The fable of the billionaires

May 31 JDN 2458999

There are great many distortions in real-world markets that cause them to deviate from the ideal of perfectly competitive free markets, and economists rightfully spend much of their time locating, analyzing, and mitigating such distortions.

But I think there is a general perception among economists, and perhaps among others as well, that if we could somehow make markets perfectly competitive and efficient, we’d be done; the world, or at least the market, would be just and fair and all would be good. And this perception is gravely mistaken. To make that clear to you, I offer a little fable.

Once upon a time, widgets were made by hand. One person, working for one eight-hour day, could make 100 widgets. Most people were employed making widgets full-time. The wage for making widgets was $1 per widget.

Then, an inventor came up with a way to automate the production of widgets. For $100 per day, the same cost to hire a worker to make 100 widgets, the machine could instead make 101 widgets.

Because it was 1% more efficient, businesses began adopting the new machine, and now made slightly more widgets than before. But some workers who had previously made widgets were laid off, while others saw their wages fall to only $0.99 per widget.


If there were more widgets, but fewer people were getting paid less to make them, where did the extra wealth go? To the inventor, of course, who now owns 10% of all widget production and has billions of dollars.

Later, another inventor came up with an even better machine, which could make 102 widgets in a day. And that inventor became a billionare too, while more became unemployed and wages fell to $0.98 per widget.

And then there was another inventor, and another, and another; and today the machines can make 200 widgets in a day and wages are only $0.50 per widget. We now have twice as many widgets as we used to have, and hundreds of billionaires; yet only half as many people now work making widgets as once did, and those who remain make only half of what they once did.

Was this market inefficient or uncompetitive? Not at all! In fact it was quite efficient: It delivered the most widgets for the least cost every step of the way. And the first round of billionaires didn’t get enough power to keep the next round from innovating even better and also becoming billionaires. No one stole or cheated to get where they are; the billionaires really made it to the top by being brilliant innovators who made the world more efficient.

Indeed, by the standard measures of economic surplus, the world has gotten better with each new machine. GDP has gone up, wealth has gone up. Yet millions of people are out of work, and millions more are making pitifully low wages. Overall the nation seems to be worse off, even though all the numbers keep saying things are getting better.

There are some relatively simple solutions to this problem: We could tax those billionaires, and use the money to provide public goods to everyone else; and then the added wealth from doubling our quantity of widgets would benefit everyone and not just the inventors who made it happen. Would that reduce the incentives to innovate? A little, perhaps; but it’s hard to believe that most people who would be willing to invent something for $1 billion wouldn’t be willing to do so for $500 million or even for $50 million. At some point that extra money really isn’t benefiting you all that much. And what’s the point of incentivizing innovation if it makes life worse for most of our population?

In the real world there are lots of other problems, of course. Corruption, regulatory capture, rent-seeking, collusion, and so on all make our markets less efficient than they could have been. But even if markets were efficient, it’s not clear that they would be fair or just, or that they would be making most people’s lives better.

Indeed, I’m not convinced that most billionaires really got where they are by being particularly innovative. I can appreciate the innovations made by Cisco and Microsoft, but what brilliant innovation underlies Facebook or Amazon? The Internet itself is a great innovation (largely created by DARPA and universities), but is using it to talk to people or sell things really such a great leap? Tesla and SpaceX are innovative, but they have largely been money pits for Elon Musk, who inherited a good chunk of his wealth and made most of the rest by owning shares in PayPal. Yet even if we suppose that all the billionaires got where they are by inventing things that made the economy more efficient, it’s still not clear that they deserve to keep that staggering wealth.

I think the fundamental problem is that we have mentally equated ‘value of marginal product’ with ‘what you rightfully earn’. But the former is dependent upon the rest of the market: Who you are competing with, what your customers want. You can work very hard and be very talented, but if you’re making something that people aren’t willing to pay for, you won’t make any money. And the fact that people won’t pay for something doesn’t mean it isn’t valuable: If you produce public goods, they could benefit many people a great deal but still not draw in profits. Conversely, the fact that something is profitable doesn’t necessarily make it valuable: It could just be a very effective method of rent-seeking.

I’m not saying we should do away with markets; they’re very useful, and they do have a lot of benefits. But we should acknowledge their limitations. We should be aware not only that real-world markets are not perfectly efficient, but also that even a perfectly efficient market wouldn’t make for the best possible world.

Coase, extortion, and pay-to-skip

Feb 9 JDN 2458889

The Coase Theorem states that under perfect property rights, perfect information, perfect contract enforcement, and negligible transaction costs, Pareto efficiency can be achieved even when there are large externalities. It was designed as an argument against Pigovian taxation, which tries to use taxes to create incentives against externalities such as pollution.

The usual argument against the Coase Theorem is that transaction costs are rarely negligible and contracts are often unenforceable, so the Pareto-efficient solution to externalities that it provides is unrealistic. (In fact, Coase himself agreed with this critique, and instead argued that regulation of externalities needs to be done on a case-by-case basis with attention to the detailed context.)

Yet this is not the real problem with the Coase Theorem. The real problem is the criterion of Pareto-efficiency: An arrangement can be Pareto-efficient without being fair, just, or even economically efficient in any real sense.

As a reminder, Pareto efficiency simply says that no person can be made better off without making some other person worse off. It doesn’t say anything about how well off people are relative to one another—inequality—or how they got what they have—justice. It doesn’t even really entail economic efficiency: Supposing that the marginal utility of wealth is always positive, if one man claims all the wealth in the world and lends it out to everyone else at interest, that does seem to be Pareto-efficient—we can’t make anyone else better off without taking something from His Majesty the Supreme Emperor—but it clearly isn’t economically efficient in any desirable sense.

And this is what’s wrong with the Coase Theorem: The kind of Pareto efficiency it generates allows for—indeed, in many cases demands—what we would ordinarily call extortion.

What is extortion, after all?

If a member of the mafia comes to your house and says, “What a nice place you’ve got here; what a shame if anything happened to it!” and then demands you pay him $500 a month, that’s extortion. He has the power to inflict a negative externality on you, and he promises not to as long as you pay him. (Here, the contract enforcement actually comes from the reciprocity in the indefinitely iterated game, and doesn’t require an outside enforcer.)

Extortion is when one party has the power to create a negative externality upon another (e.g. burn your house down, punch you in the face). They make a deal: They won’t create that negative externality, provided that you compensate them (pay them money). Is this Pareto efficient? Absolutely! They’re as well off as they would be if they hurt you, and you’re better off. But is this how we want to run a society? I don’t think so.

In the cyberpunk future in which we now live, there is a market emerging that fits the requirements of the Coase Theorem as well as any which has ever existed; and sure enough, in the absence of adequate regulation it is turning to extortion.

I am referring of course to the market for online advertisements. Perfect property rights? Not quite, but that intellectual property enforcement is very strong. Perfect contract enforcement? Not perfect, but highly reliable, like any mature market in a First World country. Perfect information and negligible transaction costs? As close as humanity has ever come.

What’s the externality? People don’t like seeing ads. Ads are annoying, distracting, and unpleasant. But businesses benefit from showing people ads (or at least think they do), and seek rents by trying to post more ads than their competition. I proposed a Pigouvian solution: Tax advertising.

What’s the Coase solution? Let people pay to skip ads. And indeed there are now sites that do this.

Note that there is a vital difference between this and, say, YouTube Premium. With YouTube Premium, you’re actually paying for the opportunity to use an ad-free version of the service. So instead of advertisers paying Google to run ads on the content you watch, you’re simply paying for the content you watch. That’s great. I have no objection to that. In fact, I strongly prefer it to the ad-supported model. Paying for content makes you the customer. Accepting ads in return for free content makes you the product.

No, I’m talking about businesses posting ads, and then offering you the chance to pay them to get rid of those ads. (Maybe a cut would go to the content provider, but that’s not really important here.) The key is that the people who make the ads get the chance to get revenue from you paying to skip them.

In Coase terms, that sounds great! Instead of me having to put you through a miserable ad that probably won’t lead you to buying anything anyway, you just pay me $0.25 or something directly. I’m better off, you’re better off, everyone’s happy.

But in fact, everyone is not happy, because here’s what I can do: I can go out of my way to make the ads as obnoxious as possible, so that you have no choice but to pay me to skip them. I’m not the first one to make this point: It’s the subject of an SMBC comic and a major plot point in a Black Mirror episode.

This is precisely the same process as extortion: Threaten a negative externality, demand compensation in return for not doing so.

I think what Coase missed in his original argument is that negative externalities aren’t always by-products of otherwise productive activities. We often—nay, usually—have the power to inflict negative externalities upon other people with no productive purpose. If externalities were always by-products, negotiation as Coase imagined it could allow us to achieve the productive benefit without the externality cost. But when externalities can be generated independently, they are a means of extracting rent from those too weak to resist you.

What’s the solution to this problem? It’s boring: We have to tax and regulate externalities after all.

To a first approximation, all human behavior is social norms

Dec 15 JDN 2458833

The language we speak, the food we eat, and the clothes we wear—indeed, the fact that we wear clothes at all—are all the direct result of social norms. But norms run much deeper than this: Almost everything we do is more norm than not.

Why do sleep and wake up at a particular time of day? For most people, the answer is that they needed to get up to go to work. Why do you need to go to work at that specific time? Why does almost everyone go to work at the same time? Social norms.

Even the most extreme human behaviors are often most comprehensible in terms of social norms. The most effective predictive models of terrorism are based on social networks: You are much more likely to be a terrorist if you know people who are terrorists, and much more likely to become a terrorist if you spend a lot of time talking with terrorists. Cultists and conspiracy theorists seem utterly baffling if you imagine that humans form their beliefs rationally—and totally unsurprising if you realize that humans mainly form their beliefs by matching those around them.

For a long time, economists have ignored social norms at our peril; we’ve assumed that financial incentives will be sufficient to motivate behavior, when social incentives can very easily override them. Indeed, it is entirely possible for a financial incentive to have a negative effect, when it crowds out a social incentive: A good example is a friend who would gladly come over to help you with something as a friend, but then becomes reluctant if you offer to pay him $25. I previously discussed another example, where taking a mentor out to dinner sounds good but paying him seems corrupt.

Why do you drive on the right side of the road (or the left, if you’re in Britain)? The law? Well, the law is already a social norm. But in fact, it’s hardly just that. You probably sometimes speed or run red lights, which are also in violation of traffic laws. Yet somehow driving on the right side seem to be different. Well, that’s because driving on the right has a much stronger norm—and in this case, that norm is self-enforcing with the risk of severe bodily harm or death.

This is a good example of why it isn’t necessary for everyone to choose to follow a norm for that norm to have a great deal of power. As long as the norms include some mechanism for rewarding those who follow and punishing those who don’t, norms can become compelling even to those who would prefer not to obey. Sometimes it’s not even clear whether people are following a norm or following direct incentives, because the two are so closely aligned.

Humans are not the only social species, but we are by far the most social species. We form larger, more complex groups than any other animal; we form far more complex systems of social norms; and we follow those norms with slavish obedience. Indeed, I’m a little suspicious of some of the evolutionary models predicting the evolution of social norms, because they predict it too well; they seem to suggest that it should arise all the time, when in fact it’s only a handful of species who exhibit it at all and only we who build our whole existence around it.

Along with our extreme capacity for altruism, this is another way that human beings actually deviate more from the infinite identical psychopaths of neoclassical economics than most other animals. Yes, we’re smarter than other animals; other animals are more likely to make mistakes (though certainly we make plenty of our own). But most other animals aren’t motivated by entirely different goals than individual self-interest (or “evolutionary self-interest” in a Selfish Gene sort of sense) the way we typically are. Other animals try to be selfish and often fail; we try not to be selfish and usually succeed.

Economics experiments often go out of their way to exclude social motives as much as possible—anonymous random matching with no communication, for instance—and still end up failing. Human behavior in experiments is consistent, systematic—and almost never completely selfish.

Once you start looking for norms, you see them everywhere. Indeed, it becomes hard to see anything else. To a first approximation, all human behavior is social norms.

Good for the economy isn’t the same as good

Dec 8 JDN 2458826

Many of the common critiques of economics are actually somewhat misguided, or at least outdated: While there are still some neoclassical economists who think that markets are perfect and humans are completely rational, most economists these days would admit that there are at least some exceptions to this. But there’s at least one common critique that I think still has a good deal of merit: “Good for the economy” isn’t the same thing as good.

I’ve read literally dozens, if not hundreds, of articles on economics, in both popular press and peer-reviewed journals, that all defend their conclusions in the following way: “Intervention X would statistically be expected to increase GDP/raise total surplus/reduce unemployment. Therefore, policymakers should implement intervention X.” The fact that a policy would be “good for the economy” (in a very narrow sense) is taken as a completely compelling reason that this policy must be overall good.

The clearest examples of this always turn up during a recession, when inevitably people will start saying that cutting unemployment benefits will reduce unemployment. Sometimes it’s just right-wing pundits, but often it’s actually quite serious economists.

The usual left-wing response is to deny the claim, explain all the structural causes of unemployment in a recession and point out that unemployment benefits are not what caused the surge in unemployment. This is true; it is also utterly irrelevant. It can be simultaneously true that the unemployment was caused by bad monetary policy or a financial shock, and also true that cutting unemployment benefits would in fact reduce unemployment.

Indeed, I’m fairly certain that both of those propositions are true, to greater or lesser extent. Most people who are unemployed will remain unemployed regardless of how high or low unemployment benefits are; and likewise most people who are employed will remain so. But at the margin, I’m sure there’s someone who is on the fence about searching for a job, or who is trying to find a job but could try a little harder with some extra pressure, or who has a few lousy job offers they’re not taking because they hope to find a better offer later. That is, I have little doubt that the claim “Cutting unemployment benefits would reduce unemployment” is true.

The problem is that this is in no way a sufficient argument for cutting unemployment benefits. For while it might reduce unemployment per se, more importantly it would actually increase the harm of unemployment. Indeed, those two effects are in direct proportion: Cutting unemployment benefits only reduces unemployment insofar as it makes being unemployed a more painful and miserable experience for the unemployed.

Indeed, the very same (oversimplified) economic models that predict that cutting benefits would reduce unemployment use that precise mechanism, and thereby predict, necessarily, that cutting unemployment benefits will harm those who are unemployed. It has to. In some sense, it’s supposed to; otherwise it wouldn’t have any effect at all.
That is, if your goal is actually to help the people harmed by a recession, cutting unemployment benefits is absolutely not going to accomplish that. But if your goal is actually to reduce unemployment at any cost, I suppose it would in fact do that. (Also highly effective against unemployment: Mass military conscription. If everyone’s drafted, no one is unemployed!)

Similarly, I’ve read more than a few policy briefs written to the governments of poor countries telling them how some radical intervention into their society would (probably) increase their GDP, and then either subtly implying or outright stating that this means they are obliged to enact this intervention immediately.

Don’t get me wrong: Poor countries need to increase their GDP. Indeed, it’s probably the single most important thing they need to do. Providing better security, education, healthcare, and sanitation are all things that will increase GDP—but they’re also things that will be easier if you have more GDP.

(Rich countries, on the other hand? Maybe we don’t actually need to increase GDP. We may actually be better off focusing on things like reducing inequality and improving environmental sustainability, while keeping our level of GDP roughly the same—or maybe even reducing it somewhat. Stay inside the wedge.)

But the mere fact that a policy will increase GDP is not a sufficient reason to implement that policy. You also need to consider all sorts of other effects the policy will have: Poverty, inequality, social unrest, labor standards, pollution, and so on.

To be fair, sometimes these articles only say that the policy will increase GDP, and don’t actually assert that this is a sufficient reason to implement it, theoretically leaving open the possibility that other considerations will be overriding.

But that’s really not all that comforting. If the only thing you say about a policy is a major upside, like it or not, you are implicitly endorsing that policy. Framing is vital. Everything you say could be completely, objectively, factually true; but if you only tell one side of the story, you are presenting a biased view. There’s a reason the oath is “The truth, the whole truth, and nothing but the truth.” A partial view of the facts can be as bad as an outright lie.

Of course, it’s unreasonable to expect you to present every possible consideration that could become relevant. Rather, I expect you to do two things: First, if you include some positive aspects, also include some negative ones, and vice-versa; never let your argument sound completely one-sided. Second, clearly and explicitly acknowledge that there are other considerations you haven’t mentioned.

Moreover, if you are talking about something like increasing GDP or decreasing unemployment—something that has been, many times, by many sources, treated as though it were a completely compelling reason unto itself—you must be especially careful. In such a context, an article that would be otherwise quite balanced can still come off as an unqualified endorsement.

Revealed preference: Does the fact that I did it mean I preferred it?

Post 312 Oct 27 JDN 2458784

One of the most basic axioms of neoclassical economics is revealed preference: Because we cannot observe preferences directly, we infer them from actions. Whatever you chose must be what you preferred.

Stated so badly, this is obviously not true: We often make decisions that we later come to regret. We may choose under duress, or confusion; we may lack necessary information. We change our minds.

And there really do seem to be economists who use it in this bald way: From the fact that a particular outcome occurred in a free market, they will infer that it must be optimally efficient. (“Freshwater” economists who are dubious of any intervention into markets seem to be most guilty of this.) In the most extreme form, this account would have us believe that people who trip and fall do so on purpose.

I doubt anyone believes that particular version—but there do seem to be people who believe that unemployment is the result of people voluntarily choosing not to work, and revealed preference has also led economists down some strange paths when trying to explain what sure looks like irrational behavior—such as “rational addiction” theory, positing that someone can absolutely become addicted to alcohol or heroin and end up ruining their life all based on completely rational, forward-thinking decision planning.

The theory can be adapted to deal with these issues, by specifying that it’s only choices made with full information and all of our faculties intact that count as revealing our preferences.

But when are we ever in such circumstances? When do we ever really have all the information we need in order to make a rational decision? Just what constitutes intact faculties? No one is perfectly rational—so how rational must we be in order for our decisions to count as revealing our preferences?

Revealed preference theory also quickly becomes tautologous: Why do we choose to do things? Because we prefer them. What do we prefer? What we choose to do. Without some independent account of what our preferences are, we can’t really predict behavior this way.

A standard counter-argument to this is that revealed preference theory imposes certain constraints of consistency and transitivity, so it is not utterly vacuous. The problem with this answer is that human beings don’t obey those constraints. The Allais Paradox, the Ellsberg Paradox, the sunk cost fallacy. It’s even possible to use these inconsistencies to create “money pumps” that will cause people to systematically give you money; this has been done in experiments. While real-world violations seem to be small, they’re definitely present. So insofar as your theory is testable, it’s false.

The good news is that we really don’t need revealed preference theory. We already have ways of telling what human beings prefer that are considerably richer than simply observing what they choose in various scenarios. One very simple but surprisingly powerful method is to ask. In general, if you ask people what they want and they have no reason to distrust you, they will in fact tell you what they want.

We also have our own introspection, as well as our knowledge about millions of years of evolutionary history that shaped our brains. We don’t expect a lot of people to prefer suffering, for instance (even masochists, who might be said to ‘prefer pain’, seem to be experiencing that pain rather differently than the rest of us would). We generally expect that people will prefer to stay alive rather than die. Some may prefer chocolate, others vanilla; but few prefer motor oil. Our preferences may vary, but they do follow consistent patterns; they are not utterly arbitrary and inscrutable.

There is a deeper problem that any account of human desires must face, however: Sometimes we are actually wrong about our own desires. Affective forecasting, the prediction of our own future mental states, is astonishingly unreliable. People often wildly overestimate the emotional effects of both positive and negative outcomes. (Interestingly, people with depression tend not to do this—those with severe depression often underestimate the emotional effects of positive outcomes, while those with mild depression seem to be some of the most accurate forecasters, an example of the depressive realism effect.)

There may be no simple solution to this problem. Human existence is complicated; we spend large portions of our lives trying to figure out what it is we really want.
This means that we should not simply trust that whatever it is happens is what everyone—or even necessarily anyone—wants to happen. People make mistakes, even large, systematic, repeated mistakes. Sometimes what happens is just bad, and we should be trying to change it. Indeed, sometimes people need to be protected from their own bad decisions.

Unsolved problems

Oct 20 JDN 2458777

The beauty and clearness of the dynamical theory, which asserts heat and light to be modes of motion, is at present obscured by two clouds. The first came into existence with the undulatory theory of light, and was dealt with by Fresnel and Dr. Thomas Young; it involved the question, how could the earth move through an elastic solid, such as essentially is the luminiferous ether? The second is the Maxwell-Boltzmann doctrine regarding the partition of energy.


~ Lord Kelvin, April 27, 1900

The above quote is part of a speech where Kelvin basically says that physics is a completed field, with just these two little problems to clear up, “two clouds” in a vast clear horizon. Those “two clouds” Kelvin talked about, regarding the ‘luminiferous ether’ and the ‘partition of energy’? They are, respectively, relativity and quantum mechanics. Almost 120 years later we still haven’t managed to really solve them, at least not in a way that works consistently as part of one broader theory.

But I’ll give Kelvin this: He knew where the problems were. He vastly underestimated how complex and difficult those problems would be, but he knew where they were.

I’m not sure I can say the same about economists. We don’t seem to have even reached the point where we agree where the problems are. Consider another quotation:

For a long while after the explosion of macroeconomics in the 1970s, the field looked like a battlefield. Over time however, largely because facts do not go away, a largely shared vision both of fluctuations and of methodology has emerged. Not everything is fine. Like all revolutions, this one has come with the destruction of some knowledge, and suffers from extremism and herding. None of this deadly however. The state of macro is good.


~ Oliver Blanchard, 2008

The timing of Blanchard’s remark is particularly ominous: It is much like the turkey who declares, the day before Thanksgiving, that his life is better than ever.

But the content is also important: Blanchard didn’t say that microeconomics is in good shape (which I think one could make a better case for). He didn’t even say that economics, in general, is in good shape. He specifically said, right before the greatest economic collapse since the Great Depression, that macroeconomics was in good shape. He didn’t merely underestimate the difficulty of the problem; he didn’t even see where the problem was.

If you search the Web, you can find a few lists of unsolved problems in economics. Wikipedia has such a list that I find particularly bad; Mike Moffatt offers a better list that still has significant blind spots.

Wikipedia’s list is full of esoteric problems that require deeply faulty assumptions to even exist, like the ‘American option problem’ which assumes that the Black-Scholes model is even remotely an accurate description of how option prices work, or the ‘tatonnement problem’ which ignores the fact that there may be many equilibria and we might never reach one at all, or the problem they list under ‘revealed preferences’ which doesn’t address any of the fundamental reasons why the entire concept of revealed preferences may fail once we apply a realistic account of cognitive science. (I could go pretty far afield with that last one—and perhaps I will in a later post—but for now, suffice it to say that human beings often freely choose to do things that we later go on to regret.) I think the only one that Wikipedia’s list really gets right is Unified models of human biases’. The ‘home bias in trade’ and ‘Feldstein-Horioka Puzzle’ problems are sort of edging toward genuine problems, but they’re bound up in too many false assumptions to really get at the right question, which is actually something like “How do we deal with nationalism?” Referring to the ‘Feldstein-Horioka Puzzle’ misses the forest for the trees. Likewise, the ‘PPP Puzzle’ and the ‘Exchange rate disconnect puzzle’ (and to some extent the ‘equity premium puzzle’ as well) are really side effects of a much deeper problem, which is that financial markets in general are ludicrously volatile and inefficient and we have no idea why.

And Wikipedia’s list doesn’t have some of the largest, most important problems in economics. Moffatt’s list does better, including good choices like “What Caused the Industrial Revolution?”, “What Is the Proper Size and Scope of Government?”, and “What Truly Caused the Great Depression?”, but it also includes some of the more esoteric problems like the ‘equity premium puzzle’ and the ‘endogeneity of money’. The way he states the problem “What Causes the Variation of Income Among Ethnic Groups?” suggests that he doesn’t quite understand what’s going on there either. More importantly, Moffatt still leaves out very obviously important questions like “How do we achieve economic development in poor countries?” (Or as I sometimes put it, “What did South Korea do from 1950 to 2000, and how can we do it again?”), “How do we fix shortages of housing and other necessities?”, “What is causing the global rise of income and wealth inequality?”, “How altruistic are human beings, to whom, and under what conditions?” and “What makes financial markets so unstable?” Ironically, ‘Unified models of human biases’, the one problem that Wikipedia got right, is missing from Moffatt’s list.

And I’m also humble enough to realize that some of the deepest problems in economics may be ones that we don’t even quite know how to formulate yet. We like to pretend that economics is a mature science, almost on the coattails of physics; but it’s really a very young science, more like psychology. We go through these ‘cargo cult science‘ rituals of p-values and econometric hypothesis tests, but there are deep, basic forces we don’t understand. We have precisely prepared all the apparatus for the detection of the phlogiston, and by God, we’ll get that 0.05 however we have to. (Think I’m being too harsh? “Real Business Cycle” theory essentially posits that the Great Depression was caused by everyone deciding that they weren’t going to work for a few years, and as whole countries fell into the abyss from failing financial markets, most economists still clung to the Efficient Market Hypothesis.) Our whole discipline requires major injections of intellectual humility: We not only don’t have all the answers; we’re not even sure we have all the questions.

I think the esoteric nature of questions like ‘the equity premium puzzle’ and the ‘tatonnement problem‘ is precisely the source of their appeal: It’s the sort of thing you can say you’re working on and sound very smart, because the person you’re talking to likely has no idea what you’re talking about. (Or else they are a fellow economist, and thus in on the con.) If you said that you’re trying to explain why poor countries are poor and why rich countries are rich—and if economics isn’t doing that, then what in the world are we doing?you’d have to admit that we honestly have only the faintest idea, and that millions of people have suffered from bad advice economists gave their governments based on ideas that turned out to be wrong.

It’s really quite problematic how closely economists are tied to policymaking (except when we do really know what we’re talking about?). We’re trying to do engineering without even knowing physics. Maybe there’s no way around it: We have to make some sort of economic policy, and it makes more sense to do it based on half-proven ideas than on completely unfounded ideas. (Engineering without physics worked pretty well for the Romans, after all.) But it seems to me that we could be relying more, at least for the time being, on the experiences and intuitions of the people who have worked on the ground, rather than on sophisticated theoretical models that often turn out to be utterly false. We could eschew ‘shock therapy‘ approaches that try to make large interventions in an economy all at once, in favor of smaller, subtler adjustments whose consequences are more predictable. We could endeavor to focus on the cases where we do have relatively clear knowledge (like rent control) and avoid those where the uncertainty is greatest (like economic development).

At the very least, we could admit what we don’t know, and admit that there is probably a great deal we don’t know that we don’t know.

How do you change a paradigm?

Mar 3 JDN 2458546

I recently attended the Institute for New Economic Thinking (INET) Young Scholars Initiative (YSI) North American Regional Convening (what a mouthful!). I didn’t present, so I couldn’t get funding for a hotel, so I commuted to LA each day. That was miserable; if I ever go again, it will be with funding.

The highlight of the conference was George Akerlof‘s keynote, which I knew would be the case from the start. The swag bag labeled “Rebel Without a Paradigm” was also pretty great (though not as great as the “Totes Bi” totes at the Human Rights Council Time to THRIVE conference).

The rest of the conference was… a bit strange, to be honest. They had a lot of slightly cheesy interactive activities and exhibits; the conference was targeted at grad students, but some of these would have drawn groans from my more jaded undergrads (and “jaded grad student” is a redundancy). The poster session was pathetically small; I think there were literally only three posters. (Had I known in time for the deadline, I could surely have submitted a poster.)

The theme of the conference was challenging the neoclassical paradigm. This was really the only unifying principle. So we had quite an eclectic mix of presenters: There were a few behavioral economists (like Akerlof himself), and some econophysicists and complexity theorists, but mostly the conference was filled with a wide variety of heterodox theorists, ranging all the way from Austrian to Marxist. Also sprinkled in were a few outright cranks, whose ideas were just total nonsense; fortunately these were relatively rare.

And what really struck me about listening to the heterodox theorists was how mainstream it made me feel. I went to a session on development economics, expecting randomized controlled trials of basic income and maybe some political economy game theory, and instead saw several presentations of neo-Marxist postcolonial theory. At the AEA conference I felt like a radical firebrand; at the YSI conference I felt like a holdout of the ancien regime. Is this what it feels like to push the envelope without leaping outside it?

The whole atmosphere of the conference was one of “Why won’t they listen to us!?” and I couldn’t help but feel like I kind of knew why. All this heterodox theory isn’t testable. It isn’t useful. It doesn’t solve the problem. Even if you are entirely correct that Latin America is poor because of colonial and neocolonial exploitation by the West (and I’m fairly certain that you’re not; standard of living under the Mexica wasn’t so great you know), that doesn’t tell me how to feed starving children in Nicaragua.

Indeed, I think it’s notable that the one Nobel Laureate they could find to speak for us was a behavioral economist. Behavioral economics has actually managed to penetrate into the mainstream somewhat. Not enough, not nearly quickly enough, to be sure—but it’s happening. Why is it happening? Because behavioral economics is testable, it’s useful, and it solves problems.

Indeed, behavioral economics is more testable than most neoclassical economics: We run lab experiments while they’re adding yet another friction or shock to the never-ending DSGE quagmire.

And we’ve already managed to solve some real policy problems this way, like Alvin Roth’s kidney matching system and Richard Thaler’s “Save More Tomorrow” program.

The (limited) success of behavioral economics came not because we continued to batter at the gates of the old paradigm demanding to be let in, but because we tied ourselves to the methodology of hard science and gathered irrefutable empirical data. We didn’t get as far as we have by complaining that economics is too much like physics; we actually made it more like physics. Physicists do experiments. They make sharp, testable predictions. They refute their hypotheses. And now, so do we.

That said, Akerlof was right when he pointed out that the insistence upon empirical precision has limited the scope of questions we are able to ask, and kept us from addressing some of the really vital economic problems in the world. And neoclassical theory is too narrow; in particular, the ongoing insistence that behavior must be modeled as perfectly rational and completely selfish is infuriating. That model has clearly failed at this point, and it’s time for something new.

So I do think there is some space for heterodox theory in economics. But there actually seems to be no shortage of heterodox theory; it’s easy to come up with ideas that are different from the mainstream. What we actually need is more ways to constrain theory with empirical evidence. The goal must be to have theory that actually predicts and explains the world better than neoclassical theory does—and that’s a higher bar than you might imagine. Neoclassical theory isn’t an abject failure; in fact, if we’d just followed the standard Keynesian models in the Great Recession, we would have recovered much faster. Most of this neo-Marxist theory struck me as not even wrong: the ideas were flexible enough that almost any observed outcome could be fit into them.

Galileo and Einstein didn’t just come up with new ideas and complain that no one listened to them. They developed detailed, mathematically precise models that could be experimentally tested—and when they were tested, they worked better than the old theory. That is the way to change a paradigm: Replace it with one that you can prove is better.