Thoughts on PSST - and then some thoughts from Brad DeLong on it

There's something very appealing in Arnold Kling's posts on "PSST", which is basically just a rebranding of a conception of the market that we've had for a very long time. PSST is essentially just an extended division of labor, after all - specialization and exchange. Modern market economies are nothing if not groups of people specializing and exchanging.

That's Adam Smith, and so it's no wonder we all find something appealing about it.

The problem comes in when you start to say that because complex specialization and exchange is what the market economy is, it follows that when market economies break it must be because something was unsustainable about the nature of the specialized exchange. This is an odd route to take, whether it is via Arnold Kling (who talks in terms of major "regime changes" - displacement of agriculture, IT revolution, etc.) or via Hayek (artifically elongated capital structure gets revealed to be unsustainable). The romance and enticement of organic, complex systems can mislead people. When other complex, emergent systems like organisms or ecosystems get sick, we don't just assume that the complexity that used to work no longer works anymore. We assume something specific went wrong with it. So why don't we all assume that with markets? I'm not sure.

Brad DeLong isn't sure either. He writes: "When you ask believers in "recalculation" what pattern of production and trade proved to be unsustainable in 2007, they answer: "building so many houses." When you ask believers why the market economy has been unable to sort out this problem in three years, they answer with nothing--silence. When you say that OK, there were $300 billion of excess houses at the start of 2007 but now construction has been so depressed for so long that there are $1 trillion fewer of houses than trend and why isn't the 2007 pattern of production and trade sustainable again, they answer once again with nothing--silence. That annoys me."

Markets work. What a lot of the PSST talk amounts to is the suggestion that not only can markets spontaneously stop working, but they have a very hard time picking themselves up when they trip after going down an unsustainable path. Hayek is slightly better on this count than Kling - Hayek actually offers a mechanism: artificially low interest rates that allow an elongated capital structure to actually build up before it is revealed to be a house of cards. That's somewhat better than Kling's story which is basically the old technological unemployment case.

We need something better than that PSST story. We know why markets work so well. We know how markets correct themselves. So when markets break you have to have a pretty specific mechanism in mind not only for why they break so sharply, but also why (in this case, as in the 30s) they don't always seem to fix themselves. The mechanism I have in mind is that a popped bubble (which is psychological and institutional - and also well understood - not vague hand waving about "patterns of exchange breaking down") increases demand for safe and liquid assets, and exogenously increases savings rates for all actors at once. Traditional monetary accomodation is limited by a zero lower bound on the nominal interest rate. Interest rates that can't adjust to the negative-whatever-it-is-according-to-the-Taylor-Rule percent they need to be depress investment because the marginal efficiency of capital consistent with full employment is negative. Massive underutilization of resources means there is little demand-pull on inflation - which is one thing that could actually help the interest rate situation (or sticky wages - if you're the sort of person that worries about that).

That's the mechanism I have in mind. It seems to me to fit the facts better than any other mechanism I've ever been offered. It also tells me why we had a recovery in 1920-21, why we didn't for a while in 1929, why we had a reasonably quick recovery for most of the post-war period, and why Japan didn't have a quick recovery in the 1990s and why we aren't having one now. When you have an explanation that fits with a broad set of data like that, that's a useful theory.

Hayek's elongation of the capital structure sounds plausible to me, and certainly interesting. Jonathan Catalan makes it more plausible by regularly reminding us that ABCT can result in a general depression - it doesn't have to have the naive "internet Austrian" impact of only being concentrated in certain sectors. But it still leaves open the question: why are we still in this pit after three years? And for that matter - why was 1921 and 1981 different from 1929 and 2008? ABCT can't answer that very well. DeLong, Keynes, Friedman, Hicks, and Krugman can answer that question.

I would add to Brad DeLong's list of absurdities that nobody can provide a reasonable answer to this question of "regime uncertainty". The argument goes that we haven't recovered because investors are tremendously uncertain. But just as Brad notes "If you want to argue that there is a disruption of patterns of sustainable specialization and trade, you need to point to such a disruption right now that is large enough to produce an 8% shortfall in spending", I could also say that if you want to argue that regime uncertainty has kept us in the doldrums for three years you need to point to something people are uncertain about that is large enough to produce an 8% shortfull in spending. Health reform? That was the schtick originally - they said that "regime uncertainty" about health reform kept investors from investing. But now it's done and passed and there's no appreciable difference in the macroeconomic situation. They try and argue that the details and regulations are still being worked out for health reform, and that's true - but are they really convinced by that? Is that really sufficient to keep us in depression? Our health reform is modest by the standards of many of our peers, and they didn't seem to get caught in a depression because of their health care system. And are any businesses actually saying that's why they're not investing? Is there any sign at all that investors are worried about tax increases or health reform? No! There's no evidence of this whatsoever. Time after time when businesses are surveyed they cite demand as the problem - not concerns about government overreach or taxes. This whole "regime uncertainty" argument doesn't even pass the smell test in the first place, and on top of that there is no empirical evidence for it.

There's a lot of bad economics out there, despite the fact that we have a pretty decent sense of what's going on. Even if we have some disagreements about what to expect from the slightly less predictable fiscal policy and whether we've fully used up monetary policy options, there is still a broad agreement about the mechanism that is causing this depression. And as Brad has pointed out in the past, it's an agreement that unites Keynesians, monetarists, and many others - back to both Jean Baptiste Say and Malthus.

Assault of Thoughts - 5/31/2011

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

- A discussion of "the eclipse of pragmatism", downplaying the idea that it ever happened. The authors don't sound especially pro-Rorty.

- Jonathan shares an interesting passage from Menger on property, but then provides an odd little claim: "I think that this is a strong case against arguments that private property is itself a coercive institution, which is something economists such as Gene Callahan have presented in the past." Of course, this is a sentiment you've heard on Facts and Other Stubborn Things too. In neither Gene's case nor my case will you ever find a hostility to property - simply an acknowledgement that this marvelously functional system or private property that we have is necessarily coercively maintained, like any social arrangement, so that pretentious ethical systems grounded on contrary assumptions are dead in the water. Anyway, what baffles me is why Jonathan thinks Menger's point is a "strong case" against this argument. I have no idea how to reconstruct his train of thought on this, and he doesn't provide the arguments so perhaps I'll leave that to him in future posts. Well, he does write this: "The institution of property isn’t coercive, it’s inevitable, because it’s the only method of solving conflict over scarce goods", but I assume that's not the full argument. Why would the inevitability of something imply it's not coercive, after all? Why can't coercive institution solve conflicts and problems? They seem to have been doing just that for quite a while now.

- LK on Kirzner on ABCT.

- I saw Tyler Cowen on Clarendon Boulevard yesterday. I should have said hi, but I didn't. First it might have been weird and second I was with other people who wouldn't have known him. Plus he's already been featured in Businessweek and I wouldn't want the fact that random people recognize him to go to his head :)

- Some people are aware I haven't exactly been impressed with much of the criticisms raised by Casey Mulligan over the last couple years. Peter Boettke is. Thankfully, a lot of his commenters (including those who often agree with him) agree with me. Boettke is usually one of my favorite Austrian economists, but lately there's been a lot of unfortunate stuff coming from Coordination Problem!

Rolling Thunder

A big group of them just passed my window on their way to the Pentagon parking lot. My favorite sight: a woman sitting on the back of one of the motorcycles, eating an ice cream cone :)

Incredible sentence of the day

"In most graduate programs, there will usually be a few faculty members who have very strong sentiments about the market as the main allocation mechanism and pessimism about the government in that role. They certainly would not dominate, but they will not be absent either."

- Peter Boettke, writing about top schools to study Austrian economics

My jaw dropped when I read these sentences. Using "free market economist" as a euphemism for "libertarian economist" - a euphemism that they will clarify if pressed - is one thing. I talked about some of that sort of usage of "free market economist" in this post. But this is a very explicit set of sentences from Boettke. I cannot think of a single economics professor teaching in the department at William and Mary or in the department at George Washington University who doesn't think that the market is "the main allocation mechanism", and who isn't pessimistic about government as an allocation mechanism. I would say unequivocally that this position "dominates" both departments, and almost all departments for that matter. To the extent that they do see a role for government, they certainly don't tout it's allocative advantages. I suppose he sincerely thinks this and I'm pretty troubled by the statement.

To undergraduates or even high schoolers looking to college I can assure you - the market is considered "the main allocation mechanism" in any department you are likely to be considering. You may not find a particularly libertarian department or a particularly Austrian department - that may take a little more searching. But the entire economics profession is in strong agreement about the market as an allocation mechanism. This is our "evolution by natural selection" - our underlying common thread that we all agree on and that informs essentially everything that we say. The allocative efficiencies of the market are the bedrock of the discipline.

The flip side of that is that if you have some kind of grudge against the market, you are not going to feel very comfortable anywhere.

In that place, of all places?

Last night I was reading some of Jefferson's letters. I told Kate that I always enjoy picking up Jefferson from time to time because he's very grounding. When you read him you realize how much of the way we think about things came from him. She suggested it's just an enlightenment outlook in general, but I disagree. I think Jeffersonianism offers something unique - enlightenment to be sure - but a brand of enlightenment that's had special meaning and resonance here.

By now I'm sure a lot of you have seen the videos of a group of dancers being assaulted by police at the Jefferson Memorial. With a statue of Jefferson towering over them, and Jefferson's words on the walls surrounding them.

More on margins of comparison

In this post I talked about the problem of confusing different margins of comparison. This is what I mean w.r.t. the public school issue:



In the United States we are living in the left columns, with a mix of public and private schools where private school students generally have better outcomes than public school students (btw - I went to public schools through high school, William and Mary is public, and George Washington University and American University are both private). We often make this comparison between public and private school students - either formally and rigorously or informally - when we discuss these issues. Those comparisons have some value, of course. From a parents' perspective it helps them think about where to send their kids, and it also helps us think about the structure of public education and the wisdom of things like charter schools and vouchers. But when we pontificate on the role of government in education its exactly the wrong comparison to think about. When we talk about the role of government we have to compare the left columns with the right columns. That's an entirely different question, and it's harder because distributional issues start to enter the equation. Not to mention the problem that we have no data on that question!

Another place this pops up is the question of wage cyclicality. If you plot out the raw data, real wages seem to be high in recessions - it looks like wages are counter-cyclical. This bolsters both New Keynesians who think that sticky wages matter a lot and anti-intervention types who want to blame the minimum wage, labor laws, etc. The problem is its a big example of margin confusion again. If high wages were the culprit in recessions, what we would want to look at is the spot market for labor - the intensive margin. We would want to look at trends in the cost of one more unit of labor over the business cycle. Easy - that's the hourly wage data series that the Bureau of Labor Statistics produces, right? Wrong. Aggregate hourly wage statistics are influenced by fluctuations on the intensive and the extensive margin, and as such they can be very misleading in discussions of wage cyclicality. The problem is that different sorts of workers are employed at different points in the business cycle, so wage data is picking up fluctuations on the extensive margin - the decisions to hire or fire different types of workers, rather than fluctuations on the intensive margin for a constant pool of workers. Brad DeLong summarizes the literature on this problem in his excellent critique of Vedder and Gallaway here. The empirical evidence on this is very consistent - wages are not highly counter-cyclical. At most they are acyclical, although some find a modest pro-cyclicality. Abraham and Haltiwanger (1995) provide a survey of this literature, and I suggest anyone who thinks empirical economics is all over the map read it. The findings are very consistent and all point to the same conclusion. Your margin of comparison matters.

I don't have time to go over it now, but this also matters a lot for the economics of discrimination and the work that Becker did (which a lot of people get confused about and draw the wrong lessons from). I'll try to post on that in the near future. But out of curiosity I want to ask - what do people think Gary Becker concluded about discrimination in the labor market?

Friedman on learning from experience and rights

David Friedman had a good post last week on a commencement speaker that he thought failed to learn from experience. Essentially, the speaker felt that everyone had a legal right to "health care, education, and financial aid", and had personally had trouble dealing with (presumably public) bureaucracy getting these sorts of benefits for his disabled adopted daughter. Friedman suggested that he didn't seem to learn from his experiences when he continued to call for public provision of these sorts of things.

Although I take his point and never promote "positive rights" thinking here, I think there are a lot of problems with this sort of logic. First and foremost, if you are the sort of person that thinks people are entitled to these sorts of things - for whatever reason - you're not failing to learn from experience if you critique a public system that fails. Let's say you think these things should be provided by the market instead. If the market leaves a lot of people unprovided for, and frustrates the people it does provide for with red tape, is that "empirical evidence" against your anti-positive rights prespective? Of course not. You console yourself with arguments that the market will correct itself as people react to these failures. That's really all the commencement speaker is doing here. He doesn't seem to me to be failing to integrate his experiences - he seems to be considering his experiences deeply and responding to them. People aren't bound to develop their understanding of rights from empirical experience with the efficacy of certian systems.

The other thing that bothers me about this sort of logic is that it presumes that whenever a government does something, people always generalize that to public provision in general. This is really an odd way of looking at things. When a particular firm fails to satisfy you, it's not sensible to say "well I guess the market can't provide X". Instead, you seek out firms that do the job better and console yourself with arguments that the price mechanism will privelege those firms. That seems to me to be all people are doing when they see a failure of government but still want to seek out a better public solution. It would be awfully myopic to take one failed approach to public provision and rule out that option. Kate and I are dealing with really obnoxious extra charges that our phone company adds no matter how many times we call them and remedy the problem. If it gets bad enough, I may consider switching phone companies - but I'm not going to start demanding state-run phone companies! Similarly, when the government fails at something that I consider to be a valid public service, my first reaction is going to be to try to change how the government works, not abandon my understanding of the appropriate role of government.

*****

There are a few other things I don't think people consider enough in these sorts of discussions:

1. There's a difference between "positive rights" and "legal rights". It may be reasonable to say that "everyone has a right to a good education" and understand that that right will go unsatisfied sometimes, without arguing that the government ought to provide that education. Anarchists, after all, generally acknowledge some set of "rights" without expecting any government provision.

2. Assessing the value of public services needs to be done with (1.) marginalism and (2.) general equilibrium effects in mind. I cannot stress this enough. It's meaningless, for example, to show that private school children do better than public school children. Of course they do. If they didn't do considerably better they wouldn't shell out tuition for it. Even more cost effective private schooling shouldn't compare averages with public schools. The appropriate comparison isn't between an existing public school and an existing private school. It's between a system of public schools (presumably with some private) and a system without public schools. Too many people who talk about this subject take a marginal effect on the intensive margin (putting a given similarly placed student into private or public school) and use it to try to say something about the extensive margin (comparing a system of public or no public schools). These are entirely different research questions. You can have too much public school on the intensive margin but still have the right approach (public provision) on the extensive margin. These intensive/extensive margin differences matter tremendously - they lead people to say dumb things like "recessions are caused by high wages".

3. Public and private, and government and market are not mutually exclusive. You can have market-based public intervention (i.e. - charter schools, carbon taxes). You can have the coexistence of public and private provision (NASA and SpaceX). Advocates of certain public solutions should not be confused with opponents of private solutions.

I can think of few more vacuous ideas than "hard and soft science"

That is all.

Assault of Thoughts - 5/27/2011

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

- Brad DeLong points to Milton Friedman's important efforts to make us all more Marshallian and less Walrasian. More could still be done on this front, I think. One of my favorite passages in economics comes from Marshall's Principles: "Nature's action is complex: and nothing is gained in the long run by pretending that it is simple, and trying to describe it in a series of elementary propositions".

- DeLong also asks "where are the speculators?" with respect to the financial crisis and the origins of the Great Recession. This is a very deep question, actually, and similar to the question I had posed earlier to determine whether the market can right itself: "can it be arbitraged?". Some people questioned whether "arbitrage" was exactly the right word for it. Maybe it's not. But the point is, we need an answer to the question "what profit seeking behavior could fix this?" if we're considering whether the market will fix itself on any specific problem.

- Subjective preferences are interesting things. Jonathan talks about how he's put down The General Theory for the time being because the writing is too hard to work through unless he has more time to focus. He's not the first one to say this about Keynes's writing. I and many others hold just the opposite view - I think he's a real pleasure to read. Very witty, and he packs a lot of content and insight in. Now I do agree that while chapters one through three are a great read, once you get into chapter four it gets a lot slower until later in the book. Still - different people look for different things. You hear the same thing about H.P. Lovecraft. Aside from the content of the writing, the style itself is one that people either love or hate.

- Peter Boettke points us to a Boston Globe article discussing the three phases of new ideas: ridicule, outrage, and obviousness. He likes it. I suppose it could work, although I haven't thought about it. An interesting sequence to consider nonetheless. I have a comment in the thread about misdiagnosing the implications of some of the "obvious" conclusions out there.

Two new blogs I'm following

One probably not new to most of you, but one might be.

- First is Octahedron's blog - a relatively new commenter here with Austrian and libertarian sympathies and from what I can tell a very open mind to other ideas. He wrote a post recently reacting to my post on the distributions of reasons for opposing certain policies to address racial inequality from 1968 here.

- Second is David Friedman's blog. I'm sure most of you are familiar with David. I am, I just haven't followed his blog until now. For those who don't realize, David is Milton's son. I'm sure having that pointed out all the time bugs him, but oh well - I have to provide context for those who aren't aware :)


If any other readers have blogs I should be following please let me know (even if you don't actually comment much here). I like to follow what people are thinking and writing.

Yes, unfortunately I delete comments now

If you can't read a post about an interesting public opinion survey without thinking someone is calling you and yours a racist, you probably shouldn't be commenting on this blog anyway.

If I were having a conversation with Bob Murphy and Octahedron on the street about a neat old dataset I found from 1968, and someone walked up to me and started telling me I had called Rand Paul a racist I would just walk away and take the conversation elsewhere. That's all that's happening people. It was my fault for engaging.

Everyone knows comments can get into extended back-and-forths on here. I don't mind that. I don't mind heated disagreements. I don't mind disagreements over meaningless little details that are at least present in the post. But I don't like two thirds of my comment section taken up by me futilely defending myself against outlandish accusations that have nothing to do with the content of the post. I post that content because I think it's interesting and I'd be interested in talking about it with people. If you don't think it's interesting, just don't comment please.

The OECD, the unemployed, and sovereign debt burdens

Matt Yglesias and Paul Krugman are rightfully pulling their hair out over the OECD call to raise interest rates. As far as I can tell, this is absolutely bizarre on three levels:

- If you are Keynesian/monetarist/mainstream of almost any type of economist it's obviously bizarre to call for increasing rates when unemployment is still so bad. Both Krugman and Yglesias make this point.

- If you are not a Keynesian/monetarist/mainstream economist but instead are an old-school moralist stable-prices fuddy-dud, then it's still crazy because as Yglesias points out, the OECD's own inflation projections are below target!

- But on top of all that, the one last hold-out for the moralizing fuddy-duds is the sovereign debt burden issue. Maybe they're not paying attention to unemployment, and maybe they're still worried about inflation despite their own forecasts, but all these guys at the OECD and IMF are always worried about "another Greece". Pushing up interest rates doesn't help countries that are struggling under a large debt burden, and a sovereign default is a lot scarier than having a modest "inflation tax" erode it away, because a little inflation doesn't spook the herd of international investors in the same way that a default does.

So this call doesn't make sense on a variety of fronts, even if you're the most Andrew Mellonesque, economics-as-morality-play international bureaucrat.

The only way it does make sense, I suppose, is if you think interest rates are artificially low and that that distorts the capital structure, setting us up for another bust and you wouldn't particularly miss modern, deficit-incurring state institutions. But I don't think these sorts of people are heavily represented at the OECD.

One day late - fifty years ago yesterday

What does it mean to be "pro-market" or a "free market economist"?

That's an honest question. I consider myself both, but it's also obvious from the way people use the term that different people think of it differently (somewhat like the issue with the term "classical liberal"). Recently some commenter (I think maybe Bob Murphy) used "free market economists" in a way that was clearly meant to exclude my sort of economist, and it was a little odd to read. And here, Jonathan Catalan refers to his "pro-market" response to me. He doesn't come out and call me "anti-market", but again it gives the impression that he has something specific in mind about why his response was "pro-market". What makes someone "pro-market" or a "free market economist"???


Let me pose my puzzlement this way:


- If you refused to give your child food unless they were able to exchange something acceptable for the food, would that make you more "pro-market" than someone who just gives their child food?


- What about respect for elders? Waiters and waitresses are paid to compose themselves in a certain way around customers as a part of their labor market transaction with the restaurant owner. If you require your elders to pay you before you act respectful towards them, does that make you more "pro-market" than if you don't?


- Or of course that most essentialist of human activities: sex. Is a patron of prostitutes more "pro-market" than someone who never transacts for sex in his life?


Why is it that "pro-market" has come to mean "thinking that the market is the appropriate institution for decision making"? Of course these examples are extreme, but they're meant to illustrate the point (so I want to be careful not to detract from that point because of the sheer extremity of the examples): why is it that an economist is more of a "free market economist" if he proposes that more things be done using the market than another economist? Why is Rothbard often considered more a "free market economist" than Friedman? It seems like an odd way of using the term to me. Clearly there ought to be a line somewhere. If you think markets are rubbish and should be used only on the rarest of occassions it doesn't seem sensible to refer to you as "pro-market". But even aside from that concern, the use of the term seems to be absurd.

It's a focused absurdity, though. You won't hear libertarians accuse people of not being pro-market because they give food to their children rather than selling it to them. You'll only really hear it with respect to the government. Under that formulation it's easier to understand why you hear nonsense like "Paul Krugman isn't a free market economist". In plain English, that's a bizarre sentence. But when "free market" means "when there is a choice between government and the market, use the market" it becomes more sensible. Krugman acknowledges a role for government, after all, as do I.

Anyway - it's just a very strange, very unique way of talking about things and sometimes I get the impression people who talk this way don't realize how weird it sounds - not only do they disagree with my points here on a cerebral level, but it actually seems normal to them too.

Some on the left don't help the situation. Joe Stiglitz frequently uses "free market economists" to be synonymous with "libertarians" too, and it bothers me to no end. But for the most part this sort of talk is fairly restricted to libertarians themselves.

To me, the market is just an institution and a particular way of making decisions. I think the market is fantastic, but it's not the only institution and it's not the only way of making decisions and in certain cases it's not the best way of making decisions. It seems weird to me that simply acknowledging that has the potential to invalidate me as "pro-market" or a "free market economist" in some people's eyes. I don't normally think of myself as "pro-government" because in almost every situation I can think of the government is much less than ideal - it's just sometimes the best available option. It's not the same way with markets for me. There are lots of situations where the market isn't just the best available option - it's a really, really great option. So saying I'm "pro-market" makes more sense.

Maybe I'm misreading people and people do consider me and Krugman and most other economists in the U.S. to be "free market economists". But I don't think the people who use that phrase on a regular basis would acknowledge us.

A nice passage from G.E. Moore

"I am not at all sceptical as to the truth of such propositions as "The earth has existed for many years past." "Many human bodies have each lived for many years upon it," i.e. propositions which assert the existence of material things: on the contrary, I hold that we all know, with certainty, many such propositions to be true. But I am very sceptical as to what, in certain respects, the correct analysis of such propositions is. And this is a matter as to which I think I differ from many philosophers. Many seem to hold that there is no doubt at all as to their analysis, nor, therefore, as to the analysis of the proposition "Material things have existed," in certain respects in which I hold that the analysis of the propositions in question is extremely doubtful; and some of them, as we have seen, while holding that there is no doubt as to their analysis, seem to have doubted whether any such propositions are true. I, on the other hand, while holding that there is no doubt whatever that many such propositions are wholly true, hold also that no philosopher, hitherto, has succeeded in suggesting an analysis of them, as regards certain important points, which comes anywhere near to being certainly true." - G.E. Moore, 1925

Moore with Keynes

Libertarian arguments against federal programs to help integrate blacks in 1968 were relatively rare

I was looking at the codebook of a survey done in fifteen cities in 1968 on attitudes toward racial integration as well as the riots. I've plotted out the results of a follow up question in the survey on the reasons why people opposed federal programs that would spend money on black social and economic integration. The percentages add up to more than 100%, because people could provide multiple answers:

Only a little over 10% of the respondents who opposed these programs opposed it because they thought it was inappropriate for government to do that sort of thing. More thought it was unnecessary, too costly, bound to fail, etc. By far the most common response was that blacks shouldn't turn to the government and instead help themselves.

With all this talk about Rand Paul and what he thought of the Civil Rights Act, it's important to keep in mind that he's joining a crowd that is motivated for decidedly non-libertarian reasons. We don't have large surveys, but the same is likely to be true of the Civil War. If there were genuine advocates of libertarianism using that argument to justify the Confederacy at the time, they were probably in the minority.

The best piece I've read on Keynes in a while

Deirdre McCloskey, Keynes was a Sophist, and a Good Thing Too.

One critique I have is that McCloskey doesn't seem to allow for the prospect of Sophist mathematical theory or a Sophist econometrics - scientific theoretical and empirical work that understands the contingency of human knowledge and that understands that science is a search for useful knowledge rather than "truth". I think she presents Keynes well - he shares her skepticism. But I still think it's a mistake.

Brad DeLong has stirred up the left

Here and here.

Sir, I wish you luck - and look forward to the response. Center-left neoliberal technocrats of the world, unite!

Who needs the founders - they're all at the Mises Institute!

This was too good not to mock. A while back we heard that Ron Paul is the modern incarnation of Thomas Jefferson. As if that wasn't sufficiently laughable, now Tom Woods is the modern Thomas Paine (somebody ought to tell him Paine supported central banking and the welfare state, and that being pro-liberty doesn't mean you're a libertarian).

I really can't stop with the Paine comparison, though - because Woods is compared to many more heroes besides Paine here:

- Gandalf: "As Gandalf deals with the problem of a dragon in The Hobbit, Meltdown deals directly with the single draconian problem of state control over our lives" (too bad Gandalf didn't deal with the dragon at all in The Hobbit - he was nowhere to be found until after the dragon was dead).

- Michael Bublé

- Dorothy from the Wizard of Oz (also interesting because some say that was a pro-bimetallism allegory - although this is disputed), and

- Harry Potter

Why don't my commenters ever seem to find the Mises Institute as thoroughly goofy as I do?

Assault of Thoughts - 5/24/2011

"Words ought to be a little wild, for they are the assault of thoughts on the unthinking" - JMK

- Brad DeLong contrasts "MIT Keynesians" with what he calls "East Anglian Keynesians" (Post Keynesians, basically). He considers himself an MIT Keynesian, and that's where I generally feel like I lie too. One of the points of the post, of course, is that East Anglian Keynesians have important things to say as well.

- The Social Democracy for the 21st Century blog discusses Herbert Hoover's deficits. My synopsis: just because you guys don't agree with him doesn't mean he's even remotely close to what we think. I agree. People get so weird about Hoover on both sides. Why is it so hard to say "Hoover was a conservative, reformist, associationalist - there are a lot of people like him today too, and he doesn't make any of us happy although he seems like he was a nice guy."

- Bob Murphy provides a great history of the cost theory of value and the introduction of subjectivism in the 1870s. He credits all the marginalists (which is good), but then goes over Menger's contribution specifically. What's amazing to me is how many Austrians think that subjectivism only made an impact on the Austrians. I've had conversations with Austrian PhD students recently who actually think that modern mainstream economists commonly hold objective or cost theories of value. How did that misunderstanding ever catch on?

- This is Keynes's Economic Possibilities for Our Grandchildren, because that is really what I'm talking about in the temporal autarky posts. The critiques have taken an odd turn. Bob Murphy, for one, has taken the whole point of my argument (that compensation can't occur) and understood it to be a counter-argument! The point is that autarky is unfortunate but inevitable in this case, but we still need to understand the implications. We don't need to sign over our life savings to future generations. But we do need to think about these sorts of things. In real terms I'm going to be wealthier than my grandparents. That's just the nature of economic progress. I'm on the right track, but not particularly wealthy yet, but by the time I get there I might not be able to pay my grandparents back. And yet when I was younger they still helped my parents pay for my college (and I understand my great-grandparents helped my grandparents pay for my parents' college). If you follow Bob Murphy's logic this is incomprehensible. Why would they do that? It can't have been a problem in the first place if the only solution was for my relatively poorer grandparents in the past to make an investment in my future so I could retire in 2050 much wealthier than they were when they retired. He's clinging to welfare criteria and market transactions when my whole point was that there's no transactional solution to this problem. He essentially reiterates the whole argument and calls that a disproof. But of course it's not a disproof at all. We care about the economic possibilities for our grandchildren, and I'm simply saying that's a good impulse and should be cultivated. Nobody is arguing that we shouldn't attend to our needs in making provisions for the future.

Quick public service announcements

1. Methdological individualism does not give you license to get upset when I use the first person plural. We can disagree with the merits of what it does say - I think it leads people who misunderstand it to fetishize microfoundations. But one thing it doesn't say is that the concept of "we" is illegitimate.

2. Nothing makes me think you're not very intelligent and not worth talking to faster than when you call me a statist or a proponent of central planning. I'm serious - I'm getting really sick of this. Stop.

3. I don't always talk about government on this blog. More often than not it enters the conversation when my commenters bring it up. Don't think when I'm talking about certain characteristics of the market I'm trying to make a case for the government.

Thinking in four dimensions

The alt text is: "She also starts every letter with 'Dear Future [your name]'."

Physics, Transaction Costs, and Production Costs

Bob asks in response to my temporal autarky posts: "Right now I have $100 I'm trying to decide what to do with. I could invest it, I could spend it on sushi, OR I could wire it to a hungry guy in Africa. Now if that guy in Africa could touch a rock and turn it into a gold bar, then ship it back to me, for sure I would consider that a great trade and I'd do it. By the same token, the guy in Africa would much rather have the stuff he could buy with $100 than the labor it takes him to touch a rock.

Ah but alas, the laws of physics don't allow him to touch a rock and turn it into gold. Hence, I myopically do not take into account the fact that if I just *gave* my $100 to the guy in Africa, he would have more utility.

Did I just spotlight another example of a problem with the laws of physics impoverishing us?"

In a sense, he absolutely did spot another example of the laws of physics impoverishing us. Physics, after all, is the primary source of scarcity in this world and scarcity is impoverishing and the whole motivation for economic action. So sure! Blame the laws of physics.

But this is an odd thing to complain about. Generally economists don't complain about the lack of superpowers as welfare-reducing.

What's different? Bob is really pointing to an infinite production cost imposed by physics. Fair enough, but production technology is usually taken as given (if he wants to make an argument why we should care more about these sorts of limitations, he's welcome to). I'm pointing to an infinite transaction cost imposed by physics. Usually economists take the inability to make transactions to be worthy of more serious consideration than the inability to succeed at alchemy. On top of this infinite transaction cost is an externality: we can impact the future but they can't impact us. This is not all that bad, of course! That's what we call "cause and effect", and we wouldn't be able to understand all that much without it. I'm not cursing the laws of physics here, I'm just trying to understand its implications for human society, and thinking through decisions we might want to make as a result of those implications.

UPDATE: And Facebook tells me it's Bob's birthday today - Happy Birthday Bob!

The Laws of Physics are Protectionist

Bob Murphy responds to my post on temporal autarky here. The angle he takes in critiquing it was a little bit of a surprise to me - he writes:

"Yes, there are potentially mutually advantageous trades that aren’t occurring between people in North America and North Korea. They aren’t occurring either because of government barriers or because of “real” transactions costs. Either way, that’s not a typical market failure. Either the government is causing the problem, or the problem is due to something “real” that can’t be solved politically. Look, there are farmers who let oranges rot in Florida even though they would be willing to sell them for a penny to people in India, and even though the people in India would be willing to pay 2 pennies for them. But it costs too much to ship them. That’s not a market failure in any conventional sense of the term.

So, if Daniel wants to use the analogy of North Korean autarky to prove that the market fails in intertemporal trade, I’d like him to first spell out exactly how the market is failing us in interspatial trade with respect to North Korea."

I'm indifferent about whether we want to call this "market failure" or not. We are dealing with an externality. Our decisions today have an impact on people living in 2311 or 2811, but they aren't a party to those decisions. That's an externality. An externality is pretty legitimately called a "market failure". I never called it that in the post, but there's nothing blatantly wrong with thinking about it that way. But we can also just think of it as protectionism. I'd like the market to work intertemporally, after all. It's not like I'm celebrating this! But the laws of physics have real consequences for the laws of economics, and I'm just trying to think through that.

If Bob is uncomfortable with the idea of "market failure" because he doesn't think you can be pro-free market if you think the market fails sometimes (I wouldn't agree with this, but some people do seem to think like this), then we don't need to think about it that way. We can maintain our free market credentials in the eyes of people who think market failures contradict them, and instead think of the laws of physics as protectionist laws of economics. Now the market works, and physics is the culprit! That's fine by me. These all seem to be equivalent claims.

Brian Cox, former musician of moderate fame and currently a physicist working at the Large Hadron Collider, explicitly talked about time as a protectionist force here (1:54):



So if Bob isn't comfortable talking about market failure that's fine - that's why I originally talked about "autarky" rather than "externality". I'm fine blaming the laws of physics (I'm sure they don't particularly care if we blame them). The point is, what are the consequences? The consequences are relative impoverishment. Humans figure out ways to work around autarky and market failure all the time. We innovate our way around these problems. Temporal autarky is another problem that we ought to invest some effort in innovating around.

The Future is an Autarkic Regime

You have a better chance of making an economic transaction with someone from North Korea today than you have of making an economic transaction with someone living 100 years from now. We typically think of North Korea as an autarkic regime, so I've always felt that it's reasonable to apply the same term to the future. We are simply not allowed to trade with anyone in the future - even our future selves. This is the problem of temporal autarky.

We have evolved to deal with this. The matter that composes us may extend in all four dimensions of space-time, but our experience of existence has evolved to be an experience of space-time as a three dimensional reality (space) moving along a fourth dimensional track (time). Einstein called this conceptualization of reality a "stubbornly persistent illusion", but it is an illusion that works decently well for both neoclassical economics and Newtonian physics. Both of these metaphors for "reality" have produced important practical results. But they have limits. We broke those limits a century ago in physics, and the twentieth century has reaped the benefits. Keynes started to crack the limits in economics seventy-five years ago (something that Andrew Bossie discusses here), but I'm not sure he fully incorporated the economics of the future into his thought.

We have one investment to consider as a society that I talk about fairly regularly on here: the exploration, terraformation, and colonization of the planet Mars. That's a costly endeavor, but also one with important benefits. But benefits to whom? Mostly to people living two hundred, three hundred, four hundred years in the future at least. It would be an adventurous, but not exactly pleasant place to live until at least that time. Now imagine if you lived in 2311, on the Earth. You have the option of living with a single planet civilization or a two planet civilization (with much better access to a resource-rich asteroid belt). You only know Earth now, of course, so you could be tempted to say you're fine with a one planet civilization, but I think that's naive. Imagine if half or even less than half of the Earth's landmass were gone: if there were no North and South America. The world would be much more impoverished place. More places, more people, more opportunities for interaction, trade, and specialization is a good thing. It's an enriching thing. Go even farther into the future - 2811 - and imagine metropolises on Mars. Imagine two Parises. Two New Yorks. Two Tokyos. Two Rios. Imagine the new cultures that would flourish there. Unambiguously more human civilization is better. Someone from 2311 or 2811 would want to make an investment in the past in this new, expansive human civilization. And in 2311 or 2811 they're going to be tremendously wealthier than we are, so investing in a Martian colonization effort in 2011 would be a pittance for them.

The problem is, these humans that coexist with us in space-time but exist in 2311 or 2811 rather than 2011 can't make this transaction with us. We are complex combinations of four-dimensional existence that can only (so far as we know) truck, barter, and exchange in three dimensions. We are living under a regime of temporal autarky, and autarky is impoverishing.

This is why I have substantial doubts about the optimality of a three dimensional market when it comes to four dimensional distributions of costs and benefits. We fake it, of course. We economists are happy to talk about "intertemporal choice". But that's not really the right term for what we're discussing. Intertemporal choice models are actually principal-agent models where our present self is acting both on his own behalf and on behalf of our future self in a transaction, but the future self has no say. Behavioral economists have pointed out that humans generally do hyperbolic discounting (to varying degrees of course). This is discussed as a sort of cognitive bias. Of course what it really is a lack of standing in the transaction for our future selves. Hyperbolic discounting is a major problem for efficiently allocating costs and benefits between future and past versions of ourselves. The problem becomes even worse when we think about allocating costs and benefits between future and past people.

What does temporal autarky imply? Well, let's think of it in terms of an autarky we're more familiar with (say, North Korea). What does the autarky of two contemporaries in the United States and North Korea imply? Well for one thing it implies that mutually beneficial exchange can't occur. So far as we know, we can't get technology from the future (Sarah Connor probably thinks that's a good thing). But if we think specifically in terms of direct investment from one trading partner to another, it means that investments that would be beneficial in North Korea and profitable to Americans can't be made in North Korea.

The same is true of the future. Our faux-intertemporal choice allows us to make a few provisions for the future, but only because we gain some utility from the expectation that some future version of ourself will gain utility. No such transaction can occur between other future humans and ourselves. The conclusion is absolutely unambiguous: the market economy underinvests in the future. Period. The market is by far and away the best institution for allocation decisions we have, but it has certain predictable blindspots and this is one of them.

Congratulations Kendra!

My sister, Kendra, now has a bachelor's degree in public administration from George Mason University! She graduated summa cum laude and got an award for being out outstanding public administration student for this year. Congratulations Kendra!!!

She's currently going to continue working with the Sexual Assault Prevention group on campus that she's been working with for a while now, helping them research other models for similar programs at other schools and making sure they conform to some new regulations released by the Dept. of Education.



Of course, my niece is cute enough that I had to include a picture with her in it too:

Being linked and getting links

Being Linked: A couple flattering ones lately

- Gene Callahan leaves some big shoes to fill while he's on vacation. This made me smile this morning :)

- David Henderson links to my discussion of the Conley-Dupor paper.

- DeLong picks up the DARPA post.

- Andrew Bossie then links DeLong and agrees with me (and cites Keynes! He knows how to get on my good side, apparently).

Getting Links: So I've gotten some reading assignments from commenters recently that I've failed miserably on. I did want to provide some - I feel like there are more, though.

- From Prateek - Skidelsky on Democracy and Finance.

- Daniel James Sanchez points me to a length piece he wrote on Misesian epistemology. I do need to get around to reading this (got through the beginning). Readers know that really especially in the last year my opinion of epistemology has declined considerably. But it's still important to know where other people are coming from.

DARPA and Temporal Autarky

DARPA wants to travel to the stars.

Fair enough - and very good in my mind. What I find even more intriguing in their Request For Information for a 100 Year Starship Study is that they are specifically interested in a business model that I've long maintained is an insurmountable problem for long-term investments. The RFI says:

"The Defense Advanced Research Projects Agency (DARPA) has initiated a study to inspire the first steps in the next era of space exploration—a journey between the stars.1 Neither the vagaries of the modern fiscal cycle, nor net-present-value calculations over reasonably foreseeable futures, have lent themselves to the kinds of century-long patronage and persistence needed to definitively transform mankind into a space-faring species... We are seeking ideas for an organization, business model and approach appropriate for a self-sustaining investment vehicle. The respondent must focus on flexible yet robust mechanisms by which an endowment can be created and sustained, wholly devoid of government subsidy or control, and by which worthwhile undertakings—in the sciences, engineering, humanities, or the arts—may be awarded in pursuit of the vision of interstellar flight."

I would love to respond to this RFI. Max submission is five double spaced pages, so it might be feasible. The problem is I have no clue how to surmount this problem. It's precisely this temporal externality that frustrates me so much and the best I can come up with is a government solution. That is riddled with problems itself, of course.

Anyway... I'm thinking on this now. The response has to be in by June 3rd. Would it be inappropriate to just submit something alleging there's no obvious solution and for the time being you have to rely on public investment (and make a case for why that's the case)?

Hawking on the End of Philosophy

Stephen Hawking says philosophy is dead because it is not keeping up with science. The video is here (most of the talk is actually about M theory).

Kaiser says it may be the physicists who dropped philosophy. To a large extent this is all a natural consequence of the academic division of labor.

Many, many philosophers have suggested they are the culmination of philosophy, and therefore that philosophy has in a sense come to an end. All have been disappointed. I think the argument that philosophy has not reached a crescendo, but has simply run its course, has more potential. Of course we'll always have a need for logic and clear thinking. If you want to call that "philosophy", then fine. But as a goal-oriented endeavor (rather than a tool building endeavor) I think Hawking has hit on something. Philosophy ought to be more like mathematics - it ought to produce tools for scientists, and perhaps amuse itself with interesting puzzles every once in a while. Philosophy can also, of course, have a historical dimension too.

Papola on DeLong on Hayek

I'm posting this against my better judgement... every time I touch on anything out of Papola the discussion seems to degenerate at a faster than average rate into pointlessness. But this introduces somewhat new material, so what the hell.

The issue at hand is a 1998 review by Brad DeLong of a book by James Scott about the problems with central planning particularly as they relate to the importance of local knowledge, which Papola mentions in this post. The local knowledge point is one that lots of people have made but of course one very famous person who made this point was Hayek, and DeLong recognizes this. Indeed in the review DeLong takes Scott to task for not mentioning Hayek more in the book. If you want a treatment of the role of very local information in social decision making and allocation, the best place to start is certainly Hayek. Papola follows this link with the statement "I think he [DeLong] was less Keynesian then than now."

I don't understand what makes people like Papola tick. I don't understand this tendency where people imagine that there has to be stark battle lines drawn in intellectual life. DeLong is Hayekian in this 1998 review so he clearly can't be Keynesian, according to Papola. What exactly does Papola think we all think? Does he think that Keynesians are generally opposed to a Hayekian outlook on the economy? I suppose he might actually think that, and I just don't understand it. Do I (and does DeLong) disagree with Hayek? Sure, on certain things. Certainly a few policy areas. Probably some methodological points. A world where there is no disagreement with Hayek is as bizarre as Papola's world where there is no agreement. And in order to generate a stark contrast between "Hayekian" ideas and "Keynesian" ideas Papola has to erect this version of Keynes that is purged of the price mechanism, purged of market efficiency, purged of free market orientation, purged of liberalism, and purged of any disaggregated conception of economics.

In other words, to get "Keynesian" and "Hayekian" to be concepts that repel in his mind, Papola reinvents Keynesianism.

I don't know - maybe life really is this stark and oppositional. I sure hope not. I don't think so. I'd like to keep my Hayek and my Keynes. The first video was pretty good (weak in expositing the point of Keynesianism, but good) because it focused on a very real point where saying you're both Hayekian and Keynesian is a lot harder: the macroeconomics of the business cycle and macroeconomic policy. The broader scope of the second video is precisely what revealed the true paucity of Papola's vision of this "fight" (what an utterly bizarre word to describe the relationship of the thought of these two tremendous thinkers). As I've said elsewhere - I'm positively disposed towards Hayek and positively disposed towards Keynes, but when you present a narrative where I'm turned off by the "Keynes" voice and find myself in agreement with the "Hayek" voice, something is very wrong.

Kumbaya, "can't we all just get along", yadda yadda yadda. I don't mean to be too pie in the sky, but I don't want to invent reasons to fight either.

Hanson, Caplan, and Yglesias on the Economics of the Far(?) Future

I don't have time to comment too much now, but I think I disagree with all of them. Here's Caplan and Hanson. Here's Yglesias. What do you think?

I have trouble thinking of robots as labor rather than capital. I have trouble understanding why Yglesias thinks Marxian growth theory implies a Marxist polity, and therefore have trouble with his assertion that we'll move into socialism. I do think we'll drift towards a socialization of investment and a smart interventionism, simply because it's the intelligent thing to do. I also think the sort of subsistence dynamics they highlight is contingent on very real resource constraints and in a world where one of our most important products is innovation that repeals resource constraints, I have a hard time swallowing this "driven to subsistence" talk. We can certainly hit painful hiccups and speed-bumps, but if robots push us to subsistence we'll just spend a little less time constructing robots that are indistinguishable from humans and a little more time mining asteroids, terraforming planets, and developing renewable energy sources.

A request

So I'm writing our chapter for the NBER volume on the engineering labor market, and one of the things I'm discussing is the transition from technical to managerial work for engineers, and occupational choice questions. I'm using the basic insights of the Roy (1950) self-selection model to talk about the factors influencing occupational choice and to make sense of some of the data. I'm trying to keep the points relatively straightforward. Not all the chapter authors are economists (my coauthor is not an economist) - some are engineers, public policy people, management people, etc. - so I want to present the Roy model in a fairly intuitive way but that's still helpful for thinking about occupational choices made by engineers.

I haven't really worked with Roy models for several years, and I'm wondering if any readers are more familiar with them than I am, and would be willing to read about a page and a half in a day or two and give me advice on whether I'm communicating the points of the model in a reasonable way. You can email me at dan.p.kuehn@gmail.com. Thanks in advance.

Some Keynes links

- Giovanni Dosi talks about the confluence between Schumpeter and Keynes at the Institute for New Economic Thinking website. I think this is very important. Some people see Keynes as saying "saving is bad and spending is good". I think that's a strange way to look at it. I see Keynes as saying "investment is good and investment doesn't always match up with savings". The latter perspective, which stresses animal spirits, etc. - this sort of view of Keynes that is more common at the Institute for New Economic Thinking - is quite commensurate with a Schumpterian entrepreneurial view of the economy.

- Brad DeLong defends Keynes against Jacques Rueff booster Benn Steil.

- Dominique Strauss-Kahn is in the news for things besides his economics, but his vision for the IMF has been similar to that of Keynes. He has pushed for the broader Keynesian vision of the IMF in the past, which was vetoed at the Bretton Woods conference. Strauss-Kahn is out of the picture, and that is a good thing. But that's not going to stop people from making this point about the role of the IMF. I don't think we've heard the end of plans for the SDRs that more closely mirror Keynes's original vision of the bancor.

- Finally, I recently came across a collection of John Maynard Keynes's Newton related papers. It's mostly letters, invoices, etc. associated with his efforts to collect Newton's papers in the 1940s. There's some really fascinating stuff in here.

And a quiz - who called Keynes a "well-known bourgeois and implacable enemy of Bolshevism"?

Some clarification on "liquidity traps"

Gary confuses liquidity preference theory and liquidity traps in the comment section of this post. I want to clear up exactly what we're talking about here, and why liquidity preference is very important (whereas liquidity traps are just an interesting curiosity).

Gary writes: "Daniel, While liquidity preference theory is not controversial amongst a subset of financial economists, how often it happens is. This was Milton Friedman's point; yeah, it is possible to get into a liquidity trap (though it is not very likely to ever occur), but to build your entire notion of economics around it (as Keynesians of all stripes do) is silly."

Liquidity preference theory says that one determinant of interest rates is the tradeoff that people make between holding and parting with liquidity. Keynes thought this was the determinant of interest rates. Most people since Keynes (myself included) think it is a determinant of interest rates, but not the only one. If liquidity preference is the only determinant of interest rate, there's no guarantee that the loanable funds market will clear or be consistent with full employment. If interest rates are determined jointly with the market for loanable funds, then the loanable funds market will clear but there's still no guarantee that it will be consistent with full employment.

That's the liquidity preference theory of the interest rate, but that has nothing at all to do with liquidity traps. You could firmly believe liquidity traps are impossible and still have a liquidity preference theory of the interest rate and a Keynesian perspective on the macroeconomy.

So then what's a liquidity trap? A liquidity trap is a situation where the demand for liquidity or money is virtually unlimited - where the money demand curve is highly elastic. Liquidity is in such high demand that no matter how much liquidity is pumped into the market, interest rates don't lower. The demand curve is not downward sloping, it is horizontal. People can't be satiated.

This is the traditional liquidity trap, at least. This is the version that Keynes speculated on briefly. Today, though, the liquidity trap has become associated with the "zero lower bound" thanks to Paul Krugman. In the 1990s, Krugman pointed out that in Japan a nominal interest rate floor acted like a horizontal money demand curve. You can think of the zero lower bound as a price floor in the market for liquidity. Money demand may not be horizontal at all, but the zero lower bound makes it look like we're in a region where it is. I've outline both of these situations (the traditional case and the Krugman case) below in red:



Most Keynesians are pretty skeptical of liquidity traps. We only think two have happened in U.S. history, with a few other cases in other countries. Here's the thing, though: all of these cases have been of the Krugman/ZIRP/faux-liquidity-trap variety. Keynes's original skepticism about a horizontal money demand curve seems to have held up pretty well. We're at the point now where the Krugman version is essentially taken to be synonymous with "liquidity trap" because it's the only version we ever see!

Liquidity traps are very bad news. I'm not of the opinion that they make monetary policy impossible. You can always create inflation with monetary policy, which lowers real interest rates even if nominal interest rates are stuck at zero. You can also do unconventional stuff like charge negative interest rates on reserves held at the Fed. However, it does make a much stronger case for fiscal policy. Creating inflation is hard in the current depressionary environment, so while in theory it's plausible to lower real interest rates that way it's a dicey proposition. Why mess with this horizontal money demand curve when we can increase public investments easily and when there are lots of worthwhile public investments to make? Why mess with a stubborn LM curve when the IS curve is easy enough to shift? So the liquidity trap/ZIRP situation is relevant to Keynesians insofar as it tips the scales in favor of fiscal policy. It has nothing to do with the broader Keynesian point about liquidity preference theory and the cause of the recessions.

A good source on this is Boinavosky (2004).

It's interesting - Krugman has been celebrated for his trade theory, but in the end he will probably be most remembered for permanently switching us from the old view of liquidity traps to the ZIRP view - first as it applied to Japan, and now as it applies to the U.S..

More on the Conley-Dupor ARRA Paper

More people have weighed in on the ARRA evaluation I mentioned this weekend. I think all of these miss what I still think is the major point - which I reiterate at the end of this post.

- Noahpinion's opinion has been getting a lot of coverage. His major point seems to be that the results are not especially statistically significant. OK, but the point estimates are pretty consistently negative... I'm not sure I entirely buy this as the major point against the paper.

- Noahpinion and Brad DeLong all pile on Karl Smith and Greg Mankiw for posting the paper without comment. I think this is a little much. I post stuff I don't necessarily agree with but find interesting all the time. Often I provide thoughts, but sometimes I don't. We ought to be more critical readers than this.

- Paul Krugman's critique is odd to me too. He argues that Conley and Dupor make no effort to control for the differential effects of boom and bust in different states. But this is the whole point of the Conley-Dupor instrumental variable approach! Krugman seems suspicious of the instruments (not a bad posture to take - people should always be skeptical of instrumental variables), but it's not clear to me exactly what the problem is. The highway funding formula sounds like a fairly good instrument for the spending. I could see some problems with the sales tax intensity instrument. There might be some public finance tradeoffs between sales taxes and property taxes, and low property taxes might be associated with housing booms - I don't know. But Krugman fails to get very specific here.

- Arnold Kling says that Conley-Dupor isn't reliable without elaborating on why he thinks that. Instead, he embraces Taylor and Cogan who make absolutely no effort at all to identify a counterfactual! Ugh. Taylor's work on the stimulus has - in my mind- been essentially worthless.
- Dean Baker has some OK sensitivity suggestions here but he also falls into this "I bet they're doing something dishonest but I really don't know" line. Look, I think we should assume honesty of scientific peers until we have reason not to. I think we should assume there's no blatant data mining going on here. Dean Baker doesn't like the instrument I find convincing (the spending instrument). I wish I knew why he doesn't like it but of course he doesn't say.

*****

The real problem with this paper: The real problem with this paper, which was a problem with an earlier state-level analysis that found a positive effect of stimulus too, is that it is state-level. Fiscal stimulus works through two major mechanisms: (1.) increasing demand for loanable funds, and (2.) the multiplier effect. Both mechanisms will bias state-level estimates in an open economy (like ours) downward. Let's think of the case of Maryland and Virginia. The impact estimator in this paper is produced by asking "what effect does a change in (VA stimulus money - MD stimulus money) have on (VA job growth - MD job growth)?" In other words, if we marginally increase stimulus money, what is the associated marginal increase in job growth? There's one big issue with estimating this that the authors do make an effort to solve. We would think that lower expected job growth would cause higher stimulus payments, right? The instrumental variables are intended to address this "endogeneity bias". Let's assume for the moment that they addressed that sufficiently.

A far bigger problem is that in an open economy we know that financial markets are national markets. So any impact that the stimulus has on these markets that might encourage job growth is going to increase both VA job growth and MD job growth simultaneously. If they both increase simultaneously, you're not going to observe the change with a state-level regression. In the same way, any multiplier effect in an open economy is going to be biased downward. We can decompose the impact estimate I discussed above (with VAst=VA stimulus, VAjc=VA job creation, etc.) into:

(dVAjc/dVAst) - (dVAjc/dMDst) - (dMDjc/dVAst) + (dMDjc/dMDst)

Now - notice which marginal effects have a negative sign in front of them when you decompose this. It's the two cross-state derivatives! Makes sense, right? If higher MD stimulus causes higher job creation in VA, then a regression that uses the difference in VA and MD stimulus to estimate the impact on VA jobs is going to be lowered in the regression even though there's a positive effect in the real world! So the question is, how big are (dVAjc/dMDst) and (dMDjc/dVAst)? A good start would be to figure how substantial interstate commerce. I tried the BEA's state GDP page, but they don't seem to calculate it (and why would they within a monetary and political union like the United States?). Does anyone know of any estimates of interstate commerce as a percent of GDP in the U.S.? That would be a good place to start to estimate how much of an underestimate this is.

So how would we go about checking on this? My first thought is to regress the residuals on state population or state GDP, but I'm not entirely sure that makes sense. I would think that interstate commerce makes up a smaller share of output for larger states, but that could be wrong - after all, a lot of big states are also major economic hubs that you would think smaller states would be more likely to do business with.

The point is, I think everyone is missing the biggest problem with this paper: state level analyses can't capture (1.) interstate effects, and (2.) impacts on national markets.

That's an enormous omission.

Russ Roberts and William Byers

Russ Roberts has one of the best Econtalks I've listened to in a while up. He's talking to mathematician William Byers about uncertainty and imperfections in science, although the discussion is wide ranging.

They make a lot of points I make here on a regular basis which can be summed up as an opposition to a justificationist or foundationalist attitude towards science.

I find Russ's position on all this practically inscrutable. On the one hand he recognizes what scientific modeling and empirical work actually is - it's not a foundationalist attempt at some deeper truth, it's just an imperfect replication of what we see in the world to try to understand it better. Russ knows this. He talks about it in this video! So why is he so critical of modeling and empirical for not living up to a standard that they were never meant to meet? Why not accept it for what it is and what it can do? I have no idea. Russ has always deeply confused me on these points, but the discussion is still good.

Some work that I think would go well with this talk:

- Kuhn's The Structure of Scientific Revolutions
- Dewey's The Reflex Arc Concept in Psychology
- Keynes's Newton, the Man

1937, the Fed, the stock market, and the Treasury

Sitting on cash when people want cash drives up interest rates. High interest rates discourage investment. They discourage investment even more when investors are already predisposed against expanding operations to provide for future demand that they're uncertain about. They discourage investment even more if there are arithmetic barriers to relief on interest rates (like a nominal price floor and weak inflation).

As far as the economy is concerned, it doesn't matter who does it: households increasing savings, businesses demanding and retaining higher profits, central bankers mandating higher reserves, or fiscal authorities sitting on money. As far as history is concerned, of course, sometimes one entity is more to blame than another.

Paul Krugman recently wrote a post on the "recession within a depression" of 1937, which he says eerily parallels the discourse we see today. He says (citing Friedman and Schwartz) that in 1936-1937 the Federal Reserve started getting concerned about the inflationary potential of the large growth in excess reserves. These concerns are not unlike those we are hearing today. They responded by raising reserve requirements, a decision which Friedman and Schwartz consider to be the source of the 1937 downturn. Krugman raises doubts about how important this policy really was, citing the Romers. Recent research looking at Federal Reserve member banks by Calamoris, Mason, and Wheelock (2011) confirms Krugman and the Romers' suspicion that Friedman and Schwartz were too quick to blame the Fed. They demonstrate that the reserve requirement rules were non-binding. This is all in the spirit of Krugman's own mentor, James Tobin, who said of the 1936-37 Fed policy that "raising reserve requirements may have been a mistake but it was probably a relatively harmless one."

Jonathan Catalan presents a response that ties Krugman to Friedman and Schwartz (which seems a little odd to me). Aside from the question of what Krugman thinks fo the Friedman and Schwartz argument, Jonathan does identify the common thread between the three economists, that "the point Krugman is trying to make is that tight monetary policy will definitely set a recovery back". Jonathan, of course, disagrees - a position which he has staked out earlier in his Mises Daily article on the 1937 recession. He blames the stock market crash for the contraction of the money supply. Falling stock prices increased precautionary demand for money, leading to a contraction in the money supply.

This is a little confusing to me. As I understand it, the stock market crashed in August of 1937, the monetary base started falling at the beginning of 1937, and output started falling earlier in the spring. How does Jonathan get the causality going from the stock market to the monetary base? I don't entirely understand the argument.

So barring an explanation from Jonathan, he seems to be wrong in pointing to the stock market (and thus businesses and households) as the source of the reduction in the money supply. Friedman and Schwartz are wrong that the Fed is to blame (according to Jonathan, Krugman, Calamoris, Mason, Wheelock, Tobin, Romer, and Romer). So what happened in 1937?

Well once again we can look to Calamoris, Mason, and Wheelock (2011), who suggest that the real culprit may have been the U.S. Treasury. In 1936 the Secretary Morgenthau decided to play central banker and sterilize billions of dollars of incoming gold by stock-piling it and paying for it by selling government securities (rather than by depositing it at the Federal Reserve). This is just as contractionary as it would be if the Federal Reserve had engaged in open market sales.

Of course taxes were raised and the deficit was cut too - that doesn't help. But the gold sterilization point is interesting because you don't hear people talking about it as much.

Does this history make sense? I'm no expert on the depression, but the literature seems to point to this explanation. Perhaps Friedman and Schwartz defenders can reinvigorate the case for the impact of reserve requirements or Jonathan could explain how the stock market is causal here.

Tying up some loose ends

- The part of this post on federalism and interstate commerce that I was personally most interested in wast he ARRA evaluation, although the comment section pretty much stuck to the piece on the Constitution. I wanted to bring people's attention to this critical review of the ARRA paper by Noahpinion. He makes different criticisms than I did.


- I also wanted to share more background material on the new Buturovic and Klein paper. This is the new paper. This is the old paper. This is my response to the old paper. The other three responses can be found here, here, and here. Evan asked some probing questions in the comment section of the last post, which a few links might help clarify: this is the list of reviewers for the journal (scroll to the bottom), this is Daniel Klein's website (I can't find one for Buturovic).

Libertarians aren't as economically enlightened as liberals

How likely do you think it is that this follow up paper by Buturovic and Klein will make the Wall Street Journal and sweep the blogosphere the way their first paper with the opposite headline did?

Of course the correct conclusion from this paper ought to be not only that my title to this post is wrong, but the first headline (that libertarians are better at economics) is wrong too. The correct conclusion is that everyone can do badly depending on the question, and in this particular paper libertarians and conservatives did badly.

I still think there are a few outstanding problems with this paper - I still think they're failing to differentiate between what people actually know and the way they answer the question (i.e. - seeing it normatively or positively). It's a misnomer to say they're looking at "enlightenment" at all. Many of these people may be perfectly enlightened, but also sentimental. They also stick to their guns on the interpretation of the "right" answer to these questions - some of which have been highly suspect.

But every study has empriical pitfalls that it will never be able to answer completely. The important thing is that you tailor the extent of your claims to those imperfections. If you have a shaky study you don't blare out a bizarre conclusion. "Libertarians are better at economics" should never have passed the smell test and it says something about the circles that the authors move in that it did pass the smell test. That study and this follow up may not be perfect, but they at least eliminate that claim.

Hopefully there is equal buzz about this finding, but I'm not optimistic.

Federalism and Interstate Commerce Links

1. I'm not going to bother linking all of them (just the one that bugs me!), but Andrew Sullivan has been writing a lot about Mitt Romney's attempt to present his case on health reform, and the political strategies involved. One of the earlier posts that bothers me is titled "Romney Hides Behind Federalism". It's very troubling to me that federalism is seen as a fake solution that is whipped out for expedience - that Sullivan isn't even serious about the prospect that perhaps Romney did health reform when he was governor because he thought it was a viable decision for governors to make and implement. Instead, people want to turn Romney into a closeted Obamacare advocate. I've said from the beginning that I would have liked to see three things out of health reform. Obama disappointed me on two of those things and succeeded on the third. He did well by relenting and agreeing to John McCain's initial proposal to end (or at least seriously cut back) the tax subsidies on employer provided benefits. He still had an individual mandate, which I opposed, and he also didn't provide a whole lot of flexibility for state experimentation.

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2. Greg Mankiw links to an evaluation of ARRA (the stimulus) that finds a negative impact on jobs. What doest his have to do with the states and interstate commerce? Well, the study is done with state-level data and more crucially the model specification is unable to incorporate the impact of interstate commerce which is - to put it mildly - an enormous omission. One nice thing about the study is that it does attempt a sophisticated identification strategy. It uses two instruments - state sales tax intensity (to instrument the decline in state budgets - which I've always noted has been an important contractionary force that people ignore), and state highway funding formulas (which should be exogenous to the recession and are an important determinant of ARRA funding levels). I'm especially glad to see them instrument for state budget losses. But here's the problem - the only impact they can estimate is between states that received relatively more or relatively less stimulus. So if Virginia received $900,000 in stimulus and Maryland received $1,000,000 in stimulus they're going to try and identify the impact of that extra $100,000 of stimulus. Theoretically that could be fine - it'll provide a marginal effect that can be attributed to the whole package. My first (more minor) concern is that when you infuse a lot of money into an economy like this you're ultimately going to run into bottlenecks and - yes - crowding out at least on the margin and in certain areas. Is that marginal effect of the last $100,000 the same as the marginal effect of the first $700,000? Likely it's not.

That's a relatively minor concern, actually. The bigger concern is the interstate commerce point. A lot of commerce is done across state lines and that can't be accounted for with this sort of estimation strategy because the ARRA funds going to Virginia not only are not used to estimate job levels in Maryland - the job levels in Maryland are actually counted against the Virginia impact estimates. To simplify things, you can think of the model as asking "what is the effect of (VA stimulus-MD stimulus) on (VA jobs-MD jobs)". If MD stimulus positively impacts VA jobs or if VA stimulus positively impacts MD jobs, you're going to actually reduce the estimated marginal effect. I don't know if this sort of thing completely eliminates the prospect of state-level studies of fiscal multipliers, but it's certainly something that needs to be taken into account.

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3. Matt Yglesias has a good treatment here of arguments against the clear English of the commerce clause that amount to "well if you can do that, what can't you do?". It's never been an especially impressive argument. Yglesias points out some obvious things you can't do, including violating other Constitutional provisions like the first amendment and rights to due process. I've noted before that you also can't violate the general welfare clause - special priveleges for the sake of private welfare skirt Constitutionality in a real way that belies these claims about "if you can do that what can't you do?". But more importantly, these arguments demonstrate a real lack of commitment to the very idea of republican virtue. The Constitution is an important document because it limits the state, thereby protecting incursions on liberty. But since when has it been the only thing standing between the state and liberty? It has always been recognized that for a republic to succeed you need a virtuous populace. You need a populace that won't pursue inappropriate uses of power (or rectify the situation when such powers are pursued).

People act as if we can't have a meaningful and successful republic if the Constitution doesn't provide the ultimate and final demarcations of power. This is an excessively myopic critique, in my mind. We want to be able to achieve public ends with the republican institutions we have set up. Half the petitions raised by Jefferson in the Declaration were complaints about George III not letting the colonial legislatures pass laws that were for the public good. Since the beginning of the republic, it has been understood that we want a government that allows us to govern ourselves - that gives us the ability to make important public investments and decisions. A nit-picking Constitution threatens that, so instead we have a Constitution with real restrictions on the state - but restrictions that are open to interpretation, and yes - deliberation. It amazes me that this very idea that things are left open to deliberation and interpretation is viewed as a threat to liberty, rather than a source of real liberty.

In a free society, we deliberate within a framework of broad restrictions on the state, and if we want to keep that free society we have to preserve the republican virtues that are required for the preservation of liberty. The Constitution is a tool, not a master. It helps us preserve liberty - it's not a free pass on deliberation or a guarantee of success or an ultimate bulwark in defense of liberty. It's like a marriage. The contract itself doesn't guarantee anything. You have to work at your goal.