Who Says No? A Climate Change Compromise

Many on the left are up in arms over Trump backing out of the Paris agreement. Ignoring the fact that the agreement says that countries are free to set their own targets and their own policies and is largely symbolic anyway, let’s work under the assumption that liberals actually believe that this policy is disastrous for the earth’s future. In fact, let’s start from the (perhaps ridiculous) assumption that everybody in this debate is being intellectually honest.

Then Republicans have a great opportunity. Offer Democrats a compromise. The United States will re-enter the Paris agreement. And they’ll go even further. Democrats will be given full control over all matters of the environment. Carbon taxes, cap and trade, clean energy subsidies, whatever they want. Completely blank check.

In return, Republicans get everything else. They can pass whatever tax code they want, any deregulation they want. Democrats will have no say in healthcare, no control over education, no input at all over any issue except climate.

So my question is: who says no? Republicans (and Trump) have to go back on one of their key issues and allow the Democrats free reign. But for sucking up their pride on one thing they get everything they’ve ever wanted for a whole range of others. And what about the Democrats? Sure they’d be sacrificing a lot. In their view, we’d be significantly worse off in the short run. But isn’t that worth saving the world? If the results of climate change are truly catastrophic, isn’t it worth some people in the richest country in the world not having health insurance? Isn’t it worth middle class Americans being required to take out student loans to attend college?

Now maybe there are some issues that are as important as climate. If you think Republican control of the military would lead to nuclear war, then of course that can’t be part of the deal. Fine, keep that one. I’ll even throw in gun control, another issue that seems to be of vital importance for the left.  You can come up with your own list of some other issues you would never want to compromise on to save the world. But that list should be very small.

So who says no? I can’t imagine any Republican ever denying the above compromise. But I also doubt a single Democrat would take it. If that prediction is right, we are left with three possible conclusions. The first, which I think we can rule out, is that Democrats believe giving Republicans complete control over anything would be worse than the end of the world. The second, which could be true, is that they believe they can convince Republicans of the correctness of their view without conceding too much. Considering their lack of success to this point, and the apparent urgency with which they believe something needs to be done, this also seems unlikely. So we are left with the third, and in my opinion most likely, option: Despite their rhetoric, Democrats are simply not that concerned about climate change.

Outrage on Net Neutrality

In a previous post I agreed with Bret Stephens that complete certainty about an issue doesn’t help convince anybody that your view is correct and may in fact work against the argument. I extended his point by arguing that not only do people express complete certainty that their ideas are right, but they also tend to find the idea that anybody could think differently completely outrageous. However, I don’t think climate change was the best example to prove that point. If you truly believe that climate change will cause catastrophic changes, you might have a right to be outraged. There is a much better example: net neutrality.

Senator Al Franken recently claimed that the FCC’s plan to roll back some of the regulations on net neutrality would be a “major step to destroying the internet as we know it.” Other reports in the media have had a similar tone: there go those idiot Republicans again trying to convince people that we don’t need the government involved in every aspect of our lives. Perhaps the worst offender is Gizmodo, who I follow for tech news, not to see articles like this one. Now, I suppose it’s possible that a writer for Gizmodo knows enough to have a strong, well qualified opinion on a topic like internet regulation, but I expect their knowledge on the topic is pretty close to mine. And I will freely admit my own ignorance on the topic. I have no idea whether net neutrality is a good idea.

To be clear, just as Bret Stephen’s article was not about the correctness of climate change, this post is not about whether net neutrality is a good idea. Instead, it is about the complete certainty with which its proponents appear to believe it’s a good idea. If you are well read on net neutrality, I’d be happy to hear a more qualified opinion on why this issue is so clear cut. From my perspective, however, the issue is not an obvious one at all and the goal of this post is to sow the seeds of uncertainty for those who haven’t tried to think through the issue in at least a small amount of detail.

I do think I understand the basic argument for net neutrality. Without net neutrality, its supporters argue, internet providers will be free to offer different prices to access different websites on the internet. Right now you pay a fixed price to your internet service provider for access to any website on the internet. ISPs are not allowed to treat bandwidth from one website different from any other. Without this guarantee, it is possible that internet providers could charge more for people who want to access popular websites. You pay $30 per month for internet, but if you want Facebook access too that’s gonna be another $5. Want Netflix too? Well maybe you can get the entertainment package for an extra $15. Even worse, if Comcast wanted to push its own video service, it could completely shutdown Netflix for its customers, leading to higher prices and lower quality service. Special treatment could also go the other way. Large companies could pay to receive faster access to their websites while small startups struggle to survive.

One of the most common ways to summarize the changes is to say that it would make the internet look more like cable TV (see this article for example). Expensive bundles, premium content, bad service. Who wants that? And that does sound bad. But hold on a second. Why do we hate cable TV service? Isn’t the main complaint that you have to buy a bunch of channels you don’t want? If I only want to watch ESPN I can’t buy just that, I have to buy the whole sports bundle. Now, it’s true that net neutrality makes these kind of bundles illegal, but it also makes selling access to individual websites illegal. With internet you only have one choice: buy everything or nothing. Perhaps this method makes more sense for internet than it would for TV, but it’s not immediately obvious that it’s better. It could be that net neutrality leads to inconvenience, higher prices, and worse service. It could also be that it leads to heavy internet users paying more than light users. That doesn’t seem so bad to me.

The good news is we don’t have to guess what the internet would look like without net neutrality. If you don’t know already, take a guess when you think the rules that currently uphold net neutrality were put into place. If you’ve heard any of the horror stories I imagine you would think that the internet has always had these kinds of regulations. You probably don’t remember the internet being a price gouging wasteland in all the time you’ve been using it so the rules must have gone into place in the 80s or 90s at the latest. There’s no way that net neutrality regulations were passed within the last 3 years right? Well…

So we pretty much know exactly what would happen if we get rid of net neutrality. We would destroy the internet as we know it and replace it with the internet of 2015. Why is that a big deal again?

Of course, as I’ve already admitted, I have no idea what I’m talking about on this issue. I think I am barely qualified to talk about macroeconomics, which I study many hours per day. So let’s defer to the experts. Maybe this article about how the effects of net neutrality are minimal. Or this one that shows that there is insufficient evidence to make a strong case that net neutrality rules are needed. The supporters of net neutrality aren’t the only ones making unsubstantiated claims. The claim that net neutrality reduces investment is probably overblown.

I’m sure you can find other articles to support either side. That’s not the point. The point is that net neutrality is not climate change. There is no 97% consensus here. And even if there was, even in the worst possible case, we end up not with the world ending, but with a slightly more expensive internet. The outrage remains regardless. In today’s political climate, every issue has to become a battleground and the urgency of the arguments appears to bear little correlation to either the size of the issue (because everything is a catastrophe) or the probability a person has the correct view (because obviously you are right about everything).

Welfare for the Rich? Are Tax Deductions the Same as Welfare Payments?

Imagine three friends (let’s call them Rich, Poor, and Average) share an apartment and have a strange deal for paying the rent each month. Average pays all the rent, but he collects money from his friends Rich and Poor. However, since Rich makes so much money, they agree that he will pay most of the rent. Each month, rent costs $1000. At first, Rich pays $700, Poor pays $100, and Average pays the remaining $200. One day, Poor loses his job and can no longer pay the rent. Average asks Rich to chip in a larger amount to cover the missing $100, but he also realizes that Poor won’t be able to buy food either. So he asks for $200 extra and gives $100 to Poor each month. Now the rental payments look like this: Average pays $200, Poor pays -$100, and Rich pays $900. Rich isn’t too happy with the arrangement, but he agrees since the other friends will kick him out if he doesn’t.

One day, the three friends notice that they need to buy some new furniture. A couch costs $300. Average tells Rich that if he buys the couch, he will deduct the $300 for his rent payments for the month. So for the month, the payments now look like: Average pays $500, Poor pays -$100, Rich pays $600 (plus $300 for the couch).

But then Poor comes to Average and starts complaining. “Rich already makes the most money, and now you’re giving him even more. I only got $100 from you this month and you gave him $300. How is that fair? And look, now you have to pay $500 rather than $200. If you just hadn’t let him deduct the couch, you could have given me an extra $100 and kept $200 for yourself.”

If this argument seems ridiculous read this article that claims rich people get government handouts just like the poor. Notice something strange about this list? Not a single one is actually a government handout. Instead, each is a tax deduction. I only linked to one article, but google “welfare for the rich” and you’ll find many similar ones. But just like in the example above, “welfare for the rich” in all of these cases is simply allowing people who already pay a large share to keep a little bit more of their money. Calling that welfare is deceptive at best. It assumes that the government already has a right to your money. Anything they allow you to keep should be considered a favor.

Let’s put it another way. Imagine there is no government. Everybody keeps everything they earn. Now a single welfare program is put into place where the top income earner pays $1,000,000 to the lowest income earner. However, mortgage interest is allowed to be deducted so the effective payment only ends up being $500,000. Soon, the richest guy starts to complain that the system is unfair and that the poorest guy gets $500,000 without doing anything. The Washington Post writes an article berating the rich guy for complaining. After all, he also receives $500,000 in handouts from the government in the form of a mortgage interest deduction. Essentially, this situation is exactly what we are dealing with here. If you really think “welfare” for the rich and poor is at all the same there is an easy test: get rid of all government welfare and reduce taxes on everybody uniformly to keep revenue the same (assuming taxes can’t go below zero). Who complains the most?

There are certainly good arguments for why we wouldn’t want to offer tax deductions. They are the same arguments for why we wouldn’t want to tax specific goods. By offering a tax deduction, we distort relative prices as these goods become artificially cheap relative to other goods. If you believe the government can do a good job figuring out which kinds of goods are beneficial for society, these kinds of policies could effectively nudge society towards a social optimum. If, on the other hand, you think government is more likely to make terrible decisions based more on special interests than economic welfare, we’re probably better off keeping deductions to a minimum.

So by all means fight against tax deductions. But stop pretending they are welfare for the rich.

What’s Wrong With Modern Macro?

After 15 posts, 17,795 words, and about 9 months, my series of posts on the problems with modern macro is finally complete. If anyone cares, here is the list of all the posts in order.

Part 1: Before Modern Macro – Keynesian Economics

Part 2: The Death of Keynesian Economics: The Lucas Critique, Microfoundations, and Rational Expectations

Part 3: Real Business Cycle and the Birth of DSGE Models

Part 4: How Did a “Measure of our Ignorance” Become the Cause of Business Cycles?

Part 5: Filtering Away All Our Problems

Part 6: The Illusion of Microfoundations I: The Aggregate Production Function

Part 7: The Illusion of Microfoundations II: The Representative Agent

Part 8: Rational Expectations Aren’t so Rational

Part 9: Carrying on the Torch of the Market Socialists

Part 10: All Models are Wrong, Except When We Pretend They Are Right

Part 11: Building on a Broken Foundation

Part 12: Models and Theories

Part 13: No Other Game in Town

Part 14: A Pretense of Knowledge in Macroeconomics

Part 15: Where Do We Go From Here?

If you made it through all of them I’m not sure if I should congratulate you or feel sorry for you, but either way thanks for reading.

What’s Wrong With Modern Macro? Part 15 Where Do We Go From Here?

I’ve spent 14 posts telling you what’s wrong with modern macro. It’s about time for something positive. Here I hope to give a brief outline of what my ideal future of macro would look like. I will look at four current areas of research in macroeconomics outside the mainstream (some more developed than others) that I think offer a better way to do research than currently accepted methods. I will expand upon each of these in later posts.


Learning and Heterogeneous Expectations

Let’s start with the smallest deviation from current research. In Part 8 I argued that assuming rational expectations, which means that agents in the model form expectations based on a correct understanding of the environment they live in, is far too strong an assumption. To deal with that criticism, we don’t even need to leave the world of DSGE. A number of macroeconomists have explored models where agents are required to learn about how important macroeconomic variables move over time.

These kinds of models generally come in two flavors. First, the econometric learning models summarized in Evans and Honkapohja’s 2001 book, Learning and Expectations in Macroeconomics, which assume that agents in the model are no smarter than the economists that create them. They must therefore use the same econometric techniques to estimate parameters that economists do. Another approach assumes even less about the intelligence of agents by only allowing them to use simple heuristics for prediction. Based on the framework of Brock and Hommes (1997), these heuristic switching models allow agents to hold heterogeneous expectations in equilibrium, an outcome that is difficult to achieve with rational expectations, but prevalent in reality. A longer post will look at these types of models in more detail soon.

Experiments

Most macroeconomic research is based on the same set of historical economic variables. There are probably more papers about the history of US macroeconomics than there are data points. Even if we include all of the countries that provide reliable economic data, that doesn’t leave us with a lot of variation to exploit. In physics or chemistry, an experiment can be run hundreds or thousands of times. In economics, we can only observe one run.

One possible solution is to design controlled experiments aimed to answer macroeconomic questions. The obvious objection to such an idea is that a lab with a few dozen people interacting can never hope to capture the complexities of a real economy. That criticism makes sense until you consider that many accepted models only have one agent. Realism has never been the strong point of macroeconomics. Experiments of course won’t be perfect, but are they worse than what we have now? John Duffy gives a nice survey of some of the recent advances in experimental macroeconomics here, which I will discuss in a future post as well.

Agent Based Models

Perhaps the most promising alternative to DSGE macro models, an agent based model (ABM) attempts to simulate an economy from the ground up inside a computer. In particular, an ABM begins with a group of agents that generally follow a set of simple rules. The computer then simulates the economy by letting these agents interact according to the provided rules. Macroeconomic results are obtained by simply adding the outcomes of individuals.

I will give examples of more ABMs in future posts, but one I really like is a 2000 paper by Peter Howitt and Robert Clower. In their paper they begin with a decentralized economy that consists of shops that only trade two commodities each. Under a wide range of assumptions, they show that in most simulations of an economy, one of the commodities will become traded at nearly every shop. In other words, one commodity become money. Even more interesting, agents in the model coordinate to exploit gains from trade without needing the assumption of a Walrasian Auctioneer to clear the market. Their simple framework has since been expanded to a full fledged model of the economy.

Empirical Macroeconomics

If you are familiar with macroeconomic research, it might seem odd that I put empirical macroeconomics as an alternative path forward. It is almost essential for every macroeconomic paper today to have some kind of empirical component. However, the kind of empirical exercises performed in most macroeconomic papers don’t seem very useful to me. They focus on estimating parameters in order to force models that look nothing like reality to nevertheless match key moments in real data. In part 10 I explained why that approach doesn’t make sense to me.

In 1991, Larry Summers wrote a paper called “The Scientific Illusion in Empirical Macroeconomics” where he distinguishes between formal econometric testing of models and more practical econometric work. He argues that economic work like Friedman and Schwartz’s A Monetary History of the United States, despite eschewing formal modeling and using a narrative approach, contributed much more to our understanding of the effects of monetary policy than any theoretical study. Again, I will save a longer discussion for a future post, but I agree that macroeconomic research should embrace practical empirical work rather than its current focus on theory.


The future of macro should be grounded in diversity. DSGE has had a good run. It has captivated a generation of economists with its simple but flexible setup and ability to provide answers to a great variety of economic questions. Perhaps it should remain a prominent pillar in the foundation of macroeconomic research. But it shouldn’t be the only pillar. Questioning the assumptions that lie at the heart of current models – rational expectations, TFP shocks, Walrasian general equilibrium – should be encouraged. Alternative modeling techniques like agent based modeling should not be pushed to the fringes, but welcomed to the forefront of the research frontier.

Macroeconomics is too important to ignore. What causes business cycles? How can we sustain strong economic growth? Why do we see periods of persistent unemployment, or high inflation? Which government or central bank policies will lead to optimal outcomes? I study macroeconomics because I want to help answer these questions. Much of modern macroeconomics seems to find its motivation instead in writing fancy mathematical models. There are other approaches – let’s set them free.

Some Thoughts on Universal Basic Income

People who oppose redistribution from the rich to the poor generally give two types of arguments against it. Perhaps the more obvious argument comes from a natural rights perspective – the person who created the wealth has a right to do whatever they want with it. However, if you don’t believe in free will (as I don’t), then this reasoning doesn’t make much sense. If you weren’t truly responsible for the circumstances that led you to create the wealth in the first place, why should you get to keep all of it? Shouldn’t some of it go to all of the people that had any influence on getting you to that position?

The stronger argument derives from incentives. Taking from the productive to give to the unproductive makes being unproductive far more attractive and we end up with a society where perfectly capable people choose not to work because they expect others to support them. Any attempt to solve poverty needs to deal with this issue, which makes designing anti-poverty measures difficult.

Our current welfare system has some checks in place that attempt to circumvent incentive problems, but it doesn’t solve them completely. Many of our current welfare programs involve cutoff levels where benefits begin to be reduced and eventually disappear altogether. This type of program introduces an implicit marginal tax on low income earners. Not only do they have to pay a higher official tax rate as their income rises, but they also lose some of the benefits they received at a lower income.

A simple way around this problem is to never phase out those benefits – to give them to everyone. This idea forms the backbone of the Universal Basic Income (UBI). One of the most complete proposals for a UBI comes from Charles Murray (yes, the same Charles Murray who gets kicked off college campuses because of his dangerous right wing ideas). In his version (laid out in his book In Our Hands), each American over the age of 21 would receive $13,000 per year in benefits unconditionally. Of this money, $3,000 has to be spent on health insurance, but the rest comes with no strings attached.

Of course, such a plan would be incredibly expensive. However, as Murray points out, our current system is already expensive. According to his calculations, if we eliminated our entire welfare system (including Social Security and Medicare), we could more than pay for the UBI. Getting rid of these programs would be difficult politically, but Murray offers several reasons why doing so would be desirable for almost everyone. Most notably, he estimates that poverty would be all but eliminated under his program vs the approximately 15% that remains under our own system.

Murray’s justification for some level of redistribution is similar to my own:

Inequality of wealth grounded in unequal abilities is different. For most of us, the luck of the draw cuts several ways: one person is not handsome, but is smart; another is not as smart, but is industrious; and still another is not as industrious, but is charming. This kind of inequality of human capital is enriching, making life more interesting for everyone. But some portion of the population gets the short end of the stick on several dimensions. As the number of dimensions grows, so does the punishment for being unlucky. When a society tries to redistribute the goods of life to compensate the most unlucky, its heart is in the right place, however badly the thing has worked out in practice
Charles Murray (2016) – In Our Hands

If we accept that some redistribution is desirable, a UBI seems like a more efficient way to carry it out than our current welfare setup. One common argument against the UBI is that it doesn’t make sense to waste resources on the rich. Bryan Caplan has given some arguments along these lines and argues that phasing benefits out gradually would avoid the implicit marginal tax rate problems without needing to give benefits to everyone. And it makes sense. If our goal is to eliminate poverty why not focus our efforts there?

But I don’t think that argument really works when you consider that a UBI is inextricably linked to the tax system. A UBI doesn’t look so universal after you consider that the rich are going to be paying for almost all of it. Everyone might get a check for $13,000, but top income earners pay far more than that in taxes. Their net benefit from government programs would still be strongly negative even after receiving the UBI. Depending on your perspective towards redistribution, this feature could actually be a negative, but given that redistribution is going to happen anyway, the UBI seems like a more efficient way of actually doing it.

It’s obviously not without fault, but I do think a UBI would be an improvement over our current system and I definitely recommend reading Murray’s book (it’s not that long) to anyone who wants to help the poor but believes we can do better than we do now.

 

Climate of Complete Outrage How the Reaction to Bret Stephens Proves His Point

The New York Times recently caused a stir by hiring Bret Stephens, a conservative journalist, for their opinion page. Stephens holds many views that clash with some of the sacred cows of the progressive movement. These ideological breaches include criticizing Black Lives Matter, saying that campus rape is not an “epidemic,” and denying that climate change will result in catastrophic changes. Naturally, his hiring has brought forth the ire of the left, and the recent publication of his first article has caused an explosion of hatred across my Twitter feed. If you haven’t already, go read the article here before continuing.

Now, just for a few minutes try to put aside any pre-existing biases you have and let’s look at Stephens article as objectively as possible. The article, titled Climate of Complete Certainty, does not argue that climate change is a hoax (“None of this is to deny climate change or the possible severity of its consequences”). It doesn’t claim that we should reject any attempts to mitigate the effects of a changing climate. Its message actually has very little to do with climate change itself. Instead Stephens attempts to make a broader point about intellectual discourse: nothing is ever certain, and pretending that it is will never convince somebody on the other side. Arrogance does not induce agreement.

It doesn’t seem like anybody listened. The responses have instead ranged from further asserting that climate change is real (which Stephens didn’t deny in this article), threatening to cancel NYT subscriptions, and attacking Stephens himself. This kind of reaction is exactly what Stephens warned about. Rather than engage his argument with a reasonable response, his opponents don’t give even a sliver of probability to the idea that he might have a point.

Disagree with the left and you’re not just wrong – you’re an idiot. You’re not just uninformed – you’re ignorant. You’re not just a skeptic – you’re evil. Some people might be 100% sure that climate change is real and that we need to do something about it right now to prevent catastrophic consequences. The reality is that some people aren’t so sure.

Perhaps it is true that the evidence is against climate skeptics. Maybe they don’t have a great argument to support their side. And certainly the scientific consensus seems to be that global warming is likely to be a major problem (although for everyone who likes to use this argument as the end of the discussion, I hope none of you agreed with Gerald Friedman’s analysis of Bernie Sanders’s economic plan either – the consensus among trained economists was just as strong against his calculations). That’s not the point. Regardless of whether you believe climate skepticism is stupid or not, the best way to convince somebody their ideas are stupid is not to tell them they are stupid. Instead the first task should be to understand why they think differently than you do.

But there’s an even bigger problem here. The certainty in the correctness of ideas also leads to outrage at the notion that anybody else could believe otherwise. And it’s not just climate. After Brexit passed last year, JK Rowling tweeted “I don’t think I’ve ever wanted magic more.” Really? Never? Even in the worst possible case of the effects of Brexit I can’t imagine it shaving more than a couple percentage points off GDP. From the UK. One of the richest countries in the world. Maybe magic could’ve helped with terrorist attacks, or disease, or starvation, or Syria, or the millions of other atrocities that occur on this earth every day. Nope. Brexit is the worst thing that’s ever happened. Well besides Trump. And whatever Paul Ryan said most recently. And this article. Wait, how many worst things ever can there be?

When every little point of dissension results in this level of vitriol, what is left for truly important issues? If we treat Trump like Hitler, what do we do in case of an actual Hitler? I don’t want to claim excessive outrage is the exclusive domain of the left either. Hillary Clinton’s emails. The Benghazi attack. Colin Kaepernick kneeling for the national anthem. Outrage from the right at all of them. Everything has become a game where it doesn’t matter how trivial the issue is as long as the other side comes out looking bad.

This is not debate. In a debate each side offers their perspective and their reasoning. The goal is to change minds, to convince the other side that your evidence is more compelling than theirs. More and more it seems that nobody actually wants that kind of discussion. The goal for many today doesn’t appear to be to change anyone’s mind. It’s much simpler: crush the dissenters (or maybe cut them open HT: Vitaly Titov).

But if you really want to change minds, I have a few suggestions. Don’t start with “How could you think that?” but “Why do you think that?” Don’t argue from outrage, but from compassion. And don’t attack Bret Stephens. Listen to him.

Equality, Value, and Merit

A common argument against absolute equality is that individuals should be paid based on merit. Should somebody who works 80 hours a week earn the same amount as somebody who sits on their couch and watches TV all week? Even the most ardent supporter of redistribution would have a hard time answering yes. One of the alleged benefits of a free market economy is that it does a pretty good job allocating resources to those who work for them. Reading Hayek, however, I find it interesting that his defense of unequal outcomes explicitly denounces the idea of meritocracy. Value, not merit, is what should determine a person’s reward.

Some clarifications are in order. “Value” and “merit” are not well defined concepts. Let’s take an example to see the distinction between these two concepts. Imagine 2 students are studying for a math exam. One student studies 8 hours per day all week for the exam, but math has never been his strength and he ends up with a hard earned B+ on the exam. For the other student math has always come easy. He takes a quick look at his notes for a couple hours the night before and breezes through with an easy A. We might say that the first student deserves a higher grade than the second. If we graded based on merit we would want to give the higher grade to the student who worked the hardest. Of course, this grading system makes no sense when we consider that a grade is meant to represent a student’s knowledge of the material. Even though he didn’t work as hard, the second student knows math better and therefore deserves a higher grade.

The same arguments can be applied to an economic context. If two entrepreneurs each develop a product, a meritocratic society might suggest paying each based on how much work they each put into its creation. However, this criteria doesn’t consider the fact that consumers might place different values on the two products. If we want to maximize the benefits to society, we don’t actually care whether a product was created by a team of people and 2 years of strenuous research and development or by a guy coming up with ideas in the shower. All we care about is the value of the two products to the consumer. In Hayek’s words, “it is neither desirable nor practicable that material rewards should be made generally to correspond to what men recognize as merit…we do not wish people to earn a maximum of merit but to achieve a maximum of usefulness at a minimum of pain and sacrifice and therefore a minimum of merit” (The Constitution of Liberty, 157, 160).

It might seem unfair that talented people tend to earn more than the less talented. The handsome actor already gets good looks and fame. How is it fair that he also gets a big paycheck? And it’s not fair. But that doesn’t mean it’s not desirable. Because without that paycheck, without that incentive, maybe he wouldn’t have become an actor at all, and the opportunity to create a product that millions would have enjoyed is gone. It’s not fair that Tom Brady gets paid so much to play a game, but the only reason he does is because so many love watching him play. The alternative might not be that he gets paid less and still plays, but that he doesn’t play at all because his incentives to work hard and become a great player are diminished.

Another problem with a meritocratic society is that merit is hard to measure. Going back to the math example, I said that one student studied more than the other. But maybe his studying was not as efficient. Maybe he was actually on Facebook half the time, or didn’t focus on the right problems. And there are other factors. Maybe the second student paid better attention in class or had worked harder in previous classes and therefore didn’t need to work as hard now. Even if we wanted to reward the students’ merit, doing so would be a challenge. Similarly, looking at two products tells us little about how much work and how much effort went into the creation. What we can see is how much people like each product (by looking at how much they pay for it).

One of the greatest benefits of a market economy is that it pushes people towards the tasks that other people actually want them to do. In Hayek’s words, “If in their pursuit of uncertain goals people are to use their own knowledge and capacities, they must be guided, not by what other people think they ought to do, but by the value others attach to the result at which they aim” (The Constitution of Liberty, 159). By rewarding value over merit we ensure that people can only earn money by offering something that others desire. Everybody acts in their own self-interest, but the market usually ensures that that interest also aligns with the interests of others. Potential earnings act as a signal that shows what society values and attempts to regulate the market will almost certainly mess with these signals.

With this perspective, it is difficult to find a reason to care about others’ wealth. Steve Jobs, Bill Gates, and Mark Zuckerberg only got rich by offering a service that other people valued. Their contribution to society is likely far greater than any monetary compensation they received. Encouraging others to continue in their footsteps, to innovate and invent, is more important to the welfare of society as a whole than any attempts to redistribute their existing wealth. In fact, attempts to accomplish the latter discourage the former. I disagree with Ayn Rand on many points, but I think the overall theme in Atlas Shrugged is about right. When society feels like it can take anything it wants from the producers, they might decide that it’s simply not worth it any more, leaving no wealth left to redistribute at all.

 

What’s Wrong With Modern Macro? Part 14 A Pretense of Knowledge in Macroeconomics

Part 14 in a series of posts on modern macroeconomics. This post concludes my criticisms of the current state of macroeconomic research by tying all of my previous posts to Hayek’s warning about the pretense of knowledge in economics


Russ Roberts, host of the excellent EconTalk podcast, likes to say that you know macroeconomists have a sense of humor because they use decimal points. His implication is that for an economist to believe that they can predict growth or inflation or any other variable down to a tenth of a percentage point is absolutely ridiculous. And yet economists do it all the time. Whether it’s the CBO analysis of a policy change or the counterfactuals of an academic macroeconomics paper, quantitative analysis has become an almost necessary component of economic research. There’s nothing inherently wrong with this philosophy. Making accurate quantitative predictions would be an incredibly useful role for economics.

Except for one little problem. We’re absolutely terrible at it. Prediction in economics is really hard and we are nowhere near the level of understanding that would allow for our models to deliver accurate quantitative results. Everybody in the profession seems to realize this fact, which means nobody believes many of the results their theories produce.

Let me give two examples. The first, which I have already mentioned in previous posts, is Lucas’s result that the cost of business cycles in theoretical models is tiny – around one tenth of one percent of welfare loss compared to an economy with no fluctuations. Another is the well known puzzle in international economics that trade models have great difficulty producing large gains from trade. A seminal paper by Arkolakis, Costinot, and Rodriguez-Clare evaluates how our understanding of the gains from trade have improved from the theoretical advances of the last 10 years. Their conclusion: “so far, not much.”

How large are the costs of business cycles? Essentially zero. How big are the gains from trade? Too small to matter much. That’s what our theories tell us. Anybody who has lived in this world the last 30 years should be able to immediately take away some useful information from these results: the theories stink. We just lived through the devastation of a large recession. We’ve seen globalization lift millions out of poverty. Nobody believes for a second that business cycles and trade don’t matter. In fact, I’m not sure anybody takes the quantitative results of any macro paper seriously. For some reason we keep writing them anyway.

In the speech that provided the inspiration for the title of this blog, Hayek warned economists of the dangers of the pretense of knowledge. Unlike the physical sciences, where controlled laboratory experiments are possible and therefore quantitative predictions might be feasible, economics is a complex science. He argues,

The difficulties which we encounter in [complex sciences] are not, as one might at first suspect, difficulties about formulating theories for the explanation of the observed events – although they cause also special difficulties about testing proposed explanations and therefore about eliminating bad theories. They are due to the chief problem which arises when we apply our theories to any particular situation in the real world. A theory of essentially complex phenomena must refer to a large number of particular facts; and to derive a prediction from it, or to test it, we have to ascertain all these particular facts. Once we succeeded in this there should be no particular difficulty about deriving testable predictions – with the help of modern computers it should be easy enough to insert these data into the appropriate blanks of the theoretical formulae and to derive a prediction. The real difficulty, to the solution of which science has little to contribute, and which is sometimes indeed insoluble, consists in the ascertainment of the particular facts
Hayek (1989) – The Pretence of Knowledge

In other words, it’s not that developing models to explain economic phenomena is especially challenging, but rather that there is no way to collect sufficient information to apply any theory quantitatively. Preferences, expectations, technology. Any good macroeconomic theory would need to include each of these features, but each is almost impossible to measure.

Instead of admitting ignorance, we make assumptions. Preferences are all the same. Expectations are all rational. Production technologies take only a few inputs and outputs. Fluctuations are driven by a single abstract technology shock. Everyone recognizes that any realistic representation of these features would require knowledge far beyond what is available to any single mind. Hayek saw that this difficulty placed clear restrictions on what economists could do. We can admit that every model needs simplification while also remembering that those simplifications constrain the ability of the model to connect to reality. The default position of modern macroeconomics instead seems to be to pretend the constraints don’t exist.

Many economists would probably agree with many of the points I have made in this series, but it seems that most believe the issues have already been solved. There are a lot of models out there and some of them do attempt to deal directly with some of the problems I have identified. There are models that try to reduce the importance of TFP as a driver of business cycles. There are models that don’t use the HP-Filter, models that have heterogeneous agents, models that introduce financial frictions and other realistic features absent from the baseline models. For any flaw in one model, there is almost certainly another model that attempts to solve it. But in solving that single problem they likely introduce about ten more. Other papers will deal with those problems, but maybe they forget about the original problem. For each problem that arises, we just introduce a new model. And then we take those issues as solved even though they are solved by a set of models that potentially produce conflicting results and with no real way to differentiate which is more useful.

Almost every criticism I have written about in the last 13 posts of this series can be traced back to the same source. Macroeconomists try to do too much. They haven’t heeded Hayek’s plea for humility. Despite incredible simplifying assumptions, they take their models to real data and attempt to make predictions about a world that bears only a superficial resemblance to the model used to represent it. Trying to answer the big questions about macroeconomics with such a limited toolset is like trying to build a skyscraper with only a hammer.

Interesting Paper on Inequality and Fairness

As a followup to my recent post on inequality, I wanted to highlight some recent research by Christina Starmans, Mark Sheskin, and Paul Bloom on fairness and inequality. Based on a survey of lab experiments and evidence from the real world, the paper argues that people don’t actually care about unequal outcomes as long as they are perceived as fair.

They highlight several studies that show that in laboratory settings people (even children) are likely to distribute resources equally. However, in many of these settings, equality and fairness are indistinguishable. Since none of the participants did anything to deserve a larger portion, participants could simply be attempting to create a fair distribution rather than an equal one. And experiments that explicitly distinguish between fairness and equality do find that people care more about the former. For example, people were not unhappy with allocations that were determined randomly even if the outcome ended up being unequal as long as everybody began with an equal opportunity. Children who were asked to allocate erasers as a reward for cleaning their rooms were more likely to give the erasers to those who did a good job.

In reality people also seem to prefer an unequal distribution of income as long as it is perceived to be fair. In surveys, while people’s perception of the true income distribution is often highly skewed, their ideal distribution is not one of perfect equality. Of course, looking at these surveys does not necessarily tell us much about what the “best” income distribution would be, but rather the one people (think they) prefer. As I argued in my last post, I think too much weight has been placed on income or wealth inequality when really all that matters are differences in people’s happiness or utility. The evidence presented here does not go that far, but it does suggest that people realize that different behavior should lead to different rewards in some cases.

One reason that I think the debate has focused mostly on income or wealth inequality rather than on fairness or another measure of inequity is due to issues with measurement. Everybody has different ideas about what is fair so it’s easier to frame the question in terms of something that can be easily reported numerically. We may want to reconsider our acceptance of those statistics as a meaningful representation of a social problem. The whole paper is well worth reading and it opens up some interesting questions about human behavior. I will have at least one more post related to inequality coming in the next week or so.