## Friday, February 25, 2011

### Countries compete for the gains from trade.

As a follow-up to my last post, I think there is yet another big problem with Greg Mankiw's column on trade and competition. His argument about trade, whether you believe it or not, doesn't really support his basic thesis - that "other nations are best viewed not as our competitors but as our trading partners." Why not? Because as soon as there are gains from trade to be had, countries can compete for those gains. Let me elaborate.

Suppose we grant Dr. Mankiw that each country really can be treated as a single person. Now let's examine what trade looks like when there are a bunch of countries. Mankiw uses the example of a kid (country 1) offering to shovel snow for his neighbor (country 2), so let's run with that example. If the world is just the kid and the neighbor, then yes, there's no rivalry or competition going on. But as soon as we bring in a third person/country, things look a little different, as Uwe Reinhardt explains:
Your driveway is covered in deep snow. Its removal is worth \$40 to you. The boy next door...would...shovel your driveway for \$20.
So if you pay him \$30 to shovel your driveway, you will both be better off by \$10...
[But] suppose...another boy from the neighborhood comes along and offers to shovel your driveway for \$10. Elated at this bargain, you pay him \$15. Now you are very much better off, and that other boy gains, too, because he would have done the job for \$10...
[But, the entry of the second boy is harmful to] the first boy, who is sorely miffed at losing out in this competition. He loses his anticipated profit... (emphasis mine)
Somewhat oddly, Reinhardt uses this example to make a point about distribution of the gains from trade within countries. But it also shows that gains from trade can be distributed unevenly between countries. Some countries are a lot better off from trade; some are only a little better off. And which is which can change over time, as trade patterns shift.

Notice that this is perfectly in line with the Econ 101 comparative-advantage theory of trade found in any Greg Mankiw textbook*. The more similar a country's cost structure is to that of other countries, the less comparative advantage that country has.

Consider Japan. In the late 1980s, most of the reliable fuel-efficient compact cars, portable consumer electronics, and high-end televisions were made in Japan; the country reaped huge gains from trade, because lots of other countries wanted these products. But with the entry of Korea, Taiwan, Finland, the U.S., and others into these high-end markets in the 1990s and 2000s, Japan was no longer the only kid on the block shoveling snow, so to speak. As a result, Japanese profits were squeezed.

So any trade regime with more than two players puts countries in competition for the gains from trade. But this is slightly different from countries competing, because for countries to "compete" implies that there is something countries can collectively do - in other words, some government policy - to protect their profit margins from the arrival of competitors. Are there such policies?

Of course there are. At the very least, there are things we should do in any case - improve public good provision, and decrease policies that needlessly increase costs**. We can improve education, rebuild our infrastructure, and spend more on research. We can reform our inefficient health care system. We can replace some of our corporate tax with personal income tax. (Side note: Reducing our reliance on corporate tax is something Greg Mankiw agrees we should do, and as a reason why, he tells us that other countries are outcompeting us on this front! Left hand, meet right hand.)

Naturally, these are things we should do in any situation, not just in the face of trade competition. But the political process is notoriously inefficient and sluggish; if trade competition can be used as a stick to force us to make the reforms we should be making anyway, then so much the better.

Now here's the strange part. President Obama's State of the Union speech, which is what Mankiw's column explicitly claims to rebut, was all about doing exactly these sort of things to improve our nation's trade position and increase our gains from trade. It was about education, infrastructure, R&D, etc. But somehow, Mankiw interpreted this as a call for trade protectionism! Where did he get that idea?

Bottom line: International competition does exist, and gains from trade are the prize for which we compete. Obama seems to understand this. Mankiw almost certainly understands it as well, but for some reason chooses to ignore it.

* The degree of competition is magnified if you allow for the existence of agglomeration economies - if one kid wins the competition for the snow-shoveling contract by even \$0.10, it can induce the neighborhood snow-shovel vendor to set up shop near that kid's house, and the neighborhood hot-chocolate vendor will then move nearby, and so on. A tiny difference in snow-shoveling advantage can multiply into a huge difference in overall economic growth.

** More controversial are "industrial policies." I won't rehash that debate here, and I'm pretty agnostic on the subject, but if you want to read a serious economist who actually thinks industrial policy can be a good thing, read Dani Rodrik. Also, some now argue that Germany has recently been having good success with this sort of policy.

## Thursday, February 24, 2011

### Is trade really always efficient?

I'm a bit late to the party on Greg Mankiw's column about trade. But better late than never, right?

Mankiw's case for trade is the textbook one (and not just because Mankiw wrote the textbook): Trade is good because it is a voluntary exchange, and voluntary exchanges benefit the people who do them (or else they would not have chosen to carry out the exchange). Hence, trade liberalization is always good, Q.E.D.

There have been quite a lot of rebuttals to Mankiw's idea popping up over the blogosphere. So far, all the ones I have seen involve some version of the "winners and losers" idea. Briefly: Trade is always efficient, for the reason Mankiw gives. But trade creates inequality in trading countries, and it's often difficult for the "winners" from trade to compensate the "losers". In other words, though a country benefits overall from trade, some people in a country may be hurt. For good discussions of this argument, and related research, see Uwe Reinhardt, Ryan Avent, Mike Konczal, Ryan Avent again, and Angus of Kids Prefer Cheese.

All of these people seem to agree (and agree with Mankiw) on one basic point: The efficiency of trade is not in question. Only the distributional effects of trade are in question.

But to me, this seems highly non-obvious. Although I don't have an empirical analysis in front of me, I can think of at least a couple hypothetical reasons (and there must be more) why trade might not lead to an efficient outcome. No one seems to be talking much about these, so I suppose it falls to me.

The question is: Since trade is a voluntary exchange,why would a country choose to trade if it were harming itself by doing so?

Answer #1: Externalities. As Angus so pithily points out, "People, the United States is not a person!" Trades are undertaken not by countries, but by individuals within those countries. Negative externalities, as every Econ 101 student knows, happen when an exchange between two people causes harm to a third. In the case of trade, the third person who is harmed may be in one of the countries that is engaging in trade.

For example, suppose that I am a landowner in China. A nuclear power company in France, facing the high costs of safe nuclear waste disposal in France, wants to pay me to store all their waste on my land. I accept this trade, and stick the waste in a hole in the ground next to a river, which carries the radioactive waste downstream, poisoning tens of thousands of people. In this case, the trade did not result in an increase in efficiency, because of the size of the negative externality. If you think this example is unrealistic, read the news.

Now, there would have to be some pretty big externalities for protectionism to actually be better than free trade in the aggregate. But certain types of trade could easily lead to reductions in overall economic efficiency. Unless every country could be persuaded to tax or otherwise mitigate the externality, liberalizing these types of trade could be a mistake, regardless of distributional effects.

Answer #2: Dynamic Inconsistency. This is a concept most often used in behavioral economics; basically, people may later come to regret the decisions that they make today. "Me today" is not really the same person as "me tomorrow," and yet, because time goes only one way, "me tomorrow" has to live with the choices of "me today." Case in point: someone who chooses to use heroin today may come to regret that decision for the rest of his life, if he becomes an addict. Dynamic inconsistency is why people often resort to commitment devices to force themselves to do things that are in their own interest.

For most individual decisions, it seems unlikely that dynamic inconsistency outweighs the benefits of voluntary exchange. Addictive drugs are one of only a handful of plausible exceptions. But again, a country is not a person. A country's decision-making process may be far more prone to dynamic inconsistency than an individual's. This could throw a wrench into the "trade is always good" argument.

Notice that neither of these exceptions are arguments for autarky, or even for across-the-board trade restrictions. They are arguments that certain instances of trade liberalization may cause efficiency losses.

Mankiw does not address either of these theoretical possibilities. As far as he is concerned, the case for trade's efficiency is iron-clad in all cases. Somewhat surprisingly, the econ blogosphere seems to accept this argument, and focus exclusively on distributional issues. That in turn allows Mankiw to wave his hand and essentially say "Yes, but distributional issues are second-order; our first order of business should be to do what's efficient, and then later we can discuss how to distribute the gains from trade."

I am against giving this sort of free pass. The supposed consensus that trade is always efficient to me smacks a bit of golden-age-ism and false consensus. You hear again and again that trade (or, at least, the efficiency aspect) is the one issue that economists have settled. But if a consensus exists, it is a result of politics and opinion, not because economic theories make an iron-clad case for the efficiency of trade. Theoretical exceptions do exist, and to ignore this fact (as we do) probably just makes people less trustful of economists in general.

Update: Yes, Mankiw's column does say this:
To be sure, there are exceptions to this rule...when other nations’ economic growth has side effects on the global environment, as it does when they emit the greenhouse gases that contribute to climate change, the United States has good reason for concern.
However, the externalities he's talking about are still externalities between countries, not between the people in a country. He's still insisting on treating each country like a single person, and that is what I see as his fundamental fallacy here.

## Wednesday, February 16, 2011

### All ethical systems are both deontological and consequentialist

I don't spend a lot of time slicing and dicing political ideologies. As I see it, ideology as it exists in the world is different for each person - a purely idiosyncratic hodgepodge of beliefs and values that is usually not even internally consistent. I find it much more useful to engage ideology on this level - to deal with what real people believe - than to spend much time in the rarefied world of idealized political philosophies.

Not so American libertarians. Read a libertarian blog, and there is a great likelihood that you will eventually come across an attempt to create a periodic table of ideologies, slicing and dicing and categorizing the chaos of reality into a rack of gleaming, perfect, Platonic forms. On the plus side, this often includes a nice colorful hexagon or other geometric pleasantry. On the minus side, it can often be smug, laden with faulty assumptions, and in general infuriating.

A common refrain one hears from American libertarians is that liberal ethics is "consequentialist." This is a very old trope, dating all the way back to the "utilitarianism vs. natural rights" debates of 18th century Britain. The basic question back then (and for many still today) is whether or not the government ought to tax people to provide for public welfare. Is it OK to use force to hurt Mr. X a "little bit", if doing so lets you help Mr. Y "a lot"? Yes, said the utilitarians, because the ends justify the means. No, said the natural rights people, because it violates people's rights, and besides, you can't really measure one person's welfare against another. That was the basic debate.

Today's political philosophers have tried to generalize this debate into a question of "consequentialist" vs. "deontological" ethics. Consequentialism, we are told, judges the rightness or wrongness of an action by the desirability of the outcome it produces; a deontological system, on the other hand, judges actions by whether or not they adhere to certain rules (e.g. "don't censor newspapers"). Modern American libertarians tend to go out of their way to say that their ethics are deontological, while liberals are consequentialists. There's an element of smugness to this; it seems to contain a subtext of "Neener neener, my principles are stronger than yours." But most American liberals just shrug and accept the dichotomy.

But I do not. The reason is that faulty logic annoys me far more than partisan smugness. And the dichotomy between "deontological" and "consequentialist" ethical systems is as faulty as logic gets.

To illustrate why this is so, observe that any consequentialist system of ethics requires deontological rules to make it tick. For example, consider the question of whether or not I should rob Peter (a billionaire) of \$3 in order to buy Paul (a starving poor man) a bowl of soup. A deontogical fellow might say "No," because he's following a rule that says "Do not rob." But suppose that I am a classic utilitarian. Suppose I conclude that Peter's utility will go down by 3 utils, and Paul's will go up by 3,000,000 utils, if I take the action, and that I should therefore rob Peter to pay Paul, because it increases overall human utility.

But why do I do the thing that increases overall utility? Only because I have a rule that tells me "Thou shalt take actions to increase the overall level of (appropriately defined) human utility!" Without a rule, I have no basis for action, or for the prescription of an action to another actor. Without a rule to say "value is desirable," assigning value to different outcomes carries no implication for behavior. As a corollary, observe that it is possible to construct any consequentialist ethical system with a set of appropriately defined deontological rules; simply define an outcome measure X, and mandate a deontological rule that says "bring about X".

Now for the converse: Any deontological system requires consequentialism for its implementation. To see why this is true, consider the deontological rule "Do not kill people." Now consider the question of whether one ought to pull the trigger of a gun. In order to apply the rule of "Do not kill people," I must know whether pulling the trigger of the gun will result in a person's death. In other words, even with a rule, I must know the consequences of my action in order to judge its desirability. This is a way of saying that all rules are conditional.

Thus, we see that it is possible to construct any deontological ethical system with a set of appropriately motivated consequentialist outcome measures; simply mandate a rule Y, and then define an outcome measure of "whether Y is followed."

We thus arrive at the conclusion that all ethical systems are both deontological and consequentialist in nature, since they all require a rule for motivation and an outcome measure for implementation. The dichotomy so beloved by today's political philosophers is in fact merely a rough difference in degree, not a fundamental difference in kind. In economics terms, pure libertarians put "liberty" (as they define it) in their preference relation instead of utility, and make social choices accordingly. And pure utilitarians are following as arbitrary a rule as any.

Of course, as I said at the beginning of this rant, this is not really how I like to think about ethics. I'm an Aristotelian rather than a Platonist when it comes to right and wrong; I see ethical systems more as attempts to order and classify a fundamentally jumbled empirical reality, rather than pure ideas from which real people's morals emerge. And as I see it, the is-ought rule means that internally self-consistent ethical systems are no intrinsically better than self-contradictory ones, so the whole exercise of trying to corral people's beliefs into a periodic table yields little practical benefit. My own ethical system is sometimes libertarian, sometimes utilitarian, sometimes both, and sometimes neither; and I'm fine with that

I think this all just feeds into my conviction that modern American libertarianism is way too focused on self-consistency and on ideological purity. All the colorfully illustrated political typologies in the world don't change the fact that if you force yourself to adhere to a rigid ideology, you inevitably end up looking like a complete doofus. Most smart libertarians are starting to realize that their principles are really a patchwork, and are suffering flak from the purists for every step they take away from dogma. Meanwhile, America - a pragmatic, patchwork, hodgepodge of a country if ever there was one - is slowly coming to the realization that pure libertarianism, like any moral "Theory of Everything," is just another intellectual snipe hunt.

## Monday, February 14, 2011

### Why don't Americans value social insurance?

Why don't people seem to realize the amount of government services they receive? I think Mark Thoma absolutely nails it:
People believe they paid for programs such as Social Security and Medicare. They put in contributions each month, the government saves that money somewhere, somehow, and when they use these programs they aren't consuming from "government," they are consuming their own contributions.

Thus, I believe the people answering this question are actually answering whether they've consumed services they didn't pay for in one way or another. The answers reflect the fact that most people believe that anything they get out of the system is far less than what they put into it (though in many cases that isn't actually true).

So it's true that people want the budget cut, but only the parts where people are forced to pay for "underserving" recipients of these government services.
This is perfectly in keeping with every conservative I've ever talked to. And it's hard to forget this conversation Matt Taibbi once had with a Tea Partier:
"Let me get this straight," I say to David. "You've been picking up a check from the government for decades, as a tax assessor, and your wife is on Medicare. How can you complain about the welfare state?"

"Well," he says, "there's a lot of people on welfare who don't deserve it. Too many people are living off the government."

"But," I protest, "you live off the government. And have been your whole life!"

"Yeah," he says, "but I don't make very much."
This Tea Partier isn't against government spending. He's not even against class-based income redistribution; in fact, it sounds like he'd be right at home in Sweden! But he's adamantly against people receiving government benefits unfairly.

Why do so many Americans think income redistribution is unfair? After all, as Thoma points out, it's really just a kind of insurance:
There is a need for social insurance...high moral character is not enough to protect you from the vagaries of the market system. One day a job can be gone, morals or not, savings can evaporate as a result, and all those years of doing the right thing -- putting a little away each month for the future -- provides little protection against financial ruin when there are no jobs to be found.
But for some reason, conservative Americans don't see that kind of insurance as something that they might ever need. Why not? I submit that a lot of it has to do with democracy's ultimate bogeyman: tribalism.

From the mid 70s through the mid 90s, America saw a massive and highly effective conservative campaign against anti-poverty programs. This campaign portrayed welfare recipients as being primarily black (remember "welfare queens"?). Of course, in reality, most American welfare recipients are white, since most Americans are white. But lots of people bought into the "welfare is for black people" trope, because of the base rate fallacy, and because of another commonly held stereotype: namely, that black people are lazy. Any hard-working white American, the conservatives told us, could find a new job if (s)he got laid off. The only reason you'd ever need social insurance is if you're lazy, and whites aren't lazy.

And after all, why would you want universal insurance if you think that you're of a type that never gets sick?

I was not, by a long shot, the first to notice this. Paul Krugman has pointed it out, as has Ezra Klein. And it was most extensively documented in Martin Gilens' book Why Americans Hate Welfare. From a review of the book:
Americans support helping the poor and are willing to support social programs that do not directly serve their own class interests; however, they are averse to supporting welfare because they believe that it primarily benefits African Americans and that African Americans lack a suitable work ethic.

White Americans believe that the majority of welfare recipients are black, even though the majority are white, because the news media consistently portray images of African Americans when reporting on poverty and welfare, Dr. Gilens points out. And to make matters worse, sympathetic stories about poverty are more likely to feature white families while critical stories more often than not focus on African Americans.
By convincing large swaths of white America that only "those lazy blacks" would ever need welfare, Republicans convinced their base to stop seeing welfare as insurance and to start seeing it as lump-sum racial income redistribution (motivated, perhaps, by liberal white guilt).

Few conservatives try to hide the fact that they believe something along these lines. After all, Rush Limbaugh and Glenn Beck both explicitly called health care reform "reparations."

In fact, I might go so far as to say that the entire post-Reagan conservative movement is held together by the bedrock assumption that "government spending" is synonymous with "taking money from whites and giving it to underserving blacks (and perhaps Hispanics)."  Every prediction of a crackup between libertarian "business conservatives" and authoritarian "social conservatives" has been wrong. The glue that holds the movement together is the fact that taxes (which business conservatives hate) go to fund the government spending that social conservatives equate with race warfare.

Sadly, anyone who has studied political economics won't find any of this very surprising. It has long been known that ethnic diversity makes it harder to get people to pay for public goods. Humankind, sad to say, tends to attribute economic outcomes to inborn racial differences. When a populace is diverse, there's always the suspicion that government spending will go to somebody else's tribe. (This is probably one reason that Africa, where post-colonial countries are a jumble of unrelated tribes, has such rapacious, irresponsible governments.)

America, with its polyglot immigrant background, just doesn't tolerate the welfare state that European and East Asian countries enjoy. That Tea Partier Taibbi met would be at home in Sweden...but Sweden we ain't.

So how are we going to fix this? Luckily, tribal identity is not fixed forever; there is evidence that, over time, national identity can overcome ethnic identity. And it's happened before, right here in America; Polish, Greek, Italian, and East European immigrants, once stigmatized, have by now been absorbed into the great mass of "whites." It sounds weird in this day and age, but I firmly believe that there's no reason Americans can't start to believe in an "American" tribe that cuts across all racial lines.

But unless and until we do manage to forge an American national identity, or somehow manage to disabuse people of the "lazy blacks, hardworking whites" stereotype, I'm just not sanguine about our hopes for getting real social insurance.

## Saturday, February 12, 2011

### Two examples of good informal economic analysis

I've spent the last couple of posts scoffing at the big ideas of a couple of big names in the econ blogosphere. But this isn't because I think all informal or off-the-cuff economic analysis is bad...far from it! And since I happened to encounter (what I consider to be) two really excellent examples of econ bloggery this week, I thought I'd share them, in order to show how I think it ought to be done.

The first econ blog win comes from Karl Smith at Modeled Behavior. He points out, far more elegantly than I managed, why much of rising inequality could easily just be a temporary result of globalization:

At the same time [we] are seeing massive growth in the pool of laborers. More laborers from rural China move to the city everyday and economic liberalism marches across South and South East Asia. This radically increases the pool of labor...

This means that the global economy is growing...but the size of the labor pool is growing faster and faster. Thus, labor’s slice of the economic pie is barely keeping pace with the size of the labor pool, itself. The result is a stagnant slice per laborer.

Indeed, I think the slice is probably declining in the Western World, so that a person with no knowledge or skills whatsoever, earns less today that he would have 20 years ago.

The greatest potential source of relief for low skilled Americans will be exhaustion of the global rural labor force. This will mean primarily a fully industrialized Asia. This will exert itself in one of two ways.

If Asian countries retain their very high savings rate then it will occur as enormous foreign direct investment (FDI) in the United States. Chinese and Indian corporations will set up shop in the United States and bid up the demand for raw US labor. One might be tempted to think that this FDI will only support “skilled jobs” but marginalist thinking suggests not.

As the price of skilled workers rises some tasks will be substituted by unskilled workers. Making predictions about what this will look like is hard, especially since it involves the future. However, an one easy vision is to imagine a world where grocery stores turn into a massive “fresh counters” where all the prep work necessary for your meal is done to order from fresh ingredients. You go home with little premeasured containers that you can combine into the recipe you want as easily as Food Network chefs do.

This is a pampered life for high skilled workers, but its also a world in which unskilled workers can regularly find work capable of supporting their families and an ever increasing standard of living.

Another alternative is for savings in Asian to decline, which would shift the balance of trade and cause at least a temporary surge in manufacturing done in the US. The transition period would be different in this scenario, but the end game likely the same. There would be a bidding up of the returns to capital in the US and rather than FDI, domestic investment would bring about the future.
I'd also like to spotlight Peter Dorman's comment on the prediction of bubbles. He points out, quite rightly, that the much-ballyhooed Efficient Markets Hypothesis only makes the timing of bubbles impossible to predict, not their actual existence:
One answer we keep hearing to that entirely reasonable question, “Why didn’t economists predict the crash?”, is that economic theory, in the form of the Efficient Markets Hypothesis, proves that reliable prediction is impossible...[N]o one outpredicts the market on a regular basis, so there is no reliable way to know whose predictions today will prove correct in the future. This, we are told, is the lesson we need to learn from the EMH.

The logical fallacy here is so obvious that I would not bother with this post if it were not for the persistence of the EMH defense. So here goes...

The [EMH says] that, while market prices may not always be a great guide to real economic forces, their movements are not systematically predictable. At every moment, prices reflect all the forecasts of all the market participants who, between them, have access to all potential information and ways of utilizing it. A price moves only when new information arises. But to be truly new, this information has to be unpredictable—otherwise it is simply an inference from information that already exists. Because the information is unpredictable, so is its effect on prices. The randomness of price movements in turn implies that no one can outperform the market in betting on where they will go.

I have no problem with this. The fallacy arises when this argument is invoked to deny the possibility that economists can identify bubbles in real time. If you’re so smart you can spot a bubble, why aren’t you rich? If people could spot bubbles with any predictability, then the EMH would be wrong—but we know it’s right.

Let’s put aside the possibility that [the] EMH can be wrong from time to time. We don’t need to go there; the error is more basic than this.

Let’s put ourselves back in 2005...Based on my perceptions, I anticipate a collapse in this market. What can I do?

If I am an investor, I can short housing in some fashion. My problem is that I have no idea how long the bubble will go on, and if I take this position too soon I could lose a bundle...What the EMH tells us is that, as an investor, not even your prescient analysis of the fundamentals of the housing market would enable you to outperform [the market].

The logical error lies in confusing the purposes of an investor with those of a policy analyst. Suppose I work for the Fed, and my goal is not to amass a personal stash but to formulate economic policies that will promote prosperity for the country as a whole. In that case, it doesn’t much matter whether the bubble bursts in 2006, 2007 or 2010. In fact, the longer the bubble goes on, the more damage will result from its deflation...

To profit from one’s knowledge of a market condition one needs to be able to outperform the mass of investors in predicting market turns, which the EMH says you can’t do. Good policy may have almost nothing to do with the timing of market turns, however.
I only wish that posts like these would get as much attention as the more flashy but less well-grounded stuff.

## Tuesday, February 08, 2011

### "Act of God" Economics

"Experts have their expert fun / ex cathedra, telling one / just how nothing can be done."  - Piet Hein

First, a disclaimer: I have not read Tyler Cowen's e-book The Great Stagnation, and - unless somebody decides to pay me to read it - I have no plan to do so. But, based on having read a bunch of reviews of the book, as well as Cowen's own summary of the ideas contained therein, I think I have a pretty good idea of what it's about, and I don't think I'm making a huge mistake by skipping it. Economists may be in the business of telling bedtime stories, but not all stories are created equal.

Cowen's main thesis is that the stagnation in American median income over the past few decades is due to a failure of technological innovation. Scientists and engineers, he claims, are just not inventing useful stuff fast enough to raise our standard of living. The reason is that we've already picked all of the Universe's "low-hanging fruit":
Most well-off countries have experienced income growth slowdowns since the early 1970s, so it would seem that a single cause is transcending national borders: the reaching of a technological plateau. The numbers suggest that for almost 40 years, we’ve had near-universal dissemination of the major innovations stemming from the Industrial Revolution, many of which combined efficient machines with potent fossil fuels. Today, no huge improvement for the automobile or airplane is in sight...

Although America produces plenty of innovations, most are not geared toward significantly raising the average standard of living. It seems that we are coming up with ideas that benefit relatively small numbers of people, compared with the broad-based advances of earlier decades, when the modern world was put into place. If pre-1973 growth rates had continued, for example, median family income in the United States would now be more than \$90,000, as opposed to its current range of around \$50,000.
There are plenty of things wrong with this thesis. The first, as some have pointed out, is that Americans' average standard of living (as opposed to the median) has continued rising steadily since '73. Check out this graph of U.S. real per capita GDP from 1870 through 2008:
Can you see a slowdown since 1973? I can't. The per capita picture is no different. If technology represents our economy's ability to produce stuff that people will pay for, then technology has not stagnated since the 70s.*

What has happened is that average income and median income have diverged, as inequality has increased. Cowen attempts to sneak around this point by saying that, well, yes, actually innovation did continue, but the recent innovations have just happened to be things that benefit only a small subset of the population. (I guess this is kind of a hand-waving version of the theory of skill-biased technological change.)

There's only one problem with this little caveat: it totally demolishes the plausibility of Cowen's "low-hanging fruit" idea. Why should inventions that benefit the masses be easier to come up with than things that help only the elite? I can't think of a reason why this should be the case. If Cowen knows such a reason, he doesn't mention it in his articles or blog posts.

So we're left with...a circular argument. How do we know that mass-benefit innovation has slowed? Only because median income has stagnated. So why has median income stagnated? Well, because mass-benefit innovation has slowed, of course!

Seriously??

In fact, in making claims about the rate of innovation, Cowen was always on shaky ground, because the consumption benefits of innovation are notoriously hard to measure. I'll outsource this argument to Stephen Williamson, who lists a bunch of ways that life for the common person has improved since the 60s, and to Ryan Avent, who points out that innovation can lower the prices of things to the point where it's hard to measure their value. Both are excellent, insightful posts.

But instead of rehashing their arguments, I want to go on to point out something about Tyler Cowen and the stories he tells about the economy.

Recall that Cowen's last big idea was "zero-marginal-product workers" - the idea that even though all people are smart enough to be perfectly rational economic calculators capable of handling infinite amounts of data (as they must be if labor markets are to function frictionlessly), unemployed workers are nevertheless too useless to be paid to spread cream cheese on a bagel. Hmm. The idea that our economic woes are caused by stagnating innovation seems downright reasonable in comparison!

But the two ideas have something big in common. They both imply that our economic problems are purely exogenous - that they are, in essence, acts of God. The implication is that we - meaning our collective use of economic policy through the government - are profoundly helpless to do anything to boost median income growth, and that therefore we should not even try:
Sooner or later, new technological revolutions will occur, perhaps in the biosciences, through genome sequencing, or in energy production, through viable solar power, for example. But these transformations won’t come overnight, and we’ll have to make do in the meantime...In the narrow sense, the solution to the stagnation of median income will not be a political one...Until science has a greater impact again on average daily living standards, the political problem will be in learning to live within our means.
So, no stimulus or quantitative easing to boost growth. No new spending on public goods like roads or research. Forget about the fact that most of the major innovations of the 20th century either had their roots in government-funded research, or depended heavily on government-funded infrastructure.

I am just going to go out on a limb here and guess that Cowen's willingness to embrace "Act of God" Economics is in some way related to his well-known and oft-reaffirmed libertarian ideology. When you believe deep down that government can't be the solution, you tend to look for reasons why problems are cosmic in nature.

But come on...can't libertarian economists do better than this**? Just looking at income growth, relabeling it "technology," saying "Well, that's that!" and going home at noon? That strategy was bad enough when the Real Business Cycle people tried it to explain recessions...but as an explanation for the divergence in income between the rich and the middle class, it starts to just look like whistling in the dark.

* Total factor productivity, a quantity economists often use to measure technology's total contribution to production, did slow down in the late 70s and much of the 80s, but has boomed since the early 90s, even as median income has grown more and more slowly.

** This seems to be a common refrain in my posts of late.

## Sunday, February 06, 2011

### The Wrongness of Raghuram Rajan

Since the crisis, Raghuram Rajan has emerged as the "reasonable conservative" voice of the econ blogosphere. Although many of his points are quite contentious (e.g. that the housing bubble was caused by govt. policies to help poor people buy houses), he has analyzed the crisis in a thoughtful and dispassionate manner. That said, I think he is often very, very wrong.

Consider, for example, his answer to the question of
why economists failed to predict the crisis:
Why did academic economists fail to foresee the crisis?

There have been several responses to that query. One is that economists simply lacked models that could account for the behavior that led to the crisis. Another is that economists were blinkered by an ideology according to which a free and unfettered market could do no wrong.

Finally, an answer that is gaining ground is that the system bribed economists to stay silent.

In my view, the truth lies elsewhere.
Rajan's rebuttals to these contentions are startlingly weak. Let's start with his defense of economists' models:
It is not true that we academics did not have useful models to explain what happened. If you believe that the crisis was caused by a shortage of liquidity, we had plenty of models analyzing liquidity shortages and their effects on financial institutions. If you believe that the blame lies with greedy bankers and unthinking investors, lulled by the promise of a government bailout, or with a market driven crazy by irrational exuberance, we had studied all this too, in great detail.
What he's saying is not technically wrong. Yes, economists did have models that could describe something a bit like the crisis of 2008 (or, more often, one small piece of it). But - and Rajan utterly ignores this fact - those models were not widely used by members of the economics profession as the basis for policy advice!

You just did not see Larry Summers or Greg Mankiw or Alan Greenspan or other prominent policy advisors saying: "Look, economists have this model that predicts liquidity shortages, and we think there is a real danger that one could happen if a bunch of these complex derivatives go bust." Or take Ben Bernanke who became famous for inventing the "financial accelerator" model, which explained how debt crises could spill over into the real economy. Did we ever see Bernanke using that model as a basis to push for limits on bank leverage during his tenure as Fed chairman? No.

In my opinion, the problem is not that economists lack a wide variety of models, but that they lack the means by which to choose between these models. When push comes to shove, economic advisors go with their gut instincts, selecting the model that they think tells the most plausible "story". In practice, this means models that don't rock the boat. Furthermore, acclaim and recognition are often given to the modelers who pioneer new mathematical tools, even if their models are terrible at describing the real economy (Ed Prescott's Nobel-winning "real business cycle" model comes to mind).

Rajan completely ignores all this.

Now let's look at Rajan's rebuttal to the idea that free-market ideology blinded economists to the dangers of a crisis:
Perhaps the reason was ideology: we were too wedded to the idea that markets are efficient, market participants are rational, and high prices are justified by economic fundamentals. But some of this criticism of “market fundamentalism” reflects a misunderstanding. The dominant “efficient markets theory” says only that markets reflect what is publicly known, and that it is hard to make money off markets consistently – something verified by the hit that most investor portfolios took in the crisis. The theory does not say that markets cannot plummet if the news is bad, or if investors become risk-averse.
Rajan seems to be arguing against his own point here! As he notes, efficient markets theory says that crises cannot be predicted in advance. As an explanation of why economists failed to predict the crisis, the fact that many of them believed that crises can't be predicted sounds rather plausible, does it not?

He continues:
Critics argue that the fundamentals were deteriorating in plain sight, and that the market (and economists) simply ignored it. But hindsight distorts analysis. We cannot point to a lonely Cassandra like Robert Shiller of Yale University, who regularly argued that house prices were unsustainable, as proof that the truth was ignored. There are always naysayers, and they are often wrong. There were many more economists who believed that house prices, though high, were unlikely to fall across the board.
So, the crisis must have been unpredictable, because most economists failed to predict it. So of course most economists failed to predict it - after all, it was unpredictable! Wow. This is just about the tightest loop of circular logic that it's possible to make.

Finally, we have Rajan's reasons why corruption in the profession was not a big part of the problem:
Could it be corruption? Some academic economists consult for banks or rating agencies, give speeches to investor conferences, serve as expert witnesses, and carry out sponsored research. It would be natural to suspect us of bias. The bias could be implicit: our worldview is shaped by what our friends in industry believe. Or it may be an explicit bias: an economist might write a report that is influenced by what a sponsor wants to hear, or give testimony that is purely mercenary.

There are enough instances of possible bias that the issue cannot be ignored...But I believe that corruption is not the main reason that the profession missed the crisis. Most economists have very little interaction with the corporate world, and these “unbiased” economists were no better at forecasting the crisis.
Rajan is defining corruption rather narrowly here. Although few economists were probably complicit in actual wrongdoing, the conflict of interest is widespread and fundamental. The finance industry provides the main source of non-academic employment for economists; this demand pushes up the salaries of econ professors everywhere (econ profs are very well paid compared to most other fields). For an academic economist, suggesting that the finance industry should be curbed, shrunk, or regulated is equivalent to advocating the devaluation of his/her own profession.

Economists didn't have to be corrupt to ignore the dangers of a crisis; they just had to be self-interested in the normal sense. (Note: the pic at the top is of Rajan receiving a "Business Book of the Year" award from the CEO of Goldman Sachs. Interpret that as you will.)

After making this string of highly dubious points, Rajan goes on to point out some alternative reasons for economists' failure: overspecialization within the profession, the "ivory tower" disconnect, and the difficulty of forecasting a chaotic system like the macroeconomy. These are good ideas, and I believe that they all played some role. But I think that the failure of macroeconomics is multidetermined. And Rajan has just not done a good job of refuting the notion that a great many economists were ignoring relevant models, blinkered by ideology, and struggling with conflicts of interest.

Is this really the best defense the "reasonable conservative" economists can muster?