## Econometric confusions

31 May, 2016 at 10:43 | Posted in Statistics & Econometrics | 11 Comments

In a recent issue of Real World Economics Review there was a rather interesting, if somewhat dense, article by Judea Pearl and Bryant Chen entitled Regression and Causation: A Critical Examination of Six Econometrics Textbooks …

The paper appears to turn on a single dichotomy. The authors point out that there is a substantial difference between what they refer to as the “conditional-based expectation” and “interventionist-based expectation”. The first is given the notation:

E[Y|X]

While the second is given the notation:

E[Y|do(X)]

The difference between these two relationships is enormous. The first notation — that is, the “conditional-based expectation” — basically means that the value Y is statistically dependent on the value X …

The second notation — that is, the “interventionist-based expectation” — refers to something else entirely. It means that the value Y is causally dependent on the value X …

Now, if we simply go out and take a statistical measure of earnings and expected performance we will find a certain relationship — this will be the conditional-based expectation and it will be purely a statistical relationship.

If, however, we take a group of employees and raise their earnings, X, by a given amount will we see the same increase in performance, Y, as we would expect from a study of the past statistics? Obviously not. This example, of course, is the interventionist-based expectation and is indicative of a causal relationship between the variables …

In economics we are mainly interested in causal rather than statistical relationships. If we want to estimate, for example, the multiplier, it is from a causal rather than a statistical point-of-view. Yet the training that many students receive leads to confusion in this regard. Indeed, we may go one further and ask whether such a confusion also sits in the mind of the textbook writers themselves.

This confusion between statistical relationships and causal ones has long been a problem in econometrics. Keynes, for example, writing his criticism of the econometric method in his seminal paper Professor Tinbergen’s Method noted that Tinbergen had made precisely this error …

The question then arises: why, after over 70 years, are econometrics textbooks engaged in the same oversights and vaguenesses as some of the pioneering studies in the field? I think there is a simple explanation for this. Namely, that if econometricians were to be clear about the distinction between statistical and causal relations it would become obvious rather quickly that the discipline holds far less worth for economists than it is currently thought to possess.

Philip Pilkington

For my own take on the issues raised by Pearl and Chen see here.

## Moments like this you never forget!

30 May, 2016 at 17:15 | Posted in Economics | 1 Comment

Last year Mark Blyth gave the U. S. Senate Budget Committee a well-earned lecture on public debt. Unforgettable and absolutely fabulous!

## Wren-Lewis/Mirowski/Syll on neoliberalism

29 May, 2016 at 18:45 | Posted in Economics | 2 Comments

Oxford professor Simon Wren-Lewis had a post up some time ago commenting on traction gaining ‘attacks on mainstream economics’:

One frequent accusation … often repeated by heterodox economists, is that mainstream economics and neoliberal ideas are inextricably linked. Of course economics is used to support neoliberalism. Yet I find mainstream economics full of ideas and analysis that permits a wide ranging and deep critique of these same positions. The idea that the two live and die together is just silly.

Hmmm …

And now he’s back again defending the mainstream economics establishment against critique waged against it from Phil Mirowski:

Mirowski overestimates the extent to which neoliberal ideas have become “embedded in economic theory”, and underestimates the power that economic theory and evidence can have over even those academic economists who might have a neoliberal disposition. If the tide of neoliberal thought is going to be turned back, economics is going to be important in making that happen.

Wren-Lewis admits that ‘Philip Mirowski is a historian who has written a great deal about both the history of economics as a discipline and about neoliberalism’ and that Mirowski ‘knows much more about the history of both subjects than I [W-L] do’. Fair enough, but there are simple remedies for the lack of knowledge.

Start take a look at this video:

Or maybe read this essay, where yours truly try to further analyze — much inspired by the works of Amartya Sen — what kind of philosophical-ideological-political-economic doctrine neoliberalism is, and why it so often comes natural for mainstream economists to embrace neoliberal ideals.

[Or maybe — if you know some Swedish — you could take part of this book-length argumentation (Atlas 2001) for why there has been such a deep and long-standing connection between the dismal science and different varieties of neoliberalism.]

## The tiny little problem with Chicago economics

29 May, 2016 at 13:22 | Posted in Economics | 6 Comments

Every dollar of increased government spending must correspond to one less dollar of private spending. Jobs created by stimulus spending are offset by jobs lost from the decline in private spending. We can build roads instead of factories, but fiscal stimulus can’t help us to build more of both. This form of “crowding out” is just accounting, and doesn’t rest on any perceptions or behavioral assumptions.

John Cochrane

And the tiny little problem? It’s utterly and completely wrong!

What Cochrane is reiterating here is nothing but Say’s law, basically saying that savings are equal to investments, and that if the state increases investments, then private investments have to come down (‘crowding out’). As an accounting identity there is of course nothing to say about the law, but as such it is also totally uninteresting from an economic point of view. As some of my Swedish forerunners — Gunnar Myrdal and Erik Lindahl — stressed more than 80 years ago, it’s really a question of ex ante and ex post adjustments. And as further stressed by a famous English economist about the same time, what happens when ex ante savings and investments differ, is that we basically get output adjustments. GDP changes and so makes saving and investments equal ex ost. And this, nota bene, says nothing at all about the success or failure of fiscal policies!

Government borrowing is supposed to “crowd out” private investment.

The current reality is that on the contrary, the expenditure of the borrowed funds (unlike the expenditure of tax revenues) will generate added disposable income, enhance the demand for the products of private industry, and make private investment more profitable. As long as there are plenty of idle resources lying around, and monetary authorities behave sensibly, (instead of trying to counter the supposedly inflationary effect of the deficit) those with a prospect for profitable investment can be enabled to obtain financing. Under these circumstances, each additional dollar of deficit will in the medium long run induce two or more additional dollars of private investment. The capital created is an increment to someone’s wealth and ipso facto someone’s saving. “Supply creates its own demand” fails as soon as some of the income generated by the supply is saved, but investment does create its own saving, and more. Any crowding out that may occur is the result, not of underlying economic reality, but of inappropriate restrictive reactions on the part of a monetary authority in response to the deficit.

William Vickrey Fifteen Fatal Fallacies of Financial Fundamentalism

In a lecture on the US recession, Robert Lucas gave an outline of what the new classical school of macroeconomics today thinks on the latest downturns in the US economy and its future prospects.

Lucas starts by showing that real US GDP has grown at an average yearly rate of 3 per cent since 1870, with one big dip during the Depression of the 1930s and a big – but smaller – dip in the recent recession.

After stating his view that the US recession that started in 2008 was basically caused by a run for liquidity, Lucas then goes on to discuss the prospect of recovery from where the US economy is today, maintaining that past experience would suggest an “automatic” recovery, if the free market system is left to repair itself to equilibrium unimpeded by social welfare activities of the government.

As could be expected there is no room for any Keynesian type considerations on eventual shortages of aggregate demand discouraging the recovery of the economy. No, as usual in the new classical macroeconomic school’s explanations and prescriptions, the blame game points to the government and its lack of supply side policies.

Lucas is convinced that what might arrest the recovery are higher taxes on the rich, greater government involvement in the medical sector and tougher regulations of the financial sector. But – if left to run its course unimpeded by European type welfare state activities -the free market will fix it all.

In a rather cavalier manner – without a hint of argument or presentation of empirical facts – Lucas dismisses even the possibility of a shortfall of demand. For someone who already 30 years ago proclaimed Keynesianism dead – “people don’t take Keynesian theorizing seriously anymore; the audience starts to whisper and giggle to one another” – this is of course only what could be expected. Demand considerations are simply ruled out on whimsical theoretical-ideological grounds, much like we have seen other neo-liberal economists do over and over again in their attempts to explain away the fact that the latest economic crises shows how the markets have failed to deliver. If there is a problem with the economy, the true cause has to be government.

Chicago economics is a dangerous pseudo-scientific zombie ideology that ultimately relies on the poor having to pay for the mistakes of the rich. Trying to explain business cycles in terms of rational expectations has failed blatantly. Maybe it would be asking to much of freshwater economists like Lucas and Cochrane to concede that, but it’s still a fact that ought to be embarrassing. My rational expectation is that 30 years from now, no one will know who Robert Lucas or John Cochrane was. John Maynard Keynes, on the other hand, will still be known as one of the masters of economics.

## Send in the clowns

29 May, 2016 at 11:01 | Posted in Varia | 1 Comment

No, I wasn’t thinking of U. S. republican presidential candidates …

## The bonus puzzle

28 May, 2016 at 09:53 | Posted in Economics | 1 Comment

Diane Coyle has an excellent article in the FT about an apparent puzzle. Why do executives get incentive bonuses (extra pay on meeting some target), but most workers do not? Her article is based around a classic paper by Bengt Holmstrom and Paul Milgrom. Their basic argument is that incentive pay linked to specific targets works (it increases effort) when tasks are simple and effort can be easily measured. However if tasks are complex, and only some aspects of performance can be accurately measured, incentive pay can distort the allocation of effort between those tasks, leading to undesirable outcomes …

So target related bonuses make sense for workers conducting simple tasks where effort can be easily measured, but are a bad idea for workers undertaking complex tasks where only some aspects of performance can be measured. To quote Diane:

“Indeed, the best arrangement would seem to be the opposite of the pattern we observe now. Corporate executives and senior bankers oing complex jobs involving many impossible-to-monitor activities are the last people who ought to be paid via an incentive scheme; while bonuses for fast-food workers or shop-floor employees make more sense.”

The implication she draws is straightforward: the bonus culture for corporate executives and senior bankers should end. But this leaves us with a puzzle: why did this bonus culture arise in the first place? Perhaps bonuses created something beneficial that we are missing …

The executive has a lot of bargaining power (what successful firm wants their CEO to quit), but whether they choose to use it depends on the reward from doing so. If top tax rates are low, the rewards are high.

The executive still has to convince their firm to pay them more. What better way to do this than to suggest they get paid a lot more only if the company is successful …

Executive bonuses are a way for senior management to extract rent from their firms, which is a quick way of saying that these high salaries redistribute money from everyone else to themselves.

Simon Wren-Lewis

At a deeper level this ‘puzzle’ confirms that the alleged close connection between productivity and remuneration postulated in mainstream income distribution theory simply does not exist.

The idea that capitalism is an expression of impartial market forces of supply and demand, bears but little resemblance to actual reality. Especially when it comes to  people that basically set their own salaries, you find a rather strong inclination for generous self-rewarding.

Wealth and income distribution, both individual and functional, in a market society is to an overwhelmingly high degree influenced by bargaining power, institutionalized political and economic norms, things that have relatively little to do with marginal productivity in complete and profit-maximizing competitive market models – not to mention how extremely difficult, if not outright impossible it is to empirically disentangle and measure different individuals’ contributions in the typical team work production that characterize modern societies; or, especially when it comes to ‘capital,’ what it is supposed to mean and how to measure it. Remunerations, a fortiori, do not necessarily correspond to any marginal product of different factors of production – or to ‘compensating differentials’ due to non-monetary characteristics of different jobs, natural ability, effort or chance.

## The real cost of euro austerity

27 May, 2016 at 16:58 | Posted in Economics | 2 Comments

The euro has taken away the possibility for national governments to manage their economies in a meaningful way — and in Greece the people has had to pay the true costs of its concomitant misguided austerity policies.

The unfolding of the Greek tragedy during the last couple of years has shown beyond any doubts that the euro is not only an economic project, but just as much a political one. What the neoliberal revolution during the 1980s and 1990s didn’t manage to accomplish, the euro shall now force on us.

But do the peoples of Europe really want to deprive themselves of economic autonomy, enforce lower wages and slash social welfare at the slightest sign of economic distress? Is inreasing income inequality and a federal überstate really the stuff that our dreams are made of? I doubt it.

History ought to act as a deterrent. During the 1930s our economies didn’t come out of the depression until the folly of that time — the gold standard — was thrown on the dustbin of history. The euro will hopefully soon join it.

Economists have a tendency to get enthralled by their theories and models, and forget that behind the figures and abstractions there is a real world with real people. Real people that have to pay dearly for fundamentally flawed doctrines and recommendations.

Let’s make sure the consequences will rest on the conscience of those economists.

## Econometrics — a Keynesian perspective

27 May, 2016 at 14:05 | Posted in Statistics & Econometrics | Comments Off on Econometrics — a Keynesian perspective

It will be remembered that the seventy translators of the Septuagint were shut up in seventy separate rooms with the Hebrew text and brought out with them, when they emerged, seventy identical translations. Would the same miracle be vouchsafed if seventy multiple correlators were shut up with the same statistical material? And anyhow, I suppose, if each had a different economist perched on his a priori, that would make a difference to the outcome.

J M Keynes

Mainstream economists today usually subscribe to the idea that although mathematical-statistical models are not ‘always the right guide for policy,’ they are  still somehow necessary for making policy recommendations. The models are supposed to supply us with a necessary ‘discipline of thinking.’

This emphasis on the value of modeling should come as no surprise. Mainstreamers usually vehemently defend the formalization and mathematization that comes with the insistence of using a model building strategy in economics.

But if these math-is-the-message-modelers aren’t able to show that the mechanisms or causes that they isolate and handle in their mathematical-statistically formalised models are stable in the sense that they do not change when we ‘export’ them to our ‘target systems,’ these models do only hold under ceteris paribus conditions and are consequently of limited value to our understandings, explanations or predictions of real economic systems. Building models only to show  ‘self-dicipline’ is setting the aspiration level far too low.

According to Keynes, science should help us penetrate to ‘the true process of causation lying behind current events’ and disclose ‘the causal forces behind the apparent facts.’ We should look out for causal relations. But models — mathematical, econometric, or what have you — can never be more than a starting point in that endeavour. There is always the possibility that there are other (non-quantifiable) variables – of vital importance and although perhaps unobservable and non-additive not necessarily epistemologically inaccessible – that were not considered for the formalized mathematical model.

The kinds of laws and relations that ‘modern’ economics has established, are laws and relations about mathematically formalized entities in models that presuppose causal mechanisms being atomistic and additive. When causal mechanisms operate in real world social target systems they only do it in ever-changing and unstable combinations where the whole is more than a mechanical sum of parts. If economic regularities obtain they do it (as a rule) only because we engineered them for that purpose. Outside man-made mathematical-statistical ‘nomological machines’ they are rare, or even non-existant. Whether econometric or not, that also, unfortunately, makes most of contemporary mainstream endeavours of economic modeling rather useless.

Econometric modeling should never be a substitute for thinking. From that perspective it is really depressing to see how much of Keynes’ critique of the pioneering econometrics in the 1930s-1940s is still relevant today.

The general line you take is interesting and useful. It is, of course, not exactly comparable with mine. I was raising the logical difficulties. You say in effect that, if one was to take these seriously, one would give up the ghost in the first lap, but that the method, used judiciously as an aid to more theoretical enquiries and as a means of suggesting possibilities and probabilities rather than anything else, taken with enough grains of salt and applied with superlative common sense, won’t do much harm. I should quite agree with that. That is how the method ought to be used.

Keynes, letter to E.J. Broster, December 19, 1939

## Economics — too much maths and too little history

26 May, 2016 at 21:18 | Posted in Economics | 1 Comment

## Solow and Damon Runyon’s law

26 May, 2016 at 20:41 | Posted in Economics | 5 Comments

The eminently quotable Robert Solow — as always — says it all:

To get right down to it, I suspect that the attempt to construct economics as an axiomatically based hard science is doomed to fail. There are many partially overlapping reasons for believing this …

A modern economy is a very complicated system. Since we cannot conduct controlled on its smaller parts, or even observe them in isolation, the classical hard- science devices for discriminating between competing hypotheses are closed to us. The main alternative device is the statistical analysis of historical time-series. But then another difficulty arises. The competing hypotheses are themselves complex and subtle. We know before we start that all of them, or at least many of them, are capable of fitting the data in a gross sort of way. Then, in order to make more refined distinctions, we need long time-series observed under stationary conditions.

Unfortunately, however, economics is a social science. It is subject to Damon Runyon’s Law that nothing between human beings is more than three to one. To express the point more formally, much of what we observe cannot be treated as the realization of a stationary stochastic process without straining credulity. Moreover, all narrowly economic activity is embedded in a web of social institutions, customs, beliefs, and attitudes. Concrete outcomes are indubitably affected by these background factors, some of which change slowly and gradually, others erratically. As soon as time-series get long enough to offer hope of discriminating among complex hypotheses, the likelihood that they remain stationary dwindles away, and the noise level gets correspondingly high. Under these circumstances, a little cleverness and persistence can get you almost any result you want. I think that is why so few econometricians have ever been forced by the facts to abandon a firmly held belief …

Robert Solow

## NAIRU — a harmful fairy tale

26 May, 2016 at 12:37 | Posted in Economics | Comments Off on NAIRU — a harmful fairy tale

The NAIRU story has always had a very clear policy implication — attempts to promote full employment is doomed to fail, since governments and central banks can’t push unemployment below the critical NAIRU threshold without causing harmful runaway inflation.

Althouigh a lot of mainstream economists and politicians have a touching faith in the NAIRU fairy tale, it doesn’t hold water when scrutinized.

One of the main problems with NAIRU is that it is essentially a timeless long-run equilibrium attractor to which actual unemployment (allegedly) has to adjust. If that equilibrium is itself changing — and in ways that depend on the process of getting to the equilibrium — well, then we can’t really be sure what that equlibrium will be without contextualizing unemployment in real historical time. And when we do, we will see how seriously wrong we go if we omit demand from the analysis. Demand policy has long-run effects and matters also for structural unemployment — and governments and central banks can’t just look the other way and legitimize their passivity re unemployment by refering to NAIRU.

NAIRU does not hold water simply because it does not exist — and to base economic policy on such a weak theoretical and empirical construct is nothing short of writing out a prescription for self-inflicted economic havoc.

The conventional wisdom, codified in the theory of the non-accelerating-inflation rate of unemployment (NAIRU) … holds that in the longer run, an economy’s potential growth depends on – what Milton Friedman called – the “natural rate of unemployment”: the structural unemployment rate at which inflation is constant …

We argue in our book Macroeconomics Beyond the NAIRU that the NAIRU doctrine is wrong because it is a partial, not a general, theory. Specifically, wages are treated as mere costs to producers. In NAIRU, higher real-wage claims necessarily reduce firms’ profitability and hence, if firms want to protect profits (needed for investment and growth), higher wages must lead to higher prices and ultimately run-away inflation. The only way to stop this process is to have an increase in “natural unemployment”, which curbs workers’ wage claims.

What is missing from this NAIRU thinking is that wages provide macroeconomic benefits in terms of higher labor productivity growth and more rapid technological progress …

NAIRU wisdom holds that a rise in the (real) interest rate will only affect inflation, not structural unemployment. We argue instead that higher interest rates slow down technological progress – directly by depressing demand growth and indirectly by creating additional unemployment and depressing wage growth.

As a result, productivity growth will fall, and the NAIRU must increase. In other words, macroeconomic policy has permanent effects on structural unemployment and growth – the NAIRU as a constant “natural” rate of unemployment does not exist.

This means we cannot absolve central bankers from charges that their anti-inflation policies contribute to higher unemployment. They have already done so. Our estimates suggest that overly restrictive macro policies in the OECD countries have actually and unnecessarily thrown millions of workers into unemployment by a policy-induced decline in productivity and output growth. This self-inflicted damage must rest on the conscience of the economics profession.

Servaas Storm & C. W. M. Naastepad

## Panglossian trade theory facing reality

26 May, 2016 at 08:36 | Posted in Economics | 4 Comments

I feel a little like Rip Van-Winkle. The consensus amongst economists in the 1980s was that trade is always and everywhere good for everyone. After attending a UCLA workshop on trade a couple of weeks ago, I learned that all that has changed. There is a new consensus, summarized in two papers, “The China Syndrome”, published in the American Economic Review, and “the China Shock”, a new working paper, by David Autor, David Dorn and Gordon Hanson (ADH). According to their research, the effects of trade with China have been truly catastrophic for the average American worker. Over to ADH —

“Our analysis finds that exposure to Chinese import competition affects local labor markets not just through manufacturing employment, which unsurprisingly is adversely affected, but also along numerous other margins. Import shocks trigger a decline in wages that is primarily observed outside of the manufacturing sector.”

Sound familiar? This is a case of academic economists catching up with what the median blue-collar worker has known for a long time. The U.S. lost jobs to China and the average American worker was not compensated by the winners. And there were winners.

“China’s economic growth has lifted hundreds of millions of individuals out of poverty. The resulting positive impacts on the material well-being of Chinese citizens are abundantly evident. Beijing’s seven ring roads, Shanghai’s sparkling skyline, and Guangzhou’s multitude of export factories none of which existed in 1980 are testimony to China’s success.”

Nor were the winners only Chinese workers. If your income is primarily generated by ownership of human or physical capital; you have benefited enormously from the chance to combine your talents, in the case of human capital, and your wealth, in the case of physical capital, with a vast pool of unskilled labor. But those benefits were never passed on to American workers and American workers are now voicing their collective displeasure at the ballot box.

Roger Farmer

## Eternity and a day

25 May, 2016 at 22:00 | Posted in Varia | Comments Off on Eternity and a day

## After work … (personal)

25 May, 2016 at 20:40 | Posted in Varia | Comments Off on After work … (personal)

After a hectic week in Prague and Vienna, yours truly, of course, couldn’t resist the temptation to make a stopover in Karlsbad (Karlovy Vary) for a couple of days. If you like to walk right into a novel by Jane Austen — and your wallet isn’t too thin — it’s a highly recommendable place …

## The witch called ‘confidence fairy’

25 May, 2016 at 16:26 | Posted in Economics | 1 Comment

Remember the old times? Here is a quote from ECB President Jean-Claude Trichet … on September 3rd, 2010:

“We encourage all countries to be absolutely determined to go back to a sustainable mode for their fiscal policies,” Trichet said, speaking after the ECB rate decision on Thursday. “Our message is the same for all, and we trust that it is absolutely decisive not only for each country individually, but for prosperity of all.”

“Not because it is an elementary recommendation to care for your sons and daughter and not overburden them, but because it is good for confidence, consumption and investment today”.

Well, think again. Here is the abstract of ECB Working Paper no 1770, March 2015:

“We explore how fiscal consolidations affect private sector confidence, a possible channel for the fiscal transmission that has received particular attention recently as a result of governments embarking on austerity trajectories in the aftermath of the crisis … The effects are stronger for revenue-based measures and when institutional arrangements, such as fiscal rules, are weak … Consumer confidence falls around announcements of consolidation measures, an effect driven by revenue-based measures. Moreover, the effects are most relevant for European countries with weak institutional arrangements, as measured by the tightness of fiscal rules or budgetary transparency.”

The confidence fairy seems to have turned into a confidence witch. One more victim of the crisis. But this one will not be missed.

Francesco Saraceno

Sad to say, Trichet isn’t the only one who has got things wrong. Leading mainstream economists in my own country — Sweden — have even made the same flimflamming confidence reasoning into some kind of national pride issue (emphasis added):

The current monetary policy framework in Sweden … was a response to an earlier malfunctioning system, which motivated a number of academic proposals on reforms, to a large extent inspired by international resarch developments in the monetary policy area … The final transition to the current regime was triggered by two developments: Swedish EU membership, which imposed requirements to do central bank reform, and the Swedish decision to stay outside the monetary union, which made it clear that credibility for low–inflation policy had to be built at home … The current monetary policy framework has been successful in achieving low inflation, in fact too successful as average CPI inflation 1997-2014 was 1 percentage point below the 2 per cent target … An issue raised by these experiences is … whether the objective of stabilising unemployment around its equilibrium level should be stated explicitly in the Riksbank Act. It has also been claimed that a somewhat higher inflation target might be desirable, as this would likely imply higher inflation, and hence a lower real interest rate that would stimulate the economy in a deep recession when the repo rate approaches zero. However, both the politicians and the Riksbank have been reluctant to contemplate such changes because of a worry that they could undermine the credibility of low-inflation policies.

Lars Calmfors (president of the Swedish Fiscal Policy Council)

How hard it seems to be for mainstream economists to grasp the simple fact that no matter how much confidence you have in the policies pursued by authorities nowadays, it cannot turn bad austerity policies into good job creating policies. Austerity measures and overzealous and simple-minded fixation on monetary measures and inflation, are not what it takes to get our limping economies out of their present day limbo. They simply do not get us out of the ‘magneto trouble’ — and neither does budget deficit discussions where economists and politicians seem to think that cutting government budgets would help us out of recessions and slumps. Although the ‘credibility’ that Calmfors talks about arguably has some impact on the economy, the confidence fairy does not create recovery or offset the negative effects of Alessina-like ‘expansionary fiscal austerity.’ In a situation where monetary policies has become more and more decrepit, the solution is not fiscal austerity, but fiscal expansion!

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