Markets and Trust

Liran Einav, Chiara Farronato, and Jonathan Levin write,

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

In The Book of Arnold, I write,

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

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

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

Ray Fair on Macroeconometrics

He writes,

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

Pointer from Mark Thoma.

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

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

Other remarks:

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

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

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

Double Liability for Bank Shareholders

Howard Bodenhorn writes,

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

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


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

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

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

International Trade and GDP

Tyler Cowen finds an FT story about data from the World Trade Monitor, which calculates that global trade contracted in the first half of 2015.

Global trade is a subset of world GDP. That is, world GDP is a measure of the value of all goods and services traded, whether across borders or not.

Let us assume that world GDP expanded in the first half of this year. What ought we to conclude?

One possibility is that cross-border trade and overall trade are not perfectly correlated, and this is a blip in the relationship. However, another possibility is that GDP is mis-measuring economic activity. The value of government purchases is not market determined. The same might be said for health care and education, in that third-party payments are important.

In other words, there are three components of world GDP: goods and services exchanged at market prices across borders; goods and services exchanged at market prices domestically; and goods and services exchanged at artificial prices. If the first component of world GDP has been contracting, then my guess would be that the second component is, also.

The Status of Models in Economics

Paul Romer says

Ultimately, the test of the model is its correspondence with the world. If we use certain frameworks, you can understand a much richer set of facts about the world. Growth is a difficult area to work because you’re addressing questions about the very long run, so you don’t have an abundance of data. You’re trying to invoke evidence from history over the very long run. We needed to come up with a way to think about all of these facts about the broad sweep of human history.

Math can be a very clear, concise, effective way to communicate ideas. What I saw in some of the people I was criticizing for mathiness was an almost obstinate adherence to positions, and then a use of any kind of mathematical argument that would support that position. What was missing was one of the characteristics of good science, which is to say “Well, given these new arguments, I may have been wrong before.”

Pointer from Mark Thoma.

Earlier, a reader’s comment brought me to Itzhak Gilboa’s review of a book by Mary Morgan.

Clearly, there are many instances in which economic analysis yields qualitative predictions, providing robust insights that allow us to predict trends, compare economic systems, and so forth. Yet, economics is not considered to be a successful science when quantitative predictions are concerned.

There is, however, another view of economics, by which it can have other successes: it is a field of enquiry whose goal is to critique reasoning about economic phenomena

This is an idea with chewing on. The purpose of a model, either theoretical or empirical, is not to provide a definitive “correspondence with the world,” as Romer would have it. Rather, it is to point out possibilities that deserve the attention of economists and those interested in economic policy.

A PSST Story for China

Tyler Cowen writes,

there is significant excess capacity on the real side of the economy. It will be very hard to fix this problem without letting significant numbers of SOEs go under. The central government fears the resulting unemployment, plus the SOEs are the Party’s power base. Yet the leaders know what must be done, and the SOEs have been reformed before. …One danger is that SOE reform leads to a loss of political stability. A second and more likely danger is that reform is incomplete and China ends up full of zombie companies and banks.

Market-oriented economies get rid of heavy accumulations of unsustainable patterns of specialization and trade through financial convulsions. For China, the process will have to be top down.

An interesting question is which sort of economy does better at putting the pieces back together. Offhand, I would say that China could get through a transition with less person-years of unemployment. However, the risk is that the new patterns of specialization and trade are no more sustainable than the ones that are discarded.

The WaPo and the Train Terror Incident

Yesterday, they put the story on page 7. They could not bear to move the story about the Cuban sustainable farmer off the front page to make room for it.

Today, they put it on the front page, with the headline “Train Suspect Known to be a Risk.” They focused their page one coverage on this aspect, and waited until the end of the story on the jump page to discuss the Americans and a Brit who overcame the terrorist.

I can only conclude that anything that smacks of Civilization vs. Barbarism is just too much for WaPo editors, or perhaps their readers, to bear.

Speaking of which, whether this “known risk” slipped through or not depends on the denominator. I mean, how many names are on this list of “terror risks”? Are we talking about 100, or are we talking about 10,000? If it’s 100, then, yes, the security forces should be able to keep tabs on them and not leave it up to unarmed heroes. On the other hand, if it’s 10,000, then the list has no tactical value, but it gives you an idea of what you are up against.

What I’m Reading

Why Him? Why Her? by Helen Fisher. A family member was reading this at the beach, and I picked it up. An attempt at personality psychology, sort of like the controversial Myers-Briggs with four main types. Think of her Explorer as an SP, her Builder as an SJ, her Director as an NT, and her Negotiator as an NF. Anyway, a couple of excerpts:

The Explorer-Explorer match does not appear to be a good strategy for raising children. Yet here, too, nature has a plan. Since Explorers are more likely to divorce and remarry, they are also more likely to bear children with more than one partner. In fact, it’s commonplace to encounter the man or woman who has married twice and had children with each spouse. I don’t recommend divorce and remarriage, but there’s genetic wisdom here…If ancestral Explorers produced more variety in their young, some of these children would survive hard times–passing on their DNA.

Recall that Robert Putnam talks about bifurcated family patterns. Perhaps a lot of Explorer-Explorer matches produce children out of wedlock.

Much later:

The Negotiator is far more idealistic. As a result, the Director can become annoyed by the Negotiator’s far-flung humanitarian concerns, while the Negotiator can begin to regard the Director’s more technological approach to fixing the world’s problems as narrow-minded and unfeeling.

The Negotiator sounds hard to argue with. To the Negotiator, economic logic just “feels” wrong.