Category Archives: Methodology

Why didn’t we see it coming?

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A lot of things in economic models are ‘exogenous’ and outside our usual frame of investigation. Not just little, unimportant things but big things, too: innovation and technological change, recessions, bubbles in markets. On some reading of economic models each of these things is unknowable and unpredictable. Obviously that’s far from satisfactory and lots of people are working hard to change things. Via Mark Buchanan, here is an interesting perspective on why things turned out this way:

To look at the economy, or areas within the economy, from a complexity viewpoint then would mean asking how it evolves, and this means examining in detail how individual agents’ behaviors together form some outcome and how this might in turn alter their behavior as a result. Complexity in other words asks how individual behaviors might react to the pattern they together create, and how that pattern would alter itself as a result. This is often a difficult question; we are asking how a process is created from the purposed actions of multiple agents. And so economics early in its history took a simpler approach, one more amenable to mathematical analysis. It asked not how agents’ behaviors would react to the aggregate patterns these created, but what behaviors (actions, strategies, expectations) would be upheld by–would be consistent with–the aggregate patterns these caused. It asked in other words what patterns would call for no changes in micro-behavior, and would therefore be in stasis, or equilibrium. (General equilibrium theory thus asked what prices and quantities of goods produced and consumed would be consistent with—would pose no incentives for change to—the overall pattern of prices and quantities in the economy’s markets. Classical game theory asked what strategies, moves, or allocations would be consistent with—would be the best course of action for an agent (under some criterion)—given the strategies, moves, allocations his rivals might choose. And rational expectations economics asked what expectations would be consistent with—would on average be validated by—the outcomes these expectations together created.)
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If we assume equilibrium we place a very strong filter on what we can see in the economy. Under equilibrium by definition there is no scope for improvement or further adjustment, no scope for exploration, no scope for creation, no scope for transitory phenomena, so anything in the economy that takes adjustment—adaptation, innovation, structural change, history itself—must be bypassed or dropped from theory.

Who can we really believe?

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In a great interview, Dani Rodrik asks why

You get trade theorists who have built their entire careers on “anomalous” results who are at the same time the greatest defenders of free trade. …the minds of analytically sophisticated [economists] turn into mush when they are forced to take seriously the policy implications of their own models.

This is something that we all encounter constantly: people who ‘should know better’ advocating a policy that seems poorly designed. Why might it happen? It is common to resort to explanations that involve mendacity and duplicity, but they are as unsatisfying as they are implausible. It is highly unlikely that everybody we disagree with lies, while we ourselves are paragons of virtue and transparency. In fact, Rodrik identifies the most convincing explanation later in his essay: “There are powerful forces having to do with the sociology of the profession and the socialization process that tend to push economists to think alike.” Exactly, and none of us are immune to it.

Psychologists have demonstrated that logic tends to be used only as a post-hoc rationalisation of our intuitive response to ideas. When economists respond to a new policy idea they will tend to draw on their toolbox of ideas to defend whatever intuitive response they have to it. Those intuitions are greatly influenced by our social identity, which develops to align the intuitions of social groups. As Rodrik points out, the prevailing view of economists at the time that free trade and unfettered markets are a good thing was far more influential than the, more ambiguous, implications of current research. Of course, economists had a vast stock of reasons why governments might fail and could mount a very convincing justification for their free market intuitions. It takes other experts with different intuitions to cut through that fog as they justify their own beliefs.

What does this mean for the way we listen to experts and interpret their opinions? As Tyler Cowen says, “Evaluate literatures not individual papers.” Individuals are incredibly unreliable for the reasons outlined above. The aggregated view of a range of people with different intuitions is much likelier to represent the truth. No individual is an oracle and following the teachings of a few people is likely to lead us astray. That is why economists tend to be sceptical of ‘surgical policy interventions’ and far more trusting of markets than most people. Of course, in saying that I’m probably exhibiting my groupish bias in favour of market solutions!

Equilibrium

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Good Noah Smith post on economic equilibrium.

Equilibrium is a term that is often thrown around as an insult (I used to hear people talk dismissively about it at university), but in truth our concern with a model isn’t that it involves some sort of equilibrium but that we believe some of the core assumptions are inappropriate.  Articulating this claim, and why we think certain assumptions are inappropriate, is where value comes from specific criticism.

I find it quite cool that the main criticisms I hear nowadays are about equilibrium and the endogeneity of the money supply – as I’ve always felt those were issues where communication feel down.  Essentially, when discussing economic phenomenon I have always used the process of equilibrium as a way to describe tendencies – rather than pin down outcomes.  Interestingly, for a concept I’m saying is important I can only find four instances where I mentioned economists looking at tendencies (here, here, here, and here) … and one time when when I misspelt tendencies and compared Economists to Jedi :P .

Obviously, I need to actually write some blog posts on Mill.

Economists vs historians

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Chris Blattman:

Most papers that show “history matters” try to convince us of some general theory of development from their very specific case study. We like our papers to tell us that the world is systematic and the forces of development are deterministic.

Judging by the paucity of papers that say so, however, we don’t like to hear that the world is complex and (sometimes) behaves in ways almost impossible to predict. Historians are more comfortable with the idea of “critical junctures”, and events that spin societies off in one direction or another.

Practical experimentation at Microsoft

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The Microsoft Bing team responsible for conducting controlled experiments have a paper out that canvasses some practical problems they’ve come across in the thousands of experiments that they’ve run. It’s an interesting read, even if the subject matter isn’t particularly fascinating for those outside the search business. A lot of the things they find sound really obvious in the general sense but would be tricky to pick up in practice.

The main points are:

  • Very few ‘good ideas’ are actually good ideas because we dont’ really understand the behaviour of people outside our social group, even if they’re our customers. About 10% of ideas that make it to experimentation actually turn out to be beneficial to the business.
  • The criteria used to judge success are not always obvious and there can be a trade-off between short-run and long-run success. For example, degrading the quality of internet search results increases market share because users have to spend more time on your page. In the long run that wouldn’t hold up but it could take many weeks to see the drop-off in the results.
  • Understanding your instruments is crucial to interpreting results. Some results are an artifact of the survey method and that can often be really hard to pick up. This is often the case for economists when we don’t read the details of survey methods. The best applied economists actually take advantage of the design details of particular surveys to conduct natural experiments.
  • Don’t extrapolate from trends in the immediate aftermath of shocks. When you watch data in real-time after a shock you’re often just seeing a trend towards the long-run mean that will shortly stabilise.

HT: Andrew Gelman

Why is Nick Rowe so incredibly clear on monetary policy?

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Here read this:

Yes, if the central bank raises or lowers interest rates, this will affect financial markets. But I thought we had gone beyond thinking of monetary policy in terms of raising or lowering interest rates. Or buying or selling bonds in an open market operation. Or raising or lowering the money supply. Or raising or lowering the exchange rate. Those aren’t monetary policies.

Targeting 2% inflation is a monetary policy. Keeping the money supply growing at 4% per year is a monetary policy. Keeping the exchange rate fixed at $0.95US is a monetary policy. Targeting “full employment” (at least, trying and failing) is a monetary policy. Following the Taylor Rule is a monetary policy. Targeting a 5% level-path for NGDP is a monetary policy.

Yes.  Exactly.  When monetary policy rules are analysed by economists this is clearly kept in mind – but when it comes to discussing it to the public we feel compelled to “tell a story” that involves whatever people are interested in.  And this confusion, although it may not have caused the crisis, hasn’t helped matters.

And why is he so clear on it, he understands the way that policy has been framed differs from the truth of what monetary policy is as a targeted rule:

OK, this is probably the weirdest post I have ever written. I am going to argue that interest rate targeting is not what central banks really do; it’s a social construction of what they really do. Interest rate targeting is not reality, it’s a way of framing reality.

That was weird enough, but I’m now going to get really weird. The failure of monetary policy is not caused by anything central banks are actually doing; it’s caused by central banks’ way of framing what they are doing, and by the rest of us accepting that same framing. The current recession was caused by those (and that includes especially central bankers themselves) who think that central banks use an interest rate as the control instrument. It’s the framing of what central banks do that caused the mess, not anything central banks are actually doing. The social construction of reality is what dunnit!

Monetary policy is about expectations, and using rule based policy to help manage these expectations, take advantage of any perceived tasty looking trade-offs, and deal with “time inconsistency”.

Interest rates, exchange rates, asset prices, are all factors that help give us information about the stance of monetary policy (relative to some prior belief, or some set of expectations).  But monetary policy is about the rule, and being clearer about this rule and what it means instead of making “neat little (partial) causal stories, that only work part of the time” is a good way to go.

Don’t get me wrong – I believe strongly in the intertemporal substitution justification for active monetary policy.  But the interest rate can only be interpreted with prior assumptions around a bunch of other things, and that point is often lost.