When Economists Were Right, Allegedly

Richard Baldwin writes,

Barry Eichengreen added specificity to this in January 2009 with his insightful column “Was the euro a mistake?”, noting: “What started as the Subprime Crisis in 2007 and morphed in the Global Credit Crisis in 2008 has become the Euro Crisis in 2009. Sober people are now contemplating whether a Eurozone member such as Greece might default on its debt.” He wrote that the alternative to default was “fiscal retrenchment, wage reductions, and assistance from the EU and the IMF for the cash-strapped government.”

He predicted – again dead on – that “[t]here will be demonstrations against the fiscal cuts and wage reductions. Politicians will lose support and governments will fall. The EU will resist providing financial assistance for its more troublesome members. But, ultimately, everyone will swallow hard and proceed … In the end, the EU will overcome its bailout aversion.” The farsightedness is astounding. In January 2009, few knew the Greeks had a problem serious enough to require debt restructuring.

Pointer from Brad DeLong, via Mark Thoma.

That sounds impressive. He also cites other economists. But a couple of cautionary notes.

1. The best way to develop a reputation as far-sighted is to make many vague, conditional predictions. Later, you call attention to those that sound correct, and if necessary you wiggle out of those that sound incorrect by pointing out the conditions or taking advantage of their vagueness. I am not accusing Eichengreen of doing this. I have others in mind. But what might Baldwin have found had he had searched through past articles and looked for bad predictions?

2. How best to generalize this point? My guess is that “Economists’ predictions should always be taken as gospel”

3. Is the correct lesson that we should pay attention when economists warn about sovereign debt issues? Consider that many of us have issued warnings about the United States.

Capital Indivisibility as a Theory of the Firm

Cameron Murray writes,

If it was the division of labour that leads to increased productivity, labour could just as easily be divided between firms. The fact that pin factories, even with only ten men, still performed all 18 tasks, instead of specialising in just 10 tasks, is clear evidence that there is something special and coordinated about the tasks themselves that arise from the particular capital investments. The tools and machines are designed to be compatible with each other, and if part of the process is done outside the firm, each of the two firms would inevitably be tied to the same compatible capital equipment, and would therefore find gains by merging into a single firm.

Pointer from Mark Thoma.

According to Alchian and Demsetz, Murray’s first sentence is false. If the value of labor is in their combined product, rather than in each individual task, someone must manage the production process and allocate payments to individual workers. Remember, in an Alchian-Demsetz firm, marginal product is not defined.

I agree with Murray that if two firms have complementary capital then there is an incentive to merge, at least if one or both firms does not have a lot of other choices for partners in production. But what Murray sees as the gains from merging firms that use compatible capital equipment also would arise from merging firms whose workers who undertake complementary tasks in a production process.

The Computer as Economic Metaphor

Cesar Hidalgo says,

So countries with a lot of trust and good institutions can create very complex computers that are able to process large volumes of information and create complex products that are rare and have a big premium on the market. So by thinking of economies in terms of information and computation, you can also connect institutions with the mix of products that countries make and with wealth. A social network is nothing other than a distributed computer.

Pointer from Mark Thoma. Read the whole interview. Perhaps he is one of those fellows who sounds deep and profound but is not really saying anything.

But I think that there is some significance in the availability of the computer and the Internet as a metaphor. In 1960, machines were the most salient sources of metaphors, and so economists thought in mechanistic terms. As we start to expand our use of computers and networks as metaphors, I think this affects how we view the economy. In some sense, the emphasis on institutions and other components of what Nick Schulz and I call the “software” of the economy are insights that are more likely to occur to economists living in the computer age.

More Essential Hayek

Again, the book will be released next week.

Another point Boudreaux makes is that in a specialized economy, our production activities are much narrower than our consumption activities. This makes rent-seeking more prevalent on the production side.

This point is easily missed. For example, Stephen G. Cecchetti and Kermit L. Schoenholtz write about the mortgage interest deduction as if its political strength comes entirely from home owners. (Pointer from Mark Thoma.) In fact, I would argue that it is the NAR, NAHB, and the MBA that make it inviolable.

We know that food stamps are popular with the farm lobby. And perhaps Medicaid does not benefit recipients as much as it does providers of medical services.

Paul Romer Issues a Clarification

He writes,

I wrote that the economists I criticize for using mathiness are engaged in a campaign of ACADEMIC politics, not one of national politics. Whatever was true in the past, the now fight is over ACADEMIC group identity.

Pointer from Mark Thoma. Read the whole thing. My remarks:

1. As I wrote in my earlier comment on Romer, I see monopolistic competition as prevalent. Perhaps the Chicago school would want to argue that even though in practice we do not see perfect competition, if you make predictions assuming perfect competition, you will typically be correct. But I do not want to speak for Chicago.

2. Romer seems to want to march under the banner of “science” in economics, and I am skeptical of that. Reader Adam Gurri pointed me to an entire book of essays that take such a skeptical position. I am not sure that the essays speak to me, but I am still pondering.

3. In my view, as the economics profession has grown stronger in math, it has grown weaker in epistemology. That is, the generations of economists that came after Samuelson and Solow lost the ability to ask “How do we know that?” They are content to re-use equations simply because they can be found in prominent publications, but (as Noah Smith has pointed out) not because they have been verified empirically, as they would be in physics or another hard science.

There is a slight overlap between Romer’s critique and mine. Romer is saying that economists are choosing models in order to maintain “group cohesion.” I say that they are choosing models based on appeals to authority.

What I wish to claim is that epistemology in economics is really difficult. It is more difficult than in physics. We have a much harder time testing our theories experimentally. We face insurmountable levels of causal density. We do not have a neat, clean answer to the question “How do you know that?” It appears to me that physicists can answer that question in ways that are much more straightforward and compelling. (I am thinking of physics at a high school level. Maybe at the research frontier physics also faces epistemological challenges.)

Because epistemology in economics is really difficult, I think that if you care about epistemology, you are going to find much published research in economics frustrating. That will be true for articles that avoid math as well for articles that use math.

Mathiness, Starting in 1937

Noah Smith writes,

Macroeconomic theory is chock full of mathiness. It’s not just Lucas and Prescott, it’s the whole scientific culture of the field.

I think you find this going all the way back to John Hicks’ famous 1937 paper, “Mr. Keynes and the Classics.”

The “i” in this model could be a short-term interest rate, or it could be a long-term interest rate. It could be a risk-free rate, or it could be a risky rate. It could be a nominal rate, or it could be a real rate.

And, as Smith points out once again, none of the equations in the IS-LM model, or any other mathematical macro model, has any demonstrated empirical validity. The equations are, at best, a way of organizing and expressing the economist’s opinions about macro.

My own opinion, as you know, is that thinking about the economy as if it were a single business (or as a single consumer who also runs a single business) is wrong-footed from the very start. Instead, I believe that it is in the shifting kaleidoscope of patterns of specialization and trade among multitudes of businesses that employment fluctuations take place.

It is fascinating to me that there are critics who will not buy the PSST story until they see it expressed using math. To me, that is as beside the point as arguing that it has no validity unless it can be told in Latin or Swahili or Yiddish.

Bernanke vs. Warren-Vitter

He writes,

The problem is what economists call the stigma of borrowing from the central bank. Imagine a financial institution that is facing a run but has good assets usable as collateral for a central bank loan. If all goes well, it will borrow, replacing the funding lost to the run; when the panic subsides, it can repay. However, if the financial institution believes that its borrowing from the central bank will become publicly known, it will be concerned about the inferences that its private-sector counterparties will draw. It may worry, for example, that its providers of funding will conclude that the firm is in danger of failing, and, consequently, that they will pull their funding even more quickly. Then borrowing from the central bank will be self-defeating, and firms facing runs will do all they can to avoid it. This is the stigma problem, and it affects everyone, not just the potential borrower. If financial institutions and other market participants are unwilling to borrow from the central bank, then the central bank will be unable to put into the system the liquidity necessary to stop the panic. Instead of borrowing, financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets for what they can get, forcing down asset prices and putting financial pressure on other firms. The whole economy will feel the effects, not just the financial sector.

Pointer from Mark Thoma.

In effect, Bernanke is saying that you have to make firms that get into trouble want to be bailed out. If you make bailouts too painful for them, then “financial firms will hoard cash, cut back credit, refuse to make markets, and dump assets.”

I am not impressed by his reasoning. What he calls “stigma” is not a bug of the Bagehot principle. It is a feature.

Paul Romer’s Case for Ad Hominem

He writes,

The only way I can see to protect scientific discourse is to limit entry into the discussions of science. But this MUST NOT BE DONE on the basis of beliefs about what is true. It must instead be based on a demonstrated commitment to the norms of science. As part of this process of defending science, exclusion by shunning, plays an essential role. People who show, by publishing even one Willie Horton paper, that they are not committed to those norms, have to be excluded. So too must the people who promote and encourage Willie Horton papers. In science, “It was my PAC, not me” should not be an acceptable defense.

Pointer from Mark Thoma.

Later, he criticizes positions taken by Milton Friedman and George Stigler against the idea of monopolistic competition. On the narrow issue of whether economists should use the model of monopolistic competition, I am entirely on Romer’s side. I tell my AP econ students that we spend most of our time on the nearly-irrelevant models of perfect competition and monopoly, when in the real world we almost always find monopolistic competition or oligopoly.

But I do not agree with Romer’s larger point. What would it mean to shun Milton Friedman because in Romer’s judgement Friedman’s opposition to the theory of monopolistic competition was politically motivated? Would we discard the permanent income hypothesis, the Friedman-Savage utility function, and the Monetary History of the United States?

As I understand Romer, he is arguing that the scientific norms in economics are so delicate that we must shun economists who fail to maintain certain standards. I look at it differently.

I believe that politics pervades the economics profession. Paul Samuelson’s textbook was a political document, and his claim to scientific neutrality was an exercise in (self-) deception. There is no economist so pure as to be free of bias.

It is not desirable to throw out the ideas of biased economists (indeed, if I am correct, that would mean throwing out all ideas in economics). Instead, the ideas ought to be debated as ideas, without regard to who proposed them. If you think that monopolistic competition matters in growth theory, then you should be able to make that case. You can do very well by pointing out the flaws in other people’s work. But attacking their motives adds nothing to the discussion. To say otherwise is to suggest that all economic discourse should consist of asymmetric insight (claiming to understand your opponents better than they understand themselves). Is that really what Paul Romer wants–to turn economics journals into Paul Krugman columns? If so, then Romer should be shunned.

On Macro and Methods

This may or may not relate to the issue of “mathiness” raised by Paul Romer, recently cited by by Joshua Gans and by Mark Thoma. It is from an essay I am working on:

Keynesianism treats the economy as a single business producing one output, called GDP. This modeling strategy focuses all attention on the problem of choosing how much to produce. It assumes away the problem of choosing among outputs or the problem of choosing from among many possible production methods or supply-chain configurations.

This single output, GDP, is produced by a single technique, called the aggregate production function. Thus, the Keynesian modeling strategy ignores the existence of multiple alternative patterns of specialization. Keynesians act as if there were exactly one pattern of specialization in the economy. There is no need to choose among alternative patterns, to discard outmoded patterns, or to discover new patterns.

In the Keynesian framework, jobs are only lost when there is a drop in demand. In the PSST framework, and in the real world, jobs are constantly being destroyed, for a variety of reasons.

Economic progress consists of re-arranging production of output to be more efficient. It is an always-ongoing process that necessarily destroys jobs. A new consumer product makes other products obsolete, or at least less desirable. A new invention or managerial innovation makes it possible to produce the same output with fewer workers. A new configuration of trade uses labor more efficiently…

In the Keynesian story, all unemployment looks like the temporary layoffs that used to occur in automobiles and steel when firms accumulated excess inventories. Once inventory balance was restored, workers were recalled to the same jobs.

In the PSST story, all unemployment looks like structural unemployment. That is, workers who lose jobs will not find that those jobs return in several months, or ever. Instead, displaced workers will have to be employed by different firms, often in different industries.

In the Keynesian story, the process of economic adjustment to a shock consists of arriving at the correct relationships between the money supply and the aggregate price level and between the price level and the aggregate wage. In the PSST story, the process of economic adjustment to a shock requires entrepreneurs to discover new arrangements of tasks that add sufficient value to generate sustainable profits. As with all entrepreneurial effort, this is a trial-and-error process. Some new businesses will fail, generating no sustainable employment. Only a few will be so successful that they create large numbers of new jobs. Sorting out this process will take time.

From the perspective of someone who finds that the PSST story fits well with economic thinking, the Keynesian modeling strategy seems contrived and misguided. By aggregating the economy into a single business, Keynesianism necessarily shoves the phenomenon of structural adjustment and the ferment of entrepreneurial trial and error into the background. Keynesians regard this as a useful simplification. Instead, Keynesianism is more like Hamlet without the Prince.

On Hypocrisy

Robert Trivers writes,

Recently something brand new has emerged about Steve that is astonishing. In his own empirical work attacking others for biased data analysis in the service of political ideology—it is he who is guilty of the same bias in service of political ideology. What is worse—and more shocking—is that Steve’s errors are very extensive and the bias very serious. A careful reanalysis of one case shows that his target is unblemished while his own attack is biased in all the ways Gould attributes to his victim.

Pointer from Jason Collins.

Paul Krugman writes,

what you should really look for, in a world that keeps throwing nasty surprises at us, is intellectual integrity: the willingness to face facts even if they’re at odds with one’s preconceptions, the willingness to admit mistakes and change course.

Pointer from Mark Thoma.

Is it a rule of thumb that if you accuse other people of committing an intellectual sin, then you yourself are committing it?