)...anyway, on to the next point. Letting TBTF banks "go hang"? While eliminating TBTF subsidies in the long term is generally held to be a good thing, the question of whether the 2008 bank bailouts ultimately helped the U.S. economy is an open one. However, an overwhelming majority of top economists surveyed by Chicago Booth's IGM Forum say that the bailouts made the crisis less bad. The percent who disagree? Zero. King Yudkowsky must be finding his "smart economists" in a different place than IGM finds theirs.

Regarding the health care system of Singapore and the e-government of Estonia, I can only admit my ignorance (I told you, we Pan-Galactic Emperors have limited time, though I will say that Singaporean accents are very cute). As for the idea of running controlled trials of various "government setups," I can only express the hope that these trials will be better controlled than those in the 1930s. 

I do like the ideas of eliminating obstacles to housing construction and weakening copyright law, though.

At any rate, I find that King Yudkowsky's ideas, while a mix of good, blah, and dubious, in general suffer from the epidemic of Reasonability that has been sweeping much of the Earth planetary internet of late. King Yudkowsky describes Reasonability in Bayesian terms later in his interview:
Yudkowsky: ...Bayes's Theorem is a kind of Second Law of Thermodynamics for cognition.  If you obtain a well-calibrated posterior belief that some proposition is 99% probable, whether that proposition is milk being available at the supermarket or global warming being anthropogenic, then you must have processed some combination of sufficiently good priors and sufficiently strong evidence.
While various suggestions have been put forth regarding what constitutes a "sufficiently good prior" in various scientific applications, it is known that a 99% posterior can always be obtained with the use of a sufficiently strong prior, no matter the evidence for or against a proposition. While incredibly strong priors are technically rational in the Bayesian sense, people in the Pan-Galactic Imperial Court have been hesitant to label this approach as "Reasonable," after the fashion of the Earth planetary internet. We have, however, employed certain alternative terminology.

All in all, I have decided to send one of my Imperial Agents, one Roko's Basilisk, to Earth to make certain adjustments in the economic policy regime. He should be having a chat with King Yudkowsky soon. 

Monday, March 07, 2016

The Folk Theory of business cycles


A lot of people seem to subscribe to what I call the Folk Theory of business cycles (not to be confused with the Folk Theorem of game theory). Roughly speaking, this is the idea that:

1. Debt growth is necessary for GDP growth.

2. As GDP grows, debt levels become too large, leading to an economic crash.

3. Therefore, booms cause busts, through the mechanism of debt accumulation.


I'm not going to say this theory is wrong, or bad. It might be right. But I have a few problems related to this theory.


Problem 1: Misunderstanding Academia

First, a lot of people who believe a version of this theory - private economic forecasters, asset managers, econ writers, heterodox economists, and random punters from the web - get exasperated with mainstream academic macroeconomics, because they think that profs have ignored this idea. I often get told that mainstream academic macroeconomists are idiots, fools, and/or knaves by people whose basic view of the world conforms to a version of the Folk Theory.

But the charge is not quite right. Yes, the main strands of academic macro (New Keynesian and RBC theories) mostly ignored debt dynamics and assumed that recessions and booms are random. Yes, economists didn't pay nearly enough attention to finance before 2007. But a version of the Folk Theory actually did exist in mainstream macro since the 1990s. It's called the Leverage Cycle. To learn more about it, check out this survey paper by the eminent mainstream macroeconomist John Geanakoplos. Since the crisis, of course, theories like this have gained more currency and attention. There is also a huge amount of somewhat-related research that I'm not referencing here, just to keep this short, but at some point I will.

Now, some people are going to look at that paper and not understand the math. Then they're going to assume that Geanakoplos fails to grasp some concept for which they have an English term ("Endogenous money"! "Double-entry bookkeeping"! "Disequilibrium dynamics"! "Complex systems"! "Reflexivity"! "Minsky moments"! etc.). Then on that basis, they're going to continue to claim that mainstream academic macroeconomics fails to believe in the Folk Theory, and continue to call mainstream academic macroeconomists idiots. But because they don't understand Geanakoplos' math - and possibly don't even understand the precise meaning of the English terms they're throwing around - they don't actually know if Geanakoplos' math represents "endogenous money" or "complex systems" or whatever. 

So you probably shouldn't listen to these people.


Problem 2: The Illusion of Knowledge

My second, and bigger, problem with the Folk Theory is how the theory fits the data. If you read Geanakoplos' paper you'll notice that it's heavy on ideas, light on facts, as are most of the papers in that literature. Well, if we want to actually apply the theory, that's a problem. The latest research on long-term economic forecasting shows that debt is important for predicting economic cycles. But what's important is not the amount of debt, but the quality of debt, as measured (for example) by credit spreads and junk bond shares. Previous studies have mostly found the same, which is why you see credit prices as leading indicators rather than credit levels. That means that, as far as we can tell, while debt does do interesting and potentially bad things to an economy, you probably can't predict recessions just by saying "Holy crap, this country is running up a lot of debt, they're about to crash!!" 

Of course, that has not deterred many in the econ media from making exactly this sort of claim, especially when it comes to China. For example, a graph in a recent piece in The Economist attempts to show that China's large increase in debt presages a coming crash:



We're supposed to see a clear pattern here. Debt rises and hits a peak, then a recession hits and debt levels collapse (deleveraging). China's debt line has recently increased a lot. Hence, we should expect it to collapse soon. It's the Folk Theory. 

But this chart is actually really bad. First of all, it suffers from massive look-ahead bias. We know these countries experienced financial crises and lost decades, so of course they're included on the graph. Actually, look-ahead bias is present for China too, since we already know that its economy is now slowing dramatically, that it's experiencing financial troubles, and that its credit quality has probably deteriorated recently.

Second of all, the chart (and the Folk Theory itself) has a huge correlation-causation problem. Suppose, for the sake of argument only, that debt had nothing to do with economic cycles. Suppose it was only along for the ride - when they're more economic activity, people borrow and lend more with each other, and when growth slows down they borrow and lend less, but the activity of borrowing and lending has no effect on how much gets produced. In this hypothetical fantasy world, we'd naturally see debt levels rise most of the time, but we'd see them fall temporarily when there's an economic downturn. In other words, we'd see exactly what's on the graph above. But rising debt levels would be no cause for alarm. 

In fact, if you look at that graph carefully, you may start asking questions that are very uncomfortable for the Folk Theory. Why did Thailand not have a debt crisis in 1991? At that point, debt-to-GDP had been rising strongly for over a decade. Why did Spain not have a crisis in 2000? Why did Japan reach a peak debt-to-GDP ratio of over 200% before it had a crisis, while Mexico topped out at 50%? Why didn't China have a recession in the early 2000s?

When I present adherents of the Folk Theory - usually econ writers or private-sector analysis - with these kind of questions, they typically just insist that "debt to GDP can't keep rising forever". But actually in principle, it can. I can borrow $1 million from you and lend $1 million to you, both at the same interest rate, every day, forever, without anything going wrong. Our total debt level will just keep increasing forever, with no limit. 

In the real world, of course, there are all kinds of frictions that probably prevent this kind of thing from happening. But unless you understand what those frictions are, and how to measure them, you won't have a good structural theory of where debt-to-GDP levels max out. And we already know that debt levels are a poor forecaster of economic performance. 

So in practice, the Folk Theory is much less useful than people believe. If you can't use a theory to make concrete predictions, what good is the theory?


Problem 3: Bad Policy Advice

But my third problem with the Folk Theory of business cycles is the biggest: I suspect that it encourages bad policy. The story the Folk Theory tells is that you can't have good economic times without increasing debt, and that increasing debt always causes a bust. So good times come at a price - you can't have prosperity today without disaster tomorrow. 

That kind of story probably has deep roots in human history - it probably comes from the Malthusian Ceiling. It is also a morality tale, rooted in partial-equilibrium thinking - if you borrow and consume too much today, you will be sad when you have to pay it back. But this is a bad way to think about the overall economy, since total debt is mostly just us borrowing from and lending to ourselves. Paul Krugman has written a lot about this

When we think of the economy as a morality play, it encourages bad policy. For example, it can lead to destructive austerity. The Folk Theory is behind silly statements like "you can't solve a debt problem with more debt." The Folk Theory also underlies the bad advice of the people Krugman calls "sado-monetarists."

The fact is, something like the Folk Theory might be operating in real life. But even if so, it is probably just one of a number of things that contribute to business cycles. And because macro data is not very informative, it will be difficult to tell how important of an effect it is. Meanwhile, the Folk Theory is exerting far too powerful an influence over the minds of the economics commentariat and (probably) the private sector.


Updates

I've (predictably) gotten a lot of pushback on this post. The biggest source has been from people who say that debt volumes actually do forecast recessions. They've sent me some evidence to this effect. Like I said, the Folk Theory might very well be right -- there's a lot of theory research, by top people, showing how it could easily be true. The question is whether the evidence so far supports it.

First, we have the papers by Jorda, Schularick, and Taylor, e.g. this one. The basic idea of these papers is that expansions that involve lots of debt are followed by deeper, longer recessions than other expansions. That doesn't help you predict the timing of a bust, but it does give you some added forecasting power for real economic variables, since it increases the likelihood of a big bust for any given likelihood of a bust. This kind of second-order effect seems much more believable, to me, than the kind of first-order story (too-high debt levels cause crashes) told in typical versions of the Folk Theory. Another example of a more complex effect of debt on growth is debt deflation. These effects stand somewhere between the Folk Theory and economic theories that ignore debt levels entirely.

But it's worth noting that the FRB forecasting study that I cited earlier conducts a "horse race" between its own price-based indicators -- junk bond shares and credit spreads -- and the Jorda, Schularick, and Taylor measures. They FRB folks find that debt levels don't add any extra forecasting power if you have standard information about debt quality. Of course, that means debt levels might be useful for forecasting if you have countries that report debt levels but not spreads (or report accurate data for levels and crappy data for spreads). But that doesn't imply the Folk Theory is right.

Another paper is this study by Mathias Drehmann of the BIS. It shows a reduced-form relationship between debt-to-GDP ratios and the risk of banking crises (which tend to cause recessions), just as the Folk Theory would predict. This study looks at multiple countries, while the FRB paper just looked at the U.S., so that adds  lot of evidence; it also poses a problem, since a lot of those crises are just going to be one crisis, the global 2008 crisis, in which we know credit-to-GDP was very high (the sample starts in 1970). That's look-ahead bias -- we just came out of an episode in which we observed historically high credit-to-GDP ratios and also a huge crash. That inspired us to think "Hey, maybe the high debt levels caused the crash!" But if all we do is go back and verify that yes, high debt levels did in fact precede the crash, we haven't shown anything. I think that studies like this BIS one are in danger of this bias, so it might be good to restrict these samples to the pre-2008 period. Also, the BIS study doesn't include credit quality measures like spreads; with that additional indicator, much of the forecasting power of debt levels might disappear.

The most convincing Folk Theory paper that anyone has sent me is this one by Matthew Baron and Wei Xiong. It uses a very long historical sample of many countries, starting in 1925. The result here is that very rapid increases in bank credit give a good indicator of recessions on the way. They use a nonlinear threshold model for this. Note that this is different from the Drehmann result, which is that levels of credit forecast recessions. Also note that like others, this paper doesn't include spreads or other credit quality measures.

So to sum up:

1. The Folk Theory might or might not be right.

2. The forecasting evidence is not at all clear. The causal evidence is even less clear, as usual in macro. There is some indication that debt levels can help predict recessions, or at least recession severity, but credit quality (sentiment) measures might capture this better than debt levels.

3. More complex interactions of debt and economic activity, such as debt deflation or debt overhangs from asset bubbles, might be good alternatives to the Folk Theory.