A Different Kind of Economic Modeling

In macroeconomics, research almost always follows a similar pattern. First, the economist comes up with a question. Maybe they look at data and generate some stylized facts about some aspect of the economy. Then they set out to “explain” these facts using a structural economic model (I put explain in quotes because this step usually involves stripping away everything that made the question interesting in the first place). Using their model, they can then make some predictions or do some policy analysis. Finally, they write a paper describing their model and its implications.

There is nothing inherently wrong with this approach to research. But there are some issues. The first is that every paper looks exactly the same. Every paper needs a model. Sometimes papers adapt existing models, but they need enough difference to be a contribution on their own (but not so much difference that you leave the narrow consensus of modern macroeconomic methodology). Rarely, if ever, is there any attempt to compare models, to evaluate their failures and successes. It’s always: previous papers missed this and that feature while mine includes it.

This kind of iterative modeling can give the illusion of progress, but it really just represents sideways movement. The questions of macroeconomics haven’t really changed much in the last 100 years. What we have done is develop more and more answers to those questions without really making any progress on figuring out which of those answers is actually correct. Thousands of answers to a question is in many ways no better than none at all.

I don’t think it’s too much of a mystery why macroeconomics looks this way. Everybody already knows how an evaluation of our current answers to macroeconomic questions would go. The findings: we don’t know anything and all our models stink. I’d be surprised if even 10% of economists would honestly suggest a policymaker to carry out the policy that their papers suggest.

Academics still need to publish of course so they change the criteria that describes good macroeconomic research. Rarely is a paper evaluated on how well it answers an economic question. Instead, what matters is the tool used to answer the question. An empirical contribution without a model will get yawns in a macro seminar. A new mathematical contribution that uses a differential equations derived from a heat diffusion equation from physics? Mouths will be watering.

The claim is that these tools can then be used by other researchers as we continue to get closer and closer to the truth. The reality is that they are used by other researchers, but they only use the tools to develop their own slightly “better” tool in their own paper. In other words, the primary consumer of economic papers is economists who want to write papers. Widely cited papers are seen as better. Why? Because they helped a bunch of other people write their own papers? When does any of this research start to actually be helpful to people who aren’t responsible for creating it? Should we measure the quality of beef by how many cows it can feed?

Again there is an easy explanation for why economists are the only ones who can read economics papers. They would be completely unintelligible to anybody else. Reading and understanding the mechanism behind a macroeconomic paper is often a herculean task even for a trained economist. A non-expert has no chance. There could be good reasons for this complexity. I don’t expect to be able to open a journal on quantum mechanics and get anything out of it. But there is one enormous difference between physics and economics models. The physics ones actually work.

Economics didn’t always look this way. Read a paper by Milton Friedman or Armen Alchian. Almost no equations, much less the giant dynamic systems in models today. Does anybody think modern economic analysis is better than the kind done by those two?

The criticism of doing economics in words rather than math is that it is harder to be internally consistent. An equation has fewer interpretations than a sentence. I’m sympathetic to that argument. But I think there are better ways to add transparency to economics than by writing everything out in math that requires 20 years of school to understand. There are ways to formalize arguments other than systems of equations, ways to explain the mechanism that generates the data other than structural DSGE models.

The problem with purely verbal arguments is that you can easily lose your train of logic. Each sentence can make sense on its own but completely contradict another piece of the argument. Simultaneous systems of equations can prevent this kind of mistake. They are just one way. Computer simulations can provide the same discipline. Let’s say I have some theory about the way the world works. If I can design a computer simulation that replicates the kind of behavior I described in words, doesn’t that prove that my argument is logically consistent? It of course doesn’t mean I am right, but neither does a mathematical model. Each provides a complete framework that an outside observer can evaluate and decide whether its assumptions provide a useful view of the world.

The rest of the profession doesn’t seem to agree with me that a computer simulation and a system of equations serve the same purpose. I’m not exactly sure why. One potential worry is that it’s harder to figure out what’s actually happening in a computer simulation. With a system of equations I can see exactly which variables affect others and the precise channel of each kind of change. In a simulation, outcomes are emergent. Maybe I develop a simulation where an increase in taxes causes output to fall. Simply looking at the rules I have given each agent of how to act might not tell me why that fall occurred. It might be some complex interaction between these agents that generates that result.

That argument makes sense, but I think it only justifies keeping mathematical models rather than throwing out computer models. They serve different purposes. And computer models have their own advantages. One, which has yet to be explored in any serious way, is the potential for visual results. Imagine that the final result of an economic paper was not a long list of greek symbols and equals signs, but rather a full moving mini economic world. Agents move around, trade with each other. Firms set prices, open and close. Output and unemployment rise and fall. A simple version of such a model is the “sugarscape” model of Axtell and Epstein which creates a simple world where agents search for and trade sugar in order to survive.

Now imagine a much more complicated version of that that looked a lot more like a real economy. Rather than being able to “see” the relationships between variables in an equation, I could literally see how agents act and interact visually. My ideal world of economic research would not be writing papers, but creating apps. I want to download your model on my computer and play with it. Change the parameter values, apply different shocks, change the number and types of agents. And then observe what happens. Will this actually tell us anything useful about the economy? I’m not sure. But I think it’s worth a try. (I’m currently trying to do it myself. Hopefully I can post a version of it here soon)

Keynesian Economics Part 2 Investment and Output

In my last post on Keynesian economics I outlined a simple example that I think captures the core of Keynes’s economics. It will help to understand this post if you read that one first.

Keynes’s key insight was that an attempt to save by an individual does not always lead to an increase in aggregate saving. I showed how using a simple example in the last post, but we can also generalize the problem. Imagine that each consumer consumes only a fraction of their income (it does not have to be the same across individuals, but I will assume it is for simplicity). Then total consumption spending is given by

    \[C = bY\]

Where C is consumption, Y is income (and total output), and b is the fraction of income spent on consumption (the marginal propensity to consume).

Let’s say that the only spending in the economy is consumption spending. You might already be able to see that we have a problem. Total spending must always equal total income in the economy so that

    \[Y = C = bY\]

Which can only be true if Y=0, so the economy breaks down. Perhaps this scenario is easiest to see if we imagine the case where there is one worker and one firm. The worker works for the firm and gets paid Y. He then decides to buy bY of the output he just produced. The firm realizes he made too much stuff, so he cuts back on production. But this means he reduces his demand for the worker’s labor and cuts his hours. But now the worker makes less so he spends even less and the process continues until no production is carried out at all. The only way we could sustain production through consumption alone would be if nobody wanted to save at all.

If consumption spending isn’t enough to keep firm production positive, we need some demand from another source. One source could be other firms in the form of investment. If we fix income at Y and assume again households only want to consume bY, it is still possible that firms can make up the additional spending by investing (1-b)Y. Keynes argued that there is no reason to expect that investment would always exactly fill gap. If desired investment by firms is less than the difference between consumption and income, they won’t be able to sell all of their product and will cut back on production. We can see that if we write out our equation again, now with investment, it becomes

    \[Y = C + I = bY + I\]

And solving for Y gives

    \[Y = \frac{I}{1-b}\]

So the level of investment determines the level of income. It was through this logic that Keynes concluded that it was the “animal spirits” of firms that determined the state of the economy. It’s possible that the level of investment exactly corresponds to the full employment level of output of an economy, but there is nothing that guarantees that it will.

There are still a few subtleties we need to consider. The first is the role of interest rates. In the classical view of the economy, when people try to save more, they increase the supply of loanable funds, which pushes down interest rates (think of banks having excess money to lend and the only way they can get rid of it is by lowering the interest rate). That lower interest rate then makes previously unprofitable investment projects become profitable and investment rises. If the interest rate falls enough, it’s possible that the increase in investment would be enough to offset the decrease in consumption.

Keynes didn’t deny this possibility. However, he argued (I think correctly), that interest rates are certainly not the only, and likely not even the primary, factor that goes into a firms investment decision. If a firm expects demand to be low due to a recession, there is no interest rate where it will be profitable for them to make that investment. And, as we saw in the last post, by failing to make those investments, firms’ expectations become self-fulfilling and their pessimism is proven correct. Interest rate adjustments alone therefore cannot save us from a Keynesian recession.

Another potential question comes from the assumptions of the Keynesian consumption function. It is obviously unrealistic to assume that each household wants to consume the same constant fraction of their income. People like Milton Friedman have argued that what people really care about when making consumption decisions is their permanent income. If my income falls today, but I expect it to return to its previous level tomorrow, I will borrow in the bad times to keep a constant level of consumption. I think this criticism is valid, but I don’t think it stops Keynes’s story. As long as aggregate consumption is less than total output (which it almost certainly will be), we still need investment to fill the gap. We still rely on expectations of firms to be correct regarding their future demand.

By focusing on the case where investment was exactly enough to move the economy to full employment, Keynes argued that “classical” economists implicitly restricted the economy to a special case. Keynes set out to correct that theory by proposing a “general theory” where investment fluctuated unpredictably and could (and often is) less than the level that would sustain full employment. I think this contribution is extremely valuable and unfortunately often overlooked. Even modern “New Keynesian” models bear little resemblance to the economy Keynes described. Models with money at all are rare and ones that allow the type of monetary disequilibrium in Keynes’s theory are all but nonexistent.

What has been emphasized instead have been the policy implications of Keynes’s work. In my next post I will provide an argument that Keynesian policies do not solve the problem Keynes described.

 

Keynesian Economics and Monetary Disequilibrium

What is Keynesian Economics about? Even if you’ve never taken an economics class you might still have some idea. The 2008 stimulus package was frequently referred to as a Keynesian policy. Government intervention and Keynesian economics often go hand and hand. If you have taken a macroeconomics class you might have an even deeper knowledge of Keynesian economics. Maybe you know about the multiplier, the Keynesian cross, the IS-LM model. And all of those are certainly related to Keynesian economics, but none really capture the heart of Keynes’s contribution.

Part of the trouble with people’s understanding of Keynes’s work is that secondary sources frequently distort what he actually said. For example, if you read Mankiw’s intermediate macroeconomics textbook you will come away with the impression that Keynesian economics is about sticky prices. We get unemployment because wages don’t adjust downward quickly enough. So called “New Keynesian” models, the modern analogue to IS-LM are also predicated on slower than optimal price adjustments to shocks. It is true that Keynes assumed sticky prices for part of his analysis, but he was careful to emphasize that “The essential character of the argument is precisely the same whether or not money-wages, etc., are liable to change” (General Theory Ch. 3).

So if not sticky prices or wages, what is it that causes unemployment in Keynes’s world? In my reading, Keynes’s story is all about monetary disequilibrium and a failure to coordinate savings and investment in a monetary economy.

Keynes famously stated that his theory refuted “Say’s Law,” which can be simply stated as “supply creates its own demand.” Now, whether or not that’s what Say actually said remains a point of contention even today, but  it’s that formulation that Keynes attempts to refute, which I think is worth exploring on it’s own. What Keynes really wants to do is draw a distinction between a barter economy and a monetary economy. I recently taught an intermediate economics class and I developed a simple example that I think helps illustrate the main points.

Let’s start with an economy with no money and only two goods, apples and bananas. There are two people in the economy. Person A can only produce apples and person B can only produce bananas. For simplicity, I will assume a fixed price ratio of 2:1. One banana is worth as much as two apples. The story gets more complicated if we allow this price to change, but I don’t think the main implications would be any different. In this economy with no money, the only trade that can occur is bananas for apples. If A wants to demand 10 bananas from B, he needs to produce 20 apples. It is in this sense that supply creates its own demand. Without money, demand for one good is precisely supply of another. The diagram below illustrates what is happening (I arbitrarily fixed prices in dollar terms, but remember there is still no money. Dollars operate only as a unit of account)

In this kind of barter setup, Say’s law is trivially true. Any demand for bananas is supply of apples so supply creates its own demand. In this case, demand for bananas is $10(20) = 200 and supply is $20(10), which are obviously equal. However, when we start to add in money, the relationship between supply and demand is not as clear.

For a second example we will assume now that bananas and apples cannot be directly traded. Instead, each good will have to be sold for dollars, which can then be used to purchase the other good. Of course, we could still have the exact same situation as above. If all transactions happen instantaneously and every time an apple is produced it is immediately sold and the proceeds immediately used to purchase an apple. However, now there is another possibility.

Imagine that for some reason the apple producer wants to consume more bananas tomorrow than today and decides to save in dollars (I assume apples cannot be saved directly – this might be a strong assumption but it will make sense later). He still wants to consume 10 bananas (so he needs to produce 20 apples), but he also wants to save $100, so he produces an additional 10 apples (30 apples total). But what if the banana producer still only wants to buy 20 apples. He doesn’t want to pay an extra $100 for the additional 10 apples that are being produced.

If you’re an economist the first question that comes to your mind should be why the price doesn’t just adjust. If demand for apples is less than supply for apples, the price of apples should fall until the market is equilibrated. So in this case, apples could fall in price to $6.67 so that 10 bananas buy 30 apples and supply equals demand again. Except then we run into a problem. After the price adjustment producer A still isn’t happy. He didn’t get to save his $100. So really this can’t be an equilibrium at all (it’s possible that the change in prices would also affect his desired saving, but as long as it’s still positive it’s still not an equilibrium).

The problem with the logic above is that we are still trying to think of the economy as a barter economy with one market (trade between apples and bananas), when it is actually a monetary economy with 2 markets (money for apples and money for bananas). Finding a single equilibrium price for two markets is not enough. We need equilibrium in both markets. What we have in the example above is an excess supply of apples and an excess demand for money. The banana producer can’t supply additional money, so he is unable to help return to equilibrium. So who can help? Who supplies money? The Fed! If the Fed simply prints money to buy the excess apples we are back to equilibrium at the same prices as before.

So what does any of this have to do with unemployment? Let’s change the example slightly. Instead of apples, assume now that A provides labor. They work for B to produce bananas. If this is a barter economy then their wage is paid in bananas (I still fix arbitrary dollar values) and demand and supply are always equal as above:

But what if the worker wants to save? He obviously can’t save labor directly (which is why I assumed no saving of apples above) and I will assume he doesn’t have the storage to save bananas either. Instead, he will try to save in dollars by buying fewer bananas (but working the same amount). If he wants to save $100 the picture becomes:

Since the worker still worked 20 hours, production of bananas didn’t fall, but demand for bananas did. The firm is forced to put the extra bananas into its inventories. Is this a problem? Maybe not. If the firm realizes that the worker will use his savings to purchase more bananas in the future, they are happy to increase their investment now in order to produce more bananas next period (an equivalent story could be told where they are building machines to increase production, but the inventory version is the simplest I think). We could then imagine a second period of this economy where the worker uses his savings from the first period to buy the bananas from the inventory in the second.

This story gives us a nice equilibrium outcome with no unemployment. The worker works his desired amount in each period, saving $100 in the first to buy five additional bananas in the second. The banana producer invests in 5 extra bananas to prepare for the increase in demand in the second period. Saving and investment are perfectly coordinated. Say’s Law holds.

But it is easy to imagine another equilibrium. What if the firm does not realize demand for its product will increase next period? All it knows is that consumers want to buy 5 fewer bananas right now. In this simple example where there is only one option for the worker to spend his money that’s hard to believe, but in the real economy with thousands of firms and millions of products, an individual producer has no idea whether increased savings will translate to future demand for its own product. If demand falls today, they might predict lower demand tomorrow as well. In this case they will not want to increase investment today. Instead they simply cut production. So we have a worse equilibrium that looks like

Here the firm doesn’t expect the decline in demand today to translate into an increase in demand tomorrow. They see demand for 5 bananas today so they only hire the worker for long enough to produce those 5. The worker still wants to work 20 hours to save an additional $100, but nobody will hire him so he only works 10 and is therefore underemployed (if we think about this as representing many people we would have some employed and some unemployed). Keynes referred to this situation as involuntary unemployment. People want to work at the prevailing wage, but since firms don’t expect their consumption of their product to compensate the cost of their wages, they don’t want to hire.

There are two interesting points here. First, note that wage cuts will not help. The worker wants to save regardless of his wage. Cutting it will only make him want to work more, which actually makes the problem even worse. Second, the firm’s prediction actually comes true. Since the worker was actually unable to save anything in the first period, his demand for bananas actually won’t increase in the future either. By expecting lower demand tomorrow, the firm actually caused that future to be realized. In this way, expectations are self-fulfilling and we get multiple equilibria.

This example is highly stylized, but I think it demonstrates Keynes’s main point. When somebody wants to save, there is no magical process that instantly transforms their saving into investment. Investment decisions are driven primarily by firms’ expectations about demand for their own products. Without perfect foresight, they must rely on cruder measures of prediction (like animal spirits). If they don’t expect increased saving to translate into future demand, we get unemployment.

I will have more to say on Keynesian economics in at least one future post (including some criticism of Keynes), but this is already getting long so I will stop here for now.

 

Seeing Like a State

I recently finished reading Seeing Like a State, an interesting book by James Scott, a political scientist at Yale. Scott argues that many attempts to coordinate and control from the top down necessarily leave out many important details that are essential to the workings of an organically developed process. In his words “Designed or planned social order is necessarily schematic; it always ignores essential features of any real, functioning social order.” His thesis is essentially a Hayekian one. Because they can never fully collect the local knowledge of individuals, state programs often forget important features of society, in some cases leading to tragic results.

Scott begins the book with an example that I think perfectly encapsulates his broader point. He describes the story of the forestry industry in late 18th century Prussia and Saxony. In order to optimize lumber yields, states decided that there was no need to keep the seemingly unordered naturally grown forest. Instead, they could optimize forest growth, planting only the most valuable trees in a grid-like setup to enable easy access. You can probably guess what comes next.

While the managed forests worked well for one generation, soon the trees stopped growing quite as large or even dying before they could be used for lumber. Without the natural habitat they had evolved to survive in, the trees no longer received the nutrients they needed from the soil. Scientists attempted to replicate the essential features of the forest, to provide the trees with the nutrients they needed while maintaining their controlled environment. As Scott describes, “given the fragility of the simplified production forest, the massive outside intervention that was required to establish it – we might call it the administrators’ forest – is increasingly necessary in order to sustain it as well.” Just as we see in countless cases of government intervention, a single intervention ends up requiring even more intervention and government becomes necessary to maintain the system despite being itself the original source of the problem.

Scott summarizes the situation:

“The metaphorical value of this brief account of scientific production forestry is that it illustrates the dangers of dismembering an exceptionally complex and poorly understood set of relations and processes in order to isolate a single element of instrumental value…Everything that interfered with the efficient production of the key commodity was implacably eliminated. Everything that seemed unrelated to efficient production was ignored. Having come to see the forest as a commodity, scientific forestry set about refashioning it as a commodity machine. Utilitarian simplification in the forest was an effective way of maximizing wood production in the short and intermediate term. Ultimately, however, its emphasis on yield and paper profits, its relatively short time horizon, and, above all, the vast array of consequences it had resolutely bracketed came back to haunt it.” (21)

It is hard to read the excerpt above without immediately thinking of other examples where governments have attempted to replace complex natural systems with more intelligible, but far simpler systems. The remainder of the book goes through many such examples, from the design of cities and languages, to the failed communist experiments of the Soviets and the Chinese and many more. Scott picks out four features that his research suggests lead to poor results of state control. They are, in his words

  1. “Administrative ordering of nature and society”
  2. “High modernist ideology”
  3. “Authoritarian state that is willing and able to use the full weight of its coercive power to bring these high-modernist designs into being”
  4. “Prostrate civil society that lacks the capacity to resist these plans”

1, 3, and 4 are pretty straightforward, but 2 deserves some further discussion. By “high modernist ideology,” Scott refers to the belief that scientists and other experts know how to design a society in a more efficient way than ones that develop without any top down intervention. It is the belief that a centralized plan can trump decentralized spontaneous order. Hayek frequently called this attitude “scientism” in his work. Both Scott and Hayek argue that high modernist thinking is too arrogant. Ancient traditions may look backwards to a modern scientist. Customs may seem strange, cultures don’t always make sense.

But it is important to remember that just because you don’t understand the reason behind something doesn’t mean there isn’t one. To the central planner who only cared about lumber production, natural forests seemed incredibly inefficient. So the solution is simple. Cut out everything we don’t need and just keep the good stuff. In doing so, however, those seemingly useless features often reveal themselves to be essential.

Overall, I found the book to be full of interesting historical examples that each serve to illustrate this theme again and again. One point that I did wish had gotten more attention was the role of corporations and their similar top down nature. Scott briefly mentions that “large-scale capitalism is just as much an agency of homogenization, uniformity, grids, and heroic simplification as the state is.” He is quick to note that there is a major difference that “for capitalists, simplification must pay.” Still, in cases like the German forests, if the results were profitable in the short run and the problems only observable after dozens of years, it is easy to imagine capitalist firms falling into the same trap. I would have liked to see some examples of historical corporations that have also failed to simplify complex systems, but I guess that would require a much longer book. As it stands, the book serves as a useful warning for any attempt to improve a natural process that is not fully understood. Well worth the read.

 

The Neoliberal Conspiracy

My name is Chris, and I’m a neoliberal. Well, at least I think I am. One can never be quite sure. The question of what defines a neoliberal and the significance of the term itself consistently drums up a somewhat bizarre debate with various points of view ranging from the idea that neoliberalism has dominated the world for the last 40 years (and literally the root of all our problems) to claims that neoliberalism is a completely meaningless term.

I don’t have any real stake in this debate – deciding what label should be used to describe people is almost always a fruitless exercise. It seems to me that neoliberal has been used primarily as an insult used by the Left to disparage people who think free markets are generally good, a point made in a recent article by Jonathan Chait. It is important to point out that neoliberal does not only refer to the hardcore libertarian end of the political spectrum. Clinton and Obama are lumped into the same label as Reagan and Bush. However, I think most people agree that the source of the so-called neoliberal movement comes from the strongest supporters of laissez-faire, market-oriented economics. Hayek, Friedman, and other big names in the libertarian community were the ones who set the neoliberal train in motion.

But as soon as they acknowledge the founding fathers of neoliberalism, many analyses of neoliberal thought tend to go off the rails. Perhaps the best example of the kind of thinking I am talking about is a 2014 article by Philip Mirowski entitled “The Political Movement that Dared not Speak its own Name: The Neoliberal Thought Collective Under Erasure.” Mirowski has dedicated much of his career to explaining the expansion of neoliberal thought. It is immediately clear that he opposes essentially all of its primary tenets, but of course anybody can be fascinated by a philosophy without agreeing with it. Unfortunately, Mirowski’s work paints (in my admittedly biased point of view) an incredibly misleading picture of not only what neoliberals believe, but also what their ultimate goals are.

Mirowski states his favored definition of neoliberal as “the dependence upon the strong state to pursue the disenchantment of politics by economics.” Hmm. Is that unintelligible to everybody or just me? Luckily, he also provides a longer list of principles he believes neoliberals adhere to (which he takes from Ben Fink):

(1) “Free” markets do not occur naturally. They must be actively constructed through political organizing. (2) “The market” is an information processor, and the most efficient one possible—more efficient than any government or any single human ever could be. (3) Market society is, and therefore should be, the natural and inexorable state of humankind. (4) The political goal of neoliberals is not to destroy the state, but to take control of it, and to redefine its structure and function, in order to create and maintain the market-friendly culture. (5) There is no contradiction between public/politics/citizenship and private/ market/entrepreneur-and- consumerism—because the latter does and should eclipse the former. (6) The most important virtue—more important than justice, or anything else—is freedom, defined “negatively” as “freedom to choose”, and most importantly, defined as the freedom of corporations to act as they please. (7) Capital has a natural right to flow freely across national boundaries—labor, not so much. (8) Inequality—of resources, income, wealth, and even political rights—is a good thing; it prompts productivity, because people envy the rich and emulate them; people who complain about inequality are either sore losers or old fogies, who need to get hip to the way things work nowadays. (9) Corporations can do no wrong—by definition. (10) The market, engineered and promoted by neoliberal experts, can always provide solutions to problems seemingly caused by the market in the first place: there’s always “an app for that.” (11) There is no difference between is and should be: “free” markets both should be (normatively) and are (positively) most the efficient economic system, and the most just way of doing politics, and the most empirically true description of human behavior, and the most ethical and moral way to live—which in turn explains, and justifies, why their versions of “free” markets should be, and as neoliberals build more and more power, increasingly are, universal.

So how many people would agree to all of the points above? I haven’t taken a survey, but if I did I can almost guarantee the result would be zero. The above description is not even a strawman of the philosophy of people like Friedman and Hayek (or me). On some points, it’s probably not too far off, but on others it’s either misleading or just blatantly false (I take particular issue with 1, 5, 7, 9, 10, and 11). Both the tone (of course all neoliberals regard people who complain about inequality as “sore losers or old fogies”) and the content are apparently designed to position neoliberalism as a front for the elites in society to retain their power. It is the unholy alliance of state and corporate power that drives the neoliberal doctrine.

Now, if you’ve ever read Friedman or Hayek (or my blog) and gotten a very different picture of what it means to be a neoliberal I don’t blame you at all (Note: I prefer to label myself libertarian, but again I’m not concerned about labels here – if Friedman and Hayek are neoliberal then so am I). While the state is certainly necessary to provide some of the features that neoliberals deem conducive to a prosperous society (property rights certainly seem to be a necessary condition), to claim that they “explicitly proposed policies to strengthen the state” is disingenuous. Mirowski gives two examples of such policies from Friedman: his plan to have the central bank grow the money supply at a constant rate and to replace public schools with vouchers. It’s certainly true that both of these policies require a state, but Mirowski chooses to avoid the fact that each requires significantly less state intervention than the current setup. Does he mean to argue that the state providing vouchers to attend private schools requires more state power than the government actually running the schools themselves? I can’t imagine.

Even Mirowski admits that the rhetoric of the neoliberal movement is aimed at promoting the freedom of the individual and limiting the power of the state. But here’s where it gets interesting. Instead of taking neoliberals at their word, Mirowski claims that all of this talk of liberty and freedom is really just a way to “postpone the truth as long as possible when it comes to the nature of the society they are dedicated to bring about.” All of those videos on Youtube of Milton Friedman exquisitely extolling the virtues of a free society? Yeah he doesn’t really believe any of that. The only reason you think he does is because you haven’t “devoted years of their lives to reading the neoliberals, as I [Mirowski] have.”

I think a more accurate statement might be that you haven’t spent years reading the neoliberals and doing everything in your power to find ways to make them look bad. As another person who has spent years reading the neoliberals, I’m almost sure that Milton Friedman believed every word of what he said in those Youtube videos. Mirowski continues in a footnote:

I am always shocked to find the infrastructure of the Neoliberal Thought Collective is always far more developed than any of my private paranoid fantasies. Not only is Free to Choose available on the ubiquitous YouTube, but there is also a slick dedicated website called FreetoChoose.tv, with extended unedited tape from the series…It also includes video lectures from many other neoliberal figures

This comment confuses me. The “infrastructure” of the neoliberal conspiracy is so highly developed that it even has videos on Youtube and *GASP* even a website?! There are two explanations. Either Mirowski has been so engulfed in his study of neoliberalism that he doesn’t realize we are in the 21st century, or he hasn’t had time to look at literally any other topic in the world. I don’t know what his “private paranoid fantasies” consist of, but if you can’t find a website dedicated to them, they must be pretty darn weird.

Jokes aside, Mirowski’s surprise at the lengths the neoliberal movement has gone to promote its message make more sense if we consider it in the context of his broad message. If the freedom rhetoric of the neoliberal movement is really just a front for its desire to strengthen the state and please the elites, his concern makes a lot more sense. For him, the tools of the “Neoliberal Thought Collective” are about as powerful and almost as terrifying as Nazi propaganda. Of course, there’s a far less pernicious reason why the reach of the free market movement extends so far: Its supporters truly care about its message and believe that it will lead to a better world.

And this point seems to be the one that those on the left have such a hard time grasping. They simply can’t believe that anybody honestly believes free markets would lead to a better society. The only explanation is that there is some grand neoliberal conspiracy driving it all. The elites (usually the Kochs take a starring role here) and their economist cronies put on a nice show. They bamboozle the public with nice words like freedom and liberty to draw support to their cause, but their real goal is to be the architects of the society they desire (and probably line their pockets while they’re at it).

Nancy Maclean’s recent book on James Buchanan is an excellent example of such a story. In her account, Buchanan carried out a “stealth plan” to destroy democracy and enact his own vision for the United States (which happened to include many racist policies). I haven’t read Maclean’s book, but I have read several interviews and I find her thesis very odd. Weren’t many of the civil rights victories only possible precisely because of limits on democracy? This post is already long and since I am not an expert on Buchanan and I haven’t read the book I don’t want to comment too much on Maclean’s point specifically (see here, here, and here for some reviews by people who do know what they’re talking about). But I think it does tie into exactly the same kind of thinking illustrated by Mirowski. Never is any probability given to the possibility that Buchanan actually just wanted to improve the system of government in the US. Since his methods were different than progressives, he must be racist and selfish. And since he can’t say those things outright, he had to hide them.

I can’t speak for Buchanan. I don’t know what was really going on in the brains of Friedman or Hayek. Maybe they are all just frauds. But I do know with certainty that there exists at least one person that supports free market policies because he actually thinks they are good (full disclosure: I have received Koch money to attend conferences at the Koch funded Institute for Humane Studies – but I got that money because I am libertarian, not the other way around). I’ve met many other people who are either great actors or are genuinely convinced that markets work well and are beneficial for the vast majority of society. They aren’t hiding those beliefs. They aren’t huddled behind closed doors trying to devise ways to lead everyone else into a trap. There is no hidden meaning behind their words. There is no neoliberal conspiracy.

Don’t Be Afraid of Trade

One of the economic concepts that is most frequently misunderstood by non-economists (and probably by economists too) is the trade deficit. First, a definition. The trade deficit refers to the difference between the amount of goods a country imports and the amount it exports. As the graph below shows, the US has had a large trade deficit for the past several decades. It has been importing goods at a much higher rate than it has been exporting them. Nobody disagrees with that definition or that fact. The debate comes in when people start to decide whether this situation is actually a problem.

Part of the problem is simply an incorrect interpretation of what the trade deficit measures. It is common for non-economists to confuse this trade deficit with the equally frequently maligned budget deficit, which measures the difference between how much the government spends and how much it takes in as revenue. Unfortunately, our own president is among those who have made this mistake. According to Trump:

“The United States has trade deficits with many, many countries, and we cannot allow that to continue … with South Korea right now, but we cannot allow that to continue. This is really a statement that I make about all trade: For many, many years the United States has suffered through massive trade deficits; that’s why we have $20 trillion in debt.”

This statement is complete nonsense. The trade deficit with South Korea or any other country has absolutely nothing to do with the US government’s $20 trillion debt. The debt is the consequence of perennial budget deficits that derive from the US spending a ton of money on military, social welfare, and other government programs.

The trade deficit isn’t really a debt at all. It simply represents the fact that the US buys more goods from foreign countries than they buy from us. In the short run, a trade deficit is almost certainly beneficial for the US. As Milton Friedman eloquently explains in a video I posted a while ago, what a trade deficit really means is that foreigners are giving us real goods and services in exchange for pieces of paper. We get TVs from Japan. All they get are US dollars.

However, a more careful criticism of trade deficits recognizes that trade deficits can be good for the country in the short run, but represent a cost in the long run. Noah Smith articulates such a point in this post, where he argues that the trade deficit is a “loan of real goods and services.” He gives the example of somebody in the US buying a car from Germany. If the US citizen pays in dollars, he calls this an IOU to Germany. At some point, a German will use the dollars to buy goods and services from the US. Even if the dollars were used to buy an asset like a stock, eventually that stock will be sold and the dollars from the sale will be used to buy goods and services. His logic makes sense. Every dollar must eventually come back to the US in some form or another at some point.

But thinking of the trade deficit as a debt seems to me to be either misleading or completely wrong. One confusing point here is that the trade deficit is a flow, while debts are stocks. What is the value of the debt the US has to repay? The stock of all goods and services ever imported minus all goods ever exported? The current stock of foreign dollar holdings? I’m not sure there is any consistent definition of what this debt is that we are supposed to repay. Even if there were, I don’t think the idea of the trade deficit as a debt is meaningful.

Let’s flip Noah’s story. Assume a Chinese citizen really wants to buy Apple stock since they think it will increase in value. They need dollars to buy Apple stock so they exchange some Yuan for dollars and buy stock. At the same time, Apple needs to buy parts from China to make iPhones, so it imports them, trading dollars for Yuan in the process. For simplicity, assume these two transactions exactly cancel out. Where are the IOUs here? Does either country owe a debt to the other? It certainly doesn’t seem like it to me. The stock of dollars and Yuan in either country is exactly the same as it was before the transaction.

It is even clearer that the trade deficit is not a debt if we consider what happens if Apple suddenly goes out of business. The value of their stock goes to zero and their imports also go to zero. The trade deficit that was created by Apple is gone and no US goods were ever given to China. I imagine Noah considers that analogous to defaulting on a debt, but I don’t buy that analogy at all. Does he think Apple owes a debt to all of its shareholders or just its foreign ones? Isn’t the risk of Apple’s stock price falling inherent in its purchase? If you still aren’t convinced, Daniel Ikenson also has an excellent rebuttal to Noah’s article.

The other important point to keep in mind that is implicit in the example above is that foreign countries don’t just buy goods and services from the US. They also buy assets (stocks, bonds, etc.) or invest directly by building their own factories and capital equipment here. The current account (goods and services) and the capital account (assets) are always in balance by definition. A current account deficit is always offset by a capital account surplus.

This fact means that there are two ways we can frame the US’s large trade deficit. It could be that Trump is correct and we are really just falling behind in competitiveness. Nobody wants US goods anymore so they don’t buy our exports while we eat up their imports (which again is not necessarily bad – we get goods and they get paper). Or it could be that the US is home to many of the safest and best performing assets in the world. Other countries are dying to invest in US companies (and treasury bonds) and the result is a huge capital account surplus. One statistic won’t tell us which story is more accurate, but I think it’s pretty safe to say that we don’t have to be too worried (either now or in the future) about the trade deficit.

Let the Facts Decide on Minimum Wage

Basic economic theory has very clear predictions on what should happen to a labor market with a minimum wage. If we assume an upward sloping labor supply curve and a downward sloping labor demand curve, a minimum wage will cause demand for workers to fall while supply increases. The result: an excess supply of workers, also known as unemployment.

The real world is obviously much more complicated than the standard Econ 101 textbook story. Perhaps the most important difference is that there is not just one equilibrium wage. No two jobs are exactly the same. Workers with different skill levels will face different labor markets. Location matters. The list of reasons why the real world doesn’t conform to the simplifying assumptions of economic theory is potentially endless.

However, those caveats do not necessarily invalidate the intuition of basic economics. I don’t think it’s a controversial statement that firms will attempt to substitute away from an input when its cost increases. In this case, that input is low skilled workers. As minimum wage increases, so does the necessary productivity of a worker who wants to be hired. A worker who only produces $10/hr of value for an employer will never be paid $15/hr regardless of the level of the minimum wage. Their choice is not between 10 and 15, but between 10 and 0 (unemployment).

But can we be sure that workers are actually paid based on their productivity? Couldn’t it be that they are simply being exploited, with firms pocketing the additional profits they generate? Under this scenario, an increase in the minimum wage could increase wages without hurting employment.

Here we see the limits of theory. Under some assumptions a minimum wage is good and under others it is bad. The clear next step is to look at the facts. Do minimum wage laws hurt or help low wage workers in the real world? Luckily, due to recent experiments with a $15/hr minimum wage in some cities, we have plenty of data to work with.

Supporters of minimum wage laws will be happy to find out that cutting edge research shows we have nothing to worry about (here’s the link to the full study). The increase in Seattle minimum wage to $13 (15 is being phased in over time) hasn’t had severe disemployment effects. There was a minimal decrease in employment, but overall, “results show that wages in food services did increase — indicating the policy achieved its goal.” So take that Econ 101. Minimum wage is great. Case closed.

Well, not quite. Because this morning, just 6 days after the study above came out, we have a new study looking at the exact same natural experiment (although with a different data set). The results are not so nice. They find that “the minimum wage ordinance lowered low-wage employees’ earnings by an average of $125 per month in 2016.”

Now what? Theory gives us conflicting results and so does data. How can an unbiased observer make a decision about the truth? Well, to be sure of the results of the studies above, they would need to sift through around 100 pages of dense statistical analysis. But of course, anybody untrained in statistics would first have to take a few classes to have any idea what they were talking about. And even with that training, they’d need to take a close look at the datasets used, weigh the pros and cons of each methodology, decide whether the results can generalize to other places, etc. Maybe after about two years of hard work they’d be able to have a qualified opinion on the two studies (never mind the dozens of other studies that have been done on the topic).

What is actually more likely to happen? Everyone who supported the minimum wage will cite the first study and look for flaws in the second (I would bet anything that Arin Dube – one of the biggest minimum wage scholars to support an increase – is scouring it right now looking for something to criticize). Everyone against minimum wage will do the opposite. Both will pretend they are letting the facts decide.

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.