Potpourri

by Levi Russell

Here's a collection of articles I've read over the last week or so.

David Henderson on Thoma on potential changes to banking regulation.

Economist Allan Meltzer recently passed away. Here and here are two commentaries on his work.

A major contribution of another recently-deceased and well-known economist William Baumol is discussed here.

Don Boudreaux has a fantastic post on the importance of Econ 101. Here's a short excerpt:

To put the point a bit differently, ECON 101 instills the good habit of looking past stage 1, which is the stage at which most non-economists stop their investigations of economic consequences.  ECON 101 prompts those who grasp it to look also to stages 2, 3, and 4.  More-advanced economics courses – all the way to ECON 999 – teach that in theory there is also the possibility of stages 5, 6, 7, …. n.  Awareness of these theoretical possibilities is, of course, useful.  But awareness of stages 5, 6, 7, … n is either meaningless or, worse, practically dangerous without also an awareness of stages 2, 3, and 4.  And nearly all economic ignorance in the real world is simple unawareness of stages 2, 3, and 4.  (It’s also mistaken to conclude – as Kwak concludes – that awareness of stages 5, 6, 7, …. n regularly nullifies policy conclusions drawn from awareness of stages 1 through 4.)

Here's a great piece at Cato on the Net Neutrality issue.

Economics blogger Jim Rose corrects Noah Smith's oft-repeated claim that the economics profession was, until recently, dominated by right-wingers and libertarians.

Specialization and Trade - A Reintroduction to Economics

That's the tile of Arnold Kling's newest book. It's published by the Cato Institute and is available in e-book format on Amazon for a mere $3.19. You can also download a PDF copy here free. Arnold Kling is an MIT trained economist who spent the bulk of his professional economic career at the Federal Reserve and Freddie Mac. Kling's blog, one of the best on the web in my opinion, is always thought-provoking. As the title of his blog suggests, he makes every effort to understand and fairly state the positions of those with whom he disagrees.

I read a couple of blurbs about the book last week and have only just finished the first chapter. So, rather than write a review, I'll reproduce a section of the Introduction that gives a short description of each chapter. Kling certainly has a unique perspective and I suspect I'll learn a lot from this relatively short book.

“Filling in Frameworks” wrestles with the misconception that economics is a science. This section looks at the difficulties that economists face in trying to adopt scientific methods. I suggest that economics differs from the natural sciences in that we have to rely much less on verifiable hypotheses and much more on hard-to-verify interpretative frameworks. Economic analysis is a challenge, because judging interpretive frameworks is actually harder than verifying scientific hypotheses. 

“Machine as Metaphor” attacks the misconception held by many economists and embodied in many textbooks that the economy can be analyzed like a machine. This section looks at a widely used but misguided approach to economic analysis, treating it as if it were engineering. The economic engineers are stuck in a mindset that grew out of the Second World War, a conflict that was dominated by airplanes, tanks, and other machines. Their approach fails to take account of the many nonmechanistic aspects of the economy. 

“Instructions and Incentives” deals with the misconception that economic activity is directed by planners. This section explains that although people within a firm are guided to tasks through instruction from managers, the economy as a whole is not coordinated that way. Instead, the price system functions as the coordination mechanism. 

“Choices and Commands” is concerned with the misconceptions held by socialists and others who disparage the market system. This section explains why a decentralized price system can work better than a centralized command system. Central planning faces an information problem, an incentive problem, and an innovation problem. 

“Specialization and Sustainability” exposes the misconception that we must undertake extraordinary efforts in order to conserve specific resources. This section explains how the price system guides the economy toward sustainable use of resources. In contrast, individuals who attempt to override the price system through their individual choices or by imposing government regulations can easily miscalculate the costs of their actions. 

“Trade and Trust” addresses the misconception among some libertarians that the institutional infrastructure needed to support specialization and trade is minimal. Instead, this section suggests that for specialization to thrive, societies must reward and punish people according to whether they play by rules that facilitate specialization and trade. A variety of cultural norms, civic organizations, and government institutions serve this purpose, but each of those institutions has its drawbacks. 

“Finance and Fluctuations” deals with the misconceptions about finance that are common among economists, who often fail to appreciate the process of financial intermediation. This section looks at the special role played by financial intermediaries in enabling specialization. Intermediation is particularly dependent on trust, and as that trust ebbs and flows, the financial sector can amplify fluctuations in the economy’s ability to create patterns of sustainable specialization and trade. 

“Policy in Practice” corrects the misconception that diagnosis and treatment of “market failure” is straightforward. This section looks at challenges facing economists and policymakers trying to use the theory of market failure. The example I use is housing finance policy during the run-up to the financial crisis of 2008. The policy process was overwhelmed by the complexity of the specialization that emerged in housing finance. Moreover, the basic thrust of policy was determined by interest-group influence. The lesson is that a very large gap exists between the economic theory of public goods and the practical execution of policy. 

“Macroeconomics and Misgivings” argues that it is a misconception, albeit one that is well entrenched in the minds of both professional economists and the general public, to think of the economy as an engine with spending as its gas pedal. This section presents an alternative to the mainstream Keynesian and monetarist traditions. I argue that fluctuations in employment arise from changes in the patterns of specialization and trade. Discovering new patterns of sustainable specialization and trade is more complex and subtle and less mechanical than what is assumed by the Keynesian and monetarist traditions.

I Can't Put Enough Scare Quotes Around "Free Market"

by Levi Russell

Earlier this month I read a couple of fantastic posts over at the Coordination Problem blog. The common thread between the two posts is that the "free market" moniker given to many individual economists and schools of thought is really about the conclusions reached through rigorous analysis of real-world institutions, not about any sort of ideological assumption.

The first is a lengthy post by Peter Boettke. Boettke lays out his perspective of the "economic way of thinking" and describes how it's used to analyze the real world:

From my perspective there is a core of the economic way of thinking that can be traced from Adam Smith to Vernon Smith and that deals with basic ideas about human rationality, human sociability, and the coordination of activity through time.  Incentives, Information, and Innovation are part of this core as they derive from the even more primordial ideas of property, prices, and profit/loss accounting.  We live in a world of scarcity, scarcity implies that we face trade-offs, that means we must negotiate those trade-offs and we hope to do so in the most effective way possible, to achieve that we need aids to the human mind, those aids come in the form of high powered incentives and clear signals so we may engaged in the economic calculus.  One of the many implications that follows is that demand curves will slope downward and supply curves will slope upward.  The shape and the magnitude of the effects that follows are empirical matters and is largely determined by the array of substitutes available to economic decision makers.  But the essential logic holds from a style of reasoning that attempts to derive the invisible hand theorem from the rational choice postulate via institutional analysis.  Hume's principles of stability of possession, transference by consent, and the keeping of promises -- in other words, property, contract and consent -- provides that institutional infrastructure within which the human pursuit of individual betterment is channeled in commercial life into publicly desirable outcomes (e.g., wealth creation and generalized prosperity; the least advantaged are made better off).  Again, property, prices and profit/loss gives economic actors high powered incentives and informational signals to allocate resources, time and effort to the most highly valued use, and the constant feedback on whether those decisions are the right ones and the incentives and information to constantly adapt and adjust to improve in the decision calculus. 

This basic economic calculus applies to all human endeavors, and when we find ourselves outside of the realm of the market sphere of monetary calculation, the question for the analyst is what institutions will serve the same function in terms of incentives, information and innovation that property, prices and profit/loss served in the marketplace.  Does electoral politics possess those institutional proxies?  Does the bureaucratic organization of public administration? How about the philanthropic entities in the non-profit sector?  This would be an implication of the economic way of thinking -- how do people weigh the marginal costs/marginal benefits of decisions in the different contexts of human interaction? 

Nothing about what I have said is "libertarian" or "free market", but it is economics.  Consider, for example, a report that was on NPR this morning as part of a series that is being developed on Politics in Real Life as the campaign season moves from primaries to the main event in 2016 -- it was on Paid Family Leave.  Again, the economist in me kicks in while hearing the story -- not the libertarian or free market, but economists.  Thus, I want to think about Means-Ends and the logical consequences of the various proposed means to obtain the desired end, and I want to learn from as much empirically as one can from historically analogous policy experience.  I empathize with the Ends sought and do not question them in the least, my concern is solely with whether the proposed means would achieve the ends sought and at what cost.  This requires recognizing that Paid Family Leave will have its impact on the labor market, and also one must think about the impact on the least advantaged in the labor market -- not the most advantaged, because the tragedy that motivates our initial concern is not the impact on the most privileged in the work force, but the least advantaged -- in economic jargon, the marginal employee.

 Boettke concludes:

But what if, I ask, the very social ills we see before us are due not to malfeasance but due to the logic of individual decision making within the institutional context so reorganized.  The same style of reasoning that explains why individuals pursuing their self-interest can produce publicly desirable outcomes such as productive specialization and peaceful social cooperation within a specific institutional context also explains why that pursuit of self-interest in other institutional contexts results in social tragedies and social tensions. 

That is ECONOMICS, not "libertarian" nor even "free market", but just ECONOMICS pursued persistently and consistently.  And unless we get away from the habit of labeling folks and arguments in order to pigeon hole and disregard our intellectual cultural will continue to fail to understand what is causing the social ills that plague us, let alone encourage creative thinking about how to address these social ills.  That would be tragic on so many dimensions.

The whole post is certainly worth a read.

Another much shorter post by Steve Horwitz also fits into this same theme.

I have been thinking a lot about the misunderstandings of Hayek's "The Use of Knowledge in Society" essay. Below I offer what I think is a quick summary of his argument that stresses both the importance of private property and the price system as jointly necessary for economic coordination.

1. Knowledge IS decentralized in that each of us has our own personal knowledge of time and place (and that is often tacit).

2. Therefore, planning and control over resources SHOULD BE decentralized so that people can take advantage of those forms of knowledge.

3. HOWEVER, decentralization of control over resources (what Hayek calls "several property") is necessary BUT NOT SUFFICIENT for social coordination.

4. Effective decentralized planning also requires that people have access, in some form, to the bits of knowledge that other people have so that they can form better plans and have better feedback as to the success and failure of those plans.

5. Providing that knowledge is the primary function of the price system. Prices serve as knowledge surrogates to enable people's individual knowledge and "fields of vision" to sufficiently overlap so that our plans get COORDINATED. 

6. In other words: decentralized control over resources is NECESSARY BUT NOT SUFFICIENT for a functioning economy. Such decentralization requires some process that actually ensures that separately made decisions are, to a significant degree, based on as much knowledge as possible so that economic coordination can be achieved. That is what the price system enables us to do. [EDIT: and the prices in question are not, and need not be, equilibrium prices.]

Decentralized decision making without a price system will produce very little coordination and prosperity. Centralized decision making will render a price system useless for economic coordination.

The fact of decentralized knowledge requires that an economy capable of producing increased prosperity for all has both decentralized decision-making (private/several property) and a price system to coordinate those decisions.

Julien Noizet on Monetary Policy

This is part 3 in an interview series with Julien Noizet. For more about Julien, see the first post.

The interview questions are:
Why do you think inflation has been low in US after the 2008 recession?
What is the most important thing economists get wrong about the way banks work? 
What are your thoughts on NGDP targeting?
What are your thoughts on free banking?


FH: What are your thoughts on NGDP targeting?

JN: I am definitely open to the idea. I believe NGDP targeting would be a strong improvement on the current inflation targeting dogma. It would lead to a more stable economic framework, would at last (in theory) release central bankers from error-prone discretionary policies, respecting the concept of the rule of law. While not my ideal, I still see NGDP targeting as a step in the right direction.

Policy Pessimism (Realism?) in Economic Theory

One of my favorite Hayek quotes regards the necessity of humility in policy design:

"The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

I've come across a few interesting posts in the last few days on this topic and thought readers would be interested. I've reproduced the first post in its entirety.

Mike Munger lists four economic theories that imply there are serious limitations on the ability of policy to fix the problems identified with standard theory:

1. The theory of the second best. 

Simply put, if the world or model has multiple distortions in it, removing only one of those distortions may not make things better. This applies so strongly to macro and development economics, but it rarely even mentioned. Consider corruption. Suppose a polity has bad laws, weak rule of law, oppressive regulations, little protection of property rights and corruption. In such an environment, an anti-corruption campaign alone may actually make many people worse off. You can no longer bribe your way out of the oppressive regulation or bribe your way into protection of your property. This one is a real doozy. 

2.  Arrow's impossibility theorem. 

Simply put, this tells us that there is no ideal, comprehensive way of aggregating individuals preferences into an aggregate choice. Arrow shows there is no mechanism that is non-dictatorial, satisfies independence of irrelevant alternatives, and pareto efficiency. 

Or as the great philosopher Robyn Hitchcock put it, "When I hear the word "Democracy", I reach for my headphones." 

3. Related is Hurwicz's impossibility theorem of mechanism design, which shows that there is no strategy-proof, Pareto-efficient, and individually rational rule for allocation. In other words, a planner cannot get truthful revelation from people about their preferences and willingness to pay without wasting resources in the process. 

4. The Folk Theorem. 

This is a strange one because some "folks" take is as a feature, rather than the devastating bug that it really is. The folk theorem shows that if people are patient enough, any behavior pattern can be an equilibrium of an infinitely repeated game. I have actually seen papers invoke the folk theorem in a positive sense, citing it to prove their preferred story is an equilibrium story, without realizing the irony that in that setting ANY story is an equilibrium story.  Ouch.

Per Bylund says economics is dead and is being killed again.

Don Boudreaux shared an interesting quote from Dierdre McCloskey's book The Bourgeois Virtues. His own commentary on the post is interesting as well.

And here are a couple of related Farmer Hayek posts:
Demsetz on Comparative Institutions
Blackboard Theory Versus the Reality of Markets

Krugman the Psychologist

In his July 25th column, Paul Krugman attempts to discredit a view he apparently doesn't understand. This time, he focused on Ron Paul, calling him names, comparing him to Bernie Madoff, and suggesting that he is a white supremacist. He claims that the only reason people would believe Ron's analysis is that they too are crotchety racists. Sadly, this is par for the course for Krugman.

When he's done psychologizing, he does manage a bit of substance in the post. He apparently thinks his criticism is utterly devastating to Ron and to Austrian Business Cycle Theory (ABCT). His claim is that, since the CPI hasn't risen due to loose monetary policy, the ABCT is wrong and so is everyone who espouses it.

ABCT has little to say about consumer prices, but a lot to say about asset prices. Though it certainly doesn't apply in all situations, ABCT can explain the dynamics of asset markets in the face of interventionist monetary policy. The 2008 crisis is a textbook example.

When it comes to consumer price inflation, proponents of ABCT have made different predictions at different times. One example is a bet between David Henderson and Bob Murphy. Mish Shedlock is another example of a proponent of ABCT who thought, at one time or another, that deflation was a bigger risk than inflation.

The Importance of Applying Market Process Theory

I came across an interesting post by Chris Dillow on markets vs gov't direction of resources. He starts off by criticizing an article in the Telegraph about privatization as a solution to the tragedy of the commons.

He rightly points out that many commentators fail to provide a sophisticated analysis of the markets vs gov't trade-off. Dillow deserves kudos for mentioning (if only briefly) the work of Elinor Ostrom in analyzing non-market and non-gov't solutions to the tragedy of the commons.

However, his own analysis of the market vs gov't trade-off lacks the important insights of market process theory. His discussion of the role of transactions costs in the examination of this trade off is problematic as well. He writes:

As Terry Anderson has shown (pdf), the emergence of property rights requires among other things that technology permits a lowish-cost enforcement of those rights.

and later

 This is, of course, a variant on Coase's famous point (pdf) - that there are costs to market transacting. These costs must be weighed against the costs of other forms of economic organisation - be it the firm or state control.

There are a couple of problems here. He claims that property rights require "lowish-cost enforcement of those rights" and that said costs "must be weighed against the costs of other forms of economic organization." First of all, there is the question of who is responsible for "weighing" these costs. If it's the state, there is clearly an incentive for politicians and bureaucrats to claim the costs of property rights are too high and that the state should control the resource on efficiency grounds. The same incentive problem exists for firms that are in a position to lobby the state for exclusive rights to the resource. Markets are clearly at a disadvantage in these cases.

Confusion on GMOs from Financial Heavyweights

Mark Spitznagel and Nassim Taleb have an interesting article in the NYT attempting to draw an analogy between systemic financial vulnerability and alleged problems with GMOs. They start off by describing some ways in which the financial system was vulnerable leading up to the crash.

I find a lot I can agree with in that section, but my agreement stops in the second half where they attempt to convince the reader that alleged problems with GMOs fit the same patterns. I'll give my thoughts on each of these 5 issues.

First, there has been a tendency to label anyone who dislikes G.M.O.s as anti-science — and put them in the anti-antibiotics, antivaccine, even Luddite category. There is, of course, nothing scientific about the comparison. Nor is the scholastic invocation of a “consensus” a valid scientific argument. 

Interestingly, there are similarities between arguments that are pro-G.M.O. and snake oil, the latter having relied on a cosmetic definition of science. The charge of “therapeutic nihilism” was leveled at people who contested snake oil medicine at the turn of the 20th century. (At that time, anything with the appearance of sophistication was considered “progress.”)

None of this should be convincing to anyone, as it doesn't have a shred of logic to it. The first paragraph has nothing to do with the usefulness or safety of GMOs, but it does reveal the authors' experience with other people who disagree with them. In the same way, the second paragraph fails to make their point. Just because some of the name calling that exists now is similar to the name calling surrounding snake oil salesmen doesn't mean GMOs are like snake oil in any other way. I would have expected more from both of these men, as they're clearly very intelligent.

Big Data and Hayek

A recent post by Matt Bogard drew my attention to a Forbes article entitled "Big Data Versus Hayek." Both Matt's post and the article are interesting, and I recommend reading both (they're short), but I want to pick a few nits with the Forbes article.

The authors mention a few examples of firms using big data methods to "set prices" and note that

What’s interesting about such centralized, algorithmic approach to price setting is how un-Hayekian it is.

This is an interesting point as far as it goes, but a couple of things should be noted. Hayek's point about centralized decision making was about markets, not firms. If complete decentralization were optimal, then no firm need exist. Of course, such an absurd conclusion can't be drawn from Hayek's work.

Firms are obviously necessary (and Matt makes some good points about this in relation to Coase), but Hayek's point is about the markets in which firms operate. Decentralized markets generate prices that reflect the availability of resources needed for production and the tastes and preferences of consumers; these prices allow firms to provide what consumers want. The USSR was (largely) without the coordinating effect of prices, a key cause of its demise.

The second problem is the idea that these firms are "setting prices." Surely a price tag or the rate offered on the Uber app will in some sense be "set" by the firm. However, the firm has very little control over the price they receive because ultimately the consumer determines the equilibrium price to which actual prices continually move. The influence of regulations, competitors, and (perhaps most powerfully) the preferences of consumers will decide what price the firm receives. The firm can "set" any price it likes, but decentralized free markets ensure that these prices come to closely approximate the value consumers place on the product.

Potpourri

I haven't done one of these in awhile, so I thought I'd put some stuff I've read recently that caught my eye.

Jayson Lusk recently blogged about my article currently in review at the Journal of Regulatory Economics on the effects of USDA and EPA regulation on ag productivity.

Don Boudreaux, spurred by a back and forth between Russ Roberts and Paul Krugman, has a couple of great posts (here and here) on economics as a science and its ability to generate falsifiable predictions. Very thought provoking.

Marc Bellemare documents the top 5 journals in ag economics based on recently-calculated impact factors. The ordering is interesting, but it's important to remember that there are many measures of journal quality. This paper, sent to me today by a colleague, puts ag and applied economics journals into groups (A+, A, B, C, D). All of this is good information which, as an assistant professor, I find very useful.

Matt Bogard has some interesting thoughts on the abilities required for working as a data scientist outside the academic world.

Perfect Markets and the Beauty of B School Economics

Don Boudreaux at Cafe Hayek has written several posts recently that are related to some of the themes I've been focusing on lately. (See his posts here, here, and here.) I'll quote from the first one and provide some of my thoughts.

The market process is chiefly one of entrepreneurs spotting market failures and sub-optimal situations – spotting problems that have yet to be ‘solved’ adequately by market (or non-market) forces – and then experimenting with actions to address such problems.  The discipline to ensure that such experiments work as well as possible over time is supplied by (1) the fact that those who do the experimenting in private markets put their own money and effort on the line (rather than money and effort forcibly commandeered from others), (2) consumers’ freedom to buy or not to buy the resulting products, and (3) the actual and potential competing experimenters who do, or might, arise along side of the initial entrepreneurial experimenter.  And this on-going process is indeed just that: a process that, as much as it improves market performances over time, never comes close to creating any situation that deserves the name “perfect market.” 

The Benefits of Free Market Monopoly

For most politically-minded people, the term "monopoly" typically brings to mind an image of greedy corporate executive laughing as he counts his wads of cash. They likely think of unjustifiably high prices and industries dominated by one or a few firms. Certainly most people view monopoly as a bad thing.

The primary reason economists consider monopoly to be a bad thing is deadweight loss. Deadweight loss refers to the loss in consumer and producer surplus due to lower optimal output relative to the outcome in perfect competition. This deadweight loss is problematic because it represents value that is never created. It's not such a concern who would have captured that value (i.e. whether it would have been consumer or producer surplus), but that the value is never created in the first place. Even if the appeal to perfect competition seems problematic, doesn't it still seem sensible to oppose monopoly on the grounds of the deadweight loss it creates?

Demsetz on Comparative Institutions

Last weekend I had a chance to read Harold Demsetz's famous 1969 article* in the Journal of Law and Economics entitled "Information and Efficiency: Another Viewpoint." The article is written as a critique of Ken Arrow's 1962 paper "Economic Welfare and the Allocation of Resources for Invention" but functions as a broader critique of the use of standard IO theory in policy analysis. Demsetz identifies this standard policy analysis as the "nirvana approach" and juxtaposes it against what he calls the "comparative institution approach."

The view that now pervades much public policy economics implicitly presents the relevant choice as between an ideal norm and an existing "imperfect" institutional arrangement. This nirvana approach differs considerably from a comparative institution approach in which the relevant choice is between alternative real institutional arrangements. In practice, those who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient. Users of the comparative institutional approach attempt to assess which alternative real institutional arrangement seems best able to cope with the economic problem; practitioners of this approach may use an ideal norm to provide standards from which divergences are assessed for all practical alternatives of interest and select as efficient that alternative which seems most likely to minimize the divergence.

An Interesting Quote on the Problem of Monopoly

Last night I was searching the web for a copy of Harold Demsetz's essay entitled "Two Systems of Belief About Monopoly" and I ran across Pete Boettke's book "The Elgar Companion to Austrian Economics." I thought I'd share a short section of the book with some commentary or clarification for the non-specialist reader in brackets.