3 very different views of economic models

The first is a famous one, from Milton Friedman, via Justin Fox’s The Myth of the Rational Market:

[T]he relevant question to ask about the “assumptions of a theory is not whether they are descriptively “realistic,” for they never are, but whether they are sufficiently good approximations for the purpose at hand. And this question can be answered only be seeing whether the theory works, which means whether it yields sufficiently accurate predictions.

As Fox writes:

To head off the obvious objection that it was ridiculous to think regular folks reason according to complex statistical rules, Friedman and Savage argued that billiards players couldn’t write down the physics formulas that underlay their shot selections but nonetheless acted as if they did.

Here’s quite a different take that I just came up on recently, from J.W. Mason of the Roosevelt Institute:

It seems to me that Deirdre McCloskey was right: Economics is not the study of the economy. Economics is just what economists do. Economic theory is essentially a closed formal system; it’s a historical accident that there is some overlap between its technical vocabulary and the language used to describe concrete economic phenomena. Economics the discipline is to the economy, the sphere of social reality, as chess theory is to medieval history: The statement, say, that “queens are most effective when supported by strong bishops” might be reasonable in both domains, but studying its application in the one case will not help at all in applying it in in the other.

Finally, a third view, from Dani Rodrik’s excellent book Economics Rules:

I wrote this book to try to explain why economics sometimes gets it right and sometimes doesn’t. “Models” — the abstract, typically mathematical frameworks that economists use to make sense of the world — form the heart of the book. Models are both economics’ strength and its Achilles’ heel; they are also what makes economics a science — not a science like quantum physics or molecular biology, but a science nonetheless.

Rather than a single, specific model, economics encompasses a collection of models. The discipline advances by expanding its library of models and by improving the mapping between these models and the real world. The diversity of models in economics is the necessary counterpart to the flexibility of the social world. Different social settings require different models. Economists are unlikely ever to uncover universal, general-purpose models.

But, in part because economists take the natural sciences as their example, they have a tendency to misuse their models. They are prone to mistake a model for the model, relevant and applicable under all conditions. Economists must overcome this temptation. They have to select their models carefully as circumstances change, or as they turn their gaze from one setting to another. They need to learn how to shift among different models more fluidly.

The New Industrialism

At the very end of 2012, I wrote a piece for MIT Technology Review (paywall) about an interesting schism in Democratic economic policy circles. Gene Sperling had replaced Larry Summers as director of the National Economic Council in early 2011, and over the next couple of years the Obama administration seemed to talk more about industrial policy, although they didn’t call it that.

The term was “advanced manufacturing.”

But in early 2012, Christina Romer, former chair of Obama’s Council of Economic Advisers, questioned the administration’s manufacturing agenda publicly, writing in The New York Times:

AS an economic historian, I appreciate what manufacturing has contributed to the United States. It was the engine of growth that allowed us to win two world wars and provided millions of families with a ticket to the middle class. But public policy needs to go beyond sentiment and history. It should be based on hard evidence of market failures, and reliable data on the proposals’ impact on jobs and income inequality. So far, a persuasive case for a manufacturing policy remains to be made, while that for many other economic policies is well established.

A survey of economists from around the same time confirmed that the conventional wisdom in the field was firmly against intervention to boost manufacturing.

I didn’t get to interview the players in this debate, but my piece highlighted a group of policy wonks willing to defend a certain sort of industrial policy. I talked to Mark Muro of The Brookings Metropolitan Program, which had released research emphasizing the importance of manufacturing, and Rob Atkinson of ITIF, a think tank promoting an aggressive innovation policy agenda.

Not much came of this debate, at least that I could see. But perhaps a broader warming to some revised form of industrial policy is now perceptible?

Enter economist Noah Smith at Bloomberg View, writing about new ideas in economic growth. Neoliberalism still has its adherents, but what’s the competition?

Looking around, I see the glimmer of a new idea forming. I’m tentatively calling it “New Industrialism.” Its sources are varied — they include liberal think tanks, Silicon Valley thought leaders and various economists. But the central idea is to reform the financial system and government policy to boost business investment.

Business investment — buying equipment, building buildings, training employees, doing research, etc. — is key to growth. It’s also the most volatile component of the economy, meaning that when investment booms, everything is good. The problem is that we have very little idea of how to get businesses to invest more.

My Tech Review story called this group the “institutionalists,” which one of my sources coined when pressed to distinguish his faction. But “New Industrialism” is far clearer.

So who’s a part of this agenda? Smith mentions The Roosevelt Institute’s excellent reports on short-termism; ITIF and Brookings Metro belong on the list; we’ve published a lot at HBR that I think would count (a few examples here, here, here, here).

And one could argue that Brad DeLong and Stephen Cohen’s forthcoming book on Hamiltonian economic policy (my employer is the publisher) is in this conversation, except arguing that such an agenda isn’t new at all. Here’s their recent Fortune piece:

Hamilton’s system was constructed of four drivers that reinforced one another, not just economically but politically: high tariffs; high spending on infrastructure; assumption of the states’ debts by the federal government; and a central bank.

As Smith writes,  “New Industrialism… is not yet mainstream,” and frankly there’s still a lot to be fleshed out before we can even ask whether such an agenda is superior to the alternatives. But he concludes that “it could be just the thing we need to fix the holes in our neoliberal growth policy.” He may just be right.

Win-win economics

The assumption that economic growth and equality are necessarily at odds is fading fast.

wsj productivity inequality

That’s via Greg Ip and The Wall Street Journal.

If inequality were the price we paid for growth, you’d expect productivity and income captured by the rich to go hand-in-hand. Instead, we see virtually the opposite.

Sure enough, the conversation here is changing. Suddenly, you’re no longer considered a pollyanna for suggesting we can further growth and equality at the same time. For instance…

Christine Lagarde, managing director of the IMF in The Boston Globe:

The traditional argument has been that income inequality is a necessary by-product of growth, that redistributive policies to mitigate excessive inequality hinder growth, or that inequality will solve itself if you sustain growth at any cost.

Based upon world-wide research, the IMF has challenged these notions. In fact, we have found that countries that have managed to reduce excessive inequality have enjoyed both faster and more sustainable growth. In addition, our research shows that when redistributive policies have been well designed and implemented, there has been little adverse effect on growth.

Indeed, low growth and high inequality are two sides of the same coin: Economic policies need to pay attention to both prosperity and equity.

And Larry Summers:

Trade-offs have long been at the center of economics. The aphorism “there is no such thing as a free lunch” captures a central economic idea: You cannot get something for nothing. Among the many trade-offs emphasized in economics courses are guns vs. butter, public vs. private, efficiency vs. equity, environmental protection vs. economic growth, consumption vs. investment, inflation vs. unemployment, quality vs. quantity or cost and short-term vs. long-term performance…

Yet I am increasingly convinced that “no free lunch” oversimplifies matters and makes economics too dismal a science. It would be true in a world where all opportunities to make things better had been fully exploited — where, to use another cliché, there were no $100 bills lying on the street. But recent experience suggests that by improving incentives or making strategic investments, we can achieve apparently conflicting objectives to a greater extent than conventional wisdom would suggest…

A quite different example involves the alleged trade-off between equity and efficiency — specifically, the concern that redistribution hurts economic performance and stymies growth. It is true that tax increases produce at least some adverse incentives and that providing income-based government benefits involves implicit taxes. But matters are much more complex than a simple trade-off. Antitrust laws that attack rent-seeking promote both equity and efficiency, as do measures that increase educational opportunity. The rational strengthening of financial regulation reduces the incidence of financial crises, thus improving economic performance while promoting fairness by helping consumers. In demand-short economies, the greater equity achieved through more progressive taxation means more spending and fuller employment of resources. These examples do not deny trade-offs between equity and efficiency. They do, however, suggest that there is nothing ineluctable about them. Both can be enhanced through proper policy.

And David Wessel, reviewing Robert Gordon’s new book:

Whatever the causes of the distressing slowdown in the growth of productivity (the amount of stuff produced for each hour of work) and the increase in inequality, what policies might both increase productivity and decrease inequality?

Many years ago, economist Art Okun argued that we had to choose between policies that increased efficiency and those that increased equity. Perhaps. But  if there are policies that could achieve both, it’s time to try them.

Tradeoffs remain real, as do unintended consequences. Here are two examples that challenged my biases. Activist hedge funds seem to represent a tradeoff between rising productivity and rising wages. And there’s some reason to think that new overtime rules won’t work the way they’re intended.

Not everything works out the way you’d hope. But sometimes the interests of growth and equality are happily aligned. Which is good, because we could use a whole lot more of both.

How to trust economists


The questions of whether we can trust economists and what economics is good for are back, thanks to a New York Times post last week making an outrageous claim:

The fact that the discipline of economics hasn’t helped us improve our predictive abilities suggests it is still far from being a science

At Bloomberg, economist Justin Wolfers notes that the post contains no actual evidence for that claim (though Wolfers himself does not offer any). My take is that economics almost certainly has improved our predictive ability, but I won’t attempt to make that case here. (I’ll also note that much research into whether experts predict things well tends to focus on the most difficult cases in the field. Related: Wolfers has documented the strong degree of consensus within the economics profession, which doesn’t always come through in the media.)

But apart from all this, it strikes me that whether we can trust economists is an impoverished debate. How to trust economists – how to interact with their claims, when to trust those claims and when not to – is more interesting, relevant, and important. Yes, economists too often take on the role of philosopher or political scientist. Yes, sometimes their biases shine through in their recommendations. Yes, economics doesn’t have all the answers. And yes, some of those answers even turn out to be wrong *cough* Great Moderation *cough*. But plenty of the time, listening to economists is a good idea!

So I thought I’d transcribe the last page of a book called The Assumptions Economists Make, a very pessimistic tour of economic models throughout history by HBS professor Jonathan Schlefer. It’s an entertaining read; Schlefer has a PhD in Political Science, and his quite critical take focuses on the inconsistencies in economic models throughout time. (If the book has a central flaw it’s that it tends to do battle with these abstractions in the abstract; their usefulness is mostly secondary to their validity.)

Nonetheless, his concluding recommendations are a must-read for anyone grappling with how to trust economists:

  • Economists should transparently describe critical assumptions. These assumptions should be realistic and pertinent to the situations that a particular model seeks to explain.
  • Economists should explain the structure of their models. The structure of a model constitutes the perspective it sheds on some crucial aspects of an economy. Thoughtful individuals should not believe, and policymakers should not use, an unexplained model.
  • However realistic its assumptions, a model stands an excellent chance of ignoring crucial aspects of an economy because, among other things, incorporating them might well make the model too complex to handle. Think what factors it might miss.
  • There are always conflicting models to explain any given aspects of an economy  In looking for practical conclusions, weigh conflicting models.
  • Macroeconomies are incredibly complex. One of the most useful things economists can do is explain publicly what they do not know.

Though many of these are focused on what economists should do, turn them around and you have a nice list of questions to ask economists about their recommendations. The fourth one is particular important. I’d add that we should what data the model successfully does and does not explain.

Taken together, this provides at least the beginnings of a toolkit for politicians, journalists, and citizens to engage with the recommendations of economists. And engagement, ultimately, will be more fruitful than either blind acceptance or dismissal.

Workaholics and redistribution: Some people like working more than others

Via Reihan Salam, here’s a bit from Greg Mankiw:

one reason that people differ in their incomes is that some people care more about having a high income than others…

Bryan [Caplan] goes on to suggest that to the extent this is true, it weakens the case for income redistribution.

He is absolutely right.  Most of the literature on optimal taxation and redistribution, following Mirrlees, assumes homogeneous preferences.  But Matthew Weinzierl has a recent paper on preference heterogeneity, which shows “ to the extent that variation in income is due to preference differences rather than productivity differences, the optimal extent of redistribution is lower, and the neglect of preference heterogeneity biases the results of conventional optimal tax analyses in favor of redistribution of income.”

Sure, but what about the flip side? Call it the striver phenomenon. Preferences for working aren’t homogeneous either. To the extent that some people get more utility out of working at a given task than others that should recommend relatively more redistribution, no?

American manufacturing, “flexibility”, and labor costs

This is a bit outside the normal scope of the blog, but I’ve been shocked to see the point not be made elsewhere. You may have seen the excellent NYT article from a couple weeks back “How the U.S. Lost Out on iPhone Work.” It’s a terrific piece of journalism but with one major error.

The big revelation, supposedly, is that labor costs aren’t the major reason why Apple does its manufacturing in China rather than the U.S.:

In part, Asia was attractive because the semiskilled workers there were cheaper. But that wasn’t driving Apple. For technology companies, the cost of labor is minimal compared with the expense of buying parts and managing supply chains that bring together components and services from hundreds of companies.

For Mr. Cook, the focus on Asia “came down to two things,” said one former high-ranking Apple executive. Factories in Asia “can scale up and down faster” and “Asian supply chains have surpassed what’s in the U.S.” The result is that “we can’t compete at this point,” the executive said.

The point about supply chains is a good one, and rooted in a rich literature around economic geography and “clusters.” But the point about scaling up and down faster – flexiblity, as it’s referred to in the article – is misleading.

I have no doubt that manufacturing flexibility is hugely valuable. The error is in treating this as separate from labor costs. From the article:

One former executive described how the company relied upon a Chinese factory to revamp iPhone manufacturing just weeks before the device was due on shelves. Apple had redesigned the iPhone’s screen at the last minute, forcing an assembly line overhaul. New screens began arriving at the plant near midnight.

A foreman immediately roused 8,000 workers inside the company’s dormitories, according to the executive. Each employee was given a biscuit and a cup of tea, guided to a workstation and within half an hour started a 12-hour shift fitting glass screens into beveled frames. Within 96 hours, the plant was producing over 10,000 iPhones a day.

“The speed and flexibility is breathtaking,” the executive said. “There’s no American plant that can match that.”

The better way to think about this is that no American plant can match this kind of flexibility at a competitive price as compared to Chinese factories. Ask yourself: how much would you have to pay American workers to be available 24 hours a day, to live in a dorm next to the factory, and to do surprise 12 hour shifts in the middle of the night? Getting this kind of “flexibility” in the U.S. is hard for a lot of reasons, but one of them is labor costs! You’d have to pay Americans a fairly high salary for them to agree to those terms.

I’m fine with emphasizing that this kind of flexibility is increasingly important in global manufacturing. But it’s a mistake to think of it as divorced from labor costs.

How inequality harms

I try to avoid politics here on the blog, even though it’s something I read about and talk about quite a bit. But there’s a point about inequality that I’ve been startled to see conservatives either missing or ignoring. In the clip above, Rich Lowry makes what I believe is a very misguided statement, arguing that inequality doesn’t cause harm per se. His exact words: “It’s just not true that [the bottom fifth of the population are] not getting ahead because of inequality… That Peter Orszag goes to Citigroup and makes two or three million dollars and merrily joins the 1% has zero effect on people who may be stuck at the bottom fifth in the Bronx, for instance.”

Woven in here is a point about poverty in America but I’m going to treat this as an example more broadly of the claim that the rich getting richer doesn’t make anyone else worse off. Perhaps I’m misinterpreting Lowry; perhaps he was very narrowly talking about the “stickiness” of serious poverty in the U.S. But the more general argument is something I’ve seen pop up elsewhere.

As for the broader claim that inequality isn’t hurting anyone… There is a logic to it, as I’ll explain, but it ultimately doesn’t really hold up to scrutiny. Before I get started, let me say this: even if everything I say here is correct, it doesn’t necessarily imply any particular policy responses to inequality. My aim here is to get past some faulty reasoning so that we can focus on the difficult questions around inequality that ultimately will determine what policies we do or don’t favor. So if you’re a conservative, try to keep an open mind as I go through this. Nothing here implies that you have to change your policy views.

A Simple Economy

To think about this, let’s consider inequality just between you and I. And even though we’ll eventually want to think about incomes, to keep it simple let’s start off just talking about wealth. I have $100 and you have $100. Now you come into some money and suddenly your wealth increases by $1000. You’re now quite a bit richer than I am, at $1100 net wealth to my $100. But am I worse off in any sense? Seemingly, no. This is the point I believe Lowry was trying to make.

Considering Alternatives

But here’s the problem with that line of reasoning: in saying I’m not any worse off, we’re comparing my current state only to my previous state, rather than to any other alternatives. Back when we each were worth $100 there weren’t many interesting alternatives to consider. I couldn’t become any richer without you becoming poorer (in our simplified, static model). Doing so would be unfair – or to stick to the language of harm, if you assume diminishing marginal utility, transferring money from you to me would lead to a loss in overall welfare.

But now that there is so much more wealth in the system, the alternatives get more interesting. What would happen if you gave me $100? I’d have $200 and you’d have $1000. Again, assuming diminishing marginal utility, that’d be a net welfare improvement. To take it even further, you could give me $500 so that we each had $600 of the full $1200 in the pot.

If at this point you’re thinking something along the lines of “It’s my money; I have no obligation to share it with you” try to put that to the side for now. It’s a legitimate feeling and I will return to it later. My point now is that from the perspective of welfare/utility/harm, the new unequal situation – while not worse for me than my previous situation – is worse than some other alternatives we can suddenly imagine.

What We Can And Can’t Afford

I want to consider one more super simplified scenario before trying to map some of this to anything approaching the real world. Imagine the same scenario where we each had $100 and then you got a sudden windfall of $1000. But now imagine that we jointly owe $100 in debt (which we inherited) to some third party. Now the Lowry’s of the world are basically saying 1) that I’m not any worse off than I was before you got that windfall AND 2) I had better cut back on my spending because I simply can’t afford to live the same lifestyle I’ve been living, given the fact that we’re jointly in debt.

As in the previous example, it’s clear that while I’m not worse off relative to my state prior to your windfall, I am worse off than I would be in various alternative distributions of the $1200 in the economy. The additional point to be made is this: I’m now being told that we can’t afford for me to maintain my lifestyle.

This is where I want to draw my first parallel to reality. Conservatives maintain that the top 1% getting filthy rich doesn’t make anyone else worse off. And then they turn around and claim that the economy simply can’t afford to maintain the social safety net (Social Security + Medicare + Medicaid) that the middle class has come to depend on. But as my examples have hopefully made clear, the 99% – while not worse off than they would have been had no one gotten richer – are much worse off than they would be if that wealth were more equally distributed. And it is in this context that claims of “we can’t afford it” become downright perverse. A world in which wealth were equally distributed would be a world in which we could afford it, at least in part.

Considering Objections

A quick recap: I’ve argued that while the rich getting richer doesn’t make the rest of us worse off relative to status quo, it does leave us worse off than we would be if that new wealth were more equally distributed. I’ve further argued that this argument has particular salience at a time when the 99% are being asked to make major sacrifices in the form of a reduced social safety net in order to reduce the deficit and pay down the debt. Claims that we can’t afford it rightly trigger consideration of alternative distribution schemes more than might be the case in less austere times.

But as I said at the outset, none of this implies that we must act to mitigate inequality (if we even could agree on how to do that). I want to mention the two most obvious objections to doing so, even if one accepts everything I’ve laid out here:

1) Property rights. If you were thinking “It’s my money; I have no obligation to share it with you” then fair enough. This is essentially an ethical question, so I won’t bother arguing about it here. If you believe that this is more a question of rights, that could be grounds for being ok with inequality. But don’t claim that it’s not hurting anyone. Relative to more equal distributions of wealth it is.

2) Economic growth. I’ve ignored the role of growth in all these little examples, but a common complaint about economic redistribution is that it tempers growth. That, one can argue, hurts even the worst off over time. That may or may not be true, but it’s at least a legitimate point to raise.

My hope is that we can move on to debating #1 and #2. They are both tough questions, but to me they’re where the action is. Claims that inequality isn’t harming anyone make little sense once alternatives are considered. I’d like to see conservatives abandon that argument so we can focus on the ethical question of property rights and the empirical question of economic growth.

UPDATE: A great graph via Mother Jones puts some numbers to this:

Review: The Penguin and the Leviathan

I have a review of Yochai Benkler’s new book up at The Atlantic today. Here’s the gist:

Benkler had described and classified the possible motivations driving Wikipedians in his 2006 tome The Wealth of Networks, in which he analyzed the Internet’s impact on the economics of information. In his new book, The Penguin and the Leviathan, Benkler builds on the lessons of Wikipedia to explain why humans cooperate, and to debunk the notion that we are compelled singularly by mere selfishness. The book is, in his terminology, a response to Wikipedia’s greatest gift. In taking aim at selfishness, Benkler puts in his crosshairs a fundamental tenet of modern economics, and this, ultimately, is what lends the book its relevance and gravity.

It’s a good book, and here’s my bottom line:

Benkler’s guidelines are useful at the micro level, but they are not far enough along to provide much guidance at the macro level. Whatever the merits of the Washington Consensus, it is an actionable macroeconomic agenda in a way The Penguin simply is not. This is not a criticism of Benkler himself, as he has done as much as anyone to push forward these lines of inquiry. But, given his framing, one cannot help but feel frustrated knowing that universal selfishness is both empirically wrong and yet necessarily at the heart of how we make decisions about economic policy.

Benkler’s work is both a formidable refutation of the assumption of narrow selfishness and a useful guide to building successful cooperative projects. And while the false assumption of selfish rationality will for now continue to guide the formal modeling of the macroeconomy, The Penguin and the Leviathan equips readers to begin changing the public conversation on the question of how humans work together. It is comforting to be reminded that most of us are not fundamentally selfish. It is long past time that our institutions in business and government realized as much.

I have some related thoughts to blog on this that I couldn’t fit into the review, but in the meantime, I wrote about much the same subjects last year in my post Markets and Networks.