Monday, July 30, 2012

Don't know much about History

In a recent paper, Erik S. Reinert refers to public governance in Florence.
"Renaissance Florence also understood the need to prevent speculation, a skill which is obviously lost today. In Florence transporting food out of the city was prohibited, as this could feed speculation [...]. Renaissance cities also managed to create what John Kenneth Galbraith dubbed a balance of countervailing power. The Florentine government – the signoría – consisted of nine members, representing different professions, and only one of them represented the financial sector. Renaissance cities also frequently rotated their elected administrators to prevent corruption, and Florence specifically cultivated its urban culture – of manufacturing and trading – by keeping the producers of raw materials, the big land owners, away from any political power".

Unemployment rate in Great Britain between 1855 and 2011,
plotted by 
Chris Dillow with data from the Bank of England.
Chris Dillow draws the chart of unemployment in Great Britain since 1855, and derives some sharp conclusion from it.
"The idea that free market policies can generate sustained full employment lacks any historical foundation, unless you want to argue that there were severe labour market regulations that caused mass unemployment in the 19th century".

About two years ago Louise Story reported some data in the  New York Times from a research by David A. Moss (those data were recently mentioned in some blog, but I can't recall which one).
"In 1928, the top 10 percent of earners received 49.29 percent of total income. In 2007, the top 10 percent earned a strikingly similar percentage: 49.74 percent. In 1928, the top 1 percent received 23.94 percent of income. In 2007, those earners received 23.5 percent".

Those facts are unrelated, but they have two characteristics in common:
  • I was absolutely not aware of them, and I would suspect that many competent economists weren't either.
  • As observed by Chris with his example, they seriously undermine some of the policy recommendations derived from the neoclassical framework. 
You may probably find numerous examples that share those two characteristics, just like you would certainly not need to search very far for finding opposite examples that would back other aspects of the neoclassical framework.
But, still, you would believe that an economist who would be aware of such historical facts would pay more attention to income disparities than the theory does, would question the reason that made Florence so wary of finance, or would not so easily buy some of the arguments of very serious people (Krugman's words for supply-siders). Econometricians should also pay more attention to 19th century data. As the economy might have been more simple then, data would be supposed to better fit the economic models.

The point is that the more knowledge an economist has of economic history, the better economist he will be.
Soul or economics,
in Chicago it's the same lyrics
Economic history should be thoroughly taught in universities, and not limited to a few hours on tulips, hyperinflation and the Great Depression.
Economic history is part of economics to the same extent models are. And it is not enough to have people who specialize in either specialty. Economists should have a general knowledge of historical economic facts. Harold James (referring to an observation of Paul Krugman)  could not make the point more relevant when he says that "the supposed German history lesson is chronologically false. It was not the famous hyperinflation of the early 1920’s that destroyed Germany’s fragile Weimar Republic and gave rise to the Nazi dictatorship. Rather, democracy was killed a decade later by depression and deflation".

I'm not saying that economic history should replace models. But both should be considered as essential and complementary elements of economics.

Saturday, July 14, 2012

Why models cannibalized economic thinking

Paul Krugman did not win the Nobel prize because of his blogging, he won it because of academic research making an extensive use of sophisticated models. Yet, in a reply to Simon Wren-Lewis, Krugman reduces the usefulness of models to the mere function of gadgets. This is not just a casual observation, it is a very strong statement that ought to trigger a much-awaited debate on the way economists think about the economy.
What makes the statement very strong is that it goes much further than the views of Wren-Lewis, who is already quite critical towards the economic profession.

What Wren-Lewis seems to be saying is that models are useful, but economists should pay more attention to the context (depressed demand, for example) when choosing a model to apply. He also believes that more sophistication (such as intertemporal optimization) helps solving questions.
Krugman considers instead that models should remain as simple as possible and don't even necessarily need to make an attempt at reflecting the reality. He sees them as tools for uncovering non-obvious mechanisms, and he names them gadgets.

"But I guess not everyone even on the sensible side of macro sees it that way. And that is a problem. A gadget is only a gadget, and you should not let it define your field."

In other words, economic thinking may be built upon sophisticated models, simple models or just logic. But logic should prevail over models, which far too often is not the case (especially if what you read between the lines is that most people on the non-sensible side of macro see it the other way).

Let's take the example of inflation. Along with growth and unemployment, this is one of the core areas of macroeconomics. Yet, this an area where models say little and economists of different schools disagree the most. Neoclassical models usually point to the undesirability of inflation, a trend that culminates in the Friedman rule of deflation. There is however a strong logical argument in favor of inflation, even when there's no need for deleveraging (don't count on logic for quantifying how much inflation is desirable though).
It derives from the empirical observation that prices and wages are sticky. They may go up, but not down. Of course, in the neo-classical framework, prices and wages are supposed to be flexible both ways, but in the real world, it looks very difficult to argue that they are (even if we're still waiting for someone to come with an undebatable explanation about that).
Now, if prices cannot go down, and inflation is nil, it means that there are no price movements at all, which implies that there can't be any relative price adjustment in the economy. As productivity increases differently across sectors, and consumers' tastes keep evolving, price adjustments are necessary for an optimal allocation of resources. Without inflation, the equilibrium is thus sub-optimal.

This leaves us with a question: why did models cannibalize economic thinking?
  • There is of course the explanation of the ideological conspiracy (I have yet to read a bit more about the Mont-Pèlerin Society, but I'm quite skeptical of conspiracy theories in general). Models served well the neo-classical agenda. So, economists of that school supposedly first provided mathematical descriptions of economic mechanisms and then used the resulting framework to suppress any ideological dissent. The maths erased history in the economic reflection, eliminating in the process all those historical facts (such as the Great Depression) that did not get along very well with the theory.
  • A more tempting explanation is to keep in mind that economists are human beings, and the key driver of human behavior is to spend the least possible energy in order to achieve any given result. In particular, humans will avoid thinking unless it is completely necessary. And here is the big advantage of models: you don't have to think, you only need to run the model (you would be supposed to think, but no one would notice if you don't). You might say that it takes some energy to understand the maths, but this is probably nothing compared to what is actually required from thinking, especially in a counter-intuitive discipline like economics. Besides, learning maths can be seen as an initial investment with a return over the entire academic career.
  • Beware of the model invasion
  • But maybe models invaded economics because they fulfill a very specific function: they allow for the discrimination of economists. Models help synthesizing what an economist thinks and understands. It would be awfully difficult for a professor to assess students if he or she could not rely on their understanding of models, and their answers  to exercises and questions based on models. Sophisticated models are taught at higher educational levels not because they deliver a better economic insight, but because they help filtering the more sophisticated students (which might be what Wren-Lewis calls "the inevitable focus at the masters level on the recent macroeconomic literature"). And it does not stop at students. Sophisticated models are usually the reason why economists receive prizes, including Nobel ones.

Thursday, July 12, 2012

You always need someone dumber than you

Simon Wren-Lewis just released a remarkable post on what macroeconomics need to learn from the crisis. It is a question that has already been much discussed in economic blogs (and I hope this will continue), but the answer of Simon Wren-Lewis is certainly one of the most comprehensive and nuanced ones that was delivered so far, and it is full of very relevant considerations that I won't list here. Instead, I'll will quote three segments that might synthesize the view of Professor Wren-Lewis:

"Let me be absolutely clear that I am not saying that macroeconomics has nothing to learn from the financial crisis. What I am suggesting is that when those lessons have been learnt, the basics of the macroeconomics we teach will still be there."
"What we already have in macro remains important, valid and useful. What I see happening today is a struggle between those who want to use what we have, and those that want to deny its applicability to the current crisis."
I think we need to recognise the political environment at the time, which includes the influence of the financial sector itself. And I fear that the academic sector was not exactly innocent in this either. A simplistic take on economic theory (mostly micro theory rather than macro) became an excuse for rent seeking."

In my own simplistic understanding, I read "There isn't so much wrong with economics, but there's something wrong with economists", and I must admit that Professor Wren-Lewis builds a convincing case. But I'm still inclined to believe there's something flawed at a higher level than just historical knowledge, open-mindedness and integrity of the practitioners of the discipline. And the flaw may be located in the relation between economists and economics.

An economic theory is a question with an answer. The answer may right or wrong, or more usually, partially right, as it will only apply to some given set of circumstances (short run solutions are typically quite different from long run solutions). But the question is almost always relevant, and it should always be listened to carefully, whichever school of thought an economist belongs to.

Let's take all the people that feel somewhat concerned with economics, and group them into four categories:
A legitimate question when real interest rates turn negative
- Neo-classical (supply-side) economists
- Neo-Keynesian economists
- Heterodox economists
- Anti-capitalists

Supply-side economists never bother with questions of other schools (or rather, they negate the questions... unemployment becomes vacation, and there can't be a demand failure). Neo-Keynesians try to answer some supply-side questions, but they are rather insensitive to questions raised by heterodox theories (especially when it comes to money). Heterodox economists pay attention to questions of the neo-schools, in the hope of finding flaws in their answers. And no one ever cares about the worries of the anti-capitalists.

But, if you recall what were the concerns of the anti-capitalists before the crisis, you may wonder if western economies would be in a better shape now if economists and policy makers had listened more carefully to their concerns.
Anti-capitalists were especially outraged by the lobbying of big corporations and the fat bonuses of their executives. Some economists may have disapproved too, but they saw such issues as political, and, at best, on the margin of economic theory.
Yet, it is now widely recognized that lobbying over financial regulations, and the risks induced by fat bonuses, have triggered the crisis.
So, there might be nothing wrong with economics, but "serious" economists should really pay attention to questions of "dumber" people, because as policy advisers, in the 21st century, the anti-capitalists have so far performed better.