Monthly Archives: October 2016

The Man Who Networked

Posted on by

I just finished Sebastian Mallaby’s The Man Who Knew, his new biography of Alan Greenspan. A few thoughts:

1. It is masterfully written. I have already recommended it to friends who are not economists. I cannot praise highly enough the book’s organization, prose, and editing. Mallaby is a gifted storyteller.

2. One central theme is Greenspan as a brilliant thinker who overcame shyness to ascend to the apex of the Washington social and political ladder. However, I finished the book wondering if the story could be told the other way around: Greenspan as a savvy social networker who exploited his connections to create the illusion that he was a brilliant thinker. As you read the book, keep my interpretation in mind and see how it does or does not fit.

Note that Greenspan’s primary occupation was that of a Wall Street economic soothsayer, a game not known for being rich in intellectual competition. Moreover, as of 1987 Greenspan was not even in the top tier of those (above him would have been Ed Yardeni, Henry Kaufman, and Steve Roach, just off the top of my head).

3. Another central theme concerns the issue of whether Greenspan was a libertarian or a compromiser. Again, I think this may be the wrong framing. I get the sense that he navigated issues piecemeal rather than by following an intellectual framework. If Greenspan often strayed from Ayn Rand’s philosophy, that may have been because his mind was just not given to systematic thinking of any sort.

The Top-Down Reformer’s Calculation Problem

Posted on by

Two recent examples.

1. I was invited to attend the Progressive Policy Institute on Wednesday, but not as a speaker. The topic is introduced by saying

Now that Congress has passed the Every Student Succeeds Act (ESSA), states are revamping their federally required systems to measure school quality and hold schools accountable for performance. But most are doing so using outdated assumptions, holdovers from the Industrial Era, when cookie-cutter public schools followed orders from central headquarters and students were assigned to the closest school.

In today’s world, that is no longer the norm. We are migrating toward systems made up of diverse, fairly autonomous schools of choice, some of them operated by independent organizations, as charter, contract, or innovation schools. Before revising their measurement and accountability systems, states need to rethink their assumptions.

2. And David Cutler must be happy to read this story.

Medicare on Friday unveiled a far-reaching overhaul of how it pays doctors and other clinicians. Compensation for medical professionals will start taking into account the quality of service – not just quantity.

A Nobel Prize in economics was just awarded in part for the insight that it is a bad idea to compensate workers on factors that are heavily influenced by luck. In my view, having someone in Washington evaluate a school or a teacher or a doctor does exactly that.

People who are close to the schooling process, including parents, peers, and principals, can use judgment to evaluate teachers. That’s the way it used to work 50 years ago, before the advent of consolidated, unionized school districts.

For doctors, the prevalence of third-party payments means that their compensation is being determined by remote bureaucrats regardless.

Factor-price Non-equalization?

Posted on by

A commenter wrote,

Given this definition of ‘discipline’, under what condition do you stop believing your intuition? What would you observe that would cause you to drop your belief in price-factor equalization, or, assortative mating?

Coincidentally, Josh Zumbrun writes,

Why would a company pay someone $80,000 if most people with an identical background—clones, in the paper’s parlance—earn $40,000? Conversely, why would someone with that background stay in the job earning $40,000 if another company will pay $80,000 for the same work?

The puzzle is that worker pay increases are highly correlated with the rate at which profit increases at the firms that they work.

My thoughts:

1. I tend to distrust the ability of economists to know more than a firm what the firm’s workers ought to be paid. Imagine an economist trying to tell Google that, based on your regression equation, it is paying its programmers more than the market wage. Google might reply that its programmers earn more because Google has selected better programmers.

2. The article offers the theory that firms with monopoly power will pay workers more. Perhaps, but a monopolist still has an incentive to avoid paying an above-market wage to its workers. In any case, if Google pays more because it has monopoly power, how pervasive is this? Do they pay above-market wages to janitorial staff? Above-market prices for office supplies? When Google employees travel, does Google pay more than the asking prices for hotel rooms and airline tickets?

3. Suppose that we grant that two workers who appear to be identical to someone running a regression equation are in fact identical in practice. It could be that each worker made a long-term commitment to a firm, and one chose a firm that happened to succeed and the other chose a firm that happened to fail. That might lead to factor-price non-equalization.

As you can see, I am very reluctant to let go of factor-price equalization. But if more evidence against it accumulates, I will be willing to change my mind.

However, in Specialization and Trade, I make the point at length that economic propositions are not falsifiable. If you want to stay committed to a proposition, you can. I say that economics deals with very few falsifiable hypotheses and many non-falsifiable frameworks of interpretation.

I can tell from the comments on previous posts that my position bothers some people enormously. They strongly oppose the situation as I describe it. Perhaps it will help to say that I have nothing against rigorous falsifiability in science, I just do not think it can be carried out in economics.

I hope you can appreciate that this is the situation with history. I doubt that we will ever be able to prove that wars are caused by X or that revolutions are caused by Y. Still, there are useful interpretive frameworks that tell us something about these issues.

I believe that all of the disciplines that deal with human society are going to have to live with this. If someone is really attached to their interpretive framework, it will be difficult or impossible to dissuade them. The best that one can hope is that people will not be so unreasonable as to assign 100 percent credibility to any information that supports their view and 0 percent credibility to any information that opposes it.

I think that we naturally try to fight back when one of our views is threatened, as mine are by the research cited above. The ideal would be for us to fight back when a study supports our views and be more accepting of studies that threaten our view, but it is difficult to live up to that ideal.

I’m Now in Cass Sunstein’s Corner

Posted on by

He writes,

If you think that Barack Obama has been a terrific president (as I do) and that Hillary Clinton would be an excellent successor (as I also do), then you might want to consider the following books, to help you to understand why so many of your fellow citizens disagree with you

I could pick a nit and say that these books only explain why a few fellow citizens disagree with the left. But they are a good selection of conservative intellectual thought. I give Sunstein a lot of credit for reading them and recommending them.

One of my biggest worries is intellectual and moral arrogance among policy makers. I think that this contributed to such disasters as Vietnam, Syria, and the housing and regulatory policies that contributed to the financial crisis.

I think that left-leaning lawyers can be particularly arrogant, and I worry about who Mrs. Clinton will appoint to the Supreme Court. If she were to appoint Sunstein, I would now be less worried. I was not such a big fan of Sunstein’s before, but the linked essay fulfills the motto of this blog.

So, let me attempt a similar exercise. What are some books that I would recommend to people who tend to agree with me about things in order to open your minds to other reasonable points of view?

1. In the area of education, I am a proponent of the Null Hypothesis (interventions do not make reliable, replicable, long-term differences). Two books that make a good case otherwise are Goldin and Katz, The Race Between Education and Technology and Elizabeth Green, Building a Better Teacher.

2. People who tend to agree with me on things often like the model of humans as rationally pursuing their interests. Daniel Kahneman’s Thinking Fast and Slow is a must-read for understanding the contrary point of view. You are bound to object to parts of it, but there is much valuable insight in this book.

3. People who tend to agree with me on things often like to emphasize what incentives can explain. However, Joseph Henrich’s The Secret of Our Success is a good reminder that there are other social norms in the background that are important. Another book on the importance of culture is Peter Turchin’s War, Peace, and War.

4. As you know, I am no fan of Keynesian economics or of macroeconomics in general. But I can recommend L. Randall Wray’s Why Minsky Matters and George Akerlof and Robert Shiller, Animal Spirits (although I detested their subsequent book). Scott Sumner’s history of the Great Depression, The Midas Paradox [link fixed], is a tour de force.

5. In Our Kids, Robert Putnam coined the phrase “bifurcated family patterns.” Isabel Sawhill’s Generation Unbound looks at the same phenomenon. Both authors are left of center, so many of you will not find their books congenial, but you can still appreciate the data and the observations.

Cosmopolitan Axis Update

Posted on by

Andrew McGill writes,

40 percent of Donald Trump’s likely voters live in the community where they spent their youth, compared with just 29 percent of Hillary Clinton voters. And of the 71 percent of Clinton voters who have left their hometowns, most—almost 60 percent of that group—now live more than two hours away.

I suspect that the cosmopolitan vs. anti-cosmopolitan axis is quite important. It might be interesting to create an index of cosmopolitanism that is based solely on a person’s location history: how much geographic variation in where they have lived and where they have vacationed. My guess is that such an index would be quite predictive of some sorts of political views and even perhaps economic success.

Nature Rebounds

Posted on by

From the WaPo, an article on the findings of Richard Fuchs.

Fuchs’ fascinating conclusion: Forests and settlements grew at the same time and Europe is a much greener continent today than it was 100 years ago. A closer look at different regions and countries reveals Europe’s recovery from the deforestation of past centuries.

In Specialization and Trade, I cite Jesse Ausubel’s Nature Rebounds on this and other phenomena showing that resource scarcity is a problem addressed by markets.

Why Do Firms Exist?

Posted on by

Kevin Bryan writes,

A perfect theory of the firm would need to be able to explain why firms are the size they are, why they own what they do, why they are organized as they are, why they persist over time, and why interfirm incentives look the way they do. It almost certainly would need its mechanisms to work if we assumed all agents were highly, or perfectly, rational. Since patterns of asset ownership are fundamental, it needs to go well beyond the type of hand-waving that makes up many “resource” type theories. (Firms exist because they create a corporate culture! Firms exist because some firms just are better at doing X and can’t be replicated! These are outcomes, not explanations.) I believe that there are reasons why the costs of maintaining relationships – transaction costs – endogenously differ within and outside firms, and that Hart is correct is focusing our attention on how asset ownership and decision making authority affects incentives to invest, but these theories even in their most endogenous form cannot do everything we wanted a theory of the firm to accomplish. I think that somehow reputation – and hence relational contracts – must play a fundamental role, and that the nexus of conflicting incentives among agents within an organization, as described by Holmstrom, must as well. But we still lack the precise insight to clear up this muddle, and give us a straightforward explanation for why we seem to need “little Communist bureaucracies” to assist our otherwise decentralized and almost magical market system.

Read the whole post. Pointer from Tyler Cowen.

I still think that Alchian-Demsetz is the best place to start. Suppose that a bunch of computer programmers, loan officers, and bank tellers get together to start a bank. They cannot just bargain with one another on roles, responsibilities, and pay. You need a decision-maker. And that decision maker must serve a definitive owner. The owner is the “residual claimant” on the firm.

I think that this is similar to why we certain key components of infrastructure are centralized. Road systems, sanitation systems, communication wiring, and the electric grid, for example. Imagine a bunch of households get together and say, “Let’s have a road system.” They cannot just each decide to build roads in the vicinity of their homes and then bargain with one another on roles, responsibilities, and tolls to charge drivers. You need a decision-maker. etc.

I think that we know intuitively why firms exist. The challenge is to articulate that intuition.

Ed Glaeser on Science and Economics

Posted on by

He writes,

Science is ultimately about method, not the degree of certainty. Economics is a science whenever economists use the scientific method, which I understand to mean Karl Popper’s process of starting with particular facts, producing refutable hypotheses and then seeing whether the data reject those hypotheses. Yet the public unfortunately takes the word science to mean “certitude,” and economists (including myself) have too often been guilty of wrapping ourselves in our scientific mantles to make ideological pronouncements seem more compelling. Messrs. Offer and Söderberg suggest that “policy requires more humility” and that economists should face “some downgrading of authority, but not all the way.” I agree with the need for humility but would point out that politicians, pundits and ideologues of all stripes regularly make statements with far less factual basis than most economists.

I think that the public has a sort of binary classification. If it’s “science,” then an expert knows more than the average Joe. If it’s not a science, then anyone’s opinion is as good as anyone else’s. I strongly favor an in-between category, called a discipline. Think of economics as a discipline, where it is possible for avid students to know more than ordinary individuals, but without the full use of the scientific method.

Insight, Proof, and Knowledge

Posted on by

A commenter writes,

So in your opinion intuition is sufficient. As long as we can tell an intuitive story about something, that is as good as proving it?

I think that “proof” is too high a standard to use in economics. If our knowledge is limited to what we can prove, then we do not know anything. I think that we have frameworks of interpretation which give us insights. This is knowledge, even if it is not as definitive or reliable as knowledge in physics or chemistry.

As an example, take factor-price equalization. The insight is that the easier it is to trade across countries, the more that factor prices will tend to converge. I think that this is an important insight. It is one of what I call the Four Forces driving social and economic trends in recent decades. (The other three are assortative mating, the shift away from manufacturing toward health care and education, and the Internet.)

Paul Samuelson proved a “factor-price equalization theorem” for a special case of two factors, two goods and two countries. However, it is very difficult, if not impossible, to extend that theorem to make it realistic, including the fact that not all industries are subject to diminishing returns. In my view, Samuelson’s theorem per se offers no insight, because it is so narrow in scope. The unprovable broader insight is what is useful.

Incidentally, I also think that factor-price equalization is hard to prove statistically. Too many other things are happening at once to be able to say definitively that factor-price equalization is having an effect, say, on unskilled workers’ wages in the U.S. and China. I believe that it is having an effect, and there are studies that support my view, but it is not provable.

In order to prove something mathematically, you have to make narrow assumptions. In physics or engineering, this often works out well. When you roll a ball down an inclined plane, ignoring friction causes only a small error in the calculation.

In economics, the factors that you leave out in order to build a mathematical model tend to be more important. As a result, the requirement to express ideas in the form of mathematical models is harmful in two ways. We waste time proving false theorems and we miss out on useful insights.

The narrow assumptions lead you to prove something which is false in the real world.. For example, the central insight of the “market for lemons” proof is that a used car market cannot work. However, once we expand the assumptions to allow for warranties, dealer reputations, mechanics’ inspections, and so on, the original theorem does not hold.

Meanwhile, there are insights that are missed because they cannot be represented in an elegant mathematical way. A lot of the insights that I offer in Specialization and Trade fall in that category.

Our goal should be to acquire knowledge. The demand for proof hurts rather than helps with that process.

Two Pointed Questions Posed as Tweets

Posted on by

1. From Josh Hendrickson:

I don’t get it. Everyone has a model; whether they use math/graphs/words. Why are only models w/math denigrated?

Other things equal, it is harder to understand what is going on in a math presentation. Other things equal, insisting on math restricts the sort of assumptions you can work with to those that you find tractable.

That would suggest that verbal arguments dominate mathematical arguments. I am not going to insist that this is always the case, but I think it does create a presumption in favor of verbal arguments. Yes verbal arguments can be vague. But a lot of hand-waving goes on in mathematical papers as well.

So the way I would put it is that today there is a strong presumption in favor of expressing models (or, to use my preferred term, interpretive frameworks) in mathematical terms. I would like to see the presumption go the other way.

Pete Boettke has an essay/post that is pertinent and aligns with my views. Strongly recommended.

2. From someone with the Twitter handle “representative agent’:

I’m thinking about PSST as a business cycle theory. what are its most distinctive implications?

One important implication is that unemployed workers will not be hired back into the same jobs they had before. I believe that in the 1950s, there were recessions that were primarily inventory corrections, so that after you went through a couple of quarters with automobile manufacturers and their suppliers laying off workers, those workers got recalled. Those examples run counter to PSST.

A related implication is that just “boosting demand” in general will not do much to deal with unemployment. The adjustments that are needed are specific to workers located in specific parts of geographic/industry/skill space. It predicts that just throwing money at, say, the green energy industry, will not necessarily increase employment.

Another implication is that shocks to sectors that are closely connected to other sectors (as might be shown by a network graph) will have more effects than shocks to sectors that are more isolated. That may explain why the crash of the dotcom bubble did very little, but shocks to the energy sector in the 1970s and to the banking sector at other times have had severe impacts.