Quote of the Day 8-3-2016

I had a growing feeling in the later years of my work at the subject that a good mathematical theorem dealing with economic hypothesis was very well unlikely to be good economics: and I went more and more on the rules – (1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This last I do often.
Alfred Marshall

Quote of the Day 8-1-2016

The train of logic departs from a picture that economists of a hundred years ago would recognize as familiar – Robinson Crusoe allocating effort between fish and bananas, say –  but barrels along at uncomfortable speed, picking up loads of subscripts on the way, into a fantasy land where the assumptions made about what people are able to know, to forecast and to calculate would leave them utterly bewildered and incredulous.
Axel Leijonhufvud “Episodes in a Century of Macroeconomics”

Blogs I Read

I spend a lot of time reading other economics blogs and I will probably be referring to many of these in future posts. Here are some of the ones I read most.

Blogs I Love

EconLog: Bryan Caplan, David Henderson, and Scott Sumner cover a wide range of economics issues. Sumner tends to write about monetary policy and Caplan focuses on immigration and education, but all three are pretty varied in their choice of topics. Usually at least one post per day and always interesting analysis.

Slate Star Codex: Not an economics blog and posting frequency is a bit lower, but Scott Alexander is a great writer and has some incredible posts. Just read this and you’ll see what I mean.

Blogs I Like

Marginal Revolution: One of the most popular economics blogs. Tyler Cowen and Alex Tabarrok from George Mason University post about a variety of different topics.

Roger Farmer’s Economic Window: Doesn’t post as frequently as some of the other bloggers highlighted here, but the analysis is always top-notch. Good source for some non-standard macroeconomic views. Also has a new book coming out soon, which I have read and highly recommend.

The Money Illusion: Scott Sumner’s personal blog. Again mostly focused on monetary policy and Sumner’s proposals for targeting nominal GDP.

Worthwhile Canadian Initiative: You’ll probably have to read each post about three times before you get the point (at least I do), but Nick Rowe is the master of thought experiments.

Cafe Hayek: If you want to see a bunch of posts arguing against the minimum wage and in favor of free trade this is the place to go.

Free Advice: Bob Murphy writes mostly about economics from an Austrian school perspective. Spends many posts criticizing Paul Krugman (coined the term Krugman Kontradiction) and Scott Sumner.

Alt-M: An interesting blog focused mostly on exploring free banking, or how a monetary system could work (and has worked) without a central bank.

Coordination Problem: A blog run by Pete Boettke, one of the most prominent modern Austrian school economists.

Noahpinion: A great blog for the analysis of macroeconomic methodology (among other topics). Noah Smith is about as critical of modern macroeconomics as I am (although I think his preferred alternatives are quite different).

The Grumpy Economist: John Cochrane is one of the leading financial economists. Probably not the easiest read if you aren’t familiar with economics and finance.

Blogs I Read, but Don’t Like as Much

The Conscience of a Liberal: Paul Krugman is a great economist, but I find his blogging to be far too partisan and antagonistic.

Wonkblog: Very strong liberal bias. Not so strong economic analysis.

Tom Woods: Still occasionally has some good posts on economics and politics from a libertarian perspective, but has recently shifted towards trying to get you to buy stuff. (Update: Tom points out in the comments that his blog is not really the focus of his website. I should have mentioned he also has a free podcast, which is much better).

Links to these and some other blogs are in the blogroll on the right sidebar.

 

 

 

Feel the Johnson

gary_johnson

 

 

 

 

 

 

Gary Johnson, the Libertarian candidate for president, held a fundraiser at Drew Carey’s house the other day. Apparently the dress code was “Libertarian comfortable, i.e. whatever you’re comfy in.”

I started imagining what the dress codes at the other candidates fundraisers must look like:

“Democrat comfortable, i.e. whatever you’re comfy in, but bring several changes of clothes just in case it offends anyone” (credit my brother for this one).

“Republican comfortable, i.e. whatever you’re comfy in as long as you’re not Mexican or Muslim.”

“Green party comfortable, i.e. whatever you’re comfy in that is made from environmentally sustainable materials by people being paid a living wage.”

Johnson and his running mate Bill Weld will be on CNN this Wednesday for a town hall discussion (they were also on last month). I recommend checking these guys out if you’re not happy with either of the major party candidates.

The Economics of Hayek

hayek_portraitAs I mentioned in my first post, Hayek has had a large influence on the way I think about economics. But despite being one of the most cited authors of all time and winning the 1974 Nobel prize, the bulk of Hayek’s ideas have either been ignored or mischaracterized by modern economic research (see Pete Boettke’s paper on how Hayek is used by modern economics). Looking at the methodology of modern economics (especially macro – more on this in future posts), I doubt there is much of anything that would have appealed to Hayek. Obviously, I think Hayek’s economics deserve a larger role in the theories of modern economists. So what is Hayekian economics? I have broken it into four pieces. If you are not familiar with formal economics, some of the comparisons I make might be a bit confusing, but I hope it is interesting regardless.

The Economic Problem

If we possess all the relevant information, if we can start out from a given system of preferences, and if we command complete knowledge of available means, the problem which remains is purely one of logic…This, however, is emphatically not the economic problem which society faces…It is rather a problem of how to secure the best use of resources known to any of the member of society, for ends whose relative importance only these individuals know
F.A. Hayek, The Use of Knowledge in Society, 1945

Most economics papers begin by doing precisely what Hayek warned against in the quote above. They define a set of preferences for consumers and a production function for firms. They then assume that consumers maximize utility and firms maximize profits and solve for an equilibrium. From Hayek’s perspective, starting from this point assumes away the most interesting questions of economics. The economic problem cannot be solved by taking derivatives of known maximization problems. Instead, it is a question of how resources can be allocated efficiently when this information is not known. It is about the process of discovery, of individuals competing and cooperating attempting to find better ways to achieve their own ends.

The Price System

I am convinced that if it were the result of deliberate human design, and if the people guided by the price changes understood that their decisions have significance far beyond their immediate aim, this mechanism would have been acclaimed as one of the greatest triumphs of the human mind
F.A. Hayek, The Use of Knowledge in Society, 1945

Hayek’s answer to the economic problem he proposed above and the mechanism that allows a decentralized economy to allocate resources is the price system. It is important to note here that Hayek’s prices are not equilibrium prices. They are not set to ensure that all markets clear or that there are no profit opportunities remaining. He is far more interested in the process by which an economy moves toward its equilibrium than he is in the equilibrium itself. Prices, then, are simply guides, providing the information that incentivizes individuals to make decisions that result in goods being allocated efficiently, even though it wasn’t anybody’s direct intention to do so. When a resource becomes relatively scarce, entrepreneurs recognize a profit opportunity, raise the price, and ensure that only those who will make the best use of the resource actually receive it. Through the price system, knowledge that is known only to a few individuals can be communicated indirectly throughout an economy.

The Meaning of Competition

[C]ompetition is by its nature a dynamic process whose essential characteristics are assumed away by the assumptions underlying static analysis
F.A. Hayek, The Meaning of Competition, 1946

The way that prices are formed in Hayek’s theory is through the competitive process. Entrepreneurs, who are usually given little to do in standard economic theory, are central to Hayek’s story. Rather than assume firms to be price takers, aware of their own cost structure and production function, their actions are instead “a voyage of exploration into the unknown, an attempt to discover new ways of doing things better than they have been done before.” In standard economic theories, “perfect competition” is a state where nothing changes as firms decisions are largely made for them. In contrast, Hayek imagines competition as a constantly moving dynamic system. Even if the economy looks stable, “the task of keeping cost from rising requires constant struggle.”

Spontaneous Order

[M]any of the ‘mere habits’ and ‘meaningless institutions’ that we use and presuppose in our actions are essential conditions for what we achieve; they are successful adaptations of society that are constantly improved on and on which depends the range of what we can achieve. While it is important to discover their defects, we could not for a moment go on without them
F.A. Hayek, The Constitution of Liberty, 1960

In the end, the actions of individuals acting on their preferences and knowledge create a “spontaneous order,” an organization of society that is  the “result of human action, but not of human design” (a quote used by Hayek, but which was originally written by Adam Ferguson in 1767). In other words, even without top down planning, there is an order to society that arises naturally. This idea applies not only to a market economy and the price system, but also to political systems, the rule of law, and more informal orders like societal norms and customs. The institutions that society develops are continuously evolving as people explore new ways to accomplish their goals. These institutions provide the basis for the market system, providing incentives for entrepreneurs to develop new products and methods of production as well as accurately set prices. They are essential to tie together the three pieces explained above.

While this brief post can only give a taste of Hayek’s work (look here for some videos and a free ebook that go into more detail), I think it highlights the main differences between his approach and that of mainstream economic theory. Disequilibrium, fundamental uncertainty, and the discovery process of entrepreneurs are all essential pieces of Hayek’s analysis that are challenging to model using the most commonly used methods of modern economic analysis. But rather than throw these concepts aside because they do not conform to these methods, I believe the right path forward is to change the methods themselves.

More on this in future posts.

 

Welcome

Welcome to the Pretense of Knowledge! I started this blog primarily for my own benefit – to organize my thoughts and polish my writing – but I hope you will find something interesting to read here as well. The main focus of most posts will be on economics, but I also plan to write on politics, philosophy, and occasionally throw in a couple posts on sports and entertainment.

Since my site shares its title with F.A. Hayek’s Nobel Prize speech, you may have already guessed that I approach most topics from a Hayekian libertarian perspective. If you don’t know what that means, here or here might be a good place to start (and if you’re feeling more adventurous try this). Essentially, it means that I won’t be voting for either Clinton or Trump in November. It means that I think markets work well most of the time and that when they don’t the government still tends to make things worse. And it means that I think the American military is about five times larger than necessary, that we should be knocking down walls rather than building new ones, and that politicians shouldn’t have anything to do with what you do in your bedroom or what you put into your body.

But besides paying my respects to Hayek, the title “the pretense of knowledge” has a deeper meaning for this blog. In his speech, Hayek criticized the arrogance of economists who believed that their knowledge was so great that they could make numerical predictions with accuracy comparable to the physical sciences. Instead, he urged the social scientist to recognize the “insuperable limits to his knowledge.” In my writing I will attempt to adhere to that philosophy. I have no doubt that a large proportion of the ideas I present turn out to be totally wrong and I fully expect in two years (or two months) I will look back on my early posts in disgust. So if you disagree with something I say, tell me why in the comments and try to keep an open mind. Hopefully, we will be able to learn from each other.

Over the next couple days I will have posts coming out about Hayek’s economics, about why 2016 is the best year yet, and about free will vs determinism. I also plan to do a series of posts criticizing modern macroeconomics and will likely have some smaller posts as well.

Thanks for reading!

Chris