Technodox Economics and ‘Deepak Chopra Mode’

Both Noah Smith and Mark Buchanan have posted replies to my earlier post on the tendency for physicists to be attracted to economics and both make good points.

After posting my original entry I thought about whether there might be areas of economics in which physicists would be able to contribute quickly and it occurred to me that perhaps finance – particularly high-frequency trading – might be such an area. Here lots of trades and market patterns might be governed by the technology of trading and could present an environment in which the skills of physicists are particularly valuable. So I was pleased to see that Mark seems to also focus on finance as an area where physicists have found a grip.

He mentions one particular area – distributions of random variables that have “fat tails” – which has specific value in modern economics. Several researchers are using such distributions to analyze economic phenomena. Xavier Gabaix has used power laws to study “granular” business cycles – the idea that random shocks which affect large players might have substantial consequences for the aggregate economy. Robert Barro, Francois Gourio, and others consider the possibility that such distributions place weight on extreme outcomes which in turn influence asset pricing (asset pricing implications of rare disasters). Trade theories, models of urban (spatial) formation, etc. use power laws. If physicists are actually the source of some of the background on fat-tailed distributions then kudos– that’s a point for physicists in economics.

Mark’s post also presents an example of what you might call ‘Deepak Chopra’ mode. This occurs when a writer (or speaker) talks about an issue which is complicated but then takes the opportunity to start hurling around complicated-sounding ideas and jargon with at best tangential relevance to the topic and at worst no relevance to the topic whatsoever. (Deepak Chopra is known to start talking about quantum healing and other new-age concepts that have the word “quantum” attached to them …). Here is Mark veering dangerously close to Deepak Chopra territory:

What the physicists DO believe, however, is that markets and economies are great examples of what scientists have come to call “complex systems” — systems of many elements (people, firms, etc.) with strong interactions between those elements which create webs of non-linear feedback. The elements learn and adapt, their interactions create “emergent” coherent structures and fluctuations at the collective level, and these structures then act back downwards to influence the behavior of the elements.

He quotes a similar sentiment from the essay by Brian Arthur:

It is this recursive loop that connects with complexity. Complexity is not a theory but a movement in the sciences that studies how the interacting elements in a system create overall patterns, and how these overall patterns in turn cause the interacting elements to change or adapt. … Complexity is about formation—the formation of structures—and how this formation affects the objects causing it.

(… and this is why we need physicists?)

OK, the economy is “complex”. There are many players on the stage and they take a variety of actions which together contribute to the aggregate behavior of the economic system. In turn, aggregate outcomes influence individual behavior. This simultaneity is indeed one feature that makes analyzing the economy so difficult. The thing is, this type of two-way feedback is what economists are doing already. We often reduce environments like this to “fixed point problems” – the players take the market conditions as given when they make their decisions and in turn, these decisions generate the perceived market conditions. In fact, we often prove that equilibria exist by appealing to mathematical “fixed point theorems” for exactly this reason. You might think that this rules out learning and adaptation to an environment. It doesn’t. Economists have been analyzing environments with learning for decades. Learning does make things a bit more difficult. In learning models, the market participants start with some subjective beliefs upon which they base their actions. These actions lead to market outcomes and beliefs are refined. The interplay between beliefs, actions and outcomes is analyzed simultaneously (and it plays out over time). A bit more difficult, yes. But not an insurmountable obstacle for the field.

If economists already do this stuff, why do smart outside observers like Mark Buchanan think we do not? Why are we being lobbied by physicists like Eric Weinstein to adopt techniques which are of such speculative value? My guess is that techno-heterodox ideas (Technodox economics?) like gauge theory, agent based models, chaos (or complexity) theory are advocated in the hope that it might either (1) provide outsiders with some authority even though they don’t really know much about the field and (2) because most practicing economists will have to admit (if they are honest) that they know essentially nothing about these techniques – an admission which could deprive them of some authority even though they do know quite a bit about the economy.

Incidentally, the jargon which comes along with a lot of these Technodox ideas allows even those who don’t understand these speculative techniques to masquerade as though they do understand them. Jargon is a very problematic part of academia. Often academic jargon is particularly imprecise on top of the fact that it allows the speaker to try to “pull rank” on the audience.

As an aside, Eric Weinstein commented on my earlier post by arguing that gauge theory was actually valuable. I told him that I was willing to be convinced but I asked him to convey his insights without referring to the mathematics. He hasn’t got back to me yet. (Eric also commented on Noah’s post with a lengthy comment with a bunch of mysterious mathematical notation. I doubt he is going to convince people by taking this route.)

Why Are Physicists Drawn to Economics?

Even before the financial crisis, there has always been a surprising number of ex-physicists who find their way to graduate study in economics. It could be that many of these math-physics people have simply concluded that they no longer like physics and are interested in economics instead. (Moreover, the job market for economics Ph.D’s is much better than the job market for physics Ph.D’s.) I suspect however that some of them are here because they have some incorrect perceptions about the field. A student with a mathematical-physics background could easily convince himself that he has superior mathematics abilities than typical economists and superior statistical and computational skills than most economists.[1] He might go on to conclude that, as a consequence of his superior mathematical and computational abilities, he should be able to enter economics and start contributing quickly and easily. He might also anticipate that he could easily adapt established models or techniques in physics to study economic phenomena and impress the profession.

If you are one of these people, let me try to disabuse you of these notions. Your mathematical abilities are actually not that much better than most economists (if they are better at all). You will have to spend a lot of time acclimating to the subject and the path to actually making contributions will be long and difficult. In all likelihood, there are very few (perhaps zero) off-the-shelf models or techniques in physics (or engineering, or chemistry, …) that will produce meaningful economic results. High-tech methods and approaches will be valued only if they can be described in simple, direct ways.

Economists are not held back because of a deficiency of mathematical tools and techniques. As soon as I hear a physicist (or a mathematician or whoever) start talking about the need for economists to use “the right mathematical techniques” I immediately think that the person has absolutely no idea what the main problems and questions in economics actually are.

Eric Weinstein for instance has somehow managed to convince himself that the instability of preferences is a huge problem for economics (it’s not) and that the application of Gauge Theory to economics will improve things. Now, I don’t know anything about Gauge Theory but I would be willing to bet that it has virtually nothing to add to economics. If Eric Weinstein has some insight that he wants to share then fine – send it my way and I’ll listen but I’m not going to listen just because the math is difficult. The fact that it’s difficult to understand something does not mean that it is important to pay attention to it. Eric Weinstein might be perfectly well-intentioned but if he thinks that because he knows some fancy mathematics, economists are obligated to grant credence to his work, he is sorely mistaken.

As another example, take Mark Buchanan, an ex-physicist who writes the blog The Physics of Finance. Mark seems genuinely interested in economics, particularly macro, but it doesn’t sound like he has a good grasp of the field or of the problems in the field. In a recent column in Bloomberg, he calls for a new age of pluralism in economics:

[M]acroeconomists should learn to speak the languages of other fields, including sociology and psychology, as well as neuroscience and engineering.

An appeal to pluralism like this is usually a sign that the appellant’s ideas are probably not particularly helpful. If you have a good idea, it won’t need affirmative action to get a hearing. True, new ideas and techniques are often met with hostility from the establishment but the reason to listen isn’t that the ideas come from outside the field. The reason to listen (if there is one) is that the ideas are good.

Lee Smolin is yet another physicist who has (at least in the past) waded in to economic waters. Smolin, like all physicists, is clearly very smart and he is asking good questions, but they are the questions of a smart undergraduate. According to Smolin, the “well known fault” of neoclassical economics is the possibility of multiple equilibria and the possibility that equilibria may be “path dependent.” Like Mark Buchanan, Professor Smolin thinks that researchers from other fields (he mentions complex systems as one) are needed to help push economics forward. Also, despite apparently having no direct familiarity with finance, Smolin is prepared to offer his diagnosis of the current state of economics as it relates to the financial crisis:

[T]he whole thing is a disaster if I can say that as an outsider. And it [was one of the reasons] why regulations were lifted on markets and trading through the decades, but when people were making arguments to Congress, to the President’s office that the economy would be better off without regulation, this was the “scientific rationale for it” and led to the very unstable situation of the last economic crisis.

Mathematical fads often pop up in economics but they won’t last unless they have concrete value. Chaos theory was tried briefly but it produced essentially nothing of any value in economics. Neural-networks, agent based modeling, path-dependent equilibria, knot theory … the list of techniques that sound impressive is long but the list of accomplishments associated with these techniques is decidedly quite short.

Naturally, there are counter-examples. The introduction of calculus in economics represented a huge leap forward. Dynamic Programming, originally developed by the mathematician Richard Bellman in the 40s and 50s, is one of the most widely used mathematical tools in economics today. The famous mathematician John Von Neumann [2] was instrumental in the early development of Game Theory, and so on. However, guys like Alfred Marshal, Richard Bellman and John Von Neumann and don’t come along all that often.

If you are a physicist and you want to work in economics, you had better strap yourself in and prepare for a long challenging path – one that is only worth following if you are really interested in the subject itself. There isn’t very much low-hanging fruit left (as Lones Smith once said, ‘there certainly isn’t any low-hanging fruit left in the middle of the yard!’). Don’t think that after watching Inside Job you can jump in to economics and save the day just because you understand the Navier–Stokes equations.

[1] For brevity I will use ‘he’ for this post when the gender is unknown.

[2] I’m not sure I should necessarily classify Von Neumann as a mathematician. It’s a testament to his genius that he is routinely “claimed” by so many fields. He’s a physicist! No, wait, he’s a mathematician! No, wait, he’s a computer scientist! No, wait, he’s an economist! No wait …

Inequality Redux

A reader sent me the message below. It makes a very good point and I felt it deserved to have its own post. The reader has asked to remain anonymous.

[As someone born in a poor foreign country] I dream of a world where Indians and Africans can confront obesity, involuntary leisure via partially insured unemployment, and dull service-sector drone work as their chief nemeses.

The inequality that therefore most concerns me, and that I would strongly suggest should most concern you and your readers, is emphatically not inequality between Americans, but inequality between Americans and their counterparts pretty much everywhere but Western Europe and the few other “rich” nations.

As many of us know, the gaps in any standard of well-being between these groups are simply astonishing. The conditions in India, Africa, and elsewhere dwarf the complaints of almost anyone I can find in the American poor. The overall lack of agency of people in their lives, their daily struggle for drinking water and space to even relieve themselves privately (for women in particular) would make inter-American concerns a dreamlike problem for several billion people on the planet. 

You might argue that this is a false choice: that one can assist both Americans and the world’s poor. But as an economist, you know that to a large extent that the answer is ‘either/or’, not ‘both.’

One might also argue that the problems outside our borders are more intractable, and lie beyond our reach as they involve institutional problems that would defeat any effort we might try. Yet, essentially every argument leveled against retaining a broader perspective on inequality and deprivation can be leveled against efforts attempting to equalize within the U.S. borders. For example, U.S. inequality has been very intractable to say the least. Intergenerational mobility is stubbornly low within rich countries as well, etc. Institutional racism and sexism have been plausibly advanced as serious impediments to achieving equality of outcomes, and opportunities alike.

Personally, I hope American movements to end inequality will approach the issue more globally, and that they will become less insistent in their promotion of what is, ironically for US-based progressives, a version of American exceptionalism: that our poverty must be seen as more urgent than that afflicting nameless strangers in foreign lands.

Why not allow people refundable credits to donate to globally-oriented charities, until it amounted to the total amount of social insurance transfers that occur at present within our borders? Or offer people a choice to either pay taxes (perhaps after they pay a minimum to fund defense), or transfer an equivalent amount to the Gates foundation, or some similar cross-national entity which is decisively worldwide in its mission and reach?

On a more positive note, maybe there is room for dealing with both American and global deprivation simultaneously: what I can offer the poor here is my leisure time, while what I can offer Africa is my money. We might exhort people to work hard, earn as much as they can, use their spare time to mentor/volunteer here, and give their money away to the third world.

Americans, at present, are strongly encouraged to transfer to other Americans. While I can see why I must contribute to national defense, I see less obvious social justice in preferring transfers to these other strangers who, by all accounts, are themselves rich in comparison to the huge mass of people who lie beyond our borders. (Two clear exceptions to this, for me personally, are African-American and Native American populations, both of whom I regard as having a hugely legitimate beef with their lot in our society, and whose conditions—especially taking into account the daily risk of violence they face–can be legitimately viewed as Third World. )

People in the U.S. would benefit from more direct encounters with conditions prevailing in much of the world, to see firsthand just how deprived people in the developing world are. It will inevitably help them decide how to prioritize any assistance they elect to give.. If widely screened, The Real Housewives of Somalia would embarrass everyone in the U.S. The former won’t have taps in the house, or even a toilet.

In the end, the focus on American inequality and poverty is, to my taste, like urging prompt action because among the ten people in business class, one is super rich. What about the 200, not even in coach, but hanging off the wings?

My comments:

The reader makes an excellent point. The differences in relative well-being between typical members of the richest nations (and the U.S. is one of the richest) and their counterparts in the poorest nations is staggering. Growth economists have in the past talked about a difference that is on the order of a factor of 30 or 40 – meaning that per capita income in the U.S. is roughly 30 or 40 times greater than average per capita income in say Ghana, Chad or the Sudan. While it is true that some of this difference can be attributed to mismeasured output (e.g., home farming or other types of home production) the true difference in well-being must be on the order of 15 or 20 even after such adjustments. These differences are simply unimaginable for most Americans. Speaking only for myself, I have never been to a developing country and so I haven’t seen firsthand the kind of poverty and desperation the reader alludes to. I am aware of it as an academic issue but that’s it.

Let me make two comments on a somewhat hopeful note:

First, while income inequality across nations is unbelievably extreme, and income inequality within countries has been increasing (for some countries quite dramatically), global income inequality has been falling overall due, essentially, to dramatic increases in well-being in China and India (though both China and India remain far behind U.S. living standards).

Second, the reader says:

You might argue that this is a false choice: that one can assist both Americans and the world’s poor. But as an economist, you know that to a large extent that the answer is ‘either/or’, not ‘both.’

I actually don’t agree with this entirely. My guess is that many of the problems which cause extreme poverty in the world are actually closely connected to “obvious” problems which could be solved without entailing substantial welfare losses for developed countries. The most severe problem facing many of these nations is civil war. Now it may be quite difficult to put an end to such conflicts but if it could be done we would greatly alleviate world suffering without transferring goods from the West. Socialism also presents a huge problem for many nations. If we could get North Korea to abandon its system of government and instead try to emulate South Korea, we could again achieve tremendous improvements without transfers.

This last point obviously also bears on the limitations of Western influence. The West has no direct authority in any developing country.  We can make suggestions and we can make donations but making progress on some of the most important problems requires structural change within these countries. If we want to improve the lives of Somalis we would need to take over the country and remove the warlords who are running things. Similarly if we want to improve the lives of North Koreans, we would have to remove the Communist government. The right path is clear and there are large gains to be had but taking this path is difficult. 

Needed: Meaningful Progress on Income Inequality

Income inequality in the United States has been rising for decades. As I’m sure many of you know, the best source for data on income inequality is Piketty and Saez.  The pictures below (which I’m shamelessly stealing from Piketty and Saez) give you a pretty good sense of the problem. [1]

Today, the top 10 percent of income earners take home roughly half of all pre-tax income earned in a year.  Inequality was really high in the first 40 years of the twentieth century but then fell sharply and remained low for the next 30 years.  Then, sometime around 1970, income inequality began rising gradually.  This basic pattern holds essentially regardless of how you define the top income earners.  This figure shows the dreaded top 1 percent of income earners.

Keep the magnitude of these figures in mind. The top 1 percent claims almost 25 percent of all income.  The top 0.1 percent is even more striking.  They take home more than 10 percent of all income.  That is, these households earn essentially 100 times what the average household earns in a year.

The source of this income is also noteworthy.  The graph below decomposes the top 0.1 percent according to the source of the income. Clearly a lot of the increase in income inequality is due to wage income. In the past, the ultra-rich were the owners. This isn’t entirely true today. Many households in this group are rich because of extraordinary labor income.  (Many CEOs are compensated for the “work” they do rather than their ownership stake in the company.)

I submit to you that this state of affairs is simply unacceptable.  This current degree of income inequality is probably the most disruptive, most corrosive and most troubling problem confronting the U.S. economy today.  Even if inequality is a “natural” consequence of market based economies it doesn’t mean that we should tolerate it. (Bee-stings and allergies are also natural but you don’t just stand there and do nothing while your friend goes into anaphylactic shock.)  I only need to watch 10 min of the Real Housewives of Orange County before I become convinced that we are really in dire need of aggressive income redistribution.  It would be nice to see someone make a reality show called The Real Housewives of Gary Indiana; or the Real Housewives of Flint Michigan; or the Real Housewives of Allentown Pennsylvania.

In the past some hard-core economists might respond to inequality by saying that we can’t make meaningful comparisons across people because utility is only an ordinal concept. This response is totally unpersuasive to non-economists – and the non-economists are right. Empathy is a very real human trait and it is completely reasonable to desire a more even distribution of income for its own sake.  (Perhaps utility has a cardinal component to it after all.)  The challenge for economists and policy makers is to propose policies which effectively redistribute income to produce a more tolerable distribution of well-being while at the same time causing the least amount of damage to markets and incentives.  This is a challenge for both Republicans and Democrats.

Republicans need to come to the realization that extraordinary income inequality is real and it’s a huge problem. A very cynical view might be that we have to deal with it because not dealing with it, courts a populist movement which could usher in a wave of really bad economic policies (think about a maximum wage policy or something similar). But the correct view is this: it’s a huge problem because none of us (even the most stoic Republican out there) wants to live in a country where we have people living in obscene opulence while at the same time, just a few miles away, we have people living in obscene poverty – the kind of poverty where basic health needs becomes an issue; the kind of poverty where food and heat become luxuries.  We aren’t dealing with this problem and we need to.  It’s as simple as that.

For Democrats, the challenge is realizing that the distorting problems of taxation and careless redistribution are real and must be properly confronted by policy makers.  We need to come up with aggressive policies (policies which make meaningful progress on inequality) but that don’t cause huge market inefficiencies.  These policies are not necessarily going to be politically popular and there are many ways of screwing things up if we don’t think carefully about how best to achieve our goals.  The recent article by the Harvard economist Sendhil Mullainathan is exactly right and every well-meaning liberal should take a moment to internalize these ideas.  Incomes in the United States really are substantially higher than incomes in Europe and it’s no accident.  (If you are a Democrat and you are thinking that the first thing we need to do is raise the minimum wage, you are confused.)  I suspect that many liberal concerns about market failures are really just stand-in’s for a concern about inequality. If income were very evenly distributed, would people really care about “predatory lending.”

[1] These figures all correspond to pre-tax income for individual tax units. After-tax measures will undoubtedly be better. In addition, the composition of the households will also matter. Joint filers will typically have more income than a single filer though this doesn’t really reflect income inequality. Correcting for these factors is important but it’s not going to undo the stark reality which is behind these figures.

Cost-Benefit Calculus and Stimulus Spending

I’ve been thinking a bit about stimulus spending recently.  In part this is because Emi Nakamura and Jon Steinsson just recently published a paper on the multiplier in the American Economic Review but it also came up as I was skimming through Paul Krugman’s lecture slides for his Great Recession class.

The logic behind economic stimulus spending is pretty straightforward.  If you are in a recession caused by low demand, the government can step in as a surrogate spender to restore demand and hopefully get the economy out of trouble.  Here is Rachel Maddow describing how she understands stimulus spending during the crisis. Her description is actually pretty good.  The only thing she leaves out is much mention of the multiplier: the ratio between the final change in overall spending to the initial change in government spending. If the government spends money, the workers it employs spend some of their new income on other businesses, and so on …  In theory, this chain of spending can imply a multiplier greater than 1.  If stimulus is to be effective, it helps to have a multiplier as big as possible.

There is actually a fairly clear picture of how big multipliers are. The Nakamura and Steinsson paper is part of a family of papers that look use cross-sectional variation to quantify the effect of stimulus. They compare regions that get additional government spending to regions that don’t and ask whether the spending encourages economic activity.  (Other papers that focus on cross-sectional variation include Shoag (2011), Wilson (2012) and Hausmann 2013).  In the cross-sectional studies, the estimated multipliers seem to be quite large (roughly between 1.5 and 2.5).

A different set of studies focuses on aggregate variation in government spending. The aggregate studies have a much more sobering message. For the most part, the aggregate studies suggest that the government spending multiplier is less than 1 (typical estimates are between 0.5 and 0.8). With a multiplier less than 1, private spending contracts in response to increased government spending. (See Ramey and Zubairy 2013, Ramey, Owyang and Zubairy 2013, Hall 2009, Ramey and Shapiro 1998, and Barro and Redlick 2011). It’s perhaps not surprising that the aggregate studies find smaller multipliers. Large aggregate changes in spending entail some crowding out which the idiosyncratic spending in the cross-sectional studies won’t. The aggregate changes also come with price tags – if the Federal Government is going to spend more then U.S. tax payers are eventually on the hook for the cash. This isn’t true for a cross-sectional experiment. If Pensacola gets a new Naval contract then the money is coming from the rest of the country (and only partially from the people who live in Florida).  If we reserve stimulus spending for periods of economic slack (or liquidity traps / ZLB events), then, in theory, the multipliers will be somewhat bigger. The IS/LM model predicts that fiscal policy will have its greatest effects if the economy is in a liquidity trap. This intuition carries over to fully articulated DSGE models (see Christiano, Eichenbaum and Rebello 2011).  The empirical evidence is not as clear on this point. There is a study by Auerbach and Gorodnichenko (2012) which seems to find evidence in support of this idea.

Even if the multiplier is substantially above 1, it is not obvious that stimulus spending is a good idea. The reason is that we are not trying to maximize output and employment – we are trying to maximize overall social well-being. At a basic level, the idea behind stimulus spending is that the government will spend money on stuff that it wouldn’t have purchased if we weren’t in a recession. The classic caricature of stimulus spending is the idea of paying a worker to dig a hole and then paying another worker to fill the hole in. This type of stimulus spending will increase employment and GDP but it won’t really enhance social welfare. True, we might get the beneficial effects of the stimulus but we could achieve that by simply giving the workers the money without requiring that they dig the holes. If we simply give out the money, GDP increases by less but social well-being goes up by more since the work effort and time wasn’t required.

Even though the Keynesian hole-digging example is silly, the same argument can be applied to any type of government spending. If a project doesn’t meet the basic cost / benefit test, then it shouldn’t be funded, regardless of the need for stimulus.  Of course, one form of fiscal stimulus used in the ARRA was providing funds to state governments so they could maintain services that they would normally provide. This is perfectly sound policy because it is allowing the government to continue to fund projects that (presumably) do pass the cost / benefit calculation. If the social value of a government project exceeds its social cost then we should continue to fund the project whether we are in a recession or not. If the social value falls short of the social cost then, even if the economy is in “dire need” of stimulus we should not fund it. If we really need stimulus but there are no socially viable projects in the queue then the government should use tax cuts. Tax cuts can be adopted quickly and aggressively and, unlike spending initiatives, apply to virtually all Americans.

There are other “legitimate” reasons for the government to expand spending during a recession. The most obvious is that many things are relatively cheap in recessions. Reductions in manufacturing and construction employment may lower the cost for government projects. But again, this decision can be made on a simple cost / benefit basis. If prices fall because of a recession and this makes some projects socially viable as a result, then it’s perfectly correct for the government to fund those projects.

If it makes people feel better we could re-label tax cuts as spending. I could pay people $200 to look around for better paying jobs. This would be counted as $200 of job searching services purchased by the government but in reality, the money would be essentially the same as a tax cut. In the clip above, Rachel Maddow jokingly says that it might be better to simply put money in envelopes and hand them out to low-income families. If the choice is to either hand out money in envelopes or give out the same amount of money to have people perform work that doesn’t meet the cost benefit calculation, then Rachel is right. The envelopes would be better.

UPDATE: Rudi Bachmann points me to a paper by Eric Sims and Jonathan Wolff.  An excerpt :

(M)ovements in the welfare multiplier are quantitatively much larger than for the output multiplier. The output multiplier is high in bad states of the world resulting from negative \supply” shocks and low when bad states result from \demand” shocks. The welfare multiplier displays the opposite pattern { it tends to be high in demand-driven recessions and low in supply-driven downturns. In an historical simulation based on estimation of the model parameters, the output multiplier is found to be countercyclical and strongly negatively correlated with the welfare multiplier.

UPDATE No. 2: In the comments JADHazell points me to this “sketch” by Paul Krugman. This also seems related. My initial reaction is that Krugman is saying that the marginal social cost of government spending drops sharply if the economy enters the liquidity trap (i.e., the ZLB). This means that the cost/benefit calculation points to an opportunity for the government to load up on goods and services during such periods. It does not say that further expansion is justified in the name of fiscal stimulus. That is, I suspect that a version of Krugman’s model in which the marginal benefit of government spending to consumers were zero (say due to satiation) would justify stimulus spending even if the economy were below full employment.

UPDATE No. 3: In the comments thread at MarginalRevolution, Tom West says that “(i)It sounds like the author is advocating that certain benefits be excluded from (the cost/benefit) analysis.” This is exactly what I am saying.  If the direct social benefit of a bridge is $100, then all the government needs to consider is whether the cost of building the bridge is greater or less than $100. If you then tell me that, because we are in a recession, there are additional stimulus benefits from the project (e.g., the workers who build the bridge take their new wage income and buy goods and services from other businesses further stimulating demand, increasing employment, and so on.), the government should exclude these additional benefits from its calculation.

Disclosing One’s Biases in the Classroom

Over at Crookedtimber, Harry Brighouse poses a very good question.

My own policy is to disclose very little, particularly with undergraduate students. The professor is not supposed to dictate positions to his or her students — I want my students to come to their own conclusions (of course they have to know the material for the exams but that’s a separate issue). In the graduate courses I disclose more. I think (hope) graduate students are less likely to passively accept the instructors views as the final word on a topic. Also, grad students are interested in what faculty think about the probable future direction of research.

For the record, when I discus behavioral economics, I usually say that I have something of a “bias” against behavioral though I emphasize that my views are in the minority. I’m not sure whether my students feel that my treatment of behavioral is fair (and balanced?) or not.

Oscar Do-Overs

I’m not a film connoisseur.  Then again, I’m also not an expert in football or basketball but it doesn’t take a genius to see that picking Greg Oden over Kevin Durant was a blunder of epic proportions.[1]  Sports drafts are littered with blunders like this: Kwame Brown drafted #1 overall by the Washington Wizards? Ryan Leaf drafted #2 by the Chargers?[2]  Sam Bowie drafted #2 by Portland (the #3 pick was someone named Michael Jordan).[3]  Basically any first or second round pick by the NY Jets during the 80s and 90s….

Similarly, the Academy is guilty of making many ridiculous award choices over its history.  Perhaps the worst award blunders came in the late 70s and early 80s.  Look at this record:

1978: Best Picture: Annie Hall over Star Wars. [Annie Hall is an exquisite movie and would normally be a no-brainer as best picture – unfortunately it’s up against the biggest landmark picture in history …]

1980:  Best Picture: Kramer vs. Kramer over Apocalypse Now [this is not completely implausible but it is probably a mess up].

1981: Best Picture: Ordinary People over Raging Bull [Oops.]

1982: Best Picture: On Golden Pond Chariots of Fire over Raiders of the Lost Ark.

Even 1983 (Ghandi Gandhi [4] over E.T. and Tootsie) seems potentially questionable.  Here I’ll make my recommendations as to how the awards since 1995 might be revised by a benevolent outsider with the ability to re-do history.  I’m going to leave out this year’s nominees since I haven’t seen any of these movies yet …

Best Picture Do-Overs:

2013.  Winner: Argo                                                  Do-Over: Zero Dark Thirty.

2013 was a very strong year.  Nominees also included Django Unchained. This is pretty close. My choice would be Zero Dark Thirty (Kathryn Bigelow out-does her own work in the Hurt Locker and Jessica Chastain turns in a flawless performance).

2012.  Winner: The Artist                                         Do-Over: The Help

Not a particularly strong year.  The Help takes it easily – amazing performances all around including Jessica Chastain again.

2011.   Winner: The King’s Speech                           Do-Over: The King’s Speech.

2010.   Winner: The Hurt Locker                             Do-Over: Avatar

I know what you’re thinking.

“But Avatar has clichéd dialogue and is filled with stock characters…”  Yep.

“But Avatar’s storyline is so predictable …”  Yep.

“But Avatar relies so overtly on special effects …”  Yep.

Avatar. Best Picture. It’s not close. (BTW, If I had to give the award to some other film that year, it would be Inglorious Basterds, not the Hurt Locker.)

2009.  Winner: Slumdog Millionaire                        Do-Over: Slumdog Millionaire

2008.   Winner: No Country for Old Men                Do-Over: Ratatouille

The Academy has committed one of the great sins of omission by passing over Pixar studios again and again over the past 20 years.  One could make a strong case that computer animation is the main change in the industry in this period  – it has essentially made every story accessible to the big screen – and Pixar is one of the leaders in developing the medium.  Pixar marries their incredible technique with some of the best writing and production on screen.  Really, how many “kids movies” use the phrase “demi chef de partie” in their dialogue?

No Country is a good movie but it’s clearly not the Cohen bros. best work.

2007.  Winner: The Departed                                   Do-Over: The Departed.

The Academy knows it messed up big-time with Martin Scorsese.  Giving him the award for The Departed is their way of admitting their boo boo.

2006.   Winner: Crash                                               Do-Over: Brokeback Mountain

That sound you hear is a collective groan coming from the voting members of the Academy…

2005.   Winner: Million Dollar Baby                         Do-Over: Million Dollar Baby

2004.   Winner: LOTR: The Return of the King        Do-Over: Monster

OK, they had to award Peter Jackson for this work – I understand the choice. The irony is that Return of the King is easily the weakest of the three LOTR movies.  By the way, if you are thinking that I’m moving Monster into the top slot based primarily on Charliez Theron’s performance, you are correct sir!

2003.  Winner: Chicago                                             Do-Over: The Pianist

2002.  Winner: A Beautiful Mind                              Do-Over: LOTR: The Fellowship of the Ring

This has to be a better allocation doesn’t it?

2001.  Winner: Gladiator                                           Do-Over: Erin Brokovich

2000.   Winner: American Beauty                            Do-Over: American Beauty

I’m resisting the temptation to give the 2000 award to The Insider.

1999.   Winner: Shakespeare In Love                      Do-Over: Shakespeare In Love

1998.   Winner: Titanic                                              Do-Over: Titanic

An incredibly strong year.  Other nominees included Good Will Hunting and The Full Monty.

1997.   Winner: The English Patient                        Do-Over: Fargo.

1996.   Winner: Braveheart                                      Do-Over: Braveheart

I’m tempted to give the award to Apollo-13 but I’ll let it stand.

1995.  Winner: Forest Gump                                    Do-Over: Pulp Fiction

Perhaps the strongest year of those I considered above.  The nominees include (in addition to Forest Gump and Pulp Fiction) The Shawshank Redemption, Quiz Show and Four Weddings and a Funeral.  Forest Gump is excellent but it’s not as good as either Shawshank or Pulp Fiction.  Pulp Fiction has to take the award – another huge landmark in Hollywood.

[1] Greg Oden may be making a comeback with the Heat.  That said, passing on Durant will go down as one of the great head-slapping choices for the Trailblazers.

[2] Many observers at the time were openly wondering whether Ryan Leaf should be taken #1 overall (over some guy named Peyton Manning…).  Double head-slap.

[3] Triple head-slap.

[4] I’m a hideous speller but that in no way justifies this mess-up. Thanks to Uday Rajan (UM Ross Finance) for pointing out my error.

Are You a Behavioralist or an Institutionalist?

Noah Smith’s response to my previous post on the future of behavioral economics makes an interesting point: behavioral economics is indeed somewhat more established in finance.  I think this is correct and the examples Noah cites are all worthy representatives of the sub-field of behavioral finance.

Is behavioral finance gaining ground in the wake of the financial crisis?  My own reaction to financial crisis is that macroeconomists indeed have a lot of work to do.  I don’t think simple modifications to existing DSGE models are going to do the trick.  Instead, I think that we need to improve our understanding of the architecture of financial markets by gathering data on financial flows and contracts of the key participants in these markets and hopefully getting a better sense of how these markets connect with the “real” economy.  We can then incorporate this institutional detail into quantitative DSGE models so we can be better prepared for the next crash.

An alternative reaction is to say that what matters most is the psychology of the market participants.  Perhaps asset price bubbles and speculative behavior is fundamentally tied to “sentiment” or other factors that have traditionally been in the domain of psychology.

Of course we don’t have to make a choice here.  It’s not as though learning more about the role of psychological or subjective forces in markets is a bad thing.  Even if I think that we would be best served by focusing on financial market institutions, we would certainly be made better off with a greater understanding of the behavioral tendencies of financial market participants.

Nevertheless, I think it’s telling to think introspectively about where more work is needed.  Do you think “originate to distribute” behavior is best understood as rational people reacting to poorly designed market institutions (or poor policies) or do you think that this behavior is caused by irrational over-optimism?  Do you think that when the loan markets “froze” (a terribly imprecise term incidentally) that this was a rational decision on the part of lenders who were justifiably concerned that they either wouldn’t get paid back or that they needed to retain their liquid assets rather than commit them to the markets or do you think that frozen loan markets were caused by irrational panicking?  How you answer these questions might tell you a bit about whether the future of behavioral finance is bright or dim.