Saturday, May 31, 2014

Quick links: Crony politics, utility, Becker, exports

The Greens proposed in parliament to implement a Federal Independent Commission Against Corruption with similar powers to the NSW Commission. Labor and Liberal refused to vote, in the process revealing their entrenched reliance on cronyism for their existence.

Former Queensland Electoral Commissioner Bob Longland on 7.30 discussing his idea for federal authority in charge of publishing political donations to all parties at all levels of government (and I guess enforcing disclosure requirements as well).

Great idea. But it seems the Queensland government is taking the opposite approach and reducing disclosure requirements.

Some brilliant detailed criticism of the leap of faith hidden between utility and welfare maximisation at Interfluidity

And a follow up post here

Forget the SMD theorem. In 1986 Gary Becker showed that market demand curves will slope downwards even under irrational choices where a budget constraint exists.

Given my previous post mentioning export-led growth via high levels of investment, here’s a chart of the export share and investment share of GDP (all countries and all time periods from the World Bank database)

Wednesday, May 28, 2014

Bogus economic excuse for inequality debunked

As I explained yesterday, saving by an individual is usually achieved by buying monopoly assets from others, forgoing consumption in order to capture a future flow of income for oneself.

This usual way to save is merely a transfer of assets whose value equals the difference between income and spending. Someone gets richer, others poorer. But importantly, the rate of saving of an individual, when understood in this manner, bears no relation to investment in the quantity of new capital goods in the economy generally and can’t be related to the rate of growth of the economy.

This point is quite obvious.

Yet it is very common to hear that rich individuals, because less of their spending goes towards consumption items, are able to save more, leading to greater levels of investment in new capital goods and higher future productive capacity.

While many economists profess a degree of caution in such analysis when challenged, the very notion that saving at an individual level equates to a proportional level of investment in new capital at a national (or global) level is embedded in the economic way of thinking.

Here’s Tyler Cowen making the point implicitly
Stocks of wealth stimulated invention by liberating creators from the immediate demands of the marketplace and allowing them to explore their fancies, enriching generations to come.
And here’s Karen Dynan et al.
…active saving corresponds to the supply of loanable funds for new investment and therefore may be helpful in gauging the effect of a redistribution of income on economic growth. 
But since saving at an individual level is almost solely about buying monopoly assets from others, this claim simply cannot be made. Saving at an individual level is nothing more than a transfer of ownership of existing wealth.

When I buy some Apple shares in order to save, I merely buy from the current owner, changing absolutely nothing in terms of Apple’s intentions to invest in new production machinery and equipment.

If saving is as I described, the fact that the wealthy have a lower propensity to consume, and therefore a higher marginal propensity to save, merely implies increasing wealth inequality, as assets accumulate in the hands of the already wealthy; a trickle-up effect if you will.

This is particularly relevant to current debates about how to address inequality. Would a wealth tax on the rich decrease overall investment? Not at all. The tax would be a transfer of ownership of resources, just like the saving of the rich is a transfer of assets and unrelated to investment in new capital equipment.

It is possible under very specific circumstances for an individual's savings to exactly match investment. For example, if I buy a specific financial instrument that pools my funds with others to finance construction (but not land purchase) of a new building. But that is a rare case that proves the general point that there is no proportional matching of saving and investment at an individual level.

While I have said nothing that contradicts economic theory, I do find it frightening that experts in the field have such contrasting views on the matter.

Tuesday, May 27, 2014

Can a nation save?

I want to offer here a brief analysis of how I think about saving and investment, and why it is important to be very clear about these concepts in policy discussions.

Usually economists equate saving and investment when they shouldn’t. I find it easier to think of savings as not consuming today in order to consume in the future, whereas investment is the production of some new capital good today, say a building, machine, vehicle, that will facilitate greater production in the future.

Let’s start by looking at saving.

I’ve argued before that you can’t borrow from the future. Debts are merely a trade of goods or services in the present for an obligation of different trades in future periods.

A similar conceptual logic is at play when we think of saving. We don’t produce warehouses full of food, clothes, machines and equipment and store them for the future. My superannuation account[1], for example, doesn’t own a share in such a warehouse in order to provide me with the goods I will need when I retire.

Instead my superannuation account owns monopoly assets. These assets are products of the institutional and legal framework of society. I might own a share of a patent monopoly; a sort of institutional power device that guarantees its owner the ability to capture a share of the income generated by the use tools and techniques covered by the patent.

Individuals save by buying assets that comprise a set of monopoly rights. The catch, however, is that all monopoly assets are owned by someone, so any individual who ‘saves’ by buying monopoly assets is merely distributing future incomes to themselves and away from others.

You may now be questioning my claim that all monopoly assets are already owned by someone. What about if I invent a new technology that I then patent. Didn’t I create new monopoly right that was taken from no one?

Actually no.

When you register a patent you are taking away the right to future incomes arising from that technology that would have been available to everyone else using it, and directing that income to yourself.

Saving at an individual level is merely a transfer, so in aggregate there is no ability to save in the way we think of individual savings.

So why is this relevant to a discussion on how nations can save?

Because a nation is one part of the global aggregate, and can save by accumulating monopoly assets currently owned by entities from other nations.

A country that is saving will run a capital account deficit and a current account surplus. They sell goods to other nations in exchange for monopoly rights to future income streams owned by foreign entities.

Usually this situation is sustained by active management of the domestic currency. To keep the domestic currency value low the central bank prints new money to buy foreign assets. This process decreases the relative value of the domestic currency, increasing demand for exports, and represents automatic saving for the country from buying those assets in the first place.

Modern cases of this mercantilist approach include Japan, South Korea and China.

Now here’s where the link between saving and investment becomes important, but where most economic discussion becomes confusing.

The country doing the saving is technically labelled as having a negative rate of foreign investment, meaning they are buying more foreign assets than foreigners are buying of their assets. Dissaving countries are labelled as having a positive rate of foreign investment.

Such terminology is deceiving; even more so when we think in terms of the investment dynamics at play.

The saving country will be a more attractive place to locate capital investments in tradable sectors because of relatively lower costs.

Countries with net foreign investment will actually become less attractive places to invest in large scale capital inputs to tradable goods production.

The key relationship to remember is this. Countries can save the way individuals can by buying monopoly assets currently owned by foreign entities. But this is merely a transfer between the two parties and cannot happen at a global level.

What national saving does is make the country a more attractive place to invest, at the expense of the non-saving country. Saving increases a countries future domestic productive capacity at the expense of future domestic productive capacity of non-saving countries.

For developing countries, mercantilist policies and national saving are a good thing. But to have a proper debate about economic policy we need to acknowledge the realities of saving and investment relationships between entities and in the aggregate.

fn.[1] The Australian version of a private retirement savings account

Wednesday, May 21, 2014

Unique economics of healthcare

I was prompted to write this follow-up on health economics after seeing a recent post by blogger Noah Smith, who weighs in with some reasonable views after some intense criticism of the ‘freakonomic’ Chicago-boy Steven Levitt. In a meeting with UK PM David Cameron, Levitt and his co-author apparently made some rather absurd remarks about health care.
They told him that the U.K.’s National Health Service -- free, unlimited, lifetime heath care -- was laudable but didn’t make practical sense.  
"We tried to make our point with a thought experiment," they write. "We suggested to Mr. Cameron that he consider a similar policy in a different arena. What if, for instance...everyone were allowed to go down to the car dealership whenever they wanted and pick out any new model, free of charge, and drive it home?"  
Rather than seeing the humor and realizing that health care is just like any other part of the economy, Cameron abruptly ended the meeting... 
This nonsense reminds me that what constitutes economic debate in the US is often laughable at best.

Health care is obviously not like most other parts of the economy. As I said last week medical services are credence goods - goods which we don’t know whether we need, and even once we’ve consumed them, still don’t know if they were good value. In economic terms, these goods suffer from the worst possible information failures, particularly with respect to the asymmetry of information between the seller (in this case the doctor) and the consumer.

For these goods the demand curve may slope any which way, and people are often left to use price as the only signal of quality (or quantity for that matter). This means that a socially optimal level of medical service provision cannot be determined using basic marginal economic analysis.

Not only that, there are substantial positive externalities to most health care services. Vaccinations are the obvious example, but the same principle applies more broadly.

Once you’ve accepted that health care and medical services don’t fall neatly into preexisting economic models, you need a better way to think about the potential efficiency of any health care system. Rarely is this step taken in public debate.

One way to assess any health system is in terms of the two main sets of incentives - those of the patients, and those of the medical service providers (doctors and suppliers of medicines, equipment and accessories).

We often hear about the patients, with the archetypal case of the lonely hypochondriac making a few extra trips to the GP or emergency department when the service is provided free of charge. Sure they exist, but as I’ve said before, pricing these visits deters both the time-wasters and those with genuine medical needs. Making prices for patients reflect production costs in health care systems has the benefit of reduced health expenditure, but comes at a cost of poorer health outcomes.

But in general no one wants major medical services even at a zero price. Here’s a comment from Noah’s blog making that point
Most medical treatments are painful, unpleasant, and time consuming, and are only desired when non treatment is worse. While making treatment costly will deprive some of access, it will do little to make treatment more undesirable than it already is.
On the other side of the ledger we have the incentives of doctors and other businesses involved in the supply of medical services - drug companies, suppliers of medical equipment and so on.

Here there are usually financial incentives to over-treat or over-prescribe. To take just one example, new evidence from Australia’s two-tiered system shows that in private hospitals there are more medical interventions for low-risk births than in public hospitals.

Indeed there is clear evidence of these interacting incentives following the announcement of the $7 GP co-payment in the Australian federal budget. Some medical centres have been text-messaging patients to remind them that they are not charging fees, possibly due to lower patient numbers. On display is the doctor’s incentive to earn a living providing medical services by marketing to customers, interacting with the uninformed patient reacting to a price that doesn’t even exist yet in a way they can't possibly know is beneficial for them or not.

As a final point, we rarely hear about the monopsony buying power of having a single medical provider, which can be significant. A single national (or State level) healthcare entity is in quite a position of power in negotiating supply contracts when they are the only game in town. In a world were drug companies are heavy political hitters, having incentives within the government to reduce drug costs to economise on health spending seems an important consideration.

If we are going to have an intelligent debate about efficient health care we need to remember three key points
  1. We must consider benefits as well as costs (including externalities) 
  2. There are serious moral judgments necessary about the scope and priorities of health care 
  3. Medical services are credence goods, hence there are unique incentives at play

Wednesday, May 14, 2014

Twisted logic of GP fees

The Budget’s proposed $7 GP co-payment fee seems quite benign to many people. After all, if you are genuinely sick or concerned about your health, why would $7 make a difference?

But there simply is no logic behind it, and the more you think about it, the more twisted any possible logic becomes. 

For example, to believe that the fee will deter time-wasters but not genuine patients, you must invoke some idea that people know beforehand whether their ailment is time-wasting or a sign of something more serious. 

It’s like saying if people already knew the diagnosis they would get from the doctor, then they would be able to determine whether they actually need to visit the doctor. 

This ignores the very purpose of general practitioners.

To be clear, medical services as usually classified in economics as credence goods. They are goods or services that we can’t properly judge will be beneficial to us or not. All expert advice falls into this category.

For example, I could hear a strange engine noise and take the car to the mechanic. They could say that it is something minor and not to worry until the next service.

Would I be a mechanic time-waster? What if it turned out to be something serious that needed immediate attention?

Underlying the whole idea of a the $7 GP fee for bulk-billed patients is an irrational belief (see comments section) that medical services are being over-utilised. 

If that were truly the case, we would see government advertising that told us to stay home when we thought we were getting sick, rather than what we in fact do see, which is a blanket message to better monitor our health with more regular check-ups and preventative health screening tests.

But that’s not the end of the failed logic.

If you still hold the irrational belief there are time-wasters over-utilising GPs because the service is free, to believe that a price signal will remedy the problem requires a great deal of faith that the price will deter only the time-wasters and not those with genuine medical needs. 

If the price does not discriminate in this way, there will be significant health costs accompanying budget savings. 

The best evidence we have for the price effect on medical care choice is the 8 year long RAND Health Insurance Experiment, run from 1974-1982. It found that greater cost-sharing “reduced "appropriate or needed" medical care as well as "inappropriate or unnecessary" medical care”.
In fact the experiment also found that the poorest in society are most likely to defer medical treatment when the price increases, meaning that the health costs of this policy will disproportionally fall on our poorest citizens, including the unemployed and the elderly.

If I can digress for a moment and tell a personal tale. When my youngest son was just a week old he had a few signs of illness including a rash, a fever, and lack of appetite. I was not overly concerned, but my wife took him to the GP in any case. Our GP had some concerns about meningitis and we were sent for various tests, including a rather traumatising (for Mum) lumber puncture, and ended up in hospital for two nights awaiting various other results, with baby being closely monitored. It turned out not to be meningitis but some other a mystery infection.

Had there been a GP fee for us at the time we may have delayed the visit another day or so. If we did, and it had been meningitis, we may received treatment too late avoid serious long term damage.

I’m sure there are thousands of similar stories about how an early visit to the GP, that may have seemed a little like time wasting, ended up preventing serious illness or even savings lives.

While $7 doesn’t seem like much of an issue to many, we should acknowledge that the economic logic for doing so is not sound. This policy is taking the exact opposite approach to what we know to be effective. Universal access to health care, with GPs as the first point of call, to screen out the time wasters and offer advice that helps people better know if they are in fact time wasters, is a system we know to be functional.

If it makes sense to charge patients to GP services to improve health outcomes, then by that logic we should charge parents to vaccinate their children. We don’t, because we know the benefits to having universal access to vaccinations provides massive health benefits to the individual and society as a whole. The same applies to GP health services.

Maybe we should trust the experts themselves, the doctors, on this one.

Thursday, May 8, 2014

Piketty's wealth tax is real, and it works

As the Piketty-train rolls on it leaves behind it a trail of confusion in economic circles about the proposition to reduce inequality via a global wealth tax.

Economic thinking, it seems, floats on the political tide. The authors of this paper in 2006 noted that
…at present there appears to be little interest in the net wealth tax. In recent years this tax has been practically excluded from any discussion or doctrinal debate on tax reforms, and over time has fallen into disfavour.
Eight years and one financial crisis later, the tide has turned dramatically in favour of using the tax system as a tool for creating a desirable wealth and income distribution.

Many sceptics, however, argue that a wealth tax, either national or globally, is technically or politically infeasible. The basic reasoning is as follows:
…it is impossible within the U.S., never mind the world, as the top 0.1% own the political machinery. Why would anyone who owns the political process agree to tax themselves?
It’s a good question. But it merely suggests we look deeper at the heart of the matter. I like to use one of Matt Bruenig’s favourite lines,“imagine people did things they already do”, as a starting point.

The point being that if the top 0.1% control the political system, then it should be impossible at all points in time to tax wealth.

Unless you are Spain, and it’s 1977. Or France and it is 1981.

Both these countries brought in annual taxes on wealth, with progressive scales just like income taxes. In France 1.5% of tax revenue came from their wealth tax in 2007, while in Spain around 0.5% of tax revenues are raised from such taxes.

Indeed most countries already raise about 5% or more of tax revenues from direct taxes on property, which is essentially a wealth tax on a slightly narrower definition of wealth.

So not only are wealth taxes possible, they are already a feature of the tax system in most countries.

Implementing a shift towards greater taxes on wealth merely requires a minor tweaking of tax rates and/or qualifying assets for taxes that already exist. The institutional machinery is already in place.

The question of the political power of the wealthy is certainly valid. But this merely provides guidance on likely political avenues for change. The obvious follow-up question is, what political circumstances led to the implementation of current wealth taxes?

I’m no expert here, and I’d appreciate any detailed accounts of the political climate at the time, especially in France and Spain. But it seems that the wealth tax was part of the French Socialist’s Party’s platform in the 1981 Presidential elections; which the right-wing party abolished in 1986, for it to be reinstated just two years later.

At first glance it appears that breaking the link between political power and the interests of the very wealthy, via democratic processes, is one successful political path for change.

It may even be of some assistance, politically, if the economic profession would stop pretending to debate the possibility of things people already do. Wealth taxes are certainly possible and are effective tools for reducing inequality.

Another wildly successful tax on wealth is the inheritance tax. Inheritance taxes are again real things, that real countries have, but that fell victim to the political tide of the 1970s in the anglosphere.

At their peak in 1968, taxes on inheritance made up 3.1% of Australian tax revenue, or 0.6% of GDP. In the UK inheritance taxes were 1% of GDP in the same year.

The chart below shows the massive shift away from such taxes at exactly the time inequality began to skyrocket across the anglosphere.

Australia, the UK and US all went through a political change in the 1970s that saw a dramatic reduction in revenue raised from this source, with Australia and the US abolishing inheritance taxation altogether in 1989.

Germany and France maintained these taxes, which have generated an increasing share of revenue since the 1970s. Australia however, chose to forgo this progressive tax and in doing so has forgone significant public revenues. Last year alone the revenue from an inheritance tax levied as per 1968 would have raised over $9billion.

Not surprisingly countries that reduced or removed inheritance taxes saw the most rapid rise in inequality since the 1980s. Below I use the data from Alvaredo, Atkinson, Piketty and Saez’s World Top Incomes Database to show this relationship.

The top 1% share of income shoots up in the 1980s in the UK, US and Australia, while staying steady in France, and also Germany (at least till the late 1990s).

Once again the political tide is in favour of taxing wealth. The economic debate, however, is settled. Wealth taxes reduce inequality. Most countries already implement taxes on wealth to some degree, either through annual or inheritance taxes, and have institutional mechanisms in places to administer the them. The sceptics do raise an important political question, but we should learn from history and see that democratic processes, in which economists play a part, can provide avenues for change.

Sunday, May 4, 2014

Those ‘tough’ social problems

Poverty is a social issue that usually attracts the label ‘tough problem’. Sometimes, when a bit of flair is in order, it is labelled 'complex' or 'multi-dimensional'. This strikes me as a major cop out.

Reducing or eliminating poverty is not ‘tough’ in any technical sense. The ‘tough’ part is our moral baggage - the distorted moral lens through which we see the problem - which provides an excuse not to make the necessary sacrifices required for change.

For example, it is simple enough to imagine a developed country without poverty. Even using a purely relative metric of poverty that is a direct function of the median income (such as 30% of median income), poverty can be eliminated through appropriate redistribution of wealth. Through either welfare payments, transfers of assets, a national job guarantee, minimum wages, or any other sets of institutions, we can get the resulting distribution of income that means poverty is all but eliminated.

It really is that simple from a technical point of view.

In case you are still skeptical of the simplicity of the solution, imagine for a minute that you are the head of a wealthy household. One of your adult children has, for some reason, flittered away their life savings, been kicked out of their apartment, and has no where to turn.

What do you do?

You invite them home. House them. Feed them. Clothe them. Give them money to help them start rebuilding their life. You probably even call in favours to help them find work.

This investment by the head of the family immediately solves that family’s poverty and homelessness problem.

Maybe this solution is temporary. Maybe this child of yours never seems to grow up. They get caught up with the wrong crowd again, and two years later you are back to square one. You invite them home. Feed them. Clothe them. Give them money.

If it makes sense to do this for your family, why doesn’t it make sense to do it more generally for fellow human beings?

It wasn’t hard. It just required a little sacrifice from the wealthy.

If we think about our country, or dare I say our world, as our extended family, our tribe, then it also makes perfect sense for the wealthiest members of the tribe to support the needy.

What makes these social problems ‘tough’ is our moral baggage. When we see a family member in need we we assume the best - that underneath they are good people, and that their situation is a product on a series of unfortunate circumstances. But when those in need are ‘outsiders’, we seem to assume the worst - that their poverty is a choice, and their poor choices reflect some innate ‘bad’ personality trait, and hence they are undeserving of support.

Poverty wouldn’t be such a ‘tough’ social problem if there were only deserving poor.

Unfortunately the most wealthy in our tribe are also politically active and socially influential, and they fear losing their ‘deserved’ wealth to these ‘underserving’ poor. The media is their weapon, and they reinforce the moral message of the undeserving poor at every opportunity.

Removing our morality goggles makes it clear that ‘tough’ social problems are technically not so tough at all, and that much of society is pretending that is the case in order to protect their own interests, and using warped morality to justify their position.

Thursday, May 1, 2014

Micro-foundations don't escape Lucas Critique

The Lucas Critique is summarised by Mark Buchanan as follows:
Any prior regularity that might have existed in a set of data had been present only in the context of the policies prevailing in the past. Change the policies and those changes, by influencing the way people act and anticipate the future, may well strongly change or destroy the regularity on which you had based your plans.
In economics this observation was made famous by Robert Lucas in this 1976 article.

Lucas' critique has justified the micro-foundations approach to macroeconomics for four decades. Put simply, unless you model the macro economy as a result of ‘deep parameters’ of the human psyche, you will never be sure whether your model will apply in a different regulatory or institutional environment. Overcoming the Lucas Critique is apparently achieved by offering a macroeconomic model that stems from a utility function of a representative agent.

But why should we believe that the ‘deep parameters’ of micro-foundations, the utility functions themselves, are somehow independent of the institutional environment?

You can’t escape Lucas’ critique by plucking a utility function out of the air and giving it to a representative agent unless you believe that utility functions are independent of the social environment.

Which raises the question, how can it be possible for an individuals preferences, their utility function, to arise in a social vacuum?

It can’t. The evidence is absolutely clear on this point. Preferences, and even perception, are socially constructed. There simply are no 'deep parameters'.

The whole micro-foundations exercise has been a waste of time for all involved.

While economics has taken seriously this critique from Lucas, they have generally ignored its logical extension of the performativity of economic analysis. Basically performativity says that the use of an economic model in society to guide decisions itself changes behaviour, thus changing the environment in which the analysis applies. Or more simply, utility functions with change in response to the use of models built upon utility functions.

The easy way to see this in action is in sports. As soon as one coach creates a play that exploits a common behaviour in other teams, using that play changes the other team’s response, and thus the environment in which the coach’s original analysis was relevant.

You can’t escape any of this logic.

The lesson is that to understand economic phenomena requires a better understanding of institutional environments, and historical and social context. The micro-foundations approach has merely been an excuse to continue to conceptualise the economy as self-stabilising and in equilibrium in the face of the Lucas Critique, while any rational response would have been to acknowledge the inherent instability of social processes, of which the performativity of economic analysis itself a part of.

Monday, April 28, 2014

Post-Crash economics clashes with 'econ tribe'

Manchester University’s Post-Crash Economics Society (PCES) released a report recently into the way economics is currently taught at Manchester, which is relevant to economics teaching at universities worldwide.

Their well articulated advocacy for pluralism in economics teaching, where neoclassical approaches are just one of many analytic techniques in the curriculum, has tapped into the current media disquiet with economics.

The involvement of the Bank of England’s new Chief Economist, Andrew Haldane, certainly helped, and the report has now found media coverage at the Financial Times, the Wall Street Journal blog, The Independent, and Paul Krugman’s New York Times blog.

In this article I first provide an overview of the PCES report in the context of the modern history of economics and the dissenting voices that came before them. Then I examine the tribal defences raised by the mainstream in response to it, which only serve to reinforce the urgency of the task of transforming economics into a socially valuable endeavour.

What is it all about?
The PCES report provides a concise overview of the systematically narrow and outdated teaching approach in economics, which unfortunately simply reflects the mainstream practice of economics. It highlights how the economics profession, and economic teaching, has seen a ‘great narrowing’ over the past two decades, all but redefining the discipline away from the study of economic phenomena, to the study of a particular family of equilibrium marginal models.

At a practical level the report offers guidance for improving teaching, and a wholeheartedly agree with the points made, which I summarise as follows (emphasis is quoted text)
  1. Economics education should begin with the study of economic problems, where economic phenomena are outlined and the student is given a toolkit and must evaluate the strengths and weaknesses of how different theories explain different phenomena.
  2. Introduce pluralism so that students understand that different models and theories can be applied or are most useful in different situations. Students should be able to consider a variety of theories before forming judgements. This is important because economic theory is not universally applicable and much depends much on institutional, historical and social contexts.
  3. Include the study of institutional power structures and politics. In doing so, students should be aware of the ethics of being an economist and a consideration of the ethical consequences of economic theory.
  4. Ensure that the philosophy of economics, or the more generally the philosophy of science, forms a core part of the curriculum. Student should be able to understand which assumptions are justified in a scientific theory and how rigorous must the ability to falsify a theory must be.
  5. Finally, provide students an understanding of the historical development of a particular model or economic paradigm in order to contextualise the approach and provide insight into the problems it was designed to solve and how context influenced its formation
The PCES report, and its proposed reforms, is itself part of a recurring theme in the history of economics. In 1973 Joan Robinson tried to revolutionise economics teaching, writing a textbook reflecting most of the reforms advocated by the PCES. Unfortunately that book is all but forgotten in economics. I certainly wish Robinson had been successful, as it would have deterred the next generation of top economists from merely repeating the nonsense that went before them.

In a strange historical coincidence, William Baumol complained of poor teaching of economics as far back as the late 1930s. At the time he found the teaching ignored what was then the cutting edge work of Keynes and Joan Robinson herself.

In 1968 it was the Union for Radical Political Economists that set about disrupting the discipline. By 1972 this movement had agitated so successfully that the then President of the American Economics Association John K Galbraith, a supporter of the movement, noted in his 1972 Presidential address to the Association that "For a new and notably articulate generation of economists a reference to neoclassical economics has become markedly pejorative". He went on to say
Neoclassical and neo-Keynesian economics, though providing unlimited opportunity for the demanding niceties of refinement, has a decisive flaw. It offers no useful handle for grasping the economic problems that now beset the modern society.
But nothing changed.

In 1992 the Foundation for European Economic Development (FEED) funded work that produced a Plea for a Pluralistic and Rigorous Economics, which was published in the American Economic Review.  Again, nothing.

More recently the Post-Austistic Economics movement emerged in Paris in 2000 with a similar mission to reform economics, followed closely by a proposal to open up economics by a group of PhDs at Cambridge in 2001.

In 2003 Harvard economics students organised a group called Students for Humane and Responsible Economics (SHARE), which launched a petition calling for a new approach to economic teaching and offered an alternative introductory course that was ultimately rejected by the university. At Manchester, the PCES has had their proposed course on Alternative Theories of the Crisis rejected by the university just a month ago.

In 2011 we also saw the EC10 class walk out on N. Gregory Mankiw’s lecture at Harvard in support of the Occupy protests, which in retrospect seems completely appropriate given Mankiw’s prostitution of economic ideas to defend the wealthiest 1%. Published at one of the leading economics journals, Mankiw’s ‘Defending the 1%’ article provides a classic example of the unscientific nature of the discipline’s ‘respectable’ journals, and the perverse anti-scientific but ideological incentive system embedded in the culture of economics.

The PCES is now one of many student societies, including for example, the German Pluralist Economics Network, justifiably calling for change in economics. Again the time appears ripe for disruption of economics, and the PCES offers useful guidance for how to achieve that.

The tribe responds
First, let me say that ‘econ tribe’, the core of the economics profession, is truly a tribe - a clique, a social construct - rather than a scientific community. As senior econ tribe member once gave me the following advice.
...the group ‘elders’ have implicit theories in their heads as to how the world works, what forms of behaviour are appropriate, what beliefs are reasonable, what questions are truly yet unanswered, what articles of faith should not be doubted, and where they and their group ultimately make their money
Oh, and that’s just the start (added emphasis).
…many economists like to pretend that even if they give practical policy advice, they as economists make no value judgment on what people want, i.e. ‘preferences are taken to be stable and can differ over all individuals’.

Such statements are then implicitly ‘backed up’ by theoretical models of decision making arising from underlying preference maps (i.e. a ‘deeper layer’).

Now, as a statement of reality this is a completely absurd and purely religious position since no-one even comes close to having ever measured a preference map despite the feeble protestations of the revealed-preference crowd, but as a defensive shield against the criticisms of psychologists and mathematically-challenged economists it is very effective. It drags criticisers into a morass few will escape from and that no outsider would be able to follow anyway, making it sound like a good riposte.

Nearly all sub-fields of economics have similar defensive religious beliefs used to deter entry by unwanted outsiders
A give-away signal of a tribe member is that they will deny the religious nature of their tribe, and pledge loyalty wherever possible by defending the tribe against all challenges. This is the sell-out that most successful economists make at some point in their career, something Yanis Varoufakis has written extensively about.

We see evidence of overt religious zeal and loyalty pledges in the mainstream responses to the PCES report. Here are the links so you can read them for yourselves - Wren-Lewis, Yates, Farmer, Krugman. Expect more in the coming weeks.

The blueprint response was that economics teaching could be better, but economics is fine. I couldn’t disagree more. This is a mere loyalty pledge.

Poor teaching reflects the poor scholarship of the discipline more broadly. This is most clearly seen in Ferrero and Taylor’s survey of economists, where 78% of professional economists (including professors) incorrectly answered a multiple-choice question about the definition of opportunity cost. The profession subsequently kicked into gear to defend itself from embarrassment, with one article in a ‘respectable’ journal making the Alice in Wonderland response that any Humpty can use opportunity cost to mean just what they choose it to mean - “neither more nor less!”

But the big defensive play to combat the PCES threat was to assert that the ‘sciency-ness’ of the mainstream is the reason for its dominance, and the reason we should respect it. Again, deny the religious aspects of economics, be loyal to the tribe.

From Wren-Lewis.
…economics is a science. Its response to data and events may be slow compared to the normal sciences, for obvious reasons, but it is progressive
From Farmer
Economics is a science…the core approach to modern economics, both macro and micro, is the culmination of a process of intellectual argument in which ideas have been sifted, debated and compared with facts. Some have survived; others have not.
Farmer’s claim is not at all true. Most of the modern macro debates were already happening in the 1800s.

It is scary to think that these economists believe what they doing is science. There are parts of economists that do take those crucial scientific steps of prediction and experimentation, and the results usually contradict mainstream theory - conflict is real, costly punishment is real, social norms can evolve and change, preferences are not well behaved, markets boom and bust, and more. Yet for some reason the preacher’s models seem immune to evidence.

A comment from Yates’ post points to the non-scientific approach deemed acceptable in economics.
If economists wished to study the horse, they wouldn’t go and look at the horses. They’d sit in their studies and say to themselves, “What would I do if I were a horse?
Physicist-turned-sociologist Duncan Watts has warned about this approach
…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. 
Krugman and Yates take the whole ‘sciency-ness’ one step further, pretending that economists do in fact know what’s going on in the economy, in banking, in financial crises, and in recessions. Or something.

Steve Keen fired off a response to Krugman, arguing that he contorted the failure of economics to foresee even the remote possibility of a debt-fuelled crisis, into a mere failure to keep an eye on shadow banking - as if better data on shadow banking would have somehow led to the whole econ tribe dropping their core money-less models of the economy in equilibrium to embrace theoretical approaches of outsiders.

A second defensive play, seen in Yates and Farmer’s responses, is that within the mainstream there is a model for everything, so no need to look outside. Again, no reference to the success of any of the models in predicting economic phenomena. It is as if the high priests response to evidence is to merely create a new god - “Ah yes, haven’t you seen, we have a Tornado God now. Solved that didn’t we” - and ignore reality.

In the past Krugman has actually made similar points. Mainstream economics ignored increasing returns to scale as a reason for trade, even though it had long been understood by ‘outsiders’. To address this he created the Increasing Returns God for the tribe.
I was, of course, only saying something that critics of conventional theory had been saying for decades. Yet my point was not part of the mainstream of international economics. Why? Because it had never been expressed in nice models. 
Which only serves to highlight the invalid non-scientific approach - ideas are not judged on the merit as predictive tools, but on whether they can be expressed in the pre-determined modelling methods of the tribe as nice totems of the modelling gods.

As I have said, the value of a scientific model is its ability to predict outcomes in new situations. In economics, the reverse is true. Most economists believe that models provide insights simply by their construction, whereas in reality we can never know if the model is useful unless it offers useful predictions.

It is telling that we see no arguments based on scientific principles in these responses. Nothing on the practical usefulness of mainstream approaches above others. No long lists of scientific battles won by the mainstream because of the useful predictive power of their approach, and plenty of silence on the battles they lost (eg. the capital debates).

That is to be expected from the tribe’s high priests. But it also shows a distinct ignorance of alternative approaches. If there was a wide understanding of alternatives a response comparing the merit of different approaches could be made. The reason it isn’t made is because once economists learn of heterodox approaches the usually leave the tribe. For example, I can’t imagine that any macroeconomist with a decent understanding of Godley and Lavoie’s integrated monetary models would really continue to believe that the mainstream ‘label the residual’ approach to a money-less equilibrium is more valid.

The future
I wish the PCES the best of luck. It is possible for economics to be a useful science, but that requires a much more humble discipline that is able to judge theoretical and methodological approaches based on proper evidence. It starts by acknowledging that in a scientific sense, the body of knowledge in economics is extremely limited, and much of what passes for economics is a collection of mere credible stories about certain phenomena, which are yet to be tested.

I hope indeed that the observation that Pilkington makes is the correct one, and that the time is ripe for transformation in economics.
…silently, behind the scenes, the heterodox have been winning the debate. Krugman would never admit this, of course — indeed, he seems to live in a bit of an echo chamber over at the NYT with all his fanboys and fangirls and he may not even be fully cognizant of it — but if you move in economics circles you’ll know this to be generally recognised.
But let me finish with more sober words from James K Galbraith, because I believe transforming economics is going to be one hell of a battle of tribal politics.
Leading active members of today’s economics profession... have formed themselves into a kind of Politburo for correct economic thinking.  
As a general rule—as one might generally expect from a gentleman’s club—this has placed them on the wrong side of every important policy issue, and not just recently but for decades.

They predict disaster where none occurs. They deny the possibility of events that then happen. ... They oppose the most basic, decent and sensible reforms, while offering placebos instead.

They are always surprised when something untoward (like a recession) actually occurs. And when finally they sense that some position cannot be sustained, they do not reexamine their ideas. They do not consider the possibility of a flaw in logic or theory. Rather, they simply change the subject.

No one loses face, in this club, for having been wrong. No one is dis-invited from presenting papers at later annual meetings. And still less is anyone from the outside invited in.

Tuesday, April 22, 2014

Corrupting Piketty in the 21st century

The media attention surrounding French economist Thomas Piketty’s new book Capital in the 21st Century is growing ever more fervent. Here are my two cents.

To me three things are clear to be about this book. First, it is a timely reminder that distribution of resources within society matters. This is especially important for an economics profession who has often ignored the issue and whose core analytical framework is a completely inappropriate tool for its analysis.

Second, and this is quite a surprise, the mainstream economics profession seems to be rather accepting of the book, which, when I read it, seemed to make the claim that most of their scholarly methods are flawed and that the economics profession knows very little about the more important elements of social organisation. While on the surface this appears to be a mature response by the profession to valid criticisms, I fear that the profession will corrupt the message of the book and will unfortunately not have the impact on improving economic scholarship that it seems intended to have.

Third, and this is my one personal gripe, the book fails to acknowledge the many social processes studied by sociologists and even ecologists that have been used to explain unequal outcomes in a wide variety of settings. For example, the process of preferential attachment is fundamental to producing the unequal distribution of the success of artists, musicians and even, ironically, authors. Such a process can not only explain the broader inequalities in terms of access to resources (income and wealth), but also the inequality of book success, where Piketty finds himself in the top 1% of economics authors (and there really is no shortage of books covering similar topics recently, for example here, here, here and here).

I want to now explore these latter two point in more detail.

The surprise hero
The mainstream acceptance of the book in economic circles is, in my view, due to the simplicity of the r > g story Piketty weaves into the long run inequality trends he has meticulously pieced together. This story is compatible with many of ridiculously simplistic explanations economists love, such as technology change, education, regulatory intervention in labour markets, and just about anything else. Yes, the mainstream is stuck on these same metaphysical explanations that Henry George made fun of back in the 1870s.

What this means then is that r > g heuristic Piketty uses is not a precise model applicable to a wide variety of circumstance, but a general framework in which a variety of political, social and institutional models will sit. This heuristic basically says that the rate of return to capital owners tends to exceed the rate rate of growth of the economy, and hence increases inequality over time. It is a similar idea to the model from Chapter 4 of Joseph Stiglitz’s PhD thesis from 1966. Piketty summarises the process as follows:
When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the nineteenth century and as is likely to be the case again in the twenty-first century), then it logically follows that inherited wealth grows faster than output and income. People with inherited wealth need save only a portion of their income from capital to see that capital grow more quickly than the economy as a whole. Under such conditions, it is almost inevitable that inherited wealth will dominate wealth amassed from a lifetime’s labor by a wide margin, and the concentration of capital will attain extremely high levels—levels potentially incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies.
This explanation is general enough not to exclude many popular but flawed neoclassical stories about inequality. Indeed Piketty peppers his explanations of potential forces leading to a divergence of wealth with hints of neoclassical theories, which definitely help him appeal to his intended audience. But ultimately he paints a political, social and institutional story of wealth distribution, one which the economic reviews seem to miss.
the inequality r > g is a contingent historical proposition, which is true in some periods and political contexts and not in others. 
It is unfortunate that the definition of capital that Piketty uses does not distinguish between scarce factors of production, like land, patents and other State-granted monopoly rights, and produced factors of production, like buildings and so forth. This matters in theoretical discussions because produced factors of production don’t necessarily produce any return unless coupled with a scarce factor of production. James Galbraith noted this in his review, along with other important measurement issues such as implicitly using value as a measure of quantity (which has been criticised elsewhere). These are certainly correct, but one can’t expect appropriate data to emerge from the history books that can be easily segregated into modern definitions. Indeed, others have argued that Piketty uses capital in the more general and appropriate way as the monetary value of assets able to be used as collateral. Which is a fine debate to have, but not much help when the body of existing economic theory uses the term to mean something else. In all, this confusion is likely to be exploited by those wishing to leverage Piketty’s new-found popularity to their advantage.

One thing we miss in this process is that if ownership of wealth was equally distributed, it wouldn’t matter whether r > g in terms of its impact on inequality. Or more precisely, institutional settings can be designed to combat any social force that concentrates wealth if we so desire and if it is politically palatable.

Corrupting the message
The Slack Wire's Suresh Naidu has already noted these obscure interpretations of the book within economics, calling the corrupting process ‘bastard-Pikettyism’. Like me, he fears the valid methodological critiques will be ignored, and the main message will be propagandised into one that is supportive of the current mainstream approach.

Let’s not pretend this isn’t the way new ideas are dealt with by the power structures within the economics tribe. Thomas Palley has extensively discussed how this same process happened following the financial crisis. He calls it ‘Gattopardo economics’, and his subtitle sums up the process: The crisis and the mainstream response of change that keeps things the same.

We can see this starting in quite a few of the now hundreds of reviews and comments emerging online. For example, Tyler Cowen seems to want to corrupt the idea of capital back into a physical thing and essentially say that the past is not a good guide to the future. Of course, Piketty is no fool and completely acknowledges the uncertainty, simply noting that we should learn lessons from history that reverting toward equality is no automatic outcome. In my mind the vagueness of the use of the term capital is allowing the profession to read it as they see fit, ignoring the political and institutional environment.

Robert Solow seems to like the book (32min mark of linked video), and particularly the idea of an r > g mechanism. We see Solow at pains to fit Piketty’s commentary on the long-run picture of inequality within his ‘model thinking’. When he discusses what he thinks is going on with the gap between r and g he says:
On the pure theory side, the sorts of influences that appear in the book suggest that there will be an increase in the capital output ratio - this is likely if the law of diminishing returns is still operating at all - is likely to push the realised rate of return on capital down a little bit. You can ask how much down if you make the technical calculations that one would normally make, and that rest on assumptions that are already in Thomas’s book, you would expect the rate of return on capital to fall when the permanent growth rate falls, and fall somewhat better than one to one, so that the gap between r and g is likely to remains positive to be somewhat narrower. So there is no reason to suggest that this process of accumulation of wealth and income at the top of the distribution to top increasing. 
Oh no, please, not those technical calculations.

The great fear I have is that the economics profession will use the book to argue that inequality is a complex issue and that changing the distribution of wealth is technically difficult. It is not. There are endless policy options for reducing inequality that are simple to implement, and often are implemented (or have been) in some part of the world. It’s not rocket science. Sure, politically redistribution is difficult. But it is not the job of the economics profession to pander to current political sensitivities - we should be offering solutions.

Here are just a few; mortgage (and other) lending constraints, limits to rent increases and more secure housing tenure for renters, limits on executive pay, higher welfare support to the most needy, shifting the tax base away from wages towards land and land-like resources, stop privatising public utilities, greater public investment in network infrastructure, and more.

Was it r > g that got Piketty’s book into the 1%?
The inequality of media attention lavished on this book [1], in preference over the many other equally worthy new economic books, is part of the same social mystery that the book itself attempts to resolve.

In my view, it is clear that owning wealth is an advantage to acquiring more wealth. In sociology, and on the fringes of economics, the process of preferential attachment is being regularly identified in social systems. This review is helpful in getting acquainted with the idea.

While the idea that r > g suggests a process of cumulative advantage, the mechanisms at play in such a process are unable to be modelled in a world of perfect markets. The fundamental feature of capitalism, it seems, is not the perfection it is made out to be in economic theory. This will be hard to deal with for the true believers in the profession.

Preferential attachment processes at the individual level can, and have been, identified empirically.

We know that already large firms are more likely to win government contracts, thus reinforcing their dominant position. We observe that corporate directors with more cross-directorships are more likely to get new directorship positions. We know that the current level of popularity of books, music and films is a good predictor of their future popularity and that ‘superstars’ are the product of a cascading process of gaining advantages.

And more relevant to this discussion, am I likely to buy, read and review a book that already has gained significant media attention than one that hasn’t? Yep.

To maintain a degree of fairness and equality when there is widespread preferential attachment occurring in society there must either be either a) institutional limits on these processes, or b) active redistribution to counteract the undesired results. In sports we see examples of a), where team salary caps are common. Piketty notes the historical role of taxes on capital as an example of b) and promotes such solutions later in the book.

To be clear, Piketty makes a great contribution to economics, especially in his call to tightly link economic analysis to historical political and social conditions, rather than pretend to solve problems of the world from detached abstract reasoning. However like all reformation efforts in the discipline, his (and fellow students of inequality) will be met by fierce internal opposition, the ultimate outcome of which is to twist his work into something it is not in order to pretend that it supports the status quo. This happened to Keynes, Coase, it happened following the Cambridge controversy, it happened in macro after the financial crisis, and it will happen again now. There are simply too many vested interests who want the profession to continue to come to the same conclusions.

fn[1]. Here’s just some of the attention the book has received: Bloomberg, Real World Economics Review, Dissent Magazine, Monthly Review, Quartz,New Yorker, Business Insider, Harvard University. Marginal Revolution, Foreign Affairs, Huffington Post, The Nation, Taleb, The Economist, New Yorker Magazine, BHL, The Conversation, Tyler Cowen again, Squarely Rooted, Joshua R. Hendrickson, RWER again