A thought on Steven Levitt...

Professors of economics at the University of Chicago like being provocative. Following the tradition of Milton Friedman, they enjoy causing a stir by making crazy, freaky claims in public. So it is really no surprise to hear economist Steven Levitt of Freakonomics fame make the claim that “it doesn’t take a whole lot of smarts or a whole lot of blind faith in markets to recognize that when you don’t charge people for things (including health care), they will consume too much of it.” This is why, he suggests, a country such as the UK would benefit by replacing their silly publicly funded healthcare system with a truly free market where people would have to pay for everything — the market could then through the price mechanism work its miracles and produce a vastly superior outcome, without anyone being tempted to over-consume.

I suspect that Levitt cannot possibly believe this — at least I hope not. If he does, then he has an embarrassingly woeful knowledge of the literature in his own field, as it doesn’t take a lot of smarts to realize that this statement ought to come with about 10 pages of qualifications and conditions. For a dose of reasoned good sense on the topic, see commentary by Noah Smith, and also this excellent insight from Cameron Murray. Makes you wonder by how many decades the Freakonomics series has actually set back the public understanding of economics.

But in the spirit of “Thinking like a Freak” — a new book pushing bold thoughts of this kind by Levitt and co-author Stephen Dubner — I thought I’d try to see if Levitt’s idea, taken seriously, might lead to something interesting. I think it does. Perhaps Levitt really is on to something freaky big and astonishingly brilliant, if we’re only brave enough to follow the logic through to its end without fear or trembling. Let’s suppose Levitt is right that “when you don’t charge people for things… they will consume too much of it,” and let’s think about the causes of climate change, as well as possible remedies.   Read more at Medium.

Conservative economists assume what they want to prove, claim victory!

I have a new column out in Bloomberg looking at some arguments by conservative economists against Thomas Piketty's work on inequality. I stumbled last week across this post by Tyler Cowen, which Barkley Rosser helpfully put into context. Cowen claimed that we don't really need Piketty because several earlier studies "already give an explanation" for the observed wealth inequality. Really? It turns out, he suggested, that you don't need any stories about returns to investment growing faster than wages. Standard economic models have already shown that inequality may just be the consequence of simple things like differences in personal patience (rich having more, of course, and the poor less), or in the effects of random shocks to peoples' ability to earn over their lifetimes.

Really?

Having looked into it, I now think this is a perfect example of Chameleon Economics, as recently described so brilliantly by Paul Pfleiderer. You tuck some preposterous assumptions A into a model, derive some apparently interesting result X, and then hope that people will soon forget about A so you can go around saying "we've shown that X" holds. The preposterous assumptions A might even include an assumption that is essentially equivalent to X, so you've assumed the result you want to prove. This trick is the real basis of the papers that Cowen pointed to, but jeez -- the authors did such a good job of plastering their arguments over with 50 odd pages of technical mumbo jumbo that it took quite a lot of effort to see what they were up to. In the paper by Krusell and Smith, for example, you can read on and on in utter semi-conscious misery before you begin to find the real secret of what the authors have done, as they finally admit:

When the representative-agent model is altered only by adding idiosyncratic, uninsurable risk, the resulting stationary wealth distribution is quite unrealistic: there are too few very poor agents, and much too little concentration of wealth among the very richest. For this reason, we consider a version of the model with preference heterogeneity: agents have random discount factors, whose values have a symmetric distribution with a small variance and whose transition probabilities are such that the average duration, or life length, of a discount factor equals that of a generation. In this fashion, we incorporate genetic differences in the population that are passed on imperfectly from parents to children. We show that this model does succeed quite well in matching the key features of the wealth distribution.

In other words, they start out seeking an explanation for the unequal distribution of wealth -- why do some people have so much more than others? Ultimately, they find that this result tumbles directly out of their economic model, IF they make the assumption that some people in the model are more patient than others, and are therefore better at saving and accumulating wealth than others. There you go -- the whole result from that one assumption (plus some others)! Science advances! 

I'm reminded of the famous claim of the doctor in Moliere, explaining how opium induces sleep? "By virtue of a faculty," the virtus dormitiva, he said, "the nature of which is to put the senses to sleep." Fortunately, Moliere was writing comedy, not pretending to do science.

Anyway, how about the following for a funny coincidence. Courtesy of a kind invitation from Ole Peters, I'm spending May at the London Mathematical Laboratory, a small mathematics center in Central London. Last week we were discussing Piketty's book, which Alex Adamou, one of the researchers here, has been diligently working his way through. Ole boldly suggested that maybe we should try to get Piketty to come here and give a talk on the book, whereupon we all chuckled at the very idea, thinking it preposterous given the outrageous current demands on his time. Piketty seems to be on a worldwide tour of epic proportions.

Yet this afternoon we learned that, at the very moment of our discussion, Piketty was actually in the very same building, one floor above our heads, giving a talk to a public policy think tank! Had we been speaking a bit louder, he might have heard us!

DSGE: the sinking Titanic of economic methodology

What's the future of macroeconomics? Does it lie in further development of the old-style models of rational optimizers and equilibrium, the dynamic stochastic general equilbrium (DSGE) models? Or will it instead be a new breed of agent-based computational economics (ABM), i.e. in computational simulations which don't restrict themselves to rational optimizing behavior, or to equilibrium?

From what I see, the DSGE people -- the old guard, if you will, as this IS the current mainstream approach -- don't take the opponent very seriously. They seem to sneer and chuckle at ABM for its lack of mathematical rigor; they don't even prove theorems! BUT, I suspect, this is only because the DSGE people secretly know very little at all about ABM, about its potential, its power and flexibility, and especially, about how far it has been developed already, for exploring banking stability,  monetary policy and so on. DSGE, as I see it, is doomed for sure. It's not going to be a fair fight.

DSGE is the Titanic of economic methodology, already taking on water, its bow looming high in the air. Message to young economists: Don’t let your career go down with it! Read more at Medium.

How to consistently beat the market -- follow trends

Several people working for the hedge fund AQR Capital Management have a working paper which looks at trend following strategies over about a century. It finds they're generally very profitable, which is surprising, I guess, if you're an EMH nut and simply can't muster the imagination required to believe that markets contain identifiable momentum. From that paper:

As an investment style, trend-following has existed for a very long time. Some 200 years ago, the classical economist David Ricardo’s imperative to “cut short your losses” and “let your profits run on”suggests an attention to trends. A century later, the legendary trader Jesse Livermore stated explicitly that the “big money was not in the individual fluctuations but in... sizing up the entire market and its trend.”

 

The most basic trend-following strategy is time series momentum– going long markets with recent positive returns and shorting those with recent negative returns. Time series momentum has been profitable on average since 1985 for nearly all equity index futures, fixed income futures, commodity futures, and currency forwards.

The strategy explains the strong performance of Managed Futures funds from the late 1980s, when fund returns and index data first becomes available. This paper seeks to establish whether the strong performance of trend-following is a statistical fluke of the last few decades or a more robust phenomenon that exists over a wide range of economic conditions. Using historical data from a number of sources, we construct a time series momentum strategy all the way back to 1903 and find that the strategy has been consistently profitable throughout the past 110 years.

 

Now comes another study doing much the same kind of analysis, but going back as far as 200 years, and finding pretty much the same thing. Yes, trend following works, and it always has. No, the markets are not efficient. I've written a little more at Medium.

Macroeconomists make a great advance -- or maybe not

By way of Unlearning Economics, who has made the effort of plowing through the details of the paper, read below and see if you've ever had a similar experience while reading some new and allegedly exciting "advance" in macroeconomic theory:

How Not to Do Macroeconomics

A frustrating recurrence for critics of ‘mainstream’ economics is the assertion that they are criticising the economics of bygone days: that those phenomena which they assert economists do not consider are, in fact, at the forefront of economics research, and that the critics’ ignorance demonstrates that they are out of touch with modern economics – and therefore not fit to criticise it at all.

Nowhere is this more apparent than with macroeconomics. Macroeconomists are commonly accused of failing to incorporate dynamics in the financial sector such as debt, bubbles and even banks themselves, but while this was true pre-crisis, many contemporary macroeconomic models do attempt to include such things. Indeed, reputed economist Thomas Sargent charged that such criticisms “reflect either woeful ignorance or intentional disregard for what much of modern macroeconomics is about and what it has accomplished.” So what has it accomplished? One attempt to model the ongoing crisis using modern macro is this recent paper by Gauti Eggertsson & Neil Mehrotra, which tries to understand secular stagnation within a typical ‘overlapping generations’ framework. It’s quite a simple model, deliberately so, but it helps to illustrate the troubles faced by contemporary macroeconomics.

The model

The model has only 3 types of agents: young, middle-aged and old. The young borrow from the middle, who receive an income, some of which they save for old age. Predictably, the model employs all the standard techniques that heterodox economists love to hate, such as utility maximisation and perfect foresight. However, the interesting mechanics here are not in these; instead, what concerns me is the way ‘secular stagnation’ itself is introduced. In the model, the limit to how much young agents are allowed to borrow is exogenously imposed, and deleveraging/a financial crisis begins when this amount falls for unspecified reasons. In other words, in order to analyse deleveraging, Eggertson & Mehrotra simply assume that it happens, without asking why. As David Beckworth noted on twitter, this is simply assuming what you want to prove. (They go on to show similar effects can occur due to a fall in population growth or an increase in inequality, but again, these changes are modelled as exogenous).

It gets worse. Recall that the idea of secular stagnation is, at heart, a story about how over the last few decades we have not been able to create enough demand with ‘real’ investment, and have subsequently relied on speculative bubbles to push demand to an acceptable level. This was certainly the angle from which Larry Summers and subsequent commentators approached the issue. It’s therefore surprising – ridiculous, in fact – that this model of secular stagnation doesn’t include banks, and has only one financial instrument: a risk-less bond that agents use to transfer wealth between generations. What’s more, as the authors state, “no aggregate savings is possible (i.e. there is no capital)”. Yes, you read that right. How on earth can our model understand why there is not enough ‘traditional’ investment (i.e. capital formation), and why we need bubbles to fill that gap, if we can have neither investment nor bubbles?

Naturally, none of these shortcomings stop Eggertson & Mehrotra from proceeding, and ending the paper in economists’ favourite way…policy prescriptions! Yes, despite the fact that this model is not only unrealistic but quite clearly unfit for purpose on its own terms, and despite the fact that it has yielded no falsifiable predictions (?), the authors go on give policy advice about redistribution, monetary and fiscal policy. Considering this paper is incomprehensible to most of the public, one is forced to wonder to whom this policy advice is accountable. Note that I am not implying policymakers are puppets on the strings of macroeconomists, but things like this definitely contribute to debate – after all, secular stagnation was referenced by the Chancellor in UK parliament (though admittedly he did reject it). Furthermore, when you have economists with a platform like Paul Krugman endorsing the model, it’s hard to argue that it couldn’t have at least some degree of influence on policy-makers.

Democracy -- has it already ended?

This article by political scientist Larry Bartels makes fascinating, if depressing, reading. In brief, a forthcoming study shows that the political influence of the wealthy is an order of magnitude larger than that of the poor (with wealthy and poor, of course, defined in a particular way). Democracy isn't the fair and equitable system you might have thought it was (if you were naive enough to think it was.... as, apparently, most political scientists still are).

I've written a little more at Medium.

Capitalism is an algorithm?

I have an essay coming out in Bloomberg tonight which looks at the fascinating article I recently mentioned by Nick Hanauer and Eric Beinhocker. I've also posted some further discussion over at Medium on one particular aspect of their article -- the notion that capitalism is best understood as an evolutionary process for finding solutions to human problems. It's messy, wasteful, chaotic, and that's precisely why it works -- by allowing a parallel exploration by many minds of the huge space of possible solutions to human problems. Capitalism is an algorithm in much the way evolution is an algorithm (or at least is LIKE an algorithm).