Knowing and Making

This evening Paul Mason leads a debate for LSE , the Adam Smith Institute  [ Update : I made this assumption based on the debate being listed on the ASI's "Events" page. A BBC editor has kindly emailed me to correct my mistake. Thanks!] and Radio 4 on Keynes versus Hayek. It’s a good day to talk about it, with UK growth figures coming in at a disappointing 0.2% and a lot of uncertainty about whether public sector austerity is slowing economic growth, or conversely enabling more private investment which will improve things in the long term. [ Update 3 August 2011 : The programme will be broadcast this evening at 8pm UK time, and will be available after that from this address ] On Hayek’s side, Jamie Whyte and George Selgin are speaking; for Keynes, Duncan Weldon and Lord Skidelsky. Do come along if you can, though the event is likely to be full so arrive early (5.30 is suggested). If you don’t get in, come to the Old Bank of England pub on Fleet Street afterwards for d...

[ Apologies to X-Factor fans: this article is about "one direction" towards a new model of macroeconomics, not about the band. But do feel free to stick around and join in the discussion. ] If you read nothing but Rajiv Sethi 's and Interfluidity 's blogs, and developed all the consequences of what they said, you'd get a spectacular career in economic research out of it. Fortunately, Mark Thoma reads them - as well as hundreds of others - and has a good commentary on a recent post of Rajiv's . I won't quote the whole thing, but here is the key message. Without the assumption of a representative agent - the idea that everyone in the economy behaves identically - current macroeconomic models can't work. But this assumption misses some of the key dynamics in the economy - the fact that some people borrow and others save; the fact that different people have different beliefs and preferences - which are fundamental to both why and how economic activity...

Paul Krugman in " Bourbon Economics " (and his commenter Peter von zur Muehlen ) complain that we've had new ideas for decades in macroeconomics, but they don't take hold. By 1988, it was already obvious that equilibrium business cycle theory had failed. Shiller had already circulated his devastating demonstration that asset prices were much too volatile to be explained by fundamentals...nothing happened. Real business cycle theory continued to prosper, developing an increasing stranglehold over the professional journals. Behavioral finance stayed on the margins. The equilibrium guys had learned nothing and forgotten nothing... Our problem, in short, isn’t lack of nifty new ideas; it’s the refusal of too many economists to face up to the fact that some of their preferred theories don’t work I sympathise - as an adherent and practitioner of behavioural finance, I could hardly not. But it's too easy to blame this on the establishment for not listening. And really, ...

Two articles this evening lead me to ask the question: how do we predict GDP growth? Before reading on, why not ask yourself this question: what do you expect next quarter's GDP growth figures to be? How about the next 12 months? And why? I'd be interested to see some of your answers in the comments to this post - please also say which particular GDP figures you're predicting (personally I'm most familiar with the UK and US figures, but would be interested in comments from the eurozone and other regions too)*. I'm not going to test you on the accuracy of your forecasts: I'm more interested in the prediction itself, and your reasoning, than whether it turns out to be right. My prompts for thinking about this are: a paper Roger Farmer sent me this evening, introducing the concept of a belief function  describing what people expect next year's growth and inflation figures to be David Smith's blog excerpt of his Sunday Times column today , in which h...

The 2010 Nobel Prize in Economics has been awarded to Peter Diamond (MIT), Dale Mortensen (NWU) and Christopher Pissarides (LSE). Tyler Cowen has written a good concise summary of each prizewinner's work and contribution (linked above). I promised on twitter earlier today to write a post about the application of their research to the 2008-2010 recession. First I'll mention Diamond's book on behavioural economics , which is one of the respected texts in the field and which I've been meaning to order for a while. Today I finally got around to it. The introduction, available here , gives a very clear and perceptive abstraction of the key contributions of behavioural economics as currently practised. It can be summarised in three departures from the standard model: bounded rationality, bounded willpower and bounded self-interest. He (and co-author Hannu Vartainen) also reference the psychological process of decision-making as an important part of behavioural analys...

Here's  a little something  on fiscal stimulus. It contains a suggestion I've seen from Tyler Cowen and Scott Sumner, among others: ...while the zero bound does not bind, the Fed might nonetheless be reluctant to engage in the appropriate amount of monetary expansion, and that a fiscal boost is therefore required. A potential response to this is that if the Fed has chosen the unemployment rate with which it is satisfied, it will simply offset any fiscal measures to push unemployment below that level. That's only true if the Fed is assumed to be a simple (rational?) agent acting with just one lever: controlling the money supply in order to choose a balance between inflation and unemployment. However, it's very plausible that the Fed is  not  happy about the current unemployment rate, and recognises that it could and perhaps should increase inflation (or NGDP) to fight it. But it is  also  worried about its long-term credibility (as Ben Bernanke indicates i...

In case you were worried, I have not been intimidated by Kartik Athreya's " Economics is Hard " into closing down my blog. I've just been so busy doing stuff and going to things that I haven't had time to write any of it up. Soon, though. Tomorrow, I hope. Meanwhile, a couple of thoughts here and in the next posting: There's an interesting discussion on nominal wage stickiness  between Scott Sumner and Bryan Caplan. Scott, as usual, has some good insights into the question: are sticky wages the primary cause of recessions? To save you reading it all, the answer is yes. This debate exposes a question of economic modelling which I've considered recently. Is the individual transaction the best level to model economic exchange? As a rational agent with no mental processing costs, it is more economically efficient to treat each single exchange as a new decision and re-optimise your choices. But it's not very realistic. Agents who require time to...

If Scott Sumner and Paul Krugman agree on something, it must be true. I think most of us would accept that as an axiom of economic sociology. Accordingly (see here and here ), we can take as read the idea that expectations of inflation and aggregate demand strongly influence actual inflation and aggregate demand. There's nothing really controversial about this: the idea of multiple equilibria is well established. If people expect deflation and recession, they will try to save more, spend little and invest less - and deflation and recession will result. If people expect inflation or growth, they will spend more quickly and invest in the hope of protecting their assets and capturing a share of that growth; and as a result, the expectation will be fulfilled. Or as it's caricatured by a self-help motto you've probably seen: if you think you can, or if you think you can't, you're right . Presumably we want to have more growth rather than less, and (mild) inflation rat...

Karl at Modeled Behavior responds to Richard Posner (I am surprised to hear Posner emphasising psychology - I thought he was talking about Richard Thaler at first): I am not sure exactly what Posner means by psychology. I have never been optimistic about feelings as an economics model. Perhaps people spend more when they feel better but how do we get a consistent measure of feelings and even more to the point how does policy consistently effect them. What I do think makes a difference is expectations . Expectations do fit nicely into macroeconomic models because they bear a simple relationship to real events. Macro models mostly deal with visible events such as monetary transactions. And an expectation is just an event, translated in time and perhaps given a probability weighting. But we do model things in economics that are not that simple. The most obvious example: preferences . Preferences are very complex - just think of all the factors that impacted on your choice of what dinne...

Everyone is looking for new macroeconomic models these days. Paul Krugman's recent article has been a prompt for a reopening of intense discussion on the matter. It seems that there are two major classes of proposal emerging: those based on cognitive/behavioural insights, and those which incorporate financial firms as part of the model instead of just assuming they transparently pass demand and money around the economy. Financial models include " New Models for a New Challenge ", Cecchetti, Disyatat and Kohler's proposal (via Mark Thoma - though a number of the comments on his posting point back towards the behavioural option). Another is Kobayashi's , which I may have mentioned before. I've explored the behavioural models more in past columns but I hadn't noticed this conference in Australia which looks to have had some interesting presentations. Krugman hints at behavioural explanations in his commentary but has not yet suggested a model incorporating ...

Andrew Lo, writing in the FT , says: ...human behaviour is hardly rational, but is driven by "animal spirits" that generate market bubbles and busts, and regulation is essential for reining in misbehaviour. Regular readers won't be surprised to see me agreeing with this, and indeed I have a proposal for how that regulation could work. However I am suspicious about any theory which does not make testable predictions, and I fear that Lo's "adaptive markets hypothesis" may fall into this category. This "Adaptive Markets Hypothesis" (AMH) - essentially an evolutionary biologist's view of market dynamics - is at odds with economic orthodoxy, which has been heavily influenced by mathematics and physics...The formality of mathematics and physics, in which mainstream economics is routinely dressed, can give outsiders a false sense of precision. ...fixed rules that ignore changing environments will almost always have unintended consequences...The only ...

Pointing out a speech by William C. Dudley, president of the New York Fed, Simon Johnson says : Dudley says that the Fed can pop or prevent asset bubbles from developing. This would represent a major change in the nature of American (and G7) central banking. It’s a huge statement - throwing the Greenspan years out of the door, without ceremony. It’s also an attractive idea. But how will the Fed actually implement? Senior Fed officials in 2007 and 2008 were quite clear that there is no technology that would allow them to "sniff" bubbles accurately - and this was in the face of a housing bubble that, in retrospect, Dudley says was obvious. But is that true? If we define a bubble as "overvaluation of assets relative to their future returns" then to spot one, we would need to compare asset prices with future returns. But although asset prices are measurable, future returns are not - and this is why people generally think that bubbles are unspottable. We wouldn't...

Robert Peston has an interesting insight into the financial regulation debate today: In other words, what's known as micro-prudential issues dovetail with macro-prudential issues. And if that's the case, it would make sense to put the central bank, the Bank of England, in charge of both. Or so the shadow chancellor believes. Intriguing. Indeed, it's true that there is a direct causal link between micro and macro behaviour in the financial markets. There are two reasons for this. First, the trivial one that all macro outcomes are ultimately caused by individual decisions. Second and more interestingly, one of the key influences on credit and asset markets is the appetite of individuals for risk. And a key factor in the stability of markets is whether these risk appetites are governed by rational preference theory and therefore have the ability to self-correct. In the long run everything (more or less) does correct itself, but an asset bubble and a financial crisis can easil...

I'm on a continuous quest to apply behavioural modelling to macroeconomics, and I have some way to go before I complete a model that is credible, tractable and predictive. But what I can do is use behavioural finance research to explain a trait that Paul Krugman discusses in his blog posting today . Put simply, people feel losses much more keenly than they imagine gains. Ask a hundred people whether they'd work an hour to earn £10 and most of them will say no. But overcharge them £10 on their mobile phone bill and watch them sit on hold, fill out forms and argue with shop assistants for as long as it takes to get their money back. And there is something about fiscal deficits that just feels like a loss. Carrying billions of pounds of debt and knowing that your income tax will go up to pay for it is a very concrete concern. But the idea that without it, you will lose 10% of potential growth in your income, is much harder to get worked up about. You could make a legitimate argume...

It seems like someone in the Treasury has been reading Shiller and Akerlof's Animal Spirits . This Budget has a strong unstated theme of 'fairness' in the sense that the authors use it - as one of the fundamental psychological phenomena that they believe contribute to economic performance. Two behavioural experiments are useful in understanding the Budget and the reaction to it. The first is the ultimatum game . This has two players, Mary and John. Mary is offered £10 to share with John as she wishes. The catch is that whatever share she offers to John, he has the chance to accept or reject it. If he rejects it, neither player gets anything. In a perfectly rational world, Mary would offer John a penny and keep £9.99 for herself. He would accept the penny - it's better than nothing, after all - and both would get their money. But in practice, John never behaves like this. If Mary offers him less than about a third of the money, he normally rejects it - so both players lo...

Lord Turner's report " A regulatory response to the banking crisis " was released yesterday. One of the key findings is that markets, and market participants, can be irrational. This can lead to problematic outcomes such as bubbles in asset prices and massive mispricing of derivatives such as CDOs and CDSs. However, Turner's recommendations barely address this problem. There are several valid recommendations about procyclical reserves and a hint at a power to intervene in momentum trading (such as short-selling which feeds on itself). But this only dances around the edges of the problem. He also recommends technical training or qualifications for bank executives. But that's not where the irrationality is. Indeed, many bankers have been all too rational throughout this crisis - extracting rents for themselves at the expense of shareholders and creditors. Turner does recognise this principal-agent problem and some of his recommendations deal with it. However it is n...

Robert Peston has an approving discussion of Hector Sants' comments about irrationality in financial markets. Sants says that "Markets have shown not to be rational" but (at least in Peston's quotes) does not distinguish between the agency problem, and the phenomena of behavioural irrationality at the individual level. It's an important distinction. The agency problem is amenable to more conventional solutions: aligning the interests of shareholders and employees through share schemes, some types of options, long-term performance based bonuses. These problems and the simple solutions are well known and have been discussed in the management literature for decades. This is obviously not enough. Perhaps the focus of investors slipped a bit in recent years (Peston discusses the inclination of shareholders to sell rather than reform the companies they invest in). Alternatively the effectiveness of some solutions might have diminished as employees learned to game the s...

Robert Peston is revisiting the argument for the Bank of England buying shares in private companies - proposed by me in December and (the slightly more eminent) Roger Farmer in January. He points out that the Hong Kong government did this in the late 1990s, during the Asian financial crisis, and succeeded in both supporting the market and making a big profit when they resold the stakes a couple of years later. Stephanie Flanders has a good piece about Tim Geithner's position and particularly about the IMF and other possibilities for fiscal burden-sharing between G20 countries. Meanwhile Paul Mason has an excellent summary of the issues to be dealt with by the G20 conference in a few weeks: Far from the emergence of a harmonised and increasingly unified world economy [globalisation] has produced a lopsided and malformed structure that is now falling apart. The low paid worker in Detroit cannot buy his new pair of trainers unless the low paid worker in Shenzhen a) makes them, b) d...

Those unfamiliar with theoretical physics may not have come across one of the most beautiful derivations in all of science: the results of statistical thermodynamics . I would like to introduce them to more people, not just because they are an intellectual tour de force in themselves, but because they hold very interesting lessons for economists. In short, these results extrapolate from some very simple rules about low-level structure and statistics to derive powerful results about the behaviour of the whole system. This is also a common theme of economics. General equilibrium results start from basic assumptions about rational market agents and efficient prices, and derive a result about the efficiency of the whole economy. The problem is that if the original assumptions are wrong, the results are wrong. And experiments show that the assumptions are indeed wrong. Economics has two possible directions from here. It can change the assumptions and recalculate the consequences. An appeal...