Tuesday, August 26, 2014

I still don't understand the philosophy of Bayesian probability



Brad DeLong is having an extremely fascinating conversation with an E.E. Doc Smith deus ex machina character, an emulation of a Princeton professor, looser emulations of two famous dead probabilists, and a made-up Greek mediator himself about the philosophy of Bayesian probability (see also here). DeLong focuses on the question of whether probabilities should be "sharp" - i.e., whether we should always say "I believe the probability of the event is x%" (as Bayesians always do), or whether we should say something along the lines of "I believe the probability of the event is between x% and y%."

But I want to focus on a deeper question, which is: What is a probability in the first place? I mean, sure, it's a number between 0 and 1 that you assign to events in a probability space. But how should we use that mathematical concept to represent events in the real world? What observable things should we represent with those numbers, and how should we assign the numbers to the things?

The philosophy of Bayesian probability says that probabilities should be assigned to beliefs. But are beliefs observable? Only through actions. So one flavor (the dominant flavor?) of Bayesian probability theory says that you observe beliefs by watching people make bets. As DeLong writes:
Thomas Bayes: It is simple. [Nate Silver assigning a 60% probability to a GOP takeover of the Senate in 2014] means that Nate Silver stands ready to bet on [Republican] Senate control next January at odds of 2-3. 
Thrasymakhos: “Stands ready”? 
Thomas Bayes: Yes. He stands ready to make a (small) bet that the Majority Leader of the Senate will [not] be a Republican on January 5, 2015 if he gets at least 2-3 odds, and he stands ready to make a (small) bet that the Majority Leader of the Senate will not be a Republican on January 5, 2015 if he gets at least 3-2 odds.
DeLong is very careful to write "a (small) bet". If he wrote "a bet", we would have to introduce Nate Silver's risk aversion into our interpretation of the observed action, if the bet size were large. DeLong is assuming that a small bet will get rid of Silver's risk aversion.

However, there's a problem: DeLong's assumption, though characteristic of the decision theory used in most economic models, does not fit the evidence. People do seem to be risk-averse over small gambles. One (probably wrong) explanation for this is prospect theory. Loss aversion (one half of prospect theory) makes people care about losing, no matter how small the loss is. To back out beliefs from bets, you need a model of preferences. And that model might be right for one person at one time, but wrong for other people and/or other times!

But isn't that just a practical, technological problem? Why do we need real-world observation in order to define a philosophical notion? Well, we don't. We already defined a probability as a real number between 0 and 1 (which gets assigned to the latter slot in the tuples that are the elements of a probability measure). That's fine. But the Bayesian philosophical definition of probability, if it is to be more than "a number between 0 and 1," seems like it has to include a scientific component. The Bayesian notion of "probability as belief" explicitly posits a believer, and ascribes the probability to that real, observable entity (note: This is also why I think the "Weak Axiom of Revealed Preference" is not an axiom). If we can't observe the probability, then it doesn't exist - or, rather, it goes back to just being "a number between 0 and 1".

So can't we just posit a hypothetical purely rational person, and define beliefs as his bet odds? Well, it seems to me that this will probably lead to circular reasoning. "Rational" will probably be defined, in part, as "taking actions based on Bayesian beliefs." But the Bayesian beliefs, themselves, will be defined based on the actions taken by the person! This means that imagining this purely rational person gets us nowhere. Maybe there's a way around this, but I haven't thought of it.

Does all this mean that the definition of Bayesian probability is logically incoherent? No. It means that defining Bayesian probability without reference to preferences (or other decision-theoretical rules that stand in for preferences) is scientifically useless. In physics, a particle that interacts with no other particles - and is hence unobservable, even indirectly - might as well not exist. So by the same token, I claim that Bayesian probabilities might as well not exist independently of other elements of the decision theory in which they are included. You can't chop decision theory up into two parts; it's all or nothing.

I assume philosophers and decision-theory people thought of this long ago. In fact, I'm probably wrong; there's probably some key concept I'm missing here.

But does it matter? Well, yes. If I'm right, it means the argument over whether stock prices swing around because of badly-formed beliefs or because of hard-to-understand risk preferences is pretty useless; there's no fundamental divide between "behavioral" and "rational" theories of asset pricing.

It's also going to bear on the more complicated question Brad is thinking about. If you're talking to people who make decisions differently than you do, it might not be a good idea to report a number whose meaning is conditional on your own decision-making process (which your audience does not know). So that could be a reason not to report sharp probabilities to the public, even if you would make your own decisions in the standard Bayesian-with-canonical-risk-aversion way. But what you should do instead, I'm not sure.

Friday, August 22, 2014

A slight clarification about the "end of labor"


MIT prof and economic policy advisor David Autor has written an excellent new paper about labor market polarization, which you should read. In that paper, he cites an article I wrote for The Atlantic last year, discussing the possibility of "the end of labor." Mr. Autor makes it sound as if I believe the "end of labor" is coming, but in fact, I only think this is one possibility among many. The point of my article - which was inspired by this Larry Summers talk - was that the "end of labor" is something we should prepare to deal with, even if there is only a low probability of it happening. The mechanism for the "end of labor", of course, could be such a huge degree of skills-based labor market polarization that even small labor market frictions would be capable of creating huge amounts of equilibrium unemployment; alternatively, it could be a continuation of the trend of increasing capital share of income, as discussed in this paper.

The Atlantic, of course, got to pick the title of my piece (as all magazines do with all pieces), and understandably went with something attention-catching rather than something that would reflect the uncertainty I tried to express in the article itself.

But in any case, thanks to Mr. Autor for the mention.

Monday, August 18, 2014

RBC models we can believe in?



At Bloomberg View, I wrote an article trying to explain the basics of RBC models to the masses, and give a little history-of-thought. Of course anyone who actually knows the situation will realize that my treatment is pretty simplistic, but you try explaining RBC in 800 words to people who know nothing about modern academic macro, in a way that's entertaining and grabs eyeballs. It is harder than it sounds. ;-)

Anyway, the post only talked about the original, historical RBC model, and mentioned a couple follow-ups, such as news shock models. But if you define "RBC" as "any macro models where aggregate uncertainty is mainly driven by productivity shocks," then the field gets a lot wider. 

In fact, if you put a gun to my head and asked me why recessions happen, first I'd kiss my ass goodbye, but then I'd say that some of them happen because of sector-specific productivity shocks, amplified by network effects and by some departures from Rational Expectations. Actually, there are a number of models popping up that try to model something like this, and I think it's a hugely interesting literature. Here are a couple examples, with abstracts.

"Noisy Business Cycles", by George-Marios Angeletos and Jennifer La'O (2009)
This paper investigates a real-business-cycle economy that features dispersed information about the underlying aggregate productivity shocks, taste shocks, and, potentially, shocks to monopoly power. We show how the dispersion of information can (i) contribute to significant inertia in the response of macroeconomic outcomes to such shocks; (ii) induce a negative short-run response of employment to productivity shocks; (iii) imply that productivity shocks explain only a small fraction of high-frequency fluctuations; (iv) contribute to significant noise in the business cycle; (v) formalize a certain type of demand shocks within an RBC economy; and (vi) generate cyclical variation in observed Solow residuals and labor wedges. Importantly, none of these properties requires significant uncertainty about the underlying fundamentals: they rest on the heterogeneity of information and the strength of trade linkages in the economy, not the level of uncertainty. Finally, none of these properties are symptoms of inefficiency: apart from undoing monopoly distortions or providing the agents with more information, no policy intervention can improve upon the equilibrium allocations.

"The Network Origins of Aggregate Fluctuations", by Daron Acemoglu et al. (Econometrica 2012)
This paper argues that in the presence of intersectoral input-output linkages, microeconomic idiosyncratic shocks may lead to aggregate fluctuations. In particular, it shows that, as the economy becomes more disaggregated, the rate at which aggregate volatility decays is determined by the structure of the network capturing such linkages. Our main results provide a characterization of this relationship in terms of the importance of different sectors as suppliers to their immediate customers as well as their role as indirect suppliers to chains of downstream sectors. Such higher-order interconnections capture the possibility of “cascade effects” whereby productivity shocks to a sector propagate not only to its immediate downstream customers, but also indirectly to the rest of the economy. Our results highlight that sizable aggregate volatility is obtained from sectoral idiosyncratic shocks only if there exists significant asymmetry in the roles that sectors play as suppliers to others, and that the “sparseness” of the input-output matrix is unrelated to the nature of aggregate fluctuations.

And just for fun, I'm going to throw in "Intermediate Goods, Weak Links, and Superstars: A Theory of Economic Development", by Charles I. Jones (2008), which bills itself as a theory of development, but seems like it could pretty easily be modified to be a business-cycle theory for developed countries.

(Also there's this Gabaix paper, which is about firm-level heterogeneity. I originally included it here, but it doesn't really fit with the others so I took it out. Heterogeneity is a very different story from networks and complexity. Still, good to see heterogeneity getting more attention.)

The basic idea here is actually pretty simple. Angeletos actually said it, when he came to present his paper at Michigan: "One firm's productivity determines other firms' demand." In other words, these network models go way beyond the traditional, typical framework of aggregate supply and aggregate demand. (Other models also do this, but usually across time rather than across firms or sectors.) 

Like I said, if you held a gun to my head, I would say that something like this is actually going on in the actual economy. Why? Because aggregate shocks are sometimes really hard to identify. There were the oil price shocks in the 1970s and Volcker's tightening in the early 1980s, but a lot of recessions don't seem to be externally provoked. So maybe that means there is some kind of random mass-psychological sentiment thing going on, or maybe it means that recessions are sunspots caused by the interaction of a whole bunch of frictions, and thus completely unknowable. But this network/linkage idea seems like a promising alternative to those unhappy possibilities. That doesn't mean I think any of these models is right - they're all going to have empirical issues, because they are basically proof-of-concept papers. But I suspect they're on to something that many have expected for a long time - the idea that economic fluctuations are the result of the complexity of economic systems.

But explaining to Bloomberg View readers that these models may or may not deserve the moniker "RBC" would have distracted from my main point, which is to teach people a little about the history of macroeconomic thought (read: academic politics in the macro field), so someday I can explain my theory of why Mike Woodford is the most important macroeconomist in the world. But now I'm getting ahead of myself...

Thursday, August 14, 2014

Thursday Roundup, 8/14/2014



Thursday Roundup is back! Saddle up, blog junkies.

Me on BV

1. Silicon Valley is solving the big problems (warning: sappiness)

2. The trend is your friend til the bend at the end (or, why "put option illusion" fools investors)

3. Barack Obama is no foreign policy wimp

4. Why I don't mind if someone calls me "stupid"

5. How hedge funds can "sharpen their Sharpe ratios" at investors' expense (featuring cool papers by Goetzmann et al. and Agarwal & Naik)


From Around the Econ Blogosphere

1. Alex Tabarrok continues to sound the alarm on FDA over-regulation of biomed technology. See also here.

2. Mark Thoma: The perennial disagreement among macroeconomists is due to a toxic mix of bad data and politics. Old news, but useful to repeat.

3. Miles Kimballl on how to turn your kid into a math person. No cyborg enhancements involved.

4. Mencius Moldbug has quit blogging. Street protests explode in cites across the globe. Antidepressant use spikes. Just kidding.

5. Roger Farmer thinks Mike Woodford is wrong about the irrelevance of QE. Good to see people realizing that Mike Woodford is the world's most important macroeconomist.

6. Data scientists are out there earning more than econ profs. Actually, data scientists have similar skill sets to empirical econ researchers.

7. Brad DeLong thinks about the philosophical problems of Bayesianism. This is something I've wondered about for a while, and I'm still not satisfied.

8. Bryan Caplan wonders if economics is based on common sense or not. This is something I've often wondered about. Most sciences prize "counterintuitive" findings. Does econ? Should econ? Should the other sciences, for that matter?

9. Robert VerBruggen thinks helping poor women delay childbearing could be a way to fight poverty.

10. John Cochrane and Anat Admati continue to fight the good fight for increased bank capital requirements. Thought: How about making them dependent on bank size, as a way of discouraging TBTF? (Not a new thought, but still a thought.)

Wednesday, August 13, 2014

Chris House on stimulus spending



Back in March, Chris House wrote a blog post explaining why he thinks that tax rebates make better stimulus than government spending. He concludes that tax rebates are the best form of stimulus, and that government spending projects should only be undertaken if the projects would pass a cost-benefit test in the absence of any stimulus effect. House:
If a project doesn’t meet the basic cost / benefit test, then it shouldn’t be funded, regardless of the need for stimulus...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... 
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.
I don't understand this assertion at all. It makes no sense to me.

Let's consider a simple numerical example. Suppose that the economy is in a recession. And suppose that, because of the Zero Lower Bound or whatever, the pure fiscal "multiplier" is substantial. Specifically, suppose that $100 of tax rebates will increase GDP by $110. In this case, stimulus spending is a "free lunch."

Now suppose that instead of doing tax rebates, the government can build a bridge. The social benefit of the bridge is $90, and the bridge would cost $100. In the absence of stimulus effects, therefore, the bridge would not pass a cost-benefit analysis. For simplicity's sake, suppose that spending money on the bridge would create exactly the same stimulus effect as doing a tax rebate - spend $100 on the bridge, and GDP goes up by $110 from the stimulus effect.

In this case, the net social benefit of spending $100 building the bridge is $90 + $110 - $100 = $100.
And the net social benefit of spending $100 on a tax rebate is $110 - $100 = $10.

Bridge wins!

In fact, it turns out that the bridge wins even with a pure multiplier of less than 1! As long as the multiplier is greater than 0.2, in fact, it's worth it for the government to build the bridge. This will mean that the apparent multiplier of bridge-building will far exceed the "pure" multiplier. In this case, the apparent multiplier from bridge-building will be 2.

This fits the results of Auerbach and Gorodnichenko (2012). It also fits with the simple Keynesian theories you'd read in an Econ 102 textbook. It also fits the results of Bachmann and Sims (2011). And if true, it means Chris House is completely wrong.

Now let's relax the assumption that the pure stimulus effect is equal for the two cases. Suppose that government spending creates waste, for example. Or suppose that due to the particular nature of the mechanism that makes stimulus effective in the first place, the people who build the bridge will tend to stick most of their fee in a bank instead, rather than spending it as people would do if they got a tax rebate. Concretely, suppose that due to government waste or reduced stimulus effect, the pure stimulus benefit of building the bridge is only $30 instead of $110 (a pure multiplier of only 0.3 for government spending vs. 1.1 for tax rebates).

In that case, the net social benefit of building the bridge is $90 + $30 - $100 = $20. Bridge still wins! House is still wrong!

The difference between bridge-building and tax rebates can be stated in simple terms. If you give people a tax rebate, they may stick the whole thing in the bank, completely negating the stimulus. If you pay unemployed people to build a bridge, they may stick 100% of their earnings in the bank - but now you have a new bridge.

So basically, I don't see how House is doing his cost-benefit analysis. His conclusion is diametrically opposed to Econ 102 textbook Keynesianism, which is fine, but I feel like there should be some justification. Almost everyone - even John Taylor! - thinks that infrastructure spending makes better stimulus than tax rebates, not worse. Chris House asserts that the exact opposite is true, and that's fishy.

Sunday, August 10, 2014

Yes, women's labor force participation matters



A bunch of social-conservative types on Twitter keep telling me that women's labor force participation doesn't matter for GDP growth. As evidence they keep linking me to this post by Scott Alexander. Here's Scott's case:
[W]hy did the entry of women into the workforce produce so little effect on GDP? Here’s the graph of US women’s workforce participation: 
 
And here’s the graph of US GDP. 
 
In about 50 years – 1935 to 1985 – we went from 20% of women in the workforce to 60% of women in the workforce. Assuming a bit under 100% of men in the workforce, that’s an increase of almost 50% over the expected trend if number of women in the workforce had stayed constant. 
I’ve already admitted I find the fixedness of the GDP trend bizarre. But how on Earth do you unexpectedly raise the number of people in the workforce by 50% and still stick to exactly the same GDP trend? 
The idea here is that the GDP growth trend looks so smooth that it has to be a law of nature. But that's certainly not the case for other countries. For example, here's a graph for Japan, on a log-log scale:



If Japan's growth rate were constant, that line would be straight. Instead, it's concave, meaning that growth slowed substantially over time. So we know that countries' economic growth rates are not fixed laws of nature - they can be affected by events.

So what were some of the events that affected U.S. GDP growth over the last century? Here's total labor force participation in the U.S. from 1948 to 2014:



As you can see, there was a big increase between around 1968 and around 1989. A lot of that was women entering the workforce (and men not leaving).

Now what else affects GDP? Population, but U.S. population growth was pretty constant. How about productivity? David Beckworth has a good graph:



We see that from the late 1960s through the mid-1900s, productivity stagnated noticeably. So the gains from increased labor force participation was one of the things that counteracted the productivity slowdown at that time.

In other words, when Scott asks:
Are we imagining here that if women hadn’t entered the workforce, GDP would have suddenly deviated downward from the trend, and totally by coincidence women rushed in to save the day?
The answer is: Yes!

(Now, one might wonder if TFP and LFPR are related. When more people work, does productivity go down? Interesting question. Economists usually assume the two are unrelated. And there are definitely lots of episodes in which the two move in the same direction instead of canceling out - Japan in the 1990s is one of these, since female labor force participation and TFP both abruptly flattened out in that decade. But some people have argued that higher employment slows down TFP in some situations. Suffice it to say that this is a minority viewpoint, but can't be ruled out.)

Actually, there have been a number of economists who have looked at a bunch of factors and tried to isolate the effect of female labor force participation on growth. Here is a summary of much of the relevant research. The conclusion is that yes, female labor force participation does contribute substantially to per capita GDP. The puzzle Scott presents us with is actually no puzzle.

Scott also asks this question:
And then when we ran out of interested women to add to the work force, again by coincidence the GDP stabilized back to its trend line?
The answer is: No. Growth has been slower since women stopped joining the labor force. The trend is your friend til the bend at the end! Scott's GDP graph is zoomed-out, so it's hard to see the "bend at the end", but it's there. There was an acceleration of productivity growth in the late 90s and early 2000s, which - again - partially canceled out the end of women's entry into the labor force. But since then, growth has been slower; there has been no return to the growth rates of the 1960s or even the 1990s.

Now, a couple of caveats. Caveat 1 is that "home production" is not counted in GDP, but matters for living standards. Caveat 2 is that women's labor force participation can affect fertility (by decreasing it or by increasing it), which may affect long-run TFP growth, and will certainly affect total GDP by changing the population size.

But the idea that women's entry into the labor force has been unimportant for GDP is not correct. My advice to social conservatives looking to give economic justifications for traditional gender roles: Stop linking to this post.

Saturday, August 09, 2014

Let me explain Japan for Westerners


"Do you want to know our secrets?
Oops, sorry, we don't have any."


(If you just want the quick explanation without all the preamble, skip to the last paragraph of this post.)

There are three common mistakes that many Westerners make when observing or analyzing Japanese culture. First, they essentialize it - they assume there are some core things that never change, and that you can understand these things by studying samurai culture, or stuff like that. Second, they exoticize it - they assume that Japanese culture is very different from Western culture, and that there are deep secrets that only Japanese people themselves understand. Third, they homogenize it - they assume that the difference between Japanese individuals or subcultures is much smaller than the group difference between Japan and other cultures.

To be fair, many Japanese people also make these mistakes, and many Westerners also make a couple of those mistakes when thinking about their own cultures. But the mistakes are especially common among Westerners visiting - or, sometimes, living in - Japan.

The blog Wait But Why is one of my favorites, and I don't want this post to be interpreted as an insult directed at Tim Urban, the blogger. But in a recent post about a visit to Japan, Tim did all three of the things that I mentioned above. Let me quote him at great length:
7) The culture is lovely to interact with, fascinating to observe, and impossible to understand... 
Japanese foreignness is really about what goes on in the depths of the mind, not the zany cartoon ads. 
It makes sense that the differences between Japanese culture and a culture like that in America would run deep. At the core of American life are European cultural roots and a Judeo-Christian value system—both of which have at one time or another influenced much of the rest of the world, through imperialism and missionary activities. But Japan spent most of its history being unusually isolated, both as an official policy and through its ability to resist forceful cultural immersion—it’s one of the few places to A) never be occupied by another country, and B) keep almost all Christian missionary activity out, making it a rare country that has been able to evolve mostly untouched by others. 
Add to this the somewhat secretive, exclusive nature of Japanese culture, and you have a pretty boggling situation for an outsider... 
As my time in Japan went on, I began getting the very distinct impression that in spite of being treated wonderfully, I was not part of the club. Nor did it seem that anyone had any interest in helping me to join it. When it comes to anything beyond the Outer Shell—who the Japanese people really are, why they act the way they do, and what they’re thinking—I know about as much now as I did before my visit. 
Given that my trip was short and I don’t speak Japanese, this isn’t a huge surprise—but what did blow my mind was talking to expats who had been living in Japan for years and spoke fluent Japanese. Without exception, each of them told me that the Japanese treat them like outsiders and that that’s not going to change. One of them was half Japanese, spoke the language without an accent, had lived there for the last ten years and was married to a Japanese man, and she said she was a permanent outsider after being raised in France. 
A visitor to any country is an outsider to the culture there—what makes Japanese exclusivity unusual is both the extent of its stubbornness and the fact that Japan is a large and prosperous world power—usually the exclusive club phenomenon is the stuff of smaller groups, often those who have faced some kind of adversity together. 
The explanation, to me, comes back to Japan’s isolated history and the fact that the cultural gap between foreigners and Japanese runs especially deep. You can speak the language perfectly, but when the Japanese are known for speaking to each other in a very specific, indirect way (someone described it like talking to someone in a semi-circle instead of a straight line) and the foreigner just doesn’t really know how to do that, they’re not part of the club. When the Japanese are horrified at the prospect of losing face and a foreigner doesn’t understand what it would even feel like to lose face, they don’t know what it feels like to be Japanese, so there will always be a distance between them.
You can see all three of the processes I discussed at work here. First, there is the essentialization - Tim explains Japan's supposedly unique culture in terms of its "isolated history". Second, there is the exoticism: Tim thinks there are strange, unknowable things going on in the "depths of the mind" of "secretive" Japanese people, to which neither he nor any non-Japanese person is privy. Third, the idea that Japan is a homogeneous "club" is clearly in evidence.

Tim is certainly right that as a foreign visitor with no local language skills, he had no real chance of fitting in. Imagine a Laotian dude, who, speaking not one word of English, shows up in Vermont and starts walking around wondering when he's going to really be in the American "club." That's you in Japan, buddy! 

But Tim also talked to expats who made the same complaint, and in fact, I've heard it from a number of expats myself. Certainly not all, though - I showed Tim's post to an American expat writer in Tokyo the other day, and he snorted and said (I'm paraphrasing): "If you go around thinking you don't fit in, you'll never fit in."

That's really the key, I think. How do you ever know that you fit in, anywhere? Suppose you're walking around your hometown, talking to people. You feel like you understand them, they understand you, you're one of them. It makes sense, after all - you come from the same place, maybe you're the same race. But what if you're wrong? What if they all secretly think you're a weirdo, and they're all just too polite (or scared, or apathetic, or mean) to say it?

The answer is, you don't know. You make an assumption. And in Japan, many Westerners make the opposite assumption - they think that they'll be perpetually regarded as outsiders by the secret core of the Japanese psyche that no one who's not Japanese will ever truly see. When you make that assumption, it's going to be damn hard to fit in, even if the assumption happens to be wrong! By assuming everyone around you sees you as an alien, you'll act like someone who expects to be treated as an alien. And people around you are going to see you as weird because of that. It's a self-fulfilling prophecy.

(Now, it is true that most Westerners in Japan do not speak Japanese and do not live in Japan. And so Japanese people will generally approach a Westerner with the assumption that (s)he does not speak the language. To English-speaking expats who have worked hard to become fluent in Japanese, I guess this can seem off-putting. But English speakers are unique - they grew up in countries that reasonably expected all foreigners to show up speaking the local language. If you meet a Laotian guy in Vermont, you don't try to speak to him in Laotian. And I guess some English-speakers in Japan expect the same treatment. But the reason we expect the Laotian to speak English is not because we've let him into the secret "club" of American society - it's because the British Empire conquered the largest empire in world history, and America produced 1/3 to 1/2 of global GDP in the years following WW2. English is a global language; Japanese is not.)

Why do I call the three attitudes - essentialization, exoticization, and homogenization - "mistakes"?

Essentialization is a mistake because it causes you to miss cultural shifts. If you think that Japan's culture of "lifetime employment" stems from some deep feudal history and thus will never change, then when it actually does start to change, you'll ignore it or disbelieve it. Essentialization thus blinds you to reality. I think it also contributes to negative trends in international relations - after all, if Japanese culture today is the same as in the 1930s, doesn't that imply that Japan is still a murderous, fascist society underneath a superficial veneer of pacifism? Actually, lots of people do think that about Japan, especially in Korea. I think this idea is wrong, and has poisoned relations between those countries.

Exoticization is bad because of the reason I mentioned above - it's a self-fulfilling prophecy. There's no more surefire way of turning yourself into a permanent outcast than assuming you are one.

Homogenization, though, is the worst of the bunch. It's really just a form of stereotyping. Nearly every bad effect of racial stereotyping is also an effect of national/cultural stereotyping. In both instances, you end up treating people you meet based on what group they're a part of, instead of what they're like as an individual. That can easily lead to stuff like this.

Homogenizing other people is really just another way of voluntarily alienating yourself. Japanese people, as they walk down the street or sit on a train, are not looking at each other and thinking "Wow! We are all the same!" They're thinking "I wonder if that guy is going to shove past me like a jerk," or "Wow, she's cute," or "Look at that silly outfit." They're constantly thinking about each other as individuals. So why shouldn't we think of them as individuals too?

Personally, I've lived in Japan for a total of about three years, on and off, over my life. These days, when I go there, I have Japanese people try to speak to me in English...but I also have Japanese people speak to me in Japanese and get annoyed when there's a word I don't know. I've had people act obviously fake toward me, and I've had people talk about their deepest personal issues and cry on my shoulder. I've had Japanese friends share a worried look with me when some weird Japanese stranger comes up and tries to talk to us. I've never felt any more out of place there than in, say, Michigan, or Long Island.

But that's just me. I'm probably weird. If you want to start learning that Japanese people are not much different than the people you grew up with, friend a few on Facebook - most Japanese people use it - and start reading their posts (use Google Translate or Rikaikun if you can't read Japanese). You'll quickly see that the stuff they post for their own friends is a little different than what Americans post - less politics, more lengthy updates about their own lives - but not particularly alien either. Sure, FB posts don't let you stare straight into someone's soul, but they're a lot better guide to what Japanese people are really like than walking around Tokyo talking to disgruntled expats.

If you don't want to spend the time and effort to do that, then just let me give you my clear, simple, Explanation of Japan for Westerners: Japan is a collection of rocks with some human beings on it. That's the vast majority of what you need to know.

Basic Income is good because it's basic




Mike Konczal has a post attacking the libertarian support for Basic Income. Paul Krugman approves. Basically, Konczal argues that the mix of programs we have now works just fine.

I think Konczal is wrong, for a one, er, basic reason. Basic Income, unlike the programs we have now, will be politically easy to raise once it's in place.

Redistribution programs (the good ones anyway) are designed to help a lot of people and hurt a few. But this means that the constituency opposing redistribution is much more concentrated and focused than the constituency in support of it. As Mancur Olson might tell you, this makes redistribution a tough sell politically.

But if you have one big, high-profile redistribution program, you can get enough popular support to overcome the concentrated opposition of the rich people footing the bill. As an example, look at the minimum wage, which gets big popular support. The Democrats can go back to the minimum wage again and again as a populist issue.

But that's not true for the whole array of redistribution programs we currently have. If the Democrats want to increase the strength of the safety net as a whole, they have to mount a populist campaign for each one of its components. That's hard to do. So a lot of the components of the safety net get left behind, or killed by Republicans when no one is looking.

Such a fate would never befall a Basic Income. It would be in the spotlight all the time.

In fact, by endorsing Basic Income, libertarians are walking right into a trap. Anti-redistributionists' great fear has always been that the masses will use the power of majority rule to simply vote themselves more money. As things stand, the fragmentation of our redistribution programs makes it easier for the anti-redistributionists to punch holes in the safety net. If the fragmented system were replaced with one universal, high-profile program, the result would be a huge political gift to redistributionists.

Libertarians will eventually realize this, and their tentative support for Basic Income will vanish. But pro-redistribution liberals should not be so quick to dismiss the idea just because it came out of the mouths of their opponents in a moment of confusion.

Friday, August 08, 2014

Can the Fed set interest rates?


Most people think that in normal times - i.e. when the Federal Funds Rate is well above zero - that the Fed is able to set that interest rate through open market operations. You don't hear a lot of people saying that OMOs have no effect on interest rates.

But that's exactly what's implied by the famous "Wallace Neutrality" paper, also known as Wallace (1979). Neil Wallace was a leading light of the "New Classical" or "freshwater" generation of macroeconomists who revolutionized the discipline in the 70s and 80s. He is one of the main intellectual predecessors of Steve Williamson, Randy Wright, and the rest of the current "New Monetarist" or "money search" movement.

Wallace shows that if the government works in a very specific way, then Open Market Operations can't change interest rates. Specifically, the government has to set fiscal policy to exactly cancel out monetary policy, by making sure that OMOs leave A) government consumption, B) taxes and transfers, and C) income distribution completely unchanged. 

In other words, Wallace Neutrality is very much like the so-called "Sumner critique" of fiscal policy. It says that fiscal policy can cancel out monetary policy if it wants to. That makes sense, at least in an idealized world, and it implies that monetary policy is inextricably bound up with fiscal policy, which is interesting.

But I don't think Wallace Neutrality should be our jumping-off point or "base case" for thinking about how monetary policy works!

In a recent post about QE, John Cochrane wrote:
[S]tandard theory makes a pretty clear prediction about [QE's] effects [on interest rates]: zero.  OK, then we dream up "frictions," and "segmentation," and "price pressure" or other stories.
The "standard theory" he's talking about is the Modigliani-Miller result. But Modigliani-Miller is about the value of firms, not of government bonds. So what he's really talking about is Wallace Neutrality, which bills itself explicitly as "A Modigliani-Miller Theorem for Open-Market Operations."

But Wallace neutrality is not Modigliani-Miller, for two reasons.

First, a sufficient condition for Modigliani-Miller to hold is the existence of frictionless complete markets. But that is not sufficient for Wallace Neutrality to hold - for that, you need a certain government policy rule. We can think about frictionless complete markets as a sort of "natural base case", and that sort of makes sense. But it doesn't really make sense to use a certain government policy rule as a "base case", especially when that policy rule seems nonsensical in the first place (Why the heck would the fiscal authority try to exactly cancel out the monetary authority's actions??). Modigliani-Miller seems deep and fundamental, while Wallace Neutrality seems more arbitrary and specific. 

Second, the government is a policy-maker, not a price-taker. Its decisions create the overall economic environment in which agents act. So even a small departure from Wallace Neutrality-enforcing behavior, or from the other conditions required for Wallace Neutrality, will allow the Fed to target interest rates, simply by doing enough OMOs. See Miles Kimball on this point.

In other words, when someone says that Modigliani-Miller doesn't hold, it makes sense to ask "Why not?" But when someone says Wallace Neutrality does hold, it makes sense to ask "Why?" 

Tuesday, August 05, 2014

Are libertarians ready to embrace a broader notion of freedom?



(This post originally appeared at Bloomberg View.)

The way we define “east” and “west” doesn’t allow us to declare one spot of land the westernmost point on the globe. But if “west” is defined more emotionally as the idea of American freedom, then the Burning Man festival might be the uttermost west. If you don’t already know what Burning Man is, you shouldn’t rely on me to explain it to you -- just read the introduction on the website, use Google Images, or read the first few chapters of Cory Doctorow’s book "Homeland.''
This year, the media is abuzz with the news that Burning Man will be getting a very special guest: Grover Norquist, president of Americans for Tax Reform. At first this might seem a bit incongruous, since conservative activists don’t seem like the type who enjoy nudism, drugs, crazy art or a “giving economy.” Also, Norquist campaigned for George W. Bush, who is about as close to the antithesis of Burning Man as any American I can think of. But Norquist explains his mission thus:
There's no government that organizes this….That's what happens when nobody tells you what to do. You just figure it out. So Burning Man is a refutation of the argument that the state has a place in nature.
This is a fun, exciting, cheerful collection of people being free of state control and doing stuff they want to do…. If somebody wants to sit in a corner and read Hayek, I think that that's allowed. If people want to run around with not as much clothes as they normally do, I think that's allowed as well.
Actually, as conservatives go, Norquist has always had a maverick streak -- he has advocated tax breaks for marijuana growers and called for shorter prison sentences. But he has spent the bulk of his career fighting for one thing -- lower taxes. In fact, in this respect, Norquist is emblematic of the entire modern American libertarian movement -- in principle, advocating a broad range of freedoms, but in practice focusing almost entirely on freedom from taxation and regulation.
This is a shame. There are many more kinds of freedom than the narrow set embraced by the modern libertarian movement. Burning Man is a showcase for those freedoms, which is why I am so happy that Norquist is going. In fact, I hope his odyssey can be a symbol of a larger shift in the focus of the libertarian movement.
Economic freedom is certainly an important thing, and we tend to take it for granted. Anyone who has lived under a regime of stifling regulation knows how infuriating it can be. When taxes used to fall more on the middle and lower-middle classes than now, that must also have seemed like a crushing burden. And who wants to have to get a license just to do his or her job? In general, an interventionist state strangles the small businesses that provide both economic lifeblood and social independence for much of any country’s middle class.
But there are other kinds of freedom that matter a lot for the vast majority of people -- people who don’t try to derive their ideologies from axioms, or spend time curled up with a Hayek book. For examplesocial freedom -- the ability to express your individuality without having people ostracize you -- is hugely important in most people’s lives. Norquist will see this freedom in action at Burning Man.
Nor is the state always a destroyer of human freedom. It’s liberating to be able to hop in a car and drive to another city without stopping to pay a toll every few miles. It’s also liberating to be able to hop on atrain and jaunt across a city without sitting in traffic.
For those freedoms, you need the government to intervene in the economy, and that’s going to involve a tradeoff, because taxpayers are going to have to pay for the freeways and the trains. But that’s just reality -- we’re always facing tradeoffs between different kinds of freedoms. My freedom to walk down the street naked has to be weighed against your freedom to walk down the street without seeing disturbing sights.
Sure, if you make all the right assumptions and mouth all the appropriate axioms, you can avoid having to make hard decisions -- you can just pick one tradeoff and call it “natural rights.” And many libertarians do this. But it feels arbitrary, and this may be one reason that Americans, despite their generally libertarian beliefs, have been reluctant to sign up for the movement.
So I sincerely hope that American libertarianism is experiencing a shift -- a shift away from obsessive focus on the government and economic freedoms and rigid logical systems, and toward a more expansive, intuitive definition of liberty. And to Grover Norquist, let me say: Have a good burn.

Monday, August 04, 2014

Nerds vs. The Empire


Charles C.W. Cooke is a staff writer for National Review. One of his specialties is penning long, scornful rants against various types of effete upper-class liberals who annoy him (quite a trick for a man who uses two middle initials!). In December 2013 we were treated to a highly entertaining broadside about “Pajama Boy,” a character in an advertisement for Obamacare. Now, Cooke has given us an even longer screed about nerd culture. Some excerpts:
[An] extraordinarily puffed-up “nerd” culture...has of late started to bloom across the United States… 
[Nerds share] the belief that one can discover all of the secrets of human experience through differential equations… 
[The nerds want you to know that they are not] southern, politically conservative, culturally traditional, religious in some sense, patriotic, driven by principle rather than the pivot tables of Microsoft Excel, and in any way attached to the past... 
For all of the hype, much of the fadlike fetishization of “Big Data” is merely the latest repackaging of old and tired progressive ideas about who in our society should enjoy the most political power. 
Now, we are to be liberated by the microchip and the Large Hadron Collider, and we are to have our progress assured by ostensibly disinterested analysts. I would recommend that we not fall for it. Our technology may be sparkling and our scientists may be the best in the world, but our politics are as they ever were.

Cooke reminds me a little bit of Bishop Berkeley, the 18th century philosopher who argued that we can’t prove that there is any extant reality, and that we live in a world of pure ideas. The “nerds” Cooke despises are like writer Samuel Johnson, who responded to Berkeley’s argument by kicking a rock and shouting: “I refute it thus!

In a cruder manner than Berkeley, Cooke is standing up for the notion that a large enough group of like-minded people can create their own reality. This notion was put forth explicitly in 2004 by Karl Rove, who declared: “We're an empire now, and when we act, we create our own reality.”

Eight years later, Rove got to test the strength of the reality his empire had created, in one of the great epistemological clashes of modern history. In the weeks leading up to the 2012 election, election forecaster Nate Silver – whom Cooke identifies as one of the chief “nerds” – had been predicting a solid Obama victory. Legions of conservative writers had lined up to attack Silver, pooh-pooh his methodology, and predict a win for Romney. As the results rolled in, the numbers were eerily close to Silver’s predictions. Karl Rove, standing by on Fox News, was the last holdout, refusing to believe the numbers, declaring stubbornly that Mitt Romney still had a chance. Rove was, of course, wrong, and his on-air meltdown seemed to mark the moment when the bizarre “reality” his empire had created kicked a rock, and found itself refuted thus.

Charles C.W. Cooke is mad at Nate Silver, and mad at all the other “nerds” who cite evidence suggesting that global warming is real and dangerous, that renewable energy is feasible, etc. He does not hold forth on whether the nerds should stop telling us that evolution is real, that inflation is low, etc., but these are all issues on which Cooke’s co-tribalists have attacked the scientific consensus in recent years. Nate Silver may have won a battle against anti-nerd-ism, but the war continues, with the “empire” retreating to ground where the evidence is not quite as overwhelming as an election result. Wherever there is a sliver of doubt, a thin band of standard error, the “empire” of Cooke and Rove makes its stand, disavowing the inconvenient results of science and flinging high-school insults at the effete intellectuals who report those results.

(For a less polite but more trenchant take on the Right's war on reality, see this 2008 piece by John Derbyshire.)

Meanwhile, Cooke’s stand against “nerd culture” is the most recent tug from a very old undercurrent of anti-intellectualism in American society. That attitude continues to hold our country back. STEM education has become an ever more important ticket to success in life, and a skills gap has probably pushed apart the upper and lower middle classes since 1980, but America still lags in teaching its kids to do math. National Review writers throwing casual insults at differential equations, Big Data, and the Large Hadron Collider are not going to kill America’s middle class, of course, but they’re not exactly helping the situation.

The popular “nerd culture” against which Cooke vents his scorn is goofy and superficial, and certainly no substitute for STEM education. It’s pop culture. But its basic message – that it’s cool to think and study evidence and figure things out – is one that America needs to hear. Cooke and the empire he serves are losing their battle against the advancing nerds, but they’re doing collateral damage as they retreat.

Saturday, August 02, 2014

Schiff vs. Shedlock: The Great Austrian Macro-Tainer Smackdown



(This post originally appeared at Bloomberg View.)


In the world of financial media, it can be hard to separate news and analysis from entertainment. Ever since the crisis, financial entertainment seems to have shifted from hot stock picks to big macro theories. One advantage of spouting macro theories instead of stock picks is that it can take years for you to be proven wrong. Another is that you get to mix politics with economics, which is good for grabbing attention and building up a loyal following.
The undisputed king of macro-tainment is Peter Schiff. Schiff has managed to combine the most effective form of political entertainment -- right-wing talk radio -- with the most popular and addictive flavor of macro-tainment, Austrian economics. Schiff was elevated to dizzying heights of popularity after 2007, when one of his manymanymanymany bubble calls proved to be right. Since then it has seemed like Schiff is everywhere -- I’ve seen his face on three banner ads in three different magazines just this morning.
But it’s tough to be the king, because ambitious dukes and barons are always angling for a shot at your job. For the last several years, Schiff has been dogged by a determined and prolific critic -- finance blogger Michael “Mish” Shedlock.
In a way, Shedlock seems like he should be a natural ally of Schiff, or even a fan. Both avow that they are students of the “Austrian school.” Schiff’s asset-management company is called Euro Pacific Capital, while Shedlock’s is called Sitka Pacific Capital Management. Even their last names go well together -- “Shedlock & Schiff” would be an incredibly catchy title for a show. But in fact, the former has been criticizing the latter since 2007.
The big Shedlock-Schiff dust-up came in 2009, when Shedlock released an epic post titled simply: “Peter Schiff was Wrong.” Here is Shedlock:
I have talked with many who claim they have invested with Schiff and are down anywhere from 40% to 70% in 2008. There are many other such claims on the internet. They are entirely believable for the simple reason Schiff's investment thesis was flat out wrong...
(L)et's discuss the main points of Schiff's thesis...
· US Equity Markets Will Crash.
· US Dollar Will Go To Zero (Hyperinflation).
· Decoupling (The rest of the world would be immune to a US slowdown).
· Buy foreign equities and commodities and hold them with no exit strategy...
[Schiff's] investment thesis centered on shorting the dollar in a hyperinflation bet, and buying foreign equities rather than shorting US equities...What happened in 2008 was that foreign equities sold off much harder than US equities, and a strengthening US dollar compounded the situation.
In other words, Schiff failed where it matters most: Peter Schiff did not protect his client's assets.
Shedlock goes on to back up his criticism with a number of Schiff quotes predicting a dollar crash, hyperinflation and other things that never happened. For each prediction, he includes charts showing just how wrong Schiff turned out to be. If you want to see the dangers of investing based on macro-tainment, Shedlock’s post is Exhibit A.
Now, in the world of macro-tainment-cum-asset-management, them's fightin’ words, to say the least. It took a few years, but in 2012 Schiff fired back with a post entitled “Mish Shedlock Exposed.” Here is Schiff:
Despite [Shedlock's] criticism of my performance, his own performance is undeniably horrible over the long term. Just about the worst investment decision one could have made was to send money to Shedlock's firm in January 2009. Since then, global stock markets and foreign currencies have rebounded sharply and Shedlock's clients have completely missed the gains...
Shedlock has been warning about the specter of deflation for years, and his strategies are apparently designed to guard against this outcome. However, like Linus sitting in that pumpkin patch, it's been eight years, and the Great Pumpkin has yet to appear...
More significantly, if investors really feared deflation and simply bought U.S. Treasuries instead of giving their money to Shedlock, they would also have been much better off. Apparently Shedlock has succeeded in developing an investment strategy that underperforms under both inflation and deflation! So, when it comes to the inflation/deflation debate, no matter which camp wins, Shedlock's clients still lose.
Schiff’s post includes a list of spreadsheets and calculations comparing Schiffian strategies with Shedlockian, and purporting to show the former crushing the latter.
Unfortunately, attempts to get the two in the same room for a debate have not yet been successful.
It might seem strange that these two are fighting, since both profess to be followers of Austrian economics. And indeed, as observers of the debate such as currency trader and blogger Simit Patel have noted, the two do agree on a number of basic ideas:
It's crucial to note that Schiff and Shedlock agree on quite a bit. Such as:
· Gold will rally
· US stocks will decline
· Japanese yen will appreciate
Every one of these predictions has turned out to be the exact opposite of what has happened in the last couple of years. Austrianism makes for great political tub-thumping and fun end-of-the-world scenarios, but if you forget that it’s fundamentally a form of entertainment, your portfolio could be in big trouble.
In fact, my own basic message is something I’ve said before: Macro-tainment contains no actionable information. If you’re one of the few people who can listen to radio shows and read blog rants about poorly defined, wordy macro theories without your investment strategy being influenced by it, then by all means, grab some popcorn, open up Zero Hedge, turn on Peter Schiff's show. But for most of us, it’s crucial to recognize that macroeconomics is something that even the world’s smartest economists still don’t understand very well, and that political ideology and economic reality don’t mix.
Update: In the comments at BV, Peter Schiff was kind enough to direct me to this earlier Shedlock response he posted in 2009, immediately after Shedlock's big attack. The response does not mention Shedlock by name, however.

Friday, August 01, 2014

Un-diversification: King of investor biases

(This post originally appeared at Bloomberg View.)
A lot of behavioral finance is basically about helping the rich and the upper-middle class. People in the middle and at the low end of the income scale don’t do a lot of individual investing -- most of their wealth, if they have any, is tied up in their house, pension or retirement account.
But that’s OK. When individual investors (i.e., you and I) make mistakes, the money we lose doesn’t flow to the poor and the unemployed -- it flows somewhere into the bowels of the financial industry. So behavioral finance researchers don’t tend to lose a lot of sleep over the fact that we’re giving the rich and the upper-middle class a hand.
Since the 1990s, a bunch of professors have found what brokers and financial planners doubtless already knew -- individual investors tend to underperform the market average. Actually, this is no surprise. Individuals have less information than the banks, hedge funds and money managers, and are usually not trained professional finance people. Of course, on average they’re going to lose, unless they all start buying index funds.
This isn't to say that all individual investors lose. We’ve all heard the stories of Uncle Bob who made a killing trading stocks. But studies repeatedly find that only 5 percent of individual investors can consistently do better than an index fund.
Why are you and I so bad at managing our investments? A lot of psychological explanations have been offered. There’s overconfidence -- the tendency of people trading stocks not to worry about why the person on the other end of the trade is so eager to take the opposite bet. There’s the disposition effect -- the tendency of people to sell winning stocks too early in order to lock in profits, or hold on to losing stocks too long in the desperate hope that they will recover. There’s the hot-hand fallacy, which is the tendency to mistake statistical blips for durable trends, and its twin brother the gambler’s fallacy, which is the mistaken notion that a run of bad luck has to be followed by a run of good luck. There’s attention bias, which draws people’s eyes to glamorous or familiar stocks and cause them to overlook more lucrative opportunities.
But according to a recent paper by a team of German economists from Goethe University in Frankfurt, there is one mistake above all others that hamstrings individual investors -- the failure to diversify.
Diversification is something we all hear about, but the logic of it has surprising trouble penetrating our heads. After all, how are you going to beat the market unless you make different bets than the market? The answer, of course, is that usually, you’re not going to beat the market -- it’s going to beat you. The German economists study an absolutely huge database of individual investors, and find that lack of diversification reduces the average investor’s performance by 4 percentage points a year!
To give you a rough ballpark idea of how much this matters consider this: if you saved $3,000 a month every month for 30 years and earned a return of 7 percent, you would end up with more than $3.6 million. But if you got a 3 percent return, you would end up with only $1.7 million, or less than half. That’s a pretty big deal.
The authors of the paper find that compared with under-diversification, all the other biases don’t matter much. That’s hardly surprising, because the more you diversify, the less room there is for any bad stock pick to affect your overall wealth.
How do you avoid the failure to diversify? Simple: Invest in index funds, or in exchange-traded funds that are similar to index funds. In other words, follow the example of a rapidly rising number of investors.
Now here’s a more unsettling question: What happens if too many people diversify too much? Markets aren’t just supposed to reduce risk -- they are also supposed to process information, and send capital to the companies that will use it for the most productive purposes. If everyone is just indexing, then the number of people dedicated to processing information -- to figuring out which companies actually deserve capital -- will go toward zero, and the markets will become just a casino.
So maybe there is reason for people to un-diversify their portfolios -- a little bit. If you have some real knowledge that other people might not have -- if you’ve done deep research on a company, or if you know an industry really well -- then maybe you should dedicate a bit (but only a bit!) of your portfolio to making a bet on that knowledge.
In general, though, the best advice that behavioral finance researchers can give you is to stay diversified.