What is Wrong With Us?

The editorial leader in this week's Economist examines "what went wrong with economics." As an economist, I regularly encounter misperceptions about what we do - when I tell people what my job is, they often ask me for predictions and investment advice. And if that's what people believe we do, than its not surprising if the financial crisis has diminished their respect for economists.

In reality, the things we know tend to be somewhat different and more specialized (for example, I'm really not sure what you should do with your 401-K, but I can tell you that intersectoral adjustment costs may contribute to real exchange rate volatility). The Economist has a better handle than most on what economists do, and is careful not to throw out the baby with the bathwater:

In its crudest form—the idea that economics as a whole is discredited—the current backlash has gone far too far. If ignorance allowed investors and politicians to exaggerate the virtues of economics, it now blinds them to its benefits. Economics is less a slavish creed than a prism through which to understand the world. It is a broad canon, stretching from theories to explain how prices are determined to how economies grow. Much of that body of knowledge has no link to the financial crisis and remains as useful as ever.

Separately, they consider two areas of economics that may be due for a little self-criticism, financial economics and macroeconomics. On macroeconomics, the leader says:

Macroeconomists also had a blindspot: their standard models assumed that capital markets work perfectly. Their framework reflected an uneasy truce between the intellectual heirs of Keynes, who accept that economies can fall short of their potential, and purists who hold that supply must always equal demand. The models that epitomise this synthesis—the sort used in many central banks—incorporate imperfections in labour markets (“sticky” wages, for instance, which allow unemployment to rise), but make no room for such blemishes in finance. By assuming that capital markets worked perfectly, macroeconomists were largely able to ignore the economy’s financial plumbing. But models that ignored finance had little chance of spotting a calamity that stemmed from it.

There is some truth in that, but the tendency to ignore the "plumbing" reflects the fact that writing an economic model - reducing the behavior of six billion crazy people on a stochastic planet to a system of equations - is, by nature, an exercise in simplification. Simplication is useful, and many of the most important insights come from the simplest models (e.g., the Solow growth model and the Krugman trade model). The goal of economic model is to gain insight into how the world works, which is not the same thing as making theory "realistic."

That said, I think they are right, in the separate macroeconomics article, to warn: "Economists can become seduced by their models, fooling themselves that what the model leaves out does not matter." However, the solution is not - as they seem to think - in introducing more complexity, but in keeping a proper perspective on the inherit limitations of the economic modeling exercise.

The articles have drawn some reactions from notables, such as Brad DeLong and Paul Krugman (seconding DeLong) and DeLong again (seconding Krugman, or third-ing himself). They both take issue with the Economist's portrayal on the disagreement within the profession over fiscal policy (the stimulus bill):

Nor can economists now agree on the best way to resolve the crisis. They mostly overestimated the power of routine monetary policy (ie, central-bank purchases of government bills) to restore prosperity. Some now dismiss the power of fiscal policy (ie, government sales of its securities) to do the same. Others advocate it with passionate intensity.

Among the passionate are Mr DeLong and Mr Krugman. They turn for inspiration to Depression-era texts, especially the writings of John Maynard Keynes, and forgotten mavericks, such as Hyman Minsky. In the humanities this would count as routine scholarship. But to many high-tech economists it is a bit undignified. Real scientists, after all, do not leaf through Newton’s “Principia Mathematica” to solve contemporary problems in physics.

They accuse economists like Mr DeLong and Mr Krugman of falling back on antiquated Keynesian doctrines—as if nothing had been learned in the past 70 years. Messrs DeLong and Krugman, in turn, accuse economists like Mr Lucas of not falling back on Keynesian economics—as if everything had been forgotten over the past 70 years. For Mr Krugman, we are living through a “Dark Age of macroeconomics”, in which the wisdom of the ancients has been lost.

The article goes on to sketch the evolution of the divide between the "freshwater" new classical "purists" and the "saltwater" Keynesian "pragmatists." Krugman responds: "The Economist reaches, I think, for a false symmetry, and glosses over too easily the sheer ignorance that has become obvious in the debates over fiscal policy." Of those purists, DeLong says:

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

The lasting legacy of the new classical economists is the methodological shift towards models based on microeconomic foundations, such as contemporary Dynamic Stochastic General Equilibrium models. However, the "policy ineffectiveness proposition" which seems, still, to reflexively guide some of the "purist" new classical thinking reflects the mistake of taking models too literally, forgetting about the simplifying assumptions made along the way. While Keynes (and the "textbook" distillation of Keynes into the IS-LM diagram) is full of methodological holes from a today's point of view, the crisis has provided numerous reminders us of how brilliantly insightful he was.

See also the reactions of Menzie Chinn and Mark Gertler, who both believe macroeconomics is doing better than some of the critics give it credit for.

Redistribution, Cincinnati-Style

In Washington:

House Democrats have proposed an income surtax on the highest wage-earners to help pay for a sweeping overhaul of the nation’s health care system. The proposal, which has little support in the Senate, would generate roughly $550 billion over 10 years.

Meanwhile, in Cincinnati:

Cincinnati panhandlers would have to pay a fee to register, pay earnings tax on their collections and toss their hand-written “Please Help” signs under a plan to be proposed next month.

Saying panhandling is as much of a business as, say, selling hotdogs, Councilman Jeff Berding is working on a plan he says will help make the city more appealing to residents and tourists.

I'm beginning to understand why this area has a "conservative" reputation...

Obama on Africa

In his speech in Ghana last week, President Obama cast his lot with the school of thought that emphasizes the centrality of institutions in development. He said:

Development depends on good governance. That is the ingredient which has been missing in far too many places, for far too long. That's the change that can unlock Africa's potential. And that is a responsibility that can only be met by Africans.

The speech got mostly good marks from Paul Collier, Bill Easterly and Chris Blattman.

Compared to What?

One of the difficulties of assessing macroeconomic policies like the fiscal stimulus is that doing so requires comparing the performance of the economy with a "counterfactual" - what would have occurred in the absence of the policy. Of course, we do not really know the counterfactual.

Last night, Barney Frank, Chair of the House Financial Services Committee, explained it well to Jon Stewart:

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A Nightmare, Condensed

Reliving the traumas of the first year of graduate school, I stumbled upon this: A "Cram101 Textbook Outline" of Mas-Colell, Whinston and Green?!? Veterans of economics PhD programs will realize that is a strange idea - who would ever conceive such a thing?

While Mas-Colell could stand to be shorter (and lighter!), I can't imagine how it could be "condensed" - if it were any more dense, light might not escape from it.

Hmmm... I am curious to see what might be inside, but for now I'll stick by my recommendation of Varian's book (and, surreptitiously, its baby brother) for anyone seeking to start out on graduate microeconomics.

The Theory of the Blackberry Class

In the Times last week, Daniel Gross revisited The Theory of the Leisure Class, the most famous work of Carleton College's most famous alumnus, Thorstein Veblen. Though much of what Veblen wrote continues to be relevant today, Gross notes that conspicuous leisure no longer seems to be a preferred way for people to display their wealth. Indeed, quite the opposite:

In the contemporary money culture, to be at leisure, to be idle, is to be irrelevant. After Bank of America acquired Merrill Lynch, John Thain, the former chief executive of Merrill, was pushed out, in part because he insisted on going skiing at Vail over Christmas and wanted to attend the World Economic Forum in Davos amid the company’s continuing crisis. A great many people can afford not to work and could spend their time shuttling between multiple homes, eating fabulous meals and playing golf. Yet they continue to work around the clock. Of course, the private jet, the BlackBerry and the Internet allow people to do all of the above. But among Type-A, self-made members of the leisure class, there’s a sort of reverse prestige associated with leisure. At Davos, which is filled with conspicuous consumers, the only people who ski are the journalists.

Ezra Klein has an explanation: unlike in Veblen's era, when tycoons derived their income from capital, their contemporary equivalents - investment bankers, CEOs, professional athletes etc. - are the beneficiaries of increasing disparities in labor income. Klein writes:

Veblen, who died in 1929, saw a large overclass that earned most of its wealth through returns on capital. Essentially, their money made money for them. Which gave them time to hang about and conspicuously consume. In the period after his death, that overclass shrank substantially, first because the Great Depression battered them and then because the New Deal disadvantaged them. But by the start of the 21st century, they were back. At least in terms of wealth concentration. Their money, however, wasn't coming from capital returns. It was coming from wages and salaries. They were -- gasp! -- working.

Tire Tracks Trade Telltale?

The US International Trade Commission has recommended safeguard tariffs on Chinese tires. The ITC's announcement says:

In accordance with Section 421 of the Trade Act of 1974, we have determined that imports of certain passenger vehicle and light truck tires from China are being imported into the United States in such increased quantities that they are causing market disruption to the domestic industry producing such tires. Under Section 421(f) of the Act, we have the responsibility of recommending actions that will remedy the market disruption. We have considered the relevant factors set out in the statute, the written and oral submissions of all parties, and other information obtained in the investigation.

To remedy the market disruption caused by rapidly increasing subject imports, we propose that the President, for a three-year period, impose a duty, in addition to the current rate of duty, on imports of certain passenger vehicle and light truck tires from China. This duty would be 55 percent ad valorem in the first year, 45 percent ad valorem in the second year, and 35 percent ad valorem in the third year. In our opinion, these tariff levels would remedy the market disruption that we have found to exist.

See also this Reuters story. The recommendation next goes to the President. Recalling that Obama's views on trade were somewhat murky during the campaign, Greg Mankiw suggests his determination in this case will be revealing. "This Chinese tire case may be one indication of the president's true feelings about trade."

Although safeguard tariffs are explicitly protectionist, not all "free traders" are opposed to them. While trade theory emphasizes the gains from trade by comparing welfare under different policies in equilibrium, much of the public concern over trade really comes from the dislocation associated with the transition between equilibria. By providing a mechanism to cushion the adjustment, safeguards may help reduce opposition to trade liberalization. Moreover, safeguards may be a preferable alternative to the more frequently utilized antidumping actions. A 2005 article about antidumping in Foreign Affairs (JSTOR) argued:

A better way to protect industries adjusting to increased competition would be through the increased use of "safeguard tariffs," a type of trade barrier that is explicitly temporary. Increased use of safeguards may fall short of the free-trade ideal, but they cost the U.S. economy far less than do antidumping tariffs. (When tariffs are in place for more than three years, the WTO allows countries whose exports are affected by the safeguards to levy retaliatory tariffs.) Like antidumping duties, safeguards can be put in place only if the ITC determines that specific imports are hurting a domestic industry. The legal hurdle for getting a safeguard, however, is higher: unlike antidumping tariffs, which can be levied when imports merely cause material injury, safeguards are permissible only when the ITC finds that no other factor is more important than imports in causing harm to a U.S. industry. In return for the higher standard of injury with safeguards, import-competing firms in the United States do not have to show that the foreign firms took any particular actions. No consideration is given in safeguard determinations as to whether trade is fair or unfair.

The law governing safeguard tariffs also gives the president an opportunity to balance the needs of the import-competing community against the interests of the rest of the country. Although the ITC issues a recommendation, the president, according to the legislation, has the discretion to impose trade barriers as he sees fit, balancing "the short- and long-term economic and social costs" of the safeguard tariffs with "other factors related to the national economic interest of the United States." And in return for trade barriers, the domestic industry must put forward a plan for adjustment and show progress in making the adjustment--or face the prospect of having the safeguard tariffs removed by presidential action.

The authors of that article? Greg Mankiw and Phil Swagel. While it will be interesting to see how the President deals with this, it would be a stretch to proclaim him a "protectionist" if he follows the ITC's recommendation.

Off for the Week

I'll be on vacation next week, and I intend to eschew glowing rectangles while I'm gone, so there won't be anything new here for a while.

The MPC is Very Low

The BEA reports disposable income increased by $178 billion in May, while consumption increased $25 billion. In the textbook Keynesian framework, that implies an extremely small marginal propensity to consume of 0.14 (25/178). That, in turn, means a modest multiplier effect. While expansionary fiscal policy is still the right thing to do, a smaller multiplier means a larger stimulus is necessary to achieve a given increase in output.

Of course, the fluctuation in the MPC serves to highlight the limitations of the "consumption function" approach...

Another implication of incomes growing faster than consumption is an increasing savings rate. In May, the savings rate was 6.9%, which means we've quickly and painfully re-attained historically "normal" levels, according to this chart at Economix, after hovering near zero over the past several years. More domestic saving also means less borrowing from the rest of the world, which is reflected in a narrowing current account deficit.

On Second Thought

They'll take the money, the Enquirer reports:

Turns out Warren County Commissioners will take the $1.87 million in stimulus dollars some of its members eagerly wished to return to the U.S. Treasury in April.

The county leaders voted Tuesday to apply for the Energy Efficiency and Conservation Block Grant and use it toward a $13 million expansion of the Common Pleas Court building in Lebanon, a top-priority project this year in Warren County.

Indeed, like I said.