The Living Dead: Thoughts on Macro and Depressions

Macro is not my field. One of the reasons it is not my field is that, so far as I can tell, it lacks a theoretical structure as solid or as well supported as price theory—popularly but misleadingly called "Micro." One result is that a course on the subject is a tour of either a cemetery or a construction site.

The cemetery is the orthodox Keynesian account according to which a depression is the result of insufficient demand due to the exhaustion of investment opportunities, monetary policy is useless because the economy is in a liquidity trap, and the proper solution is for the government to run a large deficit, converting the excess savings into government expenditure. That was the accepted wisdom fifty years ago. As best I could judge, as observer not participant, it fell out of favor among academic economists in the ensuing decades, due to both theoretical and empirical problems.

The construction site is the attempt to replace the old orthodoxy. Some of it gets labeled "monetarism," some "neo-keynesianism," some other things. None has been sufficiently successful to have achieved the status of a new orthodoxy.

That is one reason why the old orthodoxy maintained its popularity in popular culture, including that of politicians and journalists. A second is that it provides a justification for large scale deficit financing, something politicians, left and right, are fond of doing whenever they have a plausible excuse. The old orthodoxy reappeared a few years ago in full force, complete with its old claim to be what everyone who knows anything about the subject believes, and was used to justify deficit spending on a scale large even compared to the deficit spending of the previous administration.

Think of it as the rise of the living dead.

All of which leaves open the question of why things went wrong, in the Great Depression and the recent Great Recession, and what should be done to fix them. I do not have a confident answer to those questions, but there is one possible answer which I find at least plausible. It is an explanation not of why a depression or recession starts—that, in the two cases of interest, seems to depend on special circumstances—but on why it is so severe and lasts so long.

The Great Depression of the thirties and the current Great Recession have one feature in common that has not, I think, received sufficient attention—the government response to them. Hoover reacted to the 1929 stock market crash by sharply increasing federal expenditure; by 1932 it was fifty percent higher than in 1929 in nominal terms, twice as high in real terms, three times as high measured as a share of national income. FDR went on to enormously expand the role of government in the economy, creating our modern regulatory state. Obama followed a similar policy on a smaller scale, expanding government involvement (already very large) in the health care and financial industries, bailing out failing firms on a scale I think unparalleled in U.S. history, threatening additional large scale interventions to deal with global warming.

The result, in each case, was to greatly increase the uncertainty of the environment within which private actors were making their decisions. If you do not know what the future is going to be like, there is much to be said for postponing any decision that depends on the future, whether an investment in physical capital or human capital. It is risky to hire new employees if you do not know whether, a few years hence, it will be legal to fire them. It is risky to build a new factory, in any industry where energy is a major cost, if you do not know whether next year's legislation will sharply raise the cost of energy—better to wait to choose your design until you have a clearer idea of what your costs are going to be. It is risky to choose a profession, or change professions, when you do not know whether the growth field is going to be health care or bankruptcy law. Multiply such considerations many fold, and you may have an explanation of why the recovery from the initial shock, in both cases, was so slow.

Arguably, the U.S. economy is suffering from a disease in part iatrogenic. Which may explain why the doctor can't understand what went wrong.


Post Script on Labels. They sound clear enough—micro deals with small things, macro with large. But it isn't true. The world wheat market or the world oil market is properly understood with supply curves, demand curves, conventional analysis of choice over time, and similar "micro" tools. Hence, in my view, the proper labels are "price theory" and "disequilibrium theory." Understanding disequilibrium—loosely speaking, the sort of situation that price theory tells us can't exist but that sometimes does—is a hard problem.

Assuming Your Conclusions

A recent Washington Post news story describing a speech by Christina Romer, the outgoing chairman of the Council of Economic Advisors, provides a nice example of how to implicitly assume your conclusion. The author writes:

At week's end, Romer will leave the council chairmanship after what surely has been the most dismal tenure anybody in that post has had: a loss of nearly 4 million jobs in a year and a half. That's not Romer's fault; the financial collapse occurred before she, and Obama, took office. But she was the president's top economist during a time when the administration consistently underestimated the depth of the economy's troubles - miscalculations that have caused Americans to lose faith in the president and the Democrats.

The implication, reinforced elsewhere in the piece, is that the Democrats did the right thing, just not enough of it. Their only mistake was not making the stimulus even bigger. If only they had spent even more and taxed even less, the economy wouldn't be in such miserable shape.

That is one possible interpretation of what happened. Another is that Romer is like a medieval physician explaining to the grieving relatives that if only he had bled the patient a few more times, he would have recovered. One way to judge a scientific theory is by comparing what it predicts to what happens. One of Romer's predictions was that unemployment would peak at 8%. It didn't. I do not know whether Romer has considered the possibility that the reason her prediction was wrong was that her theory was wrong, but pretty clearly the author of the piece has not.

He merely takes for granted the Keynesian orthodoxy of fifty years ago, according to which the right way of dealing with a recession is to run a deficit, and the worse the recession the bigger the deficit should be. The administration followed that prescription, things didn't get better, so obviously the deficit was not big enough. The alternative possibility, that the reason things didn't get better might be that they were following the wrong policy, simply didn't occur to him.

King Tut, Statistics, and a Pet Peeve

I recently came across a National Geographic article describing the results from DNA analysis of a number of mummies, including King Tut. It was an interesting article, but there was one thing in it that annoyed me. In describing their results, the author said that the DNA analysis showed that there was a 99.9% probability of a particular relationship between two of the mummies.

That statement was false. I know it was false because that sort of analysis cannot produce that sort of result. Like many other people who use statistics without understanding it, the author was confusing the information the statistical analysis produced with the information he wanted it to produce.

A confidence result in classical statistics tells you how likely it is that you would get the result you got if the assumption you were testing was false—more precisely, if a particular alternative assumption, called the null hypothesis, was true. His 99.9% means that if the null hypothesis (presumably that the two mummies were not closely related—the article doesn't say) was true there is no more than a .1% chance that the genetic evidence that they were related would be as good as it is.

Unfortunately for the author of that article and many others, the probability of getting their result if their assumption is false is not the same thing as the probability that their assumption is false, given that they got their result. The latter is what they want, and what the assertion of a 99.9% probability for the relationship claimed. But it wasn't what they got.

To see the difference, consider a much simpler experiment. I pull a coin out of my pocket without looking at it. My theory is that it is a two headed coin; the null hypothesis is that it is a fair coin.

I flip it twice and it comes up heads both times. If it is a fair coin, the probability of that outcome is only 25%. If it is a two headed coin, it's 100%. If the probability of the result given the null assumption was the same thing as the probability of the null assumption given the result, that would mean that the odds were now three to one—75% probability—that the coin was double headed. I don't think so.

Readers interested in what it takes to actually generate a probability estimate for an assumption being true are invited to read up on Bayesian probability.

After writing this post, I discovered that I had mentioned the same point some time back in a different context.

Is Obama a Christian? Is Palin?

There has been a lot of coverage of the fact that, according to at least one report, about 18% of the population believe that Obama is Muslim. I know of no reason to believe they are correct. On the other hand, I find the confident assertion that he is a Christian by most of those commenting on the question somewhat naive.

For an American politician to announce that he was an atheist or agnostic would cost him a lot of votes in a national election. Obama is an ambitious and successful politician. So the fact that, at an early stage in his career, Obama announced that he had become a Christian tells us very little about his actual beliefs.

The same is true of other politicians. Sarah Palin was, I suppose, the most visibly Christian of the four candidates in the most recent presidential election. That may well represent her actual beliefs. But without knowing more than I do about when she first acquired political ambitions and what her life was like before that, I have no way of telling whether she is a devout believer or a competent pretender.

We do have pretty good evidence that neither Obama nor Palin is a Muslim, however. Islam requires of its believers visible actions, such as praying four times a day and fasting during Ramadan. I think someone would have noticed.

Why Don't Universities Sell Admissions?

Or do they?

It would be a mistake for schools, especially elite schools, to allocate places entirely on the basis of price, for at least three reasons.

1. Part of what schools are selling is a credential, and part of that credential comes from having been admitted. An employer prefers, ceteris paribus, employees able enough to have gotten into Harvard or Chicago. He has no reason to prefer ones rich enough to have bought a place at one of those schools.

2. The value to students of attending a school depends in part on the school's reputation, which depends in part on the quality of students admitted in the past. By basing admissions on measures of applicant quality the school may be able to raise average student quality, thus raise the performance of its graduates, thus raise the value of the school to future applicants.

3. Students are both customers and inputs. Smart students prefer an environment with other smart students, and probably learn better in such an environment. Put differently, a smart student provides positive externalities to fellow students and thus, indirectly, to the school, a dumb student provides negative externalities.

All of these explain why schools give some weight to measures of student quality in deciding whom to admit. But none of them explain why they give no weight at all to willingness to pay. A student is worth more to the school the more able he is, but not infinitely more. Even if student quality is the only thing schools care about, additional money could be used to offer more generous scholarships to able students who would otherwise go elsewhere, raising average quality. So one would expect schools to be willing to trade off, at some rate, money against SAT scores, agreeing to admit somewhat less qualified applicants at somewhat higher prices.

So far as I can tell, they do not do so. The reason might be internal ideology—elite schools for the most part are rich nonprofits, in a position to sacrifice financial benefits in order to act in ways that those running them approve of. It might be other people's ideology—schools may fear that the policy I have suggested would be seen as a corrupt favoring of the undeserving rich over the deserving poor. While everyone recognizes that wealth confers advantages on those who have it, many people find that fact objectionable, at least if the advantages are in things they think important, such as health care or education.

Both of those are, I think, plausible explanations, but not very interesting ones. Can anyone suggest a better alternative?

While discussing admission policies, it is worth also thinking about another puzzle: legacy admissions. While schools do not preferentially admit those who are willing to pay more—many claim, I suspect truthfully, that they do not even preferentially admit those able to pay full tuition over those who can only come if given large amounts of financial aid—many do preferentially admit the children of their alumni.

One possible explanation connects to the first part of this post. Legacy admissions can be seen as a covert and imperfect way of doing what I have just argued that schools do not do. Applicants are instructed to list on their applications any alumni among their close relatives. Alumni offices keep track of alumni donations; that information can be provided to admissions officers.

Are there other reasons for legacy admissions? One possibility is that the school thinks of itself as having a particular culture, being intended for a particular sort of people. Its alumni, having been not only selected to fit into that culture but instructed for four years in it, are particularly likely to be that sort of people, making their children more likely to fit in.

Another possibility is tribalism. Humans tend to divide the social world into ingroup and outgroup, us and them. One basis for such a division is what school one went to, a fact dramatically demonstrated at college football games. The people running a school and its almuni are part of the same ingroup, admission can be seen as a benefit given to those admitted, and people naturally prefer to allocate benefits to us instead of to them. They also prefer to include in the ingroup those most likely to be loyal to it. If Harvard admits the son of a Yale graduate, can he be trusted to cheer for the right team?

Other explanations?

My Arguments on other People's Blogs

I've been arguing about the meaning of Adam Smith's invisible hand on one blog and about whether it is obviously wrong for people such as orthodox Jews or Amish to bring criminal charges to their own authorities before reporting them to the police on another. Some readers may find one or both argument of interest.

Great Comment on Public Schooling

" This is probably because they interact socially with a far less age-segregated set of people (our public school system is really quite unique, and profoundly unnatural that way, it is as if someone read Lord of the Flies and decided it was prescriptive rather than descriptive)."

(Jehu, on Robin Hanson's blog, commenting on why he finds home schooled children much more likable than public school children)

Eggs: An English Lesson

The recent egg recalls have raised the issue of whether the FDA should require farmers to vaccinate their hens against salmonella, something it has so far declined to do. Thus the NYT writes:

Faced with a crisis more than a decade ago in which thousands of people were sickened from salmonella in infected eggs, farmers in Britain began vaccinating their hens against the bacteria. That simple but decisive step virtually wiped out the health threat.

But when American regulators created new egg safety rules that went into effect last month, they declared that there was not enough evidence to conclude that vaccinating hens against salmonella would prevent people from getting sick. The Food and Drug Administration decided not to mandate vaccination of hens — a precaution that would cost less than a penny per a dozen eggs.

The obvious implication is that the U.S. ought to imitate a wise British decision and require vaccination. Further down in the article, however, we discover that:

There are no laws mandating vaccination in Britain. But it is required, along with other safety measures, if farmers want to place an industry-sponsored red lion stamp on their eggs, which shows they have met basic standards. The country’s major supermarkets buy only eggs with the lion seal, so vaccination is practiced by 90 percent of egg producers, ...

Or in other words, Britain's success in drastically reducing the number of salmonella case is due not to regulation but to voluntary private action driven by market pressure.

Economics of Language and Courtesy

Someone commenting on my previous post mentioned the Gricean maxim of relevance. Checking the Wikipedia article on the Gricean maxims, I find the interesting comment that:

“Although Grice presented them in the form of guidelines for how to communicate successfully, I think they are better construed as presumptions about utterances, presumptions that we as listeners rely on and as speakers exploit.” (Bach 2005).

The maxims can thus be seen as an application of the economic approach to understanding behavior—the assumption that individuals have objectives and tend to choose the best way of achieving them. The objective is communication, the maxims describe how best to do it, and a listener dealing with potential ambiguity in speech—for example ambiguity in the meaning of “most”—can sometimes resolve it by assuming that the speaker is using the word with a meaning that achieves that objective. Where what is relevant is which candidate won an election, “most” is likely to mean a majority or even a plurality: “The party that got most votes was …”. Where what is relevant is whether there is a substantial minority for whom a statement is not true, “most” is likely to mean an overwhelming majority: “Most of my students understand English, so there is no need to provide translations of the readings into other languages.”

For a second application of economics, consider a scenario offered by a friend in a recent conversation on courtesy. Someone cuts into the checkout line ahead of you. One possible response is to accuse him of cutting into line. An alternative is to point out to him where the end of the line is, with the implication that he merely made a mistake.

My objective is to get him to go back to the end of the line, getting me through a little faster, and to do it with a minimum of unpleasantness. By treating his act as a mistake I lower the cost to him of doing what I want, since doing so does not require him to implicitly confess a deliberate violation of local norms. Lowering the cost to him of doing what I want makes him more likely to do it. What my friend regarded as behavior due to courtesy appears to me as a simple application of economics.

One can carry the argument one step further. If, instead of offering the norm violator an easy out, I loudly upbraid him, he will be less likely to quietly concede his error . But, since I will have raised the cost to him of cutting into line, he may be less likely to do it again. If my objective were the general good rather than my own private good, that might be the sensible choice, deterring future offenses against other people at some cost in current unpleasantness. In my friend’s view, the reason to be courteous was the benevolent desire to maintain social harmony. But courtesy, at least in this case, causes me to sacrifice the general good for my private good—precisely the behavior that economics predicts.