Category Archives: Economics

"Job creators"

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Maybe this is paying too much attention to a mere rhetorical trope, but I really dislike the phrase “job creator” as a synonym for “businessman”. Businessmen may or may not create jobs; if they do, it seems to me, it’s very often purely accidental. Word processors, for instance, are a great benefit to mankind, but they also take jobs away from secretaries. Everyone loves their smartphone, but that love is seemingly taking jobs away from supermarket-tabloid writers. Google Search, maybe the most magical technology of my life so far, may well radically decrease demand for librarians.

That’s just what Schumpeter called “creative destruction” (“celebrated everywhere that capitalism is actually believed in”). So on the one side, it’s not at all clear that businessmen create jobs; they may well destroy existing industries.

Then, of course, there’s the fact that a successful business very often drives out the incumbents from its own industry. Google may have created some jobs, but I assume that it also eliminated some jobs at Alta Vista.

Finally, there’s the obvious point that it’s considered a good thing when businesses squeeze more revenue out of each individual employee. This is called “increased productivity”, and historically it’s how nations increase their GDP, and thereby how living standards rise. The fraction of Americans working in agriculture is 1/3 of what it was in 1970, yet total output is 91% above what it was then. Agriculture may be the foundation of a healthy people, but it’s not because farmers are job creators. Quite the opposite, in fact.

The conceptual trouble may come from businessmen’s desire to be associated with people whom we universally admire, and whom we rightly view as advancing society — people like inventors. Not all businessmen are inventors; nor are all businessmen job creators. Today, for instance, I saw Rick Steves describe himself as “a hardworking business owner who creates jobs”. He may employ people; but if he wants to claim that he created jobs by writing travel guides, he needs to show that he didn’t take away jobs from other travel guides (Lonely Planet, say). If he’s just taking jobs away from other businesses, then he’s not a job creator. He may be an employer, but he’s not a job creator.

This was the trouble that Mitt Romney got into during the 2012 campaign. He wanted us to think that he knew something about how to run a country because he was a businessman. (Set aside everyone’s intuition that there’s a difference between a financier and an inventor, and that Romney was a financier.) But as a businessman, he would be happiest when his companies drove all of their competitors out of business and managed to produce the same output with half the workers. But inasmuch as his competitors were also American companies, the net effect on American employment is … well, it’s not obviously zero, but neither is the effect obviously to add American jobs. (Paul Krugman made the point more eloquently back in 1996, in “A Country Is Not a Company”.)

To the extent that businessmen know which policies encourage inventors to thrive, they may know how to create jobs; but even here, I think it’s really only safe to say that creating a fertile climate for inventors aids in increasing productivity; it doesn’t say anything about guaranteeing full employment, which is what “creating jobs” has to mean. It has to mean that there are more people working today than there were before you took charge.

Actually creating jobs may be the role of the Federal Reserve. The Fed is charged with maintaining stable prices consistent with maximum employment. There’s a story according to which allowing unemployment to drop too low means that inflation will start spiraling upward; that threshold level is called the Non-Accelerating-Inflation Rate of Unemployment, or NAIRU for short, and I’ve been convinced that the concept is bunk. But in any case, the question is how to ensure that everyone who wants a job has one. It’s romantic to think that a proud fellow called a “job creator” knows how to make this happen, but the true story may be that mechanically adjusting interest rates, and occasionally pushing stimulus when all else fails, is all that we need. Not surprising that the Romneys of the world would yearn for a more heroic story. Unfortunately, that story doesn’t withstand any scrutiny.

Mitt Romney on privatization, devolution to the states, and insurance

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A fellow with whom I used to work tweeted today,

Watch Mitt Romney say federal disaster relief for tornado and flood victims is “immoral” http://youtu.be/OhXyJeKaj8E

That’s not actually what Romney says in the linked video; Judd is being disingenuous. But I think Romney is wrong in there for some reasons that bear elucidating.

First he says that we need to move programs from the Federal government to the states or to the private sector when possible. He goes on to say that racking up giant debts and passing them on to our kids is immoral, as though the debt piece were connected with the privatization/devolution-to-the-states (just “privatization” from here on in) piece.

The only way this argument makes sense is if you believe that the private sector or state governments are likely to do things more efficiently than the Federal government. If you don’t believe that they will, and if you believe that the thing the Federal government is doing needs to be done — for instance, if you believe that someone needs to be handling disaster relief — then transferring this job to the states is just shifting a bucket of money from one place to the other. If states are no more efficient than the Feds at this, then you’re replacing one source of debt (the Federal government’s) with another. Most states are required to maintain balanced budgets, so shifting this burden to the states would result in an immediate tax increase for all state taxpayers.

Privatizing disaster relief has its own problems. If we’re lucky, it would be privatized such that everyone who needed it could afford it. If we as a society believe that people shouldn’t be devastated when natural disasters strike, then we’d probably have to impose some kind of regulation to ensure that everyone who wants it can get it. This starts to look like the act of pantomime that a friend has done for many years: “capitalism picks its nose like this” (right arm reached around behind the left side of the head to pick the left nostril). Rather than simply have the Federal government do what needs doing, we privatize it and then impose a lot of regulations to achieve the outcome that we as a society want. Seems wasteful. Though by all means: if it happens that society can achieve what it wants to achieve using fewer resources in the private sector than it would through government — including the costs of the necessary regulation, and including all the efforts that private industry will then go through to evade regulation and get a leg up on its regulated competitors — then that’s a strong argument for privatizing.

Another direction this disaster-relief argument might go is to privatize disaster insurance, rather than disaster relief. I don’t know how disaster insurance works offhand. With insurance in general, we want to prevent two bad outcomes: adverse selection (only the riskiest cases bother to get insured) and moral hazard (the insured take more socially harmful risks than the uninsured). The way to prevent adverse selection is to require that everyone get insurance; that way the riskiest cases and the least-risky cases are buying in together, and the market doesn’t completely unravel. So if we want flood insurance to work at all, we’re going to have to require everyone to carry it, for some value of ‘everyone’ (maybe only ‘everyone’ in flood-prone areas, for instance). So again, government regulation to make the market work properly seems unavoidable.

Federal-government involvement seems unavoidable, in particular, because you want to spread risk over as many people as possible. This is one of the virtues of living in a country as large as the United States: when one group of flood-insurance beneficiaries is cashing in because, say, there’s flooding in the Southeast, another group in the Midwest is doing just fine, and the insurer doesn’t go broke. So having separate state-by-state insurers doesn’t seem like a stable equilibrium: risks are too concentrated in one state to make this work, and we’d likely end up with national insurers. These could either be private national insurers or the government itself. If it were a private insurer, it would have to be regulated: the insurer would have to hold onto enough of a cash buffer so that it wouldn’t be bankrupted by the “storm of the century”. And we as a society want insurance to really be there when it’s needed, so there would be a government backstop of some sort to make beneficiaries whole in case the insurer goes out of business. In exchange for providing this backstop, insurers would have to subject their books to regular auditing, would have to hold sufficient reserves, etc. Again, government involvement is unavoidable.

As for the moral-hazard piece: maybe there’s an argument that people with insurance are more likely to build on flood plains, and maybe we want to discourage this. One way the private market might do this is by setting the premium on flood-prone homes very high. There would then be at least a couple possible responses: either people continue building on those spots, even though they’re not insured, or they don’t build there. Without any regulation at all, maybe a lot of people would continue planting homes on uninsurable spots; when they get wiped out by floods, they’re bankrupted, and maybe we as a society are okay with that. Alternately, maybe we just forbid people from building on spots that no one is willing to insure; the only way to do this is through law or regulation, which — again — means that government involvement is unavoidable.

I’ll give the benefit of the doubt to Romney on this: it’s hard to describe real-world privatization in a 30-second soundbite. Here’s my 30-second soundbite: if we have reason to believe that something is better done by the states or by private industry, by all means let’s consider privatizing it. But privatization is not a magic potion that makes industries efficient — particularly when you consider the government involvement that necessarily has to accompany a lot of industries. Regulation is there for a reason; it’s because we as a society believe that certain things need to be accomplished, and for whatever reason we’ve left those things up to the private market.

Of course, from there you could also ask, “Well, do we actually need to do these things?” Do we actually need flood insurance or disaster relief? The really infuriating thing about watching Romney and his Republican brethren during this interminable election has been watching them try to walk the line: on one side, they want to say that principles of good government require us to drop things like universal health insurance (Ron Paul’s uncomfortable answer when asked whether to let an uninsured patient die) and flood insurance; but on the other side, they know that the public finds these positions morally vile, which they are. Which is why the Republican approach has been to answer a different question: Romney lectures us on the evils of Federal debt rather than say whether the Federal government has a role to play in disaster relief, and Ron Paul just says that the patient should exercise personal responsibility.

I strongly suspect, without having gathered the data on this, that people are liberals when they’re not asked to self-identify that way. Ask people the same question that Wolf Blitzer asked Ron Paul: should society let him die? I suspect most people would say, no, of course not. But in return for not allowing him to die, and for picking up the tab when he falls ill, we should expect him to pay for his own insurance while he’s healthy. And what if he can’t afford to pay that insurance? Should we help him out, in exchange for his subsidizing poorer folks when he gets back on his feet?

Whether or not most people would answer yes to that, that’s the question. The debate over these big moral questions has been hidden behind a technocratic or legal shroud of late. Maybe there was actually an urgent legal question about whether the government can ‘compel you to buy broccoli’, and whether that is meaningfully different from just giving you broccoli and including that in your tax bill. I don’t think so, though. The real root of the issue is whether you believe that society has a responsibility to protect its weakest members. Having decided that the answer is yes, we can set about deciding the best way to achieve that goal. When Republicans make a stink about requiring people to buy broccoli, they’re actually saying that the answer is no, and that society needn’t serve that protective role. They should be honest and just say so.

Some probably obvious observations on economics, inspired by Apple, which just suggest that I need to read more economics

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(Attention conservation notice: 1400 words thinking aloud about innovation, Apple-style, and what connection it might have to the standard, boring sort of competition that you read about in introductory economics.)

I’ve become somewhat obsessed with Apple in recent months (see “The iPhone is a gateway Apple product”). They’re an easy company to get obsessed over, because they build the best products. When Google was building the best products, like their search engine or the maps app, I was obsessed with them too. Most of their other products are quite good, but they’re not perfect in the way that the iPhone is, in the way that the Google search app is, or in the way that Google Maps is. Every time I use Google Calendar — and I use it, mind you, a dozen times a day — I’m reminded of all the things it could do better. I never think that about Google search or about the iPhone. They are perfect.

It’s been remarkable to watch Apple’s competitors. Apple invented the iPod 10 years ago, and it has owned the category ever since. Others have tried to compete with them, but haven’t managed to produce anything even comparably good. Likewise with the iPhone. When I remember what preceded the iPhone, my mind is kind of blown. Pre-iPhone phones were thought to be such poor computers that manufacturers decided to invent their own alternate universe, including their own poor substitute for HTML, rather than just put a fast computer in your pocket. Other companies have had four years to respond, including at least one company that makes a lot of money and should, by all rights, have beaten Apple at this game.

Yet they’ve not. Not even close. Android continues to be the technology of tomorrow, just as Linux has always been, and one strains not to say that it will always will be the technology of tomorrow.

I see in this the simplified picture of markets that we read about in introductory economics. Someone starts a company — say, a bakery making artisanal bread in a big city. There’s unmet demand for this bread, so people flock to it. The lines run out the door, and the bakery is habitually sold out by noon. They ramp up their production and add some machines to augment human labor. Maybe they raise their prices. Now the lines are shorter (translation: prices have risen, so quantity demanded has decreased), but the bakery’s total amount of income has increased (translation: price elasticity is less than 1). Now the bakery is making lots of profit.

Other bakeries see this profit, and they want in. So they move into the market and try to do the same thing more cheaply. Maybe doing it more cheaply is harder, because the incumbent bakery makes its artisanal bread using giant machines that can produce individual loaves for not very much money at all (translation: high fixed cost to buy the machines, low marginal cost per loaf). Anyone who wants to move into the market would either have to make better bread for the same or higher price (think of Starbucks moving into a world of Maxwell House), or make equal-quality bread more cheaply. (Translation: high fixed costs are a barrier to entry, and make monopolies more likely.)

But if the incumbent baker makes money consistently for years, it may eventually happen that banks take notice and loan someone the money to start a competing bakery at scale. (Imagine here AMD moving into a world dominated by Intel.) Now the incumbent has to lower its prices. In some perfect-competition models, every last customer flocks to the cheaper bakery. The bakeries alternate investing huge amounts of capital to produce at cheaper prices at larger scale. We’re in a price war.

This may be a good thing — we get cheaper bread — but it’s not what Apple is doing. Instead, they’re innovating. They’re not running down the slippery slope of a price war. Instead, they’re making products that no one had and no one knew they wanted before. (I still don’t really need an iPad, though it would be handy for reading academic PDFs.) If they were a different kind of company, they could instead try to make cheaper widgets than their competitors, but where’s the joy in that? If that’s how companies operated, we wouldn’t even have BlackBerrys by now; we’d just have cheaper little knock-off LG or Nokia “feature phones.”

There are some models I remember learning in college that tried to capture this. They usually fall under the labels ‘imperfect competition’ or ‘monopolistic competition’. Coca-Cola has a legally enforced monopoly on the term ‘Coca-Cola’, for instance. But that doesn’t really capture innovation. Most of the models I remember learning, and nearly anything captured under the term ‘perfect competition’, don’t describe the sort of market where companies innovate.

I still need to finish reading Schumpeter’s Capitalism, Socialism, and Democracy, but he touches on a similar idea in there. His famous term from that book is “creative destruction”: capitalism’s great contribution to the world is that it constantly destroys industries and replaces them with new ones. No one laments all the horse-and-buggy drivers put out of business by the automobile. There are legitimate reasons to lament the end of businesses built around physical newspapers, and a just society will try to help laid-off newspaper workers land on their feet. But the innovation of the web, which gave rise to an entirely new industry that caught incumbents unawares, makes life better in many well-known ways.

One of Schumpeter’s main arguments (the book contains many arguments and ranges far afield; it argues, for instance, that soon capitalism will be destroyed when its large corporations turn into mere offices for the filling out of forms in triplicate) is that capitalist enterprises shouldn’t mainly fear that a new competitor will produce the same product for cheaper, but rather that an entire industry will come into being that renders the incumbents’ whole reason for being moot.

There’s an “innovation through cheapness” argument along these lines, most famously laid out in The Innovator's Dilemma. It goes like this: there’s some incumbent that makes a big, expensive product that’s the cream of the crop and whose lead seems impregnable. Think of Oracle databases, for instance, or the Sabre airline-reservation system, or Microsoft Windows. Some cheap competitor comes along, producing a product that doesn’t do most of what the big guys do, but does it for much less money (MySQL databases, Internet airfare searching, Linux). Initially, the big guy couldn’t care less about the newcomer — might not even notice the newcomer, in fact. The newcomer may have in fact taken away the big guy’s most annoying customers: those customers who care mostly about price, or those who demand a lot of features for not a lot of money. Good riddance, says the big guy.

Now that the newcomer has some customers, it can start adding features. Because the big guy has been around for a while, competitors have had a while to look at what customers are buying. The newcomer can bring fresh eyes to an existing market, too: the big guy has established sales forces that are trained at selling a specific kind of product, has a large bureaucracy that’s specialized in making their current product lines, and is slow to move in response to change. The newcomer is small and can be more agile. They keep adding features and taking away increasingly important customers from the big guy.

Eventually the big guy takes notice, but by this point it’s too late: the world has shifted entirely to the fresh, cheap product that the new guy is making. This hasn’t happened yet with Windows, of course. Oracle bought MySQL. A quick scan suggests only modest declines in travel-agent employment over the next 7 years. I should try to think of some other examples.

That’s at least two distinct types of innovation: innovating through inventing entirely new product lines that render existing products moot, and innovating through producing simplified subsets of existing products. The latter seems different than merely making a lower-cost version of the same product; that’s classic price competition.

Now, I’m pretty sure I never heard any coverage of innovation when I took economics classes in college. Is there any good modeling of this sort of thing?

George Will thinks high-speed trains are a collectivist plot to control your brain

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See Grist, Krugman, Yglesias. The money quote:

So why is America’s “win the future” administration so fixated on railroads, a technology that was the future two centuries ago? Because progressivism’s aim is the modification of (other people’s) behavior.

Forever seeking Archimedean levers for prying the world in directions they prefer, progressives say they embrace high-speed rail for many reasons — to improve the climate, increase competitiveness, enhance national security, reduce congestion, and rationalize land use. The length of the list of reasons, and the flimsiness of each, points to this conclusion: the real reason for progressives’ passion for trains is their goal of diminishing Americans’ individualism in order to make them more amenable to collectivism.

There are many obvious things to say about this, and many good things that the esteemed gentlemen above have written. Here’s what I’ll add: the problem with cars is that they offer the illusion of freedom even while they demonstrate collective insanity. They are a perfect illustration of what can go wrong in markets.

Obvious observation: what does a traffic jam have to do with freedom? You and a few hundred of your closest friends, each in your automobile, are each enjoying your own freedom, sitting in traffic for hours at a time. I hope you enjoy that freedom.

The point that Yglesias has been making forever is that, if we watched a video of Soviet citizens lining up for their free bread, the shelves empty and the lines stretching for blocks, we would know right away what the problem is: the price of bread has been set incorrectly. We see — we live! — traffic jams and we don’t immediately think, “pricing problem,” when that’s precisely what we should think.

Driving imposes costs on others around us. Think of your decision to drive into Manhattan at rush hour: your extra car makes traffic just a little bit worse for everyone around you. In particular, one fellow estimates that each additional car on a weekday imposes a total of more than 3 hours of delays on everyone else.

From here, George Will then has two options available: either 1) insist that car drivers be made to pay the full cost of their effects on those around them, both in terms of ecological damage (the smoke that belches into the atmosphere while you’re idling in traffic) and in terms of time wasted by others, or 2) somehow insist that people have a right to impose costs on others for free.

Republicans’ habitual support for option 2) has mystified Yglesias for a long time. By what libertarian theory do people have a right not to pay for the damage that they cause?

One potential response is that we cannot trust the state to properly estimate the damage we cause others. And even assuming we can trust the state to do that, we cannot trust it to tax the people properly. Maybe the state will have every incentive to overtax, for instance. Or maybe the state will cater to certain interest groups: focus on the needs of train riders or car drivers to the exclusion of everyone else, for instance.

That’s just the point: the state already massively favors car drivers, for the reasons listed in my review of Triumph of the City. If George Will wants to get into a debate about the proper role of the state, I’d be happy to do that; but his first step will have to be answering the question: do people have a right to cause harm to those around them without paying for it? His second step will have to be to admit that the state already plays a massive role in Americans’ use of automobiles. The first is a principle that I hope everyone can agree on; the second is a blindingly obvious observation about the world around us. If he’s not willing to do these things, then it’s not a good-faith debate.

It’s perfectly legitimate to ask why we should want state involvement in transportation policy at all, given what a hash the government has made of things already. Gas taxes are perennially off the table, because politicians expect that they won’t sell; why should we expect that the government will ever properly tax people for the damage they do to the people and environment around them?

Again, this is a fine, legitimate question, and I’d be glad to discuss this with George Will. In particular, I’m more than willing to ask him if he has a free-market solution to the problem of people imposing costs on those around them. If there is such a solution, I’d love to hear it. But Will should know that the idea of taxing people for the damage they cause has been utterly mainstream in economics since the early part of the 20th century.

It feels a little silly to treat Will’s ideas with this sort of respect, and to invite him into a polite debate. Will’s job is to carry water for the Republican Party. He wears a bowtie and has a Ph.D. in political science; he’s the intellectually respectable face of the party, even when what he writes (as in this case) is utter garbage. I’m not going to be intellectually generous or gracious to Will; for whatever reason, he’s chosen not to offer that kind of generosity to my side.

To the contrary. What I’m arguing is that, if we actually had a fair debate, Will would be forced — this is not controversial in the least — to start from some premises about state intervention that he would hate. State intervention in the market is inevitable, if people are going to pay for the messes they make. Will wants that, doesn’t he?

What's the definition of "disposable personal income"?

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Matt Yglesias today looked at the change in disposable personal income over the last few years, and I wanted to check that the definition of the term didn’t count “disposable income” as income less, say, mortgage and credit-card payments. If it did, then you’d expect to see disposable income go down as people pay down debt.

Turns out the definition doesn’t deduct debt payments, but it confuses me in other ways. Here it is:

Personal income is the income received by persons from participation in production, from government and business transfer payments, and from government interest. Personal income includes income received by non-profit institutions serving households, by private non-insured welfare funds, and by private trust funds. Income from production is generated both by the labor of individuals and by the capital that they own. Private income not earned in production, such as from capital gains or the sale of assets, is excluded. Personal income is calculated as the sum of wage and salary disbursements, employer contributions for employee pension and insurance funds, proprietors’ income, property income (personal interest, dividend and rental income), and transfer payments to individuals, less personal contributions for social insurance.

Disposable personal income is personal income less personal tax payments. While personal income does not include capital gains realized through the sale of assets, personal income taxes do include the taxes paid for these capital gains.

(Internal footnote omitted.)

I’m puzzled by a couple aspects of this definition:

  1. “[E]mployer contributions for employee pension and insurance funds” makes it in? So when my employer contributes to my 401(k), that counts as disposable income? Okay, I can half-see that: if need be, I could raid the 401(k). But I’d pay a penalty if I did, so I hope that something less than 100% of my contribution counts toward my disposable income. But then what about the “insurance funds” part? My employer’s contribution to unemployment insurance counts toward my disposable income? The employer contribution to long-term disability? To health insurance? This would seriously inflate this measure of disposable income: as has been well-documented, health-care costs have been rising, so a lot of money that might otherwise have gone toward rising salaries has instead gone into health-insurance payments.

  2. Disposable income doesn’t include capital gains? But why? That’s income I can spend, just as much as is income earned through honest toil. And if they’re not going to include capital-gains income, then why do they deduct capital-gains taxes?

I’ll look around for a more in-depth discussion of this definition. If anyone can clarify, please do.

On the virtues of heterodoxy: a pompous blog-post title in response to a pseudonymous blogger

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(Attention-conservation notice: 1,600 words on why it may be a good idea not to read cranks. Also some words on academic orthodoxy. Scattered thoughts on building institutions for seeking the truth.)

My friend, who blogs pseudonymously and will hereafter be known as “PB” (for Pseudonymous Blogger), takes me to task for suggesting the existence of cranks. (Note that I didn’t dismiss any specific people out of hand.) PB has long invited me to read the heterodox folks that he follows, including some “with a large collection of old John Birch Society literature.” As my readers know, I tend to read more from the academic wing; PB attacks academia like so:

Academics in the social science to do not get fired or demoted if they get things wrong. They do not get additional grad students if they are right. The grad school and peer review process reward one thing – conforming to the current intellectual fashions.

I believe I’ve heard about other places where leaders reward servants less for their objective correctness and more for hewing to what the leaders believe. I believe that’s called every single human institution ever.

I tease. If the problem is as PB describes, it’s an institutional incentives problem, and the question is how to build better institutions. Think of the various institutions we have in this world whose purpose is (ostensibly, anyway) to seek out truth. We have juries, to find truth in the legal realm; academia, to find it within more abstract domains; the media, to find what our leaders are hiding and bring policies to the broader public; and many others. Every one of them is guilty in some way of confirmation bias. Cass Sunstein, who’s now the head of OIRA, is famous for documenting how groups of people who believe the same things and only speak with one another are likely to arrive at a more-extreme conclusion than if they had some dissenters in their midst. He’s also famous for taking this line of research and using it to suggest that the Internet needs “general-interest intermediaries”, like the New York Times and the Wall Street Journal, to help soothe society’s emergent extremism. Of course it’s an open question whether the general-interest intermediaries serve the purpose that he thinks they do.

PB focuses on a couple successes from his heterodox sources, but recall the proverb about stopped clocks. The question is how well an institution works overall. We statisticians talk about “type I” and “type II” errors, or “false positives” and “false negatives,” respectively. A false positive, in the context that PB and I are talking about, is when you identify something as true when it’s false; a false negative is when you identify something as false when it’s true. Suppose, for instance, that I adopt as a decision rule that I will never read anything written by someone who’s been a member of the KKK. I may well reject some smart writers because my rule is too crude; these would be false negatives. The basis for my rule is that I expect most of what the KKK member utters to be false; by rejecting KKK writers out of hand, I’m trying to minimize my rate of false positives (again, accepting something as true when it’s in fact false). There are costs associated with false positives, and costs associated with false negatives. To compute the total expected cost of a decision rule, multiply the cost of a false positive by the probability of a false positive, and add to it the cost of a false negative times the probability of a false negative. Going along these lines eventually gets you to the Neyman-Pearson Lemma, which is fundamental to statistics.

Rejecting too many people as cranks may give you a high rate of type-II errors: you may reject some good people out of hand. If PB’s right, mis-labeling cranks is also likely to give you too high a rate of type-I errors: you’re just confirming the conventional wisdom, which has a terrible track record. If I’m reading PB right, then, his claim is that academia’s error rate is terrible in both directions, hence “dominated” in the game-theoretic sense. My response would be twofold: first, find me an institution that balances type-I and type-II errors better than academia. This isn’t a rhetorical question; if there is such an institution, I’d like to find it. But the point is not to focus on isolated instances where someone predicted something better than someone else; the point is to look at overall error rates in both directions. Second, I’d ask PB to suggest institutional improvement that would make academia — or juries, or the media, or pick-your-favorite-institution — do its job better.

Based on what PB wrote, I suspect we’d both look for changes in the incentive structure. If it’s empirically true that academia hires on the basis of confirming what the incumbents already believe, how do we change that? To pick one example out of the air: is there any way to make academics put their money where their mouths are? The examples PB cites from macroeconomics, for instance … is there any way to make Ben Bernanke suffer financially if the economy goes south and benefit if GDP rises? You can look to what corporations do — stock options, for instance — to put some skin in the game, but we also know all the sorts of gaming that go along with those incentives. Unless you structure them properly, you have the epidemic of “I’ll Be Gone, You’ll Be Gone.” Structuring incentives is an incredibly nontrivial problem. To pick but one book on the subject out of the air, take a look at Managerial Dilemmas: The Political Economy of Hierarchy. Or, from another angle, read Herbert Simon’s paper on “The Proverbs of Administration”, wherein Simon notes that most every managerial proverb has an equal and opposite proverb that gets thrown around just as confidently.

So in short, I’m not at all confident in my ability to construct incentives that reward the right behavior within institutions, and I certainly don’t feel as though, if I were made Dictator of Academia, I could build better incentives than those that are already in place.

Also, I’m fairly convinced that PB is just empirically wrong about the ideological homogeneity of academia. I think he may be confusing what happens within one institution with what happens in the academy as a whole. Does PB really contend that the University of Chicago and Princeton University are hiring the same economists? No, of course not: they argue bitterly. Just look at Princeton’s Nobel laureate Paul Krugman denouncing the U of C’s Nobel laureate Ed Prescott. Or look at a good century of arguing in statistics over whether we ought to be Bayesians or frequentists. And that’s in statistics, where empirical and mathematical confirmation are, at least in principle, much more readily available than in the social sciences or the humanities. I’m curious what PB’s standard for homogeneity is. Are academic disciplines homogeneous whenever they avoid pistols at dawn?

If academia is argumentative, it may well be so because the incentives encourage it. Judge Richard Posner, in Public Intellectuals: A Study of Decline, argues that academics have every incentive to be contentious — at least within the public sphere — because it gets you attention when you reject the status quo. I see very few books entitled Most Everything You Know About The World Is Basically Correct.

All of that said, PB and I would surely agree that the conventional wisdom often gets things disastrously wrong. To take but one example, you can look at conventional views of market regulation. From the New Deal through World War II and up until the 1960s, the conventional wisdom — which took canonical form, perhaps, in the great Paul Samuelson’s 1948 textbook — was that the goal of economics was to control markets toward desired ends. Eventually the conventional wisdom switched to the idea that markets were best left on their own. You can argue both sides of this — and, importantly in this context, academia has argued both sides of it, continuously, for half a century. What made the switch happen? Well, it’s complicated, but surely a part of it is that it’s convenient for businessmen to argue that they’re best left unregulated. They were going to argue this anyway; academic economics just offered them some tools. But a whole set of entirely orthodox economic results says something quite different: what individual actors do rationally on their own can lead to a disastrous, unwanted result in the aggregate. You can look anywhere within orthodox economics for confirmation of this idea (see Bowles, Microeconomics: Behavior, Institutions, and Evolution; and Schelling, Micromotives and Macrobehavior). The problem probably isn’t academic rejection of heterodoxy; it’s that economics can be used as a tool of ideology in a more direct way than can mathematics, so it is used as such a tool.

Of course PB is right that there were big glaring warning signs that we were in an unsustainable bubble. Dean Baker flagged a lot of these in Plunder and Blunder. Lots of very intelligent keepers of the conventional wisdom, like Bernanke and Greenspan (Ph.D.s both), who should have known better, got it wrong. All this tells me is that, when the economy’s booming and lots of people are making money, it’s very hard to be the guy who (as the conventional saying goes) “takes the punch bowl away.” Now that everything’s collapsed, we’ll have more people honoring the conventional wisdom. The wisdom was always there; the will to follow it was not.

As for PB’s generous invitation to read along with him on one or more topics: it’s a generous offer, but take a look at how much other stuff is either in my queue or sitting on my floor, tempting me. Add to that a chapter-by-chapter read of Adam Smith, a heretofore-unnannounced chapter-by-chapter read of Gerard Debreu’s Theory of Value, and a couple bits of big news that I’m waiting to fully ferment before I mention them here; the result is that I don’t have the time to read in what sound like fascinating areas. But I appreciate the offer.

Greg Mankiw overloads two words until they collapse

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There’s been a bit of a debate about Greg Mankiw’s recent New York Times column, with Kevin Drum giving it a rather nice smackdown. Mankiw comes back today with some responses. I didn’t get past the first one:

If no one is proposing eliminating taxes, why compare the Obama policy to a world without taxes?  Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources. [...]

My first thought was that that’s a very narrow description of “optimal allocation of resources.” If you don’t pay taxes, the government doesn’t build roads, doesn’t fund a Defense Department to keep the borders safe, doesn’t keep your food safe via the FDA, doesn’t regulate airlines via the FAA, etc. How exactly will the corn (the “resource” in this example) arrive at your grocery store (that is, be “allocated”) without a system of roads to get it there? And how will those roads be built without taxes? This is the economists’ magical definition of “optimal allocation of resources”.

That’s when I realized: all the things I mentioned are hidden within Mankiw’s “absent externalities”. Those are two bizarrely overloaded words in this context. As Justin Fox makes clear in his terrific Myth of the Rational Market, there’s been a long divide in economics between the institutionalists and the rest. (I think the rest have a name, but I’ve forgotten it.) The institutionalists emphasize that when Mankiw talks about “optimal allocation of resources,” he’s brushing aside most of what makes the world interesting.

Take contracts, for instance, which are the most basic weapon within the economist’s arsenal. Economists assume that transactions can be “completely contracted,” meaning that every detail of the transaction can be spelled out and its violation quickly detected. But a contract, so described, is an abstraction hiding a lot underneath it. What happens if I violate a contract that you and I signed? You take it to a court, presumably. The court rules against me and orders me to pay up. What happens if I don’t? The full weight of the state comes down on me to make me pay you. So even talking about “complete contracting” — which is an essential element leading to Mankiw’s “optimal allocation of resources” — requires you to talk about some sort of enforcement mechanism. That enforcement mechanism could be a government, or it could be a mafia that’s willing to break my legs, but in any case there’s an institutional structure underneath the contract. Getting the institutions to ensure complete contracts costs money: either the government has to be willing to bring cops with guns to my house to make me pay up, or the mafia has to employ dudes with baseball bats, but someone somewhere needs to be standing ready to enforce that contract.

Now then. I hope we agree that we need to give up something — be it taxes or Vinny’s valuable free time — in order to allow contracts to be signed and enforced. I hope we agree that signing contracts is vital to the optimal allocation of resources. Therefore, I hope we agree that we need to give up something to attain the optimal allocation of resources. So how does it even begin to make sense for Mankiw to say that a tax-free world is relevant in any discussion at all? I contend that it’s only relevant if you ignore institutions — which is exactly what Mankiw is doing.

(Note also that the most basic contract of them all — the labor contract — cannot be completely contracted, as has been known since 1951.)

Jamie Galbraith and the NAIRU

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I linked to Jamie Galbraith’s old NAIRU paper on Twitter, but explaining why it’s important to people who don’t care about economics, in 140 characters or fewer, turns out to be really hard. Here’s a quick note.

Basically, economists envision that there’s a tradeoff between the rate of unemployment and the rate of inflation. Suppose unemployment is very low. Now workers have more bargaining power. So they can demand higher wages. Enough of them do this, and prices rise. Eventually one can even end up with the dread “embedded inflation”: workers anticipate lots of inflation in forthcoming years, so they ask for wage contracts that guard against that inflation. Let’s say inflation was 10% per year. Now their contracts command, say, 11% raises per year. Now, inasmuch as prices depend on the costs of labor, prices will rise even more. And so the spiral goes.

There’s supposed to be a “natural rate” of inflation, an idea which apparently goes back to Milton Friedman’s 1968 presidential address to the American Economic Association and Phelps’s paper from the preceding year. This natural rate corresponds to a particular rate of unemployment called the NAIRU, for the “non-accelerating-inflation rate of unemployment”. As the name suggests, it’s supposed to be the rate of unemployment at which inflation stays where it is.

The only problem, says Galbraith, is that no one knows where the NAIRU is, and what economists say about it changes over time. Oh wait, there’s another problem: it’s not clear that labor costs have actually been responsible for inflation; it may just be that we got inflation when an “external shock” like a war or an oil embargo intervened. [1]

Most importantly, the focus on the tradeoff between inflation and unemployment takes our eyes off other, more-important things, like the unemployment-inequality tradeoff. Galbraith presents an alternative to Friedman’s “natural” rate of unemployment, which, again, is a rate above which inflation is supposed to start accelerating; Galbraith’s “natural” rate is the one above which inequality is supposed to start increasing, and he estimates it “quite stably” at 5.5 percent.

I need to emphasize just how important this is. The Federal Reserve emphasizes one goal — price stability — to the exclusion of others. Which would be fine — price stability is in the Congressional mandate — if the Fed weren’t using a phantom to achieve that goal. And the Fed is too cautious, too worried about the effects of labor costs, which likely keeps unemployment higher than it needs to be. Which, in turn, is a weapon to maintain increasing inequality.

[1] — It’s oddly unremarked-upon that the U.S. government took very active control over the U.S. economy during World War II. With the government printing so much money and dumping so much of it into the economy to get war production going, inflation would be inevitable. To avoid that end, the government had to enforce strict price controls. Jamie Galbraith’s father, the great John Kenneth Galbraith, was one of the folks in charge of these controls; he writes a bit about this in Money: Whence It Came, Where It Went, and probably in other works.

At another time, I will write about how silly I find the usual American mythologizing of World War II. Yes, maybe it had something to do with “Americans coming together, as never before, to defeat a common enemy.” A more straightforward explanation is that World War II was the natural endpoint of two centuries of capitalist development, centralized control, and the deployment of industrial processes toward warmaking. “Total war,” the idea that an entire nation’s resources are devoted toward destroying one’s enemies, and that war should naturally be brought to bear against the civilians of other countries, helped. There may be room for patriotically beating hearts in here, but these other explanations seem more fruitful.

A question about Keynesian stimulus

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Here’s my dime-store understanding of Keynes (which tells me, by the way, that I need to go reread the General Theory):

  • Companies aren’t investing because they expect that in the near future, customers won’t be buying. They expect this for the completely justified reason that customers aren’t buying right now.
  • So companies don’t put their money into new factories and new machines and so forth. Instead they put it in the bank.
  • So they don’t hire new workers to man the new machines.
  • Now there’s less money in the pockets of the workers. So they buy less.
  • So rational companies look ahead and see more of the same: nobody’s buying, so they won’t be investing.
  • And so on down the drain.

So the government steps in to halt the self-fulfilling prophecy. The government hires workers to pave the roads, build bridges, paint murals, etc. They give those workers, let’s say, $10,000 apiece. Since they’re largely on the poorer end of the economic ladder, they spend most of that money on food and other necessities. Let’s say they spend 80% of what the government pays them. So they spend $8,000 of that $10,000. Someone else has then earned $8,000; assuming the recipient is situated similarly to the spender, 80% of that $8,000 then becomes new spending. And so forth. The initial $10,000 becomes $50,000 through this process of multiplication. (In general, if people spend r% of what they earn, the initial investment gets multiplied by 100/(100-r).)

Now companies expect that things will be different. They expect that next quarter will look a lot like this one, and this one turned out not to be too bad. So they invest. They hire more workers. Those workers spend money. That money gets multiplied, as above. The pump has been primed, the economy is rolling again, and yay.

Here’s my question, though: shouldn’t we expect companies to know that the good times won’t last? Companies must be expected to know that business will only keep moving so long as the government is supplying the jobs, right? Likewise, those employees working at government-provided jobs know that their jobs — paving roads, building bridges, painting murals — are only temporary. To the extent that they have any control over it, they’re going to try to save that money for a rainy day; they know that a rainy day is just around the corner.

The only honest way I can see out of this is for the government to credibly commit to a certain amount of continuous job-creation until the economy has reached some pre-determined goal (GDP increasing by a 3% annualized rate per quarter or whatever). Once the economy is moving on its own, the government promises to stop making work; until then, it’ll do everything it can. This creates the right expectations.

On the basis of this argument, including the bit about the multiplier, I don’t see what the difference — from the perspective of getting the economy moving — would be between a) the government mailing $10,000 checks to a million newly unemployed people, and b) the government creating jobs for a million newly unemployed people. In both cases you’re putting money in the unemployed folks’ pockets, and you expect that they’ll spend roughly the same fraction in each case.

Obviously there are non-stimulus reasons to prefer employment to mailing a check: work is good for people’s self-esteem, crime goes down when people are occupied, and in any case we should be spending money to fix things that need fixing. But toward the goal of setting expectations about the future, the cash and the work seem identical.

So is there any stimulus explanation for not just giving people a check? And, to get to the earlier question: is the idea of a one-time stimulus — any one-time stimulus — just doomed from the start? If you don’t set the expectation that you’ll pay whatever is needed, for however long it’s needed, won’t minimally rational economic actors be too cautious about spending what they have?

Methods of measuring GDP

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A colleague the other day mentioned his annoyance with the Hans Rosling TED talks on global poverty. His annoyance generally stems from treating developing nations’ GDP estimates as anything more than numerical hocus-pocus.

A few things I know basically nothing about:

  • I really have no idea how hocus-pocusy these GDP estimates are.
  • I also have no idea how hocus-pocusy the U.S.’s own GDP estimates are.
  • Another thing I have no idea about is whether every year’s GDP estimates from a given country are mangled in the same way, so that (estimated GDP in year 2) minus (estimated GDP in year 1) is actually a reasonably accurate measure of year-over-year change in GDP.
  • Per-capita GDP estimates might introduce another source of uncertainty, namely uncertainty in the population estimates. I likewise have no idea how accurate most nations’ population estimates are. And I have no idea whether per-capita-GDP estimates come from sampling individual people on their incomes, or estimating the country’s aggregate GDP and dividing by an estimate of the population.

I guess what I’d like, then, is a good introduction to the problems of measurement in countries with not-very-well-established economic-measurement systems — and for that matter, an introduction to how the U.S. statistical-measurement agencies do their work. Paging Chris Blattman…