Sunday, 31 January 2010

The economics zeitgeist, 31 January 2010

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, 30 January 2010

Are governments more rational than citizens? Well, yes

Here we go again.

Every so often, somebody reads about a policy idea based on behavioural economics and thinks they're so clever to have come up with the following counter:
"Well people may be irrational, but people who work in the government are just as irrational. Therefore their attempts to regulate will be just as flawed as the behaviour they're trying to fix."
Now to be fair, Chris Dillow is clever, but he falls into the same trap here. Of course politicians and civil servants make many incorrect judgments, and have the same cognitive biases as any of us.

But this is irrelevant. We don't expect physicists and engineers to be immune from the law of gravity. Yet we still trust them to design planes that can help us transcend our own gravitational problems.

The goal, of course, is to design a limited number of interventions to help achieve agreed-on social goals - designing them carefully, rationally and with sufficient time and thought to avoid as many cognitive traps as possible. We are all subject to cognitive biases when we make fast decisions, but when we have enough time, we can also discover what those biases are and put structures in place to help avoid them.

And just as we delegate many decisions on healthcare to doctors, education to teachers, and aeroplane design to aeronautical engineers, we will delegate many of our decisions on economic policy to economic policymakers. Naturally this might include decisions about the default savings options for pensions, the design of taxes and the best ways to label consumer products. The point is not that civil servants are better or smarter than normal people. It's simply that they are specialists. They have the time and resources to think through certain decisions in a much more detailed way than you or I, living our busy, distracted lives.

I'm really not trying to stand up for George Osborne here - Chris and Tim Worstall rightly pick out some weird examples from his article - but behaviourally-informed policymaking does deserve to be defended. The idea that we shouldn't make any regulations, just because the regulators are human, is (have I heard this word somewhere before?) glibertarianism.

Thursday, 28 January 2010

Is behavioural economics moralising?

A slight misunderstanding here (in my opinion) from datacharmer at the Bluematter blog.
Tim Harford: "...[was too fascinated with] behavioural economics. But the financial system did not fail because of some psychological trait, but because it was riddled with damaging incentives"


In other words, let's get over evil bankers and the belief that moralizing will change the world, and let's focus on incentives.
But behavioural economics is not about moralising, nor is it about blaming individuals for making mistakes in the hope that they won't make them again.

It's about understanding why and how people behave the way they do; so that when we do design incentives, they will work.

Of course people respond to incentives. What else would they respond to? But if you think they respond consistently, transitively, stably, and (in the technical economic definition) rationally*, to incentives, you'll be sorely disappointed.

Even the most famous examples of Nudge-style policymaking: choice architecture (the salad at eye level), pension or organ donation defaults, or the fly in the urinal: all of these are incentives. Cognitive incentives, which in many cases are more influential than traditional material incentives. But more important is the combination of the two. Any material incentive, because it has to be communicated to people in order to affect their behaviour, must carry with it a cognitive incentive of some kind.

If you want to design the right incentives for the financial system, or the business you run, or your family or yourself, what could be more important than knowing exactly how people will react to them?

* Note that just because people aren't rational, doesn't mean they are irrational or, for that matter, unpredictable. More on that another time.

Wednesday, 27 January 2010

Science versus Europeans

I loved the, er, fair and balanced tone of this article (via Marginal Revolution):

Obsolete and disproved Marxist and socialist thinking also remained strong within European universities, including in economics departments. Many young economists, scientifically oriented and so recognizing the superiority of free markets, found the climate intellectually stultifying [my emphasis]
What fun.

While the article makes a valid overall point - the centre of gravity of the economics profession really is in the US, and there has been lots of old-fashioned thinking in some European universities - it's subtly undermined by the kind of assertion in bold text above.

I wanted to find out more about who was writing this stuff - after all it has the implied approval of Tyler Cowen - so I clicked on 'About City Journal' in the footer of the article.


City Journal is the nation’s premier urban-policy magazine, “the Bible of the new urbanism,” as London’s Daily Telegraph puts it. During the Giuliani Administration, the magazine served as an idea factory as the then-mayor revivified New York City
Not quite conclusive - after all the Giuliani administration was relatively centrist, so maybe this is just a publication which happened to spring up during those eight years.

So I click on the name of the editor, Brian Anderson (who "...is a frequent guest on talk radio"), and then through to the Manhattan Institute, the organisation from which City Journal springs. Finally a bit more clarity:

For over 30 years, the Manhattan Institute has been an important force in shaping American political culture and developing ideas that foster economic choice and individual responsibility....Our work has won new respect for market-oriented policies
Nothing wrong with that - no doubt I would agree with many of their ideas. But linguistic clues like "economic choice and individual responsibility" strongly signal a very specific set of priors which should influence our interpretation of any article, and especially comments like the first quote shown above.

Naturally everyone has prior assumptions, and as I mentioned in a previous article this applies both to left and right. But to co-opt "science" to support your political position at the expense of a whole continent really is cheating.

Cognitive barriers

From Lydia DePillis, via Andrew Sullivan:
It turns out that shoppers are now taking extreme measures to avoid paying that extra nickel—even schlepping groceries in their arms if they didn’t bring a backpack. The fee may drive people crazy, and the Journal may grumble about “bureaucracy,” but it actually seems to work: Stores report giving out half as many bags as they did before they started charging for them. And the reason seems to be rooted in how our brains operate...
And this is why micropayments will be really hard to implement.

Big Ideas: The future of news

The Big Ideas talk this month was about The Future of News, presented by Tim Luckhurst - former editor of The Scotsman and now professor of journalism at University of Kent.

Although the discussion wasn't the most enlightening use I've made of an hour and a half in the last month (or even today), it threw up a few intriguing points:
  1. That subset of "citizen journalism" which relies on unpaid, part-time people is unlikely to replace paid journalists in uncovering real stories - or, increasingly, even in the comment-and-opinion world. Indeed, I notice very clearly the differing impact of articles on this blog, between those which I've researched thoroughly and spent real time on, versus those which I dash off in half an hour as summaries of other thoughts. The correlation isn't perfect (this article is my most popular ever) but the ones that people have really commented on, and which have found their way onto places I care about, are mostly the ones I've made a proper effort on.

    For those who are interested, I spend an average of perhaps 1-2 hours a day writing this blog and reading the research and other articles that go into it. I am well aware that almost any Martin Wolf article or Economist leader has much more effort spent on it, and is of a higher quality, than my typical blog posting. Then again, if you're interested in what I write about, you mostly won't get it from Martin Wolf.
  2. A big question over journalism - especially news journalism as opposed to commentary - is the business model that will pay for it. Traditionally it was cross-subsidised by the gossip and other entertainment for which people mostly buy newspapers; but that model is breaking down due to increasing Web distribution, and a permanent revenue model for news is yet to emerge.
  3. Why do we think the Guardian (or the FT, Economist, New York Times or even the Sun) are genuine and trustworthy, as compared with the Drudge Report, Guido Fawkes or some random blog from some random guy? Partly, of course, it's resources and the backing of a big organisation with a reputation to maintain. But Drudge has a fairly big organisation now, with lots of full-time staff and plenty of money. They certainly have the resources to carry out proper investigations. What's the difference?

    He acknowledges that Guido Fawkes does break stories and in many ways qualifies a a professional journalist. I think Luckhurst's point was that there is a different culture. He insisted that anyone who can't write 120wpm shorthand couldn't possibly report accurately the contents of tonight's debate, or of a court case. More generally, he suggested (without quite stating it explicitly) that there is a qualitative difference between (a) a journalist with professional integrity, willing to put themselves on the line to speak truth to power, and (b) a blogger who just pumps out opinions, and if they do publish any facts, do it without checking and shouldn't really do it at all without a libel lawyer.

    So why is there this difference? Is it simply a legacy of the old way of doing news, and a level of trust we've built up in the old institutions which survives into today? Can new news outlets (he mentioned the Caledonian Mercury, although its article today on Chemical Ali is ironically sourced from the New York Times) only be set up by people who are former mainstream news journalists (or, presumably, trained in his Centre of Journalism at Kent)?

    If so, then this seems to be a path-dependent outcome which surely cannot survive for long. If the only thing supporting the reputation of newspapers is the reputation of newspapers, it's unlikely to be a stable position.

    But just one more thing. What gives the US dollar, the international direct-dial phone numbering system, the GSM standard or Google their default status as the standard in their respective domains? Why doesn't someone print their own scrip currency or make a phone number that uses letters? Simply because the existing standard is so widely adopted that it prevents alternatives from emerging. In other words, network effects. Perhaps traditional journalism has the same stability and momentum. It's possible, but I doubt it.
The audience questions mainly provoked Luckhurst into defending Rupert Murdoch's ownership of a media empire, and claiming that British news is the best and most free in the world, and is pretty close to perfect. I wouldn't particularly disagree with either claim. But neither is very interesting.

It was intriguing to hear the debate, and in particular an important acknowledgement that news can only be viable if it finds the right economic model. But I didn't hear anything either to sharply distinguish between blogs and newspapers, or to suggest what news will look like in the future. More radical and interesting thoughts are available from a whole host of researchers in media economics. This site looks interesting as does this one, and commentators from Chris Anderson to Tyler Cowen have written lots of provocative stuff about this.

Is there a cognitive/behavioural aspect to this? Of course. The resistance to micropayments and the cognitive barriers presented by paywalls or registration screens are basically cognitive phenomena. Hardly anyone is refusing to pay for news because they genuinely don't want to cough up $4 a month. It's all about the dozens of 3-penny decisions and do-I-trust-this-site-with-my-email-address hesitations we'd be asked to make.

Tuesday, 26 January 2010

This blog posting is not a hoax

If you received a message on an online networking site with the subject line "This letter is not a hoax mail" what would you think?

Especially if it is from someone with the job title "Bank Manager, Amalgamated Bank Ltd"?

Hmm.


Sunday, 24 January 2010

The economics zeitgeist, 24 January 2010


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, 22 January 2010

Price trickery with T-shirts

Ed Kless at Verasage presents an interesting retail pricing scenario and asks for suggestions. Best to read his post and look at the pictures before continuing, otherwise the following will not quite make sense.

If you're reading offline, here is his summary of three racks in a clothes shop:
The first offered two tee-shirts for $30 or $19.50 each.
The second, right next to it offered two tee-shirts for $30, but no mention of individual price and the third rack had individual tee-shirts for $15 each.
My thoughts:

I've noticed recently that a few places which charge "$N for two" will happily sell you a single one for $N/2. If there's no price for the single item then I imagine this would be the default policy.

I'd suggest that the existence of these two apparently redundant offers is metered price discrimination - capturing people with a higher willingness-to-pay by selling them an extra product rather than charging a higher unit price.

The $30 vs $19.50 just seems like a regular promotion, no mystery there.

So the question is whether the presence of the three racks alongside each other changes the dynamics of any individual rack. You didn't mention whether the products are significantly different but from the pictures I'll assume not.

I think the $30-for-two and $15-for-one racks probably support each other, by providing a cheaper option for people who only want to spend $15, while attempting to anchor better-off people to a default purchase of two shirts. If I were setting this price I'd make sure that the $30-for-two shirts were slightly different to the $15 singles. They wouldn't have to be objectively better than the singles, but if one range has stripes and the other has a texture (say) then people may project their own assumptions about quality onto the different products.

There are lots of behavioural experiments which show this kind of thing: if you sell people Mars bars and Snickers, and charge a higher price for Mars, they will like it more; while if you switch the pricing they'll mysteriously prefer the Snickers. No objective quality difference but people take the cognitive shortcut of assuming that higher price means higher value.

I don't know how the presence of the $30/$19 rack would affect this. Its role may simply be to confuse the consumer, so that they are more likely to be affected by subconscious cues than to make a rational calculation - which is exactly what the store wants.

Or it may be a bit more specific - about making the consumer assume that the $30-for-two shirts are actually the same as the $19.50 shirts, and therefore they are getting a discount by buying the pair; while actually they are identical to the $15 single shirts.

I am not entirely convinced that retailers always know what they're doing in this kind of situation. It may simply be random experimentation or even a supply-chain-driven decision. But I'd like to imagine they are making a calculated and cynical design choice, and we're being cunningly manipulated by the whole retail sector.

Thursday, 21 January 2010

Music, love and numbers from Marginal Revolution

Happy birthday to Tyler Cowen, prime mover behind the Marginal Revolution blog (sorry Alex, but you just don't post as often).

In honour of Tyler and MR, clearly the emperor of economics blogs, here are a few recent pages which I discovered via his targeted link-collecting.

Unlike Tyler I think this research gets to the heart of exactly why music works psychologically. I don't know the UCL or Goldsmiths people involved, but will try and find out if they work with my friends from the Judgment and Decision Making seminar.

He also links to an interesting post from okcupid, a site I am (ahem) familiar with.

And this fascinating if tenuous link about number sounds, from the Barking Up the Wrong Tree blog which I hadn't seen before, also comes via him.

Finally, you can't go far wrong by picking and reading a random article from MR and thinking through the conclusions (though Tyler has usually done that for you too, which is a pretty efficient use of scarce cognitive resources). Here's the top article right now, the fascinating: "Why is there so little money in US politics?" Update: This may possibly disprove my theory in my second-most-popular posting ever: "How much SHOULD Blagojevich have asked for?"

Wednesday, 20 January 2010

Wolf's wisdom and the appeal of authority

In a difficult moral situation, we like to have someone to tell us what to do. The hard work of weighing up factors and working through the consequences of our choices is confronting - not least when the conclusions risk conflicting with some existing assumptions about the world or ourselves.

This is where I find myself with respect to the Icelandic banking crisis.

I generally think the UK government - especially the civil service - is pretty sensible, well-intentioned and respectful of markets and the rule of law. Thus, the idea that they might have attempted to extort money out of an innocent little third-world country like Iceland raises my cognitive dissonance hackles.

The Icelandic government has done what most governments would have done in their situation - put a hold on everything while they try to sort it out and decide how much of their banks' liabilities they will stand behind. The UK's reaction - invoking anti-terrorism legislation to freeze several billion pounds of Icelandic assets - while politically understandable, is probably an overreaction; disproportionate and maybe even illegal.

But because of my innate trust of the Treasury's instincts - built up from years of observation, I hasten to add, and not just because I think they're good chaps - I find myself more sympathetic to the UK's side of this argument than perhaps I should be. I'm genuinely torn on an issue which I should be able to analyse economically and take a clear position on.

This is why it was a great relief to see Martin Wolf's article on the subject in the FT Economists' Forum. His view:
So do the ordinary Icelandic taxpayers have a legal obligation to meet the liabilities of their collapsed deposit insurance fund? The answer to that is, to say the very least, that it seems to be very far from evident. Moreover, any British or Dutch depositors who thought their money was safe because the government of Iceland guaranteed it were mad.


Do Iceland’s taxpayers have a moral obligation to pay this loan? My view is: no. The delusion that finance was the path to riches was propounded by countries that should have known far better. I cannot blame Icelanders for succumbing. I certainly do not want generations of Icelanders to bear the cost.


The final and, in truth, most important question is whether these demands are reasonable. After all, in every civilised country it has long been accepted that there is a limit to the pursuit of any debts. That is why we have introduced limited liability and abolished debtors’ prisons.
Whatever the merits of Martin's views - and there are bits that I might argue with technically - it is genuinely a relief to have an authority figure pronounce on the issue. It provides me with, in cognitive rather than literary terms, a moral anchor.

I can now forgive myself for being conflicted about the question, while settling on Martin's suggested compromise as an appropriate and balanced outcome to the fight. I will delegate all future dilemmas on this subject to Wolf's wisdom.

This must be what it's like to have a priest, or a rabbi. Or even, for that matter, a thesis supervisor.
* at least, one well on its way to the third world

Monday, 18 January 2010

Most popular blogger in the world

Do you know who the most popular blogger in the world is?

No, not me (thanks for asking).

Not Paul Krugman, Dave Winer, Perez Hilton or Cory Doctorow. In fact, I had never heard of him, and I suspect most of my readers won't have either.

His name's Han Han and his blog in China has accumulated 306 million visits. Oh, and that's just one of his careers. He's also a racing driver. And he gets away with (literally) giving the finger to senior Communist Party officials.

This FT article has some further amazing facts about him. It seems that he is so popular the Party would find it difficult to close him down. In turn, he doesn't step too far out of line. But the whole story is very revealing of the evolving dynamic of speech in China.

Quotations that are impossible to believe

I saw this somewhere:
"We cannot live in a world that is not our own, in a world that is interpreted for us by others. An interpreted world is not a home. Part of the terror is to take back our own listening, to use our own voice, to see our own light." - Hildegard of Bingen (1098-1179)
The ridiculousness of this almost makes me angry. How could this possibly have been said in the 12th century? It's just not remotely credible. At best it's a highly distorted translation of something in Old High German via Heidegger, Simone de Beauvoir and any number of new age Californians.

But this is hardly unusual. The idea that Einstein said "The definition of insanity is doing the same thing over and over and expecting different results." is insulting to Einstein, as well as to insane people. And if Mark Twain said everything that Mark Twain said, he'd never have had time to write any of his books (let alone all those short letters).

It's very convenient to adopt a famous dead person and put the words of your movement or sales pitch into their mouth. Not very respectful or honest, though.

Sunday, 17 January 2010

The economics zeitgeist, 17 January 2010



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, 16 January 2010

Cognitive/behavioural links

A few links today:

  1. Eric Fairfield, whom I met over at the Environmental Economics blog, is working on some ideas that are resonant with mine - local rationality, cross-disciplinary influences from physics, computer science and economics, and cognitive agent modelling. Not much detail on his blog yet, but some tantalising hints. We'll be speaking soon and if there's anything more I can say publicly, I will.

  2. Text-message donations to the Red Cross in the US have raised $8 million for Haiti relief in 3 days. Consumerology thinks this is a lot, but I'm not sure that it is. Compare to (say) the 2004 tsunami - after which the Red Cross raised $1.4 billion in a month or the equivalent of about $135 million in 3 days. Admittedly this is a worldwide figure - but the US number would probably have far exceeded $8 million.

    There's a more interesting story here than just whether text messages make it easier to donate - the effects of booms and recessions on donations, disaster fatigue and cultural differences in perception between Indonesia and Haiti. That research may come later. In the meantime, please do donate.

  3. Eight economic and philosophical questions from Scott Sumner at TheMoneyIllusion. This posting alone will give you a couple of hours' worth of thought if you take it seriously.

  4. And linking to the above is Arnold Kling with five possible explanations of the recession, including some discussion of psychological and intellectual-property influences.

  5. Update: A fifth link, a review by Mae Kuykendall of David Westbrook's Out of Crisis: Rethinking our Financial Markets, discusses a very interesting issue: language, and how it constructs social institutions such as markets and governments, while conditioning our assumptions about prices and claims on resources.

Thursday, 14 January 2010

Will banking be more stable? Is that a good thing?

In an intriguing example of pricing an externality, Barack Obama has announced a plan to tax American banks based on their reliance on the wholesale finance markets.

On a related subject, Nick Rowe has a neat analysis of finance as magic - the magic of borrowing short and lending long, sharing risk and creating liquidity.

To make this magic work in a more stable fashion, it's understandable that governments would want to encourage banks to move from wholesale to deposit finance. Assuming it works, what are the effects of this move likely to be?
  1. The coordination game between multiple owners of capital will work better, for two reasons. First, because no individual will have as much power as they do now. Second, because the more finance is provided by millions of depositors (instead of a few hundred managers of wholesale capital) the more statistically predictable their behaviour is likely to be. Even when there are herd changes in depositor behaviour, the movement of a larger, more granular, herd is more predictable than the movement of a small group.
  2. The amount of capital available in the economy is likely, in the short term, to shrink. Wholesale funding is a quick and efficient way for banks to lever up their reserves by lending to (and depositing with) each other through the money multiplier effect. If there is less wholesale funding, then money will be multiplied through the slower process of retail lending and deposits. The lower efficiency means the total multiplier will ultimately be lower. Slower transmission means more stability, but also less growth in the money supply.
  3. Central banks are therefore likely to pursue a looser monetary policy than they otherwise would. Thus, interest rates will be kept lower for longer and/or QE-like programs will continue. This effect will be further strengthened by the fiscal tightening that the $120 billion tax represents (because central banks, in the long run, act to neutralise the effects of fiscal policy).
  4. Non-bank providers of credit should gain an advantage. In theory, there's no reason why an unregulated (or less regulated) institution shouldn't issue its own promissory notes which can be used as capital. While these notes, because their issuer is uninsured, would presumably trade at a discount to bank money, there may be times when they have an advantage. Imagine Microsoft issues vouchers for future purchases of Windows or Microsoft Office; these might either be sold for cash or traded for other resources, and could help to finance the development of the next versions of those products. There is a paradox here: Microsoft might have the financial strength not to require such unconventional means of finance; while a smaller company which does need it, might have to issue its paper at such a large discount that it would become uneconomic. The instruments may end up being more equity-like than money-like. But there could well be points on the risk/return curve where this makes sense.
  5. Investment banking in general will become more expensive relative to retail banking. Perhaps this will nudge the US slightly closer to the European model, where large retail banks provide a higher proportion of corporate finance.
  6. If finance does become more stable, in the long term this should make investment decisions more predictable and increase the net present value of financial assets. It's possible that this would lead to a repeat of the last ten years: stability leads to asset price rises, leading to more leverage, and maybe some other currently unforeseen pressure will create the potential for another crisis. But that could also be true of anything that increases economic growth. It's probably not worth sacrificing growth for a vague idea of risk reduction.
  7. If countries outside the US don't impose such a tax, London may end up attracting more wholesale finance - quite the reverse of the exodus many people have feared.
Generally I think a flexible finance market with many forms of different capital is a good thing. But there's nothing wrong with riskier forms of money being priced a little more highly. As economic theory would predict, putting a price on a service that's currently being provided for free will encourage people to consume the right amount of it.
    Two dangers that I see. One is that it may be possible to find loopholes in the definition of "wholesale finance". The simplest definition is that it should cover any liability which is not already covered by the deposit insurance scheme. But would that then include retail deposits that are over the deposit insurance limit? If so, would that actually act as a disincentive for some deposit-taking? An more sophisticated mechanism would be to use statistical models of the volatility or riskiness of each source of finance; but that opens up all sorts of model risks of the kind we've seen with agency-based credit rating.

    The second is that the price may not be right. It seems that goal is specifically to raise $120 billion, on the basis that that was the cost of the last bailout. But there's no reason to assume that that is the correct price of the government's implicit guarantee. Maybe the next bailout will cost more - or less - than the last one. In which case wholesale capital will be under- or over-priced respectively. Still, it's probably better than not pricing it at all.

    Update: Greg Mankiw agrees.

    Wednesday, 13 January 2010

    Inflation as a cognitive forcing mechanism

    Something just struck me when reading Scott Sumner's latest (this often happens - if you're genuinely interested in macroeconomics and not subscribed to Scott's blog yet, you should be).
    For instance, if wages are sticky it may lead to suboptimal real wage movements.
    The reason why we think inflation is good for solving recessions is we believe it helps to overcome wage stickiness (NGDP, Scott's preferred target, does the same but also has a useful extra effect on the incentives for, and risks of, investment).

    In other words, recessions sometimes happen when people are in jobs which are no longer as productive as they used to be (or making products that people don't want so much). In a completely efficient market, their wages would fall, product prices could fall too, some people would move to other jobs and supply and demand would balance at the point of highest output. But in reality it's hard to reduce wages - because of both employment contracts and habit or loss aversion - the psychological defences we build around our current salary level.

    So inflation is meant to make this process easier, as a fixed nominal wage is automatically declining in value, at least relative to the prices of all other goods which are rising.

    Think of this in a slightly different way. Imagine there were no inflation, but instead all wages did automatically fall. Imagine your contract said that next year's salary would be 3% lower than this year's; with another 3% cut the year after.


    Would you just stick around and put up with it? Highly unlikely. You'd either move at the end of the year to somewhere that would match or beat your previous salary; or renegotiate with your boss, which might involve demonstrating that you're more productive or taking on more responsibility. If you couldn't be bothered, then you could stay, but you'd become cheaper and reduce your employer's cost base - letting them reduce product prices and sell more.

    Can you imagine a world where that was the default employment contract? It seems far-fetched, but ruthless as it would be, it would encourage people to think more about where and how they could add most value. Without this effect, it's easier to get away with being lazy and ignoring potential opportunities to improve. I am all for people being lazy if they want to, but they should know there's a cost to it - and not just to themselves, but to the rest of the economy too.

    In contrast, this entrepreneurial rethinking is exactly the kind of market dynamism that inflation implicitly encourages. Inflation provides a 2-3% subsidy to your efforts to keep yourself competitive. Maybe you don't need that, but look around you. Plenty of people do.

    Tuesday, 12 January 2010

    Left, right and wrong economists

    A comment from Joshua Corning on this Environmental Economics post says:
    Also it should be noted that many economists are politically neutral and are simply painted by the left. The idea that there are libertarian, conservative and leftist economists is false dichotomy (trichotomy?). The reality is that there are economists and there are left wing economists, with the left wing economists trying to paint everyone who produces work that conflicts with their ideology as being right wing.
    This comment is hilarious on its merits - just replace "left" with "right" and vice versa to see an equivalently absurd statement that would be equally happily accepted by a different group of people.

    But it raises a sort-of valid question: what does it mean to be a left-wing or a right-wing economist? In two conversations recently I've felt the need to make excuses-in-advance for an economist whose work I was recommending, but who is well to the right (in the libertarian sense) of the British mainstream. I thought the reader might think of them as a bit of a free-market extremist, so I decided to defuse this reaction by warning of it in advance.

    Now this could mean - as Corning implies - that the British mainstream is economically illiterate, which expresses itself in left-wing views, and any real economist would agree with the people I'm describing as right-wing.

    But that's not a fair representation of economic theory, or of "left-wing" economists such as - say - Paul Krugman, Brad DeLong or Mark Thoma. All three are fairly strong defenders of mainstream economics and will argue for broadly unregulated markets, free trade and a general economic understanding of people's response to incentives. Just as "right-wing" economists mostly accept the concept of public goods and that there are occasional market failures which can justify a role for government. In fact, for all that economic debate really does have a socially determined component, the discipline is quite united; and few British or European economists would disagree on basic theory with the majority of Americans.

    The differences between left and right within the economics profession are rarely about theory - they are about the weights that people put on known parameters in the theories.

    Left-wing economists tend to assume that:
    • transaction costs are often high
    • marginal utility of wealth is strongly diminishing
    • many goods are public or have public aspects
    • markets are often inefficient (e.g. due to sticky prices or asymmetric information) and the well-known government solutions to those inefficiencies are welfare-enhancing
    • labour supply and demand are inelastic
    • poverty has externalities

    Right-wing economists tend to assume that:
    • labour supply and demand are elastic - at least in the long run if not so much in the short
    • knowledge and agency problems mean that government solutions are usually worse than imperfectly efficient markets
    • the incentives provided by strong property rights lead to efficient allocation of resources even in the presence of transaction costs
    • social safety nets have important moral-hazard externalities
    None of these points contradict standard economic theory: the only question is the strength of each effect. If you think the problem of government knowledge is less important than the problem of sticky prices, you're more likely to tend leftwards. If you think transaction costs are less important than labour incentives, you may tend right. At our current level of understanding of economic theory, I'd argue that these are basically empirical questions.

    There are certainly disciplines within economics which are more likely to be pursued by those on one or other side of these questions, simply because they find the questions more important. Labour economics, environmental economics and Keynesianism would mostly be associated with the left; while monetary economics and the economics of crime and the law are more typical on the right.

    And there are heterodox theoretical approaches which are strongly associated with the left or right wing. For example the Marxist dialectic approach is linked to the left, and there are more of the Nudge-type subset of behavioural economists on the left than the right. And the free banking and real business cycle theories are associated with the right. But none of these are mainstream viewpoints.

    But overall, mainstream theory really does provide a strong common base for nearly all practising economists, and only the parameters of the theory determine their political position. Only someone with their own heavy ideological blinkers could suggest that putting different values on those parameters disqualifies you from being an economist.

    Monday, 11 January 2010

    Subsubsubclauses of the day

    Paul Krugman is a great writer. And a pretty good economist. But just as as good economists can occasionally say silly things, good writers sometimes lapse too.

    How long does it take you to figure out this sentence outside of its context:

    Still, I think it’s important that just because I think Europe does better than Americans imagine doesn’t mean that it does everything right.
    Can you count the nested subclauses on less than two hands?

    Sunday, 10 January 2010

    The economics zeitgeist, 10 January 2010


    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, 9 January 2010

    More on Amazon pricing

    You might remember a previous discussion of Amazon's pricing policy. I came across a further thread about it on...Amazon's own website! I hope that guy with the last comment is doing it for research purposes and not because he thinks it will save money.

    Some theories from that discussion: currency fluctuation (which is plausible); stock position of different suppliers (not so much); testing of the demand curve via small price adjustments (quite an interesting hypothesis and certainly possible); and adjustments to changing demand (if true, would reveal a surprisingly detailed understanding of demand for individual books - but you never know).

    Another possibility: it could be driven by competition - but as the market leader, it's less likely that Amazon adjusts its price to competitors than vice versa. Maybe then they deliberately make frequent pricing changes to stop competitors from finely undercutting them. Anyone know whether competitors can use Amazon's API to get realtime prices?

    Latest update from my own shopping basket. I wonder if I should be quite so open about what books I'm buying...



    Friday, 8 January 2010

    What's a generalised devaluation?

    1. Interesting but depressing Paul Krugman interview
    2. Interesting but depressing Economist cover story
    I was going to write about bubbles, but an almost throwaway point from the Krugman interview led me into thinking about devaluations instead. He suggests that Spain might need to (as Estonia has already done) reduce wages and prices across its economy to regain competitiveness, because they can't take the shortcut of devaluing their currency. And this, as he points out, is going to be difficult.

    Devaluations were a concept that used to fascinate me as a teenager (OK, maybe I was an odd teenager - but in my defence this was before I had a girlfriend). The topic hasn't been as prominent recently, except in the debate on the Chinese-US exchange rate.

    But Krugman's comment started me wondering just why it should be so hard to achieve a cut in prices these days. After all, wages and prices are just nominal values; yes, there are costs to changing them but they're not that high with modern technology. The British government just raised VAT by 2.5%, changing most prices across the UK overnight, and we barely noticed. In April everybody's effective wages will rise a little, with an increase in the personal income tax allowance, and nobody will notice that either.

    So could the Spanish government simply pass a law stating that all prices and wages are cut in half from tomorrow onwards? On the surface, there are two clear problems with this - but when we look deeper we'll find that they reveal a much more fundamental issue.

    First, this would not be a neutral change. Monetary wealth would double in value, enriching people with money at the expense of those with non-monetary assets (or no assets, or money liabilities). If you have €100,000 in the bank you'll suddenly be twice as rich as you were yesterday, and if you have nothing in the bank you'll gain nothing.

    Second, it would make many existing contracts (such as leases on apartments) unaffordable, since wages would be halved with rents kept the same. To solve this, the same rule would have to apply to contracts that already exist - all nominal amounts on any goods or service contracts are divided by two as well. Another problem now: people may have borrowed money to buy an apartment which they rent out. If the rent is halved, the landlord can no longer afford to make the mortgage repayments.

    So all debt service payments - and the value of all debts - would have to be reduced by the same amount too. Now you get into real trouble, because a French or German investor who's lent money to a Spaniard is hardly going to accept being repaid only half their money. Almost certainly they could take Spain to the European Court and prevent this rule from being enforced.

    Of course, this dilemma is exactly what we see in an traditional devaluation - just a little more unwieldy, and thus more obvious. Countries with their own floating currencies find it more expensive to raise loans denominated in local currency than foreign, because of the risk that the foreign investor's loan can be devalued by the local government's fiat. While if they have sold loans in foreign currency and then decide to devalue, they simply have to accept that their loans will become more expensive to service and take up a higher share of their income. That might be worth it if it makes the difference between the risk of being unemployed and having no income at all, versus retaining some competitiveness and keeping your job.

    Indeed, looking down from the national level you'll find that the same principle applies for an individual. Imagine a person who's taken on a mortgage when their salary is $100,000 and finds that they're no longer competitive at that wage. They get to choose between unemployment and a likely loan default, or reducing their wage to get a new job but lowering their standard of living to keep paying the loan. The difference is that a "personal" devaluation doesn't allow you to reduce prices, only wages, meaning that you need to cut consumption more than in the national devaluation case. Against that, the personal option leaves you free to choose your own policy independent of your compatriots, and should allow you to borrow more cheaply in your own currency because the lender doesn't have to price in a devaluation option. They are, however, pricing in a default risk instead - which might turn out to be equivalent to the "personal devaluation" risk.

    Abstracting one step further, this becomes a question of how an investment is denominated - or more clearly, in what units are you promising to repay someone? Loans by definition are denominated in fixed currency units; equity investments, by comparison, are denominated in a share of the real resources controlled by the investee; and presumably there could be other types of denomination if it suited both parties. For example a contract could be denominated in a commodity such as oil (this is what a future oil purchase contract is). And turning around that apartment lease, if we remove the distinction of "buyer" and "seller", it's a series of future exchange contracts where one party pays in units of "the right to use this apartment for a month" and the other pays in units of "euro". Ultimately the choice of denomination comes down to what things have a predictable value and to whom.

    How do those units become predictable? The value of a currency is a function of the shared beliefs of hundreds of millions of people; although the beliefs of some, such as the head of the central bank or the finance ministers, have more influence than others. Equities have a value controlled by a few thousands or tens of thousands of people; or in the case of a private company, perhaps four or ten individuals. Oil's value arises from the habitual usage of billions of people and the habitual production of about a hundred oil producers (countries and companies). And the value of that apartment might seem predictable, but if you lose your job, have to move to another city, or all your neighbours move out and the local shops close down, its value will change substantially.

    Your choice of denomination of contract will be a function of which of these groups you're in, how your future income and expenditure are correlated with those of the groups, and which groups you think are predictable in their future behaviour and beliefs.

    Currency devaluations matter because they are a function of the inertia of millions of people who have put their common faith in one shared illusion, and have reflected this in their choice of long-term contract instruments. They have settled on a common converged strategy and that settled choice in itself creates predictability. That predictability arises because people are not as flexible as a theoretical market; because people don't want to recalculate prices and values all the time; because transaction costs (such as the cost of moving house or employing a new worker) create holdout problems which are finessed with long-term contracts.

    Floating currencies are a way of drawing certain lines around this flexibility. There isn't, therefore, a pure theoretical case for or against them - the question is which group's inertia and converged strategy you want to participate in. Do you throw in your lot with the rest of the British people, the rest of Europe, or do you only trust yourself?

    And what would be the equivalent of a devaluation in differently-denominated contracts? A change in the oil price would qualify; it would simply be a "narrower" devaluation, as it would affect a smaller number of transactions than a currency devaluation. Paradoxically, a narrower devaluation is actually more noticeable; if only 10% of prices change, we will see them move relative to the other 90%; while if all prices move at once (except for those of imported goods) it's invisible.

    A reduction in property values affects the likelihood that contracts denominated in property will be fulfilled; the same effect that a devaluation of the pound has on sterling earners. The comparison is especially apt when you look at how people pay their foreign debts. Pound earners borrowing in euros must convert their devalued pounds to euros to make payment; property owners must convert their properties into pounds by renting them out. If rents are sticky, this won't be too risky; if they can be devalued, it will.

    So knowing which values are flexible and which are fixed, and where the inertia comes from, turns out to be really important. First because the various inertias and nominal rigidities are what cause recessions; and more universally, because they are solutions to some of the coordination problems at the core of economics. What is predictable and what is knowable, and by whom? Questions that govern every transaction we make with another person, but that we rarely remember to ask.

    Asking them will help us understand what assumptions are implicit in the nominal definitions of a transaction. We can get a generalised picture of the risks of our contracts changing in value. And by learning which collective assumptions control those values, we'll know what kinds of devaluations to look out for.

    A joke so obvious I feel wrong to even mention it

    Politicians called Mrs Robinson should know better than to have toy boys.

    That is all.

    Wednesday, 6 January 2010

    Cognitive economics

    I have hinted here that what is often called behavioural economics would be more fruitfully examined in conjunction with cognitive economics, the study of thoughts, beliefs and decisions, and their economic effects.

    Recently at Inon we've been developing a model for cognitive economics. It integrates the preference-based approach of conventional economics and a model of beliefs or awareness which we call the attention function. This model promises to offer explanations for a number of cognitive and behavioural phenomena which don't fit into the neoclassical model, and should also be abstract enough to be generalised to higher level economic structures.

    Today I've found someone else who agrees with the cognitive/behavioural distinction: Marco Novarese. The link is a page about developments in cognitive economics (mostly in the last ten years). This paper is a good outline of some of the issues in the field - though the paper itself proposes no cognitive theory that is generalisable to the microeconomic level, let alone macroeconomics. Novarese works at the Centre for Cognitive Economics (which I had not come across before) in University of Piemonte Orientale in Italy. I'll be following the centre's research in more detail now and will link to any interesting developments on the blog.

    Via his site I came across this Douglass North paper which touches on some similar ideas. I find North an excellent economic thinker; much of his writing has clearly identified the challenges for economics in cognition, culture and the study of institutions; and although he hasn't solved all the problems he has set out a tantalising research agenda for those interested in them.

    Some excerpts (in the area of cultural ideology North goes beyond the study of individual beliefs to which I would confine myself, but it's still very interesting):
    Therefore the central questions that confront economists in cognitive sceince are not only how human beings learn and meld beliefs and preferences to reach decisions and hence the choices that underlie economic theory but also how and why do they develop theories in the face of pure uncertainty, what makes those theories spread amongst a population or die out, and why do humans believe in them and act upon them?


    ...[on game theory] With small, personal exchange it pays to cooperate since the players interact repeatedly. But with impersonal exchange, to use the game theory analogy, it pays to defect. Historically it has been the creation of political and economic institutions that have altered the payoff to reward cooperation. But throughout most of history and still today in many societies the necessary institutions--particularly the political ones--are not forthcoming. It entails a fundamental restructuring of a society to create a world of impersonal exchange--a restructuring that has typically not been forthcoming. Since institutions reflect the belief system of a society then we must turn to the diverse cultural heritages of society...


    While institutions structure the external environment between human beings, ideologies structure the mental "environment" thereby making predictable the choices of individuals over the range of issues relevant to the ideology. But what makes individuals susceptible to having their mental environment structured?

    ...[Ken Binmore] maintains that we come equipped with algorithms that not only interpret the behavioral patterns we observe in ourselves and others in terms of preference-belief systems but actively build such models into our own operating systems.

    John Prescott's related videos

    Yesterday's blog was delayed by snow and is still stuck on the A3.

    Today I was watching a video of John Prescott (which was not very exciting, but feel free to have a look). At the end, however, something much more interesting happened. The "Related videos" list showed me some rather surprising results:



    What has John Prescott done to deserve this? Is there a secret striptease video of him on Youtube? I think we should be told.

    Monday, 4 January 2010

    Economic etymology and the AEA

    In a WSJ article about how economists are cheapskates at the AEA conference, the following unusual error appears:
    Think of the person who orders the most expensive entr[eacute]e at a restaurant, knowing that the check will be shared equally among companions.
    I find myself trying to pronounce the typo. Is this where the word 'entrecote' comes from?

    More seriously, and yet somehow also less:
    Cornell University economist Robert Frank, working with a pair of psychologists, mailed questionnaires to college professors asking them to report the annual amount they gave to charity. Their 1993 paper reported that 9.1% of the economists gave no money at all -- more than twice as many holdouts as in any other field.
    Note that twice as many reported holdouts is not the same as twice as many holdouts. Many economists, I have no doubt, are proud of their lack of charitable giving and much happier to admit it in a survey than others might be.

    And one more piece of odd speculation:
    Given their understanding of the odds of gambling, economists seldom frequent casinos, which is one reason the meeting isn't held in Las Vegas.
    But surely this is a perfect opportunity to take advantage of an inefficient cross-subsidy. Many hotels in Las Vegas can be got quite cheaply because the casino owners expect to make back the money on the slot machines (another example of metered price discrimination).

    The explanation? Someone gave away the secret. The hotels have already seen through this and don't offer the AEA any discounts:
    A decade ago, a hotel sales representative showed Mr. Siegfried a chart showing how little economists gambled compared to other people, he says.
    Note that the Business and Behavioural Science conference has been held in Las Vegas. So has the Western Economic Association's annual meeting. I don't know whether behaviourists or Westerners are less rational - or have a different set of exotic preferences - but clearly the rest of the economists have decided that gambling should be confined to the gold market and their job applications.

    Then again, it's never been in Miami either. Maybe they don't like drugs or gambling.

    No doubt there will be more entertaining reports from the AEA conference when all the other bloggers get back from it. Maybe I should become an American economist in time for next year's.

    Sunday, 3 January 2010

    The economics zeitgeist, 3 January 2010



    This week's word cloud - the first of 2010 - 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, 2 January 2010

    Is the Ponzi game over?

    Does this story sound familiar?
    • Debt rose to unsustainable levels in 2007
    • Imbalances in the world economy reached unprecedented levels - the Chinese trade surplus approaching $1 trillion, American public deficits around half a trillion dollars...
    • Oil and other commodities soared to historic highs
    • The financial system became overleveraged on the assumption that a permanent era of stable growth had been reached; removing the margin of error for slowdowns
    The whole system reached a high-water mark and fell back; banks and the rest of the financial industry were unable to cope with the failure of a few highly leveraged firms; and we ended up in an 18-month recession.

    But is it true?

    Why do we think that household debt at 150% of GDP, or oil at $150 a barrel, or US public debt of $10 trillion, is unsustainable?

    I'm quite prepared to believe that enough people were worried about debt to stop accumulating more of it; and that this was a contributing factor to a slowing of monetary velocity which led to the recession.

    But this doesn't mean the "correct" level of debt is whatever it was ten years, or twenty years, ago.

    So it's logically conceivable that we are in a Ponzi game, as William Greider, via Brenda Rosser at Econospeak suggests. But why should this be the end of it?

    None of the predictions outlined in Greider's book appear to have any quantitative component; they are pure narrative and completely untestable. And even if you believe in their plausibility, there's no way to know whether the unstable level of debt is 100%, 200% or 900% of GDP; whether the concentration of power he fears is 500, 100, 30 or 2 big companies; and whether the "eventual" end of the game he predicted was to come in 1995, 2008 or 2090.

    Skip over the eccentric references to "huge military expenditures on the Vietnam War as well as through what is arguably, an accompanied global oil price hike that was deliberately manipulated to help pay for it" and ask yourself this question:

    Does anyone have a theory which predicts a stable long-term level for public debt, private debt, Chinese trade surpluses, oil prices or the dollar exchange rate?

    If not, then it's nonsense to suggest oil is "too expensive" or there's "too much debt". I'd be confident in placing a bet that in 2030, one of the figures mentioned in this article will be at least three times its current level. I don't know which one, but I know we need to lose our attachment to the nominal values of today's economic variables.

    Friday, 1 January 2010

    An Austrian review

    I’ve spent some time over Christmas reading a comprehensive review by Mario Rizzo of recent work in Austrian economic theory. Regular readers might have noticed that, though this is a school I broadly disagree with, I have given it a lot of attention. It does seem to hold a fascination for me.

    I think the reason for this is that the founding thinkers of the Austrian school picked some really important issues to think about, and I instinctively agree with their choice of territory. Here is the list of topics Rizzo identifies:
    “(1) the subjective, yet socially embedded, quality of human decision making; (2) the individual’s perception of the passage of time (‘real time’); (3) the radical uncertainty of expectations; (4) the decentralization of explicit and tacit knowledge in society; (5) the dynamic market processes generated by individual action, especially entrepreneurship; (6) the function of the price system in transmitting knowledge; (7) the supplementary role of cultural norms and other cultural products (‘institutions’) in conveying knowledge; and (8) the spontaneous - that is, not centrally directed - evolution of social institutions”
    So the issues discussed are the right ones – but are the conclusions correct? My suspicion remains that Austrian economists start asking the right questions but often bring in some unacknowledged assumptions in deriving their results. I suspect that the original Austrians – Hayek and Schumpeter at least, and probably von Mises, were more explicit about stating their ideological assumptions than some more recent writers. And this criticism is certainly true of many other economic schools too. But either way, I remain unconvinced that all the typical conclusions flow logically from the premises.

    [Since I wrote the above Rizzo has posted another item which says something similar - also worth reading]

    But that doesn’t detract from the very interesting survey Rizzo has carried out. Here are some individual questions arising from my reading of that document. I hope these will be taken in the spirit of an interested but critical friend.
    “...inappropriateness of the capital structure (malinvestment) generated by artificially low real interest rates (that is, interest rates that are lower than the real supply of savings would allow)”
    The question is: does lending really require savings? Lending is about somebody spending their time now, in return for payment later (usually intermediated by a highly creditworthy institution such as a bank). There is no strict requirement for an existing stock of savings to enable this. In a simple example, three people could wash up on a desert island with no stock of wealth at all, and as long as two of them can find enough coconuts to support the third, she can get busy building a house for them to live in. This is lending with no associated savings. Rizzo mentions papers on 100% reserve banking, which implicitly acknowledges the possibility of zero reserve approach that I have described here.

    Why then are savings typically associated with lending? It could be to provide a discipline on lenders/borrowers/investors who have no obvious incentive to limit the amount of credit they extend (and thus risk destroying the credibility of the instruments they issue). There might be other ways to offer that discipline.
    To take a different approach, investment can be made out of the income from previously invested assets; but there’s no particular reason it has to be. There might be some moral symmetry here, that those who have foregone consumption in the past are more deserving of the benefits from investment than those who will forego it in the future; but a Coasian argument shows that this need not hold; the returns to investment can be seen simply as a property right – which could be assigned to anyone and can still reach an efficient equilibrium.
    “None of this implies that Hayek, Garrison or Horwitz are insensitive to the problems that would be induced by an aggregate increase in the demand to hold money (a fall in income velocity), which can accompany recessions. This ‘secondary deflation’ should be avoided by a concomitant increase in the supply of money by the relevant monetary institutions. Horwitz (2000) is the first to integrate Austrian macroeconomics with monetary disequilibrium theory to analyse deflationary processes. Nevertheless, recessions are not primarily deflationary phenomena (or at least need not be), but occasions for correction of the misdirection of resources. Some Austrians, however, argue that increases in the demand for money have significant negative consequences only in the presence of legal restraints on price flexibility (Salerno, 2003).”
    Good to know that the Austrians can recognise insights from other schools. However, in their view does money creation in any way impede the process of recalculation? The legal restraints argument seems unrealistic – in practice there is lots of inertia in prices and wages regardless of the law. If unemployment increases the speed of recalculation is it worth it?
    “One of the most important possible obstacles to recovery from recessions may be in the behaviour of ‘big players’. These are agents whose discretionary behaviour, insulated from the normal discipline of profit and loss, can significantly affect the course of economic effects (Koppl and Mramor, 2003; Koppl, 2002; Koppl and Yeager, 1996). Thus, discretionary behaviour on the part of monetary authorities (in the United States, the Fed), fiscal policy makers (Congress or the Executive), or even in some cases private monopolists, can increase uncertainty faced by most economic agents (‘small players’).”
    This is a useful insight. However does it really just apply to ‘big players’ or is there something broader? For example if small private players have an inertia within a certain market or group of customers (due to brand loyalty, personal connections or lack of information about alternatives) do they become effectively a big player? Or if an unprofitable shop continues to play out their business model due to sunk costs (thus gaining an effective capital subsidy over new players), either because of a cognitive/emotional attachment to their investment or the transaction costs of reallocating resources, is this any different from a government thus acting? Is it an ideological position which leads Austrians to be more concerned about government action than the economically inefficient actions of private individuals and firms? This may be the key distinction between the Austrian and Keynesian views.
    "...changes in the riskiness of investment decisions are linked to the ‘old Austrian’ concern with the degree of futurity or roundaboutness in investments. For example, in Cowen’s analysis, an increase in the acceptable level of risk will encourage undertaking more longer-term investments (as well as, of course, investments of any given length with more uncertain yields). These can be both investments in durable capital goods (that is, investments with a continuous flow of payoffs over a long period of time) and investments with a long period of gestation before the ultimate output is produced. Cowen associates less risky (‘safe’) investments with consumption and shorter-term investments.
    Cowen’s analysis is more general than the traditional ABCT because it allows many factors besides a fall in real interest rates to generate a lengthening of the capital structure. These include exogenous risk-preference shifts, increases in savings, easing financial constraints, and reductions in uncertainty (so as to reduce ‘waiting’ for acceptable investment opportunities). Any of these changes can generate an increase in the riskiness of investment. None of these changes must necessarily cause a cyclical boom and bust, but they might do so. "
    This seems a valid point. In a world where people criticise insufficient investment and excessive risk aversion, it highlights some of the deeper factors which might explain or contradict these ideas. It also hints at the asymmetric nature of risks – there are downside risks with one probability distribution, and upside risks with another. The way to treat each of these may be quite different; the patterns of each call for different investment and lending patterns, different relationships to past and future assets perhaps.
    “Free-banking advocates argue that bank profit maximization, under sound institutional constraints, will lead banks to expand or contract deposits or currency pari passu with changes in the demand for money. Banks will receive signals about the demand for (their) money as their reserves expand or contract.”
    Can it be demonstrated that, under market conditions, this process generates a stable equilibrium? Or is an increase in demand for money amplified by changes in reserves, the valuation of bank money and deposits (and the bankruptcy of banks?) The answer is not obvious. If it is stable, and if reserves and pricing can fluidly adjust to correct such problems, does this lead to either:

    1. Moral hazard/commons problems, where individual banks have an incentive to overlend on the basis that other banks share the risk and the total economy-wide reserve pool? OR...
    2. information problems and transaction costs, where the cost for individuals of understanding and distinguishing between the money of different banks acts as a brake on economic activity? This might be mitigated by technology today, though it must have been a real difficulty in previous free banking systems.

    Moving onto a chapter about entrepreneurship:
    “Even better, eschewing the excessively constraining categories of necessity and sufficiency, we might say that the serendipity of discovery favours the searching mind.”
    This is the kind of rhetoric that makes me worry about the Austrian mindset. Most people see necessity and sufficiency as simple logical constructs, not “excessively constraining categories”. It is indeed clear that there can be statistical correlations without strict necessity or sufficiency (one could count this in the domain of fuzzy logic or else provide a more detailed description of the causal chain). In the case being discussed, it is surely true that searching increases the probability of discovery without guaranteeing it. This can be stated in a less suspect way without describing logic as “constraining”.
    “In most Austrian treatments entrepreneurial discovery is important because it drives the market process.”
    This also in the entrepreneurship chapter: which is an interesting one, but it’s not clear where the concept fits into the broader theory. At any rate it does not feel like a distinction between Austrian, Keynesian or neoclassical theory, all of which are impacted broadly in the same way by entrepreneurship. Perhaps the Austrian model recognises an explicit externality cost of government action or recession-fighting policies in their inhibiting effect on enterprise; if so, it seems to offer no way to quantify it and thus determine the welfare-maximising amount of policy.
    “...a theory of entrepreneurial judgment. This theory makes entrepreneurship inseparable from asset ownership. The entrepreneur’s judgement is about the control of heterogeneous capital assets under conditions of radical uncertainty”
    This seems rather old-fashioned. Entrepreneurship surely is not primarily about control of assets; unless one considers the human capital of the entrepreneur and her employees as assets, but the formulation above specifically mentions capital assets. As before, this doesn’t feel like an important criticism as the subject seems tangential.
    "The Austrian approach to market processes is distinctive in a number of respects...First, markets are in process and not continually in equilibrium...Second, market processes are not instantaneous but take time. In the passage of time (‘real time’), knowledge changes...Third, market processes take place in the context of radical uncertainty. This is to be distinguished from risk, in which all of the possibilities are known with objective probabilities...the fourth feature of market processes: they are relatively indeterminate...The fifth, and final, feature of market processes is the communication of decentralized or scattered knowledge. Markets enable individuals to act on more knowledge than they can ever hope to possess explicitly. They can do this through entrepreneurially produced market prices and through nonprice manifestations of market behaviour."
    These all seem like useful insights but are hardly unique to Austrian theory. The recognition of non-equilibrium dynamics is very important but its mere acknowledgement provides only a limitation on standard theory, and no explanatory or predictive power.
    “spontaneous order...‘the results of human action but not of human design’... is an organic or emergent form of coordination that manifests itself in social institutions, some organizations and clusters of individual plans”
    Once again, a useful insight but is there any real analysis behind it? Ironically, this area has much in common with the work of recent Nobel-winner Elinor Ostrom, perhaps ideologically as far from Austrian economics as any mainstream economist.
    "[in the area of] law and economics...The field’s uniquely Austrian features consist of attention to (1) the process of law and state intervention in markets; (2) the need for relatively stable law in a world of external change; (3) the influence of decentralized knowledge on the character and limits of law; and (4) the privatization of some of the basic functions of the state."
    The discussion of (1) focuses on unintended consequences of regulation and wealth redistribution. Once again, good topics but the analysis may be incomplete.

    Two arguments for redistribution from an economic efficiency standard are: that diminishing returns to wealth argue for money to be partially redistributed to those who lack it; and that a lack of redistribution may lead to negative social externalities such as a breakdown of public order or public health. I imagine that the theoretical apparatus of Austrian economics can take account of these factors, but I wonder whether the typical analysis carried out by the typical Austrian economist actually does.

    On regulation, the author cites a couple of his interesting recent papers regarding behavioural economics and its interaction with regulation, and the impact in turn on the emergence of a “regulatory culture”. This is an argument against behavioural economics that I’ve heard before, and it deserves to be answered.
    First, with an emphasis that good behavioural economics is inspired by many of the same motives – understanding human cognition and its economic impact – as von Mises’ Human Action and much of the Austrian work that followed it. This – which I prefer to call cognitive economics – is a positive, not a normative, discipline.

    Second, an acknowledgment that many behavioural economists – like many Austrian economists – approach their subject with a common ideological framework and this does influence the type of results that are discovered, either through subjective interpretation of data or choice of research topics. I was interested recently to hear a conversation between Dan Klein and Russ Roberts in which Klein both highlighted the dangers of approaching the discipline from a subjective viewpoint, and admitted and demonstrated his own subjectivity. The more common view is that a scientist (or social scientist) should attempt to recognise and eliminate their subjectivity when approaching data; but it’s also worth remembering the distinction between lawyer and judge. Perhaps researchers are the lawyers of the scientific method, presenting their view and making the best case they can, while editors or even readers are expected to be judge or jury and decide between competing viewpoints.
    (2) discusses " the legal framework and its adaptability...the level of abstraction of the relevant rules...Whitman shows that an intermediate level of abstraction is optimal from the perspective of generating rules with predictable consequences...Rizzo (1980a, 1980b, 1985) and Roy Cordato (2007) both criticize the cost-benefit framework in many conceptions of negligence law because it produces legal decisions that lack predictability to those for whom the particular law is relevant... The economic data upon which efficient legal decisions are to be made are often unavailable, complex or transient."
    A valuable insight and (though I haven’t read the cited papers) potentially a powerful philosophical building block. Again there’s a way to represent this potential economic inefficiency as an externality...the cost imposed on future economic agents by additional uncertainty in the legal outcomes of their decisions. But this is an aside. Is there a way to price this externality or uncertainty? Rizzo argues for a “set of rules” rather than a standard, but in principle one of the rules could be “carry out a cost-benefit analysis based on the best available estimates of costs and benefits”. Is there a way to determine the concreteness or abstractness of a given rule?

    I was quite surprised by this:
    “Block argues that the Coasian cost-benefit approach effectively abolishes property rights”
    Again without having read the paper, I’m surprised because I think of Coase as the ultimate defender of property rights. Coase doesn’t argue that legal structures should be chosen according to costs and benefits, but that whichever definition of property rights is chosen, private individuals will trade according to their own personal cost and benefits and an efficient outcome will occur.

    No doubt Walter Block is playing against this conventional assumption in making the argument he makes, but still, I wonder if this is contrarian thinking for its own sake.

    The exposition of (3) seems broadly similar to (1):
    “The decentralization of factual knowledge is a critically important factor limiting the feasibility of many forms of intervention... Using the internal standards of three major ethical approaches - utilitarianism, natural law and Kantianism - Rizzo argues that the factual knowledge needed to determine just what the moral course of action is in concrete cases is not available to the paternalist.”
    Of course that must be true in many cases...but is it always? At the extreme, there are cases where an individual clearly does not have the capacity to choose in their own interest: a 5-year-old child or a person in a coma. In other cases, an individual might explicitly opt into letting someone else make a decision on their behalf: a defendant in a criminal trial may ask their attorney to choose the right argument for them, or a buyer of a pension plan may ask their adviser to choose on their behalf. And somewhere in between, there are open questions such as: should the default for organ donation be opt-in or opt-out; should a defendant, whose mental state cannot be evaluated by the police officers treating them, be opted into receiving legal representation if they refuse to answer police questions about it? The pragmatic question must be about determining where the boundaries lie between these cases; it seems unhelpful to deny that there is a valid question to ask.

    And finally, item (4):
    “Most economic analysis proceeds on the assumption that the state exercises at least its minimum functions: that is, provision of protection, enforcement of property rights and contracts, and the adjudication of disputes. Nevertheless some economists...have argued that privatization of at least some of these functions is feasible and desirable... Powell and Stringham (forthcoming) survey a surprisingly large extant literature on the economics of a stateless society.”
    Certainly an interesting area, and I’d be interested to read that Powell and Stringham paper. But is this an integrated and necessary consequence of basic Austrian principles, or is it another ideological add-on? To be fair, this point can certainly be seen as a corollary of the “spontaneous order” principle described earlier. I’d be fascinated to see a good marginal analysis – drawing on Ostrom, Caplan and Benson, say – of the right place to draw lines between state and non-state power.

    Ultimately this might be, for me, the chief criticism of Austrian economics. Instead of using the key analytical strength of the economic method – marginal analysis and trade-offs – the field tends to end up at firm philosophical positions based on principle rather than maximum efficiency. Some of course would see this as a strength not a weakness, and perhaps this will be the toughest thing for me to reconcile between my philosophy and the Austrian approach.

    Update: I note that Pete Boettke has renamed the "Austrian Economists" blog to "Coordination Problem". Some of his reasoning is similar to my arguments above, and I think it's a good move. I have added Coordination Problem to the blogroll on the right.