Saturday, December 14, 2013

Definitions of economics

A list of various definitions given to economics by major authors in the field over the last two and a half centuries. I think it's missing the most recent popular definition, which circulates among economists, that economics is the study of incentives. Anyway, the official positions are the following ones:
  • James Denham-Steuart, An Inquiry into the Principles of Political Oeconomy (1767): The great art therefore of political oeconomy is, first to adapt the different operations of it [the state] to the spirit, manners, habits and customs of the people; and afterwards to model these circumstances so, as to be able to introduce a set of new and more useful institutions.
  • Adam Smith, The Wealth of Nations (1776): "A branch of the science of a statesman or legislator" with two objectives: providing the people with ‘plentiful revenue or subsistence’ and providing the state with enough revenue to provide public services.
  • Jean-Baptiste Say, A treatise on political economy, or a simple account of the way in which wealth is formed, distributed and consumed (1803): A simple account of the way in which wealth is formed, distributed and consumed.
  • John Stuart Mill, "On the Definition of Political Economy; and the Method of Investigation Proper to It" (1836): "The science which treats of the production and distribution of wealth, so far as they depend upon the laws of human nature" or "The science relating to the moral or psychological laws of the production and distribution of wealth"
  • Thomas Carlyle, Latter Day Pamphlets (1850): Dismal science.
  • Alfred Marshall, Principles of Economics (1890): Political Economy or Economics is a study of mankind in the ordinary business of life; it examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of wellbeing.
  • Lionel Robbins, (1932): Economics is the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses.
  • Jacob Viner (probably): Economics is what economists do.
  • Paul Samuelson, Economics (1948): what, how and for whom to produce goods and services.
  • Paul Samuelson, Economics (1967): Economics is the study of how men and society choose, with or without the use of money, to employ scarce productive resources, which could have alternative uses, to produce various commodities over time and distribute them for consumption, now and in the future, among various people and groups in society.
  • Albert Rees, International Encyclopedia of the Social Sciences (1968): [Economics] is the social science that deals with the ways in which men and societies seek to satisfy their material needs and desires.
  • Paul Samuelson, Economics (1970): Economics is the study of how men and society end up choosing, with or without the use of money, to employ scarce productive resources which could have alternative uses, to produce various commodities and distribute them for consumption, now or in the future, among various people and groups in society.
  • N. Gregory Mankiw, Principles of Economics (2012): The study of how society manages its scarce resources.

Tuesday, October 15, 2013

Nontrivial Economics

In his biography Surely, You're Joking, Mr. Feynman, Richard Feynman recalled a story about mathematicians at Princeton challenging him with counterintuitive possibilities. One example they gave him was an orange:
It often went like this: They would explain to me, "You've got an orange, OK? Now you cut the orange into a finite number of pieces, put it back together, and it's as big as the sun. True or false?"
And that was true for the special orange that we can keep cutting indefinitely. A mathematical orange. After some time spent listening such examples, Feynman just responded to each such case with "It's trivial!"—parodying his interlocutors.

It happens in economics, too. Mathematician Stanislaw Ulam famously asked Paul Samuelson to name an economic idea that is true and nontrivial. Samuelson took a long pause and suggested Ricardian comparative advantage as an example: a country with absolute technical advantage in producing any goods still benefits from trading with less efficient nations. Like the US buying vegetables from Liberia, in which agriculture still contributes more than a half to the GDP.

The definition of "nontrivial" is itself a trivial question: you can define it as you like and get the desired property. But generally, "nontrivial" is something that goes against popular opinion. Mathematicians hold an advantage here because in math you define your own rules, and other people remain too far from this world to make educated guesses. Economists pursue a different task: finding nontrivial results in the everyday world. If the results don't go against popular opinion, then what's the point?

And these nontrivial results happen to be more numerous than Ricardo's logic exercise in the 19th century. Each field offers its own examples:

Growth theory. Geography is a long-standing favorite in explaining the income gap between countries. The impact of bad weather on work is so natural, and who needs more? Still, the geographical hypothesis is far more advanced than, say, the assertion that countries are poor because of natural intellectual limitations of their populations.

In contrast to both these stories, the institutional hypothesis suggests endogenous causes of growth. It warns against the China hysteria: the opinion that this model is viable for economically advanced societies, and we soon may see the demise of democracy. Third, it suggests that direct financial aid to developing countries not necessarily improves these countries' growth prospects.

Macroeconomics. Anything that we find out about relations between inflation and employment, or the absence of thereof, is non-trivial. What about the efficiency of fiscal policy in economic downturns? Important arguments here cannot be discovered with just common sense.

Labor economics. In the well-known 2000 study of New Jersey and Pennsylvania fast food restaurants, David Card and Alan Krueger discovered that the minimum wage increases employment. The result was so counterintuitive for economists themselves that David Card had to clarify their position to explain political attacks that followed.

The wage example shows that most interesting findings basically inform us about our gaps in understanding. We had a too-simple model of labor markets: here is one reason to look deeper. Unlike mathematics, economics has little a priori knowledge. Whether the first derivative of a labor demand function is greater or less than zero depends on our ability to discover this function's parameters. When we discover these parameters, they necessarily surprise us compared to our previous experience. Non-triviality in science is just new facts uncovering old mistakes.

Monday, October 7, 2013

Plough, Fertility, and Growth


Alberto Alesina et al. have a paper called "Fertility and the Plough," in which they show the connection between fertility and agriculture. Countries with plough agriculture tend to have lower fertility rates because the plough, authors suggest, requires physical strength:
We find a negative correlation between historic plough use and total fertility rates today across countries and among first- and second-generation immigrants in the US. We argue that the explanation for this result lies in the fact that children (like women) are less useful for plough agriculture. The plough requires strength and obviates the need for weeding, a task particularly suitable for women and children. Therefore, where plough agriculture was practiced, the cost of having children may have been lower (because women were more confined to the home), but the benefit of children was also lower (since they were less useful in agriculture). We also show that, consistent with this explanation, societies that historically used the plough were also more likely to have a preference for fewer children.
There's one more important channel the plough affects future economic decisions. Since the 1960s, Gary Becker do important theoretical work on family and education. One major point of his work is that parents invest their time in children, and the fewer children they have, the more investment each child gets. This investment is an investment in human capital, and human capital is a necessary condition for growth.

What does it have to do with the plough? Consider a few points about a plough economy:

  1. The plough reduces economic incentives of having more children. That increases parent investment per child.
  2. Since children are less useful in the major economic activity, they get better chances of doing other tasks, including learning.
  3. Since women participate less in farming, they do more household work, which also has positive spillovers for children.

Of course, points (2) and (3) are rather weak: children and women did a lot of household work, which offset the impact of being relatively free from agriculture. This is an intertemporal tradeoff between early jobs and education. Even now developing countries underinvest in their youth's human capital because parents don't have resources to invest or prefer money coming from children now to the money that may come in the future.

Point (1) partly explains a well-known negative relations between fertility and GDP:


The plough acts like this: plough agriculture → incentive to have fewer children → lower fertility → higher investment per child → higher human capital → higher output per capita. Other channels include, for instance: more educated females → more job opportunities → fewer children → lower fertility. And lower fertility reinforces investments per child, so that the plough story continues from the middle to encourage more economic growth.

Saturday, October 5, 2013

Transition to Market in China

In my previous post, I described the agency problem of the Soviet political elite reforming planned economies of the newly formed independent states. The following graph compared the post-1991 transitory period in Russia and a few Eastern European countries, former members of the Eastern Bloc:

The Russian privatization program kept public property away from producers. It redistributed ownership through vouchers, which were securities granting the right to privatized property. After they got these securities from the state, people sold them significantly lower their potential price. Vouchers happened to end in the hands of a few. Much of other public property had been privatized without any vouchers. For instance, through fraudulent shares-for-the-loan auctions organized by the Russian government in 1995.

Such was the essence of market reforms in Russia. Meanwhile, China had their own market reforms started one and a half decades earlier. And the Chinese elite did an interesting thing. No, the central government didn't act like a benevolent dictator who gives away his power by transferring property to producers. Instead, it allowed independent producers to appear by themselves. First in agriculture, then in industrial production.

The rationale behind liberalization of the economy was the following one. If the government cannot encourage politically stable growth rates, let the market support it, where possible. The government neither competed nor shared property with the private sector. The market delivered additional value, which would otherwise turn out to be a deadweight loss of a centrally planned economy.

The Party not only preserved all of its property, but also gained indirect control over the private sector, which had been intensively growing over the last three decades. Naturally, it emerged as much more powerful interest group than it was under a pure planned economy. And it did so without country's output falling to 1/2 of its pre-reform level.

That shows how various coalitions within elites lead to different policy decisions and economic outcomes. In a critical moment, the Soviet hierarchy was unable to make forward-looking decisions and balance the interest of intra-elite factions. In contrast, the Chinese counterparts came out of the similar situation as winners, through with a very powerful competitor growing next to them.

Friday, October 4, 2013

Transition from Planned Economy to Market

The Soviet Union collapsed in 1991. But this 1989 paper by Victor Nee provided an interesting insight that had closely described the forces behind Russia's market reforms in the 1990s.

Nee outlines two centers of power in a centralized economy: producers and distributors. Producers are Soviet CEOs, running factories and other elementary economic units. Distributors comprise the Soviet government and allocate resources across the economy. Under central planning, the power of producers is weak and that of distributors is strong. Both were in the Communist Party, but producers belonged to a relatively dependent group of the privileged. Distributors from the Government made major economic decisions.

Nee's point is that the transition from centralized planning to the market economy leads to redistribution of power in favor of producers. Distributors can't agree with that. And they didn't. Mikhail Gorbachev and the Soviet leadership had no plan of moving to the market.

In 1991, they had been displaced by Boris Yeltsin. It was a coup. Yeltsin represented local elites, who managed resources at the level of separate Soviet republics and led republican branches of the Party. The power shifted to the leaders of a newly formed independent republics. The 1991 events had little to do with democracy: it was the second-level distributors getting rid of some top-level distributors.

The new republics started building market economies. But the problem with the transition remained the same: distributors don't want to lose power by introducing markets. And the didn't. The new old elites did everything to prevent producers from gaining power. They established crony capitalism to become private owners of formerly public property.

The architects of the privatization, which started in the early 90s and still continues in Russia in a somewhat different manner, recently recognized that their main goal was to privatize property as fast as possible to avoid power going to what they called "red executives"—managers of Soviet factories and service units.

An official version sounded like "Red executives would bring communism back, so let anyone get the state property and forget about efficiency for a while." But red executives had little incentives to bring back communism, which would deprived them of power over their factories. Effectively, the architects prevented a really decentralized market economy, when each factory is a Smithian independent firm that competes with the others and the invisible hand paves the way to wellbeing.

The property didn't go to anyone, clearly not to the population, but to specific people, including government officials. The schemes were opaque, and it was difficult to distinguish who owned now-private businesses: government officials or their proteges from nouveau riches.

This privatization was followed by an unprecedented fall of output. That how it looks compared to countries with previously planned economies that had more democratic transitions to the market:


Though it's important to note that the degree of central planning in these states differed, the picture is the same for most former SU countries, which had lost much of GDP before returning to the trend in late 2010s. Many had not returned. The Baltic states had fewer problems. As the Eastern Bloc minus the USSR, they also got rid of communist elites before going back to markets.

Market reforms in the former SU have been conducted by the same officials who were supposed to give away their powers. Just as a typical case of moral hazard, they had designed the transition in their own interests, so that in just five years there were no free market and no economy.

Sunday, September 29, 2013

Unethical Economics

Introduction to The Oxford Handbook of International Relations edited by Reus-Smit and Snidal (2008):
Instead of a proper engagement between normative and scientific positions, we typically see either mutual neglect or mutual critiques that fall on deaf ears. The result is a divide, with “science” on one side and “normative” on the other. This separation severely impairs the ability of international relations to speak to practical concerns. On the one hand, the unwillingness of “scientists” to tackle ethical and seemingly unscientific problems means it often has little to say on the important problems of the day; on the other hand, insofar as normative international relations is insufficiently well grounded in empirical knowledge, it is not competent to say what we should do in specific cases.
Christian Reus-Smit and Duncan Snidal's concerns about normative and positive studies in international relations remind those in economics.

In economics, ethical issues about allocation of resources appear mostly in heterodox works or lobbying. Mainstream economics resolved the issue by referring to preferences, Pareto efficiency, equilibrium, and descriptive research in general. It does have inquiries in fairness, but fairness there is a factor affecting decisions, not recommendations about "fair" distributions. For instance, have a look at Matthew Rabin's paper on incorporation of fairness in game theory or Ernst Fehr's theory of fairness, competition, and cooperation. They are like, "Yes, we study economics ignoring a significant factor, and let's move closer to a more realistic description of reality."

Economists leave decision making to decision makers. That's the division of labor. Economists do research, people and their selected representatives make decisions, which are, after all, about their own lives. No philosopher kings involved.

Why scholars in international relations concern about themselves making decisions? Maybe the field is much closer to practical policymaking than economics is to business and government.

Economics separated from policymaking not so long ago. While Malthus and both Mills still were advisers on practical matters, Alfred Marshall is already academic economics. Well, Adam Smith was in the ivory tower as well and didn't hesitate to make recommendations, but the tower itself was different by that time. The century that followed after Smith had transformed the approach to economics.

Gaps happen to be not in normative judgments, but in positive understanding. Say, governments can redistribute income, but generally the consequences are too foggy. We barely understand the tradeoffs. Taxes distort incentives, but inequality leads to unstable economy. We would like to increase social welfare, but only started to understand behavioral foundations of utility functions. We can subsidize education for some, but why does tuition increase?

Taxes, social welfare, and subsidies are ethical questions because we know too little about their impact. And our beliefs about "right" things not necessary lead to the outcomes we would like to have. Economics tries to connect our desires, sometimes ethical, to actions necessary to achieve that desires. Again, this definition of economics is an invention of the 19th century.

Scientists can make normative judgments as humans, not as scientists. Science itself is about discovering facts and explaining them. If some scientific field is struggling with normative judgments, it's either not scientific or does someone else's job.

Saturday, September 28, 2013

Translating Economics

The last post was about things we know that we don’t know. This one is about things we don’t know that we know.

Macroeconomics is a difficult subject. Not only the aggregate economy is extremely complex, but the data is lacking. You may ask, “What about 148,000 time series from FRED?” 148,000 series help a little. Well, physicists have 10^80 atoms in the universe and still struggle with some unified field theory. You need right data.

Unfortunately, macro needs bad events to collect evidences that help prevent bad events in the future. Macroeconomists are not so evil to knock down the world financial system for research purposes. They have to wait. After a crisis had come, they get their part of criticism for bad economics and then collect the new facts about the economy.

But economists from other fields have more alternatives. They conduct experiments, use natural experiments to isolate certain factors, and reach facts no one previously cared about. Results attract much less attention than macro does. Unlike macro, which concerns everyone in a pretty straightforward way, broader economics studies events that have an indirect impact on people. Public demand for these studies is lower, studies rarer get into news, and politicians worry only about a small fraction of respective topics.

The public is mostly unfamiliar with academic research outside macro. Actually, economists are unfamiliar with it either once they get outside their home field. But it’s more important to establish a intergroup connection from researchers to users, rather than among distant researchers themselves.

Mostly political discussions about economic aggregates in public show that intergroup connections are possible when both sides have personal interest in understanding the subject. The most popular economic blogs either discuss politics, which cause fury and is always in demand, or tell about practical matters.

The most promising way of delivering knowledge is its framing into either emotional or practical matters. It’s easier now because research itself became more specific. Take Al Roth’s school matching or Esther Duflo’s works on education in India. Fifty years ago it was Gale–Shapely matching algorithm and Becker’s or Schultz’s returns on education. Too abstract to be accepted outside academia. Once the matching algorithm got its specific application in schools and hospitals, it was accepted. As for education, the World Bank now has to pay more attention to the efficiency of its programs.

But any economics still requires translation into the language of public interests. Communication problems leave too much knowledge unnoticed. And if you look around, you notice thousands of things that would benefit from this missing knowledge.

Macroeconomics Models and Force of Habit


The public rightly questioned macroeconomics and academic finance after the 2008 burst. Record housing prices and debt, both relative to income, look a plausible cause for concern and they are. Why, then no one prevented it?

The design of the markets discourages companies from being overly cautious. Banks didn’t quit inflated housing markets because these markets were still inflating. Profits reinforce participation.

The designers of the markets had got obvious signals too late to avoid consequences. And very few wanted to be the person who bursts balloons with a needle at a birthday party anyway. Governments and central banks waited for problems to come first.

Many more versions exist. But none of them can explain the bubble with lack of knowledge alone. People in finance see housing prices every day, and high ratios are quite telling, apart from answering the question, “When will this trend end?”

Designers and players played by the rules, and they certainly had selfish incentives. Academia was relatively free of these rules and incentives. Did macroeconomists have selfish incentives to find a bubble, instead?

Yes and no. You will barely find a major university economist who likes forecasting. Because sometimes the predictions come true. Thus, sometimes they don’t. Economists prefer discussing things that have happened already. And they do it unhurriedly. Operative policy interventions are unlikely in the environment where even publishing an academic paper takes up to several years.

More so, it’s difficult to find a serious academic paper that includes policy recommendations. Scholars explain things that have occurred. Policymakers can use these insights to forecast. By 2008, policymakers had models. Were these models good? They happened to have specific limitations. But even bankers had incentives to use the best models they might get to quit the housing market in time.

There’re no obstacles to adopting models with better predicting power. Then, maybe policymakers did use the best models they had? Rather, they used the most reliable equations: the ones that they understand and used for years. And DSGE models won over various alternatives, including those by heterodox economists, who offered equations that predicted the crisis.

A theory that predicts one-in-fifty-years events is not trusted because it can hardly earn a reputation of a reliable one. No, the theory itself may be predictive and great, but it lacks an empirical base to show its fitness. That makes this theory and underlying models an unlikely candidate for widespread use.

Macroeconomics is responsible for not knowing enough in the sense of biologists who don’t know how to cure cancer. There’re wrong turns and no malicious incentives. Right turns require outstanding efforts and time. Including time for gathering unique data, like the data that came from the terrible Great Recession. Bad theories still can be the best, until we have more evidences. Economics works when we recognize limitations of previous theories and try to build better ones.

Wednesday, September 25, 2013

No-knowledge Land

The previous post discussed detrimental impacts of false knowledge. Now, it’s time for the absence of knowledge.

Only a blind man can say that he sees everything. If not for vision, it’s true for knowledge. Anyone who dealt with knowledge carefully would confirm that we know almost nothing about anything. The quest never ends. The no-knowledge land is everywhere else, so it makes natural for humans recognition of our limitations in understanding the world.

And this acceptance is the first step to finding truth. We say, “Let’s assume we are not sure how this thing works and will try to find out.” This start doesn’t guarantee success. You still need to look into the thing right, or you’ll arrive to something like miracles of bloodletting. This acceptance just helps to start looking.

What’s so interesting about it? First, recognition of own limitations is a painful procedure, and this first step rarely occurs at all. Second, fierce enemies of this blank state are both truthful knowledge and false knowledge.

If I know how to make a wheel, I don’t feel much need to reinvent it. For that, I’m unlikely to invent the car wheel or caterpillar. That’s the place to restate the observation saying that scientific theories disappear as their authors die. Authors and supporters are committed way too much to their old theories than to anything what comes next. When you learn about things working one way, you become less perceptive to alternatives. One famous research says that scientists get Nobel Prizes for research made mainly in their thirties. Clearly, many factors matter here, but one is that mature researchers are less likely to risk for new business.

True knowledge has its own dead ends. That just means there must always be some space for alternative ways. Pluralism in the sense of Paul Feyerabend: let those scientists abandon the rules, since their most important strength is in inventing new rules. Rigid scientific methodology prevents new discoveries. And prolific researchers violated rules. They developed their fields in terms of methodology and criteria of truth. Physics and economics, for instance, are still very different in delivering concepts about the world, despite their rapid convergence over the last 50 years.

As for false knowledge, Cartesian doubts are up to this. You question everything to bring things back onto no-knowledge land. You even question things that came after rigorous research. It’s not a method. It’s a principle.

Science is kind of famous for dealing with no-knowledge lands. The issue is actually more pronounced in business and governance, where doubts are a sign of weakness and recognizing knowledge limits is something to get fired for. A boss can’t tell about her doubts because that may harm her subordinates’ confidence. And a subordinate can’t do either, because his competence would be questioned.

The areas are institutionally protected from doubts. Business and governments proceed in a Darwinist fashion, hoping that confident actors with mistaken beliefs disappear. But they don’t, while all the major decisions affecting humans still happen here. And it’s a great challenge for social sciences to understand how humans make decisions and how to improve these decisions.

Tuesday, September 24, 2013

Knowledge, Witches, and the Church

There are three kinds of knowledge: true knowledge, no knowledge, and false knowledge.

False knowledge is the most dangerous of the three. It gives assurance about things, and we start acting on extremes. Ancient doctors were sure that bloodletting was good for patients. But it was the opposite. It required two thousand years of mistakes to start questioning the practice, and another one hundred years for the doubts to eliminate the practice. Habits die hard, bad habits kill.

These bad habits have their own categories: unintentional delusions and fallacies by design. The latter again deserves more attention. Take one example. The invention of witchcraft by the Church was a tool for eliminating political opponents. Witches appeared pagan competitors, mostly unchecked by official religious authorities, who, in turn, had close connections with political leaders. Joan of Arc happened to be just the most famous victim of this political tool.

Meanwhile, in the medieval society witches served as doctors, more liberal than Church officials. One of the most brutal attacks on their practices occurred in the 15th century. After the Black Death had killed about half of European population, feudal lords sought ways of increasing their rents. Since the lords had their own fallacies about economic wealth coming from the quantity of workers around, they needed to increase birth rates.

And here, as historian John Riddle suggests, witches became an obstacle. You see, they were pro-choice and helped women with abortions and contraception. Feudal leaders couldn’t like the idea of families making independent decisions about the number of children. Still, you can’t attack the entire population that wants fewer children. What you can do is to destroy professionals who knew how to control births.

Witches did remain miles away from what are now clinical trials. But the Church did worse: it declared their practices illegal saying that some of them actually work. Clergy couldn’t just say that witches had skills people needed and elites didn’t want. Clergy had to invent the image of a dangerous woman with spells and black magic. That was false knowledge about demons on one side and angels on another: neither existed, but the illusion kept living thanks to the strong political support.

Carefully designed fallacies bear hundreds of years of attacks and still persist. They are protected because they are important. And overcoming these fallacies is decisive for human survival. It’s easy to see what false knowledge persists now and how it threatens humans. Say, one relates to the average temperature on the globe. It’s far from being clear how to dissolve this false knowledge.

First Post

“The good life is one inspired by love and guided by knowledge.”
— Bertrand Russell, What I Believe