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September 19, 2009

Economist's View - 4 new articles

Economic Inequality: The Wall Street Journal is Just Wrong

Many of the same people who argue that inequality is caused by the market rewarding highly productive people for their efforts -- that it's a good thing because it encourages productive effort -- also deny that inequality is increasing. If inequality is predominately the result of rewarding people for hard work that benefits everyone, you'd think they'd be eager to point out that inequality has been growing, and will likely continue to do so.

Recently, the Wall Street Journal claimed, as it has in the past, that inequality hasn't really been growing like just about everyone else says it has. And in any case, the WSJ says, the recession will take care of it. Bruce Judson explains why this is "just plain wrong" (there's more detail on the data and other issues in the full article):

Economic Inequality: The Wall Street Journal is Just Wrong, by Bruce Judson: For anyone with even a passing familiarity with issues associated with economic inequality, The Wall Street Journal front page story last week was shocking. Its use of bad data was a misuse of this important forum. In effect, the article says that economic inequality was never really a problem, and even if it is we no longer have to worry about it. These conclusions are just plain wrong.
The Journal article effectively leads the reader to two conclusions: First, any issues that may exist around economic inequality are disappearing, because of the likely decline in the outsize incomes of the top 1% of Americans... Second, the problem was never really that bad in the first place. ...
Unfortunately, few conclusions could be further off the mark.
In some eras, when America did well everyone did well. However, this has been far from true for the past thirty years. Moreover, as a result of the Great Recession we may have to worry more about economic inequality rather than less.
First, let's start with what we know about economic inequality. ... The basic conclusion ... that the nation suffers from extreme and growing income inequality is essentially irrefutable. ...
[T]he Journal based its claims on data that is, with very few exceptions, considered essentially worthless for measuring income inequality. ... It is ... impossible to understand how The Journal could seriously assert that the income gains at the top occurred because of a widely shared growing pie, as opposed to one group taking a far larger piece of the growth. ...
In addition, I am forced to wonder about what interviews the reporters conducted before releasing the story. The central argument in the article, that the percentage of total income received by the top 1% will decline, gains enormous legitimacy by stating near the start of the piece that "Mr. Saez and other economists expect income going to the top 1% of taxpayers…will 2010." I cannot speak for Professor Saez, and I don't know whether he was interviewed for the Journal article, but any reading of his work suggests that the article provides a skewed representation of his views.
In a short paper..., Professor Saez concludes that "the most likely outcome is that income concentration will fall in 2008 and 2009." But, he follows this conclusion by stating that in the absence of significant policy actions such declines will be temporary:
"Based on the US historical record, falls in income concentration due to recessions are temporary unless drastic policy changes, such as financial regulation or significantly more progressive taxation, are implemented and prevent income concentration from bouncing back. Such policy changes took place after the Great Depression during the New Deal and permanently reduced income concentration till the 1970s. In contrast, recent downturns, such as the 2001 recession, lead to only very temporary drops in income concentration." (references to charts omitted).
My intense study of past history, which will soon be released in It Could Happen Here is in line with Professor Saez's conclusion. Once income concentration becomes a reinforcing cycle of the kind we are witnessing, it is never stopped by pure market forces. Only extensive government intervention, of the kind that will inevitably create high controversy, reverses this trend. Indeed, the policies of the New Deal, which led to the rapid decline of inequality, reflected bitter and hard fights. Time magazine reported in April 1936, that:
Certainly no President in recent times has so bitterly aroused the enmity of a whole class as Franklin Roosevelt has aroused the economically substantial element of the U. S. Regardless of party and regardless of region, today, with few exceptions, members of the so-called Upper Class frankly hate Franklin Roosevelt.
It's possible that the growth in income concentration may take a brief respite, but without substantial intervention the long-term trend toward ever greater concentration will march forward. ... The Journal article give us the false impression that, counter to all historical evidence, we no longer need to worry about economic inequality. It will take care of itself.
Finally, it is not even clear that the central point of the article is correct. Yes, the rich are suffering relative to the past. However, the middle class and underclass are suffering as well. Jobs continue to disappear and housing could still decline substantially. With each job loss or foreclosure, another family joins the ranks of the former middle class. Simon Johnston, in a New York Times blog post, The Two-Track Economy: Inequality Emerging From Today's Recession, among others, has pointed out that the Great Recession may be creating an even less economically equal society:
The overall numbers on outcomes by groups can get complicated (here's a partial guide), but the simple version is: The top 10 percent of people are going to do fine, those in the middle of the income distribution have been hard hit by overborrowing, and poorer people will continue to struggle with unstable jobs and low wages. ...
All of this suggests that we have a lot to worry about. On its front page, The Wall Street Journal may say that it never happened, and even if it did it is fixing itself. Everything we know suggest that this reading of the past is wrong, and such a future –without determined government action — is unlikely. The larger worry is that we will emerge from the Great Recession as a society sharply divided between a small privileged upper class, and an underclass that lacks basic economic security. What happens then?

"How We Got to Where We are Today"

One more from Paul Krugman on the state of macroeconomics:

Memories of the Carter Administration, by Paul Krugman: One of John Updike's novels was titled Memories of the Ford Administration; needless to say, it wasn't about Gerald Ford — basically it was about sex, because Updike remembered the Carter years as the golden age of extramarital affairs. Similarly, this post isn't about Jimmy Carter – it's about macroeconomic theory. (Sorry.)
For the late 1970s was when macroeconomics experienced its great divide. It's a period engrained in the memory of those of us who were young economists at the time, trying to find our own paths. Yet I haven't seen a clear explanation of what went down at the time. So here's a sketch, which I hope a serious intellectual historian will fill in someday.
As I remember it, it all began with the Phelps volume: Microeconomic Foundations of Employment and Inflation Theory. The issue these papers tried to resolve is nicely summarized here. Keynes (and, for that matter, Milton Friedman) argued that a decline in aggregate demand due to, say, a fall in the money supply would lead to a fall in employment and output – and experience showed that they were right. Yet standard microeconomic theory implies that production should respond only to changes in relative prices, not changes in the overall level of prices – and this in turn implies that money should be "neutral": a 20 percent fall in the money supply should lead to a 20 percent fall in the overall price level, but no change in output or employment.
Phelps and others tried to explain why the economy looks so Keynesian in terms of imperfect information: workers and firms respond to a change in the price level as if it were a change in relative prices, because they can't at first tell the difference. Over time, however, they will realize their mistake – so that, for example, a rise in the inflation rate will reduce unemployment at first, but won't do so on a sustained basis, because eventually inflation will get built into expectations. So the new theory predicted the emergence of stagflation, a prediction that was duly confirmed.
But where do expectations come from? Robert Lucas married Phelps-type models of employment with rational expectations, the view that people in the economy use all available information to make predictions. And this led to a startling conclusion: anticipated policies have no effect on employment. Only surprise changes in, say, the money supply matter – which means that you can't use monetary or fiscal policy to stabilize the economy.
The Lucas view took the economics profession by storm – not because there was any solid evidence for it, but because it was so clever, because it led to nice math, because it let macroeconomists give in to their inner neoclassicists.
But by the late 70s it was already clear that rational expectations macro didn't work. Why? Because people have too much information.
Think about the story of unemployment I've just described. It's a story in which a contraction in the money supply can produce a recession – but only as long as people don't know that there's a recession! You see, if people do know that there's a recession, they know that the low prices they're being offered reflect low overall demand, not specifically low demand for their products.
In Lucas-type models, people were supposed to look at the prices they received, and optimally extract the "signal" from the "noise". The models broke down, however, as soon as you let people have access to any other information – say, by looking at interest rates, or reading a newspaper. And the reality, of course, is that recessions persist long after everyone knows that there's a recession, so that the confusion required by Lucas-type models is long since gone.
I recall a seminar, I think in 1980, in which Robert Barro was presenting a rational-expectations business cycle model. Someone asked him how he could reconcile his model with the severe recession taking place as he spoke. "I'm not interested in the latest residual," Barro snapped.
But by 1980 or 1981 it was basically clear to everyone that the Lucas project – the attempt to explain the evidently Keynesian behavior of the economy in terms of nothing but imperfect information – had failed. So what were macroeconomic theorists supposed to do?
The answer was that they split. One faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we have to assume that there are some limits to maximization – costs of changing prices, bounded rationality, whatever." That faction became New Keynesian, saltwater economics.
The other faction said, in effect, "OK: we can't explain what we think we see in terms of full maximization. So we must be interpreting the data wrong – things like changes in the money supply must not be driving recessions, because theory says they can't." That faction became real business cycle, freshwater economics.
But here's the thing: at this point, the freshwater school no longer remembers any of that – largely because they purged Keynesian and even monetarist thought from their classes. All they know is that Keynesianism was "disproved", and that none of it – not even New Keynesian models with rational expectations (an approach which, as Greg Mankiw says, "provides a rationale for government intervention in the economy, such as countercyclical monetary or FISCAL POLICY.") – is worth listening to.
So that's how we got to where we are today.

[For more on this see here, and though I didn't say much about the real business cycle side of the split, there's a bit on that here.]

Has Economics Failed Us?

A modest defense of macroeconomics:

A "modest" intellectual discipline, by Gilles Saint‑Paul, Vox EU: The current crisis has spurred a debate on the training and usefulness of economists. Some contend that economists are useless since they failed to forecast the crisis. Others claim that their training is inadequate because it relies heavily on applied mathematics at the expense of a broad view of how the economy works, informed by other disciplines such as psychology, sociology, and political science. Hence, ten British institutional economists have written a letter to the Queen, in response to that of Besley and Hennessy, where they state that "economics has turned virtually into a branch of applied mathematics, and has been become detached from real world institutions and events."
"Consequently a preoccupation with a narrow range of formal techniques is now prevalent in most leading departments of economics throughout the world, and notably in the UK. The letter by Professors Besley and Hennessy does not consider how the preference for mathematical technique over real-world substance diverted many economists from looking at the vital whole. It does not consider the typical omission of psychology, philosophy or economic history from the current education of economists in prestigious institutions. It mentions neither the highly questionable belief in universal 'rationality' nor the 'efficient markets hypothesis' – both widely promoted by mainstream economists. It also fails to consider how economists have also been 'charmed by the market' and how simplistic and reckless market solutions have been widely and vigorously promoted by many economists. What has been scarce is a professional wisdom informed by a rich knowledge of psychology, institutional structures and historical precedents."
In France, a similar debate has been going on for years between mainstream economists trained in micro, macro, and econometrics and a variety of critics who usually complain that economics is immoral, too mathematical, not pluridisciplinary enough, or sometimes too right-wing.
While economics is admittedly quite a "dry" discipline, I firmly believe that replacing the training of economists by some soft transdisciplinary melting pot would be a catastrophe.
It is not the job of economists to forecast crises
This claim will surprise many, yet it is true. Economists work in many places, including academic institutions, public administration, and firms. If they are academics, they are supposed to move the frontier of research by providing new theories, methodologies, and empirical findings. If they work for a public administration, they will quite often evaluate policies. Sometimes they will do forecasts, but such forecasts have to be understood as routine projections that are mostly used to get an idea of the likely evolution of the budget deficit. Finally, those who work at firms are quite often involved in providing arguments in anti-trust or discrimination trials. Those who do forecasting at places such as Goldman Sachs provide guidance to the traders about the prospects for say, Brazilian public debt or the evolution of commodity prices. Goldman would have made a lot of money if it had been able to correctly forecast the crisis, but the market economists are involved in routine activities and not in the modelling of rare systemic events.
One might think that since economists did not forecast the crisis, they are useless. It would be equally ridiculous to say that doctors were useless since they did not forecast AIDS or mad cow disease. Furthermore, even if the usual forecasting is of some use, I do not believe it is the place where economists can be most useful. Policy evaluation and principled discussion of the causes of observed phenomena are, in my view, far more important.
A crisis is by nature not forecastable
The criticism also ignores that economics is a science that interacts with the object it is studying. Economic knowledge is diffused throughout society and eventually affects the behaviour of economic agents. This in turn alters the working of the economy. Therefore, a model can only be correct if it is consistent with its own feedback effect on how the economy works. An economic theory that does not pass this test may work for a while, but it will turn out to be incorrect as soon as it is widely believed and implemented in the actual plans of firms and consumers. Paradoxically, the only chance for such a theory to be correct is for most people to ignore it.
One example of a consistent theory is the Black-Scholes option pricing model. Upon its introduction, the theory was adopted by market participants to price options, and thus became a correct model of pricing precisely because people knew it. This is so because such a pricing rule is consistent with the "efficient markets" hypothesis, meaning that no profitable arbitrage opportunity is left once the rule is applied. By contrast, any theory of pricing that leaves arbitrage opportunities would instantaneously be defeated by the markets as soon as they believe it. The attempts by participants to make profits by exploiting the arbitrage opportunity would alter prices in a direction that will invalidate the theory.
Similarly, any macroeconomic theory that, in the midst of the housing bubble, would have predicted a financial crisis two years ahead with certainty would have triggered, by virtue of speculation, an immediate stock market crash and a spiral of de-leveraging and de-intermediation which would have depressed investment and consumption. In other words, the crisis would have happened immediately, not in two years, thus invalidating the theory. Thus, most crises are by nature unforecastable. Believing that they should be forecast is actually a positivist fallacy based on a false analogy between economics and the physical world. While the physical world is deterministic except at the very microscopic level, meaning that knowledge of initial conditions implies knowledge of the entire subsequent trajectory of the object under study, this is not true of the economic world where beliefs about the future and about how the economy works affect the trajectory. So it is paradoxical that some complain that the crisis should have been forecast and at the same time that economics is too mathematical and is plagued by unwarranted scientific pretence. It is precisely because economics is different from natural sciences that crises are not forecastable – and most economists know it and do not pretend otherwise.
One of the reasons many people sneer at the economists' efficient markets hypothesis is that there are far more arbitrage opportunities in real world markets than implied by that hypothesis. Indeed, unlike Black and Scholes, most quantitative trading models that have been applied by market participants in recent decades were inconsistent with that hypothesis – and yet made a lot of money. But those models would collapse if by some mechanism market participants were able to identify the most profitable technique and use it widely. And while many of these trading strategies tend to increase volatility, this is not the case of the "efficient markets" pricing rules implied by economics, which instead tends to bring prices back to the fundamental value of the assets.
In other words, if market participants had been more literate in, or more trustful of economics, the asset bubbles and the crisis might have been avoided. It is therefore strange to advocate that the efficient market hypothesis should not be taught because it fails to explain the actual behaviour of markets. The actual behaviour of markets, unlike an immutable deterministic law of nature, depends on the beliefs of the markets, including their understanding of economic phenomena and their consequences for asset prices. While it is valuable to understand how the economy actually works, it is also valuable to understand how it would behave in an equilibrium situation where the agents' knowledge of the right model of the economy is consistent with that model, which is what we call a "rational expectations equilibrium". Just because such equilibria do not describe past data well does not mean they are useless abstraction. Their descriptive failure tells us something about the economy being in an unstable regime, and their predictions tell is something about what a stable regime looks like.
It is hard to see how forecasting ability could be improved by means other than mathematical techniques
Those considerations aside, it is strange to complain about inadequate forecasting and use of mathematics at the same time. While a "broad view" may offer insights about the institutional environment or the role of human nature, forecasting is a precise quantitative exercise which must be formulated mathematically and use mathematical technique. It is in the area of forecasting that the most sophisticated mathematical techniques (spectral analysis, cointegration, etc.) are used.
"Looking at the broad picture" does not imply a demonstrable understanding of how the economy works
There is no scarcity of economists who adopt the broad view and offer their opinion on what will happen and what should be done. Indeed economists are more eager than ever to take a broad view, in newspapers, policy briefs, or journals geared toward an informed general audience. Some are mainstream, orthodox economists who are proficient in math and underwent the "narrow-minded" training about which the above-mentioned authors complain, yet they are aware that maths should be complemented with actual economic thinking and therefore devote a substantial fraction of their time discussing broad issues and policy matters. Others are more of a literary kind. The problem with the "broad picture" approach, regardless of the intellectual quality of those contributions, is that it mostly rests on unproven claims and mechanisms. And in many cases, one is merely speculating that this or that could happen, without even offering a detailed causal chain of events that would rigorously convince the reader that this is an actual possibility. I believe it is impossible to avoid such "sloppiness" if one is trying to take stock and exert one's judgement. But that does not mean that such an attitude should be imported into the actual professional work of economists, much less their training.
Understanding the working of the economy as whole is extremely difficult
It is na├»ve to assume that if economists were only more open-minded, well read, and in tune with other disciplines, they would be able to develop an operational understanding of how the macroeconomy works. The economy is an extremely complex system – fully understanding it, as of now, is beyond our individual and collective intelligence. Given the role of beliefs, institutions, and so on, that system is surely far more complex than say, the system that describes the evolution of the distribution of matter throughout the universe. Yet physicists have trouble coming up with a satisfactory model since they have to introduce the unobserved "dark matter" to make the data compatible with their theories. And this despite that only one force, gravitation, is at work. No wonder we are ten times more in the "dark" than physicists when trying to understand the interplay of the many forces that drive the economy.
To conclude, economics is a "modest" intellectual discipline, which hopes to be helpful in understanding how the real world works. While we may sometimes sound arrogant in the public debate, it is because we tend to believe that having devoted our whole professional life to thinking about those issues, we are in a better position to talk about them than outsiders. This presumption may be proven wrong, but to my knowledge proponents of alternative approaches have not yet succeeded in offering us an operational framework with a stronger predictive power.

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