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Saturday, April 4, 2015

Macroeconomics = Fallacy of Composition


I am teaching an introductory macroeconomics course for graduates this semester at the University of Queensland. Coming up is soon is the AD-AS model and I must say, I’m having a hard time generating useful tutorial questions for my students.

The illogical contrivances required to interpret any real economic events in terms of the model is almost laughable. I have asked a number of experienced teachers of macro in the school to explain the model to me in an internally consistent way. It turns out that most economic professors don’t have grasp of what aspects of the macroeconomy the model in meant to be capturing. None could explain what the concept of the price level in the aggregate even is, nor what mechanism was meant to be at play in generating the relationship between price level and output. If anything I learnt that I should use the curves to support some kind of Keynesian story-telling exercise.

What kind of serious intellectual could be happy with this situation? Is this the way we pass on our discipline’s knowledge to the next generation?

So far my tutorials are looking quite different from your typical introduction to the AD-AS model. More like an introduction to defending oneself against the claptrap sprouted by many economists.

Perhaps we may soon leave this nonsense out of economic teaching altogether. Here's my compromise for the time being.

Question 1

What is the fallacy of composition?

Create a list of phrases, sentences or paragraphs from the description of the AD-AS model in Chapter 10 of the textbook that commit the fallacy of composition.

Additional reading material is here, here, here, and here.

Discussion

A common definition for the Fallacy of Composition is
the fallacy of inferring that a property of parts or members of a whole is also a property of the whole
In terms of the study of macroeconomics this is of particular interest, since we are trying to take lessons from the behaviours of individuals and determine the likely aggregate response in the economy as a whole.

Here are some examples from Chapter 10, though many others may be included.


1. The aggregate demand curve shows the relationship between the price level and the quantity of real GDP demanded by households (p268). 



The AD curve is downward sloping because a fall in the price level increases the quantity of real GDP demanded (p268)




The fallacy at play here is that there is an aggregate price level. As we saw in Chapter 8 on Inflation, price levels are not absolute but relative to some base year. In the economy as a whole there is no external price from which to determine a price level. Hence the idea of an economy-wide price level is in a given time period is a fallacy. 

Often the AD-AS model is interpreted as showing Real GDP related to the rate of inflation in a period (not the level, but the rate of change of price levels relative to a base year). This overcomes the fallacy of composition because it compares the price level with last year’s price level, but contradicts earlier discussions about anticipated vs unanticipated inflation. If inflation is anticipated at any reasonable level then there should be no economic effect, and hence no relationship (no curve, or a vertical line at best).


2. As income rises consumption will rise, and as income falls, consumption will fall (p269)



In aggregate the total consumption (or demand) in the economy is equal to the total incomes in the economy be definition, since someone’s consumption is somebody else’s income. This sentence, allowing from proper aggregation that avoids the fallacy of composition, merely says that aggregate incomes and consumption just rise and fall together since they are equal at any point in time by definition. 



3. When prices rise, households and firms need more funds to finance buying and selling. Therefore when the price level rises, household and firms try to increase the amount of funds they hold by withdrawing from banks, borrowing from banks or selling financial assets, such as bonds. These actions tend to drive up the interest rate charged on bank loans and the interest rate on bonds. (p269)



First, if all prices rise then households and firms also have more income, since wages and profits are also prices in the economy. 



Second, as we discussed in Chapter 4, Measuring GDP, transfers of financial assets are not included in gross value added because they are mere transfers between on individual and another. Hence, a household selling financial assets requires another household to buy those financial assets leading to no net change in the aggregate ability of households to spend on current consumption. 



Third, if these actions have no aggregate affect by their own definitions it seems implausible that there will be aggregate affects on interest-rates (another price) set in the economy.



The end of the paragraph goes on to admit that it just committed the fallacy of composition when it says


The impact of the price level on investment is known as the interest-rate effect, and is a second reason why the AD curve is downward sloping. However there is caveat to this explanation. Lenders to banks and other financial institutions - people with savings are lenders - will have their wealth increased as the interest rate rises, and will increase their consumption spending. 


Essentially this contradicts all that went before it. In addition, the wealth effect on savers is incorrect in general (higher interest rates decrease the value of financial assets, not increase it).


4. Table 10.1, government purchases and tax effect on AD curve (p272).



The second and third rows in Table 10.1 show; 1) the effect of an increase in government purchases on, 2) the effect of an increase in government taxation. If the economy is at equilibrium prior to and after either of these changes then by definition one effect must counteract the other - the shift of the AD curve from an increase in government purchases must be accompanied by an equal and opposite shift from an increase in taxation. 


5. Because changes in the price level do not affect the number of workers, the capital stock or technology, in the long run changes in the price level do not affect the level of real GDP (p275).



This contradicts all that went before it, and relies on an undefined notion of the short and long run. How can there simultaneously be both an effect and no effect?


6. The main reason firms are willing to supply more goods and services as the price level rises is that, as prices of final goods and services rise, prices of inputs - such as wages of workers to the price of natural resources - rise more slowly. Profits rise when the prices of the goods and services firms sell rise more rapidly than the prices they pay for inputs (p276).



Here we see the fallacy of composition result in many confusing comments. First, the inputs of one firm are the outputs of another firm, hence in aggregate input and output prices cannot differ systematically.

Friday, March 27, 2015

Uncertainty and morality in a dynamic economics

Ignorance of the distinction between risk and uncertainty lies at the heart of many economic conundrums, particularly dynamic behaviours through time. Yet the critical importance of this distinction in predicting economic behaviour was clear to prominent economists of the 1930s, including Shackle and Knight. Knight wrote that
... that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
Economists have now forgotten that a world of uncertainty generates a strong incentive to delay choices. We do not make immediate choices informed by the some probabilistic expectation of future outcomes. We usually can’t even know the potential scope of future outcomes. That means we delay choices to keep options alive, miss good opportunities, and sometimes commit to poor investments. Because time is irreversible, unlike in economic models, when we commit to decisions matters as well as the decisions themselves.


But the ignorance of uncertainty is evident in other social sciences as well. Approaching problems in philosophy and ethics without acknowledging uncertainty has lead to many seemingly intractable puzzles that are easily resolved in a world of uncertainty.

I hope that observing the crucial role uncertainty plays in these contexts encourages economists to take the concept more seriously and see the economy as a dynamic environment, rather than a static one.

In ethics, the Trolley Problem has occupied the minds of philosophers for decades. In its simplest example the puzzle is as follows.

In Scenario A a trolley is barreling down the tacks toward five people who will be killed unless the trolley is stopped. Luckily, there is a fork in the tracks, and by simply pulling a lever, the trolley can be diverted onto a second set of tracks. Unfortunately there is a single person in the path of the tolled on this track who will be killed if you pull the lever.


The dilemma is whether you should pull the lever and save five people by sacrificing one? In surveys most people say they would.

In Scenario B you find yourself on a bridge next to a fat man where below the same dilemma is playing out, with a trolley hurtling down the tracks towards five people. The question here is whether it is permissible to pushing the person next to you onto the tracks if you knew it would  stop the trolley and save the five people.

Most people in this scenario would not push the man off the bridge, even though the same welfare gains in terms of lives saved would be the same as Scenario A (so you know, 68.2% of philosophers would push the man to save the five). Some philosophers and psychologists put this down to a ‘dual-process’ theory and for some reason that two different setups invoke "the operations of at least two distinct psychological/neural systems".

Fundamentally the incompatibility of these two outcomes arises because we are presented with a dilemma in terms of risk, or knowable probabilities. In fact we have point distributions at perfect certainty for each outcome. You push the fat man off the bridge (assuming away the logical problem that a man fat enough to stop a runaway trolley is somehow easily able to be pushed off a bridge) you have a probability of 1 that the man will die and the trolley will be stopped. If you don’t, you have probability 1 that the five people on the tracks will be killed.

When you add risk by looking at possible probability distributions of choice outcomes you can generate the a balance of risks that predicts survey responses. This is a step in the right direction, since we know it is very difficult for people to comprehend the idea of perfect certainty. But it still overlooks the dynamic nature of true uncertainty.

Let us now look at the question in terms of uncertainty. For a start, how do we know the trolley is out of control? Is it possible to delay the decision to get more information?

A very simple resolution to arises when we add a time dimension to the problem, which is what is required under uncertainty. We can think in terms of an option-tree expanding over time, with choices unable to be fully anticipated in advance.

We can see in the diagram below that in Scenario A, switching the tracks leads to a new situation that opens up the set of possible choices in the grey shaded area while eliminating others. Switching the trolley onto the side track buys time and keeps options open without killing anyone.


In Scenario B, most people choose not to push the fat man. Here what the are doing is buying time before anyone gets killed. Even after the decision is made not to push the man, there will be time available for many other as-yet-unknowable situations to arise.

People are making choices in a way that allows them to navigate through a choice space over the irreversible dimension of time. I’ve highlighted in red a possible path for each scenario that could be envisages in the mind of somewhat making choices in a world of uncertainty.  In both cases there is an unknowable chance that a resolution to the dilemma will involve no death if the dynamic choices that arise are navigated appropriately. But choosing to push the fat man in Scenario B eliminates the option of resolving the situation without any deaths.

The whole rationale of making decisions in a world of uncertainty revolves around keeping options for desirable outcomes open, and often this involves buying time by not making a decision at all.

We know that buying time to keep an option open is a strong impulse. In experiments where participants are given the choice of which of two identical drowning swimmers to save, knowing they can only save one, many are unable to make the decision in a timely enough manner and instead spend their time searching for better information in the hope of maintain the option of saving both, but in doing so letting them both drown. Because the choice to commit to save one swimmer is associated with a commitment to allow the other to drown, the logical choice is to delay to maintain the option of saving both.

In military training overcoming this instinct to delay choices to keep options open forms a integral part of the psychological training. Soldiers are known to delay making any choice in high-stakes combat dilemmas, what amounts to ‘freezing’, or in many cases they shoot to deter rather than to kill, to keep open the option of finishing a battle with fewer deaths in general.

In criminal behaviour, Becker’s expected utility framework has been called into question due to the radical difference between human behaviour in a world of uncertainty versus a world of risk. Increasing chances of being caught and increasing punishment if caught are substitute methods for changing probability distributions of expected outcomes in a world of risk, but in a world of uncertainty they will have far different effect on criminal decisions.

The same logic of uncertainty can be applied in social psychology to understand the bystander effect. The bystander effect is the label given to the occasionally observed inverse relationship between the number of people witnessing a victim in need, and the number of people offering help. Various reasons for this empirical phenomena have emerged, with the idea of a diffusion of responsibility dominating explanations.

But when we dig a little deeper we can see the logic of uncertainty at play. Repeated experiments on the bystander effect show that the degree of ambiguity is a crucial determinant of the willingness to assist, with reaction times being much slower in the presence of more ambiguous situations. The logic of how ambiguity, or uncertainty, results in the bystander effect is as follows
…most emergencies are, or at least begin as, ambiguous events. As the bystanders are deciding whether an event is an emergency, each bystander looks to the others for guidance before acting.
… Seeing others remain passive causes the bystander to interpret the ambiguous situation as non-serious.
So it is not that anyone does not want to help, but as each person individually chooses to delay their actions to gain new information, they observe others doing the same thing. By observing others they gain the new information that the situation is non-serious, and hence as a group they ultimately choose a path through the choice space over time that resolves to a belief that the situation is a non-emergency.

What happens as people delay choices here is a cascade of new information that changes the decisions of each individual and the group as a whole. In sociology there are many simulation models of these type of choice cascades, from standing ovations, to riots, and other herding behaviour including musical tastes, and crucially for economists, asset market speculation.

Uncertainty is a primarily a concept about choices in a dynamic environment. Here I have shown that human behaviour is adapted to our dynamic irreversible environment, and as such, uncertainty is required to understand behavioural logic, morality, and sociability. Moral puzzles resolve easily in an environment of uncertainty, and many psychological phenomena, from soldiers freezing in battle, to the bystander effect, to our taste in music, can been seen to arise from a result of human tendencies to delay decisions in order to cope with uncertainty.

It is not just economists who have acknowledged that uncertainty is tremendously important, but then later ignored the concept in their analysis. Given the high stakes arising from political choices based on economic analysis, putting uncertainty front and centre in a new dynamic economics is critical.

Wednesday, March 25, 2015

Economics: Blah blah blah

Economic comedian Yoram Bauman translates Mankiw's 10 Principles of Economics in this video. The three macro concepts were immediately translated to blah, blah, blah.

Here I want to improve of his efforts and translate some of the many concepts that seem to mystify all who encounter them. Some readers might not agree. Others might have better suggestions. Let me know in the comments. 

Economic Term
Actual Meaning
Capital
Stuff
Capital
Money
Capital
Control
Money
Debts
Money
Barter
Money
Accounting unit
Money
Medium of exchange
Medium of exchange
Accounting unit
Accounting unit
Credits and debits (‘promise unit’)
Production function 
Recipe
Time
Just kidding, economists don't care about time 
Dynamic 
Static
Equilibrium 
Magic attractive force
Equilibrium 
Current state of the world
Productivity
Unexplained residual
Efficiency
New recipe
Free Markets
Very specific set of government institutions 
Rational 
Ignorant
Stylised fact
Guess
Scientific
Unfalsifiable
Deadweight loss
Difference between a real pudding, and the magic pudding
Structural reform
Non-specific legal change to give rich people more power in the name of efficiency
Imbalances
Why aren’t we in equilibrium?
Competitiveness
Low wages
Growth
Bigger numbers devoid of meaning
Degenerative scientific research programme
Why don’t people agree with me?
Objective
Laden with hidden value judgments
Strategy
Choice
Choice
Decision
Constraint
State of the world
Opportunity cost
What you could be doing instead
Price
Price
Cost
Some other prices
Rent seeking
Buying political favours
Market failure
Real life
Heterodox
Outside the club. Go home.
Pluralist
Pipe dream
Welfare
Happiness
Utility
Mystical element allowing decisions to be made
Incentives
Monetary incentives
Short run
Arbitrary time period that makes the model work
Long run
The end of time itself
Uncertainty
Perfectly known distribution of possible outcomes
Comparative advantage
Started producing it first
Comparative advantage
Was on/under the land when we conquered
Endowment
How rich your parents are
Technology
Error
Institutions
Error
Beliefs
Error
Expectations
Error
Representative agent
One person
Uniform distribution of agents
One person
Rational 
Clairvoyant 
Growth
Error
Land
Capital
Property rights
Unspecified institutional setting
Protection
Covertly transferring money to people you know
Restriction
Someone else covertly transferring money to someone they know
Trivial
Vitally important, but I can’t explain it
AggregationFallacy of composition


Tuesday, March 3, 2015

Coaches’ Calls: Should debt be on the scoreboard?

Guest post by Michael Harris, first published at Medium.
TL;DR version, because it’s long!
  1. There is no reason to think we are nationally living beyond our means at the moment.
  2. There is no “debt and deficit disaster.”
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations).
  4. It’s the real things that finally matter.
Also: why government budgets are not like household budgets (fallacy of composition; infinity; and printing presses).
1. The scoreboard

On a recent episode of the ABC’s panel show Q&A, radio announcer and former rugby coach Alan Jones declared that “there is a golden rule in sport. You look at the scoreboard. The Labor Party haven’t produced a surplus since 1989,” which certainly sounds like a damning indictment.

But why would that be the thing on the scoreboard? Imagine a football coach looking at the results and details of a match his or her team had convincingly won on the weekend. “OK, so we dominated in terms of share of possession. If we look at ground gained each time we gained possession, we dominated. And, of course, we ended up with twice as many points as the opposition. But look at how many times we dropped the ball! We dropped it twice as many times as the opposition did! This is terrible! You’re all losers!”

This would obviously, and rightly, be seen as the weirdest way possible to judge who won and who lost in that sporting contest. Obviously, the team with the most points wins, regardless of how messy the victory was. A good coach would focus on improving aspects of play that need improvement, but they wouldn’t confuse what’s on the scoreboard with other aspects of performance that contribute to — but aren’t the same thing as — the final score. The team may have dominated the game but still played with fumble-fingers, which would make ball-handling something to work on in training. But it’s not the criterion by which the outcome of the game is finally judged.


Neither is the budget, whether a deficit or surplus is achieved. Unlike a football game, there is no one single final score on which to adjudicate performance, but for a macroeconomy, the trifecta of economic growth, unemployment, and inflation are key indicators that should be up on any “economic performance” scoreboard. The average trend rate of unemployment during the Rudd and Gillard years was 5.1% (a period including the Global Financial Crisis); the average during the period since the Abbott government took office is just above 6%. Inflation is low, with the most recent annualised rate of CPI growth being under 2%, the bottom of the Reserve Bank’s target rate. Too-low inflation, like high unemployment, is symptomatic of a weak economy, a fact reflected in the most recent RBA decision to lower interest rates to a record low. Any sensible score -boarding of the macroeconomy would show that things have definitely not been improving since the 2013 election.

No reasonable analyst would contend that this is entirely the fault of the Abbott government. International conditions are challenging, with Chinese growth slowing, and Europe remaining subdued. The Reserve Bank sets interest rates without government influence, meaning options to manage the economy are few. Any government in power now would find circumstances difficult.

But this is exactly the problem; to manage an economy in difficult conditions requires an accurate understanding of the issues you face, and a willingness to seek — and an ability to listen to — expert advice from professionals on the government payroll whose job it is to provide such advice.

The first — and in current conditions, the worst — mistake to make is to confuse what should be prominently displayed on the scoreboard. As mentioned above, changes in GDP, unemployment and inflation are key magnitudes to monitor. Underpinning those are trends in employment and productivity growth, and international conditions as reflected in our terms of trade. What doesn’t belong in bright lights as a headline indicator is the budget “bottom line”. As a number, the budget outcome is best regarded as an outcome of events in the economy; as a process, the budget is a tool to assist with managing economic performance given all the circumstances it faces. The bottom-line number in any year cannot be finely controlled, and it’s foolish to claim that it can be.

Yet in Australia we repeatedly hear about budget emergencies and debt and deficit disasters. We’re told that we’re living beyond our means, and engaging in intergenerational theft by loading our children up with our debt. So why has political discourse turned so heavily towards treating the annual budget figure as a, if not the, key indicator of economic management? Why has “austerity economics” — with its inevitable focus on short-run budgetary outcomes over everything else — dominated the discussion when budget outcomes are not nearly the most important issues in people’s actual lives?

2. Bad reasons

A worst-case conspiratorial view would have it that “austerity economics” is really code for reducing public expenditure in order to shrink the size — and role — of the state. In this “starve the beast” view, the state is ever-growing as a share of the economy, and this growth must be arrested. Cuts in both tax rates and government expenditure are the intention, but this rather extreme philosophy puts the tax cuts first, in the belief that cutting taxes will reduce revenue and (hence) lead to spending cuts based on the realisation that there is simply less money available for government to spend. Since this contravenes the argument of supply side economics that cutting taxes will increase revenue, it is sometimes posited that starve-the-beast is the post-facto argument to use when it turns out that taxes cut based on supply side arguments have not in fact resulted in the expected revenue increases.

Slightly less conspiratorially, there have been seemingly respectable arguments for austerity economics coming from the economics profession, such as the claim by two leading economists that their evidence showed economic growth was hampered by a country’s high external debt levels, with particular problems emerging when debt levels reached 90% of GDP. Obviously, the principle that correlation does not equal causation applies given that causality could run either way (an economy slowing for other reasons would expect to see its debt-to-GDP ratio rise), and the authors carefully talked of correlations. However, this did not stop their work influencing conservative politicians in both the US and the UK in favour of austerity policies.

(This was not the only academic work used to support austerity economics. “Expansionary austerity” arguments, involving claims that fiscal consolidation improves business and consumer confidence sufficiently to bolster growth, have been proposed by serious academics. But this argument, too, has come under fire.)

Whether legitimate or dodgy, the academic work seems to serve more as a rationalisation than a pure justification for austerity economics narratives. Once you decide to engage in austerity policies, reference to scholarly work that seems to support your approach is convenient to refer to, but not essential to motivating your choice or action in the first place. What makes austerity so compelling in the first place, so that it can be sold to the media and the public as representing plausible and serious policy?

A focus on budget outcomes obviously engages with our intuition about managing our own budget and living within our means. It seems so intuitively simple that it’s obvious; a balanced budget means we are living exactly within our means, and an unbalanced budget means that we are not. In particular, a deficit budget is putting us into debt (successive deficit budgets driving us deeper into debt each year), while a surplus budget is required if there’s existing debt to be paid down (requiring lower spending/higher taxes in future). And if there’s a debt that’s being maintained, clearly it is something that our descendants will be left with to pay back, so we must be impoverishing them, right? Right?

It seems so obvious as to be self-evident. How are we to be convinced that, in fact, this intuition is almost entirely incorrect?

There are at least three reasons that a government budget is not like a household or business budget; so much unlike a household budget that it’s seriously misleading to compare them. They are, in turn, (i) the fallacy of composition problem aka “owing the debt to ourselves”, (ii) the effects of infinity, and (iii) the printing press. Working through these will not only make clear how much a government budget is not like a household budget, but that being in debt does not automatically represent “intergenerational theft” — far from it. But running deficits and accruing debt does have immediate distributional consequences that are worth paying attention to.

3. Government budgets are not like household budgets. Seriously. (Part 1. Fallacy of composition)

Let’s look at the first argument, sometimes referred to as “owing the debt to ourselves”. It’s a basic fallacy-of-composition argument; incorrectly asserting that what’s true of a part is therefore true of the whole. We think of a family/household budget as something run within a household, based on money coming in and going out of that household, just as though it was a single person’s budget, balancing incomings and outgoings. Instead, let’s look at a household budget as if all the debt occurred within the household, with multiple members borrowing from each other.

Think of it this way. There’s a head of the household who manages the “household budget” on a day to day basis. All members of the household earn their own individual incomes, and the head of the household collects a small amount from each of them to help fund collective household expenditures. Other than that, each individual family member manages their own personal budget personally. From time to time, the head of household borrows extra money for urgent household items or investments from other members of the household, writing IOUs that the lending household member can keep in their desk drawers for later repayment. The household head ensures agreed interest payments are made, and is responsible for eventual repayment of the debt. If a surplus fund is not available when any of the debt falls due, the household head simply borrows from another member to repay the one whose repayment is due.

Is the household as a whole impoverished as a result of what are in fact a series of internal transfers? Are future members of the household collectively on the hook for borrowing decisions being made today? The household head may need to increase the amount collected from household members, simply to repay what is owed to some of them, but this is obviously a redistribution of household resources rather than a net loss of household income. Intergenerationally, it is hard to see how all the future children of household members are being impoverished by all the current members.

Two things are worth considering in terms of impacts over time and whether “intergenerational theft” is occurring; first, who is owed repayment (compared to who will be contributing to the household fund in order to build up the surplus needed to make the repayments), and second, what the borrowed funds are used for and whether they have enriching impacts on the household over time. If borrowed funds are used to purchase furniture for common areas in the house, or upgrade the house physically or technologically, those actions will yield benefits to future occupants of the house, in which case it’s hard to see them as having been collectively “stolen from” as the result of the earlier reliance on IOUs.

(It is not for us to wonder why IOUs were used instead of the head of household simply “taxing” the household members more at the time. A deeper analysis could focus on this choice. For now, all we need to look at is the impact on one generation from the choice of a previous generation. It’s clear that the generational impact depends on spending choices made earlier — improving the house in long-lasting ways versus holding more parties, in effect. The pattern of cost-sharing can change based on the use of IOUs versus pure taxation, and that may affect consumption and savings choices of individual household members that flow on to their individual offspring. But the total impact across generations of using debt does not in any way imply future impoverishment.)

Convinced yet? We could look at this a different way, by going back to the Q&A episode we began with. Imagine the 5 guests + host are the entire population of a (tiny) country, with Tony Jones as the head of the country, responsible for its overall finances. Then imagine that Alan Jones and Heather Ridout represent the “rich” members of this society, while Chris Bowen, Jamie Briggs and Corinne Grant are the “less rich” members. Tony Jones runs a balanced budget, until one day he decides to do the following: (1) maintain expenditure as it stands, (2) reduce taxes on the rich folk (Alan and Heather) by cutting the top marginal rate, and (3) issue bonds (IOUs) to cover the difference — the deficit — which Alan and Heather buy up with their extra cash.

The most obvious thing about this is that there is an immediate distributional impact, as opposed to an intergenerational one: Alan and Heather have their tax liability reduced, and end up holding some financial assets they otherwise would not have had. A different tax change — say, an increase in the tax-free threshold — would have different distributional consequences, but these impacts would be felt far more between “rich” and “less rich” than they would between “older generation” and “younger generation.”

Governments do of course borrow “outside the family”, in other words from foreigners. Hence not all of our debt at any time is “owed to ourselves”. But to discuss this at length would require making the point that our domestic savings pool is insufficient for our desired investment, requiring imports of foreign capital, some of which would come in as public borrowing.

4. Government budgets are not like household budgets. Seriously. (Part 2. Infinity)

The above discussion is about the fallacy of composition that is involved in mistakenly treating the government budget as if it were like an individual managing their own finances. The next main difference involves the effects of infinity.

If a household were like a government, then that household would have to effectively live forever. A household led by someone with eternal life and effectively a guaranteed stream of income would be a very safe household to lend money to, and in effect, it would never have to be out of debt because rolling over its existing debt when it came due would be straightforward. The need to be out of debt at some point is a product of finite lifespans. (This is not an argument for always being in debt; just a statement of the fact that always being indebted is feasible.)

Infinity has other weird properties that come into play in working out what different patterns of consumption and investment have over time for a society — in particular, whether we are impoverishing our children by running deficits. With a society of finitely-lived people (I.e. society lasts forever, but individual humans have finite lives as usual), with each generation owning an “endowment” of goods at birth, if we could have each generation give an equally-sized gift of some of their endowment to the older generation, then the oldest generation is better off, and each later generation is no worse off.

This is an example of the weirdness of infinity, where now we are considering an infinite number of generations rather than a single immortal human. Of course, to engineer such a transfer from younger to older requires something akin to a debt transaction; but a more realistic evaluation of the impacts of transfers across generations of this kind involves thinking about (long-lasting) capital goods, population growth and more. UCLA economist Roger Farmer helpfully lists key contributions to the academic literature in this area. Two unsurprising conclusions emerge: first, the analysis is necessarily technical and very difficult for beginners to follow; and second, the answer to the question of whether current debts will cause economic hardship to future generations is ambiguous and depends on the interplay of a number of variables.

Infinity has weird properties. And since nobody knows when a government is going to bring down the shutters and have to clear all its debts — and nobody knows when society will eventually collapse, in which case debts denominated in official currencies are likely to be moot — lenders to the government (buyers/holders of its bonds) simply want to know that their debts owed by the government will be honoured in their lifetimes. A stable government can pay any individual creditor back on a due date by rolling over that debt; effectively, other creditors step in to repay the first.

The fact that people willingly purchase “consols” (bonds without redemption dates, promising an eternal stream of payments) indicates quite clearly that people regard the likely duration of sovereign states as being longer than their own lifetimes.

5. Government budgets are not like household budgets. Seriously. (Part 3. Printing press)

A third reason government budgets cannot be compared directly to household budgets is that government’s can print their own currency. This is an astonishing power that households don’t have.

Printing one’s own currency — and have it be legal tender, and have it be required for payment of taxes owed to the government — is an enormous advantage, which admittedly doesn’t come without consequences, although there are debates about what those consequences actually are and at what stage things become tricky.

Moreover, governments within federated systems (like Australian state governments) and government belonging to monetary unions (like governments of EU states) do not control their own currencies, and have greater restriction on their actions than do governments of independent nations. (Their budgets still should not be regarded as comparable to household budgets, for the previous two reasons.)

6. Conclusions

Where does this leave us?
  1. There is no reason to think we are nationally living beyond our means at the moment. “Living within our means” is a far harder concept to pin down for a government — and for the society it governs — than it would be for a single household. It is not meaningfully understood (let alone measured) by the outcome of a single annual budget. It is also not meaningfully understood by the simple existence of public debt. There are surely better ways to spend the money we’re spending, and different and better ways to raise (more) revenue than we’re currently raising, but it’s hard to have that kind of sensible conversation in a state of alarm.
  2. There is no “debt and deficit disaster.” Debt is one aspect of public finance (and I’ve glossed over much detail around the balance between taxation, borrowing, and money printing, because this post is too long and detailed already), and it’s a thing to be managed sensibly, not a thing to panic about. If we could have that conversation, it would be a significant improvement.
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations). The choice to finance some activities via debt rather than taxation has distributional consequences, but it’s not obvious that these can or should be cast simply as inter-generational effects, with later generations losing out as a result of our profligacy. Money and assets and liabilities are moving around the place, but the real resource implications (from e.g. infrastructure investments, sectoral adjustments, regional distributions, demographic transitions, productivity implications) are contingent upon subsequent policy choices made.
  4. It’s the real things that finally matter. Whether we’re living beyond our means, and whether the standard of living of future generations will rise or fall, depends on what we deplete and what we improve as we move through time. Our productive capacity, as well as our resource base and environmental quality. If we’re avoiding making productive investments out of a fear of debt—let alone we’re avoiding dealing appropriately with climate change—that’s the clear and present danger for the well-being of people in the future.



Wednesday, February 18, 2015

Housing glut can't stop bubbles

Lindsay David compiled data on Australian home prices recently and found that 52 localities in New South Wales had negative population growth over the decade from 2003-2013. But these places had just as much of a housing price boom as anywhere else, putting to rest once and for all the various arguments that regulatory supply constraints are a key element affecting Australian home prices.

It could be just me, but a town with a 15% population decline really can't be argued to face any sort of housing shortage, indeed arguably this housing glut was insufficient to counteract a 70% price increase over the decade.

Perhaps the answer is that the static demand-supply equilibrium model is an inappropriate tool to analyse the economics of housing.

Thursday, February 12, 2015

Improving 'Neoclassical man' with a gaze heuristic

The gaze heuristic describes the behaviour of people trying to catch ball, and is useful when attempting to program robots that mimic human behaviour. Gigerenzer explains that
The gaze heuristic is the simplest one and works if the ball is already high up in the air: Fix your gaze on the ball, start running, and adjust your running speed so that the angle of gaze remains constant. A player who relies on the gaze heuristic can ignore all causal variables necessary to compute the trajectory of the ball––the initial distance, velocity, angle, air resistance, speed and direction of wind, and spin, among others. By paying attention to only one variable, the player will end up where the ball comes down without computing the exact spot.
We even know that dogs follow similar dynamic heuristics when catching frisbees. In more technical terms, dogs follow a linear optical trajectory gaze heuristic. While I thoroughly recommend reading the full paper on frisbee-catching dogs, we can examine the most basic gaze heuristic described by Gigerenzer to demonstrate the logic of behaving according to these heuristics in a dynamic world of uncertainty. In essence, I want to show that due to uncertainty human behaviour is dynamic and differs radically from the homo economics behavioural assumptions almost universally applied in economic analysis. Further, such behaviour can be identified as the mechanism which connects price and investment dynamics in economic systems.

Below I summarise the basic difference in behaviour between neoclassical man, who makes a choice at a particular point in time based on expected probabilities, and dynamic uncertainty women, whose behaviour responds to the dynamics in her environment.

 
Neoclassical man observes the ball, develops a probabilistic expectation of where it will land, and instantaneously positions himself on the most probable position. Dynamic uncertainty women observes the ball and begins running from her current position towards the ball, linking her run to the ball’s trajectory by fixing her angle of gaze.

We can think about the ball as the environment our catchers respond to. Neoclassical man sees the ball’s position and generates expectations, ignoring its dynamics of velocity and acceleration, or merely developing some expectation about them. In economic models such behaviour is reflected in static optimising on price levels base on expectations. But to dynamic uncertainty woman the position of the ball has no effect on her behaviour. Her own velocity is tied to the ball’s velocity through the fixed gaze angle, no matter what their starting positions or point in her run. Only as the ball accelerates does her action change, and she will accelerate her run along with the ball, including changing directions when the ball drifts. In economic terms the ball is the business environment, and each individual or business as a catcher making their investment decisions in response to that dynamic environment. Using a gaze heuristic this implies matching running speed (investment rate) with the balls speed (rate of change in real demand).

So what happens when the business environment changes? In our analogy this implies an acceleration of the ball (a change in velocity). We know from experiments on dogs chasing frisbees thrown in order to swing severely that the reaction of a dynamically uncertain dog will be to change paths at the current relative position by adopting a new gaze angle linkage with the ball.

Below we see dogs reacting to a swing in a frisbee throw by updating their gaze heuristic, and following a new path in relation to the frisbee’s new velocity. 

Under dynamic uncertainty a change occurs via an acceleration in environmental conditions. In economic systems these environmental conditions could be asset prices, product demand, or some another indicator guiding investment decisions. Remembering of course that investment decisions by businesses in one part of the economy generate the economic conditions that other firms respond to, meaning that economic cycles are an emergent phenomena of interacting uncertain agents, be they firms, governments, consumers, banks and other actors in the economy.

Applying the a gaze heuristic to investment decisions, where asset prices are the environment to which investment responds, results in an incentive to bring forward investment when acceleration of asset prices is positive, and an incentive to delay investment when acceleration of prices is negative.

The 'micro-foundations' for this behaviour requires some explanation. In essence asset owners, be it land, or some other scarce monopoly right, face the decision of when to exercise their option to invest in irreversible capital equipment that takes advantage of those rights – construct a building to package with property rights, build a transmission tower to package with spectrum rights, and so forth. Since the option has a value growing over time without need to be exercised, the optimal time to exercise will be when its value is increasing at an increasing rate, or accelerating.

The cyclical link between asset prices and investment arises because when investment is brought forward it slows the acceleration of asset prices, providing a feedback in the system.

To be clear I show below a stylised cycle that results if people behaved like Dynamic Uncertainty Woman in an economic environment; monitoring the dynamics of asst prices and adjusting the rate at which they invest in new capital in response. We end up with an out-of-sync cycle of asset prices and investment activity.


There is also a very tight link between this behaviour under uncertainty and the numerous empirical relationships observed by Steve Keen between the acceleration of debt, the growth rate of asset prices, and the employment level.

Keen observes that the acceleration of the debt level approximates the rate of change in the price level of relevant asset classes, while my additional input is that investment growth responds to acceleration of prices.

This analysis implies the following relationships: Debt acceleration creates price growth, which creates investment (and employment), but that investment also requires debt funding, leading to more growth, and a cyclical feedback. If price acceleration is a key factor determining investment growth, then perhaps even the third derivative off debt, the jerk, is leading to tangible behavioural results and implying the potential for high degrees of instability in the system. 

To me it makes perfect sense to first look at human behaviour in dynamic settings before conjecturing about what is or is not optimal by introspection. The widely observed gaze heuristic in humans and other animals provides a clear case where dynamic behavioural rules lead to effective actions in other settings. But the same logical applies in social and economic environments as well, connection I demonstrate here. Too often the introspection approach to economic theory overlooks our easily observed biological instincts which evolved in a dynamic and uncertain world.

Monday, January 19, 2015

Economics of how Triple J makes music better

Brendan Markey-Towler
19 January 2015

As I was driving to work today I was treated to the dulcet tones of Peter Garrett’s radio voice as a guest on Triple J – the ABC’s “youth-oriented” radio station. Aside from musing about how much better I like the former contortionist and Midnight Oil front man now that he is no longer a political contortionist (also known as a federal minister – apologies to Mr Garrett, being an Australian I have an instinctive, possibly pathological, definitely worrying prejudice against politicians), I also got thinking about what economics has to say about the quirky little offshoot of Australia’s much loved “Auntie”.

For those who don’t know, the station is a little as if the pirate radio stations in the North Sea during the 1960s had been run by the BBC, funded and sanctioned by the British government. It is deliberately designed with the teenage-to-late-30s demographic in mind and seeks out artists who wouldn’t be in the mainstream of the music industry. The music is almost always that which would be classed as “alternative” – at least until it’s picked up by a major station. The artists are often Australians, Kiwis, and Brits, and less often American than one would expect. It is not uncommon for the guest artists of the station to be doing interviews on their day off work – jobs they hold to survive whilst playing the underground music scene in Australia’s capital and major cities.

The station does not host advertisements, and would be unlikely to attract them anyway if it did, given the size and demographic makeup of its listener base compared to other major radio stations. It does host ABC-quality news and current affairs programs (such as Hack) of a quality rarely available to the bulk of Australians, let alone the listeners of Triple J (who, often being the disaffected youth of our age, are probably the most likely to need its information). With this profile, in the modern commercialised age, the station would not survive on a commercial basis. So why have it? Why should the government continue to take the taxes of everyone to provide a service for the few?

It can be difficult to rationalise the ongoing support of the Australian government for Triple J using standard economic analysis, in which markets are made up of perfectly informed individuals with computational skills that would make your typical Australian blush (and then reach for their tall poppy clipper). As my teacher’s teacher Frank Hahn used to say “we’ll pretend that people know exactly what they want and exactly how to get it”. If everyone knows exactly what they want and exactly how to get it, the justification for Triple J’s basis must rest on market failures – deviations from the perfect competition model.

One failure Triple J might remedy is a lack of information – people don’t know exactly what they want, or exactly how to get it, so Triple J needs to make this information available. This argument is a little weak, given that Triple J has a niche position in the market, such that we would be able to make the case that the vast bulk of the market finds this information not particularly valuable. At least, not to the extent it is economically worthwhile to make the whole population pay for the improvement of information with their taxes.

A second argument is a much stronger, if rather vague one, about “externalities”. Triple J could be argued to have a “positive externality” – a benefit which does not accrue directly to the listeners of Triple J, but rather “spills over” to the rest of the economy – for instance, by supporting a “creative” environment for entrepreneurs in the music and other industries. This argument for Triple J’s existence is a stronger one than remedying information problems, but it is notoriously difficult to identify and measure these benefits using standard economic analysis.

I would offer another rationalisation for the ongoing support of Triple J from evolutionary economics, one which supports the standard economic analysis of Triple J as a source of positive externalities. The existence of Triple J in the Australian music industry generates variety without which the market would not have as high a quality provided to consumers as it does.

Evolutionary economics sees the market economy as an evolutionary system similar, but not identical, to an evolutionary biological system [1]. A market system, of which the music industry is one, consists of ordinary (neither rational nor irrational) human beings within production organisations (bands) trying to compete for the custom of consumers (listeners, via radio stations and album sales).

All evolutionary systems are characterised by the same three step process. In the first stage, a variety of “selection units” (genetic characteristics in biological systems, different products in a market system) is generated, before that variety is subjected to “selection” (by natural selection in biological systems, by consumer choice in market systems), and from this process emerges a set of “retained” selection units (genes which survive in biological systems, products which continue to be sold in market systems). The improvement of “fitness” in the market system comes from the selection by the system amongst the variety of different goods and services (songs in the music industry), some of which are deemed of better quality than others by consumers.

Without variety, the market cannot act to improve quality, and the more variety generated within the market, the better (with some caveats) the overall average quality within the market will be. This is actually a mathematical fact [2], which holds true of all evolutionary systems, including economic systems [3]. In general, the greater the variety within an evolutionary system, the greater will be the rate of increase in its average “fitness”, or quality. The greater the variety generated within a market system therefore, the greater will be the quality of the alternatives on offer to the customers. Many products for consumption, including artistic products, will fail to be selected, and their producers will not succeed, but without the competitive pressure generated by their existence in the first place, we would not have a basis for selection of the highest quality anyway. In evolutionary systems, it is a mathematical fact that strength comes through diversity.

What differentiates the economic system that is the music industry from a biological one is also that the generation of variety in an economic system is purposeful [4], where in biology it is taken to be random [5] or at least well beyond human control. We can ourselves choose to generate variety which helps to drive the evolutionary process. This is why there is a solid economic case for the government’s ongoing support of Triple J.

Triple J acts as a generator of variety for the music market in a manner in which commercial stations simply cannot. Commercial stations, for perfectly legitimate reasons, must be driven by the profit motive. They need advertisers to pay for airtime, which requires that they have a significant listener base, which requires that they play music they understand to be popular to a broad audience. This naturally limits what they can air, and indeed, means they will in all likelihood offers very similar listening to each other (this is very similar to the median voter theorem in economics). They literally cannot afford to air a wide variety of “alternative” music. Triple J, being funded by the government has no such concerns, and is in fact mandated, in effect if not in law, to seek out alternative, and particularly Australian content, and has a forty year history of doing so.

If it were not for Triple J expanding the variety of material in the market, we would find that the overall average quality in the market for music would be lowered, as dictated by evolutionary mathematics. Being unencumbered by commercial concerns, Triple J serves an economic purpose by bringing to the market music which people would otherwise not have known they enjoyed, and which would have been too alternative, and, Catch-22 like, unestablished for a commercial station to take a risk on bringing to the market first.

This means not only that it by itself will provide greater variety, and hence enhance the quality of the overall market, it means that the commercial stations also have a source for new artistic material which they would not otherwise have. It will often be the case that one will hear an artist on Triple J, and a few months later the same artist will be given some airtime on commercial stations, at which point they can become quite successful commercially as well as artistically. I seem to remember that the New Zealand born artist Lorde was noticed by Triple J after filling in at a festival in Australia the station had been covering. Her music, spare and trancelike with more or less only percussion, a bass and vocals is quite unlike anything else in the music industry, certainly the mainstream thereof, and one could make the case it would not have become so well-known had not Triple J been able to establish her music in the market relatively unencumbered by concerns about appealing to a broad segment of the population.

Of course, much of the material aired on Triple J will not become commercially viable, but this is simply a manifestation of the selection processes of the market. What does survive in the market place due to Triple J will enhance the overall quality of the offerings of the music industry.

This is one source of the externalities of the radio station, upon which standard economics builds its strongest case for government intervention in the music industry. Triple J and its listeners do not acquire all the benefit of their activities, some of it spills over into the commercial sphere when the commercial stations pick up an artist who is actually appealing to a broad cross-section of society, but would have been a risky proposition to give airtime to. But also, by providing a variety of music free to air which is alternative, cutting edge, pushing the boundaries and all of these too much so for airing on a commercial station, Triple J provides a platform whereby artists (not always individuals with the greatest access to material resources) can access and influence each other. The station in this manner provides a platform where the variety of miners at the coalface of music can be made available to the public, and learn new ways of advancing along and exploring their own vein.

Triple J is a (comparatively) very cheap [6], somewhat unusual and quite successful example what evolutionary economists call a “national innovation system”. National innovation systems typically involve large scale schemes for providing financial backing to many small projects which would be unable to obtain finance from responsible banks in spite of their promise and potential importance. Often these projects will go on to constitute significant advances in the quality and function of items produced by an economic system, as the mathematics of evolutionary markets dictates. Mariana Mazzucato (2011) has provided a wealth of examples where national innovation systems provided financial means for innovators to obtain the critical mass necessary for many innovations which simply would not have got funding otherwise - such as almost all technology within the iPhone. In the Australian music industry, all Triple J needs to do the same is to give airtime to some songs, at the cost of the wages of the people who run the station, the cost of broadcasting equipment, and the other incidental costs of operating a radio station. It is an excellent example of just how little the government need to intervene in the market sometimes to create a significantly improved market outcome, while leaving the positive aspects of the market process more or less unaltered.

So, on this the 40th anniversary of the foundation of Auntie’s eclectic offshoot, we can reflect once again that Australia is the “lucky country”. I am no expert on Australian political history, but the Whitlam Labor government likely instituted Triple J (Double J as it was then known) in 1974 for reasons other than promoting the generation of variety for evolutionary market processes to create a higher quality market. Much more likely, it was part of the Whitlam government’s vision for a more progressive Australia, to differentiate it in the eyes of the youth from the staid, conservative Menzies era government by reaching out to them with their music. But in trying to give the youth the music their parents disapproved of, the government also (probably inadvertently) instituted one of the most important institutions for the health and strength of the music industry in Australia.

Three cheers for Triple J.

[1]. Pioneers in this field were Nelson, R., Winter, S., 1982, An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, Massachussetts., while a more modern and generally accepted statement of the framework can be found in Dopfer, K., Foster, J., Potts, J., 2004. Micro-meso-macro. Journal of Evolutionary Economics, 14(3), 263-279.

[2]. Price, G.R., 1970. Selection and Covariance. Nature, 227, 520-521, Price, G.R., 1972a. Extension of covariance selection mathematics. Annals of Human Genetics, 35, 485-490, Price, G.R., 1972b. Fisher's "fundamental theorem" made clear. Annals of Human Genetics, 36, 129-140.

[3]. For instance, Metcalfe, J.S., 1998, Evolutionary Economics and Creative Destruction. Routledge, London., Metcalfe, J.S., 2008. Accounting for economic evolution: Fitness and the population method. Journal of Bioeconomics, 2008(10), 23-49. and Markey-Towler, B., 2014, Law of the Jungle: Firm Survival and Price Dynamics in Evolutionary Markets.

[4].  On this, one would do worse than consult Foster, J., 1997. The analytical foundations of evolutionary economics: From biological analogy to economic self-organization. Structural Change and Economic Dynamics, 8, 427-451. and Witt, U., 1999. Bioeconomics as economics from a Darwinian perspective. Journal of Bioeconomics, 1, 19-34.

[5].  For an emphatic, almost dogmatic defence of this idea, also known as the “central dogma of biology”, see Dawkins, R., 1976, The Selfish Gene. Oxford University Press, Oxford. 

[6].  National innovation systems in the Australian context have been discussed at length by Dodgson, M., Hughes, A., Foster, J., Metcalfe, J., 2011. Systems thinking, market failure, and the development of innovation policy: The case of Australia. Research Policy, 40, 1145-1156.

References

Dawkins, R., 1976, The Selfish Gene. Oxford University Press, Oxford.
Dodgson, M., Hughes, A., Foster, J., Metcalfe, J., 2011. Systems thinking, market failure, and the development of innovation policy: The case of Australia. Research Policy, 40, 1145-1156.
Dopfer, K., Foster, J., Potts, J., 2004. Micro-meso-macro. Journal of Evolutionary Economics, 14(3), 263-279.
Foster, J., 1997. The analytical foundations of evolutionary economics: From biological analogy to economic self-organization. Structural Change and Economic Dynamics, 8, 427-451.
Markey-Towler, B., 2014, Law of the Jungle: Firm Survival and Price Dynamics in Evolutionary Markets.
Mazzucato, M., 2011, The Entrepreneurial State. Demos, London.
Metcalfe, J.S., 1998, Evolutionary Economics and Creative Destruction. Routledge, London.
Metcalfe, J.S., 2008. Accounting for economic evolution: Fitness and the population method. Journal of Bioeconomics, 2008(10), 23-49.
Nelson, R., Winter, S., 1982, An Evolutionary Theory of Economic Change. Harvard University Press, Cambridge, Massachussetts.
Price, G.R., 1970. Selection and Covariance. Nature, 227, 520-521.
Price, G.R., 1972a. Extension of covariance selection mathematics. Annals of Human Genetics, 35, 485-490.
Price, G.R., 1972b. Fisher's "fundamental theorem" made clear. Annals of Human Genetics, 36, 129-140.
Witt, U., 1999. Bioeconomics as economics from a Darwinian perspective. Journal of Bioeconomics, 1, 19-34.