Archive for November, 2010

When all you have is a hammer

Samuel Bowles’ has an excellent forthcoming book, “Machiavelli’s Mistake: Why good laws are no substitute for good citizens”, which argues that there are not separate conversations between markets and incentives on the one hand and philosophy and ethics on the other.

His story starts with  Aristotle, who wrote in the Ethics that a constitution should “make the citizen good by inculcating habits in them.” There is a long line of political philosophers who similarly argued that essence of good government was the cultivation of civic virtue. However, ethics and government eventually became disassociated, exemplified by Machiavelli who argued that the purpose of laws was to make bad citizens behave. This argument was followed and perfected by Hobbes, Mandeville, Hume, Smith, and Bentham. Essentially, this line of thought argued that a constitution should be written as though citizens were wicked. [N.B. they were not all necessarily saying that humans were in fact wicked, but only that a good constitution should be written as if they were]. This assumes a “separability” between ethics and the material world, that laws have no impact on a person’s preferences or ethics. And it is the basis of all public policy issues when addressed by economics. And this is Machiavelli’s mistake.

The line Bowles takes is that maybe writing a constitution that supposes humans are selfish will make them so. That is, the “separability” assumption between economics and ethics is very false. To use the language of economics, Bowles is essentially arguing that preferences are endogenous. However hard it may be for non-economists to believe, the truth that is that economic analysis depends on preferences being exogenous (given) and stable. There is very, very little economic research that addresses endogenous preferences, that is, asking how preferences change and where they come from.

The reason for this is that the economist’s toolkit is not at all equipped to deal with endogenous preferences. Once endogenous preferences are introduced, one can no longer use the standard economics toolkit. This situation in economics reminds me of the Mark Twain quote: when all you have is a hammer, all problems start to look like nails. It is not hard to believe that people’s preferences change and come from somewhere. Perhaps it is time that economists get a new toolkit that is better equipped for the problems we face in the world today.

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Economics in 2036

I tried to avoid block-quoting in my last post, which was intended as more of an essay. Here are some follow-up points on the question of where and how economics can go.

Nassim Taleb, whose black swans I mentioned minutes ago, has a post with some predictions about our world in 2036. I think that he and I may think alike on how to approach the environment:

Science will produce smaller and smaller gains in the non-linear domain, in spite of the enormous resources it will consume; instead it will start focusing on what it cannot—and should not—do. Finally, what is now called academic economics will be treated with the same disrespect that rigorous (and practical) minds currently have for Derrida-style post-modernist verbiage.

Of course, Taleb doesn’t offer much of a vision for economics and science going forward, because that wasn’t in the scope of his post. Now, my last post certainly offered one vision for what a different economics can look like, but is limited by the scope of my own knowledge and understanding. Julie Nelson, on the other hand, is an accomplished economist and has a great open comment to the NSF on next-generational research challenges. You should read the whole thing, as she gets at many of the points I made in my previous post, but elaborates on them better than I ever could. Here’s are some of her best sentences:

There is, however, another solution, which involves recognizing the inescapable intertwining of fact and value, while continuing the systematic search for reliable knowledge. Amartya Sen has called this “transpositional” objectivity.  This (in fact more exacting) standard of objectivity requires that the viewpoints and values underlying the analysis be brought out into the open and subjected to scrutiny…

Re-evaluating the role of ethics in economics challenges assumptions that are deep-seated in the mainstream of U.S. economics. Accordingly, improving economic analysis of climate change will require a multi-pronged effort…The rising generation, given their energy and larger stake in the outcomes of  climate change policy, should be a key part of this transformation…

As Nelson points out, shifts like this one require funding bodies like NSF to embrace a new vision for economics. If more economists like Nelson speak up and NSF pays heed, economics in 2036 will look a lot more like an economics of Stewardship, and today’s academic economics will indeed look simply arachaic.

P.S. I wrote my entire last post without mention of the Catholic Social Tradition in stewardship. It would be an understatement to say it’s greatly informed my thinking of these issues. The best starting point on that topic is JPII’s Sollicitudo rei socialis. The USCCB’s pastoral letter is also helpful on these issues.

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I apologize for my light and sporadic posting recently. I transitioned jobs on Monday, and right now is the first chance I’ve had to sit back and think, relaxing in my old bedroom at the Krafft (suburban) homestead.

It’s always nice to have a chance to gather with family, reunite with old friends, and give thanks. The symbology of Thanksgiving, though, gives one pause- it’s mainly full of myriad ways in which we as people have become masters of our domain, breeding and slaughtering domesticated turkeys, conjuring something known simply as “stuffing”- yes, we’ve mastered the art of celebrating our abundance. Now, don’t jump off the boat here- this isn’t some environmentalist rant. Ok, it kind of is.

I thank Mark Thoma for linking to a blog I haven’t seen before, the Ecological Headstand. Its most recent post reexamines the idea of our economy and our ecological footprint. Reading it this morning flipped my mental approach to this day of abundance. Rather than taking for granted the gifts that the lucky among us reap from the Earth, I think it’s important to examine our attitudes towards this abundance, and how our economics of abundance reflects this attitude.

In the interest of evading nuance, I think there are essentially two approaches economics can take to the environment- an economics of Mastery, and an economics of stewardship. The economics of Mastery is best exemplified with standard cost-benefit analysis, measuring the costs without respect to externality and distribution, and the benefits without respect to hidden damages and long-run scarcity. It’s curious that at introduction, most present economics as a study of scarcity, because when it comes to our environment and natural resources, our typical economics of Mastery seems to presume nearly boundless abundance. Any abundance, of course, can be overcome by our mastery of the environment- there will always be a better fertilizer, a new fuel cell, by which we can circumvent natural limits- until, of course, we simply can’t.

What, then, is an economics of Stewardship? I’d make three main points, all borrowed from previous posts on other thinkers. The Headstand post I linked earlier, which inspired this post, makes the key first point- we cannot double count environmental destruction. That is to say, if we destroy the environment in time period 1 and ignore that loss, we can’t simply add again to GDP in time period 2 when we pay for the recovery (and we will pay). So, an economics of Stewardship will make every effort to measure and incorporate costs of depletion and destruction. Of course, we will struggle to accurately assess natural value streams, so an economics of Stewardship will recognize the limits of its methodology, and treating the environment as an equal to the economy, give it the benefit of the doubt.

The second issue is how we weight benefits and costs over time. Economists of mastery argue for higher discount rates, pegged near real GDP growth or real return on capital. They show that if you do otherwise, set it too low, then we will end up with a paradox of greater environmental value in time period 50 or 60 than GDP. This is ok, because remember, it’s GDP that’s flawed and can’t internalize the environment. Low discount rates are an embrace of stewardship because they recognize that others in the future are to benefit equally from abundance as us in the present. Worry not that they might be richer, smarter, or stronger- natural abundance is still the inheritance of all.

Third and finally, an economics of Stewardship embraces the uncertainty in the natural world. Black swans can exist in the environment, and they are not limited to possible effects of anthropogenic global warming. There are unknown unknowns here. An attitude of uncertainty is a key break from the economics of Mastery, which mainly traffics in knowns, and occasionally in known unknowns. Humble stewardship, though, recognizes that abundance is fragile and complex, and events can occur that are outside the bounds of our current scientific knowledge.

It’s easy to become complacent about what we have and what we are used to. Mainstream economics claims to be about scarcity, but is really about mastery. A humble attitude toward our environment must inevitably lead to a new economics, in which we methodologically embrace our roles as stewards, simultaneously parts and guardians of the abundance around us. I hope you’ll join me in taking part in humble thanks on this wonderful day, and examining your role as a steward, and not a master.

Happy Thanksgiving.

Update: I reflect a bit on some others’ thoughts on the future of economics in my next post. Consider it the substantive compliment to this more emotive essay.

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John Cassidy has another great piece in the New Yorker, “What Good is Wall Street?” in which he argues that most of what investment bankers do is socially worthless, and yet the finance industry booms and salaries for top bankers skyrockets:

Most people on Wall Street, not surprisingly, believe that they earn their keep, but at least one influential financier vehemently disagrees: Paul Woolley, a seventy-one-year-old Englishman who has set up an institute at the London School of Economics called the Woolley Centre for the Study of Capital Market Dysfunctionality. “Why on earth should finance be the biggest and most highly paid industry when it’s just a utility, like sewage or gas?” Woolley said to me when I met with him in London. “It is like a cancer that is growing to infinite size, until it takes over the entire body.

An interesting aspect that Cassidy touches on has to do with financial innovation:

Because trading has become so central to their business, the big banks are forever trying to invent new financial products that they can sell but that their competitors, at least for the moment, cannot. Some recent innovations, such as tradable pollution rights and catastrophe bonds, have provided a public benefit. But it’s easy to point to other innovations that serve little purpose or that blew up and caused a lot of collateral damage, such as auction-rate securities and collateralized debt obligations. Testifying earlier this year before the Financial Crisis Inquiry Commission, Ben Bernanke, the chairman of the Federal Reserve, said that financial innovation “isn’t always a good thing,” adding that some innovations amplify risk and others are used primarily “to take unfair advantage rather than create a more efficient market.”

However, he does not seem to quite get to the “race” that goes on between regulators and the regulated. Throughout the history of finance, it is a recurring theme: after a crisis, the government passes regulation to maintain stability, and soon after the regulated go to task innovating financial instruments that will circumvent that regulation. In time, another crisis occurs and the cycle happens all over.

The lesson for today is that we need a new set of regulation. But will it look like Glass-Steagall? Probably not. The economy and our society has changed significantly since the 1930s. A 21st century regulatory reform will need to address a deeper international environment and the new avenues for financial innovation which include asset backed securities, credit default obligations, structural investment vehicles, and credit default swaps.

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Paul Krugman has a write-up on VoxEU about a new paper with Gauti Eggertsson, “Debt, Deleveraging, and the Liquidity Trap.” This paper is vintage Krugman (I say that having known about the man for 4 whole years)- he comes up with a simple and elegant model, and derives salient insights. I think he moves his arrow closer to Modern Monetary Theory here, in that he begins to probe the distribution of debt. In particular, he writes,

Ignoring the foreign component, or looking at the world as a whole, the overall level of debt makes no difference to aggregate net worth – one person’s liability is another person’s asset.

I wrote about attending part of the MMT teach-in back in March. Randy Wray brought up this asset/liability idea as a way to express MMT to skeptical parties, particularly non-economists. Rather than thinking of our economy as a household, he said, realize that every asset is a liability. If one wants the non-government sector be net savers, the government sector must be a net borrower.

Now, recall that back in July, Krugman and Jamie Galbraith had a friendly skirmish over whether deficits ever matter. Krugman wrote,

And there are limits to all three. Even a country with its own fiat currency can go bankrupt, if it tries hard enough…

Since the price level is, by assumption, proportional to M, this tells us that the higher the debt burden, the higher the required rate of inflation — and, crucially, that as D-S heads toward a critical level, this implied inflation heads off to infinity…

So there is a maximum level of debt you can handle.

Then, Galbraith argued that by talking about future inflation, Krugman assumed the consequent, etc. I’m not here to rehash that. I do want to point out that in this paper, Krugman seems more concerned about the distribution of debt.

It follows that the level of debt matters only because the distribution of that debt matters, because highly indebted players face different constraints from players with low debt. And this means that all debt isn’t created equal – which is why borrowing by some actors now can help cure problems created by excess borrowing by other actors in the past. This becomes very clear in our analysis. In the model, deficit-financed government spending can, at least in principle, allow the economy to avoid unemployment and deflation while highly indebted private-sector agents repair their balance sheets, and the government can pay down its debts once the deleveraging crisis is past.

I believe MMTers would argue that this need for non-government deleveraging is necessary in cases other than a liquidity trap. I think this point is where we see the divergence, and Krugman’s eventual caution against high levels of government debt (it’s the inflation at full employment, stupid, he would say). While I side with MMT on this front, I think Krugman can move the discussion in a positive direction by encouraging folks to think clearly about debt distribution. When calling for the government sector to dissave, do conservatives and neoclassical economists really want the private sector to be saving more? In a vacuum of aggregate demand? I’m sure they will reject his model out of hand, which isn’t surprising, because much of center and right economics seems politically and not intellectually motivated. Boo on them.

As for Krugman, I’d love to see his insights on what happens when we’re not in a liquidity trap, but household debt remains a crippling burden. Remember, much of his discussion of depression economics is around this idea of a liquidity trap, Nipponization, etc. If the liquidity trap ends, and unemployment remains high and resources underutilized, does Krugman have a model for that? Because I know MMT does. Somehow I think that Krugman will sound a lot more like Galbraith in 2 or 3 years.

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I’m not much in the mood to rip on the economics profession right now (unusual, right?) However, the above comic (h/t MR) reminded me to revisit this Krugman post from this morning. Krugman lashes out at David Brooks, who (hamhandedly) criticizes neoclassical economics. First, here’s Brooks:

The economic approach embraced by the most prominent liberals over the past few years is mostly mechanical. The economy is treated like a big machine; the people in it like rational, utility maximizing cogs. The performance of the economic machine can be predicted with quantitative macroeconomic models.

Krugman rightly points out that this is most true of conservative, non-Keynesian economists. On this point, I have no quibble wih him:

First, it’s conservative economists who insist that people are always rational and utility-maximizing; liberal economists are the ones willing to invoke bounded rationality, animal spirits, etc.. The whole salt-water fresh-water split was about which you were going to believe: the assumption of perfect maximization, or your own lying eyes. And the Keynesians were the ones who preferred to believe their eyes.

However, Krugman could go further, by pointing out that there are yet other economists who go beyond these psych-applied innovations. Thus, Brooks is right to probe the disconnect between even liberal mainstream/neo-classical economics and reality. Like Krugman, he doesn’t put any stock in more radical critiques of economics, like post-Keynesian, feminist, and Marxian critiques.

So, Brooks fingers the wrong economists for simplisticly saying, “there’s an equation for that.” Krugman deludes himself into thinking that mainstream critiques of MaxU et al. go far enough. Meanwhile, the heterodox folks (like Irene Staveren) are rightly looking at other perspectives to strengthen their narrative of the economy:

I have identified the concepts of gender, the household, and unpaid work/caring as three key feminist economic concepts that would help post-Keynesian economics to deepen its analysis.

This sort of cross-pollination is what economics should strive for. However, heterodox perspectives often produce models in which there isn’t always an equation for that. Not all worthy questions have clean data and easily mathematized models. Folks as smart as Krugman, when they take off their policy hat and put on their paradigm hat, should be willing to entertain more of these messy, heterodox questions.

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It’s a well observed phenomenon that human development incomes are highly correlated with economic measures like GDP. However, that doesn’t mean that improvements in GDP cause, or even correlate with, improvements in human development indicators. Economix points to the UN’s new Human Development Report, which addresses this issue. As Catherine Rampell writes,

As you can see, the correlation between per-capita income and other measures of human development is, in the works of the report, “remarkably weak and statistically insignificant.”

Rampell goes on to explore some possible explanations:

The report offers a few possible explanations for this puzzle, including that there might be a long lag between economic growth and the types of social services and infrastructure that could lead to better national health and education systems. There also may be many other country-specific variables — like cultural differences — that mask a possible relationship between wealth and human development.

I don’t have time to read the report, but I wonder if they address the issue of inequality. Someone came to Brookings a while back and showed how inequality was a key factor in determining the poverty-reducing content of economic growth. Thus, high inequality could also hold back these indicators, which are correlated with levels of poverty.

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