LARS P. SYLL

Friedman’s response to Romer & Romer

As yours truly wrote the other day, reading the different reactions, critiques and ‘analyses’ of Gerald Friedman’s calculations on the long term effects of implementing the Sanders’ program, the whole issue seems to basically burn down to if the Verdoorn law is operative or not.

In Friedman’s response to Romer & Romer today this is made even clearer than in the original Friedman analysis:

The Romers … would acknowledge that following a negative shock, government stimulus spending may accelerate the recovery somewhat …They deny, however, that stimulus spending could change the permanent level of output … Like mosquitos on an otherwise delightful summer afternoon, slow growth is unfortunate but there is little that can safely be done about it.

Or maybe we can find safe pesticides. Here I agree with John Maynard Keynes that the economy can have a low-employment equilibrium because of a lack of effective demand, and I agree with Nicholas Kaldor and Petrus Verdoorn that productivity and the growth rate of capacity can be increased by policies that push the economy to a higher level of employment … I see an economy at low-employment equilibrium where discouraged workers have abandoned the labor market and firms have had little incentive to innovate or to raise productivity. In this situation, additional stimulus can not only temporarily raise output but by priming the pump and encouraging additional private spending and investment, it can push the economy upwards towards capacity. And, beyond because at higher levels of employment, more people will look for work, more businesses will invest, and employment will grow faster and productivity will rise pushing up the growth rate in capacity. That is why I see lasting effects from a government stimulus when, as now, the economy is in a low-employment equilibrium.

Transitivity — just another questionable assumption

My doctor once recommended I take niacin for the sake of my heart. Yours probably has too, unless you’re a teenager or a marathon runner or a member of some other metabolically privileged caste. Here’s the argument: Consumption of niacin is correlated with higher levels of HDL, or “good cholesterol,” and high HDL is correlated with lower risk of “cardiovascular events.” If you’re not a native speaker of medicalese, that means people with plenty of good cholesterol are less likely on average to clutch their hearts and keel over dead.

But a large-scale trial carried out by the National Heart, Lung, and Blood Institute was halted in 2011, a year and a half before the scheduled finish, because the results were so weak it didn’t seem worth it to continue. Patients who got niacin did indeed have higher HDL levels, but they had just as many heart attacks and strokes as everybody else.

How can this be? Because correlation isn’t transitive. That is: Just because niacin is correlated with HDL, and high HDL is correlated with low risk of heart disease, you can’t conclude that niacin is correlated with low risk of heart disease.

Transitive relations are ones like “weighs more than.” If I weigh more than my son and my son weighs more than my daughter, it’s an absolute certainty that I weigh more than my daughter. “Lives in the same city as” is transitive, too—if I live in the same city as Bill, who lives in the same city as Bob, then I live in the same city as Bob.

But many of the most interesting relations we find in the world of data aren’t transitive. Correlation, for instance, is more like “blood relation.” I’m related to my son, who’s related to my wife, but my wife and I aren’t blood relatives. In fact, it’s not a terrible idea to think of correlated variables as “sharing part of their DNA.” Suppose I run a boutique money management firm with just three investors, Laura, Sara, and Tim. Their stock positions are pretty simple: Laura’s fund is split 50–50 between Facebook and Google, Tim’s is one-half General Motors and one-half Honda, and Sara, poised between old economy and new, goes one-half Honda, one-half Facebook. It’s pretty obvious that Laura’s returns will be positively correlated with Sara’s; they have half their portfolio in common. And the correlation between Sara’s returns and Tim’s will be equally strong. But there’s no reason (except insofar as the whole stock market tends to move in concert) to think Tim’s performance has to be correlated with Laura’s. Those two funds are like the parents, each contributing one-half of their “genetic material” to form Sara’s hybrid fund.

Jordan Ellenberg

Bernie Sanders and the Verdoorn law

Reading the different reactions, critiques and ‘analyses’ of Gerald Friedman’s calculations on the long term effects of implementing the Sanders’ program, it seem to me that what it basically burns down to is if the Verdoorn law is operative or not.

Estimating the impact of Sanders’ program Friedman writes (p. 13):

Higher demand for labor is also associated with an increase in labor productivity and this accounts for about half of the increase in economic growth under the Sanders program.

Obviously, that’s a view that  Christina Romer and David Romer (p. 8) don’t share:

Friedman … argues that as demand expansion raised output, endogenous productivity growth … would raise productive capacity by enough to prevent it from constraining output … The evidence that productivity growth would surge as a result of a demand-driven boom is weak. The fact that there is a correlation between output growth and productivity growth is not surprising. Periods of rapid productivity growth, such as the 1990s, are naturally also periods of rapid output growth. But this does not tell us that an extended period of rapid output growth resulting from demand stimulus would cause sustained high productivity growth …

In the standard mainstream economic analysis, a demand expansion may very well raise measured productivity — in the short run. But in the long run, expansionary demand policy measures cannot lead to sustained higher productivity and output levels.

In some non-standard heterodox analyses, however, labour productivity growth is often described as a function of output growth. The rate of technical progress varies directly with the rate of growth according to the Verdoorn law. Growth and productivity is in this view highly demand-determined not only in the short run but also in the long run.

Given that the Verdoorn law is operative, Sanders’ policy could actually lead to increases in productivity and growth. Living in a world permeated by genuine Keynes-type uncertainty, we can, of course, not with any greater precision forecast how great those effects would be.

So, the nodal point is — has the Verdoorn Law been validated or not in empirical studies?

There have been hundreds of studies that have tried to answer that question, and as could be imagined, the answers differ. The law has been investigated with different econometric methods (time-series, IV, OLS, ECM, cointegration, etc.). The statistical and econometric problems are enormous (especially when it comes to the question, highlighted by Romer & Romer, on the direction of causality). Given this, however, most studies on the country level do confirm that the Verdoorn law holds — United States included. Most of the studies are for the period before the subprime crisis of 2006/2007, but if anything, it is more in line with Friedman than Romer & Romer.

Oh, dear.

Macroeconomics on a walk down a blind alley

I would say that people like Kydland and Prescott, and so forth, people like that … changed the way that people do macroeconomics. But in my view it was not a positive change … One predominant idea is that of external shocks—and in particular the idea that the shocks that happen to the economy should essentially be the technological shocks. As Joe Stiglitz said, what could we mean by a negative technological shock? That people forget what they could do before?

So we have this idea that we have a system which is in equilibrium and that every now and then it gets knocked off the equilibrium by ‘a shock’. But shocks are part of the system! We have gone down a track that actually does not allow us to say much about the real, major movements in the macro-economy … We should be studying non-normal periods, instead of normal ones, because that is what causes real problems. And we do not do that.

So my vision of the state of macroeconomics is that it somehow has the wrong view: an equilibrium view and a stationary state view. But what is important and interesting about macroeconomics is precisely when those two things do not hold. How can you talk of equilibrium when we move from 5% unemployment to 10% unemployment? If you are in Chicago, you say “Well, those extra 5% have made the calculation that it was better for them to be out of work”. But look at the reality; that is not what happens. People do not want to be out of work … Millions of people are out of work, and we are not worried about that?

That is the major failure in macroeconomics. It does not address the serious problems that we face when we get out of equilibrium. And we are out of equilibrium most of the time.

Alan Kirman

Yours truly is extremely fond of economists like Alan Kirman. With razor-sharp intellects they immediately go for the essentials. They have no time for bullshit. And neither should we.

Economists — dangerous arrogants

In advanced economics the question would be: ‘What besides mathematics should be in an economics lecture?’ In physics the familiar spirit is Archimedes the experimenter. But in economics, as in mathematics itself, it is theorem-proving Euclid who paces the halls …

Economics … has become a mathematical game. The science has been drained out of economics, replaced by a Nintendo game of assumption-making …

Most thoughtful economists think that the games on the blackboard and the computer have gone too far, absurdly too far. It is time to bring economic observation, economic history, economic literature, back into the teaching of economics.

Economists would be less arrogant, and less dangerous as experts, if they had to face up to the facts of the world. Perhaps they would even become as modest as the physicists.

D. McCloskey

‘Mathematical’ economists and real mathematicians

Years ago, I was involved in organising conferences with Christopher Zeeman … and we organized one between economists and mathematicians. We had some great mathematicians—John Milnor, Steve Smale, Rene Thom, and others—wonderful mathematicians. And on the other side, we had Gérard Debreu, Hugo Sonnenschein, Werner Hildenbrand, and a whole group of very distinguished mathematical economists.

After the first two, three hours, I think it was Milnor who said: “We all know that you guys can do mathematics, you do not have to show us. Everybody does his own thing. You want to show us that you are good at doing certain sorts of mathematics; that is fine. But we are interested in the economic problems. We thought that you were going to tell us about economic problems and we were going to use our mathematical tools to help you. But all you are telling us is the mathematical tools that you use and how you are doing well with them. But that is not going to create much”. I think that was absolutely right. After that, the economists were rather silenced and started shifting in their seats uncomfortably. Debreu never said very much anyway, but it was clear he was very insulted, because basically he liked to think of himself as a mathematician.

Alan Kirman

The limits of game theory

If you read Binmore’s Essays on the foundations of game theory (1990)
you will find a section where he says that, unfortunately, we get into a
kind of impasse. We get this infinite regress linked to the common
knowledge problem. For example, I drive frequently from Aix to
Marseille. You have the autoroute and parallel to it is the route
nationale. Say there is, one day, congestion on the autoroute and nobody
on the nationale. I think: “Tomorrow I will take the nationale. But, wait
a minute, these other drivers are intelligent too, so they will take the
nationale tomorrow, I would do better to stay over here. But, wait a
minute, these drivers are pretty intelligent so they can make that step
too…” It is actually not logically possible to reason to the solution of
these kinds of problems that people are supposed to be solving in game
theory.

You can surely define an equilibrium, and say that if we were there
nobody would want to move. But then you get to the problem of how we
get to this equilibrium—the exact same problem that we have with
general equilibrium …

For certain specific, local problems, game theory is a very nice way
of thinking about how people might try to solve them, but as soon as
you are dealing with a general problem like an economy or a market,
I think it is difficult to believe that there is full strategic interaction
going on. It is just asking too much of people. Game theory imposes a
huge amount of abstract reasoning on the part of people …

That is why I think game theory, as an approach to large scale interaction, is probably not the right way to go.

Alan Kirman