Archive for December, 2010

During the interwar period, there was no consensus on how economics should be done. There was no “orthodoxy”, but rather various competing schools of thought. In the US, for example, there were schools that did neoclassical theory, and there was also strong movement in American Institutionalism at universities such as Texas and Wisconsin. Today, there is a dominant orthodoxy, and that is neoclassical economic theory.

Many view this newfound orthodoxy a great improvement, from a state of “disarray” and argument to a more rigorous and exact science. However, I would like to argue that the pluralism that existed in economics during the interwar period was in fact healthy for society. It allowed for debates and conversation, and for trying new economic theories when other ones failed.

During the Great Depression, for example, neoclassical theories fell out of favor and Institutional economists flocked to Franklin Delano Roosevelt’s administration. There they were instrumental in structuring New Deal programs such as social security, unemployment insurance, and corporate laws such as the 1933 Glass-Steagall Act which included banking reforms that were aimed at regulating speculation. Institutionalists also began collecting the national income accounts and founded the National Bureau for Economic Research.

The problem that the Obama administration faces is that they do not know where to look for economists other than the ones who got us into this current crisis. Whereas during the New Deal the United States was a diversified place in terms of economic theories, today there is only one. That is why the same economists who got us into the mess are still advising the president: former Treasury Secretary Robert Rubin is an advisor to the president; Tim Geithner who was president of the Federal Reserve Bank of New York from 2003-2009 is now the U.S. Secretary of the Treasury under Barack Obama; Paul Volcker was chairman of the Federal Reserve under Carter and Reagan and is now chairman of the Economic Recovery Advisory Board. The list goes and on demonstrates the poverty of the current situation of economic theory in the United States.

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Enjoy this Barenaked Ladies’ song, “The Elf’s Lament.” The song details the hardships of being an elf, and reminds us all to remember the less fortunate this holiday season. My favorite lyric: “Toiling through the ages, making toys on garnished wages / There’s no union / We’re only through when we outdo the competition.”

Merry Christmas!

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Bourgeois Dignity: Why Economics Can't Explain the Modern World

It is no secret that modern economic theory fails miserably at explaining the tremendous explosion in economic activity and income levels that has taken place since the 18th century. We don’t have a good story of why in 1800 an ordinary person lived on $3 a day, whereas today an ordinary person in a “bourgeois” country earns over $100 a day.

In her new book, Bourgeois Virtues, Deirdre McCloskey attempts to tell such a story of why the past two centuries have been so good to ordinary people in bourgeois countries [ht:sn]. She describes how economic theory in its current state is useful for explaining how resources are allocated – but in order to explain the economic revolution that took place since 1800, economic theory needs rhetoric:

I am claiming that the economy around the North Sea grew far, far beyond expectations in the eighteenth and especially in the nineteenth and most especially in the twentieth century not because of mechanically economic factors such as the scale of foreign trade or the level of saving or the amassing of human capital. Such developments were nice, but derivative. The North Sea economy, and then the Atlantic economy, and then the world economy grew because of changing forms of speech about markets and enterprise and invention.

She takes the usual line that innovation drove the Industrial Revolution. But she has an uncustomary explanation for innovation:

But I also argue—as fewer historians and very few economists would—that talk and ethics and ideas caused the innovation. Ethical (and unethical) talk runs the world. One-quarter of national income is earned from sweet talk in markets and management.  Perhaps economics and its many good friends should acknowledge the fact. When they don’t they get into trouble, as when they inspire banks to ignore professional talk and fiduciary ethics, and to rely exclusively on silent and monetary incentives such as executive compensation. The economists and their eager students choose Prudence Only, to the exclusion of the other virtues that characterize humans—justice and temperance and love and courage and hope and faith—and the corresponding sins of omission or commission.

One will need to read the entire book to see if her argument is persuasive. I appreciate her attempts to integrate virtue into economic discourse, seemingly reminiscent of the origins of the discipline in moral philosophy. But at the same time, she endorses neoclassical economic theory as the main tool for economic analysis – a tool which grew in popularity because of its supposed value-neutrality.

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There’s been a bit of discussion on a Rajiv Sethi post about Duncan Foley’s attempts to bring strong microfoundations into macro. Mark Thoma first had comment and then Leigh Caldwell chimed in. If you have time, start with Rajiv’s post. Thoma sums up a key problem well:

That is, you need to make the representative agent assumption in order to aggregate individuals up to the macroeconomic level and still be able to guarantee uniqueness, stability, or many other properties we need to have a reasonable model.

Caldwell goes a little bit deeper into smoothing out the problem. He argues that we should abstract models of the economy into systems of agents and goods, mediated by beliefs and values. I think the problem is that Caldwell over-abstracts, though. He seems most excited that, “the model has the potential to be simple enough to be tractable.” Even though he acknowledges that, “the actual mathematics of this theory will look like is not yet obvious,” I don’t think Caldwell moves the ball forward much. What he wants boils down to:

But a simple model of choice arising from values, mediated by beliefs, under constraints on attention, accuracy and myopia provides a parsimonious and expressive description of reality. By implementing a realistic theory of decision-making into the model, we will have a closer match to the real world than current theories.

However, he eschews agent-based models which require too many assumptions. However, I think we have two choices if we want to formally model the economy. We either observe behavior on measurables and fit the model, or we make abstract assumptions about how agents behaves on squishier concepts like beliefs and values and then apply them throughout. I don’t think, though, we can get by based on observing these hard-to-measure concepts. Even if we can measure beliefs and values in some dimensions, I’m not sure how we implement them in these models without making further assumptions. And finally, if we want micro-foundations, they have to be agent-based, with a full slew of interactions. For now I side with Thoma’s third option:

give up the idea of providing microeconomic foundations for macroeconomic models and begin modeling the aggregate level directly (e.g. see Kirman’s discussion of network models)

And of course, in modeling this aggregated activity, we should be mindful that there are a variety of questions we can ask besides “what will GDP growth look like?”

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Commenter Tomboktu tipped me to an IMF working paper from last month by Michael Kumhof and Romain Ranciere, “Inequality, Leverage, and Crises.” I referenced it in my previous post about plutonomy. In this paper, the authors use conventional tools like a DSGE model to explain the curious fact that,

Both [the Depression and current recession] were preceded by a sharp increase in income and wealth inequality, and by a similarly sharp increase in debt-to-income ratios among lower- and middle-income households. When those debt-to-income ratios started to be perceived as unsustainable, it became a trigger for the crisis.

How? Their mechanism actually flows through financial channels, rather than through slacking aggregate demand, which I’ve mainly promoted as the key driver on this blog; however, the two explanations need not be exclusive. The main insight derived from their model is that,

Prior to the crisis, increased saving at the top and increased borrowing at the bottom results in consumption inequality increasing significantly less than income inequality. Saving and borrowing patterns of both groups create an increased need for financial services and intermediation. As a consequence the size of the financial sector, as measured by the ratio of banks’ liabilities to GDP, increases. The crisis is characterized by large-scale household debt defaults and an abrupt output contraction as in the 2007 U.S. financial crisis.

As their title indicates, they also describe this process in leverage terms in the conclusion:

The key mechanism, reflected in a rapid growth in the size of the financial sector, is the recycling of part of the additional income gained by high income households back to the rest of the population by way of loans, thereby allowing the latter to sustain consumption levels, at least for a while. But without the prospect of a recovery in the incomes of poor and middle income households over a reasonable time horizon, the inevitable result is that loans keep growing, and therefore so does leverage and the probability of a major crisis that, in the real world, typically also has severe implications for the real economy.

I also enjoyed the paper because of bits like this:

And as far as strengthening the bargaining powers to workers is concerned, the difficulties of doing so have to be weighed against the potentially disastrous consequences of further deep financial and real crises if current trends continue.

The takeaway for policymakers is that,

More importantly, unless loan defaults in a crisis are extremely large by historical standards, and unless the accompanying real contraction is very small, the effect on leverage and therefore on the probability of a further crisis is quite limited. By contrast, restoration of poor and middle income households’ bargaining power can be very effective, leading to the prospect of a sustained reduction in leverage that should reduce the probability of a further crisis.

I shouldn’t be so surprised that a relatively heterodox conclusion is coming from the IMF, which last year produced a working paper rethinking capital controls. The crisis is undoubtedly causing some serious rethinking in some scholarly circles. Even if this paper is using relatively conventional tools, it is asking an unconventional question is the mainstream. The key question for the economics discipline is whether papers like this, which ask the right questions, will receive the attention (and scrutiny) that they warrant.

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Rodger Malcolm Mitchell, a regular commenter whose blog I have linked here before, now has a survey on economic views. The survey itself touches on issues of deficits, federal spending areas, taxes, and deficit view formation. Most surveys with these types of questions-though Rodger’s are fairly unique- query professional economists. Blog traffickers like my readers and myself have opinions too, though. So go express yours.

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A few weeks ago, Ed Fullbrook posted about a Citibank report about the rise of a plutonomic society. The report reads, in part:

The World is dividing into two blocs – the Plutonomy and the rest. The U.S., UK, and Canada are the key Plutonomies – economies powered by the wealthy. Continental Europe (ex-Italy) and Japan are in the egalitarian bloc.

Equity risk premium embedded in “global imbalances” are unwarranted. In plutonomies the rich absorb a disproportionate chunk of the economy and have a massive impact on reported aggregate numbers like savings rates, current account deficits, consumption levels, etc. This imbalance in inequality expresses itself in the standard scary “global imbalances”. We worry less.

There is no “average consumer” in a Plutonomy. Consensus analyses focusing on the “average” consumer are flawed from the start…

We project that the plutonomies (the U.S., UK, and Canada) will likely see even more income inequality, disproportionately feeding off a further rise in the profit share in their economies, capitalist-friendly governments, more technology-driven productivity, and globalization.

Banks realize what’s going on, and they must- plutonomy has vast implications for the demand for their debt products. Of course, it has even more important political and economic implications as well. Fullbrook rightly points out that scholars largely didn’t notice the report when it came out (2005), and it has since been removed from public space. Let’s hope more people think about the structures driving inequality. I’ll have another post on Thursday that ties back to this one and shows that scholars are noticing in some unexpected placement, although this discussion still falls outside mainstream discourse.



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