Tag Archives: review

Practical social welfare

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I just finished (re-)reading Amartya Sen’s Collective Choice and Social Welfare. The parenthesis isn’t because I can’t remember but because the original 1970 book has been republished with a chunky new section. It isn’t an easy read, even with the corralling of the technical proofs into alternate, starred chapters. Sen addresses the dilemma raised by Arrow’s impossibility theorem and the wider family of impossibility results, which state that a few totally reasonable-seeming assumptions about principles of social choice end up with no decision rule able to satisfy them. The technical language is that between them the assumptions – transitivity, independence of irrelevant alternatives, unrestricted domain, the Pareto (or unanimity) principle, and non-dictatorship – leave a null set. I’ve always thought of it in the shorthand of there being unavoidable conflicts/trade-offs/dilemmas in social choice. Sen shows that for many social choice questions, the assumptions are too restrictive. ‘Unrestricted domain’ means throwing away relevant information; the Pareto condition forbids interpersonal comparisons such as between the rich and the poor. He argues that welfare economics has been impoverished by the Lional Robbins diktat that interpersonal comparisons could not be permitted: it is bizarre that the subject has had so little to say about the distribution of resources and incomes, self-hamstrung for decades.

The additional chapters extend the original and present in a more rigorous manner some of the material in Sen’s The Idea of Justice. There’s a timely chapter on democracy: “Given the mixed bag of results that we can actually get from majoritarian democracy, its defence, important as it is, needs to be seriously supplmented by probing scrutiny of its limits and conditionality.” This written after last November’s US Presidential election.

Not a book for the general reader – The Idea of Justice is a better presentation of Sen’s important work for that audience. But economists should have read Collective Choice and Social Welfare, especially those working on or in public policy. For all its logical abstractions, this is a very practical book.818GkIguxCL

Economy and society

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It’s fair to say the average economist doesn’t pay much attention to sociologists, but to the extent that (s)he does, Mark Granovetter will be a familiar name. His concept of the distinct roles of ‘strong’ and ‘weak’ ties has become widely-cited in the economics literature. Now Granovetter, a Professor of Sociology at Stanford, has published a new book – intended as the first of two volumes – aiming at a synthesis of his views on how the economy and society are enmeshed with each other (it’s out in 2 weeks, can be pre-ordered now)

. Society and Economy: Framework and Principles, sets out at a high level of abstraction definitions and relationships between concepts such as trust, power, norms, values, as they relate to economic decisions and actions.

The book starts out by quite fairly skewering the ‘Just So’ character of some economists’ uses of sociological concepts to explain how economic norms or institutions have come about. The book suggests that if economics wants to use a concept such as ‘social norm’, then it must engage with questions of how norms come about, which will involve cognition and emotion and social relations. Economics has of course started to dabble in psychology with the ‘behavioural’ revolution, but in the limited sense of simply noting behavioural regularities. Here Granovetter echoes Daniel Hausman (Preference, Value, Choice and Welfare) in arguing that it “does not seem a good recipe for scientific progress” to claim that how people reach economic decisions, or how groups settle on social norms, is simply outside the domain of economics.

If this seems a bit high-fallutin, just consider how much influence social norms have on outcomes. In the 1970s, for corporate executives to pay themselves many hundreds of times what they paid their average employee lay outside the ‘moral economy’ of the times; within a generation that norm had shifted entirely. Surely it is important for economists to understand how that came about?

The book has a particularly interesting chapter on trust, which notes that the outcome of trusting behaviour can arise for different reasons. Granovetter argues that many researchers define trust narrowly to be trust due to their favourite reason, whether that’s an internal psychological state, or an expectation of reciprocal behaviour, or risk-taking with regard to others’ behaviour for some expected benefit.

The promised second volume will apply the concepts defined and analysed in this first volume to specific topics such as corporate governance, organisational forms, and corruption. That’s something to look forward to – this first volume is pretty abstract as it concerns definitions and methodological debates in the literature. Still, the challenge to economists is a fair one, I think. We don’t all have to become competent psychologists or sociologists, but I agree that somehow economics does have to take up the methodological challenge of making sure our borrowing of concepts such as trust or norms is meaningful.

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Global (Dis)order

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I’ve been on a run of reading history books, and am about to finish Adam Tooze’s The Deluge: The Great War, America, and the Remaking of the Global Order 1916-1931. It’s beyond my professional competence to review properly, in the sense that the book clearly has a distinctive perspective on the way Woodrow Wilson used America’s financial lifeline during and after the war, and the Treaty of Versailles negotiations, to shape the impending American Century. My guess is some historians would disagree about how purposeful this exercise of financial power was. Nevertheless, to the non-expert reader, this is a brilliant and compelling book – above all for taking a global perspective. I particularly liked the inclusion of substantial sections on Japan and China, and on India and the seeds of collapse of the British Empire. It is easy for a west European to forget for example the role of Japan in Siberia, and to concentrate on Russia’s western borders.

91HjfjpIRfLThere are also illuminating perspectives on the impact of the war on America itself, including the deployment of the new Federal Reserve Board and the governance of the US economy. Tooze points out that before Wilson committed to support the Entente, substantial private finance had been directed to the war effort: “Through the private business contacts of JP Morgan, supported by the business and political elite of the American Northeast, the Entente was carrying out the mobilization of a large part of the US economy, entirely without the say-so of the Wilson Administration.” When the US officially entered the war, the state’s role in the management of capitalism expanded greatly, only to be firmly contained again in the post-war era. It is often forgotten how severe the post WW1 recession was, even in the US – Tooze underlines its impact on the inter-war order. (Another book that focuses on this event, in a fascinating albeit maverick interpretation, is James Grant’s The Forgotten Depression)

Another very interesting thread running through The Deluge, at least for economists whose only perspective to date comes from Keynes’s famous The Economic Consequences of the Peace, is Tooze’s argument that Keynes’s polemic was a distortion of the truth. Tooze argues, contra Keynes, that the Germans tricked the Entente into the armistice, rather than the other way round. He agrees that the book reflected widespread disillusion with the Treaty, but also contributed to its loss of legitimacy and “helped to further poison the atmosphere between London and Paris.” It might not even have helped Germany, Tooze suggests: “A good faith effort to honour the Treaty, even if it had fallen short, might well have steered the Weimar Republic away from the ruinous crisis of 1923.” Furthermore, Keynes painted the alternative financial settlement he suggested as “an entirely novel idea, a great opportunity that had been missed at Versailles,” knowing well (as he had been there) that it was discussed at Versailles and rejected by Wilson (not Clemenceau). For if there had been greater generosity toward the Germans, the British and French would have had to seek debt write-offs from the US. “The result was grossly to misrepresent the politics of the peace making process,” Tooze concludes.

As it happens, I was (nearly) finishing the book at the Trianon Palace hotel in Versailles where the treaty was signed. Another fine historian, Margaret McMillan (The War That Ended Peace and Peacemakers) was attending the same conference. Here she is in front of the commemorative plaque.IMG_3905

 

When Michael Lewis came to dinner

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That Michael Lewis came to dinner at our house once. This was about 30 years ago, when he was dating a friend of mine for a while, and before Liar’s Poker made him famous. He was charming – working in finance – but if only I’d known who he’d turn into, I’d have quizzed him closely about his stellar writing technique.

I’ve just devoured The Undoing Project, his much-trailed book about Daniel Kahneman and Amos Tversky, and their launching of the behavioural revolution in economics, over two evenings. It’s a wonderful book. I heartily recommend it as a Christmas gift for the economists in your life, or a treat for yourself over the holiday.

The book weaves together the personal and intellectual biographies of its protagonists. It explains the ideas, including the paradoxes requiring one to think about probabilities, beautifully clearly. It’s also just a terrific human story about an intense creative friendship as it flowed, and ebbed, over the decades and continents. If they’re not always totally likeable, the two characters are always immensely sympathetic.

It will surely send many readers on to Kahneman’s Thinking Fast and Slow, which requires some mental effort but everybody who fancies themselves an intelligent, educated person ought to have read. Although I’ve read loads of behavioural economics books and papers, and so think I know about a lot of the insights the literature has given us about how our decision-making processes function, there were still some new (to me) ones in The Undoing Project. These are two I found. Tversky had a rule that you must wait a day before replying to any invitation, even one you wanted to accept. It becoms much easier to decline the ones you don’t want. This is advice I definitely need to follow.

The other comes from thinking about reversion to the mean. An exceptionally (beyond average) good or bad performance is usually followed by one that is less good or less bad (closer to average).  Yet coaches and teachers and bosses often hold that if you praise someone for doing well, they do less well next time, and if you shout at someone for doing badly, they do better next time.  “Because we tend to reward others when they do well and punish them when they do badly, and because there is regression to the mean, it is part of the human condition that we are statistically punished for rewarding others and rewarded for punishing them,” wrote Kahneman. This strikes me as profound and something one ought to act on.

It was surprising to learn that at the height of his fame, in the years before his death, Tversky was bugged by the criticism of their work by Gerd Gigerenzer. I’ve never seen Gigernenzer’s argument that heuristic rules of thumb were rational because they economized on brain energy as a fundamental attack on Kahneman and Tversky, more an extension. There’s surely loads still to be discovered about decision making (especially under uncertainty), not least when decisions are conventionally ‘rational’ versus when ‘behavioural’ behaviour kicks in.

As economics is all about decision-making in the domain of resource use and allocation, this overlap with psychology and cognitive science is an exciting area – even though I’m deeply uneasy about the eagerness with which some economists and policy makers are leaping to adopt ‘nudges’ as another handy tool for social engineers to get the people to behave as they ought. We certainly ought to be teaching this at A level and in universities. The Undoing Project is a great book to introduce behavioural economics – and a cracking good story, told by a master.

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Rescuing macroeconomics?

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It’s always with great diffidence that I write about macroeconomics. Although I’m in good company in being sceptical about much of macro (see this roundup from Bruegel and this view from Noah Smith, for instance), I’m all too well aware of the limits of my knowledge. So with that warning, here’s what I made of Roger Farmer’s very interesting new book, Prosperity for All: How To Prevent Financial Crises.

The book starts with his critique of conventional DSGE real business cycle and also New Keynesian models. Farmer rightly dismisses the idea that it’s ok to mangle the data through a Hodrick-Prescott filter and ‘calibrate’ the model, as in the real business cycle approach. But he also has a chapter criticising the (now) more conventional New Keynesian models. He writes, “Macroeconomics has taken the wrong path. The error has nothing to do with classical versus New Keynesian approaches. It is a more fundamental error that pervades both.” This is the idea that there is an ultimate full employment equilibrium. Echoing Paul Romer‘s recent broadside, he describes both as phlogiston theory. Echoing a number of others, he describes New Keynesian models as being like Ptolemaic astronomy, adding more and more complexity in a desperate and degenerate attempt to keep the theory roughly aligned to evidence.

The book demolishes the idea that there is a natural rate of unemployment (and thus also the idea of the output gap). Farmer argues that there are multiple possible outcomes and unemployment in many of these will persist in equilibrium. His alternative model – also a DSGE approach – replaces the New Keynesian Phillips Curve with a ‘belief function’, assuming that beliefs about future expected (nominal) output growth equal current realized growth.

It seems obvious to me that this approach is preferable to the New Keynesian and certainly RBC models, although this obviousness is rooted in my intuition – of course unepmloyment can persist and there can be multiple equilibria, duh! However, some things about it are less appealing. Above all, Farmer’s assumption that consumption is a function of wealth, not income. He replaces the conventional consumption function with one more purely related to the Permanent Income Hypothesis. This troubles me, although not because I disagree  with his view that the conventional Keynesian consumption function and multiplier are inconsistent with macro data. However, I thought the permanent income hypothesis sat badly with the data also, as it implies more consumption smoothing than is observed. It seems incredible too that many people look forward very far in determining their consumption level even if they do note and respond to asset price changes. Besides, most people have low net wealth – indeed, 26% of Britons have negative net financial wealth.

As the book points out, this change of assumption, and the role of the belief function, have strong policy implications. The debate about austerity, which is in effect an argument about the size of the multiplier (which we don’t know), is a distraction: higher government deficits will not shift the economy to a lower unemployment equilibrium. Instead, Farmer advocates a policy using the composition of the central bank balance sheet to manage asset markets and thus the level of output, and beliefs, through wealth effects (rather than including asset price inflation in an inflation target, as some have advocated). Balance sheet policies are effective because financial markets are incomplete: future generations cannot trade now; parents canot leave negative bequests.

This is a policy debate I’ll be leaving to those who are more knowledgeable than me – although of course those who know what they’re talking about will also have their own horses they’re backing in the race. It is striking that these macro debates rage around the same small amount of data, which is insufficient to identify any of the models people are battling over. In his excellent book about forecasting, The Signal and the Noise, Nate Silver pointed out that weather forecasters reacted to weaknesses in their models and forecasts by gathering many more data points – more observatories, more frequent collection. I see macroeconomists downloading the same data over and over again, and also ignoring the kinds of data issues (such as the effects of temporal aggregation) that time series econometricians like David Giles point out. So something like the David Hendry model-free approach, as set out in his recent paper, seems the best we can do for now.

My reservations should not stop anybody from reading Prosperity for All. It is an accessible read – undergraduate and maybe even A level students could cope with this  – and the model is available at www.rogerfarmer.com. I’d like to have seen some discussion of non-US data, and also structural change/non-stationarity. It’s also a short book, and as a macro-ignoramus I’d have liked some sections to be explained more fully. But these are quibbles. This is an important contribution to the debate about macroeconomics, and it’s an important debate because this is what most citizens think economics is all about, and macro policy has a profound effect on their lives.

I’m keen to read other reviews of the book now. I’m sure Roger is more right than the conventional DSGE approach – but also think the how-to-do macro debate is far from settled. How open-minded are more conventional macroeconomists?

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