Opinion

The Great Debate

Does it matter whether or not economics is a ‘science’?

Recently, at the House of Sweden, there was a feisty exchange among the newest Nobel laureates. First, one of the economics winners, Robert Shiller, questioned the validity of the efficient markets hypothesis, the prize-wining idea of co-laureate Gene Fama. This prompted chemistry winner, Martin Karplus, to say “What understanding of the stock market do you really have?” He reckoned economics can’t explain the market and questioned if “the dismal science” is even a science.

That conversation demonstrates the understandable frustration people have with the economics profession. That frustration deepened with the financial crisis, which few predicted, and the anemic recovery that followed it, where economic policies failed to revive growth. It leads many to ask: “What use are economists and their theories?”

It’s important to understand that economics isn’t fortune-telling. If you judge a single economic model by its ability to predict the future, inevitably it will fail you. Economics merely aims to determine the best use of scarce resources. That requires some understanding of how different factors in the economy interact. For example, if you have limited means to boost the economy and increase government spending, what happens to income?

To answer that question, economists design models that describe how the economy functions. These models are abstractions of the real world, which is complicated and contains an uncountable number of factors. It’s similar to drawing a map: to construct a tractable map, you must make choices about what to include. If you included every tree, hill, and country road the map would be too confusing to be useful. The purpose is to understand how different, relevant factors relate to each other. That serves an important role, but it makes no guarantees. You might take a highway featured in a road atlas and a truck could slam into you on that road. But that doesn’t negate the validity of the map. Driving on a highway poses some risk and, as financial economics cautions, so do markets.

What is included or left out in an economic model is where things get contentious, but economic models are still valuable. Many maps exist of New York State that don’t resemble each other, but all are useful. For a hike in the Hudson Valley you’d use a trail map that contains every path and hill. But if you were driving from New York City to Albany, a trail map wouldn’t get you too far — you’d use a road map. Or if you wanted to understand the size and location of New York relative to Ohio, you’d look at a coarser map of the states. Each map is accurate in the right context, but often useless for other purposes.

How the Nobel economists changed investing forever

The 2013 Nobel Prize for economics celebrates that financial markets work, but cautions how little we know. One theme unifies the work of all three winners: Eugene Fama, Robert Shiller and Lars Hansen — risk. (A disclosure: until August I worked at Dimensional Fund Advisors, where Fama is a director and consultant.) Risk is unpredictable, but can be very profitable. That sounds simple enough, but it has profound implications — not only for the lords of high finance, but households, too. Risk teaches humility, to overconfident investors and also policymakers. That humility was notably absent at the IMF/World Bank meetings last week. Policymakers should take special note of the prize this year; it reveals how little we really understand about financial markets.

Fama’s work showed that prices incorporate all available information; this is known as the efficient market hypothesis. The implication is that you cannot systematically outperform the market, unless you have information other people don’t or can access part of the market others can’t. But that doesn’t mean you can’t make money. Over time you can expect, but are not guaranteed, that riskier assets generate higher returns. Stocks, on average, return more than bonds because they are riskier. The stock of smaller companies is riskier than larger ones, so they typically generate more returns. It’s a straightforward concept, but often poorly understood. Even many sophisticated investors get it wrong.

The implications of this theory changed markets, even for the average investor. The concept of efficient markets helped create demand for index funds. Index funds are a type of mutual fund, which is a collection of many different stocks. Active funds profess to know which stocks will outperform the market. Index funds don’t make that promise; stocks are weighted by their size relative to the rest of the market or use a weighting based on identifiable price or size characteristics. Because there’s no magic formula or talent presumed in constructing these funds, they are cheap; if no one can beat the market, why pay 1 or 2 percent of your assets to someone who claims they can? If you believe in efficient markets you’d only hold index funds. This has been revolutionary for the average investor. Through the 1960s few Americans owned stock at all, and if they did they only held a handful of individual stocks, which was very risky. Now about 50 percent of the population owns stock, mostly through mutual funds and increasingly with allocations based on indexing. The average household can invest as well as many hedge funds, for a fraction of the price. The existence of index funds shows that the best innovations (in finance or any industry) are often the simplest.

Mass flourishing: How it was won, and then lost

This essay is adapted from Mass Flourishing: How Grassroots Innovation Created Jobs, Challenge, and Change, published this month by Princeton University Press.

The epic story of the West is the development in the 19th century of a mass prosperity the world had never seen and its near-disappearance in one nation after another in the 20th. Mass Flourishing is a history linking this story to the rise and fall of homegrown innovation. It is also a text on the nature and sources of prosperity. It has two components. The material part is growth of productivity and wages. The non-material part is flourishing – successful exercise of creativity and talents. To flourish, people have to engage a world of challenges and opportunities. The economy’s dynamism and the resulting experience of business life are central to our well-being.

Mass prosperity came with the mass innovation that sprung up in 1815 in Britain, soon after in America and later in Germany and France: It brought sustained growth to these nations — also to nations with entrepreneurs willing and able to copy the innovations. It also brought flourishing to large and increasing numbers of people — mass flourishing. There were experiential benefits: Routine work, dull and lonely, gave way to careers that took twists and turns and jobs that were rewarding. There were also developmental benefits: As people used their imagination to create new things and their ingenuity to meet challenges, they found self-expression, self-realization and personal growth in the process.

from Nicholas Wapshott:

Robert Fogel and the economics of good health

Robert Fogel, who died this week, won a Nobel for economics by mining historical data and in the process shook up the study of history forever. Just as with cholesterol, it seems there is good data mining and bad data mining. Fogel’s was undoubtedly the good kind.

As a teenager when World War Two was ending, he switched from chemistry and physics to study economics at Cornell because he feared, as did others, that when military spending was withdrawn the economy might retrench and sink back into a reprise of the Great Depression. It didn’t turn out that way.

Governments in the Western world switched from spending money on arms to spending on hospitals and schools and the buoyancy kept another slump at bay until the economy was on its feet. Fascinated by figures, as an academic Fogel applied quantitative methods used in economics to test whether historians’ hunches about the cause and effect of events were correct. His findings led to immense controversy and, eventually, a Nobel Prize.

Where is Obama’s promised minimum-wage hike?

During the 2008 campaign, presidential candidate Barack Obama made a pledge to raise the minimum wage to $9.50 per hour by 2011. Promises like this one inspired a generation of young voters, excited long-neglected progressive voters and gave hope to millions of his supporters across the country.

President Obama ran a campaign of soaring rhetoric and uplifting ideas. Amidst two unpopular wars, a rapidly deteriorating financial crisis and the wildly unpopular presidency of George W. Bush, Americans were desperate for a change. He was viewed as a “transformational” candidate, a president who would turn the page on the stagnant politics of Washington.

It is now four years later, and there has been no increase to the minimum wage. There has been no congressional vote, much less a whisper from the White House on the minimum wage.

The late conversion of a famous monetarist

The death of Anna Schwartz has been marked with reverential obituaries. Her contribution to economics was making sense of historical facts to offer a guide to what should be done today. Posterity will know her as the co-author, with Milton Friedman, of Monetary History of the United States, 1867–1960, which revolutionized our understanding of the Great Depression. The pair concluded that, contrary to conventional wisdom, the slump was caused by the Federal Reserve not pumping enough money into the economy.

From this Friedman and Schwartz led a monetarist revolution that claimed that inflation, which had been thought to be caused by either insufficient supply or too much demand, was in all cases and solely caused by too large a supply of money. They led a counterrevolution against Keynesianism, which over three booming decades had driven economies into stagflation – a marriage of runaway inflation and stagnant growth that Keynesians were at a loss to explain or cure.

Although Friedman took much of the credit for the new orthodoxy, and won the Nobel Prize in 1976 for his efforts, Schwartz was more than the midwife of monetarism – she was an equal partner in its conception. When asked why she had not been awarded credit equal to the extrovert Friedman, she modestly responded: “I’m not a media person.” Like the winemaker Luigi Rossi, whose name appears second on Martini bottles, she was an important, if largely silent, partner. Just as no one ever asks for a dry Rossi, so few today remember Schwartz.

from MacroScope:

The Law of Diminishing Greeks

The Law of Diminishing Returns  states that a continuing push towards a given goal tends to  decline in effectiveness after a certain amount of effort has been expended. If this weren't the case, Usain Bolt would be able to run the mile in  less than 2-1/2 minutes.

From an economic standpoint, this law now seems to be fully in force in Greece. The latest jobs figures from the twice-bailed out euro zone country paint a bleak numerical picture of the impact of unrelenting austerity in ordinary Greeks, regardless of whether it was self-inflicted or not. To wit:

More than one in five Greeks is unemployed.

There are more young people without a job than with one.

The record 1.08 million people  without work in January was a  47 percent tumble  in a year.

No, a nation’s geography is not its destiny

This essay is adapted from Why Nations Fail: The Origins of Power, Prosperity and Poverty, published this week. For more from these authors, see their blog.

If you start in the city center of Nogales, Santa Cruz [Arizona] and walk south for a while, at some point you see houses become much more run down, streets turn decrepit. You have crossed the Mexican border into Nogales, Sonora. Though the two cities are made of the same cloth and were once united, now there are sharp differences between the two. Those in the north are about three times as rich, have access to much better health care, stay in school much longer and of course take part in a much more democratic political process than their cousins in the south. The differences between the two halves of Nogales are a micro, tiny version of huge differences in prosperity and living standards we see around the world. Take Mexico as a whole, for example: it has less than one quarter of the GDP per capita of the United States. Take Peru; it has about one seventh of the GDP per capita of the United States. Or take Ethiopia, Haiti, Somalia or the Congo, each of [which] has less than one thirtieth of the GDP per capita of the United States. Our thesis is that these differences are the outcome of different economic and political institutions which lead to very different incentives.

Though history bears out the defining role of institutions in shaping prosperity and poverty, most social scientists and experts have emphasized different factors. One of the most widely accepted alternative theories of world inequality is the geography hypothesis, which claims that the great divide between rich and poor countries is created by geographical differences. Many poor countries, such as those of Africa, Central America, and South Asia, are between the tropics of Cancer and Capricorn. Rich nations, in contrast, tend to be in temperate latitudes. This geographic concentration of poverty and prosperity gives a superficial appeal to the geography hypothesis, which is the starting point of the theories and views of many social scientists and pundits alike. But this doesn’t make it any less wrong.

Subsidizing people instead of corporations

Reaganomics is so well established that state officials, both Republican and Democratic, don’t call it that anymore. They simply call it smart policy.

Even so, the idea of boosting supply to raise demand, instead of the other way around, is hardly uncontroversial. States spend billions annually on economic development subsidies to try and create jobs. But recent evidence suggests tax breaks, “forgivable loans,” and the like don’t work as well as hoped.

Up to now the thinking went like this: Devoting public funds to pull companies into the state will eventually yield returns, which is to say, yield jobs. Those jobs stimulate spending, which raises demand for the very products and services of the corporation that brought the jobs in the first place. And thus the virtuous cycle is sent into overdrive. That, at least, has been the theory.

The limits of the scientific method in economics and the world

By Roger Martin
The opinions expressed are his own.

This is part one of this essay. Read part two here.

As the economy teeters and the capital markets gyrate, I can’t get out of my mind the evening of May 19, 2009.  We were near the stock market nadir and fears were cresting that we were heading straight into the next Great Depression. I was invited to a dinner along with half a dozen tables of guests to hear a very prominent macroeconomist opine on the state of the economy and the path to recovery.

The economist held forth with a detailed, analytical account of what had caused the economic meltdown in the second half of 2008 and the path that he predicted recovery would take. I was struck by how scientific he was, spewing myriad statistics, employing technical terms by the boatload, and praising his econometric model. It was ‘very sophisticated’.  Given the nods and encouraged looks in the room, it seemed as though he had provided great comfort to the guests; they could go to bed confident that thanks to his science, they could trust that this man knew where we were headed.

I wasn’t quite so confident. Being the curious sort, before coming to dinner I had checked his forecast from a year earlier, mere months before the crash.  His spring 2008 forecast for the second half of 2008 was for modest positive economic growth for America.  This was not unusual; no credible economist predicted anything less rosy for the back half of 2008, although many now claim that they did.  I don’t blame or ridicule him for being cautiously optimistic mere months before the worst economic downturn in 80 years.  Economic forecasting is fraught with peril.

  •