Two Thoughts on Douglass North

1. Deirdre McCloskey treated him as an adversary.

2. I cannot think of any other Nobel Laureate who produced anything as significant after winning the Nobel Prize as Violence and Social Orders (My most recent essay about that book is here, and more links to my use of his framework can be Googled), or even come close.

Tyler Cowen has more.

Is Larry Summers Getting Ready to Ditch Secular Stagnation?

He starts with the puzzle that employment and measured productivity growth have both been weak. If we are replacing less-skilled workers with machines and more-skilled workers, then why isn’t labor productivity going up?

This leads Summers to suggest that labor productivity is going up, but this is not being captured in the productivity statistics.

I am struck that there is likely what may well be an increase in unmeasured quality improvement. To take the first example that comes to mind and I’ll do an experiment with this group. I’ve done this experiment with other groups – which would you rather have for you and your family, 1980 healthcare at 1980 prices or 2015 healthcare at 2015 prices? How many people would prefer 1980 healthcare at 1980 prices? How many people would prefer 2015 healthcare at 2015 prices?

There are a fair number of abstainers but your answer was pretty clear. What does that mean? That means that healthcare inflation was negative from 1980. That is very different than the 6% or so that is reflected in the
national income accounts.

Again, thanks to Mark Thoma and Tyler Cowen for pointers.

My thoughts:

1. Since people do not face health care costs directly (with their own money), perhaps this is not a fair question.

2. What about Hansonian medicine?

3. And yet, I agree with Summers on this. I certainly would prefer today’s health care at today’s prices. One of the first points I made in Crisis of Abundance is that we could afford to give everyone in the U.S. the health care of 1970. The main reason we are spending more on health care today is that it is more capital intensive and more specialist intensive. (Incidentally, I predicted when Crisis of Abundance was published in 2006 that its relevance would last a decade. I am now confident that it will be relevant even longer.)

4. Ask Summers’ question about higher education. Would you prefer a 1980 college education at 1980 tuition or 2015 college education at 2015 tuition? Personally, I see no reason to choose the latter.

In some sense, it does not matter whether Summers’ point is valid. Productivity has been been going up quite well in manufacturing and in some other sectors (e.g., Walmart). However, labor is shifting to the New Commanding Heights sectors. Maybe productivity is rising in those sectors and inflation is over-stated, or maybe they suffer from Baumol’s cost disease and there is no overstatement of inflation. Either way, once we ditch the GDP factory and disaggregate the economy, the productivity puzzle goes away.

Summers points out that if you take the view that inflation is lower than what is measured, then real interest rates are higher than typically measured. This is not good for his previous views on secular stagnation, as he points out:

to be fair [it]has an implication for views that I and others have expressed about secular stagnation, at one level you can say, well real interest rates really aren’t that low once you subtract inflation. Once you subtract properly measured inflation, there has been less of a decline in real interest rates than we thought.

And what if we think about a disaggregated economy, with deflation in some sectors and inflation in others? Does it even make sense to talk about “the” real interest rate? Obviously for a business, it is the rate of price change in your sector that matters. For a household, you care about some average rate of price change, but which average? My girls are done with schooling, so do I care about college tuition changes? Does it matter to me whether health care inflation is overstated or not, given that my only option is to purchase health insurance at current prices?

“Secular stagnation” is anachronistic, AS-AD, GDP-factory thinking. We are in a specialized economy. Eventually, otehr economists are going to come around to PSST.

Is Larry Summers Getting Ready to Ditch AS-AD?

Both Tyler Cowen and Mark Thoma point to a discussion by Larry Summers.

I want to argue that the traditional oppositional pairing of supply side secular stagnation and demand side secular stagnation is more of a confusion, than a truth.

His current approach involves thinking about interactions between aggregate supply and aggregate demand. I hope the next stage in his thinking, and that of other macroeconomists, is to ditch AS-AD altogether. Don’t think of the economy as a GDP factory!

Instead, think in terms of a specialized economy. It is affected by secular trends, such as labor force participation increasing for women and decreasing for men from 1970-2000. It is affected by adjustment problems, such as the oil shock of the 1970s or the house-price and mortgage debt crash of 2008.

My Macro Framework

Scott Sumner and Tyler Cowen have given you theirs. Here is mine.

1. Ditch the concepts of aggregate supply and aggregate demand. Thinking of the economy as if it were a single business, what I call the GDP factory, is misleading. Also, there are two versions of aggregate supply, and no one can keep them straight. Version I treats the GDP factory as operating in a world without prices, or with fixed prices. Version II treats the GDP factory as operating with a sticky nominal wage, so that the profitability of output increases with price.

2. Instead, think of all recessions as adjustment problems. We are in a specialized economy, and at any point in time some people are employed in ways that do not earn a profit. These jobs are unsustainable, and the workers will be let go. Sometimes, the dislocation is temporary, and they can go back to their old jobs. But often the dislocation is permanent.

3. Arriving at sustainable patterns of specialization and trade requires two types of adjustment: static adjustment and dynamic adjustment.

4. Static adjustment means solving for the price vector that clears all markets. What I called Version II is an example of a static adjustment problem–getting “the” real wage to adjust the right level. This problem might exist, but I think it is at most one of many adjustment problems.

5. Dynamic adjustment means entrepreneurial trial-and-error to come up with businesses that employ otherwise-idle workers at a profit. Mathematical models are mostly focused on static adjustment problems, but I think primarily in terms of dynamic adjustment problems.

6. Adjustment is how we get out of a mess. How do we get into messes? To some extent, each unhappy economy is unhappy in its own way. But some elements that one tends to find include Minsky-Kindleberger manias and crashes, sudden changes in credit conditions, sharp movements in important relative prices (oil, home prices), and permanent shifts in the skill structure of work.

7. Kindleberger has a useful concept, which he calls “displacement,” which causes a large shift in wealth. For example, after a war, the winning side can feel wealthier. A bundle of technological innovations or new trading opportunities can have the same effect. The sense of increased wealth that arises from displacement can evolve into a mania. A decade after the end of the first World War, the U.S. experienced a mania. A decade after the end of the Cold War, the U.S. experienced first an Internet mania and then a housing mania.

8. Manias can create unsustainable patterns of specialization and trade and postpone the adjustment to deeper structural change. The mania of the 1920s helped to temporarily disguise the impact of the adjustment to the tractor, the truck, and the electric motor. Many jobs involving manual labor in factories and farms were becoming unsustainable. Ultimately, many of the new jobs were in wholesale and retail trade, but these jobs typically required a high school education. An important part of the adjustment process was that by 1950 a generation of poorly-educated workers had aged out of the labor force. Meanwhile, the U.S. experienced the Great Depression of the 1930s.

9. Similarly, the housing mania of the early 2000s helped to temporarily disguise the impact of the adjustment to the changes brought about by the Internet and globalization. Once again, the composition of the work force appears to be undergoing a shift, as signified by the low rate of labor force participation.

Houses and Land

Kevin Erdmann writes,

The real long term natural rate right now is about 2.5%. If you have tons of cash or you can run the gauntlet and get a mortgage, or if you are an institituional investor going through the difficult organizational process of buying up billions of dollars of rental homes, you get the preferred rate of 4% real returns.

Pointer from Tyler Cowen. Erdmann thinks that we have not built enough houses, so rents will be rising, so owning rental property is a great investment. My comments:

1. I would have thought so, too. I put a lot of money in REITs. It has not done well. I also invested a lot of money in firms that own/manage a lot of apartments. It did not do well. Maybe all that says is that I played in a segment of the market that is efficient, when the point is to try to exploit the inefficient segment.

2. If I understand his thinking, there are not enough buyers to bid house prices to their fair market value. So you can own an apartment building at a high rent/price ratio. But it seems to me that, at least in some markets, the price/rent ratio has gone up rather than down in the past few years.

3. I am not sure that I trust my intuition about housing markets. My friends and relatives tend to be located in Blue cities where regulation restricts supply. I do not have a good feel for less-regulated markets.

Saving and Investment with Rapid Depreciation

Tyler Cowen writes,

it seems to me highly premature to assume we know what is going on with short-term negative real rates

Let me try to tell the disinflation story again. Suppose that most capital goods these days have computing devices built into them. Consequently, there is rapid improvement in capital. This in turn means that:

1. Today’s capital goods are much more productive then yesterday’s.

2. The real price of capital goods is falling over time.

3. Depreciation of existing capital goods is rapid. What you buy today is obsolete in a few years.

I teach students a basic formula for the profitability of buying a durable good:

profitability = rental rate + appreciation – interest cost

Suppose that the rental rate on new capital is very high. That is, it is very productive. However, the appreciation rate is very negative. You may need a negative interest rate to convince you that it is profitable to obtain capital.

What else would be true if this were the story? Assets that do not depreciate would be very attractive. So if you believe that real estate does not depreciate, you want to invest in it. If you believe that corporate “brand value” does not depreciate it, you want to buy shares in firms that have a lot of brand value.

More needs to be worked out.

Solution Disconnected from Problem

From a WSJ profile of Raj Chetty.

High-mobility metro areas have a combination of greater economic and racial integration, better schools and a smaller fraction of single-parent families than lower-mobility areas. Integration is lagging in Atlanta, he said. “The strongest predictors of upward mobility are measures of family structure,” Mr. Chetty said.

His proposal: move poor children to high-mobility communities and remove the impediments to mobility in poor-performing neighborhoods. He now is working with the Obama administration on ways to encourage landlords in higher-opportunity neighborhoods to take in poor families by paying landlords more or guaranteeing rent payment.

Pointer from Tyler Cowen.

The problem is family structure. The solution is engineering the spatial/income distribution of households. The connection is not there for me.

And if the problem is a need to improve teacher quality, then the solution is not for economists to run regressions on test scores. The solution is to put the power in the hands of people who care about quality and are close to the situation (i.e., parents), not in the hands of teachers’ unions.

Heterogeneity of Firms and Workers, Scarcity of Management Talent

Jason Furman and Peter Orszag write,

Longstanding evidence (e.g. Krueger and Summers 1988) has documented substantial inter-industry differentials in pay—a mid-level analyst may have the same marginal product wherever he or she works but is paid more at a high-return company than at a low-return company. Newer evidence (Barth et al. 2014 and Song et al. 2015) suggests that much of the rise in earnings inequality represents the increased dispersion of earnings between firms rather than within firms. This is consistent with the combination of a rising dispersion of returns at the firm level and the inter-industry pay differential model, as well as with the notion that firms are wage setters rather than wage takers in a less-than-perfectly-competitive marketplace.

Pointer from Tyler Cowen.

I bristle at the phrase “same marginal product.” Modern workers are not widget-makers, and their value inside an organization is not visible to people outside the organization. Indeed, even within the organization, the value contributed by individual workers cannot be calculated with any precision.

I know someone, call him A, who works in information technology at a firm in a buggy-whip industry. One of his friends, call him B, just took a job at Google. Assume, probably correctly, that the difference between their two compensation packages is a lot wider than the difference in their skills. Some possibilities:

1. This is a disequilibrium situation. Information technology workers currently produce more value at Google than in the buggy-whip industry. In equilibrium, A will move out of the buggy-whip industry and go to work for Google.

2. This is an “efficiency-wage” equilibrium, in which Google pays B slightly more than B’s opportunity cost. This enables Google to be highly selective in who it hires and also to give B an incentive to provide top performance.

I am inclined toward (2). But in either case, the value of B’s work is high relative to B’s wage, which raises the question of why Google does not hire more engineers. Perhaps the value of the next engineer would be lower, because of management limitations at Google.

I think that the key factor here is that the collective management talent assembled at Google is scarce. It generates more value that the collective management talent at the firm in the buggy-whip industry.

What I am suggesting is that the value of a firm depends a great deal on collective management talent. This includes the skills of individual key executives as well as the team chemistry among them.

One of the challenges of maintaining a high-functioning management team is that the “tournament” to get to the top can become corrupt. That is, managers can start to get ahead by undermining other managers rather than by exercising better judgment. As this sort of corruption becomes widespread, a firm can rapidly deteriorate. For me, this is one of the most interesting phenomena in the sociology of organizations.

Market Denialism

Jayson Lusk and Pierre Desrochers write,

In a recent paper, Andrew Zumkehr and Elliott Campbell (2015; Front Ecol Environ 13[5]: 244–248) present a simulation study that assesses the technological feasibility of providing enough local calories to feed every American. In so doing, they suggest turning back the clock on one of Homo sapiens sapiens’ greatest evolutionary achievements: the ability to trade physical goods over increasingly longer distances, producing an attending ever-widening division of labor (Horan et al. 2005). The main benefit of this process is that one hundred people who specialize and engage in trade end up producing and consuming far more than one hundred times what any one individual would achieve on his or her own. By spontaneously relocating food production to regions with higher biotic potential for specific types of crops and livestock in order to optimize the overall use of resources, trade and the division of labor have delivered more output at lower costs.

Pointer from Mark Thoma.

I am stunned by the casual way in which environmentalists dismiss the information that markets provide concerning costs. They instead substitute their own cost estimates.

Some further thoughts:

1. If you really have a better estimate of costs than the market, then there should be profit opportunity. In the case of locavorism, you should be able to offer local food for lower prices. Do any locavorists stop to wonder why food that comes from far away cost less? Do they suppose it is some perverse conspiracy on the part of “big food” to subsidize the transportation industry (or perhaps the other way around)?

2. Consider recycling. At a local elementary school, I saw the winning poster in a county contest to promote recycling. The poster pictured a barren, brown earth, and said that this is what would happen if we did not recycle. And yet, economically, government-forced recycling is unsustainable, and it probably results in a net cost to environmental desiderata. (I wonder if people on the left would be so attached to government-run schools if the propaganda coming from those schools offended them.)

3. Consider two extremes: “free-market fundamentalism,” which says that markets always lead to optimal outcomes; and “market denialism,” which I will define as the belief that the information found in markets is of so little importance that one’s personal opinions should take precedence. I think that in practice market denialism is much more prevalent than free-market fundamentalism. In fact, it is so prevalent that no one refers to it as “market denialism.” They just presume that it is the appropriate point of view.

Related: Clive Crook cites Dani Rodrik‘s 10 commandments for economists.

“Substituting your values for the public’s is an abuse of your expertise.”

Pointer from Tyler Cowen. And how can Rodrik be immune from “abuse of your expertise”?

More Thoughts on Economic Methods

Diane Coyle writes,

Rodrik supports the mathematical nature of economics as bringing clarity of meaning, and argues that the subject is far more applied and empirical than its detractors realise. But he criticises large-scale macro models and time series regressions. “I cannot think of an important economic insight that has come out of such models,” he writes. He also flags up the lack of testability of many economic models: they purport to be deductions from theoretical principles, but as they are ‘deduced’ to explain a particular phenomenon (credit rationing, say), then that phenomenon cannot be used to test the model. “Very few of the models that economists work with have ever been rejected so decisively that the profession discarded them as clearly false.”

Pointer from Mark Thoma.

My line is that economists deal in non-falsifiable interpretive frameworks. Read Coyle’s entire post. She makes Rodrik sound like someone I would agree with, although not everything I have read of him would indicate that.

The conversation between Tyler Cowen and Dani Rodrik keeps circling back to methodological issues. For example, Rodrik is wary of overrating randomized control trials. Rodrik suggests that graduate students should spend more time in the real world.

I keep thinking of the quote of Minsky writing that economists are well trained but not well educated. You are trained to solve equations. Nowadays you are trained to do the sort of narrow empirical studies that Rodrik thinks are overrated. But you are not educated in history or financial institutions or secular changes in the economy.

Also, Noah Smith has more to say.

philosophical empiricism is far more frightening for economists than for natural scientists. Living in a world of theoryderp is easy and comforting. Moving from that world into a Popperian void of uncertainty and frustration is a daunting prospect. But that is exactly what the credibility revolution demands.

Read the whole post. As I read it, he thinks that economists will have to reconcile themselves to less theory and more empirical work. I do not really agree:

1. I think that economists rely a lot on what I call interpretive frameworks. These do not have standing in philosophical empiricism, because they are not falsifiable.

2. Philosophical empiricism does not provide a guide to evaluating interpretive frameworks. Unfortunately, economists have not thought about this question. Frameworks become popular because they are tractable or interesting, and they stay popular without ever being evaluated for usefulness.

3. I think that an interpretive framework is strong if it offers explanations in many contexts, if it does not encounter too many anomalies (phenomena that seem to run counter to the framework), and if it is reinforced by other beliefs.

4. Supply and demand is an example of an interpretive framework that is very strong. That is, it seems to explain a lot, one rarely encounters anomalies, and it is consistent with other beliefs that we tend to hold.

5. Keynesian macro is an example of an interpretive framework that is not very strong. Many anomalies have cropped up over the decades: the ability of the U.S. economy to rebound after World War II in spite of the staggering drop in government spending; the breakdown of the Phillips Curve in the 1970s; the failure of many Keynesian stimulus policies in many countries, including the U.S. And Keynesian macro is notoriously inconsistent with many other beliefs that economists tend to hold.