Thoughts on a good economist

A good economist is like a petulant child.  They always ask why, never fully accept an answer, and rarely fully reject one.

Yes, a great economist will have a bunch of other skills – both normative and analytical.  However, I’d say the desire to question and keep an open mind provides a necessary condition for any strong performance by an economist.

Yes, this is more filler – I barely have time to read the news right now, let alone post 😀

So you are getting whatever is in my head this minute 😉

A fishy conclusion from a Fisher relation

Interesting.  Both a Fed economist and Stephen Williamson (the author of one of my undergrad macro books) have been saying that persistently low interest rates “cause” deflation in the long run (ht Economist’s view) [Lots of others, WCI *, Money blog, Angry Bear, Paul Krugman, Money Illusion].  This seems a little counter-intuitive, but this doesn’t mean anything is wrong – I’m going to write down a few of my thoughts to see if I can figure out what is going on.

I mean, I agree that the Fisher equation must hold, and I agree that the long-run real interest rate will be exogenous.  But this ain’t enough to tell me that having the Fed keep rates at 0.25% forever “causes” deflation.

Why?  The average Fed rate and inflation expectations are both endogenously determined – they seem to be treating the Fed’s choice as exogenous, when they follow a decision rule. Yes it is true that the cash rate at a point in time is a choice variable – but the average cash rate in the long-run should effectively be determined by the real interest rate and long-run inflation target. [Update Think of it this way, I’m really assuming the central bank follows a Taylor rule and that determines the nominal rate given the inflation target.  The big kicker for any argument like this will be the way inflation expectations are formed].

As a result, we could just as easily interpret rates staying at 0.25% forever as an indicator that inflation expectations are -1.75% -> in other words we observe a low nominal interest rate BECAUSE there is deflation.  Fundamentally, this tells us nothing – as the Fisher relationship is an equilibrium statement, not a casual relationship.

In fact, if there is indeed a forecast of rates staying at 0.25% forever there is a STRONG argument for making policy more stimulatory now – is that what the guy is trying to say?

If we want to discuss a causal relationship we need a causal model of our endogenous variables right – the Fisher equation is not this.

Update: I see where they are coming from now.  However, I believe the key issue is with regards to current policy – fundamentally the mentioning of deflation was taken in context of the CURRENT disinflation going on in the USA, and it seemed like a statement that was pushing for an increase in rates to avoid deflation.

I’m also nervous about the use of the word “cause” when any observed relationship in the data will not necessarily be clear – but I’m always nervous about causation so oww well.  Namely, if I see an average cash rate of 0.25% and average -1.75% inflation I wouldn’t say “aha, having the cash rate at that level caused that” – I would want more information on how inflation expectations got there in the first place …

Links for today

In praise of clear targets for monetary policy:  Money Illusion.

Trade-off between gaining knowledge and creating knowledge, at the margin:  Worthwhile Canadian Initiative.

These are both excellent posts that I agree with.

Solving the prisoner’s dilemma

Saturday morning breakfast ceral has an excellent comic regarding the prisoner’s dilemma.  Of course, I was bound to appreciate it given my view that Jesus was an early applied economist.

The pill, moral relativism, and economics

“Raquel Welch has blamed the contraceptive pill for the breakdown of sexual morality.”

That is the first sentence from this newspaper article.  Now I have no doubt that the introduction of the pill led to a higher steady state level of promiscuity.  Yet, there is an undercurrent of negativity in the article – suggesting that this is a bad thing.   However, this is not necessarily the case.

This illustrates to me one of the issues that often makes explaining economics, or even trying to do analysis, difficult – moral relativism.  In the current case, the existence of the institution of marriage and the idea of low numbers of sexual partners is seen – in of itself – as a good thing.  People have followed a rule of thumb that the given set of outcomes in the social situation they are the best outcomes.  Anything that in turn undermines those institutions is “bad”.

I use the term moral relativism because that sort of behaviour is indicative of it – what people view as the appropriate set of institutions is based on the set of institutions that are in place at the time.  When we look back at what people believe is “morally right” we will often see rules based on the society they are in not some underlying true prior morality (although I believe that does exist to some degree as well).  As a result, if we try to say that the underlying situation has changed (the pill has turned up) and these old institutions that were optimal are now suboptimal, people get annoyed.

Economics is a great social discipline, because it tries to side-step the issue of moral judgments (and thereby the issues associated with moral relativism) for as long as it can in the process of analysis.  So following a “shock” an economist will try to describe the social elements, the trade-offs involved, the change in choices, how the corresponding change in institutions and choices impacts on future choices, and eventually where the social situation will settle.  Once we understand how the “distribution/allocation” of things changes, we can mix in some value judgments and come to a conclusion.

In the case of the pill, it seems highly believable that the introduction of something that made sex with a lot of partners much less costly lead to a lot more sex – that is fine.  However, we can’t conclude whether this is a good or a bad thing until we introduce value judgments to our analysis.

Those that are anti the pill will say that the introduction of the pill lead to greater promiscuity, but also made it more costly for people who didn’t want promiscuity to not be promiscuous – as a result, people who would have preferred a low sex but married social equilibrium may be worse off.  This analysis is fine, but it does rely on a set of value judgments.

Personally, I think the final steady state from the introduction of the pill will end up with more mature and responsible discussion around sex and relationship.  We can hardly say that the institutions of marriage and religion led to “magically optimal” outcomes in these matters – and people that bemoan the loss of such institutions are often looking through very rose tinted glasses.  Social interactions between people are supposed to be difficult, and I am sure individuals and the institutions that surround them will evolve in interesting ways given the pill.  However, my belief that the ultimate outcome will be better is again based on my set of value judgments.

Another perplexing picture

The Freakonomics blog provides another perplexing picture (the last one was discussed here).  This time we have a situation where it costs LESS to buy two of something then to buy just 1.  So they are PAYING people to take the second unit.  What gives?

The way I see it, there are two likely explanations:

  1. Firms realise that, given buying two units is cheaper than buying one, everyone will buy two units.  However, by pricing a single unit at such a high level they give people the impression that the good is worth more – fundamentally, in this case, the value associated with buying the good is related to its price.
  2. Individuals are time inconsistent.  Realising that one way to prevent themselves being in a situation where they suffer from this inconsistency, they want to limit the amount of the product they buy.  We discussed this with chippies a while back.  If there are two sets of customers that value the good differently, and a time inconsistency problem, this could be a form of PRICE DISCRIMINATION between the two sets of consumers.  In essence we could have one set of customers that values the commitment device strongly, and one that doesn’t!

In both cases we have to assume that there will be no resale – the search cost associated with finding a matching partner for resale is prohibitively high.  However, given this assumption both explanations could work – people could determine there value of a good based on a related price, or it could be a form of discriminating between customers based on how heavily they view buying a small packet as a commitment device.

I prefer the second explanation, as we don’t have to make an additional assumption regarding what people value.  I find the first explanation believable as well.

The main lesson I take from this is, market pricing is a crazy thing that is hard to understand – but it gets the job done.  I doubt that we can effectively try to determine what the right prices are ourselves, when we can’t understand the mechanisms firms use to maximise their profit.  So let the market do its thing, and use the government to solve identifiable market failures and co-ordination problems and redistribute.

I realise this is the lesson I take from everything …