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.

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.

Learning and Bureaucracy

The market is an evolutionary process, in which selection forces actors to learn, and price conveys the information necessary for that learning. The pressure on the individual to innovate (or face losses) is not a pressure applied strictly to firm owners and managers- it is also applied to workers and job-seekers.

The Iraqi band Acrassicauda recently acquired refugee status and settled into a nice New Jersey metal band lifestyle. One of them explained their prior training and conditioning:

“We’re good at process,” said Mr. Riyadh, 24, who has previously used the name Marwan Hussain. “Going to the U.N.H.C.R.,” he said, referring to the United Nations High Commissioner for Refugees, “standing in a queue for three or four hours. We’re good at that. But musically, we need to practice.”

This reminded me of what Irina Pantaeva said of her training in Soviet Russia:

Neither of us knew how the fashion business worked in the West. That models carry thick books full of glossy pictures, and that they made appointments and worked with agents. We knew only what we had learned in Russia: if you want something, go to where it is and be prepared to wait.

In a bureaucratic country or system, there is no pressure applied that can force the individual to work, learn, innovate, or generally train themselves. Instead, they learn to wait on lines, fill out paperwork, and ask others for handouts. Expect a lot more of this kind of learning as government continues to rapidly grow, and a lot less innovation and new technology.

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?

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?

Planning Insights from a Non-Austrian

An interesting article in the QJE from 1964 offers some nice non-Austrian insights into the problems of central planning, by looking at problems of large organizations , be they large firms or governments, and their bureaucracy.

The first insight is in this nice paragraph, imagine yourself standing in a central statistical bureau of the government - or maybe the Fed - trying to work out how to save an ailing economy:

Statistics at the center must lose cognizance of individual psychologies, attitudes, and tendencies that are too detailed, amorphous or untactful to put into summary reports, but that can be thoroughly useful in decisions. The central staff live in the midst of aggregates, trends, averages, and over-all generalizations. They are remote from the individual reality behind the words and figures that flow and jumble over their desks. They are dealing with symbols: their input is items on paper, and their output is items on paper. The individual is expendible-- both to the American Telephone and Telegraph and to the Soviet Union.

(my emphasis)

Of course, if AT&T deals with you that way, you, hopefully, can find another phone company (so long as government hasn't given them a monopoly). The point about aggregates goes deeper than is made clear here. In particular, aggregates cannot tell you the micro-level reasons for problems with coordination and growth, and macro-level targets cannot aid individuals in the coordination necessary for growth, to reach those targets.

Another good paragraph is this one. Think of Obama's community service projects and call to the spirit of "public service". Hopefully the insight is well known, if often forgotten:

Conventional wisdom in most communities of the world approves of harnessing the "highest motives," rather than the strongest motives, to achieve social goals. Down-grading the profit motive (discussed above) is only one example. Public exhortation and praise are focused on community service, mutual help traditions, and cooperate ventures. Looking after oneself, and one's own family, earns no special applause. But economic efficiency and progress mainly depend, as Alfred Marshall advises us, on making effective use of the strongest, and not necessarily the highest, motives of mankind.

He then cites Khrushchev who tried to invoke Lenin, when he realized the need for profit motive, and stressed to the people "the exceptional importance of the Leninist principle of material incentives," explaining that "It is completely erroneous to oppose material stimuli to moral ones, material incentives to ideological-education work..." -- Indeed, Adam Smith couldn't have said it better.

The two points come together when the author then goes on to discuss corruption. The author makes the important point that planners can only make decrees, they cannot set up institutions that allow the actors to fulfill the goals by following their own strongest motives. If they did the latter, they would not be planning, but providing an environment for free choice -- a market. Instead the planner must use command, which cannot ensure the target is met, but just direct the actions of the individuals. If the actions won't produce the desired ends of the individual, he may break the law, making the results unreliable. If he follows the law from fear, but knowing it won't achieve the ends, the plan won't be fulfilled.

To the extent a central authority relies on incentives-- income, status, etc-- to get work done, it is trying to make the public interest and private interest coincide. To the extent it relies on regulations or laws -- backed in the case of government by police, courts, and army -- it is forcing people to do, in the purported general interest, what they would otherwise not do. That is, giving incentive to avoidance, evasion and corruption.

On the point of corruption, the author also wins my heart with this footnote about how the more laws imposed, the more are broken, creating a social acceptance of violation of law:

It seems plausible to estimate that the average respectable citizen in the United States breaks at least one law a day (for example, did he come to a complete stop at the last stop sign?), whereas in 1800 it is doubtful whether his predecessor broke one law a year (did he murder or steal last year?).

Thank you-- still respectable even if I get fined for California stopping.

Universal versus Quantitative

Economic Laws are universal. As Mises explained, contra Caplan, because supply and demand laws - marginal utility, preferring more at a lower price - are universal, it isn't a quantitative matter but a qualitative matter that maximizing output is better achieved with a free market solution. For the given ends (maximizing output), the best means are to allow the free market to work rather than intervene.

However, while this means that markets are better than socialism, does this mean all interventions are bad? Clearly the qualitative result - the end is better achieved with markets than socialism - is true. But how much better? That is the quantitative question. The answer is clear at the system level: a lot better. But, at the intervention level, one must weigh the objectives.

If the objective of a given intervention is only to maximize output, one need not ask the quantitative question: the market will better serve. But, if one has multiple ends: (1) raise the wages of the poorest worker (2) without reducing total output by very much, then the quantitative question surfaces. For, even if the only end is to increase the wages of the poorest worker, there is a time component, and total output will ultimately lead to lower wages in the long run for the poorest worker (if higher output over time leads to higher real wages of the poorest worker, over time).

This is where the Krugmans and Card & Kreugers (and Galbraiths, who dispute the condition) like to fight. Maybe the quantitative aspect isn't large enough to offset the first round effect of the command benefit. When they argue this line, some turn to "natural rights" arguments: it isn't right to command benefits. But an economist must look at the quantitative aspect of the universal truth, and weigh the losses against the benefits. How does total output respond? How does the universal rule of competitive wage setting and profit maximization induce the employer to respond to command wage hikes? How will the benefit accrue - will it at all? To whom will it go?

And hence economics becomes difficult, and dynamic, quantitative and empirical analysis is required. Hat tips to Mises, Caplan and the struggling economists on both sides.