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A couple of links

January 26, 2012 2 comments
Busy couple of days, so not much time to write anything on these (as I would very much like to), but I highly recommend you go check them out.
  • Nassim Taleb talking with Russ Roberts about “Antifragility”, his book-in-progress. I find Taleb’s style really frustrating, and I think he too often relies in informal argument on the kind of ‘just-so stories’ he has so rightly criticised in both Fooled by Randomness and Black Swan. But his intellect is incredibly fertile (Fooled by Randomness had a major influence on my intellectual development as a teenager), and Russ’ clear questions and follow-ups are the perfect foil to Taleb’s sometimes opaque way of speaking (although his writing, in my view, is very clear). And I can’t wait for the book.
  • Waleed Hussain (of Wharton) has a working paper, entitled ‘An Alternative to the Fiduciary Theory of the Corporation‘ (H/T Matt Yglesias) which is so brilliant and raises so many complex and important issues that it made want to just drop everything I’m doing so I can think about it, work through it and tease out the implications. Unfortunately that isn’t an option, but expect posts on this topic in the not too distant future.
Categories: Economics

Should the Market Monetarists and Gary Gorton be friends? (speculative)

January 25, 2012 4 comments

This Timothy Taylor post from last week on Gary Gorton’s very important and fascinating work on the financial crisis reminded me to get back to pursuing a line of thought I started a while ago, about a potentially fruitful analogy between what structured finance products accomplish on the micro level and what the financial sector does at the macro level*. I haven’t come close to thinking this all the way through yet, but I find thinking out loud very helpful sometimes. So please take this in the open spirit of inquiry in which it is offered.

First, Gorton. He has a theory of financial crises that relies on the distinction between information-sensitive and information-insensitive debt. His thought (in its barest form) is that people often have a need for financial assets that they don’t need to worry about how new information affects the possibility of a loss. Then something happens to make those assets information-sensitive, and people sell those assets in droves to reacquire information-insensitive assets. This then wreaks havoc in the repo market, with haircuts on short term secured lending increasing dramatically due to the uncertainty over the pricing of those assets – effectively leading to a net withdrawal from the banking system:

But how do we create safe assets in the first place? The economy is mostly made up of people doing risky things: starting businesses, investing in new factories, opening new divisions or product lines etc. There’s two basic ways you can turn risky things into safe things: diversify, and structure the cashflow pooled through said diversification. In my mind, I have the whole economy as looking like a giant securitisation vehicle, spitting out bank deposits / money market funds at the top and good ol’ equity at the bottom.

Now, how much information-insensitive debt can be produced from a given set of underlying assets is a basically a function of a) the individual riskiness of the assets and b) the correlation of the risks between those assets. (I intend at some point to build a toy model to explain and show this better, but just accept this on epistemological credit for now). If the underlying assets become more risky, or if the correlation between them increases, then that means a reduction in the amount of super-safe, information-insensitive assets that can be spit out the other end.

Now, I wonder what could possibly cause both a) an introduction of risk across the entire economy and b) correlation in those risks. Well, how about a fall in aggregate demand caused by an increase in the demand for money not offset by an increase in the supply of money by the central bank? That (if the Market Monetarists are right) introduces new risks to businesses all over the place, and the risk is highly correlated across the economy. The existing structure of the economy’s cash flows can no longer sustain the same level of super-safe assets, so therefore some previously information-insensitive assets have to become sensitive and you get your crisis a la Gorton.

So when people are talking about a ‘shortage of safe assets’, you either need to restructure the cashflows of the economy to have more loss-absorbency at the bottom to support more quality at the top, or solve the problem of the underlying increase in correlated risk. If this is right, then this seems to me a pretty powerful (but embryotic) theory of how an AD shortfall could cause (or seriously exacerbate) a financial crisis like the one we experienced.

Other assorted thoughts:

  • I think this highlights a key problem with Gorton’s solution to the problem (massive extensions of deposit insurance), which is that it doesn’t in any way do anything to change the amount of super-safe assets the underlying economy can *actually* sustain
  • All the above is not to invalidate all the other potential factors that led to the crisis, (and the chart above seems to  show that the run on the repo market was already beginning by early 2008) but to identify the mechanism whereby it suddenly got a whole lot worse when NGDP (and expectations thereof) fell in mid-summer 2008, and why people are currently saying ‘we still have a shortage of safe assets’
  • Felix Salmon’s question ‘Is information-insensitive debt a good thing‘, is one worth considering very seriously

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* I’m very indebted to Arnold Kling, whose mantra “The nonfinancial sector wants to issue risky long-term liabilities and to hold safe short-term assets. The financial sector accommodates this by doing the opposite” first got me thinking down this line

Categories: Economics

Maybe/hopefully the last thing I have to write about the ‘burden’ of public debt

January 24, 2012 10 comments

[UPDATE: it does appear from reading the comments sections on a number of posts on this debate that pretty much everyone has accepted Nick Rowe's counter-example to the identity claim propounded by Dean Baker and Paul Krugman. However, it seems to me that most people, even if they have accepted the counter-example, have not yet seen the implications of it. That is what this post is (mostly) about.]

Ok, let’s try a slightly different way of thinking about this. Suppose the government wants to spend more money on x, where x could be anything. Let’s think about what happens if the government finances x through taxation, or through bonds. Assume for the sake of argument that the spending on and financing costs of x are evenly distributed through the current population, and that there are no incentive effects changing total output. Whether x is paid for through debt or taxation, money is initially just moved around the current population. The difference in the case of bonds is that everyone is left with an asset (bonds) and a corresponding liability (being part of the tax base), which initially cancel each other out.

Then, the next cohort is born and become part of the tax base. The older cohort still hold the same amount of bonds, but the liability is now spread out between both cohorts. So the older cohort now have a net asset, even though they haven’t had to forego any consumption to obtain it, and the younger cohort a net liability. If the younger cohort purchase the bonds from the older cohort, all does not end up equal – because the older cohort did not have to forego consumption to end up with bonds, whereas the younger cohort did.

So an increase in public debt does impose a burden on future cohorts (relative to tax financing), unless either a) there is a corresponding increase in bequests (i.e. assets the younger cohorts did not have to forego consumption in order to obtain) or b) the nominal interest rate on the debt is less than the rate of NGDP growth, in which case the debt can be rolled over to future cohorts forever without a tax ever being instituted (Samuelson 1958, H/T Nick Rowe). If it was the case that b) was true and a) was false, the first cohort have still increased their consumption from what it otherwise would have been, just not at anyone’s expense (although future cohort’s consumption would shift forwards in time, because they purchase bonds from the older cohort allowing that cohort to consume, but then do the same trick to the next cohort etc.).

But if you think a) is true, then whether or not the debt is held domestically or internationally is irrelevant, because it’s the increase in bequests to offset the future cohort’s liability that makes the difference no matter who holds the asset. I see no reason to think that marginal changes in bequests, insofar as they happen, would depend on whether the marginal debt was domestic or international (it would involve equal foregoing of consumption on the part of the older cohort either way). Welcome to Planet Landsburg*.

The whole debate boils down to this: unless you believe that corresponding marginal changes to voluntary bequests occur in response to marginal changes in public debt, deciding what mix of debt and taxation to plump for will have intergenerational distribution effects. Of course, it could be entirely appropriate that future people should foot some of the bill for the schools we build for them. But that is what would happen if we were to finance government spending with debt rather than taxes (unless you believe in something approximating Ricardian equivalence, or unless the debt is ponzi-sustainable a la Samuelson 1958).

[Note: This bit is more speculative, just throwing it out there] Furthermore, if we relax the assumption around the distribution of the tax burden to something more approximating reality, I think the intergenerational distribution effect actually becomes even more pronounced. This is because people living off their assets have lower taxes, and therefore form a relatively smaller part of the tax base. So when older cohorts are winding down their assets (i.e. selling bonds) in retirement, they are actually in a substantially better position (and the younger cohort in a worse position) than if you assume even distribution of taxation.

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*For the record, I don’t (as an empirical matter) believe we live on Planet Landsburg, but would be delighted to be proven wrong

Categories: Economics

Taking the biscuit – Paul Krugman edition

January 22, 2012 15 comments

‘Take the biscuit’ – British idiom meaning “to be particularly bad, objectionable, or egregious” (Wiktionary)

Like Bob Murphy, I’m almost rendered speechless by Paul Krugman’s new post on debt*. The whole economics blogosphere went through this great big massive argument about Krugman and Dean Baker‘s claim that debt cannot by definition be a burden to future generations. Almost anyone who is an anybody wrote about it, and a whole lot of nobodies as well (including myself). A lot happened in that time. Nick Rowe showed very clearly that the apparent identity claim they were making was wrong, and Bob wrote a whole semi-Socratic dialogue on the subject, with like 12 different parts (and enough wit to fill a full sitcom run on NBC**). For those of you who missed out, here’s a quick recap of the arguments. Krugman and Baker make the observation that debt is money someone owes to someone else. It is an asset as well as a liability. So, as long as debt is held domestically, it doesn’t make any sense to say that debt can be a burden to future generations, because it’s just some of them paying money to some of the others. Within a closed system, it’s a tautology to say that the debt cannot be a burden to the people within the system, because the assets equal the liabilities.

But when you introduce overlapping generations, this identity breaks down when we make the distinction between cohorts and time periods. Here is my version of Nick’s argument, which I posted last week

Assume any person alive produces 100 apples a year. In year 1, Annie is the only person alive. The government says ’100 free apples for Annie’! This is financed by the government borrowing Annie’s apples, promising to give her 110 next year (10% interest). Annie produces and consumes 100 apples.

At the beginning of year 2, Annie gives berth to Bessie, and there’s been a 10% increase in apple productivity to 110 apples. Annie and Bessie each produce 110 apples. Annie’s bond matures and needs to be paid back. The government finances the 110 apples it owes to Annie by issuing a bond bought by Bessie. In year 2, Annie eats 220 apples, Bessie none. At the end of year 2, Annie dies of old age.

In year 3, Colin is born to Bessie, and apple productivity increase by 10% to 121 apples each. Bessie’s bond matures, but since Colin is a man and can’t give birth to anyone, and Bessie will die at the end of the year, there’s no market for a bond as there’s no prospect for it being paid back. Therefore, the government taxes Colin and takes his 121 apples and gives them to Bessie. Colin gets no apples, and Bessie gets 242. Bessie dies at the end of the year.

In year 4, apple productivity increases by 10%. Colin produces and consumes 133.1 apples and dies at the end of the year.

Had the government not issued any bonds, Annie would have eaten 210 apples rather than 320. Bessie would have eaten 231 instead of 242, and Colin would have gotten 254.1 apples rather than 133.1. The debt accomplishes a transfer of consumption from Colin to Annie even though they weren’t alive at the same time, and even though (in any given year) the output was exactly the same and was consumed only by people alive at that time.

When you factor in multiple overlapping generations, it can too be the case that no output is transferred between time periods, but future cohorts lose out. In my example, Annie really does eat apples at Colin’s expense. The only way that this wouldn’t be the case is if the bonds were voluntarily bequeathed from Annie to Bessie and Bessie to Colin, rather than them purchasing the bonds. Which is basically assuming Ricardian equivalence, an assumption which Krugman never made and believes is dubious anyway. Game, set and match.

Krugman didn’t respond at all to this line of argument. And that’s OK, if a little annoying as he was responsible for the whole debate in the first place (not that I’m complaining, I initially would have been in full agreement with him until Nick Rowe showed me the error of my ways). But then yesterday he criticized an op-ed which plainly misunderstood his original argument. Now I would be the first to say that Krugman was obviously well within his rights to point out that the piece completely misunderstood his argument, but he then merely repeated the original assertion, as if nothing else had happened in the interim!

What I was actually saying, of course, is that debt is a liability that we pass to the next generation — but it’s also an asset that we pass to the next generation.

No. This only works if you don’t have overlapping generations, as Nick’s/Bob’s/[my] examples clearly demonstrate. In order for the debt to be harmlessly ‘passed’ to the next generation, it requires an actual voluntary bequest, with the older generation deliberately foregoing consumption.

Now, I’m a nobody and I don’t expect what I write to make any difference to anyone. But as primarily a consumer rather than producer of blog posts, it is still completely exasperating when this was what everyone was talking about and the person who started the whole thing (and said that to hold any other position was ‘nonsensical‘) failed to respond at all, except to criticize the seemingly weakest possible example of someone challenging his position.

If anyone else sees it any other way, I’d really like to know because I don’t think I’m being unfair here – unless my expectations about  academic civility in the blogosphere are unreasonably onerous.

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*Still managed to crank out 943 frustrated words, though…

**I mean this as a complement compliment (woops!) to Bob

Categories: Economics

Do I deserve my salary? (and how to read my blog)

January 21, 2012 Leave a comment

Given the balance of the things I write about, I get the feeling that people probably think I’m pretty conservative. I write quite a lot about taxation, the inability of the government to ‘stimulate’ the economy through spending and the fact that states are by nature coercive. And while I have become more conservative in the last 2-3 years, it is at the margin. Now, it just so happens that this is also the stuff that I find really interesting and I just feel like I have more things to say about it. It’s also the case that the standard of argument around these topics is extremely high in the blogs I read, and it’s more fun to get involved in that rather than amateur political philosophy (and Matt Yglesias has pretty much has that angle covered, with appropriate snarkiness).

But I have a whole set of prior beliefs than I haven’t written about nearly as much, but that massively inform my political thinking. For example, I think there are incredibly compelling arguments to the effect that I owe the relative level of my income to factors way beyond my control. Imagine tomorrow everyone woke up and loads more people were good at consulting and not many people at all were good at flipping burgers. Prediction: my salary goes way down, fast food worker’s salaries go way up. My salary is a function of the supply of people offering my skillset, and the demand by other people for those skills. And whatever you think about free will etc., I certainly don’t control other people’s desires or skillsets. I’m but a tiny cog in a massive machine called ‘the labour market’.

That kind of thinking makes me pretty egalitarian. And if total redistribution of income was totally costless, I’d be pretty inclined towards it. But it very much isn’t costless, and I think it would have appalling practical consequences. If human beings were perfectly charitable and unselfish, then it would be fine. But we aren’t. We value ourselves over others. We get greedy when we get power, and massive income redistribution through the government creates a massive concentration of power. We always, always need to be thinking about what will in fact happen if we try and change something.

And this is why I write about the things I do. Because I think people don’t really understand the consequences of policy – and even if they happen to be right, they are almost certainly way too sure about it. The fact that we probably understate the effective tax rate as a percentage of their income for people with savings* doesn’t remotely mean (if correct) that the capital gains tax rate should be zero, or even less than it is now. But it probably does mean that you should have a weaker preference for the tax at the margin. I want you to update your beliefs to reflect new information. Where you end up at depends on where you started (FWIW, I started out thinking they should be taxed the same. I now think it is appropriate that cap gains rates should be lower than income tax rates).

One of the best books I’ve read in the last year is Selfish Reasons to Have More Kids by Bryan Caplan. Whilst the book as a whole is fantastic, it’s the structure of Bryan’s argument that is so wonderful. Bryan presents tons of evidence from twin adoption studies to suggest that genetics has a much larger role to play in the kind of person you turn out to be in the long run than the environment you grew up in**. If true, this means that raising kids need be nowhere near as stressful as most people make it to be. Suppose Bryan is right. If Bryan is right, and your beliefs on the subject of the effect of parenting on children has changed, you should have more kids than you were planning to before hand. Why? Because the cost of having them has fallen (individual parenting decisions aren’t as big a deal as you thought, so you can stop stressing about it). General rule: if the cost of something falls, or the benefits of something increase – you should want more of that thing. This is still consistent with wanting none of that thing, if the costs still outweigh the benefits. But it’s a great example of updating our beliefs to reflect new information (and I highly recommend the book).

I can’t present you with a complete and coherent position on anything. There’s just too many things to know, too many factors to consider and I’m not clever enough. Don’t get too hung up trying to figure out what I think. I’m not too sure myself, a lot of the time! Think at the margin, for yourself. Is this right, is this wrong, how does it affect what I already believe, should I be so sure. It’s not the natural way to think, but it’s the smart way.

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* note: that statement depends on the fact that savings were at one point earned, which is obviously not true in the case of inheritance or expropriation

**provided the environment is such that adoption would be legally approved

Categories: Economics, Philosophy

Milton Friedman on method in economics

January 19, 2012 1 comment

Can’t remember how (H/T to someone), but recently came across this paper by Milton Friedman from 1966, entitled ‘The Methodology of Positive Economics’. It says pretty much everything I could ever want to say on the subject, and so much more. Here are a few fantastic excerpts:

Viewed as a language, theory has no substantive content; it is a set of tautologies. Its function is to serve as a filing system for organizing empirical material and facilitating our understanding of it; and the criteria by which it is to be judged are those appropriate to a filing system. Are, the categories clearly and precisely defined? Are they exhaustive? Do we know where to file each individual, item, or is there considerable ambiguity? Is the system of headings and subheadings so designed that we can quickly find an item we want, or must we hunt from place to place? Are the items we shall want to consider jointly filed together? Does the filing system avoid elaborate cross-references?

The answers to these questions depend partly on logical, partly on factual, considerations. The canons of formal logic alone can show whether a particular language is complete and consistent, that is, whether propositions in the language are “right” or “wrong.” Factual evidence alone can show whether the categories of the “analytical filing system” have a meaningful empirical counterpart, that is, whether they are useful in analyzing a particular class of concrete problems.

Or this

Viewed as a body of substantive hypotheses, theory is to be judged by its predictive power for the class of phenomena which it is intended to “explain.” Only factual evidence can show whether it is “right” or “wrong” or, better, tentatively “accepted” as valid or “rejected.” As I shall argue at greater length below, the only relevant test of the validity of a hypothesis is comparison of its predictions with experience.

And, finally, this

One confusion that has been particularly rife and has done much damage is confusion about the role of “assumptions” in economic analysis.  A meaningful scientific hypothesis or theory typically asserts that certain forces are, and other forces are not, important in understanding a particular class of phenomena.  It is frequently convenient to present such a hypothesis by stating that the phenomena it is desired to predict behave in the world of observation as if they occurred in a hypothetical and highly simplified world containing only the forces that the hypothesis asserts to be important.  In general, there is more than one way to formulate such a description – more than one set of “assumptions” in terms of which the theory can be presented.  The choice among such alternative assumptions is made on the grounds of the resulting economy, clarity, and precision in presenting the hypothesis; their capacity to bring indirect evidence to bear on the validity of the hypothesis by suggesting some of its implications that can be readily checked with observation or by bringing out its connection with other hypotheses dealing with related phenomena; and similar considerations.

Such a theory cannot be tested by comparing its “assumptions” directly with “reality.”  Indeed, there is no meaningful way in which this can be done.  Complete “realism” is clearly unattainable, and the question whether a theory is realistic “enough” can be settled only by seeing whether it yields predictions that are good enough for the purpose in hand or that are better than predictions from alternative theories.  Yet the belief that a theory can be tested by the realism of its assumptions independently of the accuracy of its predictions is widespread and the source of much of the perennial criticism of economic theory as unrealistic.  Such criticism is largely irrelevant, and, in consequence, most attempts to reform economic theory that it has stimulated have been unsuccessful.

If you had told me three years ago I would be approvingly quoting Milton Friedman, I would have likely laughed out loud. If you haven’t yet, go read the paper. It’s brilliant.

Categories: Economics

On civility, and the purpose of the blogosphere

January 19, 2012 4 comments

There’s two basic positions you can hold on the purpose of the economics blogosphere. One position is that it is now one of the main avenues by which advancing knowledge of economics is generated and disseminated, as opposed to the slow-moving journals and small cabals of elite scholars who all knew what was happening and got to see the papers. Paul Krugman put it well in a recent post:

So now we have rapid-fire exchange via blogs and online working papers — and I think it’s all good. Work circulates even faster than it did then, there are quick exchanges that can advance understanding, and while it’s still hard to break in, connections aren’t as important as they once were and the system is much more open.

Another way to think of it is that all the stuff we’re arguing about is incredibly important, and that the primary aim is to advocate our best view of policy. Another Nobel prize winner put this view well:

Cowen apparently wants me to make the best case for the opposing side in policy debates. Since when has that been the rule? I’m trying to move policy in what I believe to be the right direction — and I will make the best honest case I can for moving in that direction.

Ok, I lied. It wasn’t another Nobel winner, it’s the same guy. Krugman wants to both advance our collective knowledge and efficiently proselytize what he thinks to be the truth at once, and I’m afraid that doesn’t work very well. A vibrant intellectual environment requires forceful argument, but also making a proper effort to understand your opponent’s position, to not mischaracterise their views or deliberately present a weakened version of their argument – and to lay off ad hominem attacks. I’d submit that it is pretty much the definition of an honest argument that you provide your opponent’s best case and clearly show why you think it is wrong. As for ad hominem attacks, John Cochrane provides a pretty good summary of some of Krugman’s more egregious offences.

Like most economists, Krugman is highly attuned to fallacies of composition. So consider the following statement:

… there are people writing about economic issues who are a lot less confrontational than I am; how often do you hear about them? This is not a game, and it is also not a dinner party; you have to be clear and forceful to get heard at all.

But what if everyone behaves this way? If everyone shouts, then no one is heard. If the purpose of the blogosphere as a system is to advance collective knowledge, then I think this is a self-defeating strategy at what one might call the ‘macro’ level.

I would argue that civility is even more important in the blogosphere than normal academic settings, because one of the things that is highly valuable and unique about it is the quick feedback – but with that comes the tendency to initially misunderstand and mischaracterise. I cannot count the number of times that I have begun writing a post, and upon re-reading what I was linking to realised I had missed a key point. Sometimes I don’t catch it until after I’ve hit publish, and it really pains me that something wrong that I’ve written is ‘out there’. Not only is it is embarrassing, but it must also be so frustrating for the person who has been mischaracterised.

Now, I have only a very limited training in economics, but I’m also not exactly a dumb guy. This stuff is hard! And all the different parties have very different ways of talking about and conceptualising various issues, which can cause big problems with the more conversational style that blogging lends itself to. It’s very easy to see how something someone else has said doesn’t fit in to your framework, but to be able to step back and understand why a smart guy might believe something that seems *so* obviously wrong – that is actually a very difficult thing to do. I’m terrible at it. But then again, no one has seen fit to give me a Nobel prize.

Of course, if your view of the world is that the people you are arguing with are either mendacious idiots, or deliberately spewing falsehoods to advance their own agenda, then it is somewhat more understandable to take a more hostile attitude. If this really was a world of simple, Marxist ideological warfare then that point may have some merit. But to take that hostile attitude to everyone who disagrees with you is clearly counterproductive. Talking about Ari Fleischer’s tweeting, Krugman had this to say

this is an example of why policy debate is so frustrating, and why I’m not polite. The key thing about how the conservative movement handles debate is that it never gives up an argument, no matter how often and how thoroughly it has been refuted. Oh, there will be more sophisticated arguments made too; but the zombie lies will be rolled out again and again, with little or no pushback from the “respectable” wing of the movement.

In comments and elsewhere I fairly often encounter the pearl-clutchers, who want to know why I can’t politely disagree, since we’re all arguing in good faith, right? Wrong.

I’m sorry, but I completely fail to see why Bush’s former press secretary spouting nonsense on Twitter has anything to do with the live academic debates taking place in the blogosphere. If we had to document every misleading or false statement by someone who might inhabit some similar aspect of the political spectrum, we wouldn’t have time to do anything else. And I don’t exactly see Krugman pointing out every time a Democat says something utterly ludicrous about economic policy.

To cap it off, Krugman said this recently:

…by and large, ad hoc models like IS-LM are actually more useful [than rigorous models], in my judgment. But you probably do want to double-check your logic using fancier optimization models. Case in point: when I first got worried about the liquidity trap, I thought it was a myth, and set out to show that it was a myth using a simple NK model; what I actually found out was that my verbal logic was wrong, and it can indeed happen.

Was Krugman a fool and a knave before he discovered what he thought were good and rigorous arguments for something he previously believed was a myth? Of course not. So just don’t be surprised when we demand a very high standard of argument to be persuaded, rather than having our intelligence continually insulted. The condescending tone of his awful post on comparative statics, in the context of what was ostensibly a “debate” with Scott Sumner was staggering to anyone who had actually, you know, been reading what Scott was writing.

Understanding is an iterative process. It is incredibly easy to fail to grasp all the intricacies of what someone else has said, to know which particular choices of phrase were deliberate or not, and to accept the possibility of honest error. But as the process of understanding is iterative, and requires repeat interaction, this is only possible with a good dose of academic civility and the principle of charity. If we are to believe that the econoblogosphere really is the evolutionary adaptation of the profession to the age of the internet, then maybe we should start acting like it.

For the record, I’d like to say that I personally consider Nick Rowe to be the gold standard* for argumentative style among bloggers, in terms of both the way he clearly lays out his assumptions and responds to comments and rebuttals. We would do well to emulate him.

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*pun (and irony) fully intended

Categories: Economics

You don’t think about taxation the right way: capital gains edition

January 18, 2012 3 comments

Assume 50% income tax, 10% capital gains tax, and that a man (let’s call him Mitt) earns $1m in Years 1 and 2.

Scenario 1: Mitt spends all his post-tax income. His effective tax rate in Year 1+Year 2 is 50%.

Scenario 2: Mitt saves all his post-tax income from year 1, and it doubles in value. In years 1+2, Mitt’s earned income is $2m, unearned income $500k. He pays $1m in income tax and $50,000 in capital gains tax. His effective tax rate in Year 1 + Year 2 is 1.05/2.5 = 42%. But his effective tax rate in year 2 is 0.55/2 = 28%. Quoting the effective tax rate for the year in which capital gains are realised understates his overall effective tax rate, but does appear to generate the result that is overall tax burden is lower than someone without investment income.

However, this is not the right way to calculate the total ‘burden’ of the tax on Mitt. Steven Landsburg thinks about it a bit differently, as per usual, and arrives at a different result (emphasis his)

To understand Mitt Romney’s tax burden, you have to compare him to his doppelganger Timm Romney, who lives on a planet with no taxes. In the year (say) 2000, Mitt and Timm both earned (say) a million dollars. Timm invested his million dollars, saw it double over the past decade or so, and cashed out his investment this year, leaving him with two million dollars. Mitt, by contrast, paid 35% tax in 2000, leaving him with $650,000. He invested it, saw it double, and cashed out last year, paying 15% tax on the $650,000 capital gain. That leaves him $1,202,500, which is about 60% of what Timm’s got. In other words, the tax system costs Mitt almost 40% of his income.

By contrast, people on our planet without investment income collect their wages, pay 35% in taxes, and spend what’s left. The tax system costs them 35%, while it costs Mitt almost 40%. In other words, people with investment income bear a higher tax burden, as a percentage of their income, than anyone else

When I read this quickly on the train this morning, I thought this was misleading and wrote the first couple of lines of this post in an email to myself in order for me to finish it later. But very quickly I realised that Steve’s way is the right way to think about it.

Same assumptions as above

Scenario 1: Mitt spends all his post-tax income in years 1 and 2. Had there been no tax, Mitt’s income would be 2.0 times what it was ($2m rather than $1m).

Scenario 2: As above, Mitt saves all his post-tax income from year 1. Had there been no tax, Mitt’s income would be c.2.1 times what it was ($3m rather than $1.45m).

On this method, Mitt’s effective tax rate in my example above would be 52% rather than 42%. I think this is the right way to think about it, insofar as the total cost of all taxation to you is equal to the benefit you would accrue through the elimination of all taxation.

A few weeks ago, I linked to a Megan McArdle post, where she said

…we think about taxes the wrong way around. Most people think that raising a 5% tax rate to 10% is more noticeable (and painful) than raising a 50% tax rate to 55%. After all, the first represents a doubling of your tax rate; the second is only a 10% increase. But this is exactly the wrong way to think about it. The pain of a tax hike is determined not by how your current tax rate compares to your earlier tax rate, but by how your current disposable income compares to your earlier disposable income. Doubling the tax rate from 5% to 10% decreases your disposable income by about 5.25%. But raising it from 50% to 55% decreases your disposable income by 10%. That’s a much bigger whack.

Our instinct when we think about the burden of taxation is to take the tax we think we actually pay, and divide that by our pre-tax income under the existing tax regime. The right way to think about our total tax burden is the difference between post-tax income under the tax regime and post-tax income under a no-tax regime, and the right way to think about the burden of a marginal tax increase is the change in your post-tax income relative to your current post-tax income.

Alexander the Meerkat.

Categories: Economics

The somewhat suspect epistemology of economics

January 13, 2012 2 comments

“Don’t think, but look!” – Wittgenstein, Philosophical Investigations (66)

I’ve been wanting to write something about the epistemology of economics for a while, and have been spurred on by Noah Smith’s post yesterday, linking back to an older piece from Frances Woolley at Worthwhile Canadian Initiative. I recommend you go and read them yourselves if you like, and here I take a very similar line to Noah.

As anyone who did the equivalent of Logic 101 will know, deduction is essentially a schema for truth preservation. A logically valid inference is one where it is not possible for the premises and the negation of the conclusion to be true at the same time. If you put in truth and do it right you will get more truth out at the end – but if you start with garbage, then all bets are off.

People often talk about the idea of there being a conflict or dichotomy between inductive and deductive styles of reasoning. I don’t think that’s the right way to think about it. Sure, if you deduct from premises that are self-evidently false (read: most premises in economic models) then you have no reason to think the conclusion will be true. But if you go about inducting will-nilly without some kind of vaguely deductive model about how the world works, then you will end up believing all kinds of crazy things. What I think we do most of the time is create models from simplified premises that may not be ‘true’, but are a starting point from which we can see whether the simplification still gets us to the right answer. But how can we know whether it gets us to the right answer?

By testing it. By making predictions and seeing if they come true.

Deductive models, when they begin with premises that are either obviously false or gross simplifications, are only ever worth anything as a preliminary to inductive testing. Furthermore, if you are beginning with premises that you think are self-evidently true, then you need to seriously question whether you are right*, or even saying anything at all**.

In Frances’ post, she describes a genuine distinction between the ways in which traditional economist and behavioural psychologists in fact go about trying to understand the world, and ends on a wistful note:

Dabbling in economic psychology or behavioural economics is a little like taking the red pill –  you go down the rabbit hole, and wake up realizing that the entire world is an illusion…

I want a purple pill – a merging of the red and the blue – that would allow me to merge behavioural insights into a coherent model of economic behaviour…

But I don’t know if such a thing is even possible.

I can see there is a genuine issue with the mathematical complexity of a more realistic model of decision making. The model may become too complex to manipulate in order to generate novel results. But I don’t think this is the biggest problem. I’m pretty sanguine about the fact that straightforwardly false assumptions are knowingly put into models (it works in physics!). The economist’s biggest problem is that even with really simple assumptions, the phenomena he/she is attempting to model are often too complicated to be amenable to robust inductive testing. And this can be used as an excuse not to try***.

My belief that recessions are caused by monetary disequilibrium is basically the product of a model where you simplify the economy to assume there is only money, generic units of ‘output’ and sticky prices. It generates the prediction that reducing the value of currency in such circumstances will help achieve full employment of resources and an economic recovery. But who says this is the ‘right’ simplification to make? Well, this chart from a 1992 book by Barry Eichengreen, is a good place to start (h/t Brad DeLong)

Obviously, this graph by itself doesn’t constitute proof. Some people who would disagree with me also cite this chart in support of their view, or disagree that it provides much by the way of evidence. But if it wasn’t for the fact that the graph looked like this rather than the other way around, I’d think that maybe the money-output simplification is not a good one to make. The point being, the model generates predictions about what we should expect to happen in recessions when either the money supply is increased, or it is signalled that the central bank will do so if necessary. The model gives you an idea for where to look. It is not a substitute for looking.

People trained in economics are often very good at thinking at the margin. And at the margin, in macroeconomics I think we**** need a bit less abstract thinking and a lot more casual empiricism. It doesn’t take a genius to point out that some very popular explanations for the housing boom don’t even pass the laugh test once you take a cursory glance at the relevant data. It shouldn’t be a point of dispute, pace John Cochrane, that nominal changes obviously have real effects. People with some economics training ought to be very good at quickly correcting such things. But quite frankly, we could do a lot better – especially when it comes to correcting ourselves. Too often we don’t even bother to look; easily satisfied by a little just-so story about incentives, or an elegant but unrealistic model of a messy reality.

(File under self-admonishment.)

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*I’m not going to argue now about what may or may not count as ‘self-evidently true’, but suffice to say that the set of things that are self-evidently true is a somewhat miniscule subset of the things people believe to be self-evidently true

**I’ve heard people defend the economist’s model of ‘rationality’ on the basis that you can take pretty much any action by any person and identify a set of preferences that makes that action ‘rational’. But if you say that, you haven’t created a ‘theory of action’ with any useful content, but rather created a schema by which we can model people’s actions if we can identify the terms of the schema empirically. If you have no way of telling what a person’s preferences are except insofar as they are revealed by their actions, and you stipulate the preferences are always consistent, then you don’t have a useful theory of anything. You can ‘model’ ex-post facto anything I do by attributing some set of beliefs and desires to me, but that doesn’t mean you remotely understand or predict what I will do or have done

***If you think that it is not in the business of economics to generate empirical predictions, then I have the right to ask why I should give a rat’s ass about economists’ views on policy

****I did IB economics and intro micro/macro at Oxford. It counts, OK?

Categories: Economics, Philosophy

The real lesson of the debt burden debate

January 7, 2012 1 comment

It was such a simple argument.

Every ‘IOU’ has a corresponding ‘UOMe’. So, if you consider the set of all people alive at any point in time, the IOUs can’t be a burden on those people because (at the aggregate level) any repayment is being made to other people who are alive. The set of people alive cannot be burdened (if there is no transfer between time periods). Here’s Nobel laureate Paul Krugman on the topic a few days ago (emphasis mine):

That’s not to say that high debt can’t cause problems — it certainly can. But these are problems of distribution and incentives, not the burden of debt as is commonly understood. And as Dean says, talking about leaving a burden to our children is especially nonsensical; what we are leaving behind is promises that some of our children will pay money to other children, which is a very different kettle of fish.

I used to buy this line, until I grokked Nick Rowe’s argument that if different cohorts of people overlap, then Krugman’s argument (that it is nonsensical to say that debt could be a burden on our children) falls apart. There are still empirical questions as to how much of a burden it is*, but it is not a question of identity or tautology.

This is an illustration of a profound epistemological problem with using grossly simplified models of reality. Before this argument began bouncing around the blogosphere, I had a kind of model in my head that did not factor in overlapping generations of people. It produced the result that debt cannot be a burden on future people. In the context of that model, that is the correct result. But by leaving out overlapping generations, it so happened I left out a crucial detail.

There are good reasons that we simplify in order to model and understand. Sometimes (arguably always) it is just not possible to factor in everything. Whether or not this is a problem basically boils down to whether the stuff you omitted makes a difference to the answer to the question you’re asking. But how do you know you haven’t omitted a crucial detail? In the physical sciences, you can create testable predictions on the basis of your model and run experiments. Most of the time, you can’t do that in economics (or at least every result is controversial due to the problems of trying to isolate particular variables in complex systems). We can’t run an experiment in the real world and say “hmm, the future people in this experiment have been burdened by the debt, so I guess my model is missing out something important”.

Luckily, in the case of the debt burden you can show the model is quite possibly missing out something important just through a simple thought experiment. That’s the exception rather than the rule. Most of the time, we have a lot less independent confirmation of our models than we think we do.

To paraphrase CS Lewis – not only do we believe that our models are right, but it is often by our models that we decide what is right. This is, to put it mildly, a problem.

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*Essentially, it depends on the degree to which either the debt is sustainable because NGDP growth is higher than the interest rate, or older cohorts leave bequests to their children

Categories: Economics
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