I have always thought that the issue of the relationship between financial markets and the "real economy" was really deep. I thought that it was a critical part of macroeconomic theory that was poorly developed. But the economics profession for the past thirty years instead focused on producing stochastic calculus porn to satisfy young men's urge for mathematical masturbation.
I suddenly realized the remarkable extent to which the methodology of economics creates blind spots. We just don't see what we can't formalize. And the biggest blind spot of all has involved increasing returns.
at a tender age was a revelation for me, and it started a chain reaction that changed my life in a way no other book has. Paul Krugman, thank you; and the most heartfelt congratulations!
In “Hit or Miss? The Effect of Assassinations on Institutions and War,” Olken and Jones looked at the effects of political assassination, using a strict empirical methodology that takes into account economic conditions at the time of the killing and what Olken calls a “novel data set” of assassination attempts, successful and unsuccessful, between 1875 and 2004.
Olken and Jones discovered that a country was “more likely to see democratization following the assassination of an autocratic leader,” but found no substantial “effect following assassinations—or assassination attempts—on democratic leaders.” They concluded that “on average, successful assassinations of autocrats produce sustained moves toward democracy.”
The issue
Most people don't know how to deal with an externality, and don't understand the purpose of Pigouvian (not Pigovian - see footnote) taxes. 'Most people' is more likely than not to include you too.
Shock value
The extent to which people change their actions as a result of pigouvian taxation is irrelevant. So, a pigouvian tax on carbon emmissions is the best response to global warming, even if it does not lead to any reductions in carbon emissions.
The snappy part
An externality is generated when I do not take into account the full social costs of my actions when making decisions. In other words, I do something I like which you don't, but because I don't care about your feelings I end up doing it too much.
For an externality to create problems, two things must be going on:
a. no clearly established property rights (am I entitled to polluting or are you entitled to a clean environment?)
b. trade between the holder of the property rights and the non-holder is not possible (i.e. I can't compensate you to allow me to pollute if you are entitled to a clean environment, or you can't pay me to not pollute if I am entitled to pollute).
Let's stick with carbon emmissions. Property rights are well established: they are held by governments, and they can choose to represent the rights of all people of the world, the fauna and the flora of the world and generations yet unborn as they see fit. So no problems there.
The means to trade are also present: enter pigouvian taxation.
Now, most people think that a pigouvian tax ought to be imposed to reduce pollution, full stop. If the pigouvian tax has only a small effect on carbon emmisions, the thinking goes, then the pigouvian tax has 'failed' and other measures ought to be taken, namely non-price restrictions (e.g. banning carbon emmissions above a certain level, restricting the supply of oil, etc).
This is wrong. The degree to which the production of carbon emmissions changes is irrelevant. As long as your pigouvian tax equates the private to the social costs, you are in the best possible world. If you don't agree, then your problem lies with the initial allocation of property rights or with the distribution of the pigouvian tax revenue or with democracy itself, not with correcting for the externality in the world in which we live in.
The only 'problem' stemming from an 'uncorrected' externality is inefficiency, and the best way to deal with that inefficiency is to apply an appropriate pigouvian tax. Any perceived problems beyond inefficiency should not be addressed in the context of 'correcting' the externality.
Illustrative example - post starts getting boring from here onwards
I like driving my car around your garden. You like your garden to be car-free. I produce an externality in that my private actions affect your welfare.
Possibility A: You own the garden. If driving my car is worth more to me than having a car-free garden is worth to you, I can pay you so that you let me drive in your garden. If not, I don't pay you and you have a car-free garden. That's Pareto efficiency; you can't make anyone better off without making someone worse off.
Possibility B: I own the garden. If driving my car is worth less to me than having a car-free garden is worth to you, you can pay me so that I don't drive around. If not, you don't pay me and I keep driving around. That's Pareto efficiency again.
Now, substitute 'you tax me' for 'I pay you' and you can relate this to the rest of the post.
And if you believe that the outcome is not socially optimal, then you really have a problem with the initial allocation of property rights, not with the means by which the externality is handled. Voicing your concerns now doesn't make sense; your grievances have nothing to do with the externality we discuss here.
What you believe is that the initial allocation of wealth is wrong on grounds of fairness. The way to combat this is by moving some wealth from the garden guy to the car guy or vice versa. The tax/subsidy on car-driving is not really central to your argument.
Now you may want to skip to the footnote; for the remainder of the post I simply repeat everything I said earlier in an irritating manner
Tyler Cowen, who easily ranks amongst the top thinkers we have on social and economics issues, shocked me with this post. (One of the most powerful economists in the world also shocked me for similar reasons in a talk I attended recently, but I expected more from Tyler).
Tyler's post discusses whether it makes sense to drill in Alaska (the ANWR), and here's an excerpt:
2. There is a general global warming case against developing the resource. Note that supply restrictions can be far more effective than a Pigou tax. A Pigou tax doesn't guarantee the stuff won't be pumped anyway, albeit at lower profit.
3. The Pigouvian case against developing ANWR makes sense only if we are taking other systematic actions to raise the price of fossil fuels and restrict fossil fuel use.
I finally got to visit my old friend Jeremy Bentham today. We had lunch together. He didn't talk much, but he was pleasant company nonetheless. Here, you can see both of us in this picture I took - he's the one behind the glass, and I'm the one in front of it.
If you ever visit UCL, I'm sure he'll be happy to see you too - and isn't happiness what it's all about? Here's more on where to find him and his busy schedule since his death 175 years ago:
At the end of the South Cloisters of the main building of UCL stands a wooden cabinet, which has been a source of curiosity and perplexity to visitors.
The cabinet contains Bentham's preserved skeleton, dressed in his own clothes, and surmounted by a wax head. Bentham requested that his body be preserved in this way in his will made shortly before his death on 6 June 1832.Not surprisingly, this peculiar relic has given rise to numerous legends and anecdotes. One of the most commonly recounted is that the Auto-Icon regularly attends meetings of the College Council, and that it is solemnly wheeled into the Council Room to take its place among the present-day members. Its presence, it is claimed, is always recorded in the minutes with the words Jeremy Bentham - present but not voting. Another version of the story asserts that the Auto-Icon does vote, but only on occasions when the votes of the other Council members are equally split. In these cases the Auto-Icon invariably votes for the motion.
Bentham had originally intended that his head should be part of the Auto-Icon, and for ten years before his death (so runs another story) carried around in his pocket the glass eyes which were to adorn it. Unfortunately when the time came to preserve it for posterity, the process went disastrously wrong, robbing the head of most of its facial expression, and leaving it decidedly unattractive. The wax head was therefore substituted, and for some years the real head, with its glass eyes, reposed on the floor of the Auto-Icon, between Bentham's legs.
However, it proved an irresistible target for students, especially from King's College London, who stole the head in 1975 and demanded a ransome of £100 to be paid to the charity Shelter. UCL finally agreed to pay a ransome of £10 and the head was returned. On another occasion, according to legend, the head, again stolen by students, was eventually found in a luggage locker at a Scottish Station (possibly Aberdeen). The last straw (so runs yet another story) came when it was discovered in the front quadrangle being used for football practice, and the head was henceforth placed in secure storage.
The master-economist must possess a rare combination of gifts. He must reach a high standard in several different directions and must combine talents not often found together. He must be mathematician, historian, statesman, philosopher - in some degree. He must understand symbols and speak in words. He must contemplate the particular in terms of the general, and touch abstract and concrete in the same flight of thought. He must study the present in light of the past for the purposes of the future. No part of man's nature or his institutions must lie entirely outside his regard. He must be purposeful and disinterested in a simultaneous mood; as aloof and incorruptible as an artist, yet sometimes as near the earth as a politician.
John Maynard Keynes, quoted by Timothy Taylor.
Addendum: Here is Keynes's 1946 obituary in Time magazine.
Geddit? As an economist talking to non-economists, this has been the single most difficult fact to explain.
This is from Timothy Taylor's 'Principles of Economics' lecture series on video. Click the link and check the list - he is a big success on the web, and - though his speaking style is a tad bit overstated - I really like this guy!
If you clicked on the link and are perplexed, this may help explain things.
Jan Tinbergen - the first person to be awarded the Nobel Prize in Economics - became known for his 'Tinbergen Norm'. This states that if the difference between the lowest and highest income in a company exceeds a rate of 1:5, that will not help the company and may indeed be counterproductive.
In 2000, the ratio of average-CEO-to-average-worker was 525 to 1.
Disclaimer: I could not find an original source for the Tinbergen Norm. I'll have another go at it and report back soon.
In a letter to his protégée, A.C. Pigou, he laid out the following system: "(1) Use mathematics as shorthand language, rather than as an engine of inquiry. (2) Keep to them till you have done. (3) Translate into English. (4) Then illustrate by examples that are important in real life (5) Burn the mathematics. (6) If you can’t succeed in 4, burn 3. This I do often."
A couple of days ago, a friend had a 'priceless' moment with one of the world's most celebrated economists. Since anonymity prevents me from divulging any more details, here is a hillarious account of a very similar incident when Barry Ritholtz met Robert Engle. (I emailed the post to my friend and it made him feel a lot better - thanks Barry).
The moral of the story? Always check whether the person you are talking to happens to have been awarded a Nobel Prize.
This is startling:
[The paper] addresses the six-year disparity in life expectancy for blacks versus whites, arguing that much of the gap is due to a single factor: a higher rate of salt sensitivity among African-Americans, which leads to higher rates of cardiovascular disease, stroke and kidney disease.
Levitt is a veritable gas guru, a leading expert on the underappreciated field of flatus -- intestinal gas that escapes via the southern route. He admits his unusual expertise has put his three kids (one of whom is economist and "Freakonomics" co-author Steven Levitt) through expensive universities.
The article, which covers a lot of scientific knowledge on flatulence, is fun to read. I found the experiment on the potency of male vs female gases fascinating, if somewhat disturbing.
And playing amateur psychologist here, maybe it's precisely this background that gave young Steven the idea of pursuing unusual - 'freaky' - subjects in his own discipline, and most readers of this blog know all about that.
HT Odd Numbers.
Economist's view links to videos of the Nobel Prize lectures in Economics. Here's how Roger Myerson started his:
The scope of economics has changed. Economics began with Xenophon's paper Oeconomicus more than two thousand years ago, in which a model citizen of ancient Athens goes out to the countryside, to his farm, to monitor and motivate the workers he has there to make sure they are working. Then he comes back into the city to participate in various political institutions that are necessary to maintain his political status so that he can keep owning his farm.
Agents' incentives and political institutions are central concerns of economics today as they were then; they weren't always. Sixty years ago or so Schumpeter saw Xenophon as somewhat marginal or outside the scope of economic inquiry.
Excerpts from a beautiful 20-year old essay by Robert Lucas, it's very short and do read the whole thing:
Economists have an image of practicality and worldliness not shared by physicists and poets. Some economists have earned this image. Others-- myself and many of my colleagues here at Chicago--have not. I'm not sure whether you will take this as a confession or a boast, but we are basically story-tellers, creators of make-believe economic systems. [...]
Well, that is why honest people can disagree. I don't know what one can do about it, except keep trying to tell better and better stories, to provide the raw material for better and more instructive analogies. How else can we free ourselves from the limits of historical experience so as to discover ways in which our society can operate better than it has in the past?
In any case, that is what economists do. We are storytellers, operating much of the time in worlds of make believe. We do not find the realm of imagination and ideas is an alternative to, or a retreat from, practical reality. On the contrary, it is the only way we have found to think seriously about reality.
In a way, there is nothing more to this method than maintaining the conviction (which I know you have after four years at Chicago) that imagination and ideas matter. I hope you can do this in the years that follow. It is fun and interesting and, really, there is no practical alternative.
When you have a working knowledge of economics, it’s like having a mild super power.
Greg Mankiw recently wondered whether he is a typo. He shouldn't be complaining; the man in the picture, on the other hand, has every right to.
Bluematter. is proud to award Carlos M. Jarque the Distinguished Medal for Most Misspelled Economist of All Times. On Google Scholar, a search for Jacque-Bera (see note to editors at the bottom of this post) returns no less that 177 results, while a search for 'Jacque Bera normality' generates 581. Many of these papers are published in prestigious journals, and my brief inquiry revealed a handful of papers (e.g.) which include tables that give the value of the Jarque-Bera statistic while referring to the Jacque-Bera statistic in the main text. Analysis suggests that the Jarque Bera statistic is misspelled between 5% and 15% of the times in published papers. Further anecdotal evidence points to less than 20% of the people getting the true name of the JB statistic right in conversation and unpublished work. To (roughly) quote Indifference Merv: 'It makes it difficult to figure out whether there are in fact two distinct statistics, Jarque-Bera and Jacque-Bera. Jarque has been done a great injustice by the profession'.
Note to Editors: Carlos M. Jarque is an economist with a long and distinguished career in economics, politics and management. Amongst econometricians, he is best known for his contribution (with Anil K. Bera) to testing for normality of observations and regression residuals: the Jarque-Bera statistic (here is wikipedia, and here is the paper)
Postscript: Anil K. Bera does not fare much better. A search for Jarque-Berra returns 173 papers.
At his first academic job in 1909 he fought a literal duel with swords against, of all people, the librarian, because he wouldn’t make books available to his students. The librarian got an honorable scar out of it, and the two became the best of friends.
“The emotional attachment to the social order,” wrote [Schumpeter], was “the very thing capitalism is constitutionally unable to produce.” No one loves a Rockefeller. Everyone loves a Virgin Queen.
My previous post on parody and academic economics reminded me of the classic paper in this tradition, Howard Wall's 1995 'Cricket versus Baseball as an Engine of Growth' (free access). If you are a professional economist and haven't read this excellent paper before, do so now; it is only 3 pages long and is easily one of the most entertaining pieces ever to be published in an economics journal:
Until the pioneering work of Solow (1956) forced growth theorists to focus on things such as savings rates and capital accumulation, economists searched far and wide for engines of economic growth. One of the seemingly eccentric streams of the literature considered the relative effectiveness of sport in spurring economies along. Marshall (1889) was the first of the classical economists to suggest that the character-building aspect of sport may play an integral role in harnessing the capacities of an economy towards productive ends.
At the time, Marshall proposed that the sports that would best serve as an engine of growth were those that "involved the carrying, and sometimes the tossing, of a ball; and the frequent collision of opposing bodies." Subsequent research naturally looked towards gridiron football in the US, and rugby football in the UK.
Marshall’s case for gridiron and rugby did not last long. In a footnote to a theorem on the existence of irrational numbers in σ-dimensional lattices, Russell and Whitehead (1908) found an error in Marshall’s result. Russell and Whitehead had stumbled onto something would keep economists at odds for nearly fifty years. They found that the necessary, but not sufficient, conditions for a sport to be an engine of growth are (1) that it uses an ash implement to strike a round object; and (2) that at any time the majority of players spend their time standing idly in an expanse of grass, or sitting on a wooden bench doing nothing.
Within months of this result becoming public, opposing schools of thought developed, separated, as they often are, by the Atlantic Ocean. Cricket and baseball very quickly became the centers of growth theorists’ attention.
The debate raged until the entire field fell into disrepute in the early 1950s. The backlash began with attacks by the French economist Maurice Le Point. As a Frenchman, Le Point could not see any point in cricket nor in baseball, and failed to see how either could have anything at all to do with the economy. His most biting insight, which purportedly came to him while attending a St. Louis Browns baseball game, roughly translates as "there is a fine line between playing baseball and standing in a pasture dressed like an idiot." Although aimed at baseball, this certainly rings true for cricket as well.
So powerful was Le Point’s attack that nearly all traces of the two schools have been purged from the economics literature. The early works began to disappear from libraries, and later editions of Keynes (1936) do not include the original twenty-fifth chapter on the role of cricket in ending the Great Depression.
The purpose of the present paper is to revive and answer this long-forgotten question. With today’s statistical techniques and the availability of data for a large number of countries, the question of cricket versus baseball can be addressed once and for all [...]
The empirical results speak for themselves. For emerging countries without a history of cricket or baseball, baseball instruction and subsidies should be an immediate priority. The difficult problem is in devising a plan to eradicate the cricket-induced malaise of the cricket-playing countries. Clearly this is a task of Herculean proportions, rivalled only by the economic reform of formerly-communist countries. Like communism, years of cricket have polluted the very souls of these countries, and we need to measure the pace of reform in decades, not merely in years.
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