## Tuesday, December 31, 2013

### Behind neoclassicism's undiminished dominance

I am reading Yanis Varoufakis's excellent book, Economic Indeterminancy.

Today I want to share a section from that book, from which I borrowed the title of this post. It rather sadly describes the way I have observed the social aspect of theoretical (and the empirical work with close theoretical ties) economics research these days.
Neoclassicists are exceptionally open-minded people, willing to countenance any proposition, however farfetched, weird or even … leftwing. All they ask in return is that the said proposition is embedded within their three meta-axioms. This ‘openness’ is made all the more significant by the fact that, undoubtedly, any conceivable ‘story’ can be told by tinkering with neoclassicism’s first two meta-axioms (see Dasgupta, 2002). Lured by the prospect of unbounded theoretical possibility, the aspiring young economist delights in tinkering her way into the infinite vistas of potential neoclassical narratives; she even revels in sailing the oceans of indeterminacy stirred up by her tinkering.
At some point, however, the fun must give way to publications, appointments and full induction into the profession. At that point, the lurking gatekeepers (supervisor, referees etc.) present her with a fresh condition: To be allowed into the priesthood, her models must have first achieved ‘closure’ (i.e. a restricted set of equilibria); she must, in effect, submit them to the merciless tightening of the third meta-axiom’s fist, thus tracing the r or b trajectories (see the previous section’s diagram) away from indeterminacy’s cul-de-sac. At that juncture, having already invested great energy and hope in her modelling, it takes a brave and tragic theorist to desist and call it quits.
A tiny minority ‘close’ their models reluctantly, tucking critical comments away in their papers’ footnotes, biding their time and, once tenured, turn into resident critics. Some ‘close’ their models and steer clear of any controversy, but nonetheless manage to retain the memory of how determinacy’s imperatives whipped them back from a complex and rewarding inquiry to a paradigm devised for arid pure-exchange economies in which a sophisticated theory of agency, not to mention a left-of-centre political agenda, is as viable as a fire under a mighty waterfall (see Varoufakis, 2002, for the ‘postmodern’ aspect of this). Meanwhile, the vast majority not only leave no stone unturned to ‘close’ their models, often with moral enthusiasm, but also sweep under the emotional carpet any memory of how their models’ ‘closure’ was bought at the price of returning homo economicus to strict isolation from his brethren, of relinquishing meaningful social norms, and of losing social and historical contingency
The 'dance of the meta-axioms' is what separates economics from there social sciences.  In sociology, and particularly mathematical sociology, the problem of indeterminacy is widely accepted, and the approach to modelling social patterns of behaviour is far more diverse.

In a presentation of my signalling model (links to early presentation and pdf in this post) I was asked the question "In what way is this a model?" It seems that unless unique solutions are forthcoming, economists will back away from the 'wall of indeterminacy' to the happy place where all models have unique, of finite sets of, solutions. Never mind that, as Varoufakis explains, neoclassical models can be generated to support an 'infinite vista' of 'narratives'. That is, you can find any result you want within the meta-axioms if you are happy to tinker with assumptions, but you must follow the methodological conventions.

You can see this process play out across the discipline. I recently discussed how the 'Top young economists' are mostly playing at these games, getting sucked into the neoclassical vortex.

One can only hope that with the current period of naval taxing, and enough smart young economists entering the profession with much broader appreciations of the social phenomena economics attempts to explain, that the profession will gradually admit to these methodological limits and embrace alternatives.

## Sunday, December 22, 2013

### Free entry assumption means zero prices

When learning about market models, perfect or otherwise, one critical assumption is that of free entry (and implied is free exit or free disposal) of new firms into a market. In fact, it is one assumption that drives the outcome of all the economic market models (including variations such as monopolistic competition), yet its exceptionally strong implications are usually glossed over.

So what does free entry really mean, and why does it matter?

The typical explanation of free entry is that in the situation where there exists a potential economic profit in a market, new firms can freely enter the market, increasing market output and reducing profits for existing firms back to zero. Any costs they incur in the process can be recovered perfectly if things go wrong. That means if a new firms buys a building or vehicle, employ some people and produce goods, but then find can’t make a profit, they can recover all their costs and try starting another business without losing a single dollar in the process.

That such as assumption obviously conflicts with behaviour in the real world is usually ignored with reference to Friedman’s ‘assumptions don’t matter’ quip. Even if, of course, the model still fails in any predictive capacity.

But taken to its logical conclusion, this simple assumption means that in any market economy with free entry all firms will be worth zero, since their profits are zero [1]. Moreover, if all markets have free entry, then all prices will be zero.

The Twitter-verse didn’t quite understand what I meant when I said all prices will be zero, so I want to explain why this is the only logical conclusion in an economy where all markets have free entry.

First, we need to understand that the costs of production in any market for any firm are the prices set in an upstream market. That upstream market also has input costs set in an further upstream market and so on up the chain of production (and backwards through time). This is the essence of Saffra’s idea of the production of commodities by means of commodities.

The furthest upstream market is land - without a location to reside and the input of raw resources from land, no economic activity can take place. Here’s the crux of my argument. If the land market had free entry, any time the value of any piece of land became a positive non-zero amount an alternative new piece of land be instantly available to increase the stock of land and decrease all land prices back to zero [2].

The immediate downstream market, say for timber or some other naturally endowed product, would have a zero input cost for land and other resource inputs to growing their trees (rain, sunlight etc). The price of timber now reflects the cost of growing it, which is zero. The sawmill would have free land and free timber, and then cut free boards, and eventually the economy would produce free homes.

I’ve overlooked labour inputs, but in this free entry equilibrium all prices would be zero, which means even a zero labour wage rate would be infinitely valuable (you could buy every conceivable item with it).

Economic theory side-steps this issue by invoking a ‘normal’ rate of profit. Everyone goes and gets a normal rate, thanks very much. Any argument about the source of this magic normal rate is usually circular, and if price are zero it doesn’t matter what this rate is anyway!

As you might have noticed the world is finite, therefore not every market can be subject to free entry simultaneously, especially if they are already at the equilibrium point of using all the world’s resources!

The real world has no feature that correspond to the model. When we look at the short-list of conditions that invalidate free entry, we wonder where on Earth the whole idea came from in the first place. Even monopolistic competition invokes free entry in ‘the long run’ to push profits down to ‘normal’.

Clearly this assumption can’t stand up and needs to be dropped if economic models of market are going to be of any use as representations of reality, and importantly, as tools to guide public policy.

One area of economics that addresses these points explicitly is real options theory. In this theory there is no free entry and exit - when a firm enters a market it can’t simply turn around and leave and recover all of its costs exactly. Moreover, firms may find it advantageous to delay entry into markets - something not possible in the orthodox models solved in a time singularity.

fn [1]. Actually since there is another nasty assumption, that all costs embed a ‘normal’ rate of profit, a firm’s value will be proportional to its revenue.

fn [2]. In reality of course, all land is a mini-monopoly on its location and this is an impossible scenario.

## Sunday, December 8, 2013

As my online debates with ‘well trained’ economists continue with full force I will again use this blog as an outlet to expand on arguments that can’t be made in 140 characters or less, or those that simply attract religiously-held views via comment pages.

On Facebook an otherwise innocuous comment, that it is “undeniable there is an equity-efficiency tradeoff,” really leapt off the screen at me. Why would a sophisticated economist make such a strong statement that has little to no empirical support. Could it be that this little book has had such an enduring impact on the discipline?

What is rarely taught, in the haste for economics departments across the Anglosphere to pump out energetic graduates, are the numerous built-in assumptions of the core models that lead to this apparent trade-off. Nor are alternative models presented that parcel together different, often more realistic, assumptions, and which arrive at far different conclusions.

To be more concrete, if there really is an equality-efficiency trade-off at a broad level, then there should be no single regulatory change that can increase both equality and efficiency, since if there exists such a reform, or set of reforms, it negates the entire aggregation to a macro level trade-off. Nor should you be able to simultaneous decrease efficiency and equality, as this leaves the door open for reversals of such policies.

My preferred alternative way to approach such problems is to consider the set of institutions that led to the current level of equality as a whole. Then evaluate the costs of these institutions against alternative institutions that result in more, or less, equality.

One might interject at this point to say that the shifting nature of equality is a product of technology change, education, or some other such thing. I’ll leave it to Matt Bruenig to address this point
When we talk about how economic changes, technological swings, and even education will affect the distribution of income in society, we always sort of assume away our government’s distributive policy as if it will or must remain static. But that’s not true at all. At any time we can change the huge set of policies that direct the distribution of income in society to something else.
The last few decades of median income stagnation didn’t have to happen. Even if you say it was caused by international competition or technological change or whatever else, the point is that if we had put a different set of distributive institutions into place, we could have avoided the maldistribution of income that we have seen. It is not like the median incomes stagnated because the economy as a whole stagnated. Quite the contrary: the economy is much larger on a per capita basis now than it used to be. If we had wanted to make sure median incomes continued to rise, we could have done that. We would have just needed different distribution policy.
Let us now consider a couple of important cases in the set of reforms that, by most estimates, would increase both equality and efficiency.

First is shifting the tax base to land (and other resource monopolies). This is probably the simplest to  administer, and the one reform that would have the greatest efficiency boost and equality gains. Unfortunately it is also the one reform that, by virtue of its distributional impact, is the least palatable to the wealthy and therefore the least palatable politically.

The reason for the win-win nature of land taxes is that deadweight losses from taxation are reduced, increasing efficiency, while at the same time the tax will fall on those entities with the largest ownership claims to the natural wealth of a country, increasing economic quality.

The second case comprises any investment in public goods by government that would disproportionately benefit the poor due to their characteristics. I’m thinking here of, say investment in a fibre optic communications network to all homes, or investments in parks and community services in poorer neighbourhoods, or any number of things. These investments would then be provided free of charge or at token prices.

The policy space is vast, and economic thinking often limits it. Consider the case of gifts of land and accessible government-backed construction finance to households on low incomes. Such a scheme would provide the poorest in society an asset they can use to support themselves - to borrow against, to invest in, and use as a cushion in times of financial distress. We did it once before with the soldier resettlement programs, but for slightly different reasons.

In the case of Australia I might even suggest intervening in currency markets to keep the AUD low and foster local investment.

That’s a nice handful of policy ideas that appear to negate the apparent ubiquitous equality-efficiency trade-off.

Why do these ideas still hold so much sway? Why do we teach that the usual case is for a trade-off, when it is equally valid to teach that the usual case that there is no trade-off? Why constrain the thinking of graduates in this way?

I can't provide a complete answer to these questions now. I can only do my part to expand the thinking of receptive readers of this blog.

## Thursday, December 5, 2013

### Meltdowns and Mankiw

Two classic tantrums caught my attention this week, and they are both promising signs for the future of humanity (at least in some small way).

The Australian group-think collective and former news outlet had a dummy spit over the rise of, well, competitors practising journalism. John Quiggin sums up a few hilarious take-downs, but here is another

The second tantrum, although not so new this week, is from the top 1%’s economic propaganda consultant N. Gregory Mankiw. It’s a rant about how Mankiw finds it ‘hard to square the rhetoric of the left with the economist’s standard framework’.

There are many responses to Mankiw’s article - here, here, here, here, here.

Together these rants reveal the current desperation of the entrenched elites in Australia and the US. Their cushy rent-seeking positions are being eaten away by a more informed new generation. Occupy Wall Street was a massive boost for those seeking greater equality and stimulated a widespread interest in the power structures that dominate corporate and political life. Any changes that stem from this I hope will be for the better, though I fear that like any group with their backs to the wall, the elites will come out swinging with the introduction of crazy laws protecting their interests.

Change doesn’t come easy.

I want to spend some time now also discussing why Mankiw’s thinking epitomises problems with mainstream economic analysis in general.

When I suggested that Mankiw’s rant is fairly representative of mainstream economic thinking, I was immediately faced with this question on Twitter
Why is Mankiw's terrible attempt at philosophy representative of mainstream economic theory?
Since you can’t explain much in 140 characters or less, I figured I may as well elaborate on that point here. Which is that Mankiw sets up fictitious model worlds in which we are asked to consider the role of inequality. These worlds are meant to be representative of economic models of near perfect markets, while at the same time, they application of the model is inconsistent with its core properties (if you in equilibrium there can be no shocks, nor a rise in inequality). To be clear, this is exactly how economics is taught, which should be no surprise since Mankiw is one of the most popular economics textbook authors.

He concludes that
It is, I believe, hard to square the rhetoric of the left with the economist’s standard framework
Which is to say that if you believe the core economic models, you can't buy into debates about inequality.

This ignores the important issue that inequality is completely unable to be understood with the core models of economics where a mystical 'representative agent' stands in for all individuals. As soon as any degree of disaggregation occurs, such that inequality can exist, we aren't in that model world of economics anymore!

Mankiw starts by having us imagine a world of ‘perfect economic equality’. One he describes as ‘an equilibrium in which everyone earns exactly the same income’. To any economically literate reader, this reads ‘markets are complete and perfect and all are in equilibrium’. So far, he adheres to the fantasy world of the core model of economics.

Then we are to imagine that in this utopian model world an entrepreneur with an idea for a new product emerges, such as his example entrepreneurs Steve Jobs and J.K. Rowling. Through voluntary exchange, people buy this new product and these entrepreneurs get rich. So what’s wrong with that?

Nothing, so long as we forget the model!

In the model world Mankiw sets up, these entrepreneurs cannot get rich because markets are competitive and all profits are zero. They cannot sell their product for anything above its cost as consumers will substitute to any one of an infinite array of alternative goods being produced. We will simply return to the previous equilibrium.

He starts with a clear economic model, then he leaves out selected elements of it so the result suits his political agenda.

Later in the paper, he raises the common mainstream view that there is a trade-off between equality and efficiency. This is a very common view that I see in many papers and presentations, and I almost never let a presenter get away with it.

The apparent trade-off arises in a different model world where we are already at some perfect equilibrium and wish to make a change in favour of equality. Because changes are costly, moving from this equilibrium to one with more equality has a cost.

What is hidden here is that when you profess an equality-efficiency tradeoff using this model logic, you must ignore include the costs of moving from the current equilibrium to another, but ignore the costs of maintaining the status quo equilibrium.

Unlike in the model, in reality, the distribution of wealth is always and everywhere a product of the institutions we create. In this reality, the important question is, why are current institutions that allow the current degree of inequality so much less costly than the ones that allow less inequality?

Later, Mankiw elaborates the foundation of his view in why inequality is justified in the section “Listening to the Left”, where he simply asserts that the rich have earned their ‘just deserts':
My own reading of the evidence is that most of the very wealthy get that way by making substantial economic contributions, not by gaming the system or taking advantage of some market failure or the political process.
Of course he thinks that. In his model world it is impossible for political processes to be gamed, therefore he simply asserts that the model outcome must be the reality!

Given all this weaving, ducking, and model trickery, either Mankiw 1) doesn’t believe the models he has been teaching for the past two decades, or 2) he is applying them willy-nilly to support his own moral and political stance.

I suggest a little of both.

## Wednesday, December 4, 2013

### Australia's external position. Discuss

I have written about real wealth and Australia's external position in the past; in relation to a proposal for a sovereign wealth fund and exactly what it would mean for fiscal balances, and in relation to domestic asset prices (housing).

Today I want to share a graph based on yesterday's data release of Australia's external position.  I've inverted it to represent that Australia's foreign 'investment' is on the liabilities side of the balance sheet, not the asset side.

I also wanted to share a couple of graphs that extend on earlier analysis of long term housing metrics. The point I want to make is that since housing is a non-tradable good, the expectation would be that the price of housing would increase in line with other locally produced goods.

I can produce the same 'Excess price growth' charts for both non-tradables and services indexes of the CPI. They indicate simply that Australia's external position is allowing a huge shift in relative prices - housing and other locally produced goods seems expensive simply because imported goods are so cheap.

Ultimately this shift is a policy choice, since at any point we could intervene in currency markets (given the political will) to attract more diverse local investment.

The lesson here is that any whinge about prices and incomes in Australia must look at the big picture, which has been driven to a large extend by our rather backwards attitude to foreign debt and laissez faire approach to currency markets.  Anything made locally is expensive even to Aussies. It is a long road back if we want to turn these patterns around.

PS. I'm trying a new online graphing tool Datawrapper that I see Greg Jericho using to great effect.  Unfortunately it's not playing too nice today so only a single graph as a preview of what is to come.

## Tuesday, December 3, 2013

### Three years on: Cargo bike review

I am now a local ambassador for Dutch Cargo Bikes. If you would like to test rise this bike in Brisbane (or a three wheeler) email me at cameron@dutchcargobike.com.au
I’ve owned a Bakfiets (long version) from Melbourne-based importers Dutch Cargo Bikes for a little over three years now. My first impressions of the bike were very generous - smooth ride, very sturdy build, lots of smiling faces as you ride.

So what do I think now after three years of daily cycling?

I think my initial thoughts were spot in. In all seriousness, it would be very difficult to find a bike built with such quality components, and one of such size and weight that still rides so comfortably and smoothly.

I don’t really know how to structure all the things I feel I should share to prospective cargo-bikers, so I’ll used the clichéd internet format of '6 things I learnt about Bakfiets'.

1. They are a second car replacement
At various times I’ve carried a new flatscreen television, 5 old bikes, a bride and groom (for a Dutch friend’s wedding), work colleagues, tables, chairs, suitcases and more. When my youngest was a newborn we used a car capsule for him strapped to the floor of the box. A Bakfiets really is an ideal tool for daycare drop-offs, supermarket trips and any number of other short commutes. It really does open up whole new opportunities for urban transport.

2. They are more comfortable than most bikes, even other ‘sit-up’ style bikes
I ride this bike with no load most of the time simply because its comfortable. I get to wear anything, carry anything, ride at night without remembering lights, ride in the rain without getting road splashes, never forget my lock. It really is a well-thought out practical machine.

I actually planned on selling the bike last year. My eldest son rides himself most of the time now. I bought a reasonably affordable sit-up bike, but after riding it for a few days decided to sell it and keep the cargo bike.

When my bike was delivered and assembled at my local bike shop the first hill on my way home had me worried - how would I use this heavy bike every day! After a week I didn’t notice anymore and now when I ride a lightweight bike I just fly.

4. 3 adults and 2 children is possible
Don’t forget the rear rack is very sturdy and can easily hold an adult sitting or standing.

5. Making friends
Only once have I picked up a hitchhiker off the street for a ride. Although I am often asked for a lift by large drunk blokes in the city late at night - “Oh, you’re not a bike cab?”

Everyone wants to talk. Waiting at the lights people will wind down their car window and chat to you. You’ll get waves from people you’ve never seen before. Maybe this is off-putting for some people, but either it has stopped now in my area, or I’m used to it.

6. Resale
The big selling point for me choosing this bike was the trust that it was well made enough to maintain its value. I know that second hand bikes of this age now sell for about $2400 in Australia, and many people do ask me when I plan on selling. Add this to the low maintenance ($75 so far over three years to service components) it is actually quite an economical transport alternative. In all honesty it is probably the best value bike I've ever owned (and I've owned many bikes, cheap and high end).

Three years on the bike feels brand new and I still enjoy the ride.

## Sunday, December 1, 2013

### Policy and worship of prediction markets

The idea of the market as ‘information aggregator’ is, like many ideas, probably as old as humanity itself, but Friedrich Hayek is usually credited with popularising the idea in his 1945 article “The Use of Knowledge in Society”. He writes

The peculiar character of the problem of a rational economic order is determined precisely by the fact that the knowledge of the circumstances of which we must make use never exists in concentrated or integrated form but solely as the dispersed bits of incomplete and frequently contradictory knowledge which all the separate individuals possess.
The economic problem of society is thus not merely a problem of how to allocate "given" resources—if "given" is taken to mean given to a single mind which deliberately solves the problem set by these "data."
It is rather a problem of how to secure the best use of resources known to any of the members of society, for ends whose relative importance only these individuals know.

While I agree that information aggregation is a problem in maintaining a ‘rational economic order’, I disagree with the religious fervour that ‘markets’ are promoted the ‘solution’ to the problem of information aggregation. This is particularly the case with prediction markets, which are often seen as a type of mystical seer of the future. But if markets have an ability to aggregate information, there must exists alternative processes for information sharing, since markets can only reflect existing information and not provide new information.

A common modern view is that prediction markets are so good at information provision, or prediction, they should be widely extended to more areas of life. Here’s just one framing of the issue

Economists believe that financial markets do a good job in aggregating information in part because they provide the participants with strong incentives to form good predictions.

Speculative markets perform relatively well when compared with information institutions (academia, news media, experts, etc) in terms of their information aggregation and prediction accuracy when presented with the same situation or environment.
Some examples may include Florida Orange juice commodity futures which have improved on government weather forecasts (Roll, 1984), betting markets that have beaten major national opinion polls 451 out of 596 times in predicting U.S presidential election results (Forsythe, Nelson, Neumann, and Wright, 1992), and betting markets that beat out Hewlett Packard official forecasts 6 times out of 8 at predicting the computer corporation’s printer sales (Chen & Plott, 1998; Plott, 2000).
So why not incorporate such markets in areas of public choice in order to facilitate societal decision making?

To really consider this topic we must first be clear about the economic and social value of information, what we mean by aggregate, and what ‘markets’, especially prediction markets, actually do. Then we can consider when and where markets seem to be useful tools for information provision, and when and where they probably are of little value. The intention being to wrap some social and economic context around an otherwise bare, idealistic, and often skewed view of the role of markets in society.

First then to the economic and social value of information. Say, as Hayek fairly rightly assumes, that information about how to produce certain goods, where to find certain resources and so forth is known only very narrowly amongst specialists. It is almost self-evident that this knowledge is of value to production, since both having the capital equipment and knowing how to use it are inseparable ‘factors of production’.

The question then arises, what information is needed by others from these specialists in order to facilitate production and trade? Surely not everyone needs to know how to build a car, grow grain, or raise cows. The specialist need only share that information with interested parties in those markets who typically pay for such expertise. Such sharing of expertise can be provided through labour markets and other contracts directly with the individuals who hold the knowledge, but it can’t be provided by prediction markets expect under particular circumstances.

Prediction markets merely reflect the marginal participants’ willingness to gamble on a future event. In a world where the density of predictions is very high and also fairly independent (most people are predicting much the same result, they not relying on the prediction of others to form their own predictions, and the marginal gambler is somewhere near the average), we get a pretty good signal from betting or futures markets about price expectations.

Of course there are other ways to aggregate information, and many ways to improve the available information without resorting to the provision of a common signal based on the beliefs of the marginal gambler.

For example, we have some evidence that commodity futures are correlated well seasonal weather patterns. But there is no new information in the futures price that existed prior the the market being formed - it merely reflects one method for aggregating existing information held by only those participating in that market.

Society as a whole would be better off with new information, and that only comes through investment in weather monitoring and forecasting institutions and capital equipment. The supply of such is typically seen to have characteristics of a public good and is typically publicly funded.

To make my case more clearly, betting markets only provide useful information if there already exists useful information to aggregate. Imagine if we we sitting around in the 1700s and trying to figure out the depth of the Pacific Ocean. We could open betting markets, but at some point we would actually have to measure the depth to actually produce new information rather than an aggregate of beliefs

When a small number of market participants have differential abilities to control the future outcomes of the bet there are also serious problems with prediction markets. A recent survey article on the now long history of experimental testing of prediction markets say the following

Together these papers suggest that prediction markets are not universally the best choice. Rather, it is important to identify when prediction markets are a good choice. The answer depends at least in part on the extent of the robustness of these markets to insiders or manipulators.

This paper also summarised the experimental condition where there exists an ability for insiders to manipulate prices under a variety of conditions. Intrade, who extended betting to obscure outcomes, provides lessons about the ability for insiders to profit from their knowledge.

Do we really want to develop a whole espionage industry devoted to improving information for gamblers in prediction markets? As if there isn’t enough of this already in financial markets where actual ownership claims of tangible capital assets are at stake.

The real problem with wide adoption of prediction markets as policy guide is that incentive for those with money on the line to manipulate the outcomes. Politicians could bet anonymously on policy outcomes already decided behind closed doors. Powerful lobby groups can manipulate outcomes and gamble on their inside information. Imagine controlling insider trading is such broad prediction markets. I would suggest that prevalence of insider trading is one reason such markets have not taken off in their own right - only those with inside information would be willing to place bets, and no one would bet on the alternative outcome, given the knowledge that only insiders play these markets.

As the survey paper suggests, many true believers in prediction markets have suggested they be used as policy inputs is a wide variety of areas, from education funding to anti-terrorism. Of course the social question is whether the risk of having your intelligence agency relying on a signal so easily manipulated by the enemy is a wise choice.

We also know that surveys and opinion polling are pretty good aggregators of information as well. So why the devout attachment by the rational expectations crowd to gambling markets?

In almost every case where ‘prediction markets’ have been proposed, there exist alternatives that offer both new information a much richer set of aggregate information than single bets on prices and timing of future events.

For example, it has been proposed to me in conversation that tertiary education choice could benefit from signals about future earning by opening gambling markets on future earning of individuals studying different degrees and entering different professions. Student would then be able to use that signal to make a better decision about the choice of study and career path.

An almost costless alternative is to make publicly available individual income tax information along with main occupation. Say like Norway. Surely this would be more valuable information for a number of reasons, not just a guide to income of different occupations to aid career choices.

Other big calls are for wide implementation of ‘prediction markets’ as policy guides.

why not let citizens bet on, rather than submit to professional opinion on, for example, which tax policy is more likely to bring prosperity?

Yeah, maybe think that one through a little more.

The moral here is that markets don’t really aggregate information as is commonly believed - they in fact reveal the marginal beliefs of the participants in the market, or in the case of active manipulation of the market, absolutely nothing at all. All information that determines the prices already exists, and none of it is shared through prediction markets - only a single piece of information, the marginal price belief - is actually generated.

## Wednesday, November 27, 2013

### Defending the econ status quo

In post GFC naval-gazing discussions about the nature of the economics discipline important questions have arisen about the discipline’s general inability to put forth a coherent set of models explaining commercial behaviour in production and trade, particularly boom and bust cycles.

The revolution the discipline needs to have seems to be starting in the classroom rather than academic outlets such as journals. I have strong interest in the teaching of economics, having been involved with the development of Australian Learning Standards for university level economics. One thing I can say is that undergraduate economic students are spoon fed an unrealistic, often useless, outdated, and very narrow set of concepts and tools, rather than being introduced to the wider nature of economics as a moral science.

But is this teaching approach merely reflective of the discipline? Sadly, I believe it is. The neoclassical status quo is heavily entrenched.

I do see some light at the end of the tunnel. Economics now does have leaders in the revolution. While Krugman’s methods fall very neatly into the mainstream, he seems to be slowly writing more like a modern monetary theorist. Nick Rowe is as mainstream as they get, defending neoclassic models while still making the effort to understand Steve Keen’s path-breaking work in debt driven cycles.

At the student level change is being strongly advocated by the University of Manchester’s new Post Crash Economics Society. Unfortunately, this open letter by Peter Backus in response to their efforts reflects the challenge that lies ahead. Although it is one of the better defences of the economics discipline, in many ways it also reveals the flaws and ignorance of the profession I have so often noted.

Backus makes seven points in his defence of economics, which I paraphrase as headings for each following section.

Many criticisms of economics are simply that economics is not the study of politics, history or philosophy

This is a bugbear of mine; that somehow economics operates in a moral and political vacuum. As soon as you want to interpret some action, behaviour, rule or policy in terms of ‘welfare’ you are automatically making a moral judgement about what is in the interests of the people. While it might be on occasion correct that a very simply utility function can represent a common notion of welfare, this need not be the case in general. As such, all economic analysis of welfare is conditional upon a moral judgement about the desires, wishes, dreams and imaginations of all others.

This is important stuff. It gets to the heart of almost all the fundamental issues in economics - benefits of trade, incentives, information and so on. It is the departure point for many alternative schools of thought that do not profess to reduce all activity to a moral assumption about the nature of individuals in the economy.

Economics can’t also be detached from history and politics. All regulation occurs via political processes and anyone worth their salt as an advisor to policy makers needs to acknowledge the intricacies and often conflicting incentives in the political sphere. As I learnt in my days in government, history matters. A policy might appear best on paper to some economic analyst, but it must be a coherent step forward for all the stakeholders involved and must not conflict with other current, or often historical, policy directions.

While many economists agree that increasing taxes on the wealthy has almost no effect on aggregate output, this is rarely acknowledged at undergraduate level. Learning even a little economic history would reveal that high tax rates on the extremely wealth were very common through much of the 20th century and by most estimates had no measurable impacts on output and growth.

There is no monolithic neoclassical mainstream (and if there is it is not an ideology). Chris Auld, self proclaimed defender of this no-existent mainstream, also makes this point.

Yes there is. Seriously, as someone who has recently completed PhD level courses at one of Australia’s top economics schools, the neoclassical framework of utility maximising representative agent models appears to define the discipline. Whereas it simply defines one approach in a broad family of methodological approaches to economic analysis.

One commenter sums up the reality of the modern economics curriculum.

This is barely the case nowadays: it is normal in economics today that the average master’s degree student is not even able to tell in a few words what Post-Keynesian or marxist or institutionalist economics are about and what are their peculiar analytical tools compared to those of neoclassical economics. Do you know a lot of disciplines where the students are maintained in the complete ignorance of entire parts of their own discipline?

In my area of research I see sociologists embracing the tools of graph theory to analyse social interaction, while the econ crowd pay lip service and attempt to subsume social networks into their own framework, in the process negating the relevance of the concept (if a network is a powerful structure a network link must be more than a perfectly tradable commodity).

It is generally not the job of an economist to predict the future

I love this defence, only because it is a classic misrepresentation of the critique. The critique is not that economics didn’t predict this exact crisis, its timing, political response or international scope. The critique is that no mainstream economists where even analysing economic processes with models that even allowed for such an event to occur! Had the discipline been approaching economics using more dynamic modelling tools, and potentially through networked models that allow for cascading changes, there would have been a standing warning that the economy system is subject to large unexpected swings (yes, booms and busts) by the very nature of its structure.

Many of the underlying causes of the financial crash were political and regulatory and structural, not the fault of sloppy Economic thinking

Backus makes the point here that government failed to properly regulated financial markets. Fair enough. But where were the voices in the economics profession calling for greater regulation? Even talking about central bank intervention in the currency is a taboo topic with most mainstream economists I’ve met. I doubt there is a single non-trivial financial regulation that the economics profession would agree would improve the operation of financial markets.

It is usually the case that the mainstream profess a belief that markets are virtuous and always correct, and therefore deviations from perfection are typically the result of meddling governments or some other market failure.

As an example of this more common ideological thinking, Justin Wolfers recently tweeted about the dodgy practices of car salesman as an example of how regulation could improve ‘free market’ outcomes. Mainstream poster-boy Tyler Cowen replied that in fact car sales are regulated, and hence it is likely the regulation at fault.

Having worked under the Queensland version of car sales regulation (the Property Agents and Motor Dealers Act) I can tell you that the whole purpose of the regulation is improve outcomes for consumers who were constantly being ripped off in an unregulated market! Why the hell does Cowen think such regulations even exist? Because everything was fine and dandy and consumers felt they were being treated fairly in a market we know functions under massive information failures?

You often see affirmations of the belief in markets in other writings, with phrases such as “I believe in the power of markets to aggregate information”. Which is of course nonsense, since if there exist conditions for markets to aggregate information, then there exist conditions for some other non-price mechanism to do the same.

A LOT of what you guys learn as undergraduates is based on Keynes

Not true. I’ll let others expand on this, but for anyone who has read Keynes’ work there is almost nothing identifiable in any undergraduate textbook that represents his ideas.

I am happy to discuss and debate Marx and variants of Marxism with you (but be warned, I’ve been to Cuba and North Korea is bad)

Economists are always trying to do better! We are always revising theories, debating alternatives

Actually, as a young researcher I find that in fact the econ crowd to be very much a closed shop. Any analytical method that falls outside the utility maximising representative agent optimal control model solved with to some quirky modification is essentially rejected with comments such as “in what way is that a model?” Yet if it conforms to their methods it doesn’t matter how nasty the assumptions, or how irrelevant the model, it is revered and worshipped as some kind of all seeing totem.

Some might say the rise of experimental and behavioural economics is evidence of the openness of the profession to new ideas. Unfortunately the behavioural revolution has been hijacked by the mainstream who now treat such irreconcilable evidence as mere modification to an individual’s utility function.

One final point.

Backus links to a paper about taxing the wealthy, saying “you need a lot of maths under your belt to understand it”. I have said before, maths is often used in economics to disguise the conceptual links between variables and the real life objects and actions the represent. Here’s just one example of teaching economics where you learn nothing at all about the link between mathematical representations and reality. In Backus’s linked paper the whole idea is explained in two paragraphs starting on the bottom of page 4, while the maths that follows is mere intellectual obfuscation. Indeed  I find the whole 'maths thing' in economics strange. All the maths does is demonstrate that a set of concepts can be internally consistent with each other, and occasionally is helpful to communicate and compare ideas. The maths can't be used to discover anything new that was not implicitly already assumed. Every proof stems directly from an assumption made.

The challenge of reforming economics, to break down the narrow and unrealistic analytical frameworks, to update teaching to reflect improvements in theory and the rapid expansion of empirical research, is daunting. While I do have some hope, and am relieved to see some true believers softening their positions and broadening their perspective, one can’t underestimate the determination with which vested interests in maintaining the status quo will defend their territory. Good luck to the Manchester students.

## Tuesday, November 26, 2013

### Three long term housing metrics

Philip Soos does an excellent job of compiling and sharing long term Australian housing data. I don’t want to replicate that sort of comprehensive work here, but simply share a few interesting graphs that come from Nigel Stapledon’s latest work on long term housing metrics.

First we have a metric that I call ‘Excess housing share’, which is the ratio of total dwellings to occupied dwellings. Notice the massive construction boom during the ‘golden years’ of the post- WWII boom until the 1970s. We can even see the blip of the naughties construction boom.

Second is the dwelling occupancy rate in persons per dwelling. There appears to be both and inter-war decline in occupancy, as well as a post-WWII long boom all the way till 2006.

The last metric I call ‘Excess rental growth’ which is the CPI divided by the rental price index, which is a cumulative measure of the increase in average residential rents over CPI. Since the 1970s rents have outpaced CPI, with a stable period from the 1970s to early 2000s. We are currently at an historically unprecedented level of ‘excess rents’. Luckily I didn’t start this graph in 1955 because it would have been one hell of a shock, with rents growing 60% faster than CPI since that time on average.

If my gut is correct, the emerging trend of below-CPI rental growth will be with us for a few more years till this measure drops back.

I must note that some of this recent increase, and indeed some of the dramatic post-WWII increase might be attributable to the ever-changing measurement practices and techniques for both the CPI and rental index themselves. We can really only trust the short-term directions, and not the long-term magnitudes.

## Sunday, November 24, 2013

### You can’t borrow from the future!

“We are borrowing from the future” is a common phrase you might hear from economists musing about the state of the economy; about the behaviour of individuals, businesses and especially of government.

These statements arise in discussions about ageing, stimulus, social security, public investment, public debts, health, education and almost every other public policy topics in which economists self-declare some degree of expertise. To really drive home the entrenched nature of such thinking in economics, here’s Satyajit Das saying “Debt allows society to borrow from the future” and here’s something purporting to be an economics text saying the same thing.

Oh, and it’s a favourite line the double-speak repertoire of Tony Abbott and Joe Hockey.

All of this is truly odd. It’s nonsense really. Perhaps expected from politicians, but not from a profession that usually ‘looks through’ the veil of money to the utilisation of real resources in the economy.

The confusion rests on a conflation of money with resources; if money equals a claim on resources then borrowed money, or debts in general, therefore equates to resources borrowed from the future. Will Ricardian Equivalence ever die?

All debts are transfers of purchasing power for current resources, despite new bank-issued debts not requiring current funding from a third party (as in the loanable funds model). In a direct credit transaction (peer to peer lending or credit channels including loanable funds) one party gives up their current purchasing power to another, with repayments and interest being a reversing of the transaction over time. No borrowing from the future there.

When new money is created through lending from the banking system, the same thing occurs, except that the society as a whole transfers resources to the entity spending the new money through inflation via their newly available purchasing power. This is usually known as by the concept of seniorage, though rarely is new lending discussed in these terms.

The whole point is that future resources don’t exist yet, so they can’t be consumed in the present! There is no transfer of resources - no hover boards are removed from the future and brought into the present via lending.

Which brings us back to often hotly debated idea of counter-cyclical fiscal policy, which is fundamentally used to increase demand for current production outputs, increase labour demand and employment and inflation, and invest in capital goods to be used in future period to produce those as yet uncertain future products.

Luckily there are some common sense economists out there. At least there was back in 1961 when Abba Lerner wrote this note about the impossibility of shifting burdens onto the future for society as a whole in response to a rather confusing article attempting to say the opposite in the American Economics Association’s most prestigious journal in 1960. Some of the ‘new generation’ are feeling the need to repeat this mantra in blog form.

If all of this isn’t enough, here’s the clincher - if today’s debt is borrowing from future generations, can’t we simply use tomorrow’s debt to borrow from later future generations indefinitely for the infinite future? Yes, yes we can.

Money and debt are mere tools of social goals. They are not the real resources of the economy but records of transaction and ownership claims. We can change the rules at any point to suit our social desires - debts can be forgiven, defaulted on, inflated away, or they can be used to justify war.

## Wednesday, November 20, 2013

The econ-blogosphere has been Bitcoin crazy for a while now. I haven’t quite understood what all the fuss is about, and knowing the personalities involved in much of the hype, I was afraid to ask too many detailed questions.

But I did anyway.

I finally put together my views following Rabee Tourky’s post at Core Economics, and a recent note by CommSec’s Craig James earlier in the week.

So what are the big questions about Bitcoin that need answering? There are two: What is its purpose? And, how will it maintain value and avoid volatility?

To answer the first question it is worth starting with Bitcoin founder Satoshi Nakamoto’s paper about a peer-to-peer electronic cash system. He repeatedly remarks that the benefit of electronic cash is being able to avoid intermediary financial institutions, thus cutting down transaction costs, and that the reversibility of such facilitated transitions is an inherent weakness. I quote from the paper at length.

While the system works well enough for most transactions, it still suffers from the inherent weaknesses of the trust based model. Completely non-reversible transactions are not really possible, since financial institutions cannot avoid mediating disputes. The cost of mediation increases transaction costs, limiting the minimum practical transaction size and cutting off the possibility for small casual transactions, and there is a broader cost in the loss of ability to make non-reversible payments for non- reversible services. With the possibility of reversal, the need for trust spreads. Merchants must be wary of their customers, hassling them for more information than they would otherwise need. A certain percentage of fraud is accepted as unavoidable. These costs and payment uncertainties can be avoided in person by using physical currency, but no mechanism exists to make payments over a communications channel without a trusted party.
What is needed is an electronic payment system based on cryptographic proof instead of trust, allowing any two willing parties to transact directly with each other without the need for a trusted third party. Transactions that are computationally impractical to reverse would protect sellers from fraud, and routine escrow mechanisms could easily be implemented to protect buyers. In this paper, we propose a solution to the double-spending problem using a peer-to-peer distributed timestamp server to generate computational proof of the chronological order of transactions. The system is secure as long as honest nodes collectively control more CPU power than any cooperating group of attacker nodes.

Here’s where the circularity of arguments about trust comes in, and where my first question about the purpose of Bitcoin becomes rather confusing. What sort of transaction would buyers be willing to undertake without a trusted intermediary? Twitter was not much help either…

But even in the case of ‘dodgy anonymous transaction’ as one of my mates suggested on Facebook, the whole point of Bitcoin is a record of transactions or ‘money as memory’. A court could order Bitcoin's miners, online waller suppliers or others involved in the network to disclose knowledge of transaction details and wallet identities in any case. Not only that, US officials have shut down digital currency operations in the past.

Authorities have also been looking into the criminal aspects of virtual currencies. Wolf Richter’s exposition of Bitcoin examines some of their discussions.

Officials from the Secret Service, the Treasury’s Financial Crimes Enforcement Network, and the Justice Department bragged to the committee about successful investigations of crimes where bitcoin or other virtual currencies were used, including the busts of Silk Road, eGold, and Liberty Reserve. They were confident that they knew how to tamp down on criminal use of virtual currencies. No one expressed outright alarm about the new world of bit coin.
Since every transaction of every bitcoin is forever recorded and part of the system, Mythili Raman, acting assistant attorney general at the Justice Department’s criminal division, pointed out that “cash is still probably the best medium for laundering money.” And she admitted that “many virtual currency systems offer legitimate financial services and have the potential to promote more efficient global commerce.”
At the word legitimate, bitcoin soared. And I mean, SOARED.

My line of thinking about potential benefits of Bitcoins is to consider what sort of transaction I would like to be unable to reverse. Would I ever purchase items on eBay with irreversible electronic cash, assuming that eBay itself did not provide any other intermediary role apart from advertising? Nakamoto seems to suggest that the cost of financial intermediaries excludes very small transactions, yet facilities like Flatter seems to overcome this problem through batching transactions.

The success of Paypal as an online payment system is partly due to the insurance it buys for both buyer and seller for the transaction. Anyone who refused payment from Paypal would be signalling their untrustworthiness or unwillingness to meet conditions of any mediated dispute. The point being, rather than creating a payment system that doesn’t rely on trust, using Bitcoin over other payment methods will itself signal a lack of trust. All transactions require some trust. There is no escaping that. Online that is even more important. For example, you pay me with Bitcoins, then I don't post your goods, what recourse do you have?

So far there is no reasonable answer to my first question about the purpose of Bitcoins.

My second question unfortunately reveals similar unsatisfactory answers. If Bitcoins really are limited by constraints on ‘mining’, then that will mean that in a situation where they are in demand as a medium of exchange, they will also be increasing in value and be a means of investment. As more people prefer to hold Bitcoins as investments rather than exchange them, this will push their value higher still. If you can’t see it coming, the end result is a massive bubble followed by a crash when the herd realises that their investment value was purely based on herd mentality, without any fundamental resources backing it, and that the system is no longer being used as a medium of exchange. This view has been put forward previously by Eric Posner.

It’s not like alternative payment methods have not been tried many times before. Bartercard springs to mind as one system that survives in its business-to-business niche.

So let’s summarise. Bitcoins have been severely hyped online yet almost no one can suggest scenarios for both buyers and sellers in which they are actually a more useful medium of exchange than current costly reversible transactions. Furthermore, the ability for Bitcoins to hold there value is severely hampered by the nature of their technically limited supply. To top it off the only people I know of who have owned Bitcoins were speculating and never used them to transact. I can only conclude that this episode will go down in history as a lesson about the nature of money and trust in facilitating trade.

## Tuesday, November 19, 2013

### What limits housing supply… one more time

My long term view, based on experience in the property development industry and in planning regulations for water and infrastructure, is that zoning is not a binding constraint on the rate of supply of new housing.

There is no doubt that zoning and other planning measures limit the type and scale of use on any particular site, as they are intended, but in aggregate they do not constrain the rate of new housing. For zoning to truly hamper housing supply there must be no undeveloped lots available within a zoned area. Indeed, all land must currently be at its highest value use, meaning these would cease to be a development industry altogether, and land banking would be the stuff of imagination.

One reason for the confusion around housing supply is the simplification inherent in almost all economic models of markets whereby the free entry condition means that any positive NPV project is instantly produced. There is no time in the model, and therefore no ability to delay investment.

To deal with the realities of the irreversibility of investments and the ability to delay, Black, Scholes and Merton in the 1970s developed methods for valuing the option to invest in irreversible capital at some point in the future. Merton and Scholes were even awarded an Economics Nobel for their trouble in 1997.

Following these methods a large body of work has emerged that addresses firm choices with real options - that is, when the firm faces genuine options to delay irreversible investments. Firms then face compound investment decisions; what to invest in, and when to invest in it.

Why is this important for housing supply? Well, only in a world where real options exist can land remain undeveloped or in low value uses when higher value uses exist. Thus any analysis of land markets that is able to account for the large volume of undeveloped land must be based on the real options of land owners.

I have written about research into the nature of durable goods markets in the past, particularly the debate over the Coase Conjecture of how a monopoly land owner would drip feed supply to maximise the value of their land, since by building more homes now they will compete with the home they build in the future.

Yet real options is far more general, embedding these ideas into a much more robust theory. So what happens to land models when you account for real options?

Strangely enough in 1985 Sheridan Titman asked this exact question and published his results in a little journal called the American Economic Review, in an article entitled Land Prices under Uncertainty.

Titman constructs a model based on the idea of options to reveal the types of fundamental characteristics the drive the choice by a land owner to develop, which include the expectations of future changes to the optimal density of development, as well as future rental price paths.

Under his model of real options in land (and indeed any model derived from this proposition) the land owners response to external conditions is quite different that in the basic model of perfect markets. He writes

It is shown that the initiation of height restrictions, perhaps for the purpose of limiting growth in an area, may lead to an increase in building activity in the area because of the consequent decrease in uncertainty regarding the optimal height of the buildings, and thus has the immediate affect of increase in the number of building units in an area.

This is something I’ve said before, and it is worth repeating. Increasing zoning in an area provides an incentive for land owners to delay development and hold out for further changes in zoning. The reverse is also true, and I’m sure everyone would agree that if you announced a reduced maximum density in an area that there would be a rush of development prior to the loss of the ‘option’ to develop greater densities.

A similar situation will happen with changes to developer costs. Infrastructure charges are often blamed for the high cost of development, but in any theoretical picture involving real options, reductions in infrastructure charges will delay rather than accelerate development. Similar problems arise with stamp duty. Calls to reduce stamp duty arise due to equity concerns, yet they have been shown not to increase housing prices, and in other markets such transaction taxes, or Tobin taxes, are being proposed to reduce volatility.

Sure I’m all for land taxes, but replacing a rather good tax in the form of stamp duty, rather than highly distortionary taxes such as payroll and income tax, provides a much smaller social gain.

Given that rental prices in most Australian capital cities are falling relative to incomes, land markets must be functioning as roughly intended. My earlier ideas on rental controls may also reduce the rate of growth of housing prices, leading to increases in housing investment as the payoff from withholding undeveloped land decreases.

For all the talk of ‘elastifying supply’, there if very little in the way of considered logical thought about exactly what factors generate the current rate of new housing supply. Only by acknowledging the real options for future development held by land owners can we begin to understand the true fundamentals driving housing supply patterns.

## Friday, October 25, 2013

### Economics makes you selfish

I was motivated to write this post by fellow Australian young economist Gabriela D’Souza
I disagree. Selfishness is not common sense. It all seems to have started with this article, part of the periodic publicity the sprouts up around new studies into the selfishness of economists and economics students.

There is now quite a deal of evidence that economists are ‘more selfish’ than other groups. Here is some research showing lower rates of donations by economics students. Here is research showing economics students lie more, and here is a good summary of other research. The evidence is overwhelming that economists act in ways which most people find unacceptably selfish.

To me this body of evidence reveals the massive disconnect between mainstream theory in economics, that rests on the fundamental notion that greed or selfishness is the driver of coordination in a market economy, and the reality that social cooperation rests fundamentally on trust.

I would certainly agree with Francis Amasa Walker’s 1879 interpretation of the apparent social “odor” of economists arising from their disregard of “…the customs and beliefs that tie individuals to their occupations and locations and lead them to act in ways contrary to the predictions of economic theory.”

As Frans de Waal explains “Economists are being indoctrinated into a cardboard version of human nature, which they hold true to such a degree that their own behavior has begun to resemble it… Exposure in class after class to the capitalist self-interest model apparently kills off whatever prosocial tendencies these students have to begin with. They give up trusting others, and conversely others give up trusting them. Hence the bad odor.”

Without justifying this behaviour, let me just make it clear that economic indoctrination teaches that this apparently selfish behaviour is both what everyone actually does (despite ample evidence to the contrary), and that through self interest we prosper. They have swallowed this iconic Adam Smith quote hook line and sinker.

It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest

I want to use this post to provide an example of how such a view, an economic way of thinking, can lead you astray in everyday life. I draw on ideas from my good friend Uwe Dulleck, whose expertise is credence goods.

Credence goods are those whose value or utility can never be known by the buyer due to information asymmetries. The classic examples are doctors, who can prescribe medication for a diagnosed illness which you will never know is what you are truly suffering from. Or car mechanics, who diagnose mechanical failures and sell repairs, without the customer being able to know whether such repairs were either needed or carried out.

As usual Uwe’s research centres on some important questions

Under which conditions do experts have an incentive to exploit the informational problems associated with markets for diagnosis and treatment? What types of fraud exist? What are the methods and institutions for dealing with these informational problems? Under which conditions does the market provide incentives to deter fraudulent behaviour? And what happens if all or some of those conditions are violated?

Uwe introduces a simple example of a behaviour that, by economic reasoning, is expected to reduce fraud in credence goods markets

For some of us a feasible solution might be… to ask the mechanic to put the replaced part in the back of the car and to inspect the defect of this part.

Uwe is cautious about whether this advice is sound. As am I. But I reckon that most economists would be more than happy to take this advice based on the ‘economic intuition’.

But does the common sense of unselfish non-economists also support this behaviour? Or is this an example of how the economic model of self-interest can lead us astray? I suggest the latter. And as a peek at my conclusion, the behaviour I might advise is to buy the mechanic a six-pack of beer.

Imagine you are a mechanic. Occasionally you realise that a customer is a bit of a sucker with too much money, so you charge them a little extra for some repairs you didn’t do. Most of the time you are pretty straightforward and honest.

One day a new customer comes in. They don’t seem particularly knowledge about cars, and since this is their first visit there is nothing to suggest they will become a regular customer. You diagnose the problem with their car, which is a very typical problem in that model, and explain that the repair could involve replacing certain parts, but you won’t know till you start taking things apart. This new customer agrees to go ahead with the repair, but asks you to put the old parts in the boot when you are done. It’s an odd request.

You realise that by making this request the customer has revealed that they are less knowledgable about cars than you thought, have no trust in you, and are solely relying on seeing a bunch of parts in the boot to judge your service.

What do you do? I’ll tell you what I would do. I would grab a bunch of parts from around the workshop and stick them in the boot, then charge for parts and repairs I didn’t do.

By following the behaviour suggested by a model of selfish individuals you have inadvertently signalled you complete ignorance about cars and a complete lack of trust.

Now imagine you are the mechanic who dealt with this customer and they didn’t ask for you to put the old parts in the boot. Maybe you still fleeced them a little and replaced a couple of parts that really didn’t need replacing. When the customer comes to collect the car they bring you six-pack of beer and thank you for your good work as they are so dependent on having a reliable car.

Would you fleece them again next time?

My point is that society deals with credence goods through the establishment of trust, either through non-market signals, like memberships of reputable societies, or ongoing social relationships. That mainstream economic theory ignores the fundamental role of trust and the cooperative behaviours that results from it, leaves their advice typically unsuited for many circumstances. As experimentalists know, in repeated games many forms of cooperation can become entrenched, yet most economic theory relies on the selfish response to a one-shot game.

Until economics courses around the world move beyond indoctrinating students into “cardboard version of human nature” we will continue to have selfish economists.

## Sunday, October 13, 2013

### Economic models are plausible stories

‘Economists do it with models’ is one of the favourite insider jokes of the econ tribe. I recently tweeted that it would be nicer if economists did it with evidence. One of Australia’s most switched-on young economists responded and I elaborated my original point.

It is a very common attitude in economics. Models, their solutions and any data correlations consistent with those solutions, are believed to constitute evidence that the assumptions embedded in the model accurately capture causal relations of some real life phenomena.

But of course that’s not the case. The key value of a scientific model is in its ability to predict outcomes in new situations, but also to generate new questions and directions for research. The model is not the answer, its a tool for discovery.

I have been reading Australian sociologist Duncan Watts’ book Everything is Obvious, which reminded me of the importance of evidence and the limitations of the model-building and correlation approach that almost defines economics.

Watts, a physicist turned sociologist whose work on networks is revolutionising the discipline, is completely frank about the near impossibility of determining causality in the one-shot experiment that is real life. In the section ‘Whoever tells the best story wins’, he concludes that

Part of the problem is also that social scientists, like everyone else, participate in social life and so feel as if they can understand why people do what they do simply by thinking about it. It is not surprising, therefore, that many social scientific explanations suffer from the same weaknesses—ex post facto assertions of rationality, representative individuals, special people, and correlation substituting for causation—that pervade our commonsense explanations as well.

No matter how much your model appeals to your intuitive reasoning, or how well it fits the data, it cannot be shown to be of scientific value unless it offers useful predictions. For the economists out there just consider that models of constrained optimisation are simply a bunch of simultaneous equations, which read equally well in reverse (as do correlations). Moreover, micro-models of this persuasion almost always overlook methods of aggregation, leaving us to guess what sort of aggregate patterns should occur in the data.

A discussion on the use of economic models would be incomplete without referring to Milton Friedman’s views that the reality of assumptions are unrelated to the usefulness of a model.

Consider the problem of predicting the shots made by an expert billiard player. It seems not at all unreasonable that excellent predictions would be yielded by the hypothesis that the billiard player made his shots as if he knew the complicated mathematical formulas that would give the optimum directions of travel, could estimate accurately by eye the angles, etc., describing the location of the balls, could make lightning calculations from the formulas, and could then make the balls travel in the direction indicated by the formulas. Our confidence in this hypothesis is not based on the belief that billiard players, even expert ones, can or do go through the process described; it derives rather from the belief that, unless in some way or other they were capable of reaching essentially the same result, they would not in fact be expert billiard players.

My reading of this passage is that models should be judged on their predictive powers rather than their assumptions. Yet it also implies that if more plausible assumptions are possible that yield similar predictions, perhaps these generate more plausible models.

If I were to propose a model of expert billiard play I wouldn’t start with the laws of physics but rather with a model of learning by trial and error. This simple model not only has more plausible assumptions, but predicts ‘expertness’ in billiards correlates with practice. It is also a general model applicable to such games as lawn bowls, where Friedman’s calculating-man model would require significant modifications to account for the weighted bowls. Friedman’s model is merely an assumption about the data-generating process. It translates to “if I know the data-generation process from the point when a ball is struck, I can use that knowledge to make a useful model that includes a prior point in time”.

To reiterate, data can’t verify, support or prove (or even contradict) the causal assumptions in a model unless we have controlled part, or all, of the data generation process (either through experiment, natural, field or otherwise).

Meanwhile, we have a whole field of econometrics that attempts to match models to data - refining the art of assumption-hiding and promoting the illusion of causality testing. For example, Angrist and Pischke’s book Mostly Harmless Econometrics: An Empiricist’s Companion is very loose with notions of causality. They say

Two things distinguish the discipline of econometrics from the older sister field of statistics. One is the lack of shyness about causality. Causal inference has always been the name of the game in applied econometrics. Statistician Paul Holland (1986) cautions that there can be “no causation without manipulation,” a maxim that would seem to rule out causal inference from nonexperimental data. Less thoughtful observers fall back on the truism that “correlation is not causality.” Like most people who work with data for a living, we believe that correlation can sometimes provide pretty good evidence of a causal relation, even when the variable of interest is not being manipulated by the researcher of experimenter.

They go on in the quoted chapter to discuss the use of instrumental variables methods address part of the causality problem. But recall the requirements of a useful instrument

a variable (the instrument, which we’ll call Zi), that is correlated with the causal variable of interest Si, but uncorrelated with any other determinants of the dependent variable.

If you are thinking a little here you would realise we have simply introduced a second layer of model assumptions about the true data-generation process. You may believe there is a valid reason to do this, but again, the model can’t say whether this reason is sound or not. You are simply deferring one assumption about the nature of the world to an alternative, and perhaps more plausible assumption.

What is more interesting is that founders of the instrumental variables method where challenged in the 1920s by the problem of causal inference in a model of markets with supply and demand curves. Since price is the simultaneous solution to supply and demand in the model there was no way to differentiate relative movements of the curves. Such problems persist to this day when applying demand/supply models to market analysis.

Models aren't quite the scientific tools economics often believe them to be. At best they offer plausible stories about a particular phenomena and provide some predictive power. The religious attachment of the economics discipline to its core models is at times quite astounding.

It is genuinely challenging for social scientists to make gains in knowledge under the uncontrollable conditions of real life, and I can only hope that the future of research involves far more experimentation, either in the lab or in the field. In the mean time I hope the profession can be far more honest about the limits to knowledge, more humble in its policy recommendations, and more open to competing views of the world whose claims often stand on equal scientific footing.