Saturday, June 29, 2013

The dream of a post-racial America

David Brooks has a very interesting column about America's multiethnic future. This is a topic I've been thinking about for quite a while, especially after some Twitter conversations with some hard-core anti-immigrant nativists. Brooks' most important point is that America's increasing racial diversity is inevitable now:
[U]p until now, America was primarily an outpost of European civilization. Between 1830 and 1880, 80 percent of the immigrants came from Northern and Western Europe. Over the following decades, the bulk came from Southern and Central Europe. In 1960, 75 percent of the foreign-born population came from Europe, with European ideas and European heritage.
Soon, we will no longer be an outpost of Europe, but a nation of mutts, a nation with hundreds of fluid ethnicities from around the world, intermarrying and intermingling... 
If enacted, the immigration reform bill would accelerate these trends...It would boost the rise of non-Europeans...In other words, immigration reform won’t transform America. It will just speed up the arrival of a New America that is already guaranteed... 
On the whole, this future is exciting. The challenge will be to create a global civilization that is, at the same time, distinctly American. Immigration reform or not, the nation of mutts is coming.
I agree that this future is exciting. It is also scary and dangerous.

On Twitter, one of the nativists I talked to (a guy called "Heartiste") predicted that new immigrants wouldn't acquire the same national identity that earlier immigrant groups acquired, because of racial differences. A white immigrant, he argued, can acquire the culture of America's Northwest European founders, but a nonwhite immigrant cannot.

I'm much more optimistic than Heartiste, but I have to admit that what he brings up is a real worry. There is evidence that ethnic diversity reduces people's willingness to support public good provision, and that ethnic diversity makes people less likely to support redistribution. And George Orwell noted that a sense of group solidarity was essential to national defense during World War 2.

This implies that when people don't feel a sense of "in-group" commonality with their countrymen, the collective mechanisms of society break down. This is essentially the notion of "volksgemeinschaft", developed by the Germans during World War I (the height of German nationalism). It provides a rough-and-ready explanation for why Japan has such good public infrastructure, and why Sweden is such a redistributive, egalitarian society.

America seems to be already suffering from a lack of "volksgemeinschaft". The popular notion that government spending is mostly racial redistribution (from whites to blacks), promulgated by conservatives like Rush Limbaugh, has made even poor white conservatives implacably anti-government (unless their own Medicare benefits are threatened, of course). As a result, not only are we more unequal than the ethnically homogeneous rich countries of Europe and East Asia, but we have inferior public good provision - crumbling highways, falling bridges, slow internet, etc.

Will nonwhite immigration make this worse? I hope not, but I think the possibility exists.

But like I said, I am a lot more optimistic than the nativists. Why? Because I see lots of examples where multiracial nations end up working pretty well. But there's a catch - they all seem to do it by becoming post-racial.

Two good examples are Japan and Turkey. Talk to any Japanese person, and he or she will tell you that there is only one "Japanese" race. But look at Japanese people's faces, or do genetic tests, and you find that there is a fair amount of diversity; some Japanese people look like Polynesians, while others look like Russians. But these physical differences are not recognized as constituting "real" ethnic differences. Turkey is an even more extreme example; plenty of Turks look like what we would call "white" people, and plenty of others look very dark-skinned and sort of Arabic, while a few even have an East Asian look to them. But they are all just "Turks". Of course, these synthetic ethnicities took centuries to construct.

An even better example is..."white" America. Europeans, you'll notice, do not consider themselves to all be of the same "white" race; "whiteness" is an American invention. And it's an invention that keeps changing. When the country was founded, Germans and Swedes were not considered "white", but that changed as they immigrated in large numbers in the 19th Century. At that time Italians, Greeks, and other South Europeans were still not considered "white", until large numbers of them immigrated here in the 20th century. Nowadays, few if any Americans would deny that Italians are "white people". The group keeps expanding to include people who look more and more physically different from each other.

But the "white-ification" trick isn't going to work this time around. Many Hispanics will be inducted into the "white" category, but it is highly unlikely that Chinese or Indian immigrants will ever be called "white".  And Asia is where the bulk of our net immigration is coming from. If we're going to forge ethnic solidarity between whites, Asians, and the Hispanic immigrants who don't see themselves as "white", then we are going to have to find another way.

What we're going to have to do, I think, is create the notion of an "American" ethnicity.

First and foremost, this means having a common language. That language will be English. Language, it seems to me, is one of the main things (along with race and religion) that defines an ethnicity. Fortunately, despite the dire warnings of people like Sam Huntington, Hispanic immigrants seem to be switching from Spanish to English at a rate equal to or even faster than earlier ethnic groups. "Official language" and "English only" laws will not be required. And Asian immigrants are even less of a worry on this front.

Next, it means intermarriage. Racial mixing will hopefully reduce frictions between groups. As David Brooks says, we must become "a nation of mutts" (if you don't like the canine analogy, fair enough, but dog lovers will know that mutts tend to be healthier and smarter than purebreds!). Fortunately, interracial marriage is proceeding at a very rapid rate, especially for East Asians and Hispanics (South Asians are a notable exception). In terms of actual policies to encourage more intermarriage, the only thing I can think of is urbanism, which leads to more chance encounters with people from different social groups.

On the intermarriage front, history gives us reason to be hopeful. As an example, take my own ancestral religio-ethnic group - Jews. Once famed for their insularity and refusal to outmarry, Jews now have an outmarriage rate of over 50% in the United States (and that percent is going up). Jews are a much smaller group than Asians, of course, but the precedent is encouraging.

I hope that English, intermarriage, and our ubiquitous pop culture will be enough to forge a unique post-racial "American" national identity. They might be. But I worry that more might be needed. Last time we assimilated a large group of immigrants, we had the special event of World War 2 to bring different American ethnicities into close contact, force them to work together, and forge a bond against a common enemy. Thankfully, another war on that scale looks unlikely, but it means we might not get the "freebie" in terms of assimilation this time around.

Therefore, I think we - and by "we" I mean pro-immigration Americans - need to start thinking about revising our negative opinion of nationalism and cultural assimilation. The World Wars understandably gave nationalism a bad name in intellectual circles - things like pledges of allegiance, national anthems, and patriotic history classes were seen as forms of militaristic mind control. There is merit to this view. Ancestral cultures should not be purposefully stamped out or denigrated, and blind worship of the nation-state is of course a very dangerous thing.

But that said, I think we need to realize that in order to assimilate the new waves of immigrants as effectively and rapidly as possible, we should temper our distrust of nationalism and assimilation. This is more a matter of values than of actual policy. Liberals in particular should tone down our rhetoric against American flags, "jingoism", and other expressions of nationalism. And the idea that "multiculturalism" requires resistance to assimilation, and the deliberate preservation of pockets of ancestral cultures within the American whole, probably needs to go by the wayside; remnants and pockets of ancestral culture will preserve themselves just fine on their own. But a unified national culture seems like it needs more active encouragement.

On the whole I think we are already moving in this direction. The much-discussed idea of "universal national service", though probably impractical, shows that liberals are starting to remember the society-building value of the nationalism of the FDR years.

But all the assimilation and nationalism in the world will be a moot point if large groups of white Americans refuse to accept the new nonwhite immigrants. This seems to me to be the biggest danger, since our current lack of "volksgemeinschaft" seems to stem largely from conservatives' insistence that blacks, Hispanics, and urban liberals are not "real Americans". That has to stop; conservatives need to do their part in making the newcomers feel like a real part of the team. That means elevating conservative values like hard work and family values and entrepreneurial spirit - which immigrants tend to have in great quantities - above breeding and bloodlines and skin color. Conservatives need to kill their bad habit of pointing at anyone whose race they don't recognize and saying "macaca".

Anyway, like I said, I am very optimistic about the new waves of immigrants. I do not believe that they will cause our nation to disintegrate. I believe that America is not like the Germany or France or other countries that have struggled with mass immigration. America started as a multi-ethnic experiment, and we have a special ability to turn huge numbers of foreigners into normal, regular, Americans at a very rapid pace (thus altering our own culture in the process). And the signs are encouraging: Even with the percentage of foreign-born residents at an all-time high and the economy still in the doldrums, native-born Americans' attitudes toward immigrants are as positive as they've been since we started taking polls.

I was in Union Square Park in New York recently, and I was looking at the statue of George the foot of the statue, kids from every nation you could imagine were hanging out, sharing cigarettes, hitting on each other, skateboarding, and generally being goofy. Black kids, South Asian kids, East Asian kids, plenty of white kids too. I wondered what old George would think if he could see what the country he started had become. Maybe I'm wrong, maybe I'm just being romantic, but I think he'd be pretty damn pleased.

Thursday, June 27, 2013

I get what you get in ten years, in two days

"I get what you get in ten years, in two days."
- Chris Brown, "Look at Me Now"

Plenty of folks have turned out to attack Greg Mankiw's essay, "Defending the One Percent". Most of them have focused on Mankiw's numbers and factual assertions. I thought I'd take a different approach, because at its core, Mankiw's differences with the bulk of the economics world are more about values than facts.

The usual economist case for income redistribution is based on utilitarianism; the idea is that $1000 matters more to a poor person than to a rich person. Mankiw wants to ditch this idea in favor of a value system based on "just deserts":
An alternative to the social insurance view of the income distribution is what, in Mankiw (2010), I called a “just deserts” perspective. According to this view, people should receive compensation congruent with their contributions. If the economy were described by a classical competitive equilibrium without any externalities or public goods, then every individual would earn the value of his or her own marginal product, and there would be no need for government to  alter the resulting income distribution.
Here is that 2010 Mankiw essay, which is very similar to the recent one.

Now, value systems are subjective; what the government should or shouldn't do is a matter of opinion. But I think it's worthwhile to think through the implications of Mankiw's "just deserts" value system.

To do this, let's do a thought experiment, and compare two imaginary people - just for fun, let's make them two American white males in their mid-40s. The first let's call Brad CEO. He's the CEO of a big company and makes $30 million a year, which is just a tad less than the CEO of Phillip Morris made in 2012. The second let's call Mike Clerk, who works at Wal-Mart, earning the average Wal-Mart wage of $12.40 an hour, or a bit over $25,000 a year. Mike is hardly unusual, income-wise; in fact, somewhere between 20% and 25% of American households make less than Mike. Furthermore let's assume that taxes are zero; this is a world where everyone gets his "just deserts" (Note that because of elasticity, this means that Brad CEO actually takes home more than the CEO of Phillip Morris would take home in the absence of taxes; so perhaps Brad is more accurately compared to the CEO of Abercrombie & Fitch).

In 10 years, Mike gets $250,000. That is about what Brad gets in three days (not two; sorry, Chris Brown).

Now let's imagine that Mike wants to buy something big - say, a new Honda Civic (disclosure: I drive a Honda Civic). That costs about $18,000. So Mike has to save up to afford it (sure, he can just finance it, but then he has to make payments, which amounts to much the same thing). How long does it take him to save up $18,000? Let's suppose that Mike is an extraordinarily thrifty man (following the advice of blogger Noah Smith), and lives well under his means - eating cheap fast food or low-quality grocery store food without much meat content, living in a small studio apartment, biking to Wal-Mart each morning, etc. By these heroic efforts, he manages to put aside 25% of his income - over eight times the average household savings rate in America today - just to buy that Honda. (Assume the risk-free rate of return is around zero, as in America today).

It takes Mike about 5,800 hours of work to afford the Honda Civic. That is about three years of full-time work.

So Mike works and works and works, for three years. Stocking the stockroom. Punching the cash register. Dealing with angry customers. Putting boxes up on shelves. Hour after hour. Day after day. Biking home to eat his low-quality vegetarian meals in his tiny studio apartment. At the end of those three years, Mike's hands are a little more wrinkled, his hair a little grayer, his back a little stiffer. Those three years represent about 4% of Mike's entire lifetime. But he finally does it. Three years after he decided he wanted one, there it is, in his parking lot: a beautiful brand-new Honda Civic.

Now let's go over and look at Brad. Suppose Brad randomly sees Mike's new Civic in a parking lot and decides that he wants the same car. Like Mike, he decides to set aside 25% of his income to buy it. At this rate, assuming a 40-hour workweek and 50 weeks of work per year, Brad will have to work a little less than 5 hours. That's slightly more than half of one working day. Go to a couple meetings, send some emails, and the Civic is his.

Now suppose Mike goes to Greg Mankiw and asks: "Dr. Mankiw, why is it right and just that it took me 4% of my entire lifespan to buy this car, with all my heroic efforts and harsh self-denial, when it took that Brad CEO guy less than a day? I put in every bit as much effort as he does, day after day. Why does he deserve to get things with so much less effort than I put in?"

Dr. Mankiw responds:
I am more persuaded by the thesis advanced by Claudia Goldin and Lawrence Katz (2008) in their book The Race between Education and Technology. Goldin and Katz argue that skillbiased technological change continually increases the demand for skilled labor. By itself, this force tends to increase the earnings gap between skilled and unskilled workers, thereby increasing inequality...The story of rising inequality, therefore, is not primarily about politics and rent-seeking but rather about supply and demand... 
If Goldin and Katz are right that the broad changes in inequality have driven by the interaction between technology and education...then it would seem an unlikely coincidence that the parallel changes at the top have been driven by something entirely different. Rather, it seems that changes in technology have allowed a small number of highly educated and exceptionally talented individuals to command superstar incomes in ways that were not possible a generation ago.
"OK," Mike says. "But why, then, is Brad CEO so much more productive than I am? Where does his $30 million productivity come from?"

Dr. Mankiw responds:
[T]he intergenerational transmission of income has many causes beyond unequal opportunity. In particular, parents and children share genes, a fact that would lead to intergenerational persistence in income even in a world of equal opportunities. IQ, for example, has been widely studied, and it has a large degree of heritability. Smart parents are more likely to have smart children, and their greater intelligence will be reflected, on average, in higher incomes. Of course, IQ is only one dimension of talent, but it is easy to believe that other dimensions, such as self-control, ability to focus, and interpersonal skills, have a degree of genetic heritability as well.
"So let me get this straight," Mike says. "Brad deserves to be so much richer than me because of ability he was born with? People who are lucky enough to be born with high skills deserve to be able to get a Civic in half a day, while people who were born with fewer skills deserve to have to slave away for years if they want a Civic?"

Anyway, Dr. Mankiw's answer is not forthcoming, and Mike cannot leave a comment on Mankiw's blog, due to the no-comments policy. So our story continues.

Mike falls off of a ladder one day (he's in his late 40s by now, and less coordinated than he used to be). He's able to work, but only with greatly increased pain. In the old days, before Mankiw's "just deserts" theory gained widespread acceptance, Mike would have been able to collect Social Security disability; now, however, the government tells him that he does not deserve disability payments - they constitute an unfair transfer of income from the productive to the unproductive - and so he must continue to work. Additionally, Mike cannot go to physical therapy because he cannot afford health insurance, and Medicaid was canceled because Medicaid payments do not constitute the "just deserts" of the unproductive.

So Mike continues working for a short time, until his company is forced to downsize by changes in the global economy. Wal-Mart closes Mike's store and lays him off. In the old system he would collect unemployment insurance payments, but now the government tells him that unemployment payments are not his "just deserts".

Anyway, this tale is getting a bit maudlin, so I will abandon it in the middle; if you want stories about poor people that actually have endings, go read Charles Dickens. But hopefully by now I've made my point. It's easy to say that people deserve to get whatever they can manage to get in a "free" market. But when you start to actually think about the consequences of such a system, you realize that it probably doesn't fit very closely with most people's concept of the term "just deserts".

Like I said, moral values are just statements of opinion, and Greg Mankiw is certainly entitled to his own. But I somehow doubt that his opinion of "just deserts" will be able to win over a majority of Americans, even among the intellectual classes.

Wednesday, June 26, 2013

Some essential papers in behavioral finance

Nobody quite knows what "behavioral finance" means, and that's a good thing. Essentially, modern finance theory began with the notion of "efficient markets", risk-return tradeoffs, and complete markets. That theory remains the mainstream in academic circles. But at least since the 80s, finance researchers have been noticing "anomalies" in the predictions of efficient-market theories and mainstream risk models. Attempts to explain these anomalies, or to dig up more of them, loosely fall under the heading of "behavioral finance", probably because in the 80s, behavioral economics was just becoming popular. But behavioral finance isn't just behavioral econ applied to finance; it includes a whole big eclectic mix of ideas and observations about market institutions, overall market movements, and information processing, and at this point is really just "anything that isn't efficient-markets finance". The literature is really all over the place. But here are a few foundational papers to get you started.

"Speculative Investor Behavior in a Stock Market With Heterogeneous Expectations", by J.M. Harrison and David Kreps (1978)
This paper came out at a time when devotion to extreme rationality was de rigeur in most economic circles. Harrison and Kreps assume that investors have extreme irrationality, being so overconfident in their differing beliefs that they never reach agreement. As a result, financial assets carry a "speculative premium", because holding an asset gives you the option to resell it in the future to someone more optimistic than yourself. This paper really spawned the whole "overconfidence" literature, and the "heterogeneous beliefs" literature too. When Tom Sargent called himself a "Harrison-Kreps Keynesian", this is the paper he was talking about.

"On the Impossibility of Informationally Efficient Markets", by Sanford Grossman and Joseph Stiglitz (1980)
This paper basically killed the "strong form" of the Efficient Markets Hypothesis. The intuition has become so common that you might even be surprised that someone wrote a paper on it. Basically, if all information is already incorporated in market prices, then there's no incentive for anyone to go gather information. In the model in this paper, prices are just "wrong" enough to justify the cost of going out and finding new information. But we all know that in the real world this is highly unlikely to be true. The idea of "information externalities" in financial markets comes in part from this paper.

"Do Stock Prices Move Too Much to be Justified By Subsequent Changes in Dividends?", by Robert Shiller (1981)
What if your weather forecaster kept switching his one-week-ahead forecast between 85 degrees Fahrenheit and 15 degrees Fahrenheit? You would fire that forecaster. But if you think stock markets are efficient, then stock markets should be the best possible forecaster of future dividends, since dividends are the "fundamental value" of stocks. In this famous paper, Shiller showed that stock prices fluctuate more than the eventual dividends that they were supposed to have forecast. Whatever is making stock prices gyrate, it doesn't look rational.

"Information, Trade, and Common Knowledge", by Paul Milgrom and Nancy Stokey (1982)
This paper might not strike you as behavioral, since it discusses hyper-rational behavior in an efficient market, and was written by the wife of Robert Lucas. But actually, this paper is about the fact that rational-expectations theory almost certainly can't explain real-world markets. The basic reason: if everyone were rational, and this was common knowledge, there wouldn't be much trading, because everyone would always be second-guessing their counterparty (e.g. "Why would you sell me this stock at $100 if you didn't think it was worth less than $100?", and so on). The fact that we see such huge trade volumes in real-world markets means that there is probably a lot of irrationality out there.

"Does the Stock Market Overreact?", by Werner DeBondt and Richard Thaler (1985)
Here's an easy way to beat the stock market: Buy the stocks that did the worst over the past 5 years, and hold onto them for another 5. Ta-da! DeBondt and Thaler show that this strategy makes more money than just holding an index fund. Under Efficient Markets theory, that should not be the case. This is known as the "long-term reversal" anomaly.

"Bubbles and Crashes in Experimental Asset Markets", by Vernon Smith, Gerry Suchanek, and Arlington Williams (1988)
The paper that started essentially all of experimental finance. Basically, the authors put some college kids in the simplest possible artificial market setup. It should have been a no-brainer, but what happened, again and again and again, was a giant bubble and crash.

"Noise Trader Risk in Financial Markets", by J. Bradford De Long, Andrei Shleifer, Lawrence H. Summers, Robert J. Waldmann (1990)
What would you do if a horde of zombies was running your way? If there were only a few you might stand and fight, but if there were enough zombies you might have no choice but to turn around and run in the same direction, essentially becoming a zombie yourself. This is the basic idea of "noise trader" models, which show how smart, rational traders can be overwhelmed by irrational hordes of "noise traders". In a bubble situation, the smart money finds it necessary to imitate the dumb money, and smart investors "ride the bubble", making the eventual crash even bigger.

"Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency", by Narasimhan Jegadeesh and Sheridan Titman (1993)
This paper is kind of the mirror image of the DeBondt and Thaler paper above. Jegadeesh and Titman show that if you buy the stocks that performed best over the past three to twelve months and hold onto them for another few months, you will beat the market. This is the famous "momentum anomaly", and represents a severe violation of the Efficient Markets Hypothesis. Together with the long-term reversal anomaly, it implies a market where stock prices regularly "overshoot" and then return to a more reasonable level. 

"Boys Will Be Boys: Gender, Overconfidence, and Common Stock Investment", by Brad Barber and Terrence Odean (2001)
Guess what? You really suck at investing. And the reason is that you trade too often, ignoring the costs you pay every time you trade. Why do you do this? Well, maybe because you are overconfident, and you think (wrongly) that you know better than the market how to interpret the latest piece of news or data. If this is the reason, then you are more likely to over-trade if you are a man than if you are a woman, since psychologists have shown that men on average display more overconfidence than women. And guess what? The evidence says that this is true. Looking at data from a discount brokerage, Barber and Odean found that male individual investors trade more than female ones, and incur greater losses as a result.

"Hedge Funds and the Technology Bubble", by Markus K. Brunnermeier and Stefan Nagel (2004)
If "noise trader" models are right, then "smart money" investors like hedge finds should ride bubbles instead of trying to pop them. Looking at data on hedge fund behavior during the tech bubble, Brunermeier and Nagel find that this is exactly what happened.

"Subjective Expectations and Asset-Return Puzzles", by Martin Weitzman (2007)
One long-standing puzzle in financial economics was the fact that stocks tend to have much better returns than bonds, despite not having that much more risk. But as Martin Weitzman shows in this paper (with some fearsome math), the risk of stocks looks a lot larger if investors aren't sure about the underlying structure of the world. Which, of course, they aren't.

Anyway, these papers will get you started thinking about behavioral finance! Obviously there is much newer stuff, and topics other than's a big and growing field. A very exciting one in which to work, if you ask me...

Update: People have been asking "Why no prospect theory?" Obviously, "Prospect Theory: An Analysis of Decision Under Risk" (Daniel Kahneman and Amos Tversky, 1979) is one of the most important, if not the most important, behavioral econ papers ever written. And people have certainly tried to apply that theory in finance.

Podcast: All about Abenomics

Yesterday I did a very fun interview with Cardiff Garcia and Izabella Kaminska of the Financial Times, for the FT's Alphachat podcast.

The main themes were:

1. Abe, and BOJ governor Kuroda, really did surprise me with their bold monetary policy steps. But that doesn't mean the monetary stimulus of Abenomics is necessarily going to work, because A) no one really knows how or if QE really works to raise inflation, and B) there are still doubts about the willingness of the powerful and conservative Japanese Ministry of Finance to allow higher inflation in the future.

2. The BOJ is wary of capital flight, which would raise government borrowing costs. Japanese investors and policymakers may not understand or recognize the difference between interest rate rises from a recovering economy and interest rate rises from capital flight. This may make the BOJ reluctant to follow through on its promises of doing "whatever it takes" to cause inflation.

3. Structural change might help the Japanese economy a lot, but it would involve wrenching social change that nearly everyone in Japan is dreading (though many believe the changes are inevitable). So don't expect too much out of the "third arrow" of Abenomics.

Listen to the whole thing here!

Saturday, June 15, 2013

Why I am a fiscalist

The FT's Cardiff Garcia has a great rundown of the two factions within the pro-stimulus camp in the macro policy debate:
Fiscalists vs market monetarists is a breakout skirmish between rivalrous, unnatural allies whose common antagonists are in retreat...To recap, this debate is about the best way to accelerate the recovery and return to pre-crisis trend growth while interest rates are at the zero lower bound. (When rates are above the ZLB, many fiscalists — in particular the neo-Keynesians — are monetarists again.)
He mentions me:
I wanted to include Tyler Cowen somewhere, but his views are complicated and would require a longer discussion. Same with Noah Smith, who I think is a fiscalist but, given his broad scepticism, I wasn’t sure.
I am broadly skeptical, especially of macroeconomic theories. However, despite that skepticism, or maybe even because of it, I am a fiscalist. Let me explain why.

Here are three propositions about the macroeconomy:

1. The Monetary Stimulus Proposition: Monetary easing will raise real output and employment in a significantly depressed economy (and doing this is now worth the costs).

2. The Fiscal Stimulus Proposition: Government spending of any type will raise real output and employment in a significantly depressed economy (and that doing this is now worth the costs).

3. The Public Capital Proposition: The U.S. is currently below the optimum level of government provision of public capital (infrastructure, etc.).

I am skeptical about all three of these propositions, and I think you should be too. Macro data is not very informative, so while empirics can  be suggestive, it won't be decisive. And for that same reason, the relevant theories have not been reliably confirmed by real-world observation. We live in a world of extreme "model uncertainty". There is evidence for and against all 3 of these propositions.

But here's the thing. If either the Fiscal Stimulus Proposition or the Public Capital Proposition is true, we need to boost government spending. In fact, even someone who is not a supporter of any kind of stimulus might support fiscalist policy recommendations. For example, John Cochrane, who in early 2012 wrote:
Let's be clear what the "fiscal stimulus" argument is and is not about.  
It is not about the proposition that governments should run deficits in recessions. They should, for simple tax-smoothing, consumption-smoothing, and social-insurance reasons, just as governments should finance wars with debt. That doesn't justify all deficits -- one can still argue that our government used the recession to radically increase permanent spending. But disliking "stimulus" is not the same thing as calling for an annually balanced budget.  
Nor is it about debt financing of "infrastructure" or other genuine investments. If the project is valuable, do it. And recessions, with low interest rates and available workers, are good times to do it. That doesn't justify all "infrastructure" roads and rails to nowhere, of course... 
So while I am not as convinced of pro-fiscal-stimulus theories as people like Paul Krugman, the fiscalist-vs.-monetarist argument is about policy. And the fiscalist policy prescription seems much more robust to model uncertainty, because of the multiple reasons to want government spending.

Let's put some numbers on this. Suppose, after looking at the data, you think it's 40% likely that pure fiscal stimulus will be cost-effective. And suppose you think it's 30% likely that the U.S. needs to spend more on infrastructure. (And suppose you think these propositions are independent). Then you think there's a 58% chance that more government spending on infrastructure would be a good thing, for one or another or both of those reasons. So while if you had only considered one of the reasons for spending, you would recommend against it, but with the combination of two reasons, you would recommend it. See how that works?

In fact, what data we have seems to suggest that the public capital impact of government spending adds to the pure stimulus effect. Alan Auerbach and Yuriy Gorodnichenko find that the fiscal multiplier for government spending on investment is much higher than the multiplier for spending on consumption.

Monetarists who argue strenuously against any fiscal stimulus are therefore forced to assert that the Public Capital Proposition is false. For example, here is David Beckworth:
Okay, but not all fiscal policy is equal. Fiscal policy geared toward large government spending programs is likely to be rife with corruption, inefficient government planning, future distortionary taxes, and a ratcheting up of government intervention in the economy. So I will pass on this type of fiscal policy.
This kind of hand-waving dismissal of the need for public capital probably carries a lot of weight in certain intellectual circles, but to those who do not share Beckworth's strong priors, the argument is unconvincing in the extreme. (I must say that I have noticed what seems to be a greater reliance on theory and assumptions among monetarists than fiscalists, but I could be wrong about that.)

So count me among the fiscalists. But like most of the other fiscalists, I am definitely in favor of doing monetary stimulus at the same time. I'm just less certain that it will work.

Thursday, June 13, 2013

What is "neoclassical" economics?

New rule: the term "neo-" shall never be applied to anything other than Keanu Reeves' character in The Matrix.

OK, just kidding. But it's time to talk about one of my pet, peeves - the use of the term "neoclassical economists".

If you read econ blogs, especially blogs by "heterodox" bloggers (Austrians, Post-Keynesians, MMTers, etc.), then you know that the term "neoclassical" gets slung around quite a lot, usually as a pejorative. See herehere, here, and here for just a few examples. The idea is that "neoclassical" econ is the dominant paradigm, and that the "heterodox" schools are competing paradigms that lost out, and were, to use Kuhn's terminology, "simply read out of the profession...and subsequently ignored."

Well and good, but I have two problems with the way the term is used. First, I don't like the sloppiness of the way it's defined, and second, I don't like its application to people as opposed to ideas.

What kind of economics counts as "neoclassical"? Wikipedia defines it thus:
Neoclassical economics is a term variously used for approaches to economics focusing on the determination of prices, outputs, and income distributions in markets through supply and demand, often mediated through a hypothesized maximization of utility by income-constrained individuals and of profits by cost-constrained firms employing available information and factors of production, in accordance with rational choice theory.
OK, makes sense. Assumption of individual rationality, utility maximization, and supply/demand. One or more of things terms probably describes most of mainstream economics theory.

But does it describe most of maintstream economics research? Theory papers have declined from over half of top-journal econ papers in 1963 to less than 28% in 2011. Empirical papers make up most of the rest, with experimental economics growing to just over 8%.

How many of those empirical papers should be described as "neoclassical"? Some of them, no doubt. Some of them explicitly include neoclassical models; others test neoclassical theories developed in other papers. But many mainstream empirical papers contain no reference whatsoever to individual rationality, utility maximization, and supply/demand.

For example, take this famous paper by Acemoglu, Johnson, and Robinson, entitled "The Colonial Origins of Comparative Development: An Empirical Investigation" (American Economic Review, 2001). This paper measures the effect of institutions on growth. It does not make use of a neoclassical model. It does not test a neoclassical model. It does not include any assumption of rationality (or indeed, any model of individual behavior at all!). It does not include utility or supply/demand.

For an example from experimental econ, take "Bubbles and Experience: An Experiment", by Dufwenberg, Lindqvist, and Moore (American Economic Review, 2005). This experiment establishes conditions under which financial markets in a laboratory will result in asset price bubbles and crashes. No assumption of rationality is made, no model is referenced or tested, and no ideas of supply/demand or utility make an appearance.

These are mainstream papers, published in the most mainstream of econ journals. And there are many others like them. Does their very mainstream-ness automatically make them "neoclassical", even though they have zero of the elements that are commonly held to define neoclassical economics? If so, then I contend that the word "neoclassical" has lost all useful meaning.

"Neoclassical" should not be synonymous with "mainstream". "Neoclassical" should be used to describe a certain set of economic methods and/or ideas. Instead, "neoclassical" seems often to be used to describe anything that does not fall within a small well-known set of "heterodox" paradigms. I think that is wrong. The net effect of that type of thinking will be to block people from thinking of new ideas, because it defines any really new approach as "neoclassical". So people who want to subvert or replace econ's dominant paradigm will be shepherded toward old alternatives such as Austrianism, Post-Keynesianism, etc.

My second objection is related to the first. People who sling around the word "neoclassical" often apply it to people rather than ideas. "Oh, he's a neoclassical economist." Etc. Does that make sense? Take Daron Acemoglu for example. He writes papers that are clearly neoclassical. But he writes others that have none of the neoclassical elements. Should he be pigeonholed as a "neoclassical"? It seems obvious to me that he should not, but he probably is.

Or take me. I've never written a paper with individual optimization or supply/demand in it (though I'm working on some now). I've just done experiments and empirical stuff that didn't rely on any neoclassical idea. But people in the blogosphere have no qualms labeling me a "neoclassical", apparently because I've discussed neoclassical ideas on my blog. Not that I am mad, but it seems silly.

Shouldn't a researcher be free to work with a number of different types of analysis, and draw on a number of intellectual traditions, without getting pigeonholed? Isn't it counterproductive to scientific progress to enforce a "one-drop rule" for paradigms, so that any researcher who ever writes "max u(x)" on a legal pad is forever labeled a "neoclassical", and every paper (s)he ever writes as a "neoclassical" paper?

To reiterate, I suspect that the net effect of all this "neoclassical"-slinging is to discourage revolutions in econ. There are probably lots of revolutionary-minded young economists out there who would love to subvert the neoclassical paradigm. But when they try to find compatriots outside of the mainstream, they are told that if they don't join one of the pre-existing revolutionary groups, then they're a "neoclassical" and should go play with their fellow "neoclassicals". Which may have the effect of pushing them back into the arms of the actual neoclassicals, who of course are happy to welcome them into the fold...while the ancient "heterodox" movements retain their claim to be the only "real" revolutionaries out there...

A stable equilibrium, if you will.

Update: Lars Syll has a response to this post that perfectly illustrates the first of my two complaints:
The basic problem with [Wikipedia's] definition of neoclassical economics – basically arguing that the [defining characteristic] of neoclassical economics is its use of demand and supply, utility maximization and rational choice – is that it doesn’t get things quite right. As we all know, there is an endless list of mainstream models that more or less distance themselves from one or the other of these characteristics. So the heart of neoclassical economic theory lies elsewhere.
This is exactly the claim that "neoclassical" = "mainstream". The clear implication of Syll's syllogism is that no matter what sort of innovations mainstream economic theory embrace, no matter what old methods it discards, no matter what revolutions it undergoes, whatever it produces will be defined as "neoclassical" simply because it is in the mainstream. To me, that is clearly a counterproductive way of thinking about the world.

Wednesday, June 12, 2013

Should Japan default?

There are two reasons to think about what happens in the eventuality of a Japanese sovereign default. The first is that Japan's debt might be big enough, and its bond market reluctant enough, that it is forced to either default, hyperinflate, or go into severe austerity mode. In that situation, a default might be the best option. After all, after Argentina defaulted on its debt in 2001, its economy suffered for three years but then did quite well, substantially outperforming its pre-default trend:

That looks like a decently good macroeconomic scenario. And far from being an exception, this story is the norm:

So the precedent for a default is not apocalyptic. Whether this is better than hyperinflation I will leave unanswered, but it seems likely to be better than a long grinding period of austerity-induced stagnation. Also, note that austerity would redistribute wealth from Japan's young to Japan's already-comfortable older generations; a default, in contrast, represents a big transfer of wealth from the pampered old to the struggling young.

The second reason to contemplate a default is microeconomic. Observers of Japan's economy are nearly unanimous on the need for "structural reform". But Shinzo Abe's offerings on that front were extremely anemic. And given the huge edifice of special interests in Japan, and the weak political system there, we can probably expect little progress on that front. 

Structural reform is needed because Japanese productivity is stagnant. Here's a graph, from Takeo Hoshi's much-cited paper:

Hoshi attributes the stagnant TFP to "zombie" companies - companies that continue to live only through repeated infusions of below-market-rate loans. These zombies, he claims, crowd healthy, productivity-growing firms out of the market. His research with Ricardo Caballero and Anil Kashyap supports this story.

My own suspicion is that low TFP growth is also partly due to poor corporate governance in Japan. Here is a blog post I wrote about that.

A third, and related reason for low productivity growth may be the high prevalence of family businesses in Japan. There is evidence that family businesses experience slower productivity growth than non-family businesses. In this way, Japan may be similar to Portugal; I encourage everyone to read this Matt O'Brien post on family businesses and stagnation in that country.

For structural reform, Japan would need a huge blast of "creative destruction". Zombies and family businesses would need to die en masse, and healthy, independently run companies would need to emerge. The U.S. got that kind of blast in the 1980s, but Japan is unlikely to slash regulation, open up trade, and let the corporate raiders into the henhouse. The equilibrium of entrenched political interests is too strong. 

Only a big external shock is likely to be able to cause the kind of destruction needed to clear away Japan's economic ancien regime. A default would do the trick. Banks would go bamkrupt and be nationalized, and they would be forced to cut off zombies, which would then die en masse. If Japan's history is any guide, a huge burst of entrepreneurship would probably follow this die-off; witness the emergence of Sony and Honda after the shock of WW2.

So there might be some very good reasons for Japan to choose a sovereign default. But of course there would also be large costs. What would those costs be? I see three big ones: Human cost, inequality, and political risk.

The human cost could be a jump in the already sky-high suicide rate. A large number of Japanese suicides are men who lose their jobs. The close family structure of companies means that these men essentially lose access to their entire social support network. Combine this with a culture that is not very forgiving of failure, and you begin to see why a spike in unemployment might cause a large number of self-inflicted deaths.

Then again, this cost is not certain. A recovery of dynamism in Japan's economy might ultimately save more lives than it took. And human psychology is a fickle thing; it might be that in the wake of a default, unemployment might be seen as a natural disaster rather than an individual failure, and the suicide rate might even fall.

A more definite cost would be a rise in inequality. Once famed for being a middle-class society, Japan has experienced a rise in inequality over the past two decades; it is now less equal than Europe, though still more equal than the U.S. A default might change that. Family businesses might hold back productivity, but they also anchor the Japanese middle class; if large numbers of them went under, that middle class would be set adrift. 

Finally, the biggest cost of a Japanese default would be political risk. As can be seen from Argentina's example, defaults are often followed by steep drops in GDP (and rises in unemployment) that last for two or three years. That might be bad enough to destabilize Japan's already weak political institutions, and prompt the fall of the post-WW2 regime. That in turn would likely involve violence, social disruption, and increased social repression. If the winners of the coup were the "authoritarian nationalists" - basically, Shinzo Abe and his crowd - then things might not be so bad, since those guys are generally responsible and committed to a strong, stable nation. 

But if the victors were the "fanatic nationalists" - think of Toru Hashimoto and the guys in black vans - then Japan would be in for a very bad time indeed, and would quite probably revert to an unstable, violent, socially divided, repressive middle-income country like Thailand. That would be the worst possible outcome of a default.

So basically, a default would constitute a roll of the dice - a dramatic gamble that a collapse in the old order would be followed by a repeat of the kind of explosion of positive dynamism seen in the post-WW2 economic miracle or the Meiji Restoration. If the gamble failed, however, the consequence could be the end of the beautiful, peaceful, relatively free Japan that many of us have come to know and love.

Sunday, June 09, 2013

The Zero Upper Bound?

A funny thing happened the other day. As part of "Abenomics", the Bank of Japan has been buying long-term Japanese government bonds. This has seemed to have the expected positive effects - Inflation is up, inflation expectations are up, growth is up, consumption is up, exports are up, and the stock market, despite a recent drop, is way way up. But here's the funny thing - Japanese long-term government bond yields kept going up over most of the last month (meaning JGB prices went down).

That's weird, right? Econ 101 says that if you buy more of something, its price should go up, not down! In this long rant, Richard Koo attributes the rise in interest rates to increased inflation expectations. According to Koo, QE doesn't work, and Japanese private investors, realizing this, started to expect inflation without real growth, and ditched JGBs, causing rates to rise.

But Nick Rowe has another explanation. According to Rowe, the rate rise was due to greater expected growth (nominal growth, so both better real growth and more inflation). As the BOJ's easy monetary policy causes the economy to improve, Rowe says, interest rates will naturally rise; investors are simply anticipating that rise, and selling bonds now. Rowe also has these rather harsh words for Koo:
Is Richard Koo really a Keynesian? Or is he just a finance guy, who doesn't really get macro/money?

One person who would probably agree with Rowe is Paul Krugman, who is himself a big supporter of Abenomics. In this blog post, Krugman outlined three "stories" about falling bond prices. Although none of the three stories correspond to Japan's current situation (long-term bond prices are down, stock prices are up, and the yen is down), the "stronger recovery" scenario involves rising stock prices, which we have seen. Rising stock prices indicate positive expectations for real economic growth, not just inflation. (Koo explains away this by conjecturing that Japanese stock investors and Japanese bond investors have different expectations, which I guess is not totally unreasonable given that most JGB holders are Japanese, while most of the recent inflows into the Japanese stock market have been foreign money).

(I have to say, initially I was skeptical of the Rowe/Krugman story. Most models I know would say that the recovery would take a while to raise interest rates above the pre-Abenomics level; the general-equilibrium effect would take years to overcome the partial-equilibrium effect of increased BoJ purchases holding rates down. To get a Rowe/Krugman type of rapid interest rate rise, I think you'd need a "good equilibrium, bad equilibrium" sort of model, where Abenomics kicks the economy out of the bad equilibrium very abruptly, and the economy is shocked back to a sustainably higher rate of NGDP growth. But then again, I guess I do kind of believe in that sort of model. And Japan's deflationary stagnation has lasted much longer than is typically possible in the simpler models I learned in grad school. But I digress.)

So anyway...are Japanese interest rates rising because of an incipient real economic recovery? Let us hope to Amaterasu that they are not. Let us hope that the rising yields are a blip, a trick of expectations and volatile markets and jittery bond investors.

Why do I say such a crazy thing?

Nick Rowe hints at the answer at the end of his post, when he writes:
And we can only regret that Japan did not do this many years earlier, instead of wasting all those years and letting Japan's government debt/GDP ratio climb. Because that high debt/GDP ratio is the only reason why someone might want Japan's economic recovery but not want the higher interest rates that will accompany that recovery. Which is no reason to try to stop the recovery. Though it is one additional reason to regret not having done something like Abenomics a lot earlier.
Rowe is being far too blithe. At very very high levels of debt-to-GDP, a rate rise is disastrous.

Imagine, for the sake of exaggeration, that a country had a debt-to-GDP ratio of three thousand to one. Suppose this was all in 30-year bonds, so that every year the government would have to roll over about 1/30 of its total debt, or 10,000% of GDP. Suppose that interest rates are just barely above zero - low enough to allow the government to maintain this debt burden.

Now suppose that interest rates suddenly "normalize" to 1%. Next year, the government will abruptly owe 1% of 10,000% of GDP in interest on the portion of its debt that it had to roll over. 1% of 10,000% is equal to 100%, so the government would owe all of the country's GDP in interest costs, in the first year alone. In the second year of the recovery, it would roll over another 10,000% of GDP, and thus owe 200% of GDP in interest costs!

How could it pay up? You can't tax 100% of GDP. So the government would have to borrow the rest. It seems clear that the higher the debt/GDP ratio, the less likely it would be that the private sector would be to lend to the government at an interest rate less than the economy's growth rate (the necessary condition for "stable Ponzi finance"; see discussion in comments with Nick Rowe for why this would be the case).

The only entity that would then lend the government the necessary sum is the central bank. In other words, seigniorage would be the only option to avoid default. This would either push interest rates back down to about 0%, or cause hyperinflation. Alternatively, the government could have the central bank buy outstanding bonds to push rates back down to 0%.

Now, Japan is not close to a 300,000% debt-to-GDP ratio. Its gross debt is about 240% of GDP. But a rise in interest rates would still exact a heavy burden on Japan's public finances; according to this guy, an increase in JGB yields to 2.2% would mean that 80% of Japan's current tax revenue would be eaten up by interest costs. Whether that number is correct, it's clear that with debt at 240% of GDP, Japan's growth would have to go up by a lot more than its interest rates in order to avoid a big rise in interest costs.

Also, realize that higher interest costs could easily start to hurt an economy long before they reach 100% of GDP, or even 100% of tax revenue. Why? Because of fiscal Keynesian effects. If fiscal policy affects demand (as most Keynesians and neo-Keynesians believe it does), then raising taxes to pay higher interest costs would stall the economy, as would drastic cuts in transfers or government purchases. (Of course you could borrow to pay the increased interest costs, as mentioned earlier.) So if an incipient recovery quickly causes higher rates, higher interest costs could kill the recovery.

(Now of course, all this time, increased nominal growth would erode the debt-to-GDP ratio. But that takes a long time to work. And Japan, which runs big primary deficits, is probably going to see its debt-to-GDP ratio continue to climb even if a recovery comes.)

So if monetary expansion can only cause the kind of recovery where interest rates rise, Japan is in deep shiitake. Japan's only hope is to cause the kind of recovery where interest rates stay very low for a very long time. If Japan is living in a Nick Rowe type world, that will prove impossible, and Japan's only options will be stagnation, default or hyperinflation. We should pray with all our might that we are living in a Richard Koo world instead, and that there is an economic policy that will allow Japan to boost growth and inflation while keeping interest rates low.

Anyway, this whole exercise raises the possibility that very high debt-to-GDP ratios could act as a long-term growth trap. We often talk about the "zero lower bound" on nominal rates, but very high debt-to-GDP ratios mean that there is also a zero upper bound. If recoveries always cause rates to rise (as Rowe contends), then high-debt-to-GDP ratios force governments to allow their economies to stagnate forever (or default/hyperinflate). In that case, the much-maligned Reinhart and Rogoff would be right.

If you get into a high government debt situation, a long periods of very low interest rates and robust real growth is really your only hope for a clean escape.

Update: Paul Krugman weighs in, saying my concerns are unwarranted. I've been thinking in terms of nominal rates this whole time, but Paul says that what really matters are real quantities; if the real interest rate stays low, it's all good.

Update 2: The more I think about it, the more certain I am that this post (of mine) confused and obfuscated more than it clarified. I think there was a good point somewhere in here, but I failed to make it. Oh well. That happens. For a simpler and (in my opinion) better take on the matter, see this brief post by Brad DeLong.

Update 3: Nick Rowe has a follow-up post in this series that is also much better than mine. This is basically the point I was trying to make, but stated much more cleanly. Excerpt:
Let's assume the worst-case scenario. Let's assume that I am right and Paul [Krugman] is wrong, so r increases [when the economy recovers]. And let's also assume that r increases more than g, so (r-g) increases. (Or (i-n) increases, if you prefer.) So economic recovery, by assumption, makes it harder for Japan to service the debt. [<-- at="" blockquote="" get="" i="" in="" my="" nbsp="" post.="" scenario="" the="" this="" to="" trying="" was="">
Let us also assume that Japan is like an OverLapping Genererations model, where Ricardian Equivalence is false, and where the equilibrium level of (r-g) is an increasing function of the debt/NGDP ratio. 
These worst case assumptions mean that there must exist some maximum Debt/NGDP ratio, call it Rmax, such that if the actual debt/NGDP ratio exceeds Rmax, then it would be impossible for Japan to service its debt if economic recovery causes interest rates to rise. Japan would either have to default, or create a big enough unanticipated rise in the price level to inflate away the old debt and bring the debt/NGDP ratio back down below Rmax. 
Let us further assume that Japan's current debt/NGDP ratio exceeds Rmax. 
In other words, I have deliberately set up a case in which Richard Koo would be right (maybe for the wrong reasons, but let that pass). I have deliberately made worst-case assumptions so that the higher interest rates caused by loosening monetary policy creating economic recovery would cause Japan to default on its debt, either literally or via very high inflation. 
Does this mean that "Japan cannot afford recovery"?
No. It means that Japan is already dead. It just doesn't know it yet... 
If Japan is already past the point of no return, then recovery will mean default. But delaying recovery will simply mean an even bigger default.
Now I feel even more ashamed for writing a sucky post. But at least I can link to similar posts that do not suck.

Tuesday, June 04, 2013

What is "derp"? The answer is technical.

There has been much discussion lately concerning the word "derp" and its appropriate usage. For example, Josh Barro used the word to describe conservative bigmouth Erick Erickson, and Paul Krugman used it as well. This prompted a primer on the history of the term, followed elsewhere by the usual hand-wringing by self-appointed cultural policemen annoyed by the word.

Now, I myself have used the word "derp" quite a lot. Possibly more than any other pundit I know, with the exception of Dave Weigel. But in any case, not only do I consider myself an expert in the use of "derp", I also have a very precise idea of what "derp" means, and how it should be used. I think "derp" is incredibly useful as a term for an important concept for which the English language has no other word.

It has to do with Bayesian probability.

Bayesian probability basically says that "probability" is, to some degree, subjective. It's your best guess for how likely something is. But to be Bayesian, your "best guess" must take the observable evidence into account. Updating your beliefs by looking at the outside world is called "Bayesian inference". Your initial guess about the probability is called your "prior belief", or just your "prior" for short. Your final guess, after you look at the evidence, is called your "posterior." The observable evidence is what changes your prior into your posterior.

How much does the evidence change your belief? That depends on three things. It depends on A) how different the evidence is from your prior, B) how strong the evidence is, and C) how strong your prior is.

What does it mean for a prior to be "strong"? It means you really, really believe something to be true. If your start off with a very strong prior, even solid evidence to the contrary won't change your mind. In other words, your posterior will come directly from your prior. (And where do priors come from? On this, Bayesian theory is silent. Let's assume they come directly from

There are many people who have very strong priors about things. For example, there are people who believe, very strongly, that solar power will never be cost-efficient. If you confront them with evidence of solar's rapid price declines, they will continue to insist that, despite this evidence, solar will simply never be cost-competitive with fossil fuels. That they continue to insist this does not necessarily make them irrational in the Bayesian sense; they simply have very strong priors. Someday they may be convinced - for example, if and when unsubsidized solar power starts being adopted on a mass scale. It'll just take a LOT to convince them. (A more entertaining example can be seen in this classic comedy video.)

But here's the thing: When those people keep broadcasting their priors to the world again and again after every new piece of evidence comes out, it gets very annoying. After every article comes out about a new solar technology breakthrough, or a new cost drop, they'll just repeat "Solar will never be cost-competitive." That is unhelpful and uninformative, since they're just restating their priors over and over. Thus, it is annoying. Guys, we know what you think already.

English has no word for "the constant, repetitive reiteration of strong priors". Yet it is a well-known phenomenon in the world of punditry, debate, and public affairs. On Twitter, we call it "derp".

So "derp" is a unique and useful English word. Let's keep using it.

(Also, the verb associated with "derp" is "herp". It describes the action of coughing a large sticky mass of derp onto the internet in front of you. For example, to use it in a sentence: "That twerp just herped a flerp of derp!" A "flerp" is a unit I made up. It is the amount of derp that can be herped by one twerp. See?)

Atlantic column: "Should we trust economists?"

Excerpts from my latest Atlantic column:
Imagine you are the Royal Physician in England some time during the 14th century. The prince is sick, and you've been summoned to help. You call in two experts for advice. The first says: "Use leeches to suck out the evil humors." The second says "No, you must bleed him to get the evil humors out." Just to make sure, you summon a third expert all the way from Austria, who says “No, the disease is God’s punishment for the prince’s sins, you should let it run its course.” After the Austrian expert is duly led off to the dungeons and beheaded, you’re still left with the question of whether to treat the prince with leeches or bleeding. They start to argue, insulting each other in nasty epistles. "Leech guy is secretly working for the French!" alleges Bleeding Guy. "Bleeding Guy just wants the prince to die because the prince wanted higher taxes on the nobles!" Leech Guy fires back. 
What's the right move? Well, in an ideal world, you would go and get 999 patients who have illnesses similar to the prince's and give them all a variety of household substances, such as bread mold. Then you would take careful note of who died and use statistical analysis to figure out which household substances cured disease. Thus, you would discover penicillin and invent modern medicine. 
Sadly, this is not what you do, because a) if you proposed it, you would be led off to the dungeons and beheaded right next to the Austrian guy, b) it's the 14th century and you have no concept of the scientific method, and c) you don't really have the right tools for that experiment, anyway. Instead, it's bleeding or leeches. So you take your best guess and you pray you're right. 
The economic situation we find ourselves in today is a little bit like the example above...
If economists ever do succeed in developing formal models that work better, then we'll be able to go to them with questions (like "Should the Fed print more money?") and simply trust their expert advice. But until that day, all economists can really give us is intuition, suggestions, and ideas... 
No matter how much we might wish they were, economists are not go-to experts who know just how the world works or how to fine tune it...But they do have a lot of interesting things to say. They might help you clarify or re-evaluate your own beliefs about how the economy functions. They can also help you spot the flaws in each other's arguments. 
And in the end, you're the Royal Physician. You may not know everything, but the prince is dying, and you pick from among the "experts" you've got.
You can read the whole thing here. Unfortunately, the part about the Austrian guy was edited for length. :(

Regular blog readers will recognize material from some of my past blog posts, such as:

"What can you do with a DSGE model?"

"The swamps of DSGE despair"

"A world without macroeconomists?"

"A satisfactory philosophy of ignorance"