Retirement confusion: Savings are not investment

I’m constantly surprised at how fundamental concepts in economics are so easily confused as soon as they are applied to real-life policy.

Take the issue of fully-funded versus pay-go pension systems. In a pay-go system, pensions are paid to qualifying individuals each year by the government out of general revenues. In the fully-funded system, individuals are forced to save in their working years to fund their retirement in later years.

Australia and many other countries have transitioned towards fully funded systems in the past couple of decades. This change can partly be attributed to a fear that pay-go systems are unsustainable, and partly because economic theory suggests that fully funded systems can increase the growth path of the economy through their effect on increasing savings, and therefore increased investment.

But the fear of unsustainable pay-go pensions, and the growth effects of fully funded systems, are both unfounded.

This is a very confusing area for many people, which is why it was so important to clarify the difference between saving and investment in my earlier post. When an individual or group within society spends less of their income, this does not automatically imply increased investment in new capital goods in proportion to that saving.

When my fully-funded pension account buys BHP shares, it buys them from existing owners, who may very well be retirees selling down their assets to fund their retirement.

Using this basic example we can see that a fully funded pension system involves the young buying assets from the old, which is a transfer to the old in exchange for an asset.

But this is exactly what a pay-go system is as well. It is a transfer from the young to the old via the tax system rather than via other financial vehicles. Or we could think of it as an exchange of the asset of a guaranteed retirement income instead of a BHP share. The diagram below summarises this point.

Regarding the investment effects, some have argued that when pension accounts buy shares they force prices up, thereby generating more investment. But to believe this you then need to explain some mechanism by which the share price was a binding constraint on new investment.

Does the BHP share price determine investment decisions in new mining ventures? Or is it the expected price path of the minerals, the ability to secure contracts for future output, and the costs of the facility?

Sure, there may be some small cases where equity value is binding, but that doesn’t mean that an investment opportunity will not instead be undertaken by a separate entity that doesn’t have that constraint.

Others have suggested that the share of savings that does go to direct investment funding, such as the example here, is sufficient to make the point. To me, this is the rare exception that proves the general rule and moreover makes the point that under normal circumstances debt, in the form of bank lending, is the almost universal investment funding tool.

To wrap up this point, here is the breakdown of assets in Australian superannuation (retirement savings) accounts from APRA. Only a very small share of these assets could be interpreted as being new investment. Most shares would be purchases of existing assets, with a rare exception of capital raising for new ventures. Cash and property are obviously not related to new investment, leaving fixed interest assets that may also involve a component of new investment.

The other important point here is that anything that makes a pay-go system unsustainable also makes a fully-funded system unsustainable, though I think neither system is. Each is merely a transfer from one group to another in society, with the same level of output to be shared at each point in time. 

Let’s be clear about this. In the pay-go system, wealth is transferred between taxpayers and the retirees each year. The retirees share of the economic pie is whatever is determined by demographics and government policy on retirement pensions.

In the fully-funded system, we have the bizarre situation of working age people buying assets from retired people who had accumulated them in the past, so that they can then sell them when they retire. There is a lot of asset churn in this system to generate what is a transfer from working age to the retired at all points in time. In essence, it is a pay-go system with the added cost of private funds management.

I have made this point in more detail in the past. 

My point here is that this is yet another example of economists inappropriately equating savings, which are transfers, with investment, which is the production of new capital equipment.

Quick links: Crony politics, utility, Becker, exports

The Greens proposed in parliament to implement a Federal Independent Commission Against Corruption with similar powers to the NSW Commission. Labor and Liberal refused to vote, in the process revealing their entrenched reliance on cronyism for their existence.

Former Queensland Electoral Commissioner Bob Longland on 7.30 discussing his idea for federal authority in charge of publishing political donations to all parties at all levels of government (and I guess enforcing disclosure requirements as well).

Great idea. But it seems the Queensland government is taking the opposite approach and reducing disclosure requirements.

Some brilliant detailed criticism of the leap of faith hidden between utility and welfare maximisation at Interfluidity

And a follow up post here

Forget the SMD theorem. In 1986 Gary Becker showed that market demand curves will slope downwards even under irrational choices where a budget constraint exists.

Given my previous post mentioning export-led growth via high levels of investment, here’s a chart of the export share and investment share of GDP (all countries and all time periods from the World Bank database)

Bogus economic excuse for inequality debunked

As I explained yesterday, saving by an individual is usually achieved by buying monopoly assets from others, forgoing consumption in order to capture a future flow of income for oneself.

This usual way to save is merely a transfer of assets whose value equals the difference between income and spending. Someone gets richer, others poorer. But importantly, the rate of saving of an individual, when understood in this manner, bears no relation to investment in the quantity of new capital goods in the economy generally and can’t be related to the rate of growth of the economy.

This point is quite obvious.

Yet it is very common to hear that rich individuals, because less of their spending goes towards consumption items, are able to save more, leading to greater levels of investment in new capital goods and higher future productive capacity.

While many economists profess a degree of caution in such analysis when challenged, the very notion that saving at an individual level equates to a proportional level of investment in new capital at a national (or global) level is embedded in the economic way of thinking.

Here’s Tyler Cowen making the point implicitly

Stocks of wealth stimulated invention by liberating creators from the immediate demands of the marketplace and allowing them to explore their fancies, enriching generations to come.

And here’s Karen Dynan et al.

…active saving corresponds to the supply of loanable funds for new investment and therefore may be helpful in gauging the effect of a redistribution of income on economic growth. 

But since saving at an individual level is almost solely about buying monopoly assets from others, this claim simply cannot be made. Saving at an individual level is nothing more than a transfer of ownership of existing wealth.

When I buy some Apple shares in order to save, I merely buy from the current owner, changing absolutely nothing in terms of Apple’s intentions to invest in new production machinery and equipment.

If saving is as I described, the fact that the wealthy have a lower propensity to consume, and therefore a higher marginal propensity to save, merely implies increasing wealth inequality, as assets accumulate in the hands of the already wealthy; a trickle-up effect if you will.

This is particularly relevant to current debates about how to address inequality. Would a wealth tax on the rich decrease overall investment? Not at all. The tax would be a transfer of ownership of resources, just like the saving of the rich is a transfer of assets and unrelated to investment in new capital equipment.

It is possible under very specific circumstances for an individual's savings to exactly match investment. For example, if I buy a specific financial instrument that pools my funds with others to finance construction (but not land purchase) of a new building. But that is a rare case that proves the general point that there is no proportional matching of saving and investment at an individual level.

While I have said nothing that contradicts economic theory, I do find it frightening that experts in the field have such contrasting views on the matter.

Can a nation save?

I want to offer here a brief analysis of how I think about saving and investment, and why it is important to be very clear about these concepts in policy discussions.

Usually economists equate saving and investment when they shouldn’t. I find it easier to think of savings as not consuming today in order to consume in the future, whereas investment is the production of some new capital good today, say a building, machine, vehicle, that will facilitate greater production in the future.

Let’s start by looking at saving.

I’ve argued before that you can’t borrow from the future. Debts are merely a trade of goods or services in the present for an obligation of different trades in future periods.

A similar conceptual logic is at play when we think of saving. We don’t produce warehouses full of food, clothes, machines and equipment and store them for the future. My superannuation account[1], for example, doesn’t own a share in such a warehouse in order to provide me with the goods I will need when I retire.

Instead my superannuation account owns monopoly assets. These assets are products of the institutional and legal framework of society. I might own a share of a patent monopoly; a sort of institutional power device that guarantees its owner the ability to capture a share of the income generated by the use tools and techniques covered by the patent.

Individuals save by buying assets that comprise a set of monopoly rights. The catch, however, is that all monopoly assets are owned by someone, so any individual who ‘saves’ by buying monopoly assets is merely distributing future incomes to themselves and away from others.

You may now be questioning my claim that all monopoly assets are already owned by someone. What about if I invent a new technology that I then patent. Didn’t I create new monopoly right that was taken from no one?

Actually no.

When you register a patent you are taking away the right to future incomes arising from that technology that would have been available to everyone else using it, and directing that income to yourself.

Saving at an individual level is merely a transfer, so in aggregate there is no ability to save in the way we think of individual savings.

So why is this relevant to a discussion on how nations can save?

Because a nation is one part of the global aggregate, and can save by accumulating monopoly assets currently owned by entities from other nations.

A country that is saving will run a capital account deficit and a current account surplus. They sell goods to other nations in exchange for monopoly rights to future income streams owned by foreign entities.

Usually this situation is sustained by active management of the domestic currency. To keep the domestic currency value low the central bank prints new money to buy foreign assets. This process decreases the relative value of the domestic currency, increasing demand for exports, and represents automatic saving for the country from buying those assets in the first place.

Modern cases of this mercantilist approach include Japan, South Korea and China.

Now here’s where the link between saving and investment becomes important, but where most economic discussion becomes confusing.

The country doing the saving is technically labelled as having a negative rate of foreign investment, meaning they are buying more foreign assets than foreigners are buying of their assets. Dissaving countries are labelled as having a positive rate of foreign investment.

Such terminology is deceiving; even more so when we think in terms of the investment dynamics at play.

The saving country will be a more attractive place to locate capital investments in tradable sectors because of relatively lower costs.

Countries with net foreign investment will actually become less attractive places to invest in large scale capital inputs to tradable goods production.

The key relationship to remember is this. Countries can save the way individuals can by buying monopoly assets currently owned by foreign entities. But this is merely a transfer between the two parties and cannot happen at a global level.

What national saving does is make the country a more attractive place to invest, at the expense of the non-saving country. Saving increases a countries future domestic productive capacity at the expense of future domestic productive capacity of non-saving countries.

For developing countries, mercantilist policies and national saving are a good thing. But to have a proper debate about economic policy we need to acknowledge the realities of saving and investment relationships between entities and in the aggregate.

fn.[1] The Australian version of a private retirement savings account

Unique economics of healthcare

I was prompted to write this follow-up on health economics after seeing a recent post by blogger Noah Smith, who weighs in with some reasonable views after some intense criticism of the ‘freakonomic’ Chicago-boy Steven Levitt. In a meeting with UK PM David Cameron, Levitt and his co-author apparently made some rather absurd remarks about health care.

They told him that the U.K.’s National Health Service -- free, unlimited, lifetime heath care -- was laudable but didn’t make practical sense.  

"We tried to make our point with a thought experiment," they write. "We suggested to Mr. Cameron that he consider a similar policy in a different arena. What if, for instance...everyone were allowed to go down to the car dealership whenever they wanted and pick out any new model, free of charge, and drive it home?"  

Rather than seeing the humor and realizing that health care is just like any other part of the economy, Cameron abruptly ended the meeting... 

This nonsense reminds me that what constitutes economic debate in the US is often laughable at best.

Health care is obviously not like most other parts of the economy. As I said last week medical services are credence goods - goods which we don’t know whether we need, and even once we’ve consumed them, still don’t know if they were good value. In economic terms, these goods suffer from the worst possible information failures, particularly with respect to the asymmetry of information between the seller (in this case the doctor) and the consumer.

For these goods the demand curve may slope any which way, and people are often left to use price as the only signal of quality (or quantity for that matter). This means that a socially optimal level of medical service provision cannot be determined using basic marginal economic analysis.

Not only that, there are substantial positive externalities to most health care services. Vaccinations are the obvious example, but the same principle applies more broadly.

Once you’ve accepted that health care and medical services don’t fall neatly into preexisting economic models, you need a better way to think about the potential efficiency of any health care system. Rarely is this step taken in public debate.

One way to assess any health system is in terms of the two main sets of incentives - those of the patients, and those of the medical service providers (doctors and suppliers of medicines, equipment and accessories).

We often hear about the patients, with the archetypal case of the lonely hypochondriac making a few extra trips to the GP or emergency department when the service is provided free of charge. Sure they exist, but as I’ve said before, pricing these visits deters both the time-wasters and those with genuine medical needs. Making prices for patients reflect production costs in health care systems has the benefit of reduced health expenditure, but comes at a cost of poorer health outcomes.

But in general no one wants major medical services even at a zero price. Here’s a comment from Noah’s blog making that point

Most medical treatments are painful, unpleasant, and time consuming, and are only desired when non treatment is worse. While making treatment costly will deprive some of access, it will do little to make treatment more undesirable than it already is.

On the other side of the ledger we have the incentives of doctors and other businesses involved in the supply of medical services - drug companies, suppliers of medical equipment and so on.

Here there are usually financial incentives to over-treat or over-prescribe. To take just one example, new evidence from Australia’s two-tiered system shows that in private hospitals there are more medical interventions for low-risk births than in public hospitals.

Indeed there is clear evidence of these interacting incentives following the announcement of the $7 GP co-payment in the Australian federal budget. Some medical centres have been text-messaging patients to remind them that they are not charging fees, possibly due to lower patient numbers. On display is the doctor’s incentive to earn a living providing medical services by marketing to customers, interacting with the uninformed patient reacting to a price that doesn’t even exist yet in a way they can't possibly know is beneficial for them or not.

As a final point, we rarely hear about the monopsony buying power of having a single medical provider, which can be significant. A single national (or State level) healthcare entity is in quite a position of power in negotiating supply contracts when they are the only game in town. In a world were drug companies are heavy political hitters, having incentives within the government to reduce drug costs to economise on health spending seems an important consideration.

If we are going to have an intelligent debate about efficient health care we need to remember three key points

1. We must consider benefits as well as costs (including externalities) 
2. There are serious moral judgments necessary about the scope and priorities of health care 
3. Medical services are credence goods, hence there are unique incentives at play

Twisted logic of GP fees

The Budget’s proposed $7 GP co-payment fee seems quite benign to many people. After all, if you are genuinely sick or concerned about your health, why would $7 make a difference?

But there simply is no logic behind it, and the more you think about it, the more twisted any possible logic becomes. 

For example, to believe that the fee will deter time-wasters but not genuine patients, you must invoke some idea that people know beforehand whether their ailment is time-wasting or a sign of something more serious. 

It’s like saying if people already knew the diagnosis they would get from the doctor, then they would be able to determine whether they actually need to visit the doctor. 

This ignores the very purpose of general practitioners.

To be clear, medical services as usually classified in economics as credence goods. They are goods or services that we can’t properly judge will be beneficial to us or not. All expert advice falls into this category.

For example, I could hear a strange engine noise and take the car to the mechanic. They could say that it is something minor and not to worry until the next service.

Would I be a mechanic time-waster? What if it turned out to be something serious that needed immediate attention?

Underlying the whole idea of a the $7 GP fee for bulk-billed patients is an irrational belief (see comments section) that medical services are being over-utilised. 

If that were truly the case, we would see government advertising that told us to stay home when we thought we were getting sick, rather than what we in fact do see, which is a blanket message to better monitor our health with more regular check-ups and preventative health screening tests.

But that’s not the end of the failed logic.

If you still hold the irrational belief there are time-wasters over-utilising GPs because the service is free, to believe that a price signal will remedy the problem requires a great deal of faith that the price will deter only the time-wasters and not those with genuine medical needs. 

If the price does not discriminate in this way, there will be significant health costs accompanying budget savings. 

The best evidence we have for the price effect on medical care choice is the 8 year long RAND Health Insurance Experiment, run from 1974-1982. It found that greater cost-sharing “reduced "appropriate or needed" medical care as well as "inappropriate or unnecessary" medical care”.

In fact the experiment also found that the poorest in society are most likely to defer medical treatment when the price increases, meaning that the health costs of this policy will disproportionally fall on our poorest citizens, including the unemployed and the elderly.

If I can digress for a moment and tell a personal tale. When my youngest son was just a week old he had a few signs of illness including a rash, a fever, and lack of appetite. I was not overly concerned, but my wife took him to the GP in any case. Our GP had some concerns about meningitis and we were sent for various tests, including a rather traumatising (for Mum) lumber puncture, and ended up in hospital for two nights awaiting various other results, with baby being closely monitored. It turned out not to be meningitis but some other a mystery infection.

Had there been a GP fee for us at the time we may have delayed the visit another day or so. If we did, and it had been meningitis, we may received treatment too late avoid serious long term damage.

I’m sure there are thousands of similar stories about how an early visit to the GP, that may have seemed a little like time wasting, ended up preventing serious illness or even savings lives.

While $7 doesn’t seem like much of an issue to many, we should acknowledge that the economic logic for doing so is not sound. This policy is taking the exact opposite approach to what we know to be effective. Universal access to health care, with GPs as the first point of call, to screen out the time wasters and offer advice that helps people better know if they are in fact time wasters, is a system we know to be functional.

If it makes sense to charge patients to GP services to improve health outcomes, then by that logic we should charge parents to vaccinate their children. We don’t, because we know the benefits to having universal access to vaccinations provides massive health benefits to the individual and society as a whole. The same applies to GP health services.

Maybe we should trust the experts themselves, the doctors, on this one.

Piketty's wealth tax is real, and it works

As the Piketty-train rolls on it leaves behind it a trail of confusion in economic circles about the proposition to reduce inequality via a global wealth tax.

Economic thinking, it seems, floats on the political tide. The authors of this paper in 2006 noted that

…at present there appears to be little interest in the net wealth tax. In recent years this tax has been practically excluded from any discussion or doctrinal debate on tax reforms, and over time has fallen into disfavour.

Eight years and one financial crisis later, the tide has turned dramatically in favour of using the tax system as a tool for creating a desirable wealth and income distribution.

Many sceptics, however, argue that a wealth tax, either national or globally, is technically or politically infeasible. The basic reasoning is as follows:

…it is impossible within the U.S., never mind the world, as the top 0.1% own the political machinery. Why would anyone who owns the political process agree to tax themselves?

It’s a good question. But it merely suggests we look deeper at the heart of the matter. I like to use one of Matt Bruenig’s favourite lines,“imagine people did things they already do”, as a starting point.

The point being that if the top 0.1% control the political system, then it should be impossible at all points in time to tax wealth.

Unless you are Spain, and it’s 1977. Or France and it is 1981.

Both these countries brought in annual taxes on wealth, with progressive scales just like income taxes. In France 1.5% of tax revenue came from their wealth tax in 2007, while in Spain around 0.5% of tax revenues are raised from such taxes.

Indeed most countries already raise about 5% or more of tax revenues from direct taxes on property, which is essentially a wealth tax on a slightly narrower definition of wealth.

So not only are wealth taxes possible, they are already a feature of the tax system in most countries.

Implementing a shift towards greater taxes on wealth merely requires a minor tweaking of tax rates and/or qualifying assets for taxes that already exist. The institutional machinery is already in place.

The question of the political power of the wealthy is certainly valid. But this merely provides guidance on likely political avenues for change. The obvious follow-up question is, what political circumstances led to the implementation of current wealth taxes?

I’m no expert here, and I’d appreciate any detailed accounts of the political climate at the time, especially in France and Spain. But it seems that the wealth tax was part of the French Socialist’s Party’s platform in the 1981 Presidential elections; which the right-wing party abolished in 1986, for it to be reinstated just two years later.

At first glance it appears that breaking the link between political power and the interests of the very wealthy, via democratic processes, is one successful political path for change.

It may even be of some assistance, politically, if the economic profession would stop pretending to debate the possibility of things people already do. Wealth taxes are certainly possible and are effective tools for reducing inequality.

Another wildly successful tax on wealth is the inheritance tax. Inheritance taxes are again real things, that real countries have, but that fell victim to the political tide of the 1970s in the anglosphere.

At their peak in 1968, taxes on inheritance made up 3.1% of Australian tax revenue, or 0.6% of GDP. In the UK inheritance taxes were 1% of GDP in the same year.

The chart below shows the massive shift away from such taxes at exactly the time inequality began to skyrocket across the anglosphere.




Australia, the UK and US all went through a political change in the 1970s that saw a dramatic reduction in revenue raised from this source, with Australia and the US abolishing inheritance taxation altogether in 1989.

Germany and France maintained these taxes, which have generated an increasing share of revenue since the 1970s. Australia however, chose to forgo this progressive tax and in doing so has forgone significant public revenues. Last year alone the revenue from an inheritance tax levied as per 1968 would have raised over $9billion.

Not surprisingly countries that reduced or removed inheritance taxes saw the most rapid rise in inequality since the 1980s. Below I use the data from Alvaredo, Atkinson, Piketty and Saez’s World Top Incomes Database to show this relationship.



The top 1% share of income shoots up in the 1980s in the UK, US and Australia, while staying steady in France, and also Germany (at least till the late 1990s).

Once again the political tide is in favour of taxing wealth. The economic debate, however, is settled. Wealth taxes reduce inequality. Most countries already implement taxes on wealth to some degree, either through annual or inheritance taxes, and have institutional mechanisms in places to administer the them. The sceptics do raise an important political question, but we should learn from history and see that democratic processes, in which economists play a part, can provide avenues for change.

Those ‘tough’ social problems

Poverty is a social issue that usually attracts the label ‘tough problem’. Sometimes, when a bit of flair is in order, it is labelled 'complex' or 'multi-dimensional'. This strikes me as a major cop out.

Reducing or eliminating poverty is not ‘tough’ in any technical sense. The ‘tough’ part is our moral baggage - the distorted moral lens through which we see the problem - which provides an excuse not to make the necessary sacrifices required for change.

For example, it is simple enough to imagine a developed country without poverty. Even using a purely relative metric of poverty that is a direct function of the median income (such as 30% of median income), poverty can be eliminated through appropriate redistribution of wealth. Through either welfare payments, transfers of assets, a national job guarantee, minimum wages, or any other sets of institutions, we can get the resulting distribution of income that means poverty is all but eliminated.

It really is that simple from a technical point of view.

In case you are still skeptical of the simplicity of the solution, imagine for a minute that you are the head of a wealthy household. One of your adult children has, for some reason, flittered away their life savings, been kicked out of their apartment, and has no where to turn.

What do you do?

You invite them home. House them. Feed them. Clothe them. Give them money to help them start rebuilding their life. You probably even call in favours to help them find work.

This investment by the head of the family immediately solves that family’s poverty and homelessness problem.

Maybe this solution is temporary. Maybe this child of yours never seems to grow up. They get caught up with the wrong crowd again, and two years later you are back to square one. You invite them home. Feed them. Clothe them. Give them money.

If it makes sense to do this for your family, why doesn’t it make sense to do it more generally for fellow human beings?

It wasn’t hard. It just required a little sacrifice from the wealthy.

If we think about our country, or dare I say our world, as our extended family, our tribe, then it also makes perfect sense for the wealthiest members of the tribe to support the needy.

What makes these social problems ‘tough’ is our moral baggage. When we see a family member in need we we assume the best - that underneath they are good people, and that their situation is a product on a series of unfortunate circumstances. But when those in need are ‘outsiders’, we seem to assume the worst - that their poverty is a choice, and their poor choices reflect some innate ‘bad’ personality trait, and hence they are undeserving of support.

Poverty wouldn’t be such a ‘tough’ social problem if there were only deserving poor.

Unfortunately the most wealthy in our tribe are also politically active and socially influential, and they fear losing their ‘deserved’ wealth to these ‘underserving’ poor. The media is their weapon, and they reinforce the moral message of the undeserving poor at every opportunity.

Removing our morality goggles makes it clear that ‘tough’ social problems are technically not so tough at all, and that much of society is pretending that is the case in order to protect their own interests, and using warped morality to justify their position.

Micro-foundations don't escape Lucas Critique

The Lucas Critique is summarised by Mark Buchanan as follows:

Any prior regularity that might have existed in a set of data had been present only in the context of the policies prevailing in the past. Change the policies and those changes, by influencing the way people act and anticipate the future, may well strongly change or destroy the regularity on which you had based your plans.

In economics this observation was made famous by Robert Lucas in this 1976 article.

Lucas' critique has justified the micro-foundations approach to macroeconomics for four decades. Put simply, unless you model the macro economy as a result of ‘deep parameters’ of the human psyche, you will never be sure whether your model will apply in a different regulatory or institutional environment. Overcoming the Lucas Critique is apparently achieved by offering a macroeconomic model that stems from a utility function of a representative agent.

But why should we believe that the ‘deep parameters’ of micro-foundations, the utility functions themselves, are somehow independent of the institutional environment?

You can’t escape Lucas’ critique by plucking a utility function out of the air and giving it to a representative agent unless you believe that utility functions are independent of the social environment.

Which raises the question, how can it be possible for an individuals preferences, their utility function, to arise in a social vacuum?

It can’t. The evidence is absolutely clear on this point. Preferences, and even perception, are socially constructed. There simply are no 'deep parameters'.

The whole micro-foundations exercise has been a waste of time for all involved.

While economics has taken seriously this critique from Lucas, they have generally ignored its logical extension of the performativity of economic analysis. Basically performativity says that the use of an economic model in society to guide decisions itself changes behaviour, thus changing the environment in which the analysis applies. Or more simply, utility functions with change in response to the use of models built upon utility functions.

The easy way to see this in action is in sports. As soon as one coach creates a play that exploits a common behaviour in other teams, using that play changes the other team’s response, and thus the environment in which the coach’s original analysis was relevant.

You can’t escape any of this logic.

The lesson is that to understand economic phenomena requires a better understanding of institutional environments, and historical and social context. The micro-foundations approach has merely been an excuse to continue to conceptualise the economy as self-stabilising and in equilibrium in the face of the Lucas Critique, while any rational response would have been to acknowledge the inherent instability of social processes, of which the performativity of economic analysis itself a part of.

Post-Crash economics clashes with 'econ tribe'

Manchester University’s Post-Crash Economics Society (PCES) released a report recently into the way economics is currently taught at Manchester, which is relevant to economics teaching at universities worldwide.

Their well articulated advocacy for pluralism in economics teaching, where neoclassical approaches are just one of many analytic techniques in the curriculum, has tapped into the current media disquiet with economics.

The involvement of the Bank of England’s new Chief Economist, Andrew Haldane, certainly helped, and the report has now found media coverage at the Financial Times, the Wall Street Journal blog, The Independent, and Paul Krugman’s New York Times blog.

In this article I first provide an overview of the PCES report in the context of the modern history of economics and the dissenting voices that came before them. Then I examine the tribal defences raised by the mainstream in response to it, which only serve to reinforce the urgency of the task of transforming economics into a socially valuable endeavour.

What is it all about?
The PCES report provides a concise overview of the systematically narrow and outdated teaching approach in economics, which unfortunately simply reflects the mainstream practice of economics. It highlights how the economics profession, and economic teaching, has seen a ‘great narrowing’ over the past two decades, all but redefining the discipline away from the study of economic phenomena, to the study of a particular family of equilibrium marginal models.

At a practical level the report offers guidance for improving teaching, and a wholeheartedly agree with the points made, which I summarise as follows (emphasis is quoted text)

1. Economics education should begin with the study of economic problems, where economic phenomena are outlined and the student is given a toolkit and must evaluate the strengths and weaknesses of how different theories explain different phenomena.
2. Introduce pluralism so that students understand that different models and theories can be applied or are most useful in different situations. Students should be able to consider a variety of theories before forming judgements. This is important because economic theory is not universally applicable and much depends much on institutional, historical and social contexts.
3. Include the study of institutional power structures and politics. In doing so, students should be aware of the ethics of being an economist and a consideration of the ethical consequences of economic theory.
4. Ensure that the philosophy of economics, or the more generally the philosophy of science, forms a core part of the curriculum. Student should be able to understand which assumptions are justified in a scientific theory and how rigorous must the ability to falsify a theory must be.
5. Finally, provide students an understanding of the historical development of a particular model or economic paradigm in order to contextualise the approach and provide insight into the problems it was designed to solve and how context influenced its formation. 

The PCES report, and its proposed reforms, is itself part of a recurring theme in the history of economics. In 1973 Joan Robinson tried to revolutionise economics teaching, writing a textbook reflecting most of the reforms advocated by the PCES. Unfortunately that book is all but forgotten in economics. I certainly wish Robinson had been successful, as it would have deterred the next generation of top economists from merely repeating the nonsense that went before them.

In a strange historical coincidence, William Baumol complained of poor teaching of economics as far back as the late 1930s. At the time he found the teaching ignored what was then the cutting edge work of Keynes and Joan Robinson herself.

In 1968 it was the Union for Radical Political Economists that set about disrupting the discipline. By 1972 this movement had agitated so successfully that the then President of the American Economics Association John K Galbraith, a supporter of the movement, noted in his 1972 Presidential address to the Association that "For a new and notably articulate generation of economists a reference to neoclassical economics has become markedly pejorative". He went on to say

Neoclassical and neo-Keynesian economics, though providing unlimited opportunity for the demanding niceties of refinement, has a decisive flaw. It offers no useful handle for grasping the economic problems that now beset the modern society.

But nothing changed.

In 1992 the Foundation for European Economic Development (FEED) funded work that produced a Plea for a Pluralistic and Rigorous Economics, which was published in the American Economic Review.  Again, nothing.

More recently the Post-Austistic Economics movement emerged in Paris in 2000 with a similar mission to reform economics, followed closely by a proposal to open up economics by a group of PhDs at Cambridge in 2001.

In 2003 Harvard economics students organised a group called Students for Humane and Responsible Economics (SHARE), which launched a petition calling for a new approach to economic teaching and offered an alternative introductory course that was ultimately rejected by the university. At Manchester, the PCES has had their proposed course on Alternative Theories of the Crisis rejected by the university just a month ago.

In 2011 we also saw the EC10 class walk out on N. Gregory Mankiw’s lecture at Harvard in support of the Occupy protests, which in retrospect seems completely appropriate given Mankiw’s prostitution of economic ideas to defend the wealthiest 1%. Published at one of the leading economics journals, Mankiw’s ‘Defending the 1%’ article provides a classic example of the unscientific nature of the discipline’s ‘respectable’ journals, and the perverse anti-scientific but ideological incentive system embedded in the culture of economics.

The PCES is now one of many student societies, including for example, the German Pluralist Economics Network, justifiably calling for change in economics. Again the time appears ripe for disruption of economics, and the PCES offers useful guidance for how to achieve that.

The tribe responds
First, let me say that ‘econ tribe’, the core of the economics profession, is truly a tribe - a clique, a social construct - rather than a scientific community. As senior econ tribe member once gave me the following advice.

...the group ‘elders’ have implicit theories in their heads as to how the world works, what forms of behaviour are appropriate, what beliefs are reasonable, what questions are truly yet unanswered, what articles of faith should not be doubted, and where they and their group ultimately make their money

Oh, and that’s just the start (added emphasis).

…many economists like to pretend that even if they give practical policy advice, they as economists make no value judgment on what people want, i.e. ‘preferences are taken to be stable and can differ over all individuals’.

Such statements are then implicitly ‘backed up’ by theoretical models of decision making arising from underlying preference maps (i.e. a ‘deeper layer’).

Now, as a statement of reality this is a completely absurd and purely religious position since no-one even comes close to having ever measured a preference map despite the feeble protestations of the revealed-preference crowd, but as a defensive shield against the criticisms of psychologists and mathematically-challenged economists it is very effective. It drags criticisers into a morass few will escape from and that no outsider would be able to follow anyway, making it sound like a good riposte.

Nearly all sub-fields of economics have similar defensive religious beliefs used to deter entry by unwanted outsiders…

A give-away signal of a tribe member is that they will deny the religious nature of their tribe, and pledge loyalty wherever possible by defending the tribe against all challenges. This is the sell-out that most successful economists make at some point in their career, something Yanis Varoufakis has written extensively about.

We see evidence of overt religious zeal and loyalty pledges in the mainstream responses to the PCES report. Here are the links so you can read them for yourselves - Wren-Lewis, Yates, Farmer, Krugman. Expect more in the coming weeks.

The blueprint response was that economics teaching could be better, but economics is fine. I couldn’t disagree more. This is a mere loyalty pledge.

Poor teaching reflects the poor scholarship of the discipline more broadly. This is most clearly seen in Ferrero and Taylor’s survey of economists, where 78% of professional economists (including professors) incorrectly answered a multiple-choice question about the definition of opportunity cost. The profession subsequently kicked into gear to defend itself from embarrassment, with one article in a ‘respectable’ journal making the Alice in Wonderland response that any Humpty can use opportunity cost to mean just what they choose it to mean - “neither more nor less!”

But the big defensive play to combat the PCES threat was to assert that the ‘sciency-ness’ of the mainstream is the reason for its dominance, and the reason we should respect it. Again, deny the religious aspects of economics, be loyal to the tribe.

From Wren-Lewis.

…economics is a science. Its response to data and events may be slow compared to the normal sciences, for obvious reasons, but it is progressive

From Farmer

Economics is a science…the core approach to modern economics, both macro and micro, is the culmination of a process of intellectual argument in which ideas have been sifted, debated and compared with facts. Some have survived; others have not.

Farmer’s claim is not at all true. Most of the modern macro debates were already happening in the 1800s.

It is scary to think that these economists believe what they doing is science. There are parts of economists that do take those crucial scientific steps of prediction and experimentation, and the results usually contradict mainstream theory - conflict is real, costly punishment is real, social norms can evolve and change, preferences are not well behaved, markets boom and bust, and more. Yet for some reason the preacher’s models seem immune to evidence.

A comment from Yates’ post points to the non-scientific approach deemed acceptable in economics.

If economists wished to study the horse, they wouldn’t go and look at the horses. They’d sit in their studies and say to themselves, “What would I do if I were a horse?

Physicist-turned-sociologist Duncan Watts has warned about this approach

…social scientists, like everyone else, participate in social life and so feel as if they can understand why people do what they do simply by thinking about it. It is not surprising, therefore, that many social scientific explanations suffer from the same weaknesses—ex post facto assertions of rationality, representative individuals, special people, and correlation substituting for causation—that pervade our commonsense explanations as well. 

Krugman and Yates take the whole ‘sciency-ness’ one step further, pretending that economists do in fact know what’s going on in the economy, in banking, in financial crises, and in recessions. Or something.

Steve Keen fired off a response to Krugman, arguing that he contorted the failure of economics to foresee even the remote possibility of a debt-fuelled crisis, into a mere failure to keep an eye on shadow banking - as if better data on shadow banking would have somehow led to the whole econ tribe dropping their core money-less models of the economy in equilibrium to embrace theoretical approaches of outsiders.

A second defensive play, seen in Yates and Farmer’s responses, is that within the mainstream there is a model for everything, so no need to look outside. Again, no reference to the success of any of the models in predicting economic phenomena. It is as if the high priests response to evidence is to merely create a new god - “Ah yes, haven’t you seen, we have a Tornado God now. Solved that didn’t we” - and ignore reality.

In the past Krugman has actually made similar points. Mainstream economics ignored increasing returns to scale as a reason for trade, even though it had long been understood by ‘outsiders’. To address this he created the Increasing Returns God for the tribe.

I was, of course, only saying something that critics of conventional theory had been saying for decades. Yet my point was not part of the mainstream of international economics. Why? Because it had never been expressed in nice models. 

Which only serves to highlight the invalid non-scientific approach - ideas are not judged on the merit as predictive tools, but on whether they can be expressed in the pre-determined modelling methods of the tribe as nice totems of the modelling gods.

As I have said, the value of a scientific model is its ability to predict outcomes in new situations. In economics, the reverse is true. Most economists believe that models provide insights simply by their construction, whereas in reality we can never know if the model is useful unless it offers useful predictions.

It is telling that we see no arguments based on scientific principles in these responses. Nothing on the practical usefulness of mainstream approaches above others. No long lists of scientific battles won by the mainstream because of the useful predictive power of their approach, and plenty of silence on the battles they lost (eg. the capital debates).

That is to be expected from the tribe’s high priests. But it also shows a distinct ignorance of alternative approaches. If there was a wide understanding of alternatives a response comparing the merit of different approaches could be made. The reason it isn’t made is because once economists learn of heterodox approaches the usually leave the tribe. For example, I can’t imagine that any macroeconomist with a decent understanding of Godley and Lavoie’s integrated monetary models would really continue to believe that the mainstream ‘label the residual’ approach to a money-less equilibrium is more valid.

The future
I wish the PCES the best of luck. It is possible for economics to be a useful science, but that requires a much more humble discipline that is able to judge theoretical and methodological approaches based on proper evidence. It starts by acknowledging that in a scientific sense, the body of knowledge in economics is extremely limited, and much of what passes for economics is a collection of mere credible stories about certain phenomena, which are yet to be tested.

I hope indeed that the observation that Pilkington makes is the correct one, and that the time is ripe for transformation in economics.

…silently, behind the scenes, the heterodox have been winning the debate. Krugman would never admit this, of course — indeed, he seems to live in a bit of an echo chamber over at the NYT with all his fanboys and fangirls and he may not even be fully cognizant of it — but if you move in economics circles you’ll know this to be generally recognised.

But let me finish with more sober words from James K Galbraith, because I believe transforming economics is going to be one hell of a battle of tribal politics.

Leading active members of today’s economics profession... have formed themselves into a kind of Politburo for correct economic thinking.  

As a general rule—as one might generally expect from a gentleman’s club—this has placed them on the wrong side of every important policy issue, and not just recently but for decades.

They predict disaster where none occurs. They deny the possibility of events that then happen. ... They oppose the most basic, decent and sensible reforms, while offering placebos instead.

They are always surprised when something untoward (like a recession) actually occurs. And when finally they sense that some position cannot be sustained, they do not reexamine their ideas. They do not consider the possibility of a flaw in logic or theory. Rather, they simply change the subject.

No one loses face, in this club, for having been wrong. No one is dis-invited from presenting papers at later annual meetings. And still less is anyone from the outside invited in.