Economic Science: Back To The Basics

My book (on lessons from socialism) is about using the grand experiment -- to run an economy efficiently through replacing the market with a plan -- to understand economics. After all, economics is precisely about what an economy is: the question of whether this experiment should work, and why, seems very central. Is an economy by nature a market economy? Or is it just as workable to replace the market with a plan? Or, if not completely replace the market, can you replace bits of it, or guide the market? And, if the latter, then why can't you replace the whole thing (why is that different?) and does the answer to that question have bearing on how well a partial replacement or guidance will work?

So, my interest in economics is very basic: getting back to the basics of what economics is. Getting to the core. And, I think generally this is what Austrian economics is about. Austrian economists do not want to take what other economists have done and add fancy and tangential extensions to it, or mathematically prove something into or out of existence. Austrian economists want to ask fundamental questions about economic systems that often appear easy or obvious, and then carefully and methodically work out the answers.

This is also what makes Austrian economists great teachers: at least a couple of Austrian economists that I know are, in my opinion, at their worst when they attempt to do conventional-type work that they can publish in top journals, and at their best when lecture to students or present to (or publish for) non-academics. Does this mean that Austrian economics is not scientific - that it is only palatable to the uneducated? No, I do not think so at all. Conventional economics is based on absurd, often times bizarre, assumptions. Economists realize this, but excuse it because they hope the simplifications will help to generate useful predictions. Economists then build elaborate models and equations based on these assumptions, and learning all about what they've done takes years of academic training.

However, most of Austrian economic insight is not built on such assumptions, and it is therefore not simplified enough to build elaborate models and equations upon. It therefore does not take years of academic training to understand these basic insights--instead it takes a few hours to begin to understand the basic insights (if they are taught well). After that, of course, they can be more and more deeply understood, and applied to different policy questions, economic questions, and other pursuits.

This also leads me back to where I started: Austrian economics is about the basics. Understanding and applying basic economic principles to questions in daily life. I think this is good. I do not think that we need elaborate models built on absurd assumptions: models are fine, but they are not the really critical thing. The really critical thing is to understand what economic system works best for what ends, and why. This can then answer "how can we increase economic growth?" and "can we help developing countries to grow? why are they poor in the first place?" and "should we nationalize the banks?"

It is highly unlikely that an elaborate economic model built on incredibly simplifying assumptions will answer this first and most fundamental question better than a study of the fundamentals.

The Time Factor

Pete Leeson wrote recently, on the Somali pirate situation, that "the market has spoken," he said:

The market has spoken: Even in today’s pirate-infested waters off Somalia, the low probability of being captured by pirates, together with the fact that pirates release their hostages unscathed, means it’s cheaper--and safer--to go without armed guards.

There were a lot of pretty good responses to this argument in the comments. However, one really fundamental one is this: the market takes time to gather knowledge, respond to incentives and price fluctuations. When we forget this, as Austrians, we look like the neoclassical economist who disbelieves that there is really a dollar in front of his eyes, on the ground, because someone would have already picked it up. As Austrians we should know better.

The planners were right about this. What they got wrong was that a quick government fix would be better. They assumed that government would know, and could then use its swift ability to fix any flaws seen. This is not correct, despite the loud proclamations that we have to "do something" because any quick action is better than nothing--even if the gas truck arrives first, any old liquid is not better than nothing on a house fire. If government's actions both exacerbate the problem, and make it harder to figure out the right solution, it is not better than nothing either.

Government doesn't know, but sometimes the market doesn't know either: before it learns. So, the idea that the "market has spoken" is not necessarily correct. And in some cases, like this one, the "right solution" is based on unknowns, probabilities, and changing circumstances. What this means is that whatever the market "chooses" may or may not work out best. The choice that produces 60% success is a better choice than the one that produces 50% success, if they cost the same, but there is still a 40% chance it will fail.

Then, if it works out poorly, it will be assumed that this was the wrong choice--but it may have actually been the choice with the higher probability of success. It may have been safer, cheaper or wiser, but there is no way to know, at least without a hundred randomized trials. We don't have that--any other similar situation still has a thousand variables, just for the one data point.

If the market chooses, we won't know if it was the right choice. Market purists are wrong to say that the choice was right simply because the market chose it. The choice may be wrong, humans are fallible, information is scarce, and evolving the best choice takes time. Sometimes there simply isn't enough time. There are mistakes and trials along the way. Sometimes it would have been better to choose differently--its a learning process. On the other hand, even if it looks wrong, it may have been right, even as planners point to the failure: statistics are statistics.

If government chooses, we also won't know if they chose correctly. Market purists will say that the choice that emerged in the market was right, because the market chose it. Planners and lovers of the government fix will assume that what government chose was right, because "the people," or the voters, chose it. But, we don't know. We can't know--that is just the fate of being human, and living in a world of time and uncertainty. Life would be pretty boring if this weren't the case, but it makes economics a lot less precise than is usually assumed.

Austrian Media Appearances

After watching this excellent Brooklyn libertarian cable interview with Cameron Weber, I started putting together a list of some appearances by Austrian-leaning economists. Here are some I have found and really enjoyed:

http://freedomwatchonfox.com/ is one of the bigger-name (but also watered down, and sound-bite filled) choice, it regularly has Peter Schiff and Ron Paul.

Here is an interview with Steve Horwitz.

Bob Higgs, who was brilliant, in a long C-SPAN in depth talk.

Excellent Alex Tabarrok talk at TED.

Finally, here is a Hayek video from his later life.

Ideology and Rationality

In an article in the Review of Political Economy on Marx and Schumpeter, there is an interesting mention of Schumpeter's idea of why rational arguments do not dissuade people from socialism.

It reads:

Political attack cannot be met by reason. Reasoned argument may tear the rational garb of attack but it cannot reach the extra-rational impulse that drives it. In any case, in political matters, the masses are generally incapable of seeing where their true interest lies. They see only monopolistic practices, high profits and social inequality. To see the case for capitalism, they would need to see further than the short run, and that requires powers of analysis that are quite beyond them.

In a footnote, the author explains that Schumpeter believes that the rational thinking of most people extends only to everyday concerns and not to broader social and political issues (public choice literature would say that this is because their vote doesn't count anyway, and Bryan Caplan would add that they get comfort at little to no cost believing what they do.)

I think there is some truth to all of this, but why is there such a strong political contingent for socialism, despite so much evidence that it reduces freedom for all and makes every income level in society worse off economically? There is a simple answer.

Consider the following. Imagine that a certain person, lets call him Daniel, is faced with irrefutable logic showing that the socialist society produces an economy in which the income curve is strictly lower than the income curve in a free market society (and one can imagine the same for the 'freedom curve' too). So, the poorest person in the free market society is still richer than the poorest person in the socialist society. The two curves may not differ in relative income either, and in the socialist society, there may even be some at zero income (famine levels).



Faced with this rational argument that free markets are better for everyone, one might think that the rational response to this would be "then they must be better for me, so I should be for free markets!" Perhaps this would be the rational response if he were behind a veil, but he is not. It would also perhaps be a rational response if the way to become wealthy in the two societies was the same--but it is not. In a socialist economy, one gets ahead through politics, schmoozing with the elites, and getting handouts for people in exchange for bribes and power. In a free market economy, one gets ahead by producing things for the customer.

Daniel knows his own talents, so for Daniel what matters is not the absolute level of income in the society over the whole income curve, but where on the curve in each society he personally will land.



So, if Daniel expects to be at position A in the socialist economy, but position B in the free market economy, he will always prefer socialism. Daniel would expect this if he is good at political maneuvering and not so good at creative solutions to fill the demands and desires of his fellow countrymen. This, in a nutshell, is why there will always be a contingent in favor of socialism: its a tragedy of the commons.

The best we can hope for is that most people will take account of the rational argument, and perhaps spread the values and foster the talents of creative entrepreneurship, over the values and talents of politics and schmoozing. Unfortunately, once the rent-seeking begins, it builds upon itself and rewards those values, making it difficult to reverse the trend.

Changing the Terms of the Debate

Basically every pro-intervention policy economic argument goes like this:

(1) The neoclassical model says if we do this, output will be lower but

(2) it is naive and unrealistic to believe the neoclassical model represents reality.

Unfortunately, most of the time the free market defender resorts to something like "yes, but it approximates it close enough."

Until we rid economics of the absurd assumptions of the neoclassical model, we will always be on the defensive, and the arguments will be weak. Just think of the eternally frustrating "trickle down" economics description. Yet, very few public figures can explain Austrian methodology, assumptions and models in the soundbite format of modern policy debate; and the public is already familiar with the neoclassical model, and assumes that any free market advocate believes in perfect competition and the tooth fairy.

It is the dominant role of the neoclassical model and synthesis (and mathematical economics) during the twentieth century that brought us belief in the superiority of planning and the supply side/demand side dichotomy. This reminds me of the socialist/fascist dichotomy: they are both wrong and actually similar not opposites. There is an actual alternative on the opposite end of the spectrum, being ignored.

The terms of the debate need to change. In order not to be on the defensive, we need to loudly declare the actual assumptions and structure of our model, and the reasons why it claims that intervention will lower growth, if it does. This is starting - between Freedom Watch and the Ron Paul revolution, the Austrian name is seeing some light of day again. And, now with the Tea Party protests, the tide is turning in the popular mood. Folk Austrianism is trickling in so to say...hopefully with a better face than "trickle down" economics.

There are several Austrian economists working hard to popularize some of the ideas. Lets keep pushing this forward, not be afraid to call it "Austrian" economics, to distinguish it from the neoclassical synthesis, and make sure to point out the major difference: we don't assume that markets produce zero economic profit and everyone is omniscient. We are realistic. You can't wave your hand and say we're naive and so government has to help. They are naive; they are the ones that beleive government produces zero waste and is omniscient.

If You Can't Explain It, It Probably Isn't Right

I spoke to a non-economist today about the housing crisis, credit crunch, financial crisis, bailouts and recession. She had some basic insights about supply and demand, listened and agreed with me that the policies were likely to blame (regulations pushing low-income loans, interest rates, subsidies and so on), and we agreed that expanding these policies would make it difficult for entrepreneurs to spur recovery. My explanation was consistent with - in fact was pretty much exactly - the Austrian position.

Could a Keynesian explanation and solution have been as easily explained? The person I spoke to was not predisposed toward a free market solution or a government answer. I wonder if some of the credit crunch explanations that get into all the complexities are necessary, and with their confusing intricate details and delicate cures, whether they are able to get at the essence of something so big and far-reaching.

Of course, some simple explanations - especially ones that blame some minority group - are a distraction, scapegoat. So, perhaps if the explanation is complicated, it is unlikely to be right, but if it is simple it could be right or wrong. Then it just comes down to common sense. Since anyone is able to understand it, it comes down to being rational and honest in examining the logic. What do you think?

Using the Lessons from Socialism

As part of something I recently wrote, I made the following argument about the potential uses for studying comparative economic systems. I wonder how many readers will agree:

I am particularly drawn to the study of more extreme and pure systems. I believe these offer the best chance to draw out universal laws. Careful study of systems which avoid mixing of different incentive structures may present the best opportunity to view a single behavioral or systemic result, as if isolating it in a laboratory. Some of the results of this kind of analysis confirm basic economic laws and theory, such as the importance of the profit motive for keeping costs low and quality high. Even analysis illuminating such well known theory can be an effective learning tool, highlighting economic insights important for theoretical models.

Often economists begin with the simplest form of a model, and then begin to add to the model the complexities of reality. Similarly, the model which is the pure economic structure may be such an extreme example as to simplify the lesson. Yet, the economist can then adjust the simple lesson with the modifications seen in less extreme examples of the policy. The advantage of the pure economic system is that its implementation of the policy is the pure form and may represent the noise-free truth underlying other implementations.

One example is the socialist policy of eliminating unemployment which parallels less extreme policies undertaken in market economies. The lessons from the Soviet attempt to eliminate unemployment are interesting. Planning labor entirely was too difficult; for most periods most labor was free. Working was mandatory and extreme measures were taken to keep all workers employed, including forcing the manager to personally find a new job for each worker laid off. Yet, unemployment remained at about the “natural rate” for the duration of the Soviet socialist experiment. The negative effects of the labor policy included incredible labor inefficiency, underemployment, and a rigidity across the whole economy as firms could not adjust to changes introduced because they could not attract the necessary specialized skilled labor.

Similar lessons can be found with regard to investment and interest rates, monetary policy, and the need for marketing and middlemen among other areas. In the pure socialist economy, the extreme results can be seen across the whole economy, and are easy to study. The lessons can then help to inform or confirm theoretical models, or be combined with them in order to better describe potential policy consequences.

My original argument was going to make a slightly different case, which I ended up not feeling able to defend well. I originally argued not just that a lesson could be extracted, but that a pure isolated truth could be extracted and put into a model, which then could be modified to reflect the differences seen in less extreme policy manifestations. I believe that, but I am not sure I can defend it as of yet. Then again, it isn't really much different than what I say above - it is just that I reduced the claim to "lesson" instead of "model". I am curious what others think about this: are we not learning enough from economic systems such as socialism, which in many cases offer the most pure version of policies which we also pass in market countries?

A Collective Delusion

Pete Boettke, over at AE, posted about the Keynesian legacy. I have some thoughts on that, in particular, I agree that belief in those models represent the economists' collective delusion. I question why we have fallen for them - for private joy or public purse - and I fear that our policies are still colored by them.

I fear that economists have a herding mentality that grasps onto popular figures and then economists cling to the models of these "brilliant" chosen ones. But those who are chosen are not brilliant, they are only popular -- they generally have, like Keynes or Marx, gotten the ear of government. They come up with simplistic models that are easily used to churn numbers or explain phenomena, even though a child could see right through them.

When I took intermediate macro we used Mankiw's book. It was filled with Solow, Keynesian AS/AD, phillips curve, and on and on. I could barely believe that it was for real. None of it made any sense, none of it had any microfoundations (read: basis in reality).

I spent class time with a horrified gawking stare frozen on my face, wondering about the future of mankind if these were our leading economists, and asking the most basic of questions ("If savings is what drives growth according to the Solow model, then wouldn't communism work just as well or better than capitalism? Where are policies and institutions in this model?") and get answers such as "Well, this is just to simplify and explain the basics. Those details can be added later."

And I would be left wondering, about Solow and Keynes: who decided that the aggregate level of saving is more important than whether an individual, or a collective or government owns that savings? Who decided that aggregate investment is more important than whether it is private investment or investment by government in make-work programs? Doesn't it matter if the economy is split 90/10 private or 50/50 private or 10/90? When these models were being made economies spanned that whole spectrum, and yet these guys did not seem to think it mattered who was consuming resources - government or private consumer - who was investing or saving, just so long as the aggregate totals fit into the equations and made them balance nicely.

There were other problems - contradictions about what was better, savings or consumption? and so on - but the idea that private and public spending could be considered equal after the experiment with socialism and the interventionist state was well under way was just crazy. How could anyone think these models were useful at all? These seemed like child's play, fantasy, mind candy maybe. But not important, not something economists or policymakers should be using.

Why would economists fall for these models? And perhaps even worse: why do so many economists still cherish them, and hold them in esteem? What is this collective delusion? Is it that they love the "logic game" of it? Or is it the political clout they love? If they feed politicians with what they want to hear, they will be famous and win a Nobel -- isn't that better than being a no-name who sticks to reality? Isn't it more fun to make convoluted logic games, and be out in the public square?

Clearly for personal gain it is better for economists to engage the delusion. But this kind of absurd modeling still finds voice, and still drives our policies: "President-elect Obama's economic team is counting on investment in America's wind energy infrastructure to create thousands of jobs in a wide range of industries and help preserve existing jobs in other areas, particularly manufacturing."

Our government officials must "create jobs" by subsidizing or publicly providing work in specific targeted sectors. This will spur consumption (aggregate demand) and prevent collapse. This is all based on aggregate factors, and entirely devoid of microeconomic factors. We're also planning on propping up sectors despite their paying 3x normal salaries, by taxing regular workers, without concern over the need for the industry or the company to fail if it isn't profitable. We prevent jobs from "going overseas" as if trade is a bad thing.

Have we learned nothing about the failure of these models? Is this all political, is it useless to appeal to common sense?

The Efficient Muffin Hypothesis

During this financial "crisis" and subsequent bailout, some Austrian economists have surprised me with their optimism. Essentially, they argued that the market will pull through. Even if stupidity got us into the mess, and stupidity was going to compound the mess, so long as the market is allowed to chug along we will always ultimately "grow our way out." In the end, these Austrians argued, we would end up better off after the crisis and bailouts are all over (say, a few years hence) than we were before the whole thing started. We might have been even better off had we not passed some of the stupid policies, but we would only lose growth, we would not shrink in real terms.

Austrians also talk a lot about inflationary policy, or other kinds of foolish policies that governments engage in for a short term fix, despite having bad longer term consequences, as being like a drinking binge. They then argue that you can't cure a hangover with more drinking.

Now, if original hedonistic policy is like the binge drinking of a wild night, then the morning is the time for recovery. And if, in fact, if a semblance of protection for private property rights is all it takes to "grow our way out" then we can pretty much use whatever hangover cure we want, and be alright.

We can call this the "efficient muffin hypothesis," because the muffin we eat for breakfast manages, as it breaks down, to metabolize away the worst of the negative effects of our night of drinking. This theory says that we will make it through the hangover and to complete recovery fairly quickly. We can even have a mimosa with the muffin to take the edge off.

The inefficient muffin hypothesis, then, would state that in fact any old hangover cure may not work, the effects of these policies may compound each other, and we may never recover. In this scenario, the muffin cannot purge the poison, nor can time alone, and permanent damage may have been done.

Now, if the efficient muffin hypothesis is true this has significant implications. If, so long as the market is not completely banned, the wee market left can always "grow us out" of any idiocy of government policy, then we might have to take a second look at whether these policies are so bad. A night of drinking ain't a bad thing, sometimes.

Seminar Topic - What Has Economic Science Learned From Socialism?

This is a recurring theme for me, but one which I maintain is very key. I ran into a note I had written up last spring on this topic, and then a post at The Austrian Economists seemed a good place to promote the idea. However, it didn't catch any traction there. I will post in here, so it is not entirely forgotten.

The socialist calculation debate brought to light many fundamental economic issues, and problems of the classical and neo-classical modeling. While classical economists believed strongly in markets, their models could not explain exactly why socialism would not work. But, while the calculation problem provided a lot of insight and generated a lot of profound and interesting investigations, it did not resolve the issue. In fact, Lange's concept of market socialism for some time was considered a refutation of the arguments against socialism. A new set of economic theory rose from the ashes of that debate, focused on beneficial government interventions.

Comparative political economists continued to ask which system worked best, and market failure theorists worked out how government could solve the problems of the market. But then the "other" system fell, and upon cracking open revealed a rotting interior. In fact, the critics appeared to be correct after all. All of the problems they pointed out turned out to be true.

Now what? How has this revelation begun to change the face of economic theory? Is some of the faith in the ability of government to solve market failure on the way out? Do we now consider government failure as often as market failure? Do we now focus on the institutions that make markets possible- what of the old institutions of socialism, can we learn from why they failed? Can we still learn from the calculation debate, by considering why the socialists were wrong and what was wrong with their models and by looking again at the arguments of the opponents of socialism?

If the old models could not prove the problems of socialism, do we now have new models which can? Many of the core problems with the old models concerned their static nature and dependence upon equilibrium. Are we finally moving away from those kind of models, to a more dynamic approach? Should we look to the Austrians, the most adamant critics of socialism, for a better starting point and methodology? How has the science benefited so far, and what more can we learn?

The idea is that economists of all stripes should come together and review the old debates and the models that underlie them, between those who favored socialism and those who were critical, determine what failed in those models that so many fewer economists today would argue for socialism in those same terms, and explore whether we have rid ourselves of those assumptions in the models we use today. Some great work was done right around the collapse which touched on these issues - for example Stiglitz who I posted about a few days ago. But, I am not sure that something like this seminar has occurred, and even if it has perhaps we need more of them.

For example, have we rid ourselves entirely of misuses of equilibrium theory? Static models similar to the perfect competition model? Probably as important as the flaws in the static models are the flaws in aggregation - from Keynes to Solow to DGE models, some of the most highly respected theory and modeling has used fantastic aggregation that would seem ridiculous to a child, and which cannot adequately address institutional structures or behavioral responses to them. Are we still too dependent on aggregation without microfoundations?

Assuming for the moment we have indeed learned our lessons and rid ourselves of these fallacies, it would still be very useful to go over this bit of history, cleanse ourselves of our past and explore the way that these lessons have been incorporated into our current models. It seems to me that any science which believed a falsehood for a long period needs this kind of cleansing, needs to face its own past and take some time to explicitly re-think its models.

Really grasping the mistakes of the past is the best way to ensure they are not repeated. Understanding the way in which the flaws in past models fooled past economists into thinking that socialism could triumph will prevent those today who want to simplify from making the same errors in simplification in new forms. We may think we know the obvious: institutions, institutions, institutions. But what of static models - when can they be used safely? What of aggregation, still used so much in dynamic modeling today, when can it backfire badly? What other lessons can we extract from this long period of darkness in economic science?

Stiglitz on Socialism

I'm flipping through Stiglitz's Whither Socialism, which I've not read before, and finding many interesting thoughts to chew on.

Many of these are of course old news by 1989 when he wrote this, (but not conceded by all economists!), and some are not correct but still interesting. He seems to be a thought provoking guy with some very insightful arguments and connections. He also packs a lot into a short space, and keeps it very readable.

1. Futures Markets: the perfect competition model, which Stiglitz admits is too flawed to inform the choice between markets and socialism, assumes a complete set of markets including the ability for markets to allocate investment efficiently.

But investment into the future requires futures markets, which many sectors don't have. "These futures markets are essential for making the correct investments allocations." He goes on to argue that they must extend infinitely -- of course this would only be in order to be as efficient as a planner with complete and perfect knowledge, so it seems to be a weak argument. p. 16

2. On Austrian methodology:

My concerns are two-fold: First, because Hayek (and his followers) failed to develop formal models of the market process, it is not possible to assess claims concerning the efficiency of that process, and second (and relatedly), in the absence of such modeling, it is not possible to address the central issue of concern here, the mix and design of public and private activities, including alternative forms of regulations (alternative "rules of the game" that the government might establish) and the advantages of alternative policies toward decentralization-centralization.

p. 25

3. Stiglitz does as well as Hayek showing the paradox of perfect competition assumptions, such as complete markets and perfect information (or "informed" markets), see e.g. p. 38

4. Stiglitz points to the incentive/calculation problem of using targets which specify output not according to profit, but according to a single measurement that so plagued socialist economies, calling it the problem of not fully specifying commodity prices. p. 85

He points to this later as a way in which planning failed in precisely the way that the neoclassical model failed, when he invokes the planners inability to specify commodities as creating "an incomplete set of markets" and concludes that it is "one of the reasons that the neoclassical model fails" and "Exactly the same set of factors are at work in explaining why socialism fails." p. 198-99

5. The theory of contests as a replacement for perfect competition-- isn't this very similar to the Austrian concept of competition as a driving force (Kirzner) or a market process (Mises)? Although he finds some areas in which he believes competition can be destructive, he indicates that the active role of the competitive driving force of competition is crucial to its ability to induce innovation, cost minimization, and improving quality. Hence he finds "not only that the ordinary usage of the term competition is not well reflected in the traditional economic paradigm of 'perfect competition' but that the traditional perfect competition model may give us only limited insights into the roles that competition plays." p. 115

And so much more!!

As a side note, he also speaks on such interesting topics as short term incentives when firm managers care about short run stock market valuation (p. 96); rent-seeking to get around patents (p. 129), and lots else not so directly related to comparative systems.

Austrians should look to Stiglitz for good insight, especially, I think, when he looks at socialism.