I recently noticed that swap rates purchases were discussed as an unconventional monetary policy tool are discussed in Reserve Bank’s bulletin “Aspects of implementing unconventional monetary policy in New Zealand”.

Namely, they state:

“Purchasing interest rate swaps could be a way to signal that the Reserve

Bank expects to keep the OCR low for a prolonged period. Swap rates

comprise the expectations of future policy rates, the term risk premium,

and margin for bank credit risk.”

So why would we want to keep OCR persistently low in long-term? Let’s have a closer look at this.

The reduction of long-term rates is actually a pretty contentious issue.  The goal is to move expenditure forward.  So if we have a view that there is some “long-run interest rate” and we are lowering the current interest rate relative to that to get people to shift expenditure forward.

Now lower long-rates appear to violate this – as suddenly the incentive to shift expenditure forward is lower!  But how exactly are we “lowering long rates”.  There are two ways to think about this that can make it expansionary:

1. We are doing so by purchasing illiquid assets with a long maturity and replacing them with liquid assets (cash), bidding up the price of these long held assets are reducing their yield (the interest rate).  The increase in liquidity allows credit constrained agents spend.
2. People may be unwilling to invest now as they expect interest rates to increase in the future, or the relevant interest rate for them is a longer term rate.  By “committing” to keep this rate lower, or just reducing the fixed rate of investing in the long term, people will be incentivised to invest.

The commitment models provided the main explanation of the idea of “forward guidance at the zero lower bound” – which is what Woodford wrote about here.

Essentially, the central bank has some rule where it will respond to inflation, but the optimal policy SHOULD let inflation go above its target in the future.  To credibly commit to breaking the inflation target, the bank needs to make it costly to change their future interest rate and they do this with forward guidance and asset purchases!  A previous TVHE post explained this with respect to QEIII here.

However, concerns about this logic is valid – it is dangerous to argue from a price change alone. Why?

1. After all r = i – inflation (the real interest rate is equal to the nominal interest rate minus inflation, approximately), so if we push down long-run i and r is determined by the economy then aren’t we just saying that inflation will be low?
2. Furthermore, in so far as monetary policy is working through substitution and NOT income effects a flatter path of interest rates certainly does not imply an increase in aggregate expenditure.

These are both arguments that have been made (although they are both different), hence why we need an income effect reason (eg credit constraints for borrowers) and we need to have a model of how r can differ for a persistent period of time (co-ordination games, the potential for “instability” in inflation to drag us between multiple equilibrium).

I prefer the idea that long-rates are set by the market, and that we focus on shifting demand now by direct asset purchases rather than trying to “flatten the curve”.  A healthy economy will generate a certain long-run interest rate, so trying to hold that down seems perverse.  However, the mainstream is definitely about forward guidance with interest rates above asset purchases.

Now that might seem entirely random, but hear me out.  Making firms close on Good Friday is a way to ensure that no-one is working, and that everyone is on holiday at the same time.  As a result, having the day off today isn’t just having the day off – it is having the day off while everyone else is having the day off.  It is an enforced holiday for all.  This may be a good thing, if there is a “co-ordination failure” in terms of when people take time off.

How does this work?  Say that you value having the day off more when all your friends, family, and arbitrary other people are also having the day off than having the day off with everyone else still busily working – or at least you like that to occur a few times a year.  However, it is costly and difficult to organise a situation where that happens with people.  If individuals take days off on the basis of specific personal plans, or at random, then we will end up in a situation where people take holidays at different times – and as a result, we end up in a pareto inferior equilibrium.  But if the government, or some overarching institution (the Church) organises a day we can all have off together, then we can do that and all be a bit happier for it.

How is this like bus timetables?  Well, the co-ordination of bus routes is another type of co-ordination game – if you have to catch two buses, you would like the times to line up.  If the first bus is too early, your trip takes longer.  If your first bus is too late, you can’t take trip!  As a result, having bus routes planned help out.

Anyway, I’m done with this.  I’m going to go find a service station so I can buy something to eat!  Happy Easter and all that!

The first post was over at Uneasy Money, a blog I really enjoy if you don’t already read it

Here the book was discussed, and although David Glasner was uncomfortable with elements of it he found it interesting.  This is cool.  From his description of the book I immediately decided I wanted to buy it, there were two reasons for this:

1. David notes that the book was strongly tied to GE/representative agent theory, which is a standard starting point macro.  I wanted to see how this was delivered “in words”.
2. David notes that co-ordination failure concepts were generally put to the side.  I would like to see why, given I find the argument for activist monetary policy as a type of co-ordination failure argument.

So this was all gravy, at this point there is nothing about trying to undermine some mythical macroeconomic methodology.  Then John Quiggin came along.  I had a lot of issues with his post.

As a starting point, I get frustrated when people say “macroeconomics began with Keynes”.  Keynes was extending on contemporary concepts (in a way he wanted to sell as a type of revolution – go marketing), and even a number of ideas that are seen as archetypically Keynesian were already being discussed at the time (this type of historical context is part of the reason why I like David Glasner’s blog so much).  Keynes tied together ideas about inflation and interest rates (coming from thinkers as diverse as Hume and Fisher) with the debate between Ricardo and Malthus regarding unemployment.  In the General Theory I got the impression that a) Keynes liked to badmouth contempories and b) he saw himself as extending Malthus’s argument.

Activist monetary policy as a concept existed before Keynes, and outside of economics.  Activist fiscal policy was more novel, but was already taking place in countries like Sweden before Keynes released the General Theory.  Now don’t get me wrong, Keynes was amazing and contributed a lot to the discipline – but treating him like some touchstone messiah that splits good economics from bad is a mixture of historic revisionism and dis-ingenuity.

Sidenote:  When I was 14 my brother gave me my second book on economics (the first being a brief loan of Das Kapital by my English teacher) it was “Keynes for beginners”.  I did my speech that year for school on Keynesian economics, and won, so yah.  The books conclusion was that we’ve forgotten Keynesian economics and it is “due for a comeback” in 1992.  Nowadays I’m glad I don’t have a copy of my old speech, and I realise that people simply use these “names” to create easy good and evil narratives to argue about.

It is in this environment that John writes about the book, and honestly as a criticism of “macroeconomics” he is well off point – many of the ideas he attacks as irrelevant are important for understanding the “macroeconomy” and should be part of a mainstream research program.

He has a comment below his post which I am a lot closer to agreeing with:

 I am interested in general equilibrium theory and think that, viewed with an appropriate scepticism, it yields some useful insights. I’ve even had a go at it myself

…

But the idea of using Walrasian GE to understand either the Great or Lesser Depression seems to me to be self-evidently silly.

Indeed, if we want to understand what happens with a particularly large shock, we may need to use a different set of tools.  In this context if he had said “I think this book has too little on analyzing what happens in the face of large economic shocks (the type where assumptions about log-linearization become too strong)” that would be fine – instead he attacks all of macroeconomics.

We are starting to get to something here.  Do we actually have different definitions of macroeconomics floating around?

Noah Smith then goes on to discuss how it appears the book is more about macroeconomic method, than economic history/hypotheses.  I wouldn’t really find that terribly surprising in a book that is about explaining the method macroeconomists do – however, I do see his point that macroeconomists in turn need to explain “why” they do it.  Again, we need to define what we mean by “macroeconomists” here, and things are left just vague enough for me to have little to say.

Stephen Williamson then comes out and is not happy with the negative comments, specifically from Quiggin and Smith.  He notes that even if we focus on just the crisis, the methods discussed in the book allow us to actually have testable hypotheses about the crisis, and to figure out what went wrong and how we can improve policy and institutions.  Quiggin’s comments degrading the use of tools such as “mechanism design” come off as incredibly inappropriate under Williamson’s definition of macroeconomics – as mechanism design is a central tool for understanding how we can improve policies and make institutions function better (or be more robust where appropriate).

Most importantly, macroeconomics is not a “finished field” with a set of “known answers for all states of the world” – we are researching and trying to create knowledge.

I agree with Williamson’s view.  A lot of the “criticism” of macroeconomics seems to stem from loose definitions and an annoyance that they couldn’t persuade policy makers during the GFC.  Your inability to persuade someone is not a reason to degrade a scientific research programme – instead you should look more carefully at why you can’t seem to persuade people.

What is macroeconomics?

There is a kicker here as well – no-one seems willing to define macroeconomics in of itself.  It is the study of “aggregates” rather than individual markets, sure.  But we know there is a relation between aggregates and individual choices – and so we need to think through this issue in more detail before we could really define a scope for the discipline!

It turns out that different views about this relation, and about the scope of macroeconomics that comes out of it, lead to different views on what is “good macroeconomics”.

Macroeconomics, science, methodology – what the hell do those things have in common?

I’m glad you asked.  In macroeconomics, just like in other economic, social, and physical disciplines, we use the scientific method.  That’s nice.  But in terms of the relation between methods, and thereby what is “scientific” in macroeconomics there are two broad areas to think about:

1. Reductionism:  Can we reduce macroeconomic phenomenon (aggregates, their trends and movements) into microeconomic arguments given perfect data.
2. How close can we get to “perfect data”.

In Kevin Hoover’s “Is Macroeconomics for real” he discusses the fact that reductionism of aggregates may not be possible (in fact there is a lot of literature to suggest that already as I note in this document), and the “synthetic” aggregates we do measure do not bear a relation to our perfect data. [I would note here that measurement issues, and the lack of unique identification of causal mechanisms, are issues that exist within microeconomics – and in fact in pretty much everything]

However, this is not a call to just compare aggregates to each other and leave it at that without causal relationships!  Macroeconomic events are still the result of microeconomic choices, we just may not be able to identify them uniquely – but macroeconomic variables still supervene upon microeconomic ones.  We still need to understand the structure of causal relationships in order to understand POLICY – and this is why the Lucas Critique still holds firm.

Now as I also note in this document at the start, representative agent models do not fully satisfy the Lucas Critique – in fact we can’t make anything that does “fully satisfy it” due to data limitations (although the types of assumptions we make play a role, and should be discussed).  In that context, understanding that our knowledge of effects are conditional and partial is important.  Attacking “macroeconomists” because they are taking this into account and not just making sweeping generalisations and following universal laws isn’t a good idea.

Conclusion

The Lucas Critique remains important as a call to understand policy by actually understanding cause-and-effect in some manner.  As Mas-Colell (1989) states with regards to GE and capital markets, the fact we can’t a prori come up with tendencies that will always hold is a call for modesty and the use of empirical evidence.  That is exactly what the modern macroeconomists are trying to do – create conditional slices of knowledge.

If economists are answering the “wrong” questions, and statisticians are measuring the “wrong” things, then we should chat about that – and we should ask why incentives are aligned the way they are.  In fact, I am convinced that this is exactly what thinkers like Krugman and Smith are considering when they discuss these issues – and it is in this way that this comment on Smith’s post (which he tweeted approvingly) is interesting.  Update:  Kling seems to think it is the wrong methods as well as wrong questions – I am still not convinced.

However, acting like we have universal laws (which is how Quiggin’s expression of Keynes in his post comes across), and that people that disagree are idiots (which is a common theme from a number of bloggers), may get people attention in public.  But it is bad form for economists.

Disclaimer:  I actually think all the above authors will agree with the sentiments I have here about methodology in a large part – but they view the discipline as more partisan than I do, and perhaps also believe that their evidence is “self evidently” more persuasive than I may.  I also think that they all discuss interesting ideas, and I am in no way dismissive of their actual work – I am just disappointed at the rhetoric they are using to discuss the discipline, a negative rhetoric I think is undeserved.

Update:  Interesting comments from Chris House.

Shamubeel has already discussed this when thinking about the broad idea of equality, and so has Sen – although those posts were just us quoting him!  However, a lot of recent discussions have been specifically on a more narrow measure, that of measures of static income inequality [think Gini coefficient, inter-quartile range, 80-20 income range, etc].  We are being told these are inherent bads which must be squashed!  But does this make sense?  Or is some inequality in these measures really a good thing?

Note:  I read this post after writing my post.  It is very good.

Bah, inequality is bad – it’s obvious

Yes, yes, the most common response I get – but you’re here now, so lets have a think about what we are doing.  Let us start with a couple of quotes from Dalton (1920) – where Hugh Dalton was trying to push English economists to think about why we may care about inequality, and how to conceptualise this.  First, when discussing the view that the economist studying the inequality in the distribution of wealth is equivalent to a biologist studying the inequality of any physical characteristic he states:

But this is clearly wrong.  For the economist is primarily interested, not in the distribution of income as such, but in the effects of the distribution of income upon the distribution and total amount of economic welfare which may be derived from income.

What does this mean for the economists problem?

We have to deal, therefore, not merely with one variable, but with two, or possibly more, between which certain functional relationships may be presumed to exist.

Here we go.  We care about social welfare, which we can’t observe.  We can observe some indicator of income and income inequality, and we have to ASSUME some functional relationship between this measure and social welfare.  Given this assumed set of value judgements we can discuss our preference for inequality.

This of course does not mean we should ignore the issue altogether – instead we can ask which potential distributions of income will be favoured given an assumption about the form of social welfare.  In this case we get a clear idea of the set of assumptions that would need to hold for us to favour less or more equality in the distribution of incomes.

Accepting that this functional relationship is unobservable – a limit in the social sciences that does not exist to the same degree in the physical sciences – we can discuss certain principles.  Atkinson (1970) [REPEC] got this underway by comparing distributions with the same mean, but differing degrees of inequality.  Given diminishing marginal utility (or more directly, risk-aversion among individuals), the more equal distribution is preferred.  This concept – extended into the Atkinson-Shorrocks methodology to deal with differing means, and the Atkinson-Bourguignon method for dealing with different assumptions about “need” over household characteristics – provides the base for why many people seem so confident that “less inequality = good”.

Given the focus is solely on measures of “inequality” it is the Atkinson-Shorrocks view that is being leant on.  But using these measures solely as an indication of what is good, and applying them to static measures of inequality, involves assuming specific things – things we may be uncomfortable with.  Say that we introduce a series of value judgements that capture the way we feel income is valued between groups based on household characteristics (an equivalence scale).

By treating the line of ‘complete equality’ as the ‘egalitarian line’ we are at a minimum ignoring:

1. The fact that income is not a blob floating around – but the result of co-ordination between those with access to different inputs in a production process. [Note:  Remember much of this literature, given its focus, is treating measured income as endowment]
2. Given (1) the differences in the value of marginal value of consumption relative to leisure (the purpose of income) within groups. [Part of the distribution is in fact representative of revealed preferences of people who feel very differently about the relative value of consumption, investment, and leisure]
3. Differences, both in characteristics and subjective perceptions of need, based on groups we have not recorded or measured.
4. Differences in the individual/households position in their lifecycle.

When we bemoan inequality, we are picturing two individuals who are similar, putting in the same effort, but being rewarded in different ways.  Yes, I can indeed understand how this is seen as unfair, and wanting to reduce this type of inequality is fully understandable!  But this isn’t what static income inequality measures tell us.  Some differences in income at a point in time are due to choices, and more fundamentally our capability to turn income and the cost of work into satisfaction.

A determination to make incomes equal based on these measures ignores the fact that people are inherently different.  At a point in time, an individual who values consumption highly relative to leisure will work more, earn more, and spend more than someone who doesn’t – this factor turns up in our indices as “inequality”, but it is a good thing.  Pushing the person who values leisure to work more and the person who values income to work and earn less will make both individuals worse off.

This is part of the reason why ‘economic mobility’ is so highly focused on by economists and policy makers – people’s ability to shift between bundles of {consumption, leisure} based on their preferences is a great thing.  With mobility, inequality will exist at a point in time, but it will be relatively more to do with “choice” – this is where equality of opportunity comes in.  Of course, we also need to be careful with these measures – sometimes what looks like mobility in a distribution is really just an indication that income is more volatile, which is something individuals and households do not like

But this is not the whole story

In this discussion we have focused on the idea of inequality for a given level of income.  However, this has ignored the elephant in the room – the trade-off between policies that change the distribution of income and the level of income itself.

Take for example the idea of the government somehow being able to enforce equal renumeration for all jobs.  In this case:

1. What happens to the incentive to invest (both in human capital, and in physical capital) – why a large part of it evaporates
2. What happens to the choice of work – well people would favour jobs with non-income characteristics.  So “status jobs” and “low effort jobs” would experience an excess supply of workers, while other jobs would experience an excess demand.  If wages are truly fixed, and non-income characteristics that are not part of the role cannot be used, this is very allocatively inefficient.
3. What happens to any sum of the absolute gaps between the social value of the work individuals do and its private value – it rises, again more allocative inefficiency.

As a result, these extreme versions of equality WILL lower income – there is an equity-efficiency trade-off along some margin!

This is the kicker, the Atkinson-Shorrock methodology is useful for comparing two distributions when we know what the counterfactual will be given our policies.  Using this we can tell what value judgements have to hold in order to prefer one policy to another.

But the relation of this to a “target level of inequality” is very weak.  We need to know what the impact of the policy is, we need to have a clear idea of the value judgements we hold, and then using these ideas we can choose trade-offs.

Saying  “let’s just lower this variable” involves ignoring the trade-offs, it involves excessive certainty that what we are doing is “right”, “fair”, and “just”.  This makes me nervous.  It makes me especially nervous when I see the case being based on a book that does not recognise this, and pretends the trade-offs do not exist – the Spirit Level.

Note:  This is an introduction into where my blog posts will be going now – I have essentially stopped writing about financial stability and macroeconomics, and will now be discussing income inequality instead.  Party.

At first brush I would like to note that we have a psychology lecturer suggesting that this implies more people should study psychology – it might be the economist in me talking but this sounds a bit like these recommendations are a touch self-interested themselves

But this would be a digression.  While I don’t disagree that economists do need to be humble about the conditional nature of their knowledge (a point that holds equally for other social, and physical, sciences mind you!) I stick by my general conclusion that:

Saying “we shouldn’t look at trade-offs because then we lose our sense of community” sounds strangely like “we shouldn’t study the natural world or we will lose our sense of faith” don’t you think

Economics is a descriptive discipline that uses specific counterfactuals to try to interpret our limited, and fuzzy, data on social co-ordination.  Just look at how often we discuss co-ordination here – and we fit into the “business economist” category that is most maligned by these articles!

Now much of the psychology today article relies on one reference that it links to repeatedly – ‘Does studying economics inhibit cooperation?” [REPEC].  This paper is about economics training 20 years ago, and discusses survey results.  You may wonder why survey results would matter – especially if you trust the papers that suggest there is no difference between how people act in hypothetical situations and in situations where actual money is on the line [an assumption I still view as up for grabs!].

Well I would still be a bit careful here!  After all, the size of the reward does have an impact on decision making.  And the differences in hypothetical and ‘real’ behaviour in of themselves differ based on the game being played!  This makes sense if we think of rule based, unconscious processes in the same way we think about a computer program – and that once the money on the line reaches a certain level there is a ‘break’ in the loop, and we go into conscious decision making mode.

Given this view of the individual, what are some of the hypotheses could we attribute to the gap in responses between economists and non-economists in these surveys?

1. Economists are inherently cold hearted people, and the training makes them even worse – the only hypothesis being claimed in the articles at the start.
2. Economists trust others less following the education (I suspect this does occur – and I suspect that if it was the case we would find it quite widely across anyone who spends all their time thinking about individuals eg psychologists)
3. Economics trains people to use rules, or break out of standard rules more quickly, than other individuals,
4. Economists are less prone to make mistakes,
5. After studying these games, economists view some answers as a form of image crafting, and as a result change their behaviour accordingly.
6. Economists recognise the hypothetical situation as a game – and as a result, value it completely differently
7. Update:  I missed one, economists may be more honest

Note, outside of the first two, and some instances of the third one, all these results would lead to an economist being just as co-operative for the big issues!

The sixth one is one of my personal favourites.  In 1st year I played the prisoner’s dilemma in class, I was first up, we did a practice game where we both co-operated.  I took that as a hint, co-operated on the real game, the other guy defected – I lost!  Burn.

Now nothing is on the line in these games, except your relative position.  Furthermore, we learn how to solve these for relative position.  As a result, when it comes to playing the hypothetical game you do play it differently.

For example, in third year we had a big lab going with many games – and you would move between them every 5 mins.  We had been studying repeated games, and how there will be some co-ordination early, and then people would start defecting – however, my goal was to get the best relative position, so I defected from the start knowing that each time I was competing against different people!

When we looked at the choices later, you could see that the people I’d played against immediately started defecting as well – they were annoyed at losing.  It was a big dark streak that got larger and larger as the game went on!

Now, if there was actual money I would not have been so quick to cause a mess – not just because I could have worked to get a slightly higher “payoff” myself (albeit with a lower relative position) but also because many of these people were my friends, so I would value them getting a return as well.

In fact, our entire economics education was focused on description, admitting that people value different things, and just trying to frame behaviour from an atomistic (individual) level – as that is where choice is made!  This isn’t, and never is, to say that an individual is independent of their society and doesn’t care about them – and to be honest I find the presumption that economists, and economic students, are making an assumption that this occurs and is true to be patently absurd and insulting.  You may fundamentally disagree with methodological individualism, or economists use of it, for some reason – as I believe some of the literature pointed at tends to – but at this point we are moving into policy, thereby explicitly invoking normative views, and we are debating those.  We should have those debates, instead of trying to discredit economists before they’ve even started

Now, the person at psychology today could have admitted there are a variety of reasons why economists behave differently when playing these games, and how this issue warrants further investigation (after all, there is still a lot of research to be done into how hypothetical results translate into real decision making activity – note my constant excitement about neuroeconomics and the empirical analysis in behavioural economics).  Instead, they chose to pick the hypothesis that placed economists in the worst light in order to sell their own discipline.

I don’t think you have to be an economist to see why this should be taken with a grain of salt, and why this isn’t “scientific evidence” of why you may believe that economists are douches

A lot of people are complaining about there not being enough jobs.  But is it jobs we want, or the income/consumption that comes from them?  As Paul Walker notes in many ways the job is a cost – not a benefit!

We touched on this idea when making fun of the increasing push for compulsion for matters such as savings – here and here.

But this doesn’t feel quite right does it.  As we’ve pointed out in the past when we talk about an economy, and jobs, we are really discussing an issue of co-ordination between individuals.  A job provides us a social group, perhaps even a purpose, and these things give us value.  Stumbling and Mumbling covers this off very nicely.

In this way, the question becomes more complicated – merely giving someone the income that they would receive in a job does not necessarily imply that are better or worse off as:

1. There is a benefit from no long having to supply our labour – we get to consume “leisure” and don’t have to do something that we may dislike!
2. There is a lost opportunity from social interaction, and it is unclear what exactly could or would fill this void.  Furthermore, if jobs are currently seen as a means to providing someone purpose in their life – how will someone find purpose if we move into an economy without scarcity that doesn’t require human work.  [Note:  I have a bias here as the novel I’m working on is on this issue ].

Anyway, happy labour day and all of that!

Side bleg:  I have a preference for writing ‘co-ordinate’ rather than ‘coordinate’ and from what I’ve read both variants mean the same thing and are correct.  But ‘coordinate’ is more common.  Is there anything I’m missing that should know?

Instead of targeting an arbitrary set of outputs that treat New Zealand like a machine, policy should be based on the inherent trade-offs that exist for the policy question we are asking.  Focused research on the costs and benefits of educational achievement, health outcomes, benefit policy etc – these are the ways we can incrementally improve policy, and build a better society together.

These outputs may suggest to us there is an issue that deserves investigations– but they should not be seen as an end to themselves.

Policy justified on the basis of the target of an arbitrary GDP or happiness index doesn’t do this, and instead threatens to tie our outcomes closer and closer to someone else’s view of what is right, what is just, what is happiness, and what wellbeing.  Instead the aim of government policy should be to ensure people in society have the ability to reach, and access to, choices that allow them to gain wellbeing.

A factor that often gets missed when discussing policy options in public is that the real “target” is not observable.  If we are not careful about the way “observable” things translate into the underlying issues we really care about, we will make a lot of false policy conclusions.

One of the reasons economists use a counterfactual that involves no government involvement is because of the idea of “revealed preferences” – that individuals will make choices that reveal the value they place on things.  Individuals know (at least to a greater degree) what they value, while the rest of us cannot hop into the minds of others and figure out what they value.

A clear view of trade-offs, and the use of markets to help ensure people reveal preferences, gets us a long way. Given that we can then go about considering the views of co-ordination that Matt also touched on last week.

While I am not married, I think the idea of marriage is grand.  I think it is a great way of dealing with a social issue that involves both search and relationship specific investment! When entering into a relationship, make sure that you are a perfect match. There is a reputable dating site that will help you find the right one for you. Visit this website, https://www.perfect12.com/, for more hints about ideal dating.

Now, you may think I’m being too romantic here by bringing up terms like “relationship specific investment” – but let us not forget the awesome power of economics for dealing with these ideas.  The question is, given marriage as an institution what specific type of co-ordination failure did marriage turn up to solve?

As individuals we all have an idea about the qualities we are attracted to in a partner – that or we at least get the feeling that we are attracted to certain things.  This is all well and good.  However, when we are out looking around we know that there is currently some set of people available to have a relationship with, and someone in that set embodies a set of qualities that differs from our ideal in some way.

Over time this set changes (of qualities, and the pool of qualities available), and there are direct costs from “searching” for additional people in the population to increase this set of potential partners.  Have a quick peak at search theory and matching theory in Wikipedia.

Now this sounds absolutely awful.  But it would be more than a mistake to stop our view there – after all, what is the point of marriage in this example?

Here our view could get even worse.  When we decide to “stop searching”, marriage creates a contractual relationship that makes it costly to leave!  Is marriage really about trying to restrict the other persons ability to leave in the case where their set of available partners has changed, by increasing the cost of doing so?

Why are you being so mean!

Wait a second here, remember I’m a fan of the concept of marriage.  So I must think that the above description is not telling us the whole story!

Yes marriage makes it more costly for someone to leave a relationship, but it is a cost both partners are willing to take on for a specific reason – relationship specific investment.

A relationship is not some big ball of matching characteristics.  It is also the result of the investment of time and resources by the individuals involved into the relationship.  Now, investing in a relationship will create gains for both parties – but only if both parties stay in the relationship.   When it is more costly for one of the partners to leave it is less likely they will leave, as a result the expected benefit of investing in relationship specific capital is higher!

To quote the literature:

Marriage acts as a commitment device that fosters cooperation and/or induces partners to make relationship-specific investments

And there is a lovely corollary to this.  By investing in relationship specific capital, capital that is sunk outside of the relationship, you can make a relationship into “the best available to you” at a point in time – as although someone else may embody better characteristics, they would require costly investment in relationship specific capital to get them up to the level of satisfaction you currently enjoy.

We’ve discussed these things before (here, here, and here and in the comments), but it cannot hurt to reiterate how romantic economists really are

He then goes on to discuss a prisoner’s dilemma that exists between government around global warming – implying that organisation that may help individuals co-ordinate in some place (daylight savings) may fail to co-ordinate themselves about broad action (such as global warming).  Concluding he states:

Here we have concentrated on examples where government, and other institutions, can help individuals co-ordinate their actions – helping improve outcomes.

This is a great way to view, and understand, government policy.  However, we always need to keep in mind that individuals are co-ordinating themselves, by making choices given the incentives they face.  Prices, which are determined by the relative supply and demand of products, offer the main device for co-ordination in our society.

To understand the role of government, we need to think about how the use of prices, and co-ordination move generally, may fail – and in what ways government can sensibly recognise this and lend a hand.

The hard thing with global warming is that individual governments do not have an incentive to solve this problem, which was the original justification for the Kyoto Protocol.  With that failing there is a genuinely concerning policy issue here, which the global community does not appear to be able or willing to face.

Then the post:

Mr Cable has a point. It is hard to fault measures, like the Automotive Council and the HVM, that correct what economists call “collective action problems”—where firms can only solve their difficulties by clubbing together to share costs and risks. By inviting joint bids for funding, the government is encouraging businesses to form such talking shops. On the same day that Mr Cable gave his speech, for example, a group of 242 employers in the creative sector announced a proposal for a co-investment partnership.

Yet however scientific the spending decisions, the risk of faddishness or cronyism will exist so long as politicians are the ultimate paymasters. Creating lists of priorities, even when their purpose is to root out market failures, can generate new distortions: if the government supports eight great technologies, for example, what happens to the ninth? And why invest in specific skills that fallible businesses think they need when Britain suffers from a shortage of employees trained in general disciplines like maths that can be applied across a wide range of industries?

The new interventionism is one of the few areas on which all three main parties agree—making these questions all the more pressing. On September 18th Nick Clegg, the deputy prime minister, told the Liberal Democrat conference that “businesses across every region are being given billions to help them grow.” Such talk is worrying—and smacks of the age-old urge to throw money at problems. That is the thing with industrial activism: for politicians elected to “do something”, it is much harder to own up when inaction, not action, is the best policy.

As individual, hell as economist, it is tempting to think about how government can get things going, or to view society as one big optimal control problem.

But let us be a bit more careful.  There are limits to our knowledge – both of the impact, and what the impact “means”.  If we are not careful the determination to improve outcomes for the society we all care about can quickly become the determination to create work which provides us income, which other people in society are being forced to pay for.

Government is a institution that helps with co-ordination.  So are firms, co-operatives, communities.  Within this, implied prices help to determine this coordination (either shadow prices or explicit prices – prices are at least implicit even with government choice) – let us make sure that we keep this in mind, and that we ensure our explanations remain consistent within areas of policy advice.

Government has a role in delivering services and helping co-ordination when the broad public asks for it, but we have to be incredibly careful that we have a consistent and accepted argument for intervention before doing so.

Of course, this is where New Zealand is good – policy advice is careful, considered, attempts transparency, and there is a recognition of limits!  As the public we should always be poking and prodding to find out more though

Note:  I’ve seen people commenting on the Economist article saying “that is what a democratic organisation can do” and “should do”.  I appreciate that argument but we can take it too far, as a result I think there is some confusion here.  If every party decides they want to do this type of intervention with specific businesses largely behind closed doors then society hardly has a choice, and they are forced to allow this sort of experimentation to occur.  The government is extractive in that sense.  Even if society is pro the concept, then we also need to make sure there are safeguards in place to avoid this becoming “subsides for business”.

A large institution that convinces the public it controls their everyday lives, extracts resources from them to transfer to businesses who rub them up, and does so under the “faux coordination” claiming a democratic mandate is not really what we picture when talking about a democratic regime.  Instead, that sounds more like the United States