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Adventures In Economics Part II

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Why do poor people stay poor? How can institutions overcome market failures? Why does capital not flow naturally from more affluent individuals to those less so, and from richer countries to poorer countries? Questions like these have been studied extensively and go back, in some form or another, to Adam Smith’s inquiry into the wealth and poverty of nations.

At the start of this academic year I wrote an article, titled ‘Adventures in Economics’, the modest aim of which was to explore and present the continuity of modern economic thought from writings of Adam Smith to the relatively more recent work of the likes of Gary Becker, Kenneth Arrow and Paul Samuelson. In order to facilitate the reader’s comprehension of this long period, the article focused on applications of economics to two observed phenomena that at first seem incompatible with economic theory, namely altruism and the exchange of information.

In the case of altruism, it is often and incorrectly thought that all economic models are based on the assumption that agents are motivated exclusively by material self-interest. This assumption seems to be at odds with overwhelming empirical evidence from behavioural sciences which systematically refutes the self-interest hypothesis and suggests that concerns for altruism, reciprocity and fairness strongly motivate many people. Moreover, it has been demonstrated that these observed phenomena can be explained by economic theory in a rigorous and tractable manner.

Then there is the economics of information, a fertile area of scholarship which has led to explanations of economic and social phenomena that otherwise would be hard to understand. For example, it is now acknowledged that information is imperfect, that obtaining information can be costly and that there are important asymmetries of information. As a result, many models of reputation have involved both hidden actions and hidden information. Contributions to both these fields have led to several Nobel Prizes in Economic Sciences being awarded. For example, Joseph Stiglitz won his prize for his work on asymmetric information, which he shared with others.

At this stage, an alert reader with strong priors may point out that most of the histories of economics fail to give attention to the pre-Smithian era, which ignores a substantial body of contemporary social thought that is traceable to, for example, Hellenistic schools. Indeed, it was the ancient Greeks who first introduced the term ’oikonomia’, which means the management of household affairs. They also first brought forward critical economic concepts, such as value, the distribution of labour, the functions of money, the just distribution of wealth, and the importance of contracts relating to private property. And yet, while it is true that several Hellenistic, Arab-Islamic, and Byzantine schools referred to economic problems, they did not create an autonomous Economic Science, nor did they aim at doing so.

WHAT HAS MACRO EVER DONE FOR US?

While in the first part of this article we have explored the realm of microeconomic theory, now we will touch upon macroeconomics – the part of economics that focuses on the aggregate level of economic activity. Macroeconomics, or simply macro, is an interesting subject, not least because of it being the subject of intense controversy. In contrast to other areas of economics, observers looking at macro may perceive this field as not only composed of different schools of thought but also characterized by a somewhat recurrent state of disarray. Naturally, one comes to expect a level of scrutiny. Given that macro performance and public policy are closely connected, the major issues of the discipline are also the subject of constant media attention and inevitably play a central role in political and public debate.

Modern macro can be thought of in terms of competing schools of thought. Any theory, consisting of a set of views about the way the economy operates, is organised within a logical framework and forms the basis upon which economic policy is designed and implemented. Theories, by definition, are simplifications of reality. This must be so given the complexity of the real world. The intellectual problem for economists is how to capture, in the form of specific models, the complicated interactive behaviour of millions of individuals engaged in economic activity.

By way of illustration of these dividing lines, the former President of the American Economic Association, Robert Hall, at one point divided macroeconomic thought into two opposing schools: the freshwater school, which referred to the new classical economists (and later the real business cycle economists) located in universities near lakes or rivers such as the University of Chicago, Carnegie-Mellon and Minnesota; and the saltwater school comprising the Keynesians at universities like Harvard, Berkeley, MIT, Princeton, Stanford and UCLA near the east and west coasts of the US. As Hall explains:

The freshwater view holds that fluctuations are largely attributable to supply shifts and the government is essentially incapable of affecting the level of economic activity. The saltwater view holds shifts in demand responsible for fluctuations and thinks government policies (at least monetary policy) is capable of affecting demand. Needless to say, individual contributors vary across a spectrum of salinity.

Part of the difficulty for any neutral observer is that much of the criticism directed towards macro, particularly in the wider media, is badly informed. One only has to pick up a copy of The Guardian for strikingly vitriolic accusations, with headlines like ‘Neoliberal policies have no place in the post-crash world’ and ‘Will this recession signal the end of neoliberalism? Things will have to get a lot worse before UK policymakers ditch the current model for a new Keynesian revolution’ dominating the pages. In contexts such as these, the term ’neoliberal economics’ is little more than a pejorative term loosely aimed at any form of pro-free market policy or ideology, and usually refers to any economic policy that is not primarily based on Marx or the less credible interpretations of Keynes.

The sentiment of such articles, often echoed in other media outlets, is that the reputation of ’mainstream’ macroeconomists has sunk in the wake of the Financial Crisis, so time has come to disregard their opinions. Of course, given that The Guardian aims to sell its copies, any opinion it presents should be taken with a healthy dose of scepticism. A more studious reader interested in the nuances that arise out of the interplay of competing schools of thought may start by considering the debate between Keynes and the old classical model before tracing the development of the orthodox Keynesian school, the monetarist school, the new classical school, the Real Business Cycle school, the new Keynesian and then the Post Keynesian schools.

CRITIQUE OF MACRO IN THE MEDIA

In July 2009, The Economist put on its cover a cartoon of a wax-like book, titled Modern Economic Theory, melting into a puddle like the Wicked Witch of the West in the 1939 film The Wizard of Oz. The Economist derided the economics profession for (1) helping to cause the crisis, (2) failing to spot it, and (3) having no idea how to fix it. However, there is no accusation here that economists of a specific school of thought ‘caused the crisis’, even though some did see it coming, and many have since helped to fix it. A more sceptical reader may point out that The Economist is hardly the representative of views of the economics profession as, ultimately, it is a current affairs magazine written by non-economists hired for their pithy and catchy writing style, rather than a publication that aims to promote research-based policy analysis and commentary by leading scholars. However, the points that were raised in that issue clearly resonated with a great number of individuals and campaign groups around the globe.

Critiques of macroeconomics and, more specifically, of how the subject is taught, are being voiced by student groups in some of the UK’s universities. One such group is the Manchester Post-Crash Economics Society (PCES). As the FT’s Claire Jones put so succinctly,

Since the financial crisis, student groups have attacked economics departments for failing to deal with the world’s most pressing social issues, including inequality and global warming. They have also criticised professors’ reluctance to teach a range of economic theories, with courses instead focusing on neoclassical models which they claim do little to explain the 2008 meltdown.

While macro-forecasting is clearly not the main purpose of economics, some economists had reportedly ’predicted’ the crisis. However, almost none had forecast the amplification of shocks that was its unique trait. In this respect, amplification mechanisms (or multipliers) converted losses on subprime mortgages of perhaps USD250 billion into a 2007-09 loss of world GDP of twenty times as much and a loss on the world’s stock markets between 2007 and late 2008 of roughly 100 times as much. Is this a syndrome of symptomatic failure of mainstream macro? The answer is no. The big problem here is that accounts of the financial crisis place too little emphasis on the role of regulatory failure, which began back in 1999 with the Clinton Administration’s decision to repeal 1930s-era banking legislation known as the Glass-Steagall Act that had erected a wall between commercial and investment banking. In this respect, perhaps the most crucial issue was the absence of adequate regulation requiring stringent deposit requirements on residential mortgages.

So what next? All disciplinary establishments rightly attract criticism and, as the adage goes, good economists have two hands, thick skin and a healthy sense of pragmatism. It is true that repeated predictive failures have given rise both to ridicule among the critics and to more modest goal setting among practitioners. Yet, whatever view is adopted about the ambitions of economics, there will always remain some room for the critic to be dissatisfied with its performance. In this respect, PCES’ efforts are really just a continuation of a tradition of critique of how we think about and do economics.

The reality is that although many university programmes offer optional units of heterodoxy, virtually every economist hired by policy analysis institutions, industry, governments or banks has their core training in the standard curriculum. And while there are many students who are campaigning for curriculum reform, the overwhelming majority of students are not. Perhaps this is due to them having done their due diligence and having come to a realisation that a 3 year degree can only do so much. Even the most rigorous undergraduate economics programmes – at say Cambridge or MIT – only scratch the surface.

Charles Shaw
Birkbeck Economics And Finance Society
Twitter: @BirkbeckEFS

Comment, Politics, Society

Adventures in Economics

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Introduction

Human beings are by nature economic animals who, according to Adam Smith, have an inherent propensity to “truck, barter and trade”. In order to facilitate exchange and improve their well-being, people create money, markets and institutions. Interaction of entirely selfish individuals may produce a mutually beneficial and a Pareto optimal outcome. Coordination among the activities of individuals participating in a market is spontaneous and is guided by
the “invisible hand” of self-interest. This “invisible hand” was rigorously encapsulated in the First and Second Theorems of Welfare Economics.

But despite claims of universality of economic laws, economists have extreme difficulty identifying such laws and agreement on the validity of such laws may be impossible to achieve.

For this reason John Stuart Mill referred to economics as an inexact science and characterised its laws as tendency laws. Such expressions of tendency are, in simple terms, generalisations
regarding what will happen if no disturbing event should intervene.

Economics is, and rightly so, concerned with insight appreciably more than it is concerned with prediction of events. In Keynes’s words,

“the theory of economics does not furnish a body of settled conclusions immediately applicable to policy. It is a method rather than a doctrine, a technique of thinking, which helps its
possessor to draw correct analytic conclusions.”

These scant references to the history of economic thought figure as aids to a non-anachronistic understanding of the past, not as gratuitous arrows pointing to the relevance of earlier ideas.

The limitations of Mill’s and Carlyle’s philosophically expressed understanding of economics are obvious not only when compared to modern theories, but also when set within the course of economic history. At the same time, all can enjoy and benefit from applications of the “dismal science” that are relevant, insightful and anything but dismal.

Modern industrial market societies show enormously complex functional integration. Although economists’ models of the market exhibit why we need only enforce certain abstract rules – such as prevention of fraud and property rights – in order to achieve an efficient social order, they do not explain how the set of rules itself can be created, adapted to new situations, or sustained. The provision of the moral and legal framework for a market economy is itself a public good, and subject to the free rider problem.

And yet, today economics is the most rigorous and systematic of the social sciences and a starting point for understanding not only the economy but other aspects of society. An economic model is an intellectual mechanism, used to explain a particular variable or event. Although a model can take a literary form, the economics profession has preferred that models be expressed in formal mathematical terms.

Mathematics is vitally important in terms of the expression and communication of ideas in economics. This in itself is a matter of interest, particularly with respect to the public understanding
of economics. However, the use of mathematics in economics has drawn criticism from a variety of source, mainly from outside the profession.

In essence, a formal model contains a set of endogenous variables whose values (prices, quantities etc.) are determined logically within the model. Economic theory is used to develop mathematical statements about a set of observable endogenous variables which are related to another set of observable explanatory variables. Economic theory may also relate the endogenous
variables to a set of unobservable variables. Thus, economics is essentially a collection of formal models applied to analysis of specific problems and to an explanation of specific
phenomena.

The economics of information

There have always been organisations and institutions capable of creating and disseminating knowledge: from the medieval guilds through to the modern market research agency. One
hardly needs reminding that information is a valuable resource: knowledge is power.

And yet, realistic economic study of information and information producing industries is a relatively recent development in the evolution of economic thought. Developments in economics
that have taken place since the 1990s have led to improved understanding of the extent to which markets, agents and institutions process and convey information.

The subject of the economics of knowledge poses fascinating and challenging questions – theoretical, empirical, conceptual and normative. Although knowledge has been at the heart of economic growth and the gradual rise in social well-being since antediluvian times, social scientists spent the last century realising that value itself was not some intrinsic property of the world, but more a construction of our interaction with the world. Arguably,  economic analysis alone is not sufficient, since knowledge is context-dependent. However, focusing on scarcity and cost helps us to understand that psychology.

For a long time, formal modelling in economics was based on assumptions about perfect information (including efficiency, full employment of resources and uniform prices). While
the fact that information imperfections are pervasive in the economy was recognised by all economists, it was hoped, in the spirit of Alfred Marshall’s dictum”Natura non facit saltum,”
that it was defensible as an assumption: a heuristic by which to approximate behaviour.

Of course, one can make the Wittgensteinian argument that no general analysis of knowledge can exist since no general analysis could capture the nuance and variety of contexts in which
human beings recognise instances of human knowledge. However, the exploration of this philosophical thread yields surprisingly little about economic behaviour.

The marginal productivity of information depends on how the quantity of information is measured. Some economists, such a Stigler (Nobel Prize 1982), argued that information is just
a transaction cost – that is to say, once the real costs of information were taken into account, the standard results of economics still hold. However, it was famously shown by Stiglitz (Nobel
Prize 2001) that this was not true, and the conclusions derived from it do not hold. One of the main implications from this research was that even a small amount of information imperfection could have a profound effect on the nature of the equilibrium.

The economics of altruism

With regards to the discipline of economics, a common misconception is that economists think that people are self-interested or rational, or should be self-interested. Although this is
not strictly true, the assumption of rational self-interested behaviour has been a highly fruitful one in modern economic theory.

In The Theory of Moral Sentiments, Adam Smith points out that people often care for the well-being of others and that this may have significant economic consequences. Similar observations are made by Gary Becker, Kenneth Arrow and Paul Samuelson. In fact, there is extant literature on economic behaviour and policy analysis when agents are altruistic or exhibit other-regarding preferences.

So, what insights can we gain into altruism? First, we must make distinctions between economic, biological, anthropological and psychological theories of altruistic motivation. In fact, altruism can be defined in numerous incompatible ways. In the interests of brevity, here we are only concerned with what economics says about altruism.

However, things are far from easy. Altruistic behaviour does not necessarily lead to a more socially efficient outcome. It is also known that competitive equilibria with transfers need not be efficient when agents are altruistic. In this context, if altruistic transfers are permitted then both First and Second Welfare Theorems of Classical Welfare Economics do not generally hold.

A theoretical framework for distinguishing between economically altruistic and non-altruistic acts must specify a number of different goods which enter into each individual’s utility function and distinguish those which are directly beneficial to the individual’s economic well-being. Some economists use a concept of “felicity” which corresponds with happiness or experienced utility.

It is also worth pointing out that there are different types of behaviour contained in the spectrum of altruism. Such behavioural types range from true selfishness to true altruism, where
there is no ambiguity about the social desirability or divergence between appearance and motivation of an altruistic phenomenon. Apparently non-altruistic behaviour which is not altruistically
motivated and is socially detrimental will have different implications to apparently altruistic behaviour which is altruistically motivated and is socially beneficial.

Into the former category would fit standard cases of market failure where rational self-interested individuals are, for whatever reason, not led to behave socially efficiently by the economic environment in which they make their decisions. On the other hand, the latter scenario fits closely with the classic case of an altruistic act, which benefits others at a cost to the altruistic individual, and where the total benefit conferred is greater than the cost. Here, an individual
with truly altruistic preferences would carry out such an action because it would increase their utility. This includes the felicity of other individuals.

An understanding of the (repeated) prisoners’ dilemma leads to the conclusion that cooperation can emerge and be sustained in small groups. On the other hand, co-operation is much more difficult with a large number of players. This is due to problems of monitoring and
the threat of Nash reversion or other strategies to punish the individual defector. This is the reason why some externalities cannot be negotiated away via Coasian bargaining. Yet, this is
also the reason why competition works.

Charles Shaw
Birkbeck EFS
Birkbeck EFS is a society. Their interests lie in bringing together fellow students and furthering their interest in Economics and Finance by inviting speakers, organising events, and engaging in discussion on contemporary issues.