Tag Archives: economics

A Book That Needed To Be Written

By James Kwak

I have previously written about (here, for example) what I call economism, or excessive belief in the little bit that you remember from Economics 101. The problem is twofold. First, Economics 101 usually paints a highly stylized, unrealistic view of the world in which free markets always produce optimal outcomes. Second, most people in the world who have taken any economics have only taken first-year economics, and so they never learned that, from a practical perspective, just about everything in Economics 101 is wrong. (Complete information? Rational actors? Perfectly competitive markets?) This produces a nation of people like Paul Ryan, who repeats reflexively that free market solutions are always good, journalists who repeat what Paul Ryan says, and ordinary people who nod their heads in agreement.

The problem is not the economics profession per se. These days, to make your mark as an economist, it helps to be arguing (or, better yet, proving) that the free market caricature of Economics 101 is wrong. The problem is the way it is taught to first-year students, which pretty much assumes that Joseph Stiglitz, Daniel Kahnemann, Elinor Ostrom, and many others had never existed.

What we need, I have often thought, is a companion book for students in Economics 101, one that points out the problems with the standard material that is covered in the textbook. For a while I was thinking of writing such a book, but I decided against it for a number of reasons, one of them being that I am not actually an economist. Fortunately, John Komlos, who really is an economist, has written a book along these lines, titled What Every Economics Student Needs to Know and Doesn’t Get in the Usual Principles Text.

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The Costs of “Good” Economics

By James Kwak

If there is a central argument to 13 Bankers, it is that politics matters. The financial crisis was the result of a long-term transformation of the financial sector and its place in the overall economy, and that transformation occurred because of—and contributed to—a shift in the political balance of power.

Daron Acemoglu and James Robinson, authors of Why Nations Fail, take up this theme on a much broader scale in their recent article in the Journal of Economic Perspectives, “Economics Versus Politics: Pitfalls of Policy Advice,” burnishing their reputations as two of the most subversive thinkers around. People have always known that economics and politics are related: that economic power produces political power and that political institutions constrain economic policy choices. Still, however, at least for the past several decades, the universal assumption has been that good economic policy is always good policy, full stop: for example, that it is always good to eliminate market failures.

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Why Is Finance So Big?

By James Kwak

This is a chart from “The Quiet Coup,” an article that we wrote for The Atlantic three years ago next month. Many people have noted that the financial sector has been getting bigger over the past thirty years, whether you look at its share of GDP or of profits.

The common defense of the financial sector is that this is a good thing: if finance is becoming a larger part of the economy, that’s because the rest of the economy is demanding financial services, and hence growth in finance helps overall economic growth. But is that true?

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How Much Do Taxes Matter?

By James Kwak

Christina and David Romer’s new paper, “The Incentive Effects of Marginal Tax Rates: Evidence from the Interwar Era,” is available as an NBER working paper (if you are so lucky). Given the current debates about taxes, the paper is likely to garner some attention.

In the central section of the paper, Romer and Romer regress reported taxable income against the policy-induced change in marginal after-tax income share. The after-tax income share is the percentage of your gross income that is left after taxes; policy-induced changes are those caused by tax changes rather than be macroeconomic changes. They do this for the top 0.05% of the income distribution, broken down into ten sub-groups by income, because the income tax only affected the very rich during the interwar years.

Their headline finding is that “The estimated impact of a rise in the after-tax share is consistently positive, small, and precisely estimated” pp. 15–16). They find an elasticity of taxable income with respect to changes in the after-tax income share of 0.19.

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What Did the SEC Really Do in 2004?

By James Kwak

Andrew Lo’s review of twenty-one financial crisis books has been getting a fair amount of attention, including a recent mention in The Economist. Simply reading twenty-one books about the financial crisis is a demonstration of stamina that exceeds mine. I should also say at this point that I have no arguments with Lo’s description of 13 Bankers.

Lo’s main point, which he makes near the end of his article, is that it is important to get the facts straight. Too often people accept and repeat other people’s assertions—especially when they are published in reputable sources, and especially especially when those assertions back up their preexisting beliefs. This is a sentiment with which I could not agree more. One of the things I was struck by when writing 13 Bankers was learning that nonfiction books are not routinely fact-checked (Simon and I hire and pay for fact-checkers ourselves). As technology and the Internet produce a vast increase in the amount of writing on any particular subject, the base of actual facts on which all that writing rests remains the same (or even diminishes, as newspapers cut back on their staffs of journalists).

I’m not entirely convinced by Lo’s example, however. He focuses on a 2004 rule change by the SEC. According to Lo, in 2008, Lee Pickard claimed that “a rule change by the SEC in 2004 allowed broker-dealers to greatly increase their leverage, contributing to the financial crisis” (p. 33). That is Lo’s summary, not Pickard’s original. This claim was picked up by other outlets, notably The New York Times, and combined with the observation that investment bank leverage ratios increased from 2004 to 2007, leading to the belief that the SEC’s rule change was a crucial factor behind the fragility of the financial system and hence the crisis.

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The Smugness of Unintended Consequences

By James Kwak

After my post on Corey Robin’s new book, a friend recommended Albert O. Hirschman’s Rhetoric of Reaction. As the title suggests, the book is about the rhetorical style of conservative thought dating back to Burke. Hirschman identifies three common tropes: perversity (that great-sounding progressive idea you have will have the opposite of its intended effect), futility (that great-sounding progressive idea won’t change anything, because you don’t understand the fundamental laws of the world), and jeopardy (that great-sounding progressive idea will destroy some other thing that we all agree is valuable, making everyone worse off in the end). Hirschman doesn’t dwell on this specific point, but it’s obvious that, similar to the argument Robin makes, these rhetorical devices can only exist in opposition to some progressive reform movement.

I thought the description of the contemporary form of the perversity thesis (e.g., welfare programs create poverty) was especially good. “Here the failure of foresight of ordinary human actors is well-nigh total as their actions are shown to produce precisely the opposite of what was intended; the social scientists analyzing the perverse effect, on the other hand, experience a great feeling of superiority—and revel in it” (Belknap Press, 1991, p. 36). This seems to me an accurate description of why the Economics 101 ideology is so powerful. People get a sense of superiority from owning counter-intuitive theoretical insights—even if those insights are wrong.

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The Myth of the Natural Economy

By James Kwak

“The general equilibirum view tends to lend support to those who want to make the economy more efficient in the sense of having fewer ‘distortions’—you know, all of these neutral economic words—from taxes, from labor unions, from minimum wages, and so on. Now, what has happened in the last thirty years—and this is what Hacker and Pearson note in their book [Winner-Take-All Politics]—is we have gotten ourselves into a feedback situation. As people have gotten richer, conservative people have funded organizations which generate economic research promoting their political views.”

That’s from an excellent interview with economic historian Peter Temin in The Straddler. Temin’s main point is that what he calls general equilibrium approaches to macroeconomics have a political agenda, but they hide that agenda behind an ideology of naturalness. The “natural,” perfectly clearing, perfectly efficient economy, of course, has never existed and can never exist, but it is used to justify certain political prescriptions.

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Allocative Efficiency for Beginners

By James Kwak

I was catching up on some old Planet Money episodes and caught Allen Sanderson of the University of Chicago talking about how to allocate scarce resources. The first day of introductory economics, he says, there are always more students than seats. Say there are forty extra people, and he can only accept ten more into the class. He asks the class: how should the ten slots be allocated? You can easily guess the typical suggestions: by seniority, because seniors won’t be able to take the class later; by merit (e.g., GPA), because better students will contribute more to the class and get more out of it; to the first ten people outside his office at 8 am the next day, since that is a proxy for desire to get in; randomly, since that’s fair; and so on. Someone also invariably suggests auctioning off the slots.

This, Sanderson says, illustrates the core tradeoff of economics: fairness and efficiency. If you auction off the slots, they will go to the people to whom they are worth the most, which is best for the economy as a whole.* If we assume that taking the class will increase your lifetime productivity and therefore your lifetime earnings by some amount, then you should be willing to pay up to the present value of that increase in order to get into the class. An auction therefore ensures that the slots will go to the people whose productivity will go up the most. But of course, this isn’t necessarily fair, especially when you consider that the people who will get the most out of a marginal chunk of education are often the people who have the most already.

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Is Economics the Problem?

By James Kwak

For a class, I recently read “The Psychological Consequences of Money,” a 2006 article in Science by Kathleen Vohs, Nicole Mead, and Miranda Goode. It describes nine experiments testing how reminding people of money leads them to behave differently — in ways that we should not be proud of. You may have heard of these experiments.

In Experiment 5, participants first played Monopoly, after which the game was cleared except for a large or a small amount of play money; then they were asked to imagine a future with abundant finances or with strained finances (there was also a control group); then someone walked into the room and dropped a box full of pencils. People who saw more money and imagined having a lot of money picked up fewer pencils. In Experiment 7, participants saw a screensaver with currency symbols floating underwater or fish swimming underwater; then they were asked to move two chairs together for a conversation with another person. People who saw the currency symbols placed the chairs further apart than people who saw fish.

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Disclosure Rules for Economists

By James Kwak

In October, Gerald Epstein and Jessica Carrick-Hagenbarth released a paper documenting potential conflicts of interests among academic economists writing about the financial crisis and financial reform. Focusing on the Squam Lake Working Group on Financial Regulation and the Pew Economic Policy Group Financial Reform Project, they found that a majority of the economists involved had affiliations with private financial institutions, yet few of them disclosed those affiliations even in academic publications (where they do not face the word constraints imposed by print newspaper editors), preferring to identify themselves by their universities and as members of prestigious institutions such as NBER. To be fair, they did not find a strong relationship between economists’ affiliations and their positions on financial reform, perhaps because of the small sample and the limited amount of variation in the positions of members of these groups.

Epstein and Carrick-Hagenbarth called in their paper for economists to disclose any potential conflicts of interest, especially when writing for a general audience. This proposal has picked up some steam, first in the blogs (me; Nancy Folbre in EconomixFelix Salmon (“it’s not going to happen: there’s too much money riding on the continuation of the status quo”); Mark Thoma; Mike Konczal; Planet Money) and, more recently, thanks in part to the movie Inside Job, in the mainstream press. According to Sewell Chan in The New York Times, the AEA claims that it will consider a new ethical code or at least disclosure rules for economists – although, in a forthcoming book, “[George] DeMartino describes concerns dating to the 1920s about the influence of business on economic research, and cites multiple calls within the association for a code of conduct — all of which have been rebuffed.”

Epstein and Carrick-Hagenbarth have drafted a letter to the president of the AEA asking for the adoption of a code that requires economists to avoid conflicts of interest and to disclose ties that could create the appearance of a conflict of interest. If you are an economist and would like to sign on, you can email Debbie Zeidenberg (peri at econs dot umass dot edu) by Sunday evening. The full text follows.

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The More Things Change …

By James Kwak

As a holiday gift to myself, I’ve actually been reading a real book, on paper — The Worldly Philosophers, by Robert Heilbroner. The book itself was not a gift to myself; I have my sister’s old copy, which is the 1980 edition. The book is a traditional intellectual history of some of the main figures in economics. As the original was written in 1953, it focuses less on the mathematical line of economics, from Walras and Marshall through Arrow-Debreu to the present, and more on what used to be called political economy: Smith, Ricardo, Mill, Marx, Keynes, etc. It’s not a way to learn economics, but a way to learn something about the historical conditions that helped give rise to some important economic ideas.

But some passages seem oddly relevant today. Discussing the conventional economic wisdom of the early nineteenth century (pp. 121-22):

“They lived in a world that was not only harsh and cruel but that rationalized its cruelty under the guise of economic law. . . . It was the world that was cruel, not the people in it. For the world was run by economic laws, and economic laws were nothing with which one could or should trifle; they were simply there, and to rail about whatever injustices might be tossed up as an unfortunate consequence of their working was as foolish as to lament the ebb and flow of the tides.”

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Free Books and Board Seats

By James Kwak

Here in the blogging world, some of us are very sensitive to the potential appearance of impropriety. A year ago, the FTC published new rules requiring bloggers to disclose cash and in-kind payments they receive for reviewing products. The upshot, for most of us, is simply that now, when we discuss a book, we say if we got a free copy of the book from the publisher. (Although it’s not clear that that disclosure is required, since getting a free copy is something that readers should expect; I don’t think the New York Times Book Review bothers pointing out that, for every book they review, they got a free copy, although they almost certainly did.)

All the more relevant, then, is Gerald Epstein’s post about conflicts of interest in the economics profession.

“Jessica Carrick-Hagenbarth and I did a study of 19 prominent academic financial economists who were members of two influential groups that have played a key role in the financial reform and regulation debate in the U.S. Of the 19 academic economists in these groups, 70% advised, owned significant stock in or were on the board of private financial institutions. But you wouldn’t know by looking at their self-identification in media appearances, policy work or academic papers.”

There are certainly economists who were talking up the housing market in the summer of 2008 without disclosing their financial ties to banks–who were desperately hoping that housing prices would not collapse.

C’mon, guys. I don’t even get very many free books (maybe one per month on average–I decline most of them), and I always disclose that. I know it’s not feasible to list every company that ever paid you to give a speech. But really, if you’re a paid director of a bank and you write about the banking industry, can’t you at least point that out?

Yet Another Reason to Like Elizabeth Warren

By James Kwak

Bob Lawless points me to this 2006 blog post by Elizabeth Warren. Warren describes a first-year contracts class on the case that upheld a fine-print forum selection clause (a clause saying that if you want to sue us, you have to sue us in X jurisdiction–Florida, in this case) on the back of a cruise ship ticket.

Warren’s entire class (Harvard, let me say for the record) insists that, as a factual matter, this decision is good for consumers because . . . well, regular readers of this blog should be able to fill in stock Mickey Mouse economistic hand-waving as well as any first-year law school student. Of course! Forcing people to sue in Florida (or to accept binding arbitration in the forum of the company’s choice) deters frivolous lawsuits and lowers costs for the company, and it can pass those savings onto consumers. Why does it pass those savings onto consumers instead of putting them into shareholders’ (or managers’) pockets? Because in a perfect competitive market, if Alpha Cruise Lines doesn’t, then Beta Cruise Lines will, and Beta will underprice Alpha, . . . Consumers will read the fine print and can make an informed choice between the lower price with the forum selection clause and the higher price without the forum selection clause.

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The Perils of Studying Economics

By James Kwak

Patrick McGeehan at the New York Times recently wrote about a New York Fed study finding that studying economics makes you a Republican. The headline conclusion is that the more economics classes you take, the more likely you are to be a Republican. Majoring in economics or business is also more likely to make you a Republican. (See Table 2 in the original paper.) The study is based on thousands of observations of undergraduates at four large universities over three decades, so it is focused on undergraduate-level economics.

Studying economics also affects your position on several public policy issues. Of seven issues, economics courses were significantly associated with the five following positions (Table 6):

  • Tariffs are bad.
  • Trade deficits are not so bad.
  • The government should not cap oil prices in response to a supply shock.
  • Raising the minimum wage increase unemployment for low-wage workers.
  • Income distribution should not be more equal.

These are all pro-free market, anti-government intervention positions.

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The Role of Government

By James Kwak

Last week Simon gave a talk sponsored by Larry Lessig’s center at Harvard. Afterward there was a dinner and then another question-and-answer session. Jedediah Purdy (another person to write a book while at Yale  Law School; he is now a professor at Duke’s law school) asked a question that I have rephrased as follows (the words are mine, not Purdy’s; I may have also distorted his original question so much that it is also mine):

“You’ve criticized the government for withdrawing from the economic and particularly financial sphere and allowing private sector actors to do whatever they wanted. Do you think the government should simply act so as to correct the imperfections in free markets? Or do you see a positive role for government in determining what kind of an economy we should have?”

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