The market: catalyst for rationality and filter of irrationality

If we assume that consumers can be irrational, an interesting question is, What effect does this have on market outcomes? Do markets become "irrational" because of the irrational participants or does the market filter out the effects of irrational participants?

Given this question, I was interested to come across this paper "The Market: Catalyst for Rationality and Filter of Irrationality" by John A. List and Daniel L. Millimet, The B.E. Journal of Economic Analysis & Policy: Vol. 8: Iss. 1 (Frontiers), Article 47.

Available at: http://www.bepress.com/bejeap/vol8/iss1/art47.

The abstract reads

Assumptions of individual rationality and preference stability provide the foundation for a convenient and tractable modeling approach. While both of these assumptions have come under scrutiny in distinct literatures, the two lines of research remain disjointed. This study begins by explicitly linking the two literatures while providing insights into whether market experience mitigates one specific form of individual rationality—consistent preferences. Using field experimental data gathered from more than 800 experimental subjects, we find evidence that the market is a catalyst for this type of rationality. The study then focuses on aggregate market outcomes by examining empirically whether individual rationality of this sort is a prerequisite for market efficiency. Using a complementary field experiment, we gathered data from more than 380 subjects of age 6-18 in multi-lateral bargaining markets at a shopping mall. We find that our chosen market institution is a filter of irrationality: even when markets are populated solely by irrational buyers, aggregate market outcomes converge to the intersection of the supply and demand functions.

What this suggests is that we must avoid making the leap from individual irrationality to "market failure." List and Millimet suggest that even if there is individual irrationality then market failure does not immediately follow. The List and Millimet results point towards the view that markets actually filter out individual irrationality and thus help channel individual action to social benefit.

This kind of result also backs up the Levitt and List critique of behavioural economics in which they argue that while no one argues that exceptions to the standard rational actor model cannot be found in the lab, there are pressures in the real world that means these exceptions are not of great significance. As Steven D. Levitt and John List have put it,

Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. We have recently discussed several factors, ranging from the properties of the situation — such as the nature and extent of scrutiny — to individual expectations and the type of actor involved. For example, the competitive nature of markets encourages individualistic behavior and selects for participants with those tendencies. Compared to lab behavior, therefore, the combination of market forces and experience might lessen the importance of these qualities in everyday markets.

A chocolate fish for .......

In this latest blog posting on the BERL study Eric Crampton writes,

But BERL does more than just step outside of the rational addiction model: they drive gross benefits down to zero for all consumption, including all below-the-threshold consumption, the instant your consumption exceeds their epidemiological threshold.

and

Instead, BERL threw in a step function that I cannot believe is consistent with any plausible utility function: prior to the threshold, benefits at least equal costs; after the threshold, benefits don't just equal zero, they're sufficiently negative to precisely offset all of the gross benefits from any prior consumption. Now, I've conducted an unscientific poll of members of the Department of Economics here at Canterbury. Half of those providing a response say you can't build a utility function that has these characteristics. The other half say that believing any model consistent with those characteristics would itself be evidence of the irrationality of the model's author.

I'm part of the you can't do it half of the survey. Or more correctly I don't think you can write down an utility function with the standard properties which would meet the BERL requirements. In particular I can't see how BERL's function can be continuous. Eric goes on to say,

The best utility function (in my view) of the ones we've come up with has a discontinuity at the harmful threshold that jumps down towards negative infinity for the epsilonth unit after the threshold but then jumps back up to zero for all subsequent units. Or, in discrete terms, benefits are positive and match costs up to the 40th gram of alcohol for men; the 41st gram has very large negative benefits that just offset all of the benefits from the prior 40 grams, and then consumption from the 42nd gram onwards provides zero benefits. Fortunately, I don't believe this model. (Emphasis added.)

The bit I have put in bold above is as far as I can tell, and I may be missing something, what a utility function would have to look like to be consistent with BERL's results. You will note that such a function is not continues, in fact it is discontinues at two points, the 41st gram and the 42 gram of alcohol consumed.

So I'll give a chocolate fish to the first person who can come up with a locally nonsatiated, continuous, concave, monotonic utility function consistent with BERL's results.

Keynes versus Hayek

Mario Rizzo over at the ThinkMarkets blog points out that we are seeing Keynes versus Hayek: A rerun of the 1930s. Rizzo writes that

The dispute between Hayek and Keynes was over what we call today “macroeconomics.” At the time, this would have been considered monetary or trade cycle theory. Hayek was opposed to the macro-aggregation of Keynes’s approach to questions of employment, interest rates and cycles. He believed that the aggregates chosen by Keynes obscured the fundamental changes that constitute macroeconomic phenomena. As the economist Roger Garrison points out, for Hayek there were indeed macroeconomic phenomena but only microeconomic explanations.

Macroeconomics is where we look at the economy is the aggregate. Issues like inflation, unemployment, government spending, government debt etc. Microeconomcis is where we look at the disaggregated economy, things like firms, consumers and individual markets. The view that Keynes told of the economy was

Keynes focused on the labor market, insufficient aggregate demand and the associated idea of less-than-full-employment income. In effect, Keynes thought of aggregate output as if it were just one undifferentiated thing and investment as a volatile form of spending that brought this output into existence.

Hayek took a very different view,

Hayek focused on structure of capital. By this he meant the array of complementary (and substitutable) capital goods at different distances from consumable output. These capital goods work with labor and other factors to produce what Keynes would call “aggregate output.” Thus for Hayek “investment” wasn’t a homogeneous aggregate but represented specific changes to a structure of interrelated capital goods. When the central bank lowered interest rates excessively (below the rate that would equate planned savings with planned investment), the structure of production would be distorted. It is not just that “output” increased but its composition was altered.

Rizzo continues,

This typically meant a number of unsustainable changes. Low interest rates discourage savings and yet at the same time encourage certain types of investment. Housing, commodities, and other sectors with long time-horizons would expand. But at the same time consumers would try to consume more. So the Keynesian is misled to think that, “See, consumption and investment are not alternatives. We can have more of both. In fact, consumption stimulates investment!”

What really occurs in the boom, however, is too much consumption and too much investment in sectors far from consumption. Overconsumption and malinvestment. Isn’t this what we have just seen?

Is this what we have just seen? Looks a lot like it.

Narrow view of the world?????

From Newstalk ZB

Economic think-tank BERL says critics of its report into the social cost of alcohol have a very narrow view of the world.

Economists Eric Crampton and Matt Burgess have labelled the government report as grossly exaggerated after it put the social cost of alcohol at $4.79 billion a year.

They say it was based on bizarre methodology which assumed problem drinkers are incapable of knowing what's good for them.

But BERL Chief Economist Ganesh Nana says the methodology is internationally accepted and more realistic than their critics'. He says their view that consumers are rational beings who make all their decisions with all the information at hand is a narrow way of looking at economics.

Mr Nana says BERL stands by its report.

Internationally accepted by whom? Berl’s report can be reasonably characterized as a New Zealand implementation of a methodology developed by Professors Collins and Lapsley, cited over 100 times in the Berl report. These same authors provided the external peer review of the report. This is being internationally accepted?

And as for realism, just what form of utility function do you need to give the welfare results that Berl seem to be assuming? Berl assumes all harmful alcohol and drug consumption is irrational. Irrational consumers are incapable of detecting private costs in excess of private benefits. To the extent those private costs exceed benefits, they are counted as social costs. In addition they assume that irrational consumers enjoy zero gross (not net) benefits, meaning all private costs are counted as social costs. The second and third assumptions are not justified – they are simply asserted by Berl. This is realism?

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Academics slam result of study into alcohol abuse (updated)

Or so says Mike Houlahan in The Press this morning. The article says

The Ministry of Health and the ACC are standing by the findings of an alcohol-harm study, despite a review of the report that says the study has "few redeeming features".

The $135,000 study, commissioned by the ministry and the ACC, was compiled by Wellington-based economic consultants Business and Economic Research Ltd (BERL).

The study's findings have been savaged by economists Eric Crampton, of the University of Canterbury, and Matt Burgess, from Victoria University, in a review released yesterday.

The study put the annual social cost of alcohol abuse at $4.79 billion, but Crampton and Burgess said their research found the cost was $146 million.

They also found fault with BERL's analysis and methodology, and said the report had elementary errors and misunderstandings of economics.

It goes on to note that,

BERL economist Ganesh Nana, one of the authors of the report, defended his work, saying the university economists had "a different world view" from his colleagues.

"A different world view"??? That's why your numbers are so weird, you have a "different world view". Just what in hell does that even mean?

Nana is also quoted as saying

"We used the method used by all in the field looking at the cost of alcohol and other addictive substances. That method has been used widely across the world," he said.

"It really does depend on whether you believe, in a nutshell, that consumers are rational in their decisions about how much alcohol to drink. "Most of us are we're not saying we aren't but there is a significant subset of the population who aren't, and that's where the costs lie."

Errr no, you go way past that. You make very strong assumptions about people being "irrational" when it comes to alcohol. You seem to be assuming that all consumption by men who drink more than two pints of beer per day (one pint for the ladies) is harmful and thus irrational, and consequently has only costs.

And what did the government agencies have to say,

Barbara Phillips, group manager of the Health Ministry's minimising harm group, said: "The ministry is aware that other studies have been conducted using different assumptions which put a different cost on alcohol and illegal drugs," she said.

"The ministry will consider the relevance of those studies in future policy work."

Does this mean, business as usual, we will ignore it as it doesn't confirm our prejudices?

ACC general manager of injury prevention Katie Sadleir said the corporation had just received the review and was not able to comment yet.

"However, from ACC's perspective, we do know that alcohol is a factor in many of the claims we receive," she said.

"Our own research a few years ago found that up to 22 per cent of all ACC claims had alcohol as a contributing factor. Given that we pay nearly $3 billion a year in claims, that means the cost of alcohol-related claims to ACC alone is around $650 million each year."

Actually no. This could be true if alcohol was the only contributing factor but given that there are likely to be a number of other factors involved in these claims you can't just attribute all of the cost of the claims to alcohol. The question is what is the marginal effect of alcohol in these claims? Alcohol could be neither necessary nor sufficient for any given claim.

Update: Not PC thinks Berl are up to Step 2 of a nine-step programme: Denial.

Samuelson on Friedman and Greenspan

This is from an interview with Paul Samuelson by Conor Clarke appearing in the Atlantic:

Milton Friedman?

Milton Friedman. Friedman had a solid MV = PQ doctrine from which he deviated very little all his life. By the way, he's about as smart a guy as you'll meet. He's as persuasive as you hope not to meet. And to be candid, I should tell you that I stayed on good terms with Milton for more than 60 years. But I didn't do it by telling him exactly everything I thought about him. He was a libertarian to the point of nuttiness. People thought he was joking, but he was against licensing surgeons and so forth. And when I went quarterly to the Federal Reserve meetings, and he was there, we agreed only twice in the course of the business cycle. .

That's asking for a question. What were the two agreements?

When the economy was going up, we both gave the same advice, and when the economy was going down, we gave the same advice. But in between he didn't change his advice at all. He wanted a machine. He wanted a machine that spit out M0 basic currency at a rate exactly equal to the real rate of growth of the system. And he thought that would stabilize things.

Well, it was about the worst form of prediction that various people who ran scores on this -- and I remember a very lengthy Boston Federal Reserve study -- thought possible. Walter Wriston, at that time one of the most respected bankers in the country and in the world fired his whole monetarist, Friedmaniac staff overnight, because they were so off the target.

But Milton Friedman had a big influence on the profession -- much greater than, say, the influence of Friedrich Hayek or Von Mises. Friedman really changed the environment. I don't know whether you read the newspapers, but there's almost an apology from Ben Bernanke that we didn't listen more to Milton Friedman.

But anyway. The craze that really succeeded the Keynesian policy craze was not the monetarist, Friedman view, but the [Robert] Lucas and [Thomas] Sargent new-classical view. And this particular group just said, in effect, that the system will self regulate because the market is all a big rational system.

Those guys were useless at Federal Reserve meetings. Each time stuff broke out, I would take an informal poll of them. If they had wisdom, they were silent. My profession was not well prepared to act.

And this brings us to Alan Greenspan, whom I've known for over 50 years and who I regarded as one of the best young business economists. Townsend-Greenspan was his company. But the trouble is that he had been an Ayn Rander. You can take the boy out of the cult but you can't take the cult out of the boy. He actually had instruction, probably pinned on the wall: 'Nothing from this office should go forth which discredits the capitalist system. Greed is good.'

However, unlike someone like Milton, Greenspan was quite streetwise. But he was overconfident that he could handle anything that arose. I can remember when some of us -- and I remember there were a lot of us in the late 90s -- said you should do something about the stock bubble. And he kind of said, 'look, reasonable men are putting their money into these things -- who are we to second guess them?' Well, reasonable men are not reasonable when you're in the bubbles which have characterized capitalism since the beginning of time.

Reported costs of alcohol abuse "grossly exaggerated" according to economists (updated x10)

The following comes from the Offsetting Behaviour blog:

MEDIA RELEASE
17 June 2009

FOR IMMEDIATE RELEASE

Reported costs of alcohol abuse "grossly exaggerated" according to economists

A widely publicised $135,000 government report on the cost of drug and alcohol abuse has been slammed by two economists, who say the report’s findings are grossly exaggerated.

Economists Eric Crampton and Matt Burgess have released a research paper which examines the report, by Wellington economics consultant Business and Economic Research Limited (BERL), after Law Commission President Sir Geoffrey Palmer cited its findings in support of proposed new regulations on alcohol.

“What we found shocked us. BERL exaggerated costs by 30 times using a bizarre methodology that you won’t find in any economics textbook,” Dr Crampton said.
The BERL report was commissioned in 2008 by the Ministry of Health and ACC, and put the annual social costs of alcohol at $4.79 billion. Crampton and Burgess said the net social costs instead amounted to $146 million – 30 times lower than that calculated in the report.

“BERL has virtually assumed its answer. The majority of the reported social costs rest on two very strange assumptions which BERL has asserted without any reason or evidence,” said Dr Crampton said.

“The report assumes that one in six New Zealand adults drinks because they are irrational; that is, they are incapable of deciding what is good for themselves. BERL further assumes that these individuals receive absolutely no enjoyment, social or economic benefit from any of their drinking,” Dr Crampton said.

“These assumptions allowed BERL to count as a cost to society everything from the cost of alcohol production to the effect of alcohol on unpaid housework. That’s bad economics.”

Among other serious flaws, Dr Crampton said the report’s external peer review was done by the authors of the report’s own methodology, important findings in academic literature that alcohol had health and economic benefits were ignored, BERL did not properly warn readers about the limitations of its methodology, and used language in the report that was frequently misleading.

The BERL study caught the economists’ attention when it was cited by the Law Commission as the basis for supporting proposed new taxes and regulations on alcohol.
“We’re doing this because we don’t want to see legislative decisions being misguided by bad research. In our view, the Law Commission should give no weight at all to the findings in the BERL report,” Dr Crampton said.

Dr Crampton stressed their review wasn’t an attack on the “very real” issues of alcohol and drug abuse. “These are deep problems, but rather than being taken seriously they have instead been trivialised by numbers that beg the question,” Dr Crampton said.
/ENDS

The review of BERL’s report is available for download here; supporting calculations available here. The BERL report is available here.

Eric Crampton is Senior Lecturer in Economics at the University of Canterbury. Matt Burgess is a Research Associate at the Institute for the Study of Competition and Regulation. The views expressed solely reflect those of the authors, and do not necessarily represent those of the institutions with which they are affiliated or their constituent members.

Update: Brad Taylor comments on Crampton and Burgess on the BERL Report while BK Drinkwater ponders the Hurly-BERLy of it all.

Update 2: Kiwiblog points out that Alcohol costs grossly exaggerated and Not PC reckons that You’ll never get poor promoting the government line.

Update 3: Eric explains Correcting the BERL report part 1: overview.

Update 4: Not PJ ponders A Report into the Costs of Harmful Economic and Other Social Policy Analysis.

Update 5: Eric now explains more about Correcting the BERL report part 2: Lost output

Update 6: Will de Cleene thinks Das BERL report ist Krap

Update 7: Mitchell Hall at the NBR writes on The cost of getting it wrong: Berl alcohol report fundamentally flawed.

Update 8: Stephen Franks is up for a bit of Biffo on costs-of-alcohol report. He makes a nice poitn when he says

BERL must convincingly answer the criticims (or preferably other economists for them) if their future work is to have credence.

Update 9: Eric continues to discuss Correcting the BERL report part 3: Alcohol Production Costs .

Update 10: More from BK Drinkwater on the Hurly-BERLy with regard to the BERL report and Hurly-BERLy: A Furtive Marxasm Under The Dinner Table.

Economic impact of the super city

BK Drinkwater has commented on the report "Economic Impact of Super City Amalgamation on Peripheral Councils (Manukau, Waitakere, Rodney, North Shore, and Franklin)" by Rhema Vaithianathan. I think he is right with regard to his generalised concerns about multiplier effects. Multiplier type argument always seem strange to me. Eric Crampton says about the same report,

Rheema Vaithianathan, Auckland University economist, worries that the Auckland supercity will lead to job losses and in particular will hurt the suburbs.

I'm worried that the opposite will happen.

And there are good reasons for his concern.

When I gave the report a very quick look, one thing I noticed was the following comment,

The analysis above has assumed no change in rates. However, the extent to which efficiency savings flow into reduced rates is uncertain. There is considerable evidence that following privatisation, efficiency savings did not in fact flow through to the customers as reduced prices but to executives as increased compensation8. For example following privatization in the UK Electricity Industry, top executive salaries increased three-fold.

The 8 above refers to a footnote which reads,

“Increases in Executive Pay Following Privatization”, Catherine D. Wolfram (2004) Journal of Economics, Management and Strategy Pages 327 - 361

This looks at bit odd to me since I don't see the relationship between privatising the UK electricity industry and the rates in an Auckland Supercity. Second, from the quick look at the paper mentioned in footnote 8, it appears that salary increases were due to rent extraction by executives of the privatised companies based on the way the industry was being regulated. Again I'm not sure what UK electricity regulation has to do with the Auckland Supercity.

Also there is a comment in the Wolfram paper,

On the one hand, the small data set limits both the power of some of my statistical tests and the generality of my results.

So the Wolfram results don't generalise and thus are they in any way relevant to the Auckland Supercity?

I'm guessing Vaithianathan is right that there will be no change in rates, but I'm sure the above argument makes this case. In fact as Eric argues rates could go up as expenditures increase, not decrease.

EconTalk this week

Charles Platt, author and journalist, talks with EconTalk host Russ Roberts what it was like to apply for a job at Wal-Mart, get one, and work there. He discusses the hiring process, the training process, and the degree of autonomy Wal-Mart employees have to change prices. The conversation concludes with a discussion of attitudes toward Wal-Mart.

How many jobs are onshorable?

Offshoring has become one of those things everybody knows nothing about, but they still somehow manage to hate it. Offshoring seems to be one of the scarcest things on rich nations’ economic radar screens, all of our good jobs being sent overseas. In the US economist Alan Blinder was one of the first to point out the threat in his 2006 Foreign Affairs article “Offshoring: The Next Industrial Revolution?” In this article he said,

constant improvements in technology and global communications virtually guarantee that the future will bring much more offshoring of ‘impersonal services’’— that is, services that can be delivered electronically over long distances with little or no degradation in quality.

More recently Blinder has produced some estimates of the size of the revolution. And they make it look like "the big one". Blinder (2009): "I estimated that 30 million to 40 million US jobs are potentially offshorable."

Richard Baldwin takes issue with the implications of those numbers. In a column at VoxEU.org Baldwim writes

The trouble is that his numbers are being interpreted in the light of the “old paradigm” of globalisation – the world of trade theory that existed before Paul Krugman, Elhanan Helpman, and others led the “new trade theory” revolution in the 1980s.

Baldwin expands on this point by saying

Krugman’s contribution, which was rewarded with a Nobel Prize in 2008, was to crystallise the profession’s thinking on two-way trade in similar goods.1 This was a revolution since the pre-Krugman received wisdom assumed away such trade or misunderstood its importance. In 1968, for example, Harvard economist Richard Cooper noted the rapid rise in two-way trade among similar nations and blamed it for the difficulty of maintaining fixed exchange rates. Using the prevailing trade theory orthodoxy, he asserted that this sort of trade could not be welfare-enhancing. And since it wasn’t helping, he suggested that it should be taxed to make it easier to maintain the world’s fixed exchange rate system – a goal that he considered to be the really important thing from a welfare and policy perspective (Cooper, 1968).

Trade economists back then took it as an article of faith that trade flows are caused by macro-level differences between nations – for example, national differences between the cost of capital versus labour. Nations that had relatively low labour costs exported relatively labour intensive goods to nations where labour was relatively expensive.

This is the traditional view that Blinder seems to be embracing.

What Krugman (especially Krugman 1979, 1980) showed was that one does not need macro-level differences to generate trade. Firm-level differences will do.

In a world of differentiated products (and services are a good example of this), scale economies can create firm-specific competitiveness, even between nations with identical macro-level determinants of comparative advantage. Krugman, a pure theorist at the time, assumed that nation’s were identical in every aspect in order focus on the novel element in his theory (and to shock the “trade is caused by national differences” traditionalists). His insight, however, extends effortlessly to nations that also have macro-level differences, like the US and India.

This now brings us to interpreting Blinder’s 30 to 40 million offshorable jobs figure. Baldwin argues that,

Blinder’s approach is easy to explain – a fact that accounts for much of its allure as well as its shortcomings.

• Step 1 is to note that Indian wages are a fraction of US wages.
• Step 1a is to implicitly assume that Indians’ productivity-adjusted wages are also below those of US service sector workers, at least in tradable services.
• Step 2, and this is where Blinder focused his efforts, is to note that advancing information and communication technology makes many more services tradable. The key characteristic, Blinder claims, is the ease with which the service can be delivered to the end-user electronically over long distances.
• Step 3 (the critical unstated assumption, if not by Blinder, at least by the media reporting his results) is that the new trade in services will obey the pre-Krugman trade paradigm – it will largely be one-way trade. Nations with relatively low labour costs (read: India) will export relatively labour-intensive goods (read: tradable services) to nations where labour is relatively expensive (read: the US).

Note in passing the comment in Step 3: "the critical unstated assumption, if not by Blinder, at least by the media reporting his results". The media reporting on such issues often overlooks important details.

The catch in all of this? This last step is factually incorrect. That is step is wrong is shown in recent work by Mary Amiti and Shang-Jin Wei (2005). Baldwin continues,

They note: “Like trade in goods, trade in services is a two-way street. Most countries receive outsourcing of services from other countries as well as outsource to other countries.”

Source: Author’s manipulation of data from Amiti and Wei (2005), originally from IMF sources on trade in services. [Click to make larger]

The US, as it turns out, is a net “insourcer”. That is, the world sends more service sector jobs to the US than the US sends to the world, where the jobs under discussion involve trade in services of computing (which includes computer software designs) and other business services (which include accounting and other back-office operations).

The chart shows the facts for the 1980 to 2003 period. We see that Blinder is right in that the US importing an ever-growing range of commercial services – or as he would say, the third industrial revolution has resulted in the offshoring of ever more service sector jobs. However, the US is also “insourcing” an ever-growing number of service sector jobs via its growing service exports. The startling fact is that not only is the trade not a one-way ticket to job destruction, the US is actually running a surplus.

Baldwin's conclusion from all of this,

None of this should be unexpected. The post-war liberalisation of global trade in manufactures created new opportunities and new challenges. To apply Blinder’s logic to, say, the European car industry in the early 1960s, one would have had to claim that since the German car industry (at the time) faced much lower productivity-adjusted wages, freer trade would make most French auto jobs “lose-able” to import competition. Of course, many jobs were lost when trade did open up, but many more were created. As it turned out, micro-level factors allowed some French firms to thrive while others floundered, and the same happened in Germany. Surely the same sort of thing will happen in services, as trade barriers in that sector fall with advancing information and communication technologies.

In short, what Blinders’ numbers tell us is that a great deal of trade will be created in services. Since services are highly differentiated products, and indivisibilities limit head-to-head competition, my guess is that we shall see a continuation of the trends in the chart. Lots more service jobs “offshored” and lots more “onshored”.

Overall, offshoring isn't one of the scarcest things imaginable. In fact its something that should be embraced.

• Amiti, M. and S.J. Wei (2005), “Fear of Service Outsourcing: Is it Justified?”, Economic Policy, 20, pp. 308-348.
• Blinder, Alan (2006). “Offshoring: The Next Industrial Revolution?” Foreign Affairs, Volume 85, Number 2.
• Blinder, Alan (2009). “How Many U.S. Jobs Might Be Offshorable,” World Economy, 2009, forthcoming.
• Cooper, R. (1968). The Economics of Interdependence. New York: McGraw-Hill.
• Grossman, G. and E. Rossi-Hansberg (2006a). “The Rise of Offshoring: It’s Not Wine for Cloth Anymore,” July 2006. Paper presented at Kansas Fed’s Jackson Hole conference for Central Bankers.
• Krugman, Paul (1979). "Increasing returns, monopolistic competition, and international trade," Journal of International Economics, Elsevier, vol. 9(4), pages 469-479,
• Krugman, Paul (1980). "Scale Economies, Product Differentiation, and the Pattern of Trade," American Economic Review, vol. 70(5), pages 950-59, December.
• Krugman, Paul (1991), “Increasing Returns and Economic Geography”, Journal of Political Economy 99, 483-499.

Dogbert the CEO

Getting the incentives for management right is important for any company. Executive pay is at the heart of the issue.

An interview with Paul Krugman

It is from The Guardian, see here. Here is a nice bit,

It's Germany on a global scale that is the concern. We worry about the drag on world demand from the global savings coming out of east Asia and the Middle East, but within Europe there's a European savings glut which is coming out of Germany. And it's much bigger relative to the size of the economy.

What? Saving in now bad? Aren't we always being told that the current account deficit means we don't save enough? Doesn't the US-and New Zealand- have a problem with a lack of savings? So is saving good or bad?

(HT: Marginal Revolution)

Russ Roberts on empirical economics: part 3

Earlier I commented on a question raised by Russ Roberts on the usefulness of empirical work in economics, see here and here. Roberts has now added another post on Fancy empirical work.

Roberts notes the responses from Cowan and Caplan-see here-and also notes an email he received which suggested suggests Time on the Cross, Fogel and Engerman's study of slavery. Roberts then goes on to say,

Most or all of these observations miss the point, or at least the point I was trying to make.

Empirical work is very important.

Facts matter.

A careful study of the facts can have tremendous influence.

Sophisticated regression analysis can narrow our guesses as to magnitudes. But I don't think we need fancy regression to conclude that people aren't always rational. Or that police can reduce crime. Or to look at the nature of resale price maintenance. On the stuff where people have priors and bias—such as the dynamic impact of taxes on revenue—I don't think the empirical evidence is very convincing of the skeptic.

I understand that science moves slowly and that people at the margin are who eventually count.

But I really don't think the empirical record of sophisticated empirical work is very impressive. In fact, I think I could make a case that sophisticated empirical work is most productive for publishing papers and less productive at establishing truth or useful findings that are reliable.

As to establishing truth or results that are reliable, I argued before that the thing to keep in mind is that a single result or paper will not settle a question. But a series of results giving the same answer to the same question involving different data sets, different time periods, different countries, different approaches to answering the question etc will do so. I think what convinces people as the rightness of a result in the accumulation of evidence in its favour. This evidence may or may not involve the kind of sophisticated empirical work Roberts is referring to.

The Fed and the politicisation of credit

Having made some comments on the problem of the politicisation of provision when the government is involved earlier, I was interested to come across this article from the New York Times, Lender’s Role for Fed Makes Some Uneasy by Edmund L. Andrews.

Andrews opens his article by noting,

For most of its history, the Federal Reserve has been a high temple of monetary matters, guiding the economy by setting interest rates but remaining aloof from the messy details of day-to-day business.

But the financial crisis has drastically changed the role of the Fed, forcing officials to get their fingernails a bit dirty.

Andrews continues

Since March, when the Fed stepped in to fill the lending vacuum left by banks and Wall Street firms, officials have been dragged into murky battles over the creditworthiness of narrow-bore industries like motor homes, rental cars, snowmobiles, recreational boats and farm equipment — far removed from the central bank’s expertise.

A growing number of economists worry that the Fed’s new role poses risks to taxpayers and to the Fed itself. If the Fed cannot extract itself quickly, they warn, the crucial task of allocating credit will become more political and less subject to rigorous economic analysis.

By this may not be the biggest problem for the Fed. This hands on involvement could undermine the Fed’s political independence and credibility as an institution that operates above the fray.

Executives and lobbyists now flock to the Fed, providing elaborate presentations on why their niche industry should be eligible for Fed financing or easier lending terms.

Hertz, the rental car company, enlisted Stuart E. Eizenstat, a top economic policy official under Presidents Bill Clinton and Jimmy Carter, to plead with both Fed and Treasury officials to relax the terms on refinancing rental car fleets.

Lawmakers from Indiana, home to dozens of recreational-vehicle manufacturers like Gulfstream and Jayco, have been pushing for similar help for the makers of campers, trailers and mobile homes.

And when recreational boat dealers and vacation time-share promoters complained that they had been shut out of the credit markets, Senator Mel Martinez, a Republican from Florida, weighed in on their behalf with the Treasury secretary, Timothy F. Geithner, who promised he would take up the matter with the Fed.

Andrews notes,

The central bank is increasingly having to make politically sensitive choices. For example, it is weighing whether loans to people who buy speedboats and snowmobiles are as worthy of help as those to people who buy cars. And it is being besieged by arguments from R.V. manufacturers and strip-mall developers that they play a crucial role in the economy and also deserve help.

And the lobbying of the Fed, and the Treasury, by industry groups and politicians has increased.

But the Recreational Vehicle Industry Association and Indiana lawmakers — among them, Representative Joseph Donnelly, a Democrat, and Representative Marc Souder, a Republican — were already lobbying the Fed to include loans for recreational vehicles on its list of eligible collateral that the Fed would accept.

They were not alone. Rental car companies were pushing the Fed to finance their fleets. Hertz, which is owned by two private equity firms — the Carlyle Group and Clayton, Dubilier & Rice — hired Mr. Eizenstat to make its case.

In trying to persuade the Fed to relax its loan terms, Mr. Eizenstat led delegations of Hertz officials to both the Treasury and the Fed. They reached out to Ron Bloom, the co-chairman of the Treasury Department’s auto task force, as well as to top aides to Mr. Geithner. They also made detailed financial presentations to Fed officials in Washington and New York.

The Andrew's article also says that

Fed officials say they, too, are uncomfortable with their new role and hope to end it as soon as credit markets return to normal.

But may it not be that the Feds very involvement is one of the things preventing, or at least slowing down, that return to normal?

The task of allocating credit can only become more political and less subject to rigorous economic analysis within this type of framework. When politics rather than economics allocate credit the results are predictable, a misallocation of credit will occur. Businesses that shouldn't get credit, on economic grounds, will obtain it simply because they are better at playing the political game. Those with less lobbying skills, but perhaps better business ideas, will miss out. And ultimately the standard of living of ordinary Americas will suffer because of it.

Obesity: the links with age and socioeconomic status

In this audio from VoxEU.org, Christopher Ruhm of the University of North Carolina at Greensboro talks to Romesh Vaitilingam about his work with Charles Baum, which analyses data from the US National Longitudinal Survey of Youth to explore how body weight and obesity change with age and how that relates to socioeconomic status.

Interesting blog bits

1. Eric Crampton on Chutzpah. There's a reason economists make fun of French labour laws. (Actually there's a lot more about the French economy to make fun of!)
2. David Neumark on Delay the Minimum-Wage Hike. A recession is the worst time to raise the cost of low-skilled employment.
3. N. Gregory Mankiw and Matthew Weinzierl ask Do you really want to tax ability? Should the income tax system include a tax credit for short taxpayers and a tax surcharge for tall ones? This column explains how the standard utilitarian framework for tax policy analysis says that individual attributes correlated with wages, such as height, should determine tax liabilities. Taller individuals should pay higher taxes. If this is objectionable, then something is wrong with the standard framework.
4. David F. Hendry and J James Reade ask How should we make economic forecasts? A vital challenge confronting economists is how to forecast, especially during a recession because livelihoods depend on those forecasts. This column discusses choosing amongst forecasts and outlines the concerns involved in averaging across models or using general-to-specific model searches.
5. At Oxonomics they ask Is Cristiano Ronaldo worth £80? May be, may be not.
6. Lynne Kiesling on Water footprint as the next big thing. You have to wonder if people will continue resisting the accurate pricing of water as this issue evolves.

Russ Roberts on empirical economics: part 2

Tyler Cowen takes up the challenge to answer Russ Robert's question from a posting I noted earlier. Roberts asked,

I'd like one example, please. One example, from either micro or macro where people had to give up their prior beliefs about how the world works because of some regression analysis, ideally usually instrumental variables as that is the technique most used to clarify causation.

Cowen writes,

I will cite a few possible examples, although I won't stick with instrumental variables:

1. The interest-elasticity of investment is lower than people once thought.

2. We have a decent sense of the J Curve and why a devaluation or depreciation doesn't improve the trade balance for some while.

3. Dynamic revenue scoring tells us over what time horizon a tax cut is partially (or fully) self-financing.

4. Most resale price maintenance is not for goods and services involving significant ancillary services.

5. More policing can significantly lower the crime rate (that one does use instrumental variables).

6. The term structure of interest rates is whacky.

I see other examples but in general I agree with Russ's point that empirical work fails to settle a great number of important disputes, most disputes in fact. Many of the examples I would cite turn out to involve an elasticity being lower than we had thought. And many more involve macroeconomics (rather than micro) than you might expect.

Peter Boettke also posts on the Robert's question, giving a Austrian view. He says,

Does the fact that statisical tests cannot provide unambiguous refutations of economic theory imply that we learn nothing from statistical analysis? I would argue definitely NO, we can learn a lot from statistical analysis. But what we cannot do is "test" theories with statistical tests. Does it also mean that we cannot refute economic theories? Again, I would argue NO. Refutations of "theoretical" propositions result from demonstrations of logical error, and one can also demonstrate the irrelevance of a logical argument to a contemporary problem due to the inapplicability of the theory to the situation to be examined because one or more of the various subsidiary assumptions that make up the network of statements that constitute a theoretical construction might not hold.

Bryan Caplan's response to the question is to say,

I can't meet Russ's challenge. But his challenge is excessive for two reasons:

1. Ending a controversy and creating a consensus almost always takes dozens, if not hundreds, of empirical studies. As well it should - virtually every specific study is open to reasonable doubt.

2. What exactly counts as "ending a controversy and creating a consensus"? Does every active researcher in the world have veto power? Or is convincing two-thirds of them enough? What if the "former opponents" just quietly give up rather than admitting error?

Having made these points, Caplan modifies the Roberts question to ask:

Name a body of empirical work that is so well done, it won over two-thirds of active researchers and induced half of the unconvinced to quietly give up or recant?

His answer to this question is

By this standard, the obvious response for economists is behavioral economics. I don't know any economist under the age of 40 who denies that there are major exceptions to the standard rational actor model. Many older economists are unconvinced, but they don't publish much about it.

A response to the Caplan example could be that while no one argues that exceptions to the standard rational actor model cannot be found in the lab, there are pressures in the real world that means these exceptions are not of great significance. As Steven D. Levitt and John List have put it,

Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. We have recently discussed several factors, ranging from the properties of the situation — such as the nature and extent of scrutiny — to individual expectations and the type of actor involved. For example, the competitive nature of markets encourages individualistic behavior and selects for participants with those tendencies. Compared to lab behavior, therefore, the combination of market forces and experience might lessen the importance of these qualities in everyday markets.

I think the thing to keep in mind is that a single result will not settle a question. But a series of results giving the same answer to the same question involving different data sets, different time periods, different countries, different approaches to answering the question etc will do so. I think what convinces people as the rightness of a result in the accumulation of evidence in its favour.

Russ Roberts on empirical economics

Over at Cafe Hayek Russ Roberts writes,

I think too much of modern empirical economics is the economics-free application of sophisticated statistical techniques that does little to actually advance our understanding of the social world. It's not just that it isn't about trade-offs or incentives, the role of trade-offs and incentives are ignored. I also don't think we've made "massive progress" in understanding the social world. We've made massive progress in publishing papers on the social world. But understanding? Not so much. We treat the natural world as if the sophisticated tools of statistics can turn reality into a natural experiment. But the world is usually (always?) too complex for the results to be reliable.

You won't get an argument out of me on this one. I have often thought that a lot of empirical economics these days is just applied stats. Roberts continues,

I continue to ask the question: name an empirical study that uses sophisticated statistical techniques that was so well done, it ended a controversy and created a consensus—a consensus where former opponents of one viewpoint had to concede they were wrong because of the quality of the empirical work.

A good question that I'm willing to bet no one can answer.

Larry Summers argued in his paper, "The Scientific Illusion in Empirical Macroeconomics", Scandinavian Journal of Economics, 1991, v. 93, iss. 2, pp. 129-48, that formal econometric work, where elaborate technique is used to apply theory to data or isolate the direction of causal relationships when they are not obvious a priori, virtually always fails. He went on to argue that the only empirical research that has contributed to thinking about substantive issues and the development of economics is pragmatic empirical work, based on methodological principles directly opposed to those that have become fashionable in recent years.

You go girl!

(Picture from City Journal)

Anna Schwartz was born in 1915 in New York, but despite this fact she can still be found nearly every day at her office in the National Bureau of Economic Research where she has been tirelessly working, gathering data, since 1941.

Guy Sorman has an article on Schwartz in the Spring 2009, vol. 19 no. 2, issue of City Journal. He calls the article Monetarism Defiant: Legendary economist Anna Schwartz says the feds have misjudged the financial crisis.

Sorman writes

This lesson of the recent past seems all but forgotten, Schwartz says. Instead of staying the monetarist course, Volcker’s successor as Fed chairman, Alan Greenspan, too often preferred to manage the economy—a fatal conceit, a monetarist would say. Greenspan wanted to avoid recessions at all costs. By keeping interest rates at historic lows, however, his easy money fueled manias: first the Internet bubble and then the now-burst mortgage bubble. “A too-easy monetary policy induces people to acquire whatever is the object of desire in a mania period,” Schwartz notes.

Greenspan’s successor, Ben Bernanke, has followed the same path in confronting the current economic crisis, Schwartz charges. Instead of the steady course that the monetarists recommend, the Fed and the Treasury “try to break news on a daily basis and they look for immediate gratification,” she says. “Bernanke is looking for sensations, with new developments every day.”

On Ben Bernanke Schwartz is also quoted as saying,

Bernanke is right about the past, Schwartz says, “but he is fighting the wrong war today; the present crisis has nothing to do with a lack of liquidity.”

Sorman goes on to write,

President Obama’s stimulus is similarly irrelevant, she believes, since the crisis also has nothing to do with a lack of demand or investment. The credit crunch, which is the recession’s actual cause, comes only from a lack of trust, argues Schwartz. Lenders aren’t lending because they don’t know who is solvent, and they can’t know who is solvent because portfolios remain full of mortgage-backed securities and other toxic assets.

To rekindle the credit market, the banks must get rid of those toxic assets. That’s why Schwartz supported, in principle, the Bush administration’s first proposal for responding to the crisis—to buy bad assets from banks—though not, she emphasizes, while pricing those assets so generously as to prop up failed institutions. The administration abandoned its plan when it appeared too complicated to price the assets. Bernanke and then–Treasury secretary Henry Paulson subsequently shifted to recapitalizing the banks directly. “Doing so is shifting from trying to save the banking system to trying to save bankers, which is not the same thing,” Schwartz says. “Ultimately, though, firms that made wrong decisions should fail. The market works better when wrong decisions are punished and good decisions make you rich.”

What of the often cited problem of deflation rather than inflation?

Should we worry about inflation when some believe deflation to be the real enemy? “The risk of deflation is very much exaggerated,” she answers. Inflation seems to her “unavoidable”: the Federal Reserve is creating money with little restraint, while Treasury expenditures remain far in excess of revenue. The inflation spigot is thus wide open. To beat the coming inflation, a “new Paul Volcker will be needed at the head of the Federal Reserve.”

One could add that a new Don Brash will be needed to head the Reserve Bank here as well.