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March 31, 2009

Economist's View - 6 new articles

Asia and the "Bond Bubble"

Yu Qiao says Asian countries are worried about their large investment in dollar denominated US assets and would like one of those one-sided, heads we win, tails the taxpayers loses deals that everyone else seems to be getting:

Asia is the victim if the bond bubble bursts, by Yu Qiao, Commentary, Financial Times: ...Most of Mr Obama's stimulus spending is devoted to social programmes rather than growth promotion, which may exacerbate America's over-consumption problem and delay sustainable recovery. On top of this, the unprecedented fiscal stimulus, with the Federal Reserve's move to inject money into credit markets, contains self-destructive seeds. ... In the long term, America may seek to resolve its economic mess by devaluing the dollar at best and a default at worst. ... It is the foreign holders of US obligations denominated in dollars that would end up paying.

Analysts have warned of the dangers of the US Treasury bond bubble that developed in late 2008. ... If this bubble burst, east Asians would be victims..., the consequences would devastate Asians' hard-earned wealth and terminate economic globalisation.

No other international monetary system offers a viable alternative. However, we can make the main reserve currency power more accountable by creating an instrument to help manage the global crisis.

The basic idea is to turn Asian savings, China's in particular, into real business investments rather than let them be used to support US over-consumption... [E]quity claims on sound corporations and infrastructure projects are at less risk from a currency default. But Asians do not want to bear the risk of this investment because of market turbulence and a lack of knowledge of cultural, legal and regulatory issues in US businesses. However if a guarantee scheme were created, Asian savers could be willing to invest directly in capital-hungry US industries.

First, Asian countries could negotiate with the US government to create a crisis relief facility. The CRF would be used alongside US federal efforts to stabilise the banking system and to invest in capital-intensive infrastructure projects such as a high-speed railway from Boston to Washington DC.

Second, Asians could pool a proportion of their holdings of Treasury bonds under the CRF umbrella to convert sovereign debt into equity investment. Any CRF funds, earmarked for industrial commitment, would still be owned and managed by their respective countries. In return, Asians would hold minor equity shares that would, like preferred stock, be convertible .

Third, the US government would act as the guarantor, providing a sovereign guarantee scheme to assure the investment principal of the CRF against possible default of targeted companies or projects. Fourth, the Fed would set up a special account with the US government to supply liquidity that the CRF requires to swap sovereign debt into industrial investment in the US.

The CRF would lessen Asians' concern about implicit default of sovereign debts caused by a collapsing dollar. It would cost little and help the US by channelling funds to business investment. Conventional Keynesian policies – fiscal and monetary expansion on a national basis – cannot solve the problem but will make it worse.

If China and other Asian countries were to fix their under-consumption problem, that would help too (though not right now, if the cheap foreign loans dry up that will make recovery harder).


"The End of Universal Rationality"

Yochai Benkler discusses the use of the "assumption of universal rationality and a sub-assumption that what that rationality tries to do is maximize returns to the self" as a primary analytical foundation for our models of sociological, political, and economic behavior:

The End of Universal Rationality, The Edge: The big question I ask myself is how we start to think much more methodically about human sharing, about the relationship between human interest and human morality and human society. The main moment at which I think you could see the end of an era was when Alan Greenspan testified before the House committee and said, "My predictions about self-interest were wrong. I relied for 40 years on self-interest to work its way up, and it was wrong." For those of us like me who have been working on the Internet for years, it was very clear you couldn't encounter free software and you couldn't encounter Wikipedia and you couldn't encounter all of the wealth of cultural materials that people create and exchange, and the valuable actual software that people create, without an understanding that something much more complex is happening than the dominant ideology of the last 40 years or so. But you could if you weren't looking there, because we were used in the industrial system to think in these terms.

A lot of what I was spending my time on in the 90s and the 2000s was to understand why it is that these phenomena on the Net are not ephemeral. Why they're real. But I think in the process of understanding that, I had to go back and ask, where are we really in between this what's-in-it-for-me versus the great altruists and the stories of Stahanovich and the self-sacrifice for the community? Both of them are false. But the question is, how do we begin to build a new set of stories that will let us understand both? The stories are actually relatively easy. How we build actual, tractable analysis that allows us to convert what in some sense we all know, that some of us are selfish and some of us aren't. That actually most of us are more selfish some of the time and less selfish other of the time and in different relations. That we don't all align according to the standard economic model of selfish rationality, but that we're also not saints. Mother Teresa wouldn't be Mother Teresa if everybody were like her.

So this is the puzzle that I'm really trying to chew on now, which is how we move from knowing this intuitively and having a folk wisdom about it to something that probably won't in any immediate future have the tractability and precision of mainstream economics. Not, by the way, that as we sit here today, mainstream economics necessarily enjoys the high status that it might have a few years ago, but nonetheless so that we will be able to start building systems in the same way that we thought about building organizational systems around compensation, like options that ties the incentives of the employees to that of the business, like we thought with regard to political science that's completely pervaded today by the understanding of, how does politics happen? Well, it depends on what the median voter wants and what the median Senator wants, and all of that.

We have a lot of sophisticated analyses that try, with great precision, to predict and describe existing systems in terms of an assumption of universal rationality and a sub-assumption that what that rationality tries to do is maximize returns to the self. Yet we live in a world where that's not actually what we experience. The big question now is how we cover that distance between what we know very intuitively in our social relations, and what we can actually build with. ... [...continue reading or watch the video...]


Lessons from the New Deal

The Senate committee for Banking, Housing, and Urban Affairs held a hearing today on "Lessons from the New Deal":

Panel 1

  • Honorable Christina Romer Chair, Council of Economic Advisors

Panel 2

  • Dr. James K. Galbraith Lloyd M. Bentsen Chair Lyndon B. Johnson School of Public Affairs, University of Texas at Austin
  • Dr. J. Bradford DeLong Professor of Economics University of California Berkeley
  • Dr. Allan M. Winkler Professor of History Miami (Ohio) University
  • Dr. Lee E. Ohanian Professor University of California, Los Angeles

Here's the video:

View archive webcast (starts at the 29:00 minute mark)


DeLong: Kick-Starting Employment

Brad DeLong:

Kick-Starting Employment, by J. Bradford DeLong, Commentary, Project Syndicate: Unemployment is currently rising like a rocket... In response, central banks should purchase government bonds for cash in as large a quantity as needed to push their prices up as high as possible. Expensive government bonds will shift demand to mortgage or corporate bonds, pushing up their prices.

Even after central banks have pushed government bond prices as high as they can go, they should keep buying government bonds for cash, in the hope that people whose pockets are full of cash will spend more of it...

In addition, governments need to run extra-large deficits. Spending ... boosts employment and reduces unemployment. And government spending is as good as anybody else's.

Finally, governments should undertake additional measures to boost financial asset prices, and so make it easier for those firms that ought to be expanding and hiring to obtain finance on terms that allow them to expand and hire.

It is this point that brings us to US Treasury Secretary Timothy Geithner's plan to take about $465 billion of government money, combine it with $35 billion of private-sector money, and use it to buy up risky financial assets. The US Treasury is asking the private sector to put $35 billion into this $500 billion fund so that the fund managers all have some "skin in the game," and thus do not take excessive risks with the taxpayers' money.

Private-sector investors ought to be more than willing to kick in that $35 billion, for they stand to make a fortune when financial asset prices close some of the gap between their current and normal values. ... Time alone will tell whether the financiers who invest in and run this program make a fortune. But if they do, they will make the US government an even bigger fortune. ...

The fact that the Geithner Plan is likely to be profitable for the US government is, however, a sideshow. The aim is to reduce unemployment. The appearance of an extra $500 billion in demand for risky assets will reduce the quantity of risky assets that other private investors will have to hold. ... When assets are seen as less risky, their prices rise. And when there are fewer assets to be held, their prices rise, too. With higher financial asset prices, those firms that ought to be expanding and hiring will be able to get money on more attractive terms.

The problem is that the Geithner Plan appears to me to be too small - between one-eight and one-half of what it needs to be. Even though the US government is doing other things as well -fiscal stimulus, quantitative easing, and other uses of bailout funds - it is not doing everything it should.

My guess is that the reason that the US government is not doing all it should can be stated in three words: Senator George Voinovich, who is the 60th vote in the Senate - the vote needed to close off debate and enact a bill. To do anything that requires legislative action, the Obama administration needs Voinovich and the 59 other senators who are more inclined to support it. The administration's tacticians appear to think that they are not on board - especially after the recent AIG bonus scandal - whereas the Geithner Plan relies on authority that the administration already has. Doing more would require a legislative coalition that is not there yet.

We're losing, roughly, 600,000 jobs per month, which is about 20,000 per day. There are many costs associated with job loss, but I wonder how many foreclosures per day are generated from the loss of 20,000 jobs? And that's in addition to the foreclosures we'd have anyway.

The administration has an obligation to protect people from cyclical fluctuations in the economy, to help them avoid losing their jobs, their houses, and other sources of security. For example, if bank nationalization is the safer path to pursue ex-ante to stabilize the banking system, then that means convincing the 60th vote in the Senate, one way or the other, to support the action. If more fiscal stimulus, or a larger version of the Geithner plan is needed, then there should be no rest until the votes are there. If the "tacticians appear to think that they are not on board," or someone takes the time - as I hope they did - to ask them and finds out that, in fact, they aren't aboard, then do whatever it takes to change that.

Maybe the effort was there prior to the Geithner plan, and maybe the effort is there now to try to enhance the Geithner plan through legislative authority, to set the stage for a second stimulus in case it's needed, and to change the public perception of what has been done to date. Perhaps a lot of it is behind the scenes, and all that can be done, is being done. Maybe the administration is saving political capital for other things. But prior to the announcement of the Geithner plan, I had the impression that many of the minds within the administration that counted the most were already made up, or if not fully made up that they had a preference for clever market-based solutions (that the public had no hope of understanding, which makes obtaining the public's support much more difficult), and that stood in the way of a true full court press toward nationalization. As for now, I also wonder if concerns within the administration about the deficit are causing hesitation to pursue more aggressive policies. So I'm not so sure that Voinovich was and is (or will be) the only thing standing in the way.


links for 2009-03-31


"Why Bother with Adam Smith?"

Gavin Kennedy reacts to some of the recent criticism of economists for reading and citing the sacred texts and ancient tomes:

Thought for the Day - 3, Adam Smith's Lost Legacy: ...There is a debate underway among historians of economic thought on whether economists really need to study the history of ideas in what we may loosely term our discipline. Those economists who take the view that the history of economic ideas really has nothing to do with modern economics, point to it being unnecessary for 'real scientists' to read the works of Isaac Newton, and his lesser luminaries, so why bother with Adam Smith and the rest? My views on this debate (I have not joined in, so far) are predictable. The physical world is fairly constant – each and every carbon atom is assumed to behave the same way, and has done so through the ages, and unless that changes in known circumstances, its properties and relationships with other atoms are not expected to change. Knowledge gains in hard sciences build upon earlier knowledge gains, and future knowledge gains continue the process. Turning to economics – part of human sciences – it is quite different. We hardly know about past economic history; even recent history is controversial and is well short of arriving at a settled view. There are political views of economic behaviours – as far as I know, we do not have 'leftwing' or 'rightwing' carbon atoms – and we do not have a settled view on what constitutes economic society or on what would constitute a society that could be said to be the basis for all further societies without (controversial) changes.

As economics was derived from political economy, shedding within a century, philosophy, sociology, anthropology, history, politics, psychology, and such-like, though, unfortunately not shedding mysticism, idealism, utopianism, and, eventually, all traces of real human beings, an imaginary world has replaced the real world.

Now, that there were great gains from this process is not disputed, of course, but questions arise as to the costs in what the great 'gains' do not explain. Apart from which there is genuine concern about the usefulness of the abstract when directed at policy-making in real human societies. Even among the most mathematically-oriented of economists there is no agreement as to whether policy A is 'better' than policy B (or policy C to Z).

It is not as if modern economists are better fitted in 2009 to understand (stepping down from 'to advise') than their predecessors, already starting down the road we've travelled, in 1909 (or for that matter 1809). The current 'global crisis' has not produced a consensus among the brightest in our profession (Nobel prize winners stand on opposite sides with different prescriptions) as what should be (could be) done, even if the players in the mix of, say, the G20 were minded to accept whatever advice the equations would give them. And that's the rub. The players do not behave as the mythical Homo economicus prescribes, and neither do all the other players in all the levels below them. The aggregates in an economy, however expressed neatly in well-behaved functions, do not capture what the models require of them. And their authors are impotent to make them do so. It is not as if we are talking about wildly improbable outcomes from clearly defined categories (the effect of heat on molecules of a specific quality as taught in Physics 101). For a 'hard science', surely we can expect a straight answer to a simple operation like 'quantitative easing' and its likely affect on activity? My colleagues among the historians of economic ideas are debating, hotly, just now about what constitutes money. Unlike, the physicists, who agree on the role of gravity, modern economists are not so sure about the venerable role of money. No wonder, that ideas of modern economics fall foul to the barely understood ideas of past economists, where they are not simply made up (as has been the fate of Adam Smith among many modern economists who assert his so-called ideas shamelessly without reading him). We may not need to read Newton's Principia to add to the knowledge base (so far it has not let us down, though it has been improved upon safely because its foundations were so strong), but where did our ideas about money, for instance, come from, and where may our ideas about money be built on less secure foundations than the 'certainties' we were taught recently? I leave these thoughts for the thoughtful readers...

March 30, 2009

Economist's View - 6 new articles

Rodrik: Simon Johnson's Morality tale

Dani Rodrik responds to Simon Johnson:

Simon Johnson's morality tale, by Dani Rodrik: Simon Johnson tells a simple and compelling story: the U.S. has been afflicted by a version of the crony capitalism that has been the scourge of so many emerging markets, except that Wall Street has bought its influence and power not by bribery but by shaping the ideology of our times...

The solution, to Simon, is equally clear. Finance needs to be cut down to size. What the U.S. needs is what the IMF would have told any country...

As with any story built around clear villains easy solutions, there is something in this account that is quite unsatisfying. For one thing, I think it puts the blame too narrowly on the bankers. Yes, there can be little doubt that banks badly misjudged the risks they were taking on. But they were aided in all this by the broader economics and policymaking community--not because the latter thought the policies in question were good for bankers, but because they thought these would be good for the economy. Simon himself says as much. So why pick on the bankers? Surely the blame must be spread much more widely.

And I find it astonishing that Simon would present the IMF as the voice of wisdom on these matters--the same IMF which until recently advocated capital-account liberalization for some of the poorest countries in the world and which was totally tone deaf when it came to the cost of fiscal stringency in countries going through similar upheavals (as during the Asian financial crisis).

Simon's account is based on a very simple, and I believe misguided, theory of politics and economics. It is an odd marriage of populist and technocratic visions. Countries fail because political elites always end up in bed with economic elites. The solution, apparently, is to let the technocrats (read the IMF) run your affairs.

Among the many lessons from the crisis we should have learned is that economists and policy advisors need greater humility. Too many of us thought we had the right model when it turned out that we didn't. We pushed certain policies with much greater confidence than we should have. Over-confidence bred hubris (and the other way around).

Do we really want to exhibit the same self-confidence and assurance now, as we struggle to devise solutions to the crisis caused by our own hubris?

[Dani is generally opposed to a global financial authority. He says "the logic of global financial regulation is flawed." See his article and the discussion at the Rodrik Roundtable.]


Rogoff: Brave New Financial World

Like Edmund Phelps, Kenneth Rogoff is also worried about regulatory overreach in response to the crisis:

Brave New Financial World, by Kenneth Rogoff, Commentary, Project Syndicate: A huge struggle is brewing within the G-20 over the future of the global financial system. ... In all likelihood, we will see huge changes in the next few years, quite possibly in the form of an international financial regulator or treaty. ...

The United States and Britain naturally want a system conducive to extending their hegemony..., other countries would like to see more fundamental reform. Russia and China are questioning the dollar as the pillar of the international system. ... These are the calmer critics. ...Czech Prime Minister Miroslav Topolanek, openly voiced the angry mood of many European leaders when he described America's profligate approach to fiscal policy as "the road to hell." He could just as well have said the same thing about European views on U.S. financial leadership.

The stakes in the debate over international financial reform are huge. The dollar's role at the center of the global financial system gives the U.S. the ability to raise vast sums of capital without unduly perturbing its economy. ...

More fundamentally, the U.S. role at the center of the global financial system gives tremendous power to U.S. courts, regulators, and politicians over global investment throughout the world. That is why ongoing dysfunction in the U.S. financial system has helped to fuel such a deep global recession. ...

Fear of crises is understandable, yet without these new, creative approaches to financing, Silicon Valley might never have been born. Where does the balance between risk and creativity lie?

Although much of the G-20 debate has concerned issues such as global fiscal stimulus, the real high-stakes poker involves choosing a new philosophy for the international financial system and its regulation.

If our leaders cannot find a new approach, there is every chance that financial globalization will shift quickly into reverse, making it all the more difficult to escape the current morass.

As I said here in response to an op-ed by Becker and Murphy where they also express concerns about regulatory overreach, my fear is the opposite, that powerful interests will prevent us from taking the steps we need to take:

While it's possible that regulation will go overboard in response to the crisis, there are powerful interests that will resist regulatory changes that limit their opportunities to make money (and [anti-regulation] Nobel prize winning economists willing to back them up), so my worry is that regulation will not go far enough, particularly with people like Kashyap and Mishkin arguing that we should wait for recovery before making any big regulatory changes to the financial sector. They may be right that now is not the time to change regulations because it could create additional destabilizing uncertainty in financial markets, and that waiting will give us time to see how the crisis plays out and give us the time to consider the regulatory moves carefully. But as we wait, passions will fade, defenses will mount, the media will respond to the those opposed to regulation by making it a he said, she said issue that fogs things up and confuses the public as well as politicians, and by the time it is all over there's every chance that legislation will pass that is nothing but a facade with no real teeth that can change the behaviors that go us into this mess.

I was talking about the U.S., but the same is true at an international level where change is even harder to coordinate, and the danger that compromise to please all will produce reform that does little to restrict behavior is even greater.


Phelps: Financing Dynamism and Inclusion

I was asked to post this abridged version of a letter from Edmund Phelps to G-20 leaders:

Financing Dynamism and Inclusion, by Edmund S. Phelps: This commentary is based on an open letter sent to Prime Minister Gordon Brown and other leaders of the G-20 ahead of their summit in London on April 2, 2009. The unabridged version of the letter is published here. The letter sums up the main recommendations presented in New York City on February 20 at a conference at Columbia University's Center on Capitalism and Society. The conference,"Emerging from the Financial Crisis," brought together distinguished policymakers, bankers, regulators, journalists, and scholars. The list of conference panelists, video excerpts, including Paul Volcker's luncheon speech, can be found here. Participants' presentations, elaborating the conceptual foundations and policy recommendations put forth at the conference, are here.

When the G-20 leaders convene in London next week to propose measures to address the global economic crisis, re-regulation of the financial sector will be high on the agenda.

Although the need for re-regulation is clear, the key issue is how to design regulation without discouraging funding for investment in innovation in the non-financial business sector. In regulators' understandable desire to rein in the financial sector's excesses, there is the danger that policymakers – often pushed by the public – will adopt rules that dampen incentives and competition to the point that the sources of dynamism in the economy are weakened.

The need to encourage entrepreneurship and ensure that young people have the opportunity to start new businesses is acute. Even in the usually innovative American economy, dynamism has declined over the current decade, with economic inclusion – high employment rates and careers permitting ordinary people throughout society to flourish – also decreasing.

The housing boom, of course, masked this decline in economic dynamism and inclusion. Now that the boom has ended, it is clear that a durable return to a normal degree of prosperity and inclusion will not take place until the financial sector is reoriented away from mortgage lending and reshaped to serve first and foremost the business sector.

A new regulatory framework must be internationally consistent, particularly in areas such as capital adequacy, liquidity management, and financial reporting standards for financial and non-financial corporations. The "non-cooperating centers" must also be regulated on a global and consistent basis. And new international arrangements should address the devastating impact of financial contagion from advanced countries on many emerging markets, in part by providing additional resources to multilateral lenders.

At the same time, several key areas should be on the reform agenda. The first concerns regulating the scope of activities of banks, which, since the extreme dismantling of the regulatory framework in the late 1990's and early 2000's, have engaged in highly speculative and leveraged trading activities.

Since the costs of financial conglomeration are not offset by its informational advantages, some have called for a return to "narrow banking." Commercial banks would use their deposits to make loans to consumers and small and medium-sized businesses, which would also facilitate risk management by re-personalizing relationships between bankers and their clients. Investment banks might not be allowed to accept deposits from households and, possibly, non-bank businesses.

By focusing regulation on deposit-taking banks, all other financial institutions – including hedge funds, private equity funds, and other sources of risk capital that underpin economic dynamism – could bear the risk of bad decisions, without much regulation or potential cost to taxpayers (though with supervision to avoid systemic risk). Narrow banks could restart effective intermediation and ensure that consumers and employment-creating small and medium-size enterprises are adequately financed and can contribute to the reactivation of the economy.

Moreover, the demise of banking conglomerates during the crisis offers an opportunity to devote at least the part of the public resources that have been earmarked for restructuring existing banks to the creation of a new class of banks. The new institutions will catalyze the reorientation of the financial sector toward serving the business sector by financing long-term investment and innovative projects.

At the same time, countries ranging from France and the Netherlands to Singapore and Chile are adopting subsidies to companies for ongoing employment of low-wage workers. A development bank – specializing in project finance for infrastructure development, new technologies, and investing in the working poor, the environment, and other capital projects – could be the ideal institution to channel and monitor this type of subsidy.

The crisis also appears to provide an opportunity to develop more inclusive financial markets. The new regulatory framework should aim to "democratize finance" by redressing asymmetries in information, mainly stemming from informational the gap between sophisticated institutional market players and retail customers. This would enable households to expand their risk management through futures markets, home equity insurance, and continuous workout mortgages.

Finally, the new regulatory framework must address excessive swings in equity, housing, and other asset prices. It was the sharp reversal of upswings in equity and housing prices far above historical benchmark levels that helped to trigger – and continue to fuel – the financial crisis. As the downswings continue, there is a real danger that they may also become excessive and drag the economy and the financial system into an even deeper crisis.

A new conceptual framework – Imperfect Knowledge Economics (IKE) – provides the rationale for policy intervention in asset markets, and also has important implications for how regulators should measure and manage systemic financial risk.

IKE acknowledges that, within a reasonable range, the market does a far better (though not perfect) job in setting prices than regulators can. But it also recognizes that price swings can become excessive, imposing high social costs. IKE suggests a panoply of novel measures, including "guidance ranges" for asset prices and targeted variation of margin and capital requirements, to help dampen such excessive movements.

One of this framework's important policy conclusions is that wholesale restrictions on short-selling (and other such measures that pay no regard to whether an asset is over- or undervalued) could actually lead to greater instability. Yet improving the ability of financial markets to self-correct to sustainable values is the entire point of prudential regulation. Rules that are beneficial in some circumstances may become counterproductive in others. The prevailing view that policymakers should be bound by fixed rules will not do.


Paul Volcker on the Financial Crisis

Paul Volcker at the "Emerging from the Financial Crisis" Conference More video from the conference


Paul Krugman: America the Tarnished

The financial crisis has damaged our global authority, credibility, and leadership, and that will make it much harder for the world to accomplish the essential task of coordinating a common response:

America the Tarnished, by Paul Krugman, Commentary, NY Times: Ten years ago the cover of Time magazine featured Robert Rubin,... Alan Greenspan,... and Lawrence Summers... Time dubbed the three "the committee to save the world," crediting them with leading the global financial system through a crisis..., although it was a small blip compared with what we're going through now.

All the men on that cover were Americans, but nobody considered that odd. After all, in 1999 the United States was the unquestioned leader of the global crisis response. ... The United States, everyone thought, was the country that knew how to do finance right.

How times have changed..., ... our claims of financial soundness — claims often invoked as we lectured other countries on the need to change their ways — have proved hollow.

Indeed, these days America is looking like the Bernie Madoff of economies: for many years it was held in respect, even awe, but it turns out to have been a fraud all along. ...

Simon Johnson..., who served as the chief economist at the IMF..., declares that America's current difficulties are "shockingly reminiscent" of crises in places like Russia and Argentina — including the key role played by crony capitalists.

In America as in the third world, he writes, "elite business interests — financiers, in the case of the U.S. — played a central role in creating the crisis, making ever-larger gambles, with the implicit backing of the government, until the inevitable collapse. More alarming, they are now using their influence to prevent precisely the sorts of reforms that are needed, and fast, to pull the economy out of its nosedive."

It's no wonder, then, that an article in yesterday's Times about the response President Obama will receive in Europe was titled "English-Speaking Capitalism on Trial."

Now, in fairness ... the United States was far from being the only nation in which banks ran wild. Many European leaders are still in denial about the continent's economic and financial troubles, which arguably run as deep as our own... Still, it's a fact that the crisis has cost America much of its credibility, and with it much of its ability to lead.

And that's a very bad thing... I've been revisiting the Great Depression,... one thing that stands out ... is the extent to which the world's response to crisis was crippled by the inability of the world's major economies to cooperate.

The details of our current crisis are very different, but the need for cooperation is no less. President Obama got it exactly right last week when he declared: "All of us are going to have to take steps in order to lift the economy. We don't want a situation in which some countries are making extraordinary efforts and other countries aren't."

Yet that is exactly the situation we're in. I don't believe that even America's economic efforts are adequate, but they're far more than most other wealthy countries have been willing to undertake. And by rights this week's G-20 summit ought to be an occasion for Mr. Obama to chide and chivy European leaders, in particular, into pulling their weight.

But these days foreign leaders are in no mood to be lectured by American officials, even when — as in this case — the Americans are right.

The financial crisis has had many costs. And one of those costs is the damage to America's reputation, an asset we've lost just when we, and the world, need it most.


links for 2009-03-30

March 29, 2009

Economist's View - 5 new articles

Greenspan: Equities Show Us the Way to Recovery

Alan Greenspan says that once stocks start to recover, all will be well with the world:

Equities show us the way to recovery, by Alan Greenspan, Commentary, Financial Times: Global economic policymakers are currently confronted with their most daunting challenge since the 1930s. ... Counterfactual scenarios are highly problematic to say the least. But there are intriguing possibilities that offer comfort that, if all else fails, the global economy is not on a track towards years of stagnation or worse.

In one credible scenario ... lie the seeds of recovery. Stock markets across the globe have to be close to a turning point. Even if a stock market recovery is quite modest, as I suspect it will be, the turnround may well have large (and positive) economic consequences. ...

Global losses in publicly traded corporate equities [are]... almost $35,000bn, a decline in stock market value of more than 50 per cent and an effective doubling of the degree of corporate leverage. Added to that are thousands of billions of dollars of losses of equity in homes and losses of non-listed corporate and unincorporated businesses that could easily bring the aggregate equity loss to well over $40,000bn, a staggering two-thirds of last year's global gross domestic product.

This combined loss has been critically important in the disabling of global finance because equity capital serves as the fundamental support for all corporate and mortgage debt and their derivatives. These assets are the collateral that powers global intermediation, the process that directs a nation's saving into the types of productive investment that fosters growth. ...

A rise in global private sector equity will tend to raise the net worth (at market prices) of virtually all business entities. ... In the current environment, new equity will open up frozen markets and provide capital across the globe to companies in general, and banks in particular. Greater equity, after addressing the shortage of bank net worth, will support more bank lending than currently available, enhance the market value of collateral (debt as well as equity), and could reopen moribund debt markets. In short, liquidity should re-emerge and solvency fears recede. ...

The substitution of sovereign credit for private credit has helped to fend off some of the extremes of the solvency crisis. However, when we look back on this period, I very much suspect that the force that will be seen to have been most instrumental to global economic recovery will be a partial reversal of the $35,000bn global loss in corporate equity values that has so devastated financial intermediation. A recovery of the equity market, driven largely by a receding of fear, may well be a seminal turning point of the crisis.

The key issue is when. Certainly by any historical measure, world stock prices are cheap... The pace of economic deterioration cannot persist indefinitely. ... The current pace of deterioration is bound to slow and with it there should come a lessening of the level of fear. ...

As the level of fear recedes, stock market values will rise. Even if we recover only half of the $35,000bn global equity losses, the quantity of newly created equity value and the additional debt it can support are important sources of funding for banks. As almost everyone is beginning to recognise, restoring a viable degree of financial intermediation is the key to recovery. Failure to do so will significantly reduce any positive impact from a fiscal stimulus.

Maybe there was a Greenspan put after all?


"King Solomon's Dilemma and Behavioral Economics"

David Andolfatto uses mechanism design to help King Solomon solve his dilemma:

King Solomon's Dilemma and Behavioral Economics, Macromania: When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament. But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon. The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics." Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior). Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king). So what is the solution to Solomon's dilemma?... [...continue reading...]


Micromotives and Macrobehavior

Daniel Little on Thomas Hobbes and the microfoundations of aggregate social outcomes. This is related to the discussion below on macroeconomic modeling, though it's more about how such models ought to be constructed than about the usefulness of models per se:

Hobbes an institutionalist?, by Daniel Little: Here is a surprising idea: of all the modern political philosophers, Thomas Hobbes comes closest to sharing the logic and worldview of modern social science. In Leviathan (1651) he sets out the problem of understanding the social world in terms that resemble a modern institutionalist and rational-choice approach to social explanation. It is a constructive approach, proceeding from reasoning about the constituents of society, to aggregative conclusions about the wholes that are constituted by these individuals. He puts forward a theory of agency -- how individuals reason and what their most basic motives are. Individuals are rational and self-concerned; they are strategic, in that they anticipate the likely behaviors of other agents; and they are risk-averse, in that they take steps to avoid attack by other agents. And he puts forward a description of two institutional settings within which social action takes place: the state of nature, where no "overawing" political institutions exist; and the sovereign state, where a single sovereign power imposes a set of laws regulating individuals' actions.

In the first institutional setting, he argues that individual competition in the context of the absence of sovereignty leads to perpetual violent competition. In the second institutional setting, he argues that individual self-striving within the context of a system of law leads to the accumulation of property and peaceful coexistence.

Here are some of Hobbes's premises about individual agents from chapter XIII of Leviathan:

From this equality of ability ariseth equality of hope in the attaining of our ends. And therefore if any two men desire the same thing, which nevertheless they cannot both enjoy, they become enemies; and in the way to their end (which is principally their own conservation, and sometimes their delectation only) endeavour to destroy or subdue one another. And from hence it comes to pass that where an invader hath no more to fear than another man's single power, if one plant, sow, build, or possess a convenient seat, others may probably be expected to come prepared with forces united to dispossess and deprive him, not only of the fruit of his labour, but also of his life or liberty. And the invader again is in the like danger of another.

So that in the nature of man, we find three principal causes of quarrel. First, competition; secondly, diffidence; thirdly, glory. The first maketh men invade for gain; the second, for safety; and the third, for reputation. The first use violence, to make themselves masters of other men's persons, wives, children, and cattle; the second, to defend them; the third, for trifles, as a word, a smile, a different opinion, and any other sign of undervalue, either direct in their persons or by reflection in their kindred, their friends, their nation, their profession, or their name.

The passions that incline men to peace are: fear of death; desire of such things as are necessary to commodious living; and a hope by their industry to obtain them. And reason suggesteth convenient articles of peace upon which men may be drawn to agreement. These articles are they which otherwise are called the laws of nature, whereof I shall speak more particularly in the two following chapters.

And these motives and forms of behavior by individuals lead to a predictable outcome for the collectivity in the state of nature: a war of all against all.

Whatsoever therefore is consequent to a time of war, where every man is enemy to every man, the same consequent to the time wherein men live without other security than what their own strength and their own invention shall furnish them withal. In such condition there is no place for industry, because the fruit thereof is uncertain: and consequently no culture of the earth; no navigation, nor use of the commodities that may be imported by sea; no commodious building; no instruments of moving and removing such things as require much force; no knowledge of the face of the earth; no account of time; no arts; no letters; no society; and which is worst of all, continual fear, and danger of violent death; and the life of man, solitary, poor, nasty, brutish, and short.

This is an institutionalist argument. It models the behavior that is expected of a certain kind of agent within a certain kind of institutional setting; and it projects the consequences of these "microfoundations" for the aggregate society. In other words, Hobbes is offering a micro- to macro-argument based on analysis of modes of agency and assumptions about a particular institutional context. Compare this logic with a description of the logic of social explanation offered by contemporary rational-choice social theorist James Coleman in Foundations of Social Theory:

A second mode of explanation of the behavior of social systems entails examining processes internal to the system, involving its component parts, or units at a level below that of the system. The prototypical case is that in which the component parts are individuals who are members of the social system. In other cases the component parts may be institutions within the system or subgroups that are part of the system. In all cases the analysis can be seen as moving to a lower level than that of the system, explaining the behavior of the system by recourse to the behavior of its parts. This mode of explanation is not uniquely quantitative or uniquely qualitative, but may be either. (2)

So the logic of Hobbes's argument is fairly clear; and it is deeply similar to that of institutionalist rational-choice theorists. Thomas Schelling's title, Micromotives and Macrobehavior, captures the idea in three words: derive descriptions of macro-level social arrangements and behavior from premises concerning individual-level motivation and action. It is not a profound criticism of Hobbes's philosophical analysis to quarrel with Hobbes's specific assumptions about what is possible within the state of nature. And in fact, a number of contemporary political scientists argue that it is possible for men and women to create non-political institutions within the context of what Hobbes calls the state of nature. Coordination and cooperation are indeed possible within a "state of nature"; it is possible to achieve coordination within anarchy. From a sociological point of view, this is really a friendly amendment; it simply adds a further premise about the feasibility of certain kinds of cooperation. So the "cooperation within anarchy" criticism of Hobbes is advanced as a substantive argument about the feasibility of durable social institutions that do not depend upon a central coercive authority. And it depends upon several specific assumptions about the circumstances and mechanisms through which local groups of people can establish self-enforcing forms of cooperation that overcome free-riders and predatorial behavior. It is likely enough that Hobbes would not have been persuaded by this argument; but ultimately it is an empirical question. Several arguments against Hobbes's conclusions about the state of nature are especially valuable from this point of view. First, I find Michael Taylor's arguments in Community, Anarchy and Liberty particularly convincing -- essentially, that peasant communities have traditionally found ways of creating and sustaining cooperative institutions and relationships that persist without the force of law to stabilize them. "Contracts" backed by legal systems are not the only way of establishing coordination and cooperation among independent agents. Robert Netting provides relevant examples in Smallholders, Householders: Farm Families and the Ecology of Intensive, Sustainable Agriculture, around traditional forms of labor-sharing and seasonal cooperation. And Elinor Ostrom and her collaborators make similar arguments in their historical and sociological studies of "common property resource regimes" -- essentially, stable patterns of cooperation maintained by local voluntary enforcement rather than central legislation (Governing the Commons: The Evolution of Institutions for Collective Action). Ostrom documents dozens of important historical cases where traditional communities have managed fisheries, forests, water resources, and other common properties without having a central state to support these patterns of cooperation and coordination. But these are empirical and theoretical refinements to a fundamentally coherent model of social explanation that is full-fledged in Hobbes's work in the mid-seventeenth century: explain aggregate (macro) social outcomes as the result of mechanisms and actions at the level of individual actors.


"What Use is Economic Theory?"

Given the discussion below, it seems like a good time to rerun this, a post that was suggested in a comment from Hal Varian:

I've weighed in on this debate in this essay. My thesis is that economics should not be compared to physics but to engineering. Or, alternatively, not to biology but to medicine. That is, economics is inherently a "policy science" where the value of an economic theory should be judged according to its contribution to economic policy.

There are many who disagree with this view, but hey, let a thousand flowers bloom.

Here it is:

What Use is Economic Theory?, by Hal R. Varian, August, 1989: Why is economic theory a worthwhile thing to do? There can be many answers to this question. One obvious answer is that it is a challenging intellectual enterprise and interesting on its own merits. A well-constructed economic model has an aesthetic appeal well-captured by the following lines from Wordsworth:

Mighty is the charm Of these abstractions to a mind beset With images, and haunted by herself And specially delightful unto me Was that clear synthesis built up aloft So gracefully.

No one complains about poetry, music, number theory, or astronomy as being ''useless,'' but one often hears complaints about economic theory as being overly esoteric. I think that one could argue a reasonable case for economic theory on purely aesthetic grounds. Indeed, when pressed, most economic theorists admit that they do economics because it is fun.

But I think purely aesthetic considerations would not provide a complete account of economic theory. For theory has a role in economics. It is not just an intellectual pursuit for its own sake, but it plays an essential part in economic research. The essential theme of this essay that economics is a policy science and, as such, the contribution of economic theory to economics should be measured on how well economic theory contributes to the understanding and conduct of economic policy.

1. Economics as a policy science

Part of the attraction and the promise of economics is that it claims to describe policies that will improve peoples' lives. This is unlike most other physical and social sciences. Sociology and political science have a policy component, but for the most part they are concerned with understanding the functioning of their respective subject matters.

Physical science, of course, has the potential to improve peoples' standards of living, but this is really a by-product of science as an intellectual activity.

In my view, many methodologists have missed this essential feature of economic science. It is a mistake to compare economics to physics; a better comparison would be to engineering. Similarly, it is a mistake to compare economics to biology; a better comparison is to medicine. I think that Keynes was only half joking when he said that economists should be more like dentists. Dentists claims that they can make make peoples' lives better; so do economists. The methodological premise of dentistry and economics is similar: we value what is useful. None of the ''policy subjects''--- engineering, medicine, or dentistry---is much concerned about methodology, and economists, by and large, aren't either.

When you think about it, it is quite surprising that there isn't more work on the methodology of engineering or medicine. These subjects have exerted an enormous influence on twentieth century life, yet are almost totally ignored by philosophers of science. This neglect should be contrasted with with other social sciences where much time and energy is spent on methodological debate. Philosophy of science, as practiced in philosophy departments, seems to be basically concerned with physics, with a smattering of philosophers concerned with psychology, biology, and a few social sciences.

I think that many economists and philosopher who have written on economic methodology have not given sufficient emphasis to the policy orientation of most economic research. One reason for this is the lack of an adequate model to follow. There is no philosophy of engineering, philosophy of medicine or philosophy of dentistry---there is no model of methodology for a policy science on which we can build an analysis. The task of constructing such a theory falls to economists. This is, in my view, one of the most interesting problems for those concerned with methodological issues and the philosophy of the social sciences.

2. Role of theory in a policy science

Given my view that economics is a policy science, if I want to defend a practice in economics, then I must defend it from a policy perspective. So I need to argue about how economic theory is useful in policy. The remainder of the paper will consists of list of several such ways. The list is no doubt incomplete, and I would welcome additions. But perhaps it can help focus some discussion on why economists do what the do, and how theory helps them do it.

Theory as a substitute for data

In many cases we are forced to use theory because the data that we need are not available. Suppose, for example, we want to determine how a market price will respond to a tax. We could estimate this effect by running a regression of market price against tax rates, controlling for as many other variables as possible. This would give us an equation that we could use to predict how prices respond to changes in taxes.

We rarely have data like this; taxes just don't change enough. But if people only care about the total price of a good, inclusive of tax---a theory---then we can use estimated price elasticities to forecast the response of price to the imposition of a tax.

This uses a theory about behavior---people will respond to the imposition of a tax in the same way that they respond to a price increase---in order to allow data on price responses to be useful. We can use the theory to forecast the outcome of an experiment that has never been done.

Here is another, slightly more esoteric example. Consider the assumption of transitivity of preferences mentioned briefly above. This theory asserts that if A chosen when {A,B} is available and B is chosen when {B,C} is available, then we can predict A will be chosen when {A,C} is available. This is certainly a theory about behavior; it may or may not be true.

If we had data on choices between all pairs of A, B, and C, then the theory wouldn't be necessary. When we want to predict the choice out of the set {A,C} we would simply look at how the person chose previously---that is, we would just use brute induction. And we know why induction works---it has always worked in the past!

But we rarely observe all possible choices; typically we observe only a few of the possible choices. Theory allows us to interpolate from what we observe to what we don't observe. In the case of the {A,B,C} example brute induction requires observing all choices the consumer could make from the various proper subsets available, which requires 3 choice experiments. But if the assumption of transitivity holds, then 2 choice experiments are all we need. The theory of consumer choice allows us to economize on the data.

Naive empiricism can only predict what has happened in the past. It is the theory---the underlying model---that allows us to extrapolate.

Theory tells what parameters are important and how we might measure them.

The Laffer curve depicts the relationship between tax rates and tax revenue. At some tax rates tax revenue decreases when the tax rate increases. It has been said that the popularity of the Laffer curve is due to the fact that you can explain it to a Congressman in six minutes and he can talk about it for six months.

The Laffer analysis demonstrates both good and bad economic theory. The bad theory is that inference that because the Laffer effect can occur it does occur. The good theory is that we can use simple supply and demand analysis to determine what magnitudes the elasticity parameters have to be for the Laffer effect to occur. We can then compare the magnitudes of estimated elasticities to estimated labor supply elasticities. In the simplest model a marginal tax rate of 50% requires a labor supply elasticity of 1 to get the Laffer effect. The theory tells us what the relevant parameters are; without the theory, one would have no idea of the relevant parameters are. Indeed, if one examines the rather sordid history of the use of the Laffer curve in public policy debates in the U.S. this becomes painfully clear.

For another example, consider the theory of investment in risky assets. I take it as given that risk is a ''bad.'' Therefore when wealth goes up, people may want to purchase less of it. On other hand, you can afford to bear more risk when you have more wealth. So an argument based on intuition alone shows that investment in a risky asset can go up or down when wealth increases. A systematic theoretical analysis shows what the comparative statics sign depends on: how risk aversion changes with wealth. So the risk aversion parameter is the one you want to estimate in order to predict how investment in risky assets changes with wealth. Conversely how investment changes with wealth tells you something about how risk aversion changes with wealth.

Theory helps keep track of benefits and costs

I indicated above that the sorts of optimizing models used by economists serve the purpose of providing guidance for policy choices. Indeed one of the important roles of economic theory is to keep track of benefits and costs. The idea of opportunity cost is a fundamental one in economics, and would be very difficult to use without a theoretical model of economic linkages.

This brings up the important point that the correct way to measure an economic benefit or cost can only be determined in light of a theoretical model of choice: a specification of what objectives and the constraints facing an economic agent.

Consider for example, the practice of computing present value or risk adjusted rates of return. These computations are only meaningful in light of a model of choice behavior. If the model of behavior does not apply, the policy prescription cannot apply either.

Benefit-cost analysis is only one small field of economics. But the idea behind benefit-cost analysis permeates all of economics. If economic agents are making choices to maximize something, then we can get an idea of what is being optimized by looking at agents' choices. This objective function can then be used as an input to making policy decisions. In some cases, one may need a quantitative estimate of the objective function. In other cases, one may want to show that one kind of market structure, or tax structure, may do a better job of satisfying consumers' objectives than another. But the basic framework of moving from individual objectives, to individual choice, to social objectives and social choice is common to many, many economic studies.

Theory helps relate seemingly disparate problems

If one describes a model in a purely mathematical way, it often happens that the underlying equations will describe a rich set of economic phenomena. The classic example of this phenomenon is the Arrow-Debreu general equilibrium model. The concept of ''good'' can be interpreted as a physical commodity available at different times, locations, or states of nature. One theoretical model can thereby provide a model of intertemporal trade, location, and uncertainty.

Another example from general equilibrium theory is the First Welfare Theorem. This result shows the intimate relationship between the apparently distinct problems of equilibrium and efficiency.

A third example is that a formal analysis of the problem of second-degree price discrimination shows that it is equivalent to the design of an auction or the determination of optimal provision of qualities. Quality discrimination, auction design, and nonlinear price discrimination are essentially the same sort of problem.

Each of these insights came from examining an abstract theory. Once the the ''irrelevant'' details are stripped away, its becomes apparent that the same essential choice problem is involved.

Theory can generate useful insights

Let me illustrate this role of economic theory with an example. In the U.S. most interest receipts are taxable income, but many kinds of interest payments are tax deductible. This policy has been criticized as ''subsidizing borrowing.'' Does it?

The answer depends on the tax brackets of the marginal borrowers and lenders. If the tax brackets are the same, for example, the policy has no effect at all on the equilibrium after-tax interest rate. The supply curve tilts up due to the tax on interest income, but the demand curve tilts up by the same amount due to the subsidy on interest payments. This is a simple insight, but it would be very difficult to understand without a model of the functioning of the market for loans.

A theory that is wrong can still yield insight

Pure competition is certainly a ''wrong'' theory many markets; pure monopoly is a wrong theory for other markets. But each of these theories can be very useful for yielding significant insights for how a particular market functions. No theory in economics is ever exactly true. The important question is not whether or not a theory is true but whether it offers a useful insight in explaining an economic phenomenon.

In my undergraduate textbook I examine a very simple model of conversion of apartments to condominiums. One result of the model is that converting an apartment to a condominium has no effect on the price of the remaining apartments---since demand and supply each contract by one apartment.

This result can hardly be thought of as literally ''true.'' There are a host of reasons why converting an apartment to a condominium might influence the rent of remaining apartments. Nevertheless, it focuses our attention on a crucial feature of such conversions: they affect both the supply and the demand for apartments. The simple supply-demand framework shows us how to start thinking about the impact of condominium conversion on apartment prices.

Theory provides a method for solving problems

I take the method of neoclassical microeconomics to be 1) examine an individual's optimization problem; 2) look at the optimal equilibrium configuration of individual choices; 3) see how the equilibrium changes as policy variables change.

This methods doesn't always work---the models of behavior or equilibrium may be wrong. Or it may be that the specific phenomenon under examination is not fruitfully viewed as an outcome of optimizing, and/or equilibrium behavior. But any method is better than none. In the words of Roger Bacon: ''More truth arises through error than confusion.''

Methodological individualism is a limited way of looking at the world, no question about it. It probably doesn't do very well in describing phenomenon such as riots or class loyalty. Certainly this sort of individualistic methodology works better for describing some sorts of behavior than others. But it is likely to add insight to all problems.

Theory is an antidote to introspection

Most people get their economic beliefs from introspection and their personal experience- --the same place that they get their beliefs about most things. Economic theory---and indeed science in general, can serve as an antidote to this kind of introspection.

Consider, for example, the widely held belief that all demand curves are perfectly inelastic. If the price of gasoline increases by 25%, a layman will argue that no one will change their demand for gasoline. He bases this argument on the fact that he would not change his demand for gasoline.

Indeed, it is perfectly possible that most people wouldn't change their demand for gasoline...but some would. There are always some people at the margin; these people would change their demand. At any one time, most people are infra-marginal in most of their economic decisions. The marginal decisions are the ones that you agonize over. If the price were a little higher or a little lower, the results of your agonizing might be different, and this is what causes the aggregate demand curve to slope downward.

Another nice example of this phenomenon is free trade. It's hard to convince a layman of the advantages of free trade since it is easy to see where the dollars go, but difficult to see where they come from. People have personal experience with imports of foreign goods of foreign goods; but they rarely encounter their own country's exports unless they travel abroad extensively. Only by abstracting from introspection can we see the total picture.

A third example is the bias in perceptions of inflation: price moves are perceived to be exogenous from the viewpoint of the individual, but wage movements are personalized. Even if prices and wages move up by the same amount, people may feel worse off since they think that they would have gotten the wage increases anyway.

Verifying that something is obvious may show that it isn't

One of the criticisms that economists have to deal with is that they spend a lot of time belaboring the obvious. Isn't it obvious that demand curves slope down and supply curves slope up? But many theories that seem to be obvious turn out not to be. It may be obvious that demand curves slope down---but as the theoretical analysis shows, it is possible to have demand curves that don't.

Economic theory shows that a profit-maximizing firm will decrease its supply when the output price decreases. But farmers often claim that removing milk price supports will increase the supply of milk since farmers will have to increase output to maintain the same income. The second effect sounds like it might be possible---after all, farmers wouldn't advance the claim unless it had some plausibility. However, theory shows us that this particular claim cannot be true if the farmers attempt to maximize profits.

Strategic interactions are a good source of counterintuitive results. A simple analysis of a two-person zero-sum game shows that improving your backhand in tennis may lead to your using it less often.

It would seem that a public offer to match any competitor's price is a sign of a highly competitive market. But when you think about the problem facing a cartel it is not so obvious. The prime problem facing a cartel is how to detect cheating on the agreed-upon prices and quotas. Offering to match a competitor's price is a cheap way to gain information about what your competitors are doing. What appears to be a highly competitive tactic can easily be viewed as a device to support collusion.

Theory allows for quantification and calculation

According to Lord Kelvin, ''When you cannot measure it, when you cannot express it in numbers, your knowledge is of a meagre and unsatisfactory kind.''[1]

Theoretical economics gives us a framework to calculate and quantify economic relations. Consider the Laffer curve mentioned above. Laffer gave the existence proof, but it took some theoretical calculations to see what magnitudes were important.

In fact, one of the major differences between economics and the other social sciences is that in economics you can compute. There is very little computation in sociology, political science, history or anthropology. But economics is filled with computation.

Economic theory is useful since you can use it to compute answers to problems. They aren't always the right answers---that depends on whether the model you have is right. (Or, at least, whether it is good enough for the purposes at hand.) But a desideratum of a good model is that you can compute with it: the model can be solved to determine some variables as a function of other variables.

In my view, it is impossible to learn economic theory without solving lots of problems. Richard Hamming, a highly prolific electrical engineer, once gave me some excellent advice about how to write a textbook. He told me to assemble the exams and problem sets that you want the students to be able to solve by the time they had finished the course, and then write the book that would show them how to solve them. In general, I have tried to follow this advice, with, I think, some success.

Economics is amenable to experimental verification

Because neoclassical economic models enables one to compute answers to problems, it is possible to compare the answers you get with the outcomes of controlled experiments. In my view, experimental economics has been one of the great success stories of the last 20 years. We now have rigorous ways to test models of human behavior in the laboratory. Some standard models, such as supply and demand, have turned out to be much more robust than we would have thought 20 years ago. Other models, such as expected utility, have turned out to be less robust.

But this is to be expected---if there were no surprises from experiments, they wouldn't be worth doing. The growth of experimental economics has led many theorists to construct theories that simple, concrete and testable, rather than theories that are complex, abstract, and general. And experience in observing human subjects in the laboratory has no doubt contributed to the current emphasis on investigating models of learning. Laboratory observations have also been instrumental in alerting us to theoretical dead ends, such as some of the more convoluted refinements of game-theoretic equilibrium concepts.

I expect that the interaction between theory and experimentation will continue to grow in the future. As economists become more comfortable with experimentation in the laboratory, they will also become better at identifying ''natural experiments'' in real-world data. Such developments can only lead to better models of economic behavior.

3. Summary

I have argued that in order to understand why economic theorists behave in the way they do one has to understand the role of economic theory's contribution to policy analysis. The fact that economics is fundamentally a policy science allows one to explain many aspects of economic theory that are quite mysterious otherwise. ___________________ 1 However, the same poet whose praise for abstraction and synthesis I quoted in the introduction also once said: ''...High Heaven rejects the lore of nicely calculated less or more.''


links for 2009-03-29