It is time to stop quivering in our boots in pointless fear of the future and just roll up our sleeves and build it.
- Ray Pierrehumbert

Friday, April 3, 2009

Economics survey

I'm looking over the blog from last year to see if I have anything worth nominating as a "best science blog" entry of the year. So far, well, no.

But I find this comment submission from Tidal which I probably didn't give its due at the time well worth highlighting:
This will be a bit of core dump, but I wanted to engage this discussion.

Even "mainstream" economics is struggling with it's evident shortcomings:
Robert Solow: Economic History and Economics
"modern economics has an ambition and style rather different from those I have been advocating. My impression is that the best and brightest in the profession proceed as if economics is the physics of society. There is a single universally valid model of the world. It only needs to be applied. You could drop a modern economist from a time machine-a helicopter, maybe, like the one that drops the money-at any time, in any place, along with his or her personal computer; he or she could set up in business without even bothering to ask what time and which place... We are socialized to the belief that there is one true model and that it can be discovered or imposed if only you will make the proper assumptions and impute validity to econometric results that are transparently lacking in power.... Of course there are holdouts against this routine, bless their hearts... Let me recapitulate. If the project of turning economics into a hard science could succeed, it would surely be worth doing. No doubt some of us should keep trying... There are, however, some reasons for pessimism about the project. Hard sciences dealing with complex systems-but possibly less complex than the U.S. economy-like the hydrogen atom or the optic nerve seem to succeed because they can isolate, they can experiment, and they can make repeated observations under controlled conditions. Other sciences, like astronomy, succeed because they can make long series of observations under natural but essentially stationary conditions, and because the forces being studied are not swamped by noise. Neither of these roads to success is open to economists. In that case, we need a different approach."

Or Joseph Stiglitz: There is no invisible hand "Adam Smith's invisible hand - the idea that free markets lead to efficiency as if guided by unseen forces - is invisible, at least in part, because it is not there.... That such models prevailed, especially in America's graduate schools, despite evidence to the contrary, bears testimony to a triumph of ideology over science. Unfortunately, students of these graduate programmes now act as policymakers in many countries, and are trying to implement programmes based on the ideas that have come to be called market fundamentalism... Good science recognises its limitations, but the prophets of rational expectations have usually shown no such modesty."

Two branches of the "holdouts", as Solow refers to them, would include "ecological economists" (Daly, Costanza, Ayres, Farley... I recommend Michael Common's text

More radically, you have the Post-Autistic Economics folks.

Nevertheless, this stuff is so radical compared to today's social memes, etc., it's hard to imagine their broad adoption on the timescales required... Part three of Climate Code Red posits that until we start acknowledging the "problem" as an emergencychallenge we are not likely to get much traction in changing our institutions/policies... Some of Ian Dunlop's quotes are particularly good: "we have created a political and capitalist system which has proved incapable of recognising that the most important factor for its own survival is the preservation of a global biosphere fit for human habitation. Our institutions are totally short-term focused; politically due to the electoral cycle and corporately due to perverse incentives. Thus we are uniquely ill-equipped to handle these major problems, which are all long-term.
Our ideological preoccupation with a market economy based on short-run profit maximisation is rapidly leading towards an uninhabitable planet. As inconvenient as it may be politically and corporately, conventional economic growth and rampant consumerism cannot continue. Markets are important, but they operate within rules. Henceforth, the rules must change to ensure long-run sustainability.
Nationalism and short-term vested interests have so far prevented the development of a global governance framework capable of handling this “Tragedy of the Commons”. However, the issue of global sustainability is now much bigger than any nation state. Global warming, in particular, is moving far faster than the scientists had predicted, to the point where we are already in the danger zone.
The stark fact is that we face a global sustainability emergency. But it is impossible to design realistic solutions unless we first understand and accept the size of the problem. We know those solutions; what is lacking is the political will, firstly to honestly articulate the problem and secondly to implement those solutions."

The first two sections of that report (which were previously published separately last year as "The Big Melt" and "Target Practice") make the case that we are already in emergency mode. And it discusses how reticent most of us are to adopt this position for fear of being seen as "alarmist" or "crazy" or "not practical"... I can certainly relate to those feelings... But the case they make for the status quo continuing unless we collectively frame this as an "emergency" is persuasive... Unfortunately, I have trouble imagining the "Pearl Harbour" that will trigger that mindset shift "in time"... if the Arctic melt in '07, or Katrina '05 aren't enough, what will be?

But on that point, much of the third part of "Code Red" uses military metaphors... one quote is from Admiral Stockdale, a "Hanoi Hilton" POW: "you must never confuse faith that you will prevail in the end - which you can never afford to lose - with the discipline to confront the most brutal facts of your current reality, whatever they might be"

Well, like I said, a core dump... But I really think that this is the next big issue... The "science" has done its part... Now it is up to society to implement policies to deal with the crisis... The question is whether we can do so within the current economic and institutional paradigms, or do we have to fix both issues at the same time? I certainly hope the existing paradigms are up to the challenge, because that would reduce the overall challenge... but I fear that they are not...


Belette said...

Stiglitz sez: "There is no invisible hand / People don't behave rationally. So why do orthodox economists still cling to their discredited rational expectations theory?"

This is a non-sequitor. Just because people don't behave optimally-rationally, doesn't mean the IH doesn't work.

Are you aware of any evidence that the IH doesn't work (I mean with its own domain, for common-place purposes; I don't mean boom-and-bust).

Michael Tobis said...

Well, maybe Tidal can answer. I know somebody who knows Stiglitz, but I'm guessing S. won't show up here.

My understanding, though, is that traditional economic theory presumes that aggregate behavior is utility-optimizing. New results which show otherwise simply indicate their theorems apply only in narrow regimes where the idea of aggregate utility optimization holds. That is, where there is error but no bias, you can still come to some of the conventional conclusions, but if I understand correctly, it is clear from the Kahneman work that there commonly is bias as well as error.

One of my own gripes about economists is that they seem to presume that there is only one regime and all their results have to be applicable always. If a useful economic theory is possible I think it will need to overcome this particular blind spot.

Michael Tobis said...
This comment has been removed by the author.
John Mashey said...

By coincidence, there's a recent discussion on differences between *ecological economics* and *biophysical economics* at Charlie Hall's, and it might be worth looking at E3 network and Frank Ackerman.

Belette said...

"that traditional economic theory presumes that aggregate behavior is utility-optimizing..." not quite the same thing. "Invisible hand" is a general theory, perhaps somewhat hand-wavy, but with no maths involved. Basically it says that markets are a good idea. "trad econ theory" is something else - a mathematical abstraction and simplification of this, probably. Disproving TET doesn't disprove IH. But S ought to know this, so why is he misleading us?

Bunty said...

One of the main problem with the invisible hand 'theory', is that people use it with Invisble Context (#insert cat macro here).

To go to the source:

Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to the society.

First, every individual endeavours to employ his capital as near home as he can, and consequently as much as he can in the support of domestic industry; provided always that he can thereby obtain the ordinary, or not a great deal less than the ordinary profits of stock.

Thus, upon equal or nearly equal profits, every wholesale merchant naturally prefers the home trade to the foreign trade of consumption, and the foreign trade of consumption to the carrying trade. In the home trade his capital is never so long out of his sight as it frequently is in the foreign trade of consumption. He can know better the character and situation of the persons whom he trusts, and if he should happen to be deceived, he knows better the laws of the country from which he must seek redress. In the carrying trade, the capital of the merchant is, as it were, divided between two foreign countries, and no part of it is ever necessarily brought home, or placed under his own immediate view and command. The capital which an Amsterdam merchant employs in carrying corn from Konigsberg to Lisbon, and fruit and wine from Lisbon to Konigsberg, must generally be the one half of it at Konigsberg and the other half at Lisbon. No part of it need ever come to Amsterdam. The natural residence of such a merchant should either be at Konigsberg or Lisbon, and it can only be some very particular circumstances which can make him prefer the residence of Amsterdam. The uneasiness, however, which he feels at being separated so far from his capital generally determines him to bring part both of the Konigsberg goods which he destines for the market of Lisbon, and of the Lisbon goods which he destines for that of Konigsberg, to Amsterdam: and though this necessarily subjects him to a double charge of loading and unloading, as well as to the payment of some duties and customs, yet for the sake of having some part of his capital always under his own view and command, he willingly submits to this extraordinary charge; and it is in this manner that every country which has any considerable share of the carrying trade becomes always the emporium, or general market, for the goods of all the different countries whose trade it carries on. The merchant, in order to save a second loading and unloading, endeavours always to sell in the home market as much of the goods of all those different countries as he can, and thus, so far as he can, to convert his carrying trade into a foreign trade of consumption. A merchant, in the same manner, who is engaged in the foreign trade of consumption, when he collects goods for foreign markets, will always be glad, upon equal or nearly equal profits, to sell as great a part of them at home as he can. He saves himself the risk and trouble of exportation, when, so far as he can, he thus converts his foreign trade of consumption into a home trade. Home is in this manner the centre, if I may say so, round which the capitals of the inhabitants of every country are continually circulating, and towards which they are always tending, though by particular causes they may sometimes be driven off and repelled from it towards more distant employments. But a capital employed in the home trade, it has already been shown, necessarily puts into motion a greater quantity of domestic industry, and gives revenue and employment to a greater number of the inhabitants of the country, than an equal capital employed in the foreign trade of consumption: and one employed in the foreign trade of consumption has the same advantage over an equal capital employed in the carrying trade. Upon equal, or only nearly equal profits, therefore, every individual naturally inclines to employ his capital in the manner in which it is likely to afford the greatest support to domestic industry, and to give revenue and employment to the greatest number of people of his own country.

Secondly, every individual who employs his capital in the support of domestic industry, necessarily endeavours so to direct that industry that its produce may be of the greatest possible value.

The produce of industry is what it adds to the subject or materials upon which it is employed. In proportion as the value of this produce is great or small, so will likewise be the profits of the employer. But it is only for the sake of profit that any man employs a capital in the support of industry; and he will always, therefore, endeavour to employ it in the support of that industry of which the produce is likely to be of the greatest value, or to exchange for the greatest quantity either of money or of other goods.

But the annual revenue of every society is always precisely equal to the exchangeable value of the whole annual produce of its industry, or rather is precisely the same thing with that exchangeable value. As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

What is the species of domestic industry which his capital can employ, and of which the produce is likely to be of the greatest value, every individual, it is evident, can, in his local situation, judge much better than any statesman or lawgiver can do for him. The statesman who should attempt to direct private people in what manner they ought to employ their capitals would not only load himself with a most unnecessary attention, but assume an authority which could safely be trusted, not only to no single person, but to no council or senate whatever, and which would nowhere be so dangerous as in the hands of a man who had folly and presumption enough to fancy himself fit to exercise it.

To give the monopoly of the home market to the produce of domestic industry, in any particular art or manufacture, is in some measure to direct private people in what manner they ought to employ their capitals, and must, in almost all cases, be either a useless or a hurtful regulation. If the produce of domestic can be brought there as cheap as that of foreign industry, the regulation is evidently useless. If it cannot, it must generally be hurtful. It is the maxim of every prudent master of a family never to attempt to make at home what it will cost him more to make than to buy. The tailor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own clothes, but employs a tailor. The farmer attempts to make neither the one nor the other, but employs those different artificers. All of them find it for their interest to employ their whole industry in a way in which they have some advantage over their neighbours, and to purchase with a part of its produce, or what is the same thing, with the price of a part of it, whatever else they have occasion for.
Wealth of Nations - Book 4 Ch2

He was, of course, also talking about the economic system of the time - 1776. It certainly doesn't hold now, as the returns from mass-hysterical wooly-minded asset inflation (be it real estate, dot coms, or tulips) far outstrip (in the short term, before it goes bang), the returns from investing in actual production. In result, stealing capital and human resources from production in order to engage in gambling.

If more of the people that quoted Smith had even 1/100th of his insight then the dismal science would be in a far better state (IMLTHO).

guthrie said...

Exactly, Bunty. Invisible hand theory can join neo-classical economics in the dustbin.

as far as I can tell, not being an economist, but clearly knowing more than Gordon Brown, the Treasury and many banks, since I predicted the boom would bust and based my mortgage arrangements upon the conclusion, micro economic theory is accurate enough within its limits. Macroeconomic theory is still awaiting a unifying paradigm.

For further reading I reccomend "The truth about markets" by John Kay, and this post here by a non-mainstream economist:

The Chicago school of economics was shown to have some sevee flaws back in the 80's; Thatcher tried their policies, found they dind't work, and did something else instead. Chile tried their policies, found they didn't work, and did something else. That is not to say Keynes was hugely better, since his biggest work is somewhat impenetrable and did not cover the entirety of ecnonomics. (I've still got to actually read my copy) Hence the rise of post-keynesians, who in what I have read, manage to make a better statement of what the real world does.

IIRC the new economics foundation is also looking at things a diffferent way.

I don't recall an economy based upon short run profit maximisation being what it was all about for much of history. Through the 19th and 20th centuries it has been recognised that the market has a tendency to get too short term, hence gvt intervention to set up schools, universities, sponsor new businesses, join in long term investment etc. Ok, it leads to corporatism. But on the other hand we have too many companies cutting what we would call useful investment in order to inflate the margins for the short term.

Not to mention the overbearing finance sector.

David B. Benson said...

Adam Smith should have known better. Already there had been the South Sea Bubble and the earlier Tulip Mania. Surely he knew of at least one of these?

guthrie said...

DAvid Benson - there is mention of the South Sea bubble in the index of my copy of the WEalth of nations. However it seems the index does not match up with the page numbers, they might have kept the original index although that is unclear to me.
SO he knew about it, but I do't have time right now to read through to find out what he thought about it.

tidal said...

There is some actual "maths" behind "invisible hand", notably by Leon Walras. But as Michael alludes to, so-called pareto-optimality/allocative efficiency can only be assured of holding under idealized conditions. I.e. complete markets condition, price taker condition, complete information, etc.

Certainly "markets work" at micro levels, but the reality for modern economies is that market failure is the norm. Meeting the required idealized conditions is the exception. Most of the applied study of economics is really about dealing with situations where we are dealing with market failure.

Apropos to this discussion, of course, are unpriced externalities and specifically Stern's remark about AGW being "the biggest market failure the world has ever seen".

And I think that is largely what Stiglitz is pointing out. We are NOT getting efficient allocations from a market left to its own devices and dealing with issues that have negative externalities with spatial and intertemporal characteristics of AGW, to name one biggie.

I HOPE that by effectively pricing externalities, we can get solve a lot of our problems by THEN letting markets do their thing. What disturbs me is (1) how complex that will potentially be (pricing nitrogen? mercury? etc., etc.); (2) if we need to "cap" physical consumption/production of various resources/substances... can several of our modern institutions even function?

The second part is what really bugs me. I think we can have low-growth/sustainable economies... I think we could point to the past and say that we have gone long periods when that was at least approximately the case. And I have little doubt that we can achieve this again, within the context of modern, technologically-advancing global economy. Supply and demand, price and quantity clear... all good.

But many of our present economic actors have largely arisen in their current configuration in a period where physical consumption/production has only accelerated. Are they even fit for a future where that is not the case? Do they have "physical growth" hard-wired into their actual structure? I am thinking about capital markets, modern insurance companies, corporate pension plans, and several others. Don't know, but not a happy camper when I consider it.

Another anecdote that always makes me nervous: Wealth of Nations (IH) and Watt's first steam engine were coincidentally both introduced in March, 1776. What if we are giving outsize credit to IH, much of which is really cheap, "externality"-free applied energy...

In the end, I think we are going to have to dance with neoclassical economics, with a heavy dose of "carbon pricing"-like controls overlaid... It's foggy as hell out there...

(William's point that IH does not require individuals to each act rationally is correct, as long as there is no aggregate bias, as mt pointed out. Again, I think that Stiglitz contends there is systemic bias.)

David B. Benson said...

This review of The Great Warming offers some perspective on earlier economies; some failed, some survived, some prospered.