Sharpening my knife
There is, of course, no reason why imaginability should have any relationship to underlying likelihood – plausibility has no correlation with probability other than in our minds.
and that’s why regulation doesn’t work. The author samples from Kahnman and Tversky’s work and he excerpts from Berkshire Hathaway’s annual report.
Commenter slocum at CT:
The reason tax rates aren’t higher and bankers are getting bailed out on hugely generous terms isn’t because Rawlsians have outvoted Cohenites behind the veil of ignorance, or even because lots of economists believe the Laffer hypothesis. It’s because the rich and powerful are, well, rich and powerful.
No. Tax rates aren’t higher because of the widespread belief among U.S. voters that high tax rates are harmful to economic growth. In places and eras where those beliefs were less prevalent, tax rates are higher (despite the fact that those eras and places also have their own rich and powerful). That charges of ‘class warfare’ and ‘the politics of envy’ are effective is a result of those general beliefs. In other places and eras, class struggle was seen as a positive by enough voters, for it to be a vote-getter rather than the reverse.As for the bailouts—does Brad Delong’s clear support for the latest Geitner bailout plan indicate he’s one of the self-serving rich and powerful (or is being paid to serve their interests, or suffers from false consciousness)? Or is it possible that the main motivation for the bailouts comes from the fact that those in charge are scared shitless (justifiably or not) about the potential for general collapse if the banks are not bailed out?
Lastly, what all y’all Rawls fans will never seem to grasp is the declining returns of high income in an increasingly wealthy society. Because of that, the lives of the rich and poor have been converging (pretty dramatically) in material ways—gini indexes notwithstanding. In the 19th century, the lower classes were physically smaller because they were malnourished. 40 years ago when I was a kid, the middle classes had clotheslines instead of dryers, black and white TVs, window fans instead of air-conditioning, rarely ate in restaurants, and most had never traveled on an airplane. Living in bog standard suburbia not rural Appalachia, I knew kids whose families who always drank powdered milk rather than fresh to economize.
But what kinds of material possessions do the wealthy in the U.S. now have that the lower classes do not? It’s hard to come up with much—yes, the rich have fancier versions and more prestigious brands, but that’s mostly it. Despite the name, Sub Zero refrigerators don’t keep your beer any colder. Material differences in living conditions have been reduced pretty dramatically even as nominal dollar inequality has grown, and they’ve been reduced by increasing societal wealth overall, not redistribution.
On the other hand, I have some relatives about my who live on wages that are, say, 1 1/2 to 2x minimum wage. You could double their wages, and they couldn’t live my lifestyle, whereas you could cut my wages to their level and I could (and did so for many years as grad student). In my late 40s, I enjoy the same vigorous activities I did in my 20s, and those cost very little (hiking, backpacking, biking, canoeing). Pandora, Project Gutenberg, and my $8.99 NetFlix subscription keep me well supplied with entertainment. They, on the other hand, are overweight smokers, don’t eat well, get little exercise, and so are developing the typical chronic health problems —the years have taken much more of a toll. They’re also not good at deferred gratification, tend to be impulsive shoppers, and so always have credit card debt problems. You get the picture. In other words, those differences that remain—and they’re not trivial—are not ones that could be readily ameliorated by transfer payments. Most of the difference that matter would persist. As societies get wealthier, it is increasingly the case that the quality of your life depends on who you are rather than how much money you have—what would Rawls say about that?
Now, you might say—well, if you don’t really need as much money as you make, then we should raise taxes on higher earners and redistribute the proceeds. But the problem is that because higher incomes bring diminishing returns, higher tax rates will have more of a discouragement effect than they would otherwise. Even at my existing marginal rates of ~50% (when you figure fed, FICA, state and local), more leisure looks pretty attractive. So I’d argue that the poor are better off if you keep marginal rates low enough that the wealthy keep working hard rather than kicking back and relaxing more. But if increasing tax rates make it more normal for people like me to demand additional leisure rather than additional income, that would be OK, too. Societally, I think it would be a mistake, but for me personally it’d really be OK —I can adapt.
This long Sumner post is well worth it. My favorite part is all of it but bloggy customs require an excerpt:
The intuition is that if the Fed always targets the forecast, and if Fed forecasts are pretty close to the consensus private sector forecast, and if the Fed never targets an NGDP growth path which is expected to generate a recession, and if recessions are avoidable right up to the moment they begin, then recessions will never be predicted by the consensus forecast. It may seem implausible that recessions are avoidable right up to the last minute, but recall that the recession that began in December 2007 saw positive real GDP growth in the first two quarters of 2008. A highly expansionary monetary policy in mid-2008 might well have prevented a downturn in the second half, and the first half of 2008 might not have been retrospectively labeled a recession. Recessions are not just downturns, they are prolonged downturns, and hence are preventable even after they have started.
and
Despite that fact that we teach our students out of textbooks that suggest the zero lower bound doesn’t prevent highly effective monetary stimulus, and despite the many foolproof escapes from a liquidity trap put forward by Bennett McCallum, Lars Svensson, and even Ben Bernanke himself, there never in fact was any kind of consensus that the zero bound did not inhibit monetary stimulus. The profession as a whole is just as afraid of a liquidity trap as was Keynes, maybe even more so.
The argument is that policy makers had it all figured out, resulting in the the 20 beautiful years of the Great Moderation, but lost faith when interest rates hit zero.
By screaming about liquidity traps, Paul Krugman caused the recession!
The first sentence of Vernon Smith’s Rationality in Economics:
The principal findings of experimental economics are that impersonal exchange in markets converges in repeated interaction to the equilibrium state implied by economic theory, under information conditions far weaker than specified in the theory.
Results from psychology or experimental economics don’t (as in DO NOT) translate directly into equilibrium behavior. This is because one person’s psychological bias may cancel out another person’s bias. Or even if people have anomalies that systematically bias behavior, the presence of a few non-biased actors may reverse the bias of the rest.
Psychologists usually report the systematic sorts of biases, so there’s not very many examples of the first kind of equilibrium outcome in that literature. That said, examples of human impreciseness are apparent. As individuals, for example, we’re imprecise estimators of value. For every potential widget buyer that overestimates the value to him of a widget, there’s a potential widget buyer that underestimates its value to her. The price will be set somewhere in between and would be equal to the price set if the buyers didn’t make mistakes1.
On the other hand, psychologists and experimental economists love to report systematic biases, so-called anomalies. The examples of these are numerous. Just today, The Economist cited evidence of the money illusion2 and here they are talking about regret. It turns out people feel buyers remorse soon after buying, but after a while they start to think they should have consumed more.
In the case of money illusion, we know — in, like, an empirical sense — that money is neutral in the long run; doubling money will double prices. In other words, there’s some mechanism at play that corrects for this psychological bias. In the case of the finding about regret, its not clear at all if this would have systematic effects. Does the long term effect swamp out the short term effect? Does either effect have real affects on consumption decisions?
One way to assume these anomalies have macro effects is to assume all agents have perfectly coordinated states of mind (e.g. every last investor becomes chicken little). This isn’t exactly a bleedingly obvious assumption, so my theory of equilibrium mass psychology sucks. Can you do better?
We can’t just assume individual instances of “irrationality” aggregate up into systematic irrationality. Given our general ignorance of these individual psychological effects, their aggregate properties and the mechanisms underlying this aggregation, a theory like rational expectations that assumes anomalies wash out seems prudent to me.
Now excuse me, I need to go read Vernon Smith.
I haven’t been following the bail-out debate between Krugman and Delong, there are dissertations to write. Jonah Lehrer claims to summarize the disagreement. Krugman thinks toxic assets really aren’t worth that much and Delong thinks investors are risk averse en masse. Lehrer adds:
I think one way to evaluate these dueling positions is to look at how people generate perceptions of risk. Investors have concluded that these toxic assets are simply too risky to invest in, at least without large infusions of government money. How rational are these perceptions of risk? Are investors wary of buying toxic assets because they have good evidence that the toxic assets are virtually worthless? Or are they wary of these investments because they’re irrationally scared?
He then goes on to cite some evidence from psychology that people can mis-perceive risks.
The problem is “investors” aren’t a person. “Investors” don’t have a psychology, they have psychologies. There’s no telling how those psychologies aggregate. For example, all it takes is one big non-Delongian investor to fix the supposed high risk-aversion of “investors”. This big, risk loving investor would buy up all the toxic assets because he’d know they’re a steal.
The fact that no such investor has materialized is support for Krugman’s point of view. These are crappy assets.
Delong’s response is most likely something about the government (i.e. the U.S. federal government) being the only investor big enough to ride out the wave of pessimism. To which I say, really? There’s no big buy and hold institutional investors? There’s no sovereign wealth funds? All the PE funds have suddenly lost their long horizons? There’s no other big governments?
Is Delong going to invest in these assets? He has tenure and he’s far away from retirement.
I don’t know by what mechanism expectations are set. Conditioned on this mysterious process connecting Fed policy and the public’s expectations, people should know the Fed plans to keep interest rates low for a long time. This probably means they will be low even after recovery starts and that definitely means there will be inflation.
Got that you public? There will be inflation, damn you! Hey you over there socking cash under the mattress: cash will be worth less in the future and your better off investing it. Seriously. The Fed is dead set about making that cash worth less!
Now, credibility sets in, bringing about recovery. I’m holding my breath.
(PS – Prof. Sumner, Fed GDP forecasts are nominal targets. Forecasting is the only credible way to create targets.)
UPDATE 5am – Ooops… See how easy it is to condense all types of monetary policy into “interest rates”!
Eric Rauchway has an interesting post on objective historians or objective history making (or whatever the work of historians is called). He says you can’t do it, so you shouldn’t. To me, he’s mixing method and purpose. Of course, you have purpose when you’re doing research and this purpose colors your method. If you think FDR and the New Deal was the greatest thing since sliced bread, this will tend to have you favor facts that support that conclusion.
Objectivity is a discipline, a tool, for exploring reality. Its not the end, only the means. Rauchway believes historians shouldn’t attempt to separate purpose and method, they shouldn’t attempt objectivity because perfect separation is impossible. This is like saying athletes shouldn’t practice because not everyone can be Micheal Jordan.
The completely objective person is an instrument; he doesn’t have a soul. This was Nietzsche’s point when he called the scientists of his day self-polishing mirrors. The point, as should be obvious, isn’t that one shouldn’t polish one’s mirrors. Polishing is ok; just being a mirror isn’t.
At the recent “Stimulus Smackdown” here at Davis, Rauchway got up to ask the panel a question. Before he did so, he produced the throw-away line “I’m a historian; we don’t do models.” I know he was joking, but this is completely ridiculous. Of course, they do models, they just don’t explicitly write them down. This makes the job of objectivity hard, but I guess it allows the historian to be more whimsical. As a consumer of his product, of history, I’m not sure what his whimsy buys me, though.
He presented a great paper (I don’t see it on his website but here’s a volatile link to Davis’ seminar page). Using just graphs and a stunningly beautiful data set from Denmark, he showed that people do, in fact, adjust their labor supply in response to tax changes (surprisingly, this is a controversy in micro). I may be a macroeconomist but I get a warm feeling in my belly when someone gives conviencing evidence that people respond to incentives.
Before the talk, I asked him about where he sees micro- and macroeconomics intersecting. He said that he likes the questions macro asks, but he believes the answers micro provides. “There’s an arbitrage opportunity for researchers to take the methods of micro and apply them to macro,” he said. Too bad I want to go the other way!
I wanted to ask him what he thought of DSGE models, but our time ran out before I could.
Also, after about two sentences explaining my research, he isolated the fundamental issue I’ve been struggling with and was able to give really useful advice. He’s more or less a genius.
You’ve heard before that Christie “I heart fiscal policy” Romer wrote a paper claiming monetary policy ended the Great Depression and that it ends recessions in general. I thought this criticism of the latter paper was interesting:
Romer and Romer completely ignore all of this literature. There is not a mumble of an apology in the direction of Tobin and Solow’s methodological concerns, much less their formal statements by Sims and others. Despite its fundamental importance for identification, there is not a hint of a reference to monetary theory, even David Romer’s thesis or the collection of papers in his book with Greg Mankiw (1991). The empirical findings of the huge VAR literature go unmentioned (with one lonely exception). The paper reads as if Romer and Romer are the first to ever examine recognition, decision, and action lags at the Federal Reserve.
The underlying economics, like the empirical methods, is straight from the 1960s: The paper does not ask whether the economy returns to a natural rate without policy intervention; the 1970s challenge that systematic policy might have no real effects is not even dismissed, to say nothing of the 1980s challenge from stochastic growth models that not even the beginnings of recessions need policy shocks.
The omission is so glaring it must be intentional. Here is my — quite sympathetic — interpretation. The last 30 years of macroeconomics are difficult, and the period hasn’t provided firm answers to the earlier questions. VARs address Tobin and Solow’s criticisms, but lots of problems remain. One has to identify shocks from the residuals, consider the potential effects of omitted variables, and worry about whether the AR representation, MA representation, or some combination is policy invariant. Identification isn’t easy. The empirical results are sensitive to specification; the standard errors are big, and one ends up with the impression that the data really don’t say much about the effects of monetary policy-which may in fact be true. Theoretical models seem equally sensitive to assumptions and do not connect easily with empirical work.
We’ve been at this over 30 years, and look how little progress we have made toward answering such simple questions! Can understanding monetary policy really be so difficult? Why don’t we just throw all the formal methodology overboard and go read the history of obvious episodes and see what happened? If, like me, you have struggled with even the smallest VAR, this approach is enormously attractive.
Perhaps this is Romer and Romer’s motivation. But if so, I think that Romer and Romer are falling into the same trap that ensnared the rest of us. Perhaps they started with a desire to just look at the facts. But then they wanted to make quantitative statements. How much would output have changed if the Fed followed a different policy? To do so, they reinvented the St. Louis Fed approach-an econometric technique. Despite the desire to “do something simple” (David Romer, during the discussion), they in fact evaluated policy from the autoregressive representation of an output-fed funds VAR. Now they face Tobin and Solow’s classic causal and identification problems, which cannot be addressed by quotes from FOMC meetings.
Adam and Eve in the garden of Friedman, they have taken one bite of the forbidden econometric fruit. But the serpent (me) is still there, whispering “go ahead, just add a few more variables;” “you can fix that, just put in a Fed reaction function;” “Why don’t you write down a few structural models and verify what your regressions are picking up?” I don’t see how they can resist taking bite after bite, until they are cast out of the garden, explicitly running VARs, and working hard for identification with the rest of us.
This sounds like the dialog in my head when I’m reading Prof. Kling. Then there’s this line: “VAR methods did not evolve as recreational mathematics. They evolved as the best response a generation of talented economists could come up with to genuine and serious concerns.” The same goes for DSGE models and modern theory. Macroeconomics is difficult and its frustrating that we don’t know more.
