The cost of fixed ideas

Books on economic policy aren't generally page turners. But a new book by economist David Colander and businessman Roland Kupers certainly is. It makes the argument that some of the assumptions economists made many decades ago -- especially about people having fixed preferences -- have effectively created a trap for policy analyses. We're stuck as a result with endless, useless arguments about markets versus government. Change those assumptions, and it's possible to imagine policies that don't have markets and government in opposition; it ought to be possible to have free markets and a useful and smaller government at the same time, and achieve not only material prosperity but a wide range of social goals too.

I wrote about the book in a Bloomberg column a few days ago. That column has garnered all of 4 comments so far, which I think also illustrates another problem we have. The column is all about how we might find a way around all of the sterile arguments of markets vs government, and not too many people seem to be interested in that.... or at least not motivated to comment. From past experience, I know that any column which seems to take a side in those arguments stirs up a lot of protest. 

Anyway, read Colander and Kupers' book. Here's the column:

From financial regulation to health care to climate change, we can't agree on what to do about anything. Free-market enthusiasts celebrate the creative power of markets and want smaller government; critics counter that we desperately need government intervention to solve problems that markets can't handle. Neither side can understand the other.

Is there any way out? Well, if you're discouraged, I suggest looking to an inspiring new book by an economist, David Colander, and a businessman, Roland Kupers, who believe the deadlock needn't be permanent. We can have better markets, they say, and more effective (and smaller) government too, if only we can muster a little more economic imagination.

The book is called ``Complexity and the Art of Public Policy,'' and its main point is that our policy debates have fallen into a trap that economists inadvertently created some 50 years ago. That's when they started building mathematical models of economic systems, and, to simplify things, made the assumption that people have fixed or unchanging preferences and desires. Sounds innocuous; it wasn't, and isn't.    Read more.

Medium Tedium

In comments on my last post, Gekko asks quite rightly why I've been doing this silly business of posting two paragraphs and then linking to "more at Medium." It's a good question, so let me explain what's going on. I know it's irritating, and I'd like not to do it, but ....

A while back, Medium asked me to write some things for them. They pay a few writers (a little, very little, in my case) and are in the stages of trying to get their project growing. What it will grow into remains unknown. I do like their layout, and would like to be involved in Medium if and when it turns into the next big thing, whatever that might be.... but I also don't want to just go over there and abandon my blog. First, Medium is just articles; you can't have any sidebars with links to other people's sites, and I think such links are valuable, so visiting there is very different. Two, I don't know if Medium won't just disappear two months from now.

So, I'm left with this very unsatisfying business of posting two paragraphs here, and then linking there. (By contract, I'm not supposed to post in both places, at least not before a significant delay.). I'm not sure what else to do. The dilemma has in fact hurt my blogging, as some days I've started writing about something, then fallen into internal debate about whether to post here, or over there, or what else I might do, and then.... just gave up after an hour and did something else, like clean the gutters or walk the dogs.

If anyone has any ideas, I'd love to hear them!

Defending economists -- from themselves

I am on occasion a fairly harsh critic of modern economics, for many reasons. I think economists use the concept of efficiency in a slapdash manner. I think they make a fetish of rigorous mathematics even when they gain no insight from it; it's too often imported as a tool to impress others, rather than as a legitimate means to understanding (see the absurd Appendices of this paper, for example, proving various irrelevant theorems about Markov processes). I think economists (most of them) don't make use of enough modern mathematics from dynamical systems theory.

I also think economists often infect their social analysis with their own subjective values, even while mistakenly and dangerously believing otherwise (as a result of their training). I think the modelling assumption of rational expectations, for agents dealing with anything but the simplest environments, is just a silly idea. I would go so far as to say that I think many economists don't appreciate basic elements of scientific method, preferring the logical beauty (?) of deductive theories to empirically relevant ones. Etc. Read almost anything I've written on this blog for similarly critical opinions.

But I do, just the same, also think there's lots of good and useful economics, some of it even beautiful. And I think economists themselves should do a better job standing up for it. Some very prominent and well known economists are giving the field a bad name. Let me explain.

Read the whole thing at Medium.

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.