Sunday, 30 August 2009

The economics zeitgeist, 30 August 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Friday, 28 August 2009

Three kinds of economic story

Anthony J. Evans (who kindly linked to my camel story earlier in the year - or as he notes, perhaps not all that kindly) has written a paper about economic counterfactuals. He confirms what's now becoming a mantra among economists (if not their public): economists can't make predictions.

However, he says, rather than giving up completely on exploring the future, they should do so with two tools of the economist's imagination: counterfactual analysis and scenario building.

Counterfactuals are stories about the past - a retrospective prediction if you will - considering what might have happened had a different decision been taken at a key moment. For example, what if the financial sector had not been rescued by governments in 2008? Or what if governments themselves had defaulted on their debts?

Scenarios are possible alternative futures - constructed not so that you can predict which one will happen, but so that you can prepare to understand events as they unfold. Each scenario lays clues as it starts to emerge: the V-shaped recession has certain indicators, hyperinflation has others, and so forth. By knowing what to look for, you'll have some forewarning of what is happening.

These exercises are undoubtedly valuable to test and explore one's model of the economy. But I fear that the interpretations can become self-confirming.

Evans outlines four scenarios, potential future paths for the economy. Against each, he indicates several signs that might indicate this scenario is becoming real. However one principle of science is that you can only disprove a theory, never prove one. It would be more scientifically convincing to tell us how to spot that the scenario is not happening.

I appreciate these scenarios are not meant to have the force of scientific theory - they are more of a guide to understand what's happening in the world - but if we hold them to higher standards, we'll have more confidence in them if they pass.

The counterfactuals are, by their nature, impossible to disprove - but we can apply some logical analysis to them to see whether they stack up.

By this standard, a couple of the examples in this paper are suspect. Evans proposes the following remedies for wage rigidities and the adaptability of business:
  • eliminate corporation tax
  • raise retirement age (to reduce pension obligations)
  • repeal minimum wage laws
  • ease restrictions on migrant workers
I can't for the life of me see how corporation tax causes wage rigidity, nor how it has any major impact on corporate flexibility. Raising the retirement age has an equally vague connection with the intended outcome. While these ideas might have their own merits, the interpretative nature of counterfactuals can lead us to mix in our own policy preferences instead of rigorously maintaining the logic of the argument.

My own interpretation is that wage rigidity is a psychological phenomenon as much (or more) than an institutional one, though both factors do make a contribution. But perhaps I'm just revealing my own bias there.

In Evans' third counterfactual, the UK acts to slow credit growth, increasing interest rates and reserve requirements, and seizes control of the financial industry. He points out that this version of events does have a few echoes in the UK government's actual actions, as well a much closer match to the policies of Croatia, Ireland and Poland (I do not agree with him that it describes Germany, despite Angela Merkel's rhetoric). However it bears a much closer resemblance to another set of events in real history: the Federal Reserve's actions at the start of the Great Depression.

Most economic historians agree that the Fed's tightening of credit after the Wall Street Crash was the main trigger for the depression of the 1930s. Remember that they did not know they were at the start of a depression - all they could see was that a credit-fuelled boom had precipitated a crisis. Perhaps it seemed natural to cut back on credit, even if it was a little too late. But the crisis was only indirectly caused by the growth of credit - in fact its proximate cause, just like in 2008, was the too-sudden withdrawal of credit when lenders and savers panicked. For the central bank to compound the problem by restricting credit even further, was a disaster - and would be again today.

As my camel story - perhaps clumsily - showed, a third tool of the economic imagination is analogies. An apposite analogy here is a patient who hyperventilates, leading to an asthma attack. Even though the cause of the attack may have been too much oxygen, it doesn't follow that the correct response is to reduce oxygen intake even more. A long-term plan to manage the problem might indeed include tools to stabilise the patient's oxygen consumption, but it cannot be right as an emergency response.

Like counterfactuals and scenarios, analogies are always imperfect approximations to life - and indeed I'm wandering from the epistemological discussion about how to use these tools, into an indulgence in my own example.

So even though I disagree with most of the models and interpretations that Evans chooses in this paper, its key point on "the economic method" provokes some useful thoughts. These three techniques are all different forms of story-telling, and stories have a capability to illuminate and explore issues which is powerful though - critically - has the potential to be highly misleading.

Stories are very convincing to the human mind, which makes them incredibly useful as political (or sales) rhetoric; but should warn scientists to treat them with great care.

Despite this caveat, the paper is a useful contribution to finding the right role for economists and setting the right expectations for the authority of what they say.

Wednesday, 26 August 2009

Economics blog roundup: healthcare, Sahara and rationality

Tyler at Marginal Revolution has an excellently succinct summary of how politics works in healthcare:
...one needs to signal a more extreme symbolic affirmation with the proper "showing that you care" values than what the other side is doing...
This statement is so perfectly borne out by the UK experience since 1997 that there is a kind of beauty to how true it is.

Talking of healthcare, the US plan should become a lot cheaper if this trend continues: placebos are becoming more effective. On current trends placebo should be more effective than all current drugs by 2011; by 2013 sugar pills will overtake some common forms of surgery and in 2016, it should no longer be necessary to use Band-Aids or brush your teeth. Fortunately the US does still have some indirect price supports on sugar, or else the pharmaceutical companies would have no way to make profits at all.

Derek Thompson asks whether the Sahara could power Europe. It's even better than that: I estimated this week that 0.1% of the Sahara's surface would satisfy the whole world's 2 TW demand for electricity (at current photovoltaic efficiency rates).

From Stumbling and Mumbling: a bit more on the eternal debate about "what irrationality means". And while I mention it, I've just started Stuart Sutherland's Irrationality, kindly donated by my stepdad. Looks like a good summary of cognitive biases without as much interpretation as Nudge or Predictably Irrational.

Monday, 24 August 2009

The economics zeitgeist, 23 August 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Saturday, 22 August 2009

What is the return on fiscal stimulus?

Menzie Chinn attempts a valiant defence of fiscal stimulus against innumerate accusations from Richard Posner and others. Posner, to be fair, has corrected his arithmetic now and restated a few of his points in a more nuanced way.

However Chinn is now having to fight a battle against his own anonymous commenters, who say things like:
So explain to me still, how an 89B (regardless of interest expense) is a good investment if we only get a 39B return. It seems even if we got a multiplier of 2, we'd still only be at 80B and that is still a negative return. It seems like we're just delaying the pain.
This comment misunderstands the nature of stimulus and imposes a meaningless standard on the "return" on government spending. Here is what has actually happened:
  1. The government borrows $89 billion.

    Savers have handed over an asset ($89 billion in cash) in return for another asset ($89 billion of government bonds). The government gains an asset ($89 billion cash) and creates a new liability ($89 billion of bonds). Net impact on both parties: zero.

    There may be a small net impact due to the difference between the discount rate on foregone current private consumption and the interest rate on government bonds, but at present this is a minor effect. Depending on the discount rate we use, the effect could go in either direction. I have therefore ignored both discounts and interest payments in the remainder of this calculation to keep the calculations simple. Feel free to disagree with this in the comments.

  2. The government spends $89 billion.

    Let's say it gives away A in transfers and spends B on goods and services, with A + B = $89 billion.

    Then the government's balance sheet is reduced by A, but the public's holdings are increased by A. Thus this is not an "investment" by the government which is meant to generate a return as if it were a private investment; it is simply a movement from one part of society to another. Society's total wealth does not change.

    B is slightly more complex. Some government purchases are inefficient because they are being made on behalf of other people; on these, there is a loss in total economic value compared with the equivalent amount of private spending. Other government purchases are efficient because they are on public goods which bring a positive net benefit to society. Naturally there is an intense debate, broadly between right and left-leaning economists, about which effect predominates. But let's give the stimulus a harder challenge and assume that overall, there is a loss of 20% on B.

    In the current quarter, B only represents around 25% of the total, so the economic loss overall is around 5% of the $89 billion, or $4.5 billion.

  3. The money - or some of it - is spent again in the private sector: the Keynesian multiplier.

    I'm going to take Menzie Chinn's figures as given, as this was our starting point for the debate: so $39 billion of economic activity is created, compared to the counterfactual where no stimulus occurred. This is new activity created out of thin air (actually, out of otherwise unemployed resources) so it accrues on the positive side of the economy's balance sheet: new net wealth is created.

    There is an argument that this $39 billion of GDP, based on measurable economic transactions, is achieved at the expense of non-measured benefits such as leisure time. There is some truth in this, but looking realistically at involuntary unemployment it is hard to argue that the desire for leisure is anywhere near a straight trade-off for the alternative. Some would even argue that involuntary unemployment has negative utility and not positive; but again, if we impose high hurdles for the stimulus, we can accept that there is some positive utility. I would consider it credible that the opportunity cost is a third of the GDP-measured value of the alternative: thus, $13 billion.

  4. Finally, taxes must be collected to repay the $89 billion.

    Taxes generally create an economic loss because of both the effort required to collect them, and the incentives they create either to spend time on tax avoidance, or to reduce work effort since your income per hour worked is lower. It's not easy to agree on what that "deadweight loss" is, but Tyler Cowen suggests twenty percent or more. Unfortunately "or more" doesn't give us any guidance on the upper bound, so I'm going to use the figure of twenty percent (noting also that Tyler's views are on the libertarian side).

    As Paul Krugman pointed out a few months ago, the stimulus partly pays for itself in new tax revenue. So of the $39 billion of new economic activity, somewhere between 15-35% will come back in increased federal taxes. However, this doesn't count as net benefit because once again it is a transfer. It does mitigate the argument of the deadweight loss, however.

    On the figure of 20%, the economic cost of collecting this $89 billion will be just under $18 billion.
Thus the correct figure on the "cost" side of the equation is not $89 billion, but the total economic cost of executing all these transfers:
Cost = $4.5 billion + $13 billion + $18 billion = $35.5 billion
(Recall that I have tried to estimate the costs on the high side to give the stimulus a high bar to jump over.) The benefit, in this quarter alone, on Menzie Chinn's figures, is $39 billion.

So, give or take a few billion, this quarter's stimulus has paid for itself by the end of the quarter. Any remaining impact in GDP in future periods - which is likely to be substantial, perhaps the same amount again - comes for free.

What's more, the utility of a $39 billion gain in the middle of a recession far outweighs the impact of a $35 billion cost in a future period of economic growth. This aside from the argument that redistribution from richer to poorer people in general (which to some extent is a feature of nearly any stimulus package) anyway improves total utility.

Now this is an unashamedly utilitarian argument; I accept there is a libertarian case against redistribution, no matter if it does increase total welfare. But the question here is about the "return" on stimulus, and that is a utilitarian question.

All in all, Chinn's calculations (and by extension, Christina Romer's) are a pretty convincing argument for the success - on its own terms at least - of the fiscal stimulus so far.

Thursday, 20 August 2009

Three ways to annoy an economist

1. Confuse causation and correlation.

Economists have to go to quite some lengths to demonstrate that their work is actually correct. Which makes it irritating that any old blogger can just write things like "Blogging dramatically increases website traffic":
Blogging is good for your business. A new study from Hubspot shows that companies that are blogging get more visitors than businesses which do not write a regular blog. Indeed, the analysis of data from more than 1,500 businesses reveals that firms which have blogs get 55% more traffic than those which do not.
Now I'm sure that firms which have full-time janitors also get more traffic than those which do not. Of course they do - the more successful a company is, the more web traffic it has, and the more likely it is to hire a janitor. Does that mean that my easiest route to increasing my web traffic is to hire a whole team of janitors?

2. Get the whole argument right except the conclusion

I promised not to mention Scott Sumner for a while but sorry, here he is. A very interesting post on China, where he is visiting right now. All well-argued right up to the last paragraph:
The most important component of living standards (once you have enough to eat) is housing... Wealth allows you to buy privacy, to get away from people you don’t like.
Actually, this isn't annoying so much as revealing. It amazes me that someone could make such a brazen assumption about other people's preferences, apparently without noticing that he was doing so.

But then, we all have prior assumptions that we bring to a conversation. A more left-wing, socially minded economist might say:
The most important component of living standards (once you have enough to eat) is housing... Wealth allows you to buy the emotional security of owning your own piece of land, a place that can't be taken away from you, a home to build and raise your family.
The data is the same; the conclusion is simply a function of the interpretation we place on the world.

Despite the fact that I share many policy conclusions with libertarian economists, some of their cultural assumptions - for instance, that the purpose of wealth is to protect you from spending time with other people - shock me every time I read them.

3. Ask him to define opportunity cost

This is an old article, but it bears another look. See if you can answer the following question. If so, you did better than 78% of professional economists.
You won a free ticket to see an Eric Clapton concert (which has no resale value). Bob Dylan is performing on the same night and is your next-best alternative activity. Tickets to see Dylan cost $40. On any given day, you would be willing to pay up to $50 to see Dylan. Assume there are no other costs of seeing either performer. Based on this information, what is the opportunity cost of seeing Eric Clapton? (a) $0, (b) $10, (c) $40, or (d) $50.
Take your guess before reading the writeup in the New York Times by Robert Frank and commentary on Marginal Revolution by Alex Tabarrok.


And finally, how to pleasantly surprise an economist? Hide a fascinating article under a boring and misleading headline. A piece in the New York Times titled "Supreme Court to Hear Case on Executive Pay" is nothing to do with executive pay at all.

It turns out actually to be a very interesting study in our three favourite market failures: behavioural economics, asymmetric information and principal-agency problems. These problems have been recognised by a federal court as potentially creating a rationale for regulating mutual fund fees. It's important that this work (behavioural economics in particular) is starting to be recognised as having legally effective status.

Tuesday, 18 August 2009

Behavioural economics software

Nice little iPhone application highlighted here at Consumerology.

It is intended to help close the gap between action and reward which is the chief cause of procrastination.

Could be a good add-on to any workflow system - I'll definitely be downloading it (as soon as I get my iPhone, which ironically suffers from a two-month gap between placing my order and getting my reward).

A rather different approach to implementing behavioural economics in software is taken by my company, Inon - have a look at our CVM software, which helps you find better ways to sell more personalised services to each customer.

Monday, 17 August 2009

An alternative interpretation of rent-seeking

This article at VoxEU implies that companies in Italy which are 'connected' with politicians make 5% more profit.

Could be true.

But an equally plausible story is that companies become less profitable around election time because they are spending 5% of their profits on subsidising politicians.

On this interpretation, contributing to political campaigns is seen as a cost of doing business, and depresses profits immediately before an election. Note that in the graphs shown in the article, the firms' profits take a dip in the year before the politician's term ends.

Far be it from me to impugn the Italians' proud record of rent-seeking and corruption - my Italian friends would claim they have a unique comparative advantage in this field, and lead the world in their craftsmanship (though there are some volume producers in Africa and Asia who compete for sheer scale of bribery). But I want to allow them the elegance of a convincing escape clause - which is, after all, an essential component of every perfectly balanced protection racket.

Sunday, 16 August 2009

Guest post at missmarketcrash

If you're interested in predicting political behaviour or business outcomes, or want to know what's going to happen in Iran in October, you might be interested in Bruce Bueno de Mesquita's work.

It's written up in my guest posting on missmarketcrash's blog today.

The economics zeitgeist, 16 August 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Saturday, 15 August 2009

Saturday links go salmon fishing

A superb little piece from Steven Landsburg. I forget sometimes what a good writer - and what a good economist - he is. This one is about whether it's right to retrospectively punish bad, but legal, behaviour. The same argument could very well be applied to the payment of large bonuses by banks.
There are two competing principles here. The first principle is: Nor shall private property be taken for public use without just compensation, a principle enshrined in our Bill of Rights...

But here's the countervailing principle: Bad behavior ---even legal bad behavior---should be punished eventually, because that precedent deters future bad behavior. If that principle were applied consistently and predictably, firms might not have overinvested in the wrong technologies [or overpaid their risk-seeking employees?] to begin with.
This speech by James Montier is a very nice, funny and persuasive argument against the EMH. Of course being funny and persuasive can hide many logical flaws and I don't think this speech is a knockout blow. But it opens up a bunch of good paths to a better theory. (unfortunately the site seems to be down for the moment but hopefully back up by the time you read this)

If you think you're good at playing economic games, try this one. It's not the same without Noel Edmonds, though.

And talking of Noel Edmonds, do you agree with Scott Locklin that Nassim Taleb is a clown?

Thursday, 13 August 2009

A perfect example

This story, from the Washington Post via Free Exchange, is a perfect example of the challenge for behavioural economics.
For weeks after he was laid off, Clinton Cole would rise at the usual time, shower, shave, don one of his Jos. A. Bank suits and head out the door of his Vienna home -- to a job that no longer existed.
It's easy to look at this and say "he's not behaving rationally. How amusing - people are a bit nuts sometimes".

It's much harder to look at it, work out a plausible model for why he behaves that way, find an abstract description of the model, extrapolate it to other situations which appear different on the surface, and test your theory against experiment or data.

But that's what behavioural economics - or cognitive economics, or the study of decision-making - has to do.

I've just finished Vernon Smith's memoir Discovery, about which I may write more later - but here's a very perceptive couple of quotes:
...the cognitive psychologists, and behavioral economists, tended to have the same perspective of the economics profession: When subjects got it "wrong", they were being "irrational", and we should not question the theory or our interpretation of it.
Some have naively defined behavioral economics as the search for results contrary to standard models. [As] I see it...its successes represent potential extensions of reformulated standard models.
If behavioural economics is going to be useful, we have got to get around to doing this modelling work. That means doing mathematics, and making simplifying assumptions, and all those things that some economists have suddenly become squeamish about. Don't be afraid of these techniques: they are the essence of economics.

Are negative interest rates enough?

I'm going to mention Scott Sumner one more time and then give him a break.

For the last six months he's been recommending that central banks (mainly in the US, but presumably worldwide) pay a negative interest rate on commercial bank reserves.

(for reference, here's another in a string of recent articles justifying why the Federal Reserve pays positive interest on reserves, without even mentioning the negative interest option. Are they under instruction not to discuss it?)

In short, the argument is this. Quantitative easing works by paying banks cash in return for their government bonds. Since they don't earn any interest on cash (unlike on the bonds they were holding previously) they will want to lend out the newly acquired cash into the private sector so that they at least make some money on it. This (depending on your model) will boost the velocity of money, or increase the relevant measures of money supply, or increase inflation expectations, or increase investment, all of which boost GDP.

But at present, when the banks get this money, the Fed pays them interest to keep it on deposit with them. This means they have less incentive to lend it out. Scott wants to charge them interest for the privilege of holding the cash safely in the Federal Reserve vaults. This will make it more expensive for them to hold cash and (relatively) more profitable to lend the money.

Now clearly this will make some difference at the margin. For each interest rate, there is undoubtedly an optimal balance for banks to keep in reserve. If the rate is lowered by one percentage point (from 0.5% to -0.5%) this optimal balance will change.

However, will it change very much? Rational theory implies that the change from 0.5% to -0.5% is pretty much identical to a change from, say, 5% to 4%. But banks are still keeping $800 billion in reserves while they can earn (at least in the UK) up to 12% on business loans or 18% on personal loans. In economic terms, what is the price elasticity of supply on lending?

When I first saw Scott's argument, I wondered if it was based more on psychological expectations. If a bank expects to lose 6% on a certain loan (one which is presumably some way along the $800 billion curve away from the marginal decision), it shouldn't make any difference whether they make 0.5% or lose 0.5% by keeping the money on deposit in central bank reserves. So it feels highly unlikely that a negative interest rate would make a big impact on that $800 billion. Maybe $50 or $100 billion would head out the door, but the majority of the money can't be that sensitive to such a relatively small tweak.

But if the bank's shareholders suffer from loss aversion when their capital is being eroded, maybe they'd rather tell the execs to lend out the money and take a chance that the 6% losses won't really happen. This kind of behaviour is clearly observable in lab experiments; but we would like to believe sophisticated bank executives are immune to it. Are they, though?

Healthcare misinformation is contagious

While the Americans don't want a British-style healthcare system, it seems that some Brits are very keen on American-style healthcare rhetoric.

After Alan Duncan's hilarious outburst we now have Chris Ayres in the Times. Claiming that Obama should abandon his plans to replicate the NHS, in favour of a scheme that "combines the best of both systems".

Now anyone who is listening honestly to the debate, or has looked at the healthcare bill being proposed, couldn't possibly think that Obama is proposing a universal, public-funded and public-supplied health sector.

If anything, the main criticism of the proposal is it doesn't go far enough towards this goal. The main content is still a public insurance plan - no public ownership of hospitals or provision of services, and no single-payer system.

If a British writer (based in the US) can't tell the difference between the US plan and the NHS, despite writing more than one article comparing them, why is he still being published by the Times?

To coin a phrase: Why oh why can't we have a better press corps?

Wednesday, 12 August 2009

Alan Duncan: the British Art Laffer

In a bizarre Art Laffer-like incident today, Alan Duncan reminded us of the good old days when all Tories were mad.

In the midst of a number of other infelicities, widely reported in left and right wing newspapers nationwide, Duncan said of the House of Commons:
Basically, it's being nationalised.
Now I am spoiled by my choice of targets. I have:
  • American economists who think that the government doesn't run Medicare
  • American financial journalists who argue that Stephen Hawking would have been left to die by the NHS if he'd been British (which he, er, is)
  • A British MP who thinks - and is willing to admit - that the House of Commons used to be a private company
Republicans must be terrified that, if Obama gets his way, they are going to end up with a publicly owned government. Thank goodness free enterprise still reigns in that branch of the economy.

Their favourite monetary economists

An chain of favourites is emerging in recent blogs. Let me show you how it works.

Chuprevich's favourite economist is Tyler Cowen (he is a few other people's favourite too).

It follows of course that his favourite monetary economist is also Tyler Cowen*.

Tyler Cowen's favourite monetary economist is Scott Sumner.

Scott Sumner's favourite monetary economist is Bennett McCallum.

Bennett McCallum's favourite monetary economist is not currently known.

Can this chain of favourite monetary economists be extended in either direction? Perhaps Professor McCallum will leave a comment to assist. If anyone's favourite monetary economist is Chuprevich, do let us know. I am having trouble investigating that as his website makes me dizzy, not to mention the fact that Chuprevich may not be a real person.

Can we develop a theory of favouritism among monetary economists? This Google search shows a few more favourites (note the American spelling) and a fair inference is that for an economist E, E's favourite monetary economist tends to be of higher status than E. The sole exception to this is Tyler's favouriting of Scott Sumner.

Though it all depends on how you measure status. Scott certainly has many more Google hits than McCallum; but McCallum has more citations (see here or here, for example). However neither Scott nor Tyler appears in either list, or in the RePEc database at all. Nor, it should be noted, do Chuprevich, Steve S, huangshan or La Beet.

I think this post has gone about as far as it reasonably can; but if you have further ideas for the development of this esoteric field of economic sociology, please say so.

* Note: on the basis that there is a finite number of economists in the world, this assertion does not require the axiom of choice. It does, however, require that Tyler Cowen be a monetary economist. For the purpose of this exercise, that will be an axiom instead.

Tuesday, 11 August 2009

Supply and demand...for anarchy?

Scott Sumner has got me spotting supply and demand mistakes all over the place.

This post combines that theme with the question of 'the price of anarchy', outlined by Gravity and Levity last week.

Niall Ferguson has blended both of them into a particular detail of his FT article on "lucky" Barack Obama. It would take a long time to critique the whole article, but here's the salient point:
Iraq is likely to become more unstable as US troop levels are reduced.
Now on the surface, that sounds obviously correct. But how about if we turn it around to make the real causality clear:
US troop levels are being reduced as Iraq becomes more stable.
The thing about supply and demand, like any equilibrium system, is that any change tends to create a pressure to counteract itself. In this case, the reduced "supply" of anarchy has increased its price, thus reducing the production returns on its complementary good, the US Army. Thus the army's supply curve shifts left and its quantity falls. OK, mapping this onto supply and demand is a bit confusing, but it's the same principle.

A simpler example of equilibrium forces: a ball in the bottom of a curved bowl. If the ball is pushed upwards away from the lowest point, a force is created to move it back down again.

If you only notice the counteracting pressure and not the original change, you may completely misread the direction of the effect.

One moment you see a ball at the bottom of the bowl; blink, and you see the ball moving downwards. Would you infer that it's now below the bottom of the bowl? I hope not.

But this is the argument that Ferguson is making about Iraq, just as the supply and demand mistake leads people to think the opposite of what's really happening.

Update: James Fallows, Paul Krugman and Brad DeLong have somewhat more substantive criticisms of Ferguson's article, all of which I agree with.

Monday, 10 August 2009

Solow on rational macroeconomics

I have complimented Robert Solow before on this blog (as if he needs my praise) but I think it's time to link again - via Mark Thoma - to a speech he wrote in 2003. This says, concisely and persuasively, most of what the macroeconomic doubters have been talking about for the last few months. And six years ahead. Impressive.

Sunday, 9 August 2009

The economics zeitgeist, 9 August 2009


This is a word cloud from all economics blog postings in the last week. I generate this every Sunday so please subscribe using the links on the right if you'd like to be notified each time it is published.

It has been constructed from a list of economics RSS feeds from the Palgrave Econolog and other sources, and uses Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

More buyers than sellers?

David Smith of the Sunday Times is talking about the property market:
there are more buyers than sellers... It is a market, though. Trying to predict the balance between buyers and sellers over the next 12 months is hard
Just how hard? Here's my prediction: there will be exactly the same number of buyers as sellers over the next 12 months.

Working out how I came up with this prediction is left as an exercise for the reader.

Saturday, 8 August 2009

Democracy, markets and perfect information

Matthias Wasser, in a response to Tyler Cowen's progressivism post, writes:
In a large state true democratic governance is impossible, because unlike the market, a perfectly functioning democracy would require every voter to have perfect global knowledge.
Is this true?

Note that Matthias is not necessarily giving his own view here, but (as per Tyler's challenge) his characterisation of libertarian opinion.

But it's an intriguing statement. Many people think the converse: that the efficient markets hypothesis requires all market participants to have perfect information, and the action of an informed and beneficent government is a way around this problem.

He's correct to point out that this is not in fact a condition of the EMH. But surely it would be possible to design a democratic system where the same thing holds: where, somehow, distributed knowledge enables society to make the right collective choices. What are your ideas on this? Comments are invited.

Friday, 7 August 2009

Misreadings and readings

When the following post from Mark Thoma came up in my RSS feed:
for some reason I first parsed "Corn" as the verb in the sentence. I don't know quite why my brain responded that way...I am not sure what corning would be, and as for a "reality prick"?

A few other links before I go out for the evening:
  • Mark's contribution to the Lucas roundtable at the Economist (do click through to see the other articles, including Tyler Cowen who seems to be getting good at identifying a nice balance point at the fulcrum of many economic debates)
  • Richard Thaler's FT article (one of many on the EMH in the last few weeks)
  • Another EMH discussion - excerpted from John Quiggin's forthcoming book - at Crooked Timber
  • What looks like a fascinating book by Kenneth Arrow (h/t Paul Krugman)
  • The "Cripes" growth model from Worthwhile Canadian Initiative. A very neat idea and entertainingly written but I think it misses some countervailing pressures which act against growth, more or less assuming that the tendency towards size must always dominate
  • I thought I would have more comments to make on this FT article, What is the point of economists? But I don't find myself with much to say. I liked Paul de Grauwe's contribution.
  • Me quoted by Christopher Swann at Reuters
  • When I try to view this image in Google Chrome, and it can't find the NYTimes server, it does its usual clever trick of trying to parse the URL into a search query in Google. Perhaps Google has some new Irish programmers: it interprets "freakonomics" as "Freak O'Nomics"
Have a lovely evening, no doubt I'll speak to you tomorrow.

What is libertarianism?

Tyler Cowen challenged progressives to come up with an intelligent defence of libertarianism. While I might not be considered especially progressive by European standards, I probably am on the American spectrum. I thought that a view from a European might be interesting given that he makes several comparisons between the two continents in his list.

Incidentally, I think his list is not a bad summary of the progressive position, though I'd disagree with 3 and the second part of 8. Maybe those points are where I am revealing my libertarian bits.

Here's my attempt to return the favour:

  1. As a matter of principle, freedom is both a good in itself and a bulwark against damaging authoritarianism.
  2. In general, each individual knows more than anyone else about their own interests and the context they live in, and by making their own choices they are best able to maximise those interests. Indeed, the only way we can get any genuine insight into someone else’s interests is by observing the choices they make. For these two reasons, our principle should be to allow everyone to make their own decisions wherever possible.
  3. There are circumstances where this leads to problems - externalities, collective action problems or asymmetric information. If we choose to correct these, we should do so with narrowly targeted solutions that fix only the problem itself and do not spill over.
  4. Arguments about the differing utility of wealth between rich and poor people can never be proven, because there is no way to compare interpersonal utility; we can only compare intrapersonal utility by looking at the choices individuals make.
  5. There are discrepancies in the power and resources available to different members of society, but these are mostly the result of individual choices freely taken, and should not be corrected by the majority force of those who regret their own past choices.
  6. If a person bears a high proportion of the costs and benefits of their actions, they have a powerful incentive to maximise the benefits. This implies that greater individual freedom will lead to higher total welfare (expressed, for instance, as economic growth) in a society.
  7. Because we live in a shared world, some actions freely taken can impose costs on other people. Limiting these costs, or allowing them to be compensated, is the main justification for restricting complete freedom of action.
  8. Empirically, societies which implement principles 6 and 7 have borne out their predictions with high levels of economic growth.
  9. We should support free trade and more immigration. Foreign aid should have exactly the same status as redistribution within a country; this may create challenges in achieving political support, but libertarianism is about principle, not pragmatism.
  10. Collective action in general involves agency problems, so we need to carefully restrict the power of those agencies (governments) which individuals cannot opt out of. Collectively enforced power should be executed at the lowest possible level so that decision making is better informed, and so that there are exit options for those who lose out from collective decisions.
  11. The libertarian strand in American history is deeply ingrained and shared by most citizens. Even if Europeans have chosen greater collectivity, what works in their culture will not work in the United States.

It's a good challenge and helped to convince me that writing from a less partisan point of view is much more intellectually stimulating than doggedly defending your corner, even if it generates less traffic.

Update: Matt Yglesias has a go too. And there's an interesting (if occasionally extreme) debate in the comments of Tyler's post. The comments on Matt's come much more from one side of the spectrum, which seems rather to miss the point of the exercise. Thanks to all for the thoughtful comments on my own post.

Thursday, 6 August 2009

Britain is doing very well - here's why

Paul Krugman has been cheerleading for Britain for a while. I'm not sure I agree with him that the pound is cheap, but it's good to see we that some of our signs of robustness are visible from outside.

Why is our economic performance so good? This is one - charming - theory.

Wednesday, 5 August 2009

A puzzle about incentives

Interesting puzzle from Chris Dillow today: is it possible to genuinely align the incentives of employees and investors?

This in response to Lord Myners' debate about whether long-term shareholders should have more voting rights than short-term traders. I've touched on this question before but the question of whether shareholders have a real understanding of the company's interests is an excellent one.

I have a particular interest in this question because part of my business is designing structured pricing approaches, which are intended to align the interests of supplier and client in a commercial relationship.

Structured pricing generally rewards the supplier for achieving business objectives of the client. But while it's a big improvement over traditional contracts, it is still not perfect in theory.

For instance, if you hire a telemarketing agency the traditional way to pay them is a fee for each day of time. They'll spend a day on the phone and charge £350. If they set up five sales meetings, lucky you; if they set up none, you still have to pay the same price. In this structure there's little formal economic incentive for them to do a good job (not to dismiss the supplier's motivation from pride and their desire to win future business - but this is a distinct issue). In fact, their incentive is to win as few meetings as they can get away with, so that you keep paying them for more days.

To correct this, you may want to pay them not for each day of calls made, but a percentage of the sales you make. This incentivises them to find good leads, set up meetings that are well qualified, and keep working for you as long as they can keep getting meetings.

This type of contract isn't perfect either, however, for two reasons. It incentivises the supplier to set up more meetings than the optimal number, because they do not bear the full cost of the meeting (you have to travel to the meeting, spend time selling and following up). To control this you might subtract some of the sales cost before working out the revenue share.

On the other hand, the supplier's reward depends on factors outside their control: your sales ability, the quality of your products, your negotiating skills. You might construct a formula to take some of this into account, but it's very hard to invent a structure which creates the perfect incentives and is easy to monitor in practice.

I suspect that designing such structures for managing a company would be equally difficult.

However, if you are willing to be radical, I did read one suggestion (I think in one of Tim Harford's or Stephen Landsburg's books) to perfectly align employee and company incentives. The proposal - in the example, I believe the company was General Motors, ironically - is that every one of the company's 50,000 employees receives the entire profits of the firm - let's say $1 billion - as their salary. Yes, that's a total salary bill of $50 trillion.

Of course, this would bankrupt the company and would be completely unreasonable, so as a quid pro quo, the employee has to buy their job by making an advance payment to the company. How much? Just under $1 billion, as it happens. This provides every employee with exactly the right incentives to maximise company profits and not to take excessive risks.

You don't need to be a behavioural economist to think this scheme is impractical. But it illustrates the trouble with finding a theoretically robust way to solve this agency problem. The best we are likely to achieve is a system that provides some scaled-down version of the correct incentives - profit sharing, say, in recognition of the material interest of the employees in the success of the company - and relies on a bit of humanity for the rest. Cultural factors and employees' personal connection to their firm, colleagues and customers will go a long way to aligning the interests of all stakeholders.

Tuesday, 4 August 2009

Slow EMH and diversity

A perceptive article by Tony Jackson in the FT illustrates two theoretical points I'll be developing in more detail over the next few weeks.

First, he equivocates about the efficient markets hypothesis (EMH):
When we make a killing in a rising market, we dwell on our own smartness rather than the irrationality of prices having been too low.
This is a key point to understand in markets - especially illiquid ones such as property. Some commodities tend to exhibit long-term bear and bull markets. Residential property in the UK showed a consistent rising trend from the early 1990s until 2007. It's hard to argue, even having seen subsequent falls, that this obeyed the "random walk" theory of the pure EMH.

Instead, it's more convincing to posit that there was a "correct" efficient value - perhaps the 2004 or 2005 price? - and that most people from the mid-90s onwards could see that the correct value was higher than the current price. However, natural caution, slow turnover of properties and the structure of the mortgage market meant that the price could not jump directly to its correct market-clearing value. The mechanism for getting there involved millions of market participants gradually testing out higher and higher prices on each other to see if they would stick. When they did, the market price ratcheted up and the process continued.

Of course, the process can also overshoot, despite the tiptoeing built into it. That happened in 2000 with technology stocks and in 2007 with housing. The reason seems to be that after a time, people come to mistake experimental price-setting for permanent momentum.

This phenomenon is what I call the "slow EMH" and it does offer opportunities for profit if you have the capital and time to take advantage of it.

Jackson also points out that not everyone can do this. If you are not compensated by finding true market value but by beating your peers in a quarterly contest, you may know about trends in the market that you can't act on. Warren Buffett is the classic exception to this rule, but Jackson makes a more general point at the end of the article:
That is the fundamental failing in the efficient market hypothesis. You cannot beat the market today or next week. But you can beat it in the long run, provided you do not want what the average does - or not at the same time, anyway.
That point, insightful as it is, is much more important than a mere rule of investment. In fact, it's at the heart of all economics. We can't all want the same things at the same time - and if we do, we must be induced to change our minds. Otherwise, we will create for ourselves a completely unnecessary shortage - of food, energy, land, money or any other scarce resource.

Much more on this later.

Monday, 3 August 2009

Advertising: beer, tax, Gordon Ramsay or Google?

According to this posting from Felix Salmon (if I can match Gawker's CPM) I could make about £150 a month if I sold advertising on Knowing and Making.

Some way to go before I can give up the day job. Please refresh the page a few more times if you want to help.

Still, it could just about pay for one of the following:
  • all my visits to the pub
  • my council tax
  • dinner at Gordon Ramsay once a month
  • a subscription to the FT, the Economist, and all the economics books I read
  • the money I pay Google for advertising my software on their site
Maybe it's worth it. That is, if I could get Gawker to sell the ads for me. Think they'd be up for it?

Supply and demand: bank loans

Scott Sumner has published a couple of good articles about the difficulty of understanding supply and demand, and Robert Peston's posting today may be an excellent illustration of that.

Robert says:
Here's the great and resonant unknown of the moment.

Is the credit contraction a reflection of less demand from you, me and millions of others? Or are the banks rationing much more than they had been doing?

The answer is - probably - a bit of both.
But does that make any sense? Well, it could - but is it plausible that demand for loans just happens to fall at the same time as the banks tighten their standards? And why would the banks "ration" credit anyway? Professor Sumner might give a simpler explanation.

Occam's razor, as you know, says that the simplest explanation is usually the best. So can we identify a single cause of this phenomenon? Yes we can.

Imagine that there is a stable market for credit in 2007. Then just one thing happens: the supply curve for loans shifts leftwards. This means that a lower amount of loans will be supplied at any given interest rate. Assume that the demand curve stays exactly the same.

The consequence? Loans get more expensive; fewer transactions take place. A new equilibrium is reached, further leftwards along the same demand curve, where a lower quantity of transactions takes place at higher prices.

People might be demanding just as much credit - indeed, they could be looking for more. Some businesses need more working capital and some people want to borrow to replace temporary lost income from unemployment or wage cuts. But if the supply has fallen, then the price of borrowing will go up and the amount will decline.

Why would supply fall? Two reasons. First, if wholesale lending is no longer available. Second, if loans have become riskier - and therefore their cost has gone up. Both of these effects shift the supply curve upwards.

Anecdotally, this is very plausible. Business loan rates seem to be a couple of percent higher than before; credit card interest rates are up; and an acquaintance wanted to top up a personal loan which is currently being paid off at a rate of 6.3%. The quote for the top-up loan? 17.9%.

My view: the problem in 2007 was not that the banks lent too much - it is that they did not take enough deposits. Governments [update: and central banks] have done the right thing in replacing (some of) these deposits through their various liquidity schemes but they haven't replaced the entire quantity. In addition, they can't do much about rising costs caused by loan writeoffs without offering straight subsidies.

Fortunately as the economy stabilises, these costs will reduce, and we're already seeing Chinese banks entering the UK market with lower loan rates than the domestic banks. Let's hope a bit more financial globalisation can help us fix this problem.

Sunday, 2 August 2009

Healthcare, trust and selection: comments on other blogs

I heard somewhere that what people do on blogs is write comments about what other people said on blogs. I guess I do a bit of that, but I'm sure my rate is below average. Therefore time to catch up.

In this post I'll look at a couple of interesting points on the American healthcare debate:


Megan McArdle looks at rates of insurance among unhealthy people and finds that the adverse selection theory is wrong. But I think there's a serious flaw in her argument. Her finding is that since uninsured people are about as healthy as insured people, adverse selection can't be happening. But she relies on the following assertion: "we would expect the uninsured to be sicker than the general population". I don't think that's correct at all. Surely sick people have far more incentive to get insured than healthy, and so we'd expect the uninsured to be substantially healthier than the average? After all, we would assume that people who don't own cars probably have less need of cars than average; and those who don't own swimsuits probably do not want to swim very much. Therefore, if a significant proportion of uninsured people are sick, and therefore need healthcare very much, there does appear to be a big failure in the market.

Megan also says that we don't want to gut the healthcare system in order to solve a problem affecting only 0.3% of the population. But actually the healthcare system's job is mainly to help people who are sick. Thus it's sick people, not the whole population, who are the relevant population here. On the basis that 15% of the population don't have insurance, and that percentage is slightly higher among those who are ill (in "fair" or "poor" health), the healthcare system is failing about 18% - more than one in six - of the relevant population. Perhaps that still doesn't justify a complete restructuring; but the argument is very different.


Next, Greg Mankiw makes a very good point: a lot of the healthcare debate - and many other economic debates - reveal something about the kind of institutions that people trust. Greg explains his reasons for trusting market-based solutions and private companies more than governments.

(An aside: Greg quotes Paul Krugman saying he doesn't trust private healthcare because "your treatment is their cost" and thus they have an incentive not to treat you. But that's true of all private companies: providing any service to you is a cost to them. Single-play game theory indicates that all companies should try as hard as they can to rip you off. The sandwich shop should give you the smallest, cheapest sandwich they possibly can. Multiple-play theory, however, shows why they don't - because they want you to like them and to come back again. There is far less repeat purchasing in healthcare than in sandwiches, so that argument is less strong. However the principle still works with cars, which we buy only occasionally, because there is a wide popular conversation about cars which shares consumer information about them and boosts the value of a good reputation. Maybe that would work for healthcare too)

This - and something I was asked by a potential customer a few weeks ago - got me wondering about the best ways to model trust. My theory of how people make economic decisions is broadly based on the idea that they have a mental model of the world, with many different components, each of which has some kind of expected utility function attached to it. For instance I expect that another cup of coffee will bring me a certain level of happiness; making lunch similarly; and going out for a beer something else again (at which point I may want to take into account the difference between short and long term utility).

These expected utility functions each have some degree of credibility associated. I can predict better how the coffee is going to make me feel than the lunch, partly because I have just had a coffee and can remember it; and partly because my lunch today will be something new that I haven't had before. I might really enjoy the lunch or it might leave me indifferent. The lunch utility function has much less credibility than that of the coffee (even though my actual enjoyment of the lunch could well be greater).

I believe that this credibility value is correlated with trust. If we buy a private health insurance policy - or decide to rely on the public system - my uncertainty about the level of utility it will provide is mainly mitigated by my trust in the provider. I have a reasonable idea about the level of care I'll get from the NHS. But for me, there is much less certainty (through lack of experience) about the service level and outcomes of private health treatment. I suspect it would be better, because after all BUPA has to compete with the NHS and still get people to pay money, but I don't (yet) trust the company enough to be confident it would be much better.

Of course this doesn't just apply to healthcare: a big challenge for my software company, for instance, is to get people to trust us enough to try us out. We know we'll do a good job, but the prospective customer doesn't.

There are other factors involved in credibility apart from trust - uncertainty about the general present state of the world, unpredictability of future circumstances, and in some cases straightforward randomness; but trust has a big influence and is perhaps the easiest one to control.

One way that trust can be enhanced is by providing more information. In software we do that through references and testimonials, detailed proposals, and by offering low-risk low-cost trials of our services which will give people an understanding of what we do - and attach more credibility to our utility function. Another is through personal affinity - we tend to trust those that we feel something in common with - and so those customers that we personally get on with are more likely to believe that we can provide a good service.

Healthcare providers might do well to consider this. Transparency could be good for everyone - that is, if it were enforced across the board. Shouldn't you be able to find out both the death rates for certain operations at your local hospital and also the proportion of claims that your insurance company refused or policies they rescinded last year? Assuming that the refusals are rare, releasing these figures should enhance overall trust in the sector; and if they are not, then consumers are entitled to know it, and competition should drive them down. Of course no company would release these figures alone - it would take legislation or some other means of enforced coordination.

This leaves open Greg's question of how much you should trust the federal government. No doubt some incentives could be designed for that situation too, but I'll leave that for another time.

The economics zeitgeist, 2 August 2009


This is a word cloud from all economics blog postings in the last week. I generate this every Sunday so please subscribe using the links on the right if you'd like to be notified each time it is published.

It has been constructed from a list of economics RSS feeds from the Palgrave Econolog and other sources, and uses Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Behavioural economics and alcohol limits

Dr Nick Sheron of the Alcohol Health Alliance has objected to the government's publication of daily instead of weekly alcohol limits. But his protest shows a failure to understand both behavioural reasons for the advice, and the economics of alcohol consumption.

First the behavioural aspect:
Dr Sheron says we should go back to using the old weekly limits, which are based on sound research. The 1987 sensible drinking limits, which set the bar at 21 units per week for men and 14 units per week for women, remained in place until 1995.
I have no doubt that, as he says, the medical research was based on the idea of weekly limits and not daily. The problem is that this is not a medical issue. It is a behavioural issue.

The government's objective in publishing the recommended limits is not to give medical advice or influence doctors. It is to change people's behaviour. It's far easier for people to influence their own behaviour through short-term goals and fast feedback, than through longer-term targets and responses.

In simple terms, do you expect anyone to count up to 21 units over the course of a week and then stop drinking? By contrast, counting up to 4 within an evening is quite realistic.

Now there are other valid behavioural concerns here which Dr Sheron could have mentioned. One is the tendency for the limit to be ignored once it is breached. If you are already at five units it's easier to think "what the hell, I've broken the rules already" and drink eight or ten (a similar result is well established with daily calorie counting).

Another valid question is whether this advice has meaningful efficacy at all. I am sure it makes some difference - I sometimes use it myself as a rule of thumb, even if nobody else does - but I don't know whether there have been studies of the overall impact either on median or excessive consumers.

That aside, Dr Sheron makes a pretty fundamental economic mistake:
"The weekly limits were based on robust studies and were set at a level at which alcohol harms outweigh any putative benefit."
No doubt what he is thinking of is the idea that moderate alcohol consumption can be good for the heart, or something like that. But this ignores what is by far the greatest benefit, "putative" or otherwise, of consuming alcohol: people like it.

They like it so much that, not only are they willing to put up with health risks and hangovers, they will actually pay money for the privilege!

Any honest analysis of consumer choice must be based on the fact that people broadly do what they want to, and their choices can be taken as an indication of what they like. Life is - most people would agree - much better when you can do what you enjoy. So it's not really for a doctor to tell us what the benefits of alcohol are.

Choices and preferences of course do arise from the context in which they are made, and the context is influenced by many things: the information available to people, the culture they live in, their own self-discipline, and even the amount of alcohol they have already consumed. I don't take the libertarian view that government should make no interventions in anything: it's entirely appropriate that the government should publish these recommended limits.

But we must remember that these limits are about highlighting the costs of alcohol use. It's much more difficult for policymakers to second-guess the benefits that you get.