Economics, Public Policy, and Whatever Else Interests Me
The Bank of Sweden Prize in Economic Sciences in Memory of Alfred Nobel 2005 was awarded to Robert J. Aumann and Thomas C. Schelling "for having enhanced our understanding of conflict and cooperation through game-theory analysis." The full press release is here.
I am an expert in neither's area of specialty, so I simply recommend to you the fine posts being offered up at Marginal Revolution on Aumann and Schelling, respectively.
Guest-blogging over at AndrewSullivan.com is Walter Kirn, who takes the occasion of his first post to question our nation's response to terrorism:
I'll start with something that's been bugging me but that I haven't had a forum to write about: this idea, almost universally agreed upon, that Americans mustn't let terrorism change our way of life. I disagree. Our way of life had its problems before Osama appeared, and we probably could have stood to change it then, but now that we have the added impetus of being collectively attacked in ways that we never dreamed about in past years, I think it's high time that we did a few thing differently that maybe we should have done already ... Like, say, spread out a little geographically.
Reading a bit between the lines of Walter's post, the lesson we are not learning is that we need to separate out two distinct phenomena. The first is that the quality of life in a world with terrorism is substantially worse than the quality of life in a world without it. At this point, that issue is settled, and pretending that we live in the other world doesn't make us better off and it doesn't help us win. The second is that, even in a world with terrorism, we can make ourselves better off by reacting optimally to our (new) environment. I discussed two ways in which society will evolve--in response to the newly inflated price of congestion and anonymity in an age of suicide [sic] bombers--in this earlier post.
There is a time and a place for making things harder on ourselves than we might otherwise have them, particularly in wartime when we need to signal to our enemies that we are a more determined foe and stronger adversary than they think. (Consider the now famous example of James Stockdale as a POW in Vietnam.)
Effective signals necessarily make life more difficult (in the near term) than it would have to be, but not everything that makes life more difficult is an effective signal. To be an effective signal, the action has to be associated with some characteristic that is hard to observe and that would change our enemies' assessment of us. We want to signal our resolve to protect our Constitutional republic and our society based on liberty. Like anything else, we want to economize on the signal--to pick the signals that give us the most protection from or intimidation of the enemy at the lowest cost.
Walter mentions an example of poor signaling near the end of his post:
There's a price for supersaturating small areas with people, wealth, and technology, and now we're paying it by trying to secure in thousands of ways targets that are inviting as they come. This folly of rebuilding the World Trade Center proves that we'd rather be proud and stubborn than safe. Here we go piling up the blocks again just to show how bloodied but unbowed we are instead of learning our lesson and reshaping things.
He is right. Our enemy doesn't care how proud and stubborn we are, or even how much sorrow we feel for what happened on 9/11. What we do at Ground Zero should, first and foremost, honor the victims of 9/11 (and only 9/11). If there are new office buildings to be built, they ought to reflect the needs of the post-9/11 world. The best idea I have read about the non-memorial part of Ground Zero is to insist that the United Nations relocate its headquarters to those new buildings. Putting the UN there doesn't make the re-building an effective signal per se--it just stops the building of a large office tower there from being a childish dare to hit us again without being much better protected than we were before.
What are some affirmative signals that we could be sending? I would start by taxing every product whose revenues flow back to terror sponsors, with the revenues redistributed progressively back to the taxpaying population through the income tax. Given our current enemies, that means a pretty large tax on oil. I'm sure we could come up with other suggestions.
The crew at Crooked Timber has cooked up something really interesting on Freakonomics. Five of them review it and then give Steve Levitt a chance to respond. They call it--quite appropriately--a seminar. Read the whole thing. For my part, there were two key lessons.
First, Levitt gives an interesting characterization of his research style:
The only things I’m good at, really and honestly, are asking questions that people seem to find interesting, and figuring out how to trick data into answering those questions. I will never be even a passable sociologist, political scientist, or psychologist. But that is okay. I think the thing that gets a lot of economists into trouble is the false belief that they can be good at everything.
That has been true ever since his undergraduate thesis. Later in that paragraph, he continues:
But, by starting from the position that I don’t know much, I am open-minded enough to co-author with an ethnographer (Sudhir Venkatesh), an econometrician (Jack Porter), a political scientist (Tim Groseclose), and now a journalist (Stephen Dubner). And maybe, in addition to making it safe for someone to publish a book without in a theme in the future, I will make it easier for academics from all social sciences to follow the sort of “adisciplinary” (as opposed to inter-disciplinary) path I’m on.
Adisciplinary--I like that.
Second, in one of the commentaries, Henry Farrell refers to my earlier post on Freakonomics:
Andrew Samwick argues that Levitt represents a continuation of this tradition (for Samwick, Levitt is a sort of Becker on steroids).
Good characterization, though I'd be the last to say Levitt is doping. He then adds some insight as to where I came up short, by trying to push my Chicago-School analogy too hard:
Now this is an interesting characterization of Levitt, and as Samwick argues, Levitt is clearly influenced by the earlier generation of the Chicago school. Still, Samwick is wrong in some very important ways. Levitt, unlike Friedman or Becker, seems to be primarily driven by the specific research question and by the data rather than by the desire to see everything through the lens of economics. When the question and the data point in the direction of interactions that can be modeled using optimization and equilibria, this is where Levitt goes. Thus, his work on cheating among Sumo wrestlers, and (my personal favourite, which isn’t mentioned in Freakonomics) on mixed strategies in football penalty kicks. However, much of Levitt’s work on other topics, including what is perhaps his most widely read article (the piece on abortion and crime rates in future generations) appears to have nothing to do with the economic approach, in either Becker’s formulation or Samwick’s slightly pared-down version of same. Neither equilibria nor optimization come into his story. One can go further – Levitt’s work on choice over names for babies supports a set of assertions that go against the economic model as Becker and Samwick describe it.
Fair enough. With the storage and processing capabilities of modern computing, it is now possible to learn quite a bit more from simple (or not-so-simple) data analysis than in generations past. Among social scientists, I think it is fair to say that economists jumped out to an early lead in using those quantitative methods in their research. Much of my own field of public economics (at least as it is practiced in the U.S.) is now entirely data driven. That doesn't necessarily make it uninteresting--it just means that one can be a leading economist while relying less on core economic theory than in an earlier era. So, perhaps in a reflection of his times, Levitt can also be an economist (albeit an adisciplinary one) who can occasionally take a break from testing a theory of incentives and just ask interesting questions of data.
We should also bear in mind that it may be a bit too early to draw firm conclusions: we don't know if Levitt will settle down into a couple of key areas, like Becker or Friedman, or if the next generation of Chicago School economists will resemble the old school any more than Levitt does.
The comments to my first two posts about Freakonomics provide some interesting discussion. (The thread was continued as well at Stumbling and Mumbling, under Bold, True, or Trivial.) My assertion was that economics is about exactly two ideas--optimization and equilibrium.
I still maintain that this is the right way to think about what economics introduces to any given situation that may be underappreciated by other social science disciplines. This is the context in which Freakonomics is making its contribution. But I shouldn't put words in the authors' mouths on this. Here is their take, in excerpts from the book (p. 13 -14):
Economics is above all a science of measurement. It comprises an extraordinarily powerful and flexible set of tools that can reliably assess a thicket of information to determine the effect of any one factor, or even the whole effect. That's what "the economy" is, after all: a thicket of information about jobs and real estate and banking and investment. But the tools of economics can be just as easily applied to subjects that are more--well, more interesting.
This book, then, has been written from a very specific worldview, based on a few fundamental ideas:
- Incentives are the cornerstone of modern life. ...
- The conventional wisdom is often wrong. ...
- Dramatic effects often have distant, even subtle, causes. ...
- "Experts"--from criminologists to real-estate agents--use their informational advantage to serve their own agenda. ...
- Knowing what to measure and how to measure it makes a complicated world much less so. ...
These are not incompatible with "optimization and equilibrium," but they are much more focused on measurement than frameworks. (That's what makes Levitt such an interesting innovation in the Chicago School.) And the comment by Max, and several good comments by rjw, were about what economics professors would teach their students or others trying to learn the field. They bristled at the notion that I would list "tools" as the essence of the field. I confess, I do tell this to my students in the first meeting of each term, but then I proceed to show them many applications of these tools that are successful to varying degrees.
In fact, the first topic we address in my finance seminar is embodied in these two papers:
Shleifer, Andrei and Lawrence H. Summers, “The Noise Trader Approach to Finance,” Journal of Economic Perspectives, Vol. 4, No. 2 (Spring 1990): 19-33.
De Long, J. Bradford, Andrei Shleifer, Lawrence H. Summers, and Robert J. Waldmann, “Noise Trader Risk in Financial Markets,” Journal of Political Economy, Vol. 98, No. 4 (August 1990): 703-738. (optional)
I teach these papers because the noise trader model represents a thoughtful use of these tools--both optimization and equilibrium. In the mid- to late-1980s, the finance profession had two camps--noise is incidental, and noise is fundamental. In a nutshell, this paper finds a principled middle ground by adding just two reasonable assumptions--that arbitrage is limited (and therefore risky) and that some investors are influenced by sentiment (which is correlated across investors). The end result is a model in which noise traders can survive in a market, despite their tendency to buy high and sell low. There was now a way to model noise as having an impact on financial markets without having to characterize those markets as completely uninterpretable. That innovation has been fundamental to the science of finance over the subsequent 15 years.
We would be remiss as a profession if we did not teach the tools, and it doesn't seem to me to be unnatural that both Freakonomics and my post on it characterize economics by its main tools of analysis (though we differ in the way we have specified those tools). But, as the commenters have pointed out, we would be equally remiss if we suggested (which I did not) that a pre-occupation with technique was the key to success in the profession more broadly. That rests in the thoughtful use of those tools and the ability to see their relevance in a broad range of environments. Ultimately, its ability to do that will determine the success of Freakonomics.
On Thursday morning, I happened to catch Messrs. Levitt and Dubner on the Today Show discussing Freakonomics. I did a double take at the discussion of this excerpt about what contributes to high test scores for children (p. 172 in the book):
Matters: The child has many books in his home.
Doesn't: The child's parents read to him every day.
So I interrupted the world's most enjoyable 15 minute walk to work with a stop at the new and improved campus bookstore (thank you Barnes and Noble!) to pick up my copy. I read the relevant chapter over some chai.
On the show, they didn't really get to explain why having the books matters while reading them doesn't, which might lead one to believe that spending money on a home library that wasn't used would be a good idea. In the book, the authors' provide a theory--that having books in the home is an indicator for parents who are themselves smart and transmit this genetically or who value education (and instill this in many ways that are more critical than reading the actual books). They do explain the difference between causality and correlation, in this and many other instances.
But what is a parent to do in light of this? What exactly is prescriptive about the finding? The book has a Calvinist thread running through it. How do I know whether buying the book would be useful--maybe I'm the type of person who should have books in his home, because I am smart or I value education--but how do I know? I'll buy the books, just in case, to show that I am predetermined to have high-scoring kids ...
As with linear regression on the Daily Show earlier, the TV roadshow isn't allowing some of the broad points of econometrics to come through. Add the difference between causality and correlation to the things we economists need to be able to explain in just a couple of quick sentences, for a TV audience. I'll take your suggestions in the comments section.
Max takes issue with my last post, and perhaps with most of the economics profession as well:
Andrew Samwick sums up everything that is wrong with economics as practiced in the nation's economics departments (as opposed to departments of urban planning, public policy, geography, sociology, political science):
"What does it mean to "see the economics" in a given situation? Economics consists of exactly two ideas: optimization and equilibrium."
Insofar as optimization and equilibrium do not explain behavior and outcomes, which is to say a ton, "economics" is useless, if not toxic. I should say that theories founded on optimization and equilibrium as employed by Steve Levitt, Samwick, and others can be illuminating, in and of themselves, but I don't think I've ever seen such a breathtakingly narrow characterization of economics.
This raises two issues that bear further comment. First, what have I left out? The challenge for Max, and anyone else who wants to play, is to enumerate other ideas in economics that are as fundamental as optimization and equilibrium that should be included in the statement. Certainly "behavior" and "outcomes" aren't ideas in the way that I have used the term (if that was the intent of including them). The Comments section is open and awaits your entries.
Second, Max has the proposition inverted. Neither Freakonomics nor my last post are an attempt to "see the economics" to the exclusion or even the diminution of other disciplines that may be relevant in understanding a given situation (unless statistical evidence bears that conclusion out). On the contrary, what Levitt has done is to show that economics (characterized by me, not necessarily Levitt, as optimization and equilibrium) is relevant in situations where it might not seem to apply: baby naming, teacher cheating, sumo wrestling, criminal activity, and others. As I noted in the previous post, this ability to spread the insights of economics into new areas has been the hallmark of the Chicago School and Levitt is its leading member in this generation.
Steve Levitt appeared on The Daily Show with Jon Stewart on Comedy Central last evening to discuss his new book, Freakonomics (buy
Steve is the next generation of the "Chicago School" of economics, in which the basic price theory of economics is inserted into every social environment imaginable. The original generation--Friedman, Becker, and Stigler--focused on what are by now traditional areas like education, the family, and the law. But I'd wager that even the founders of the School would have to admit that Steve's ability to see the economics in unusual situations is without equal, past or present. The next generation also comes armed with modern computing power and thus a much greater ability to analyze data in support of their claims. I will soon get my copy of Freakonomics and enjoy my chance to read it.
What does it mean to "see the economics" in a given situation? Economics consists of exactly two ideas: optimization and equilibrium. Optimization is the process by which all economic agents--households, workers, firms, governments--achieve their objectives subject to constraints on their resources. It leads to the familiar condition that an activity is undertaken until its marginal reward equals its marginal cost. Equilibrium is the process by which the competing efforts to optimize by these agents form a stable arrangement. An equilibrium is defined by relative prices, and those prices typically form the basis of either the marginal reward or the marginal cost in the individual agents' optimization processes. So "seeing the economics" means figuring out what is driving the optimization and equilibrium in a given context. As I often tell my students, if you cannot see the optimization and the equilibrium in what I am saying, then I am not talking about economics.
Here are the book's chapters, from the Freakonomics website, showing where the authors are looking for optimization and equilibrium:
On The Daily Show, Jon Stewart thought Chapter 4, in which the book supports a hypothesis that the reduction in crime in the late 1990s was attributable to fewer "unwanted" children in the wake of Roe v. Wade entering their prime criminal years, was the most interesting. He then asked Steve how he "controlled" for other factors that might affect the crime rate, like the number of police. Steve then tried to give an answer based on multiple regression (which he did in an excerpt from the book, shown here). That's got to be a first for late night television.
Reading the New York Times this morning, I found myself immersed in this article, "Big Farms Reap Two Harvests With Subsidies a Bumper Crop." The main topic in the article is well expressed in this paragraph:
For despite the fact that farm income has doubled in two years, federal subsidies have also gone up nearly 40 percent over the same period - projected at $15.7 billion this year, and $130 billion over the last nine years. And that bounty is drawing fire from people who say that at this moment of farm prosperity, the nation's subsidy system has never made less sense.
Yes, farm subsidies. How could I have blogged this long without going crazy about farm subsidies? I don't see any economic rationale for them, and the statements above (and supporting information in the article) suggest that they fail in their main purpose of providing the most income in the years when farm income is lowest. (It seems like they focus too much on price and not enough on price x quantity, as a first pass.) Certainly the obligatory "get the farmers' point of view" quotes in the article are not very reassuring:
Farm groups say the subsidies provide for a stable food supply, and ensure that major sectors of American agriculture will be competitive on the global market.
"When people ask me what the justification for this is, I point out that in nearly every country in the world you find government involved in the food supply," said Bob Young, an economist at the American Farm Bureau Federation, the powerful trade group for major agricultural producers.
This is standard interest-group pandering. Eventually, all farm subsidies ought to go, but I don't know enough about agrarian America to know what that would do to families, livelihoods, and communities in the short run. I'm open to suggestion as to how these subsidies should be unwound and over what horizon that should happen.
The reporter (Timothy Egan) clearly has a view that the subsidy system is not adequately helping small and medium-sized farms. He even marshals bad statistics to support his case. Consider the next paragraph:
But because nearly 70 percent of the subsidies go to the top 10 percent of agricultural producers, the recent prosperity is not seen or felt among many small to medium-size growers who keep the struggling counties of the Great Plains alive.
We naturally would want to know how much of the production that top 10 percent accounts for. If it is about 70 percent, then we would figure that there is probably nothing perverse about the way the subsidies are being doled out. Several paragraphs later, we accidentally get this piece of information:
Farm production has doubled over the last 50 years, while the number of farms has fallen by two-thirds. Economists say about 150,000 of America's 2.1 million farms produce 70 percent of the major food crops. But only certain crops - wheat, corn, cotton, soybeans and sunflowers among them - qualify for subsidies.
So if we have 2.1 million farms, the top 10 percent would be 210,000. But it only takes 150,000 of them to get to the 70 percent of production (assuming these "major food crops" are analogous to the "agricultural producers" above). So this means that even though the top 10 percent produce more than 70 percent of the crops, they only get 70 percent of the subsidies. I don't believe that the article provides any evidence that the subsidies are distributed in accord with anything other than total production. It may be true--but the article hasn't shown it.
Bad NYT. Go get some fact-checkers and a professional research staff. Help your reporters to do a better job.
But the last sentence of that paragraph is the one that surprised me. I guess I should have known this all along, but only a few crops get subsidies. And, in particular, a few paragraphs earlier in the story, we find:
The subsidies have also drawn criticism from farmers who grow fruits, vegetables and nuts - nearly half of American agriculture - but have nothing like the elaborate safety net in place for corn, cattle, wheat and hog producers.
We are a nation with rising obesity rates, and we decide to keep in place extensive subsidies for wheat, corn, beef, and bacon, but not for fruits and vegetables. Now this looks like a government program. It provides little insurance, seems to reward patronage rather than need, and appears to be at odds with sensible nutritional advice.
At Dartmouth, as at many other institutions, incoming first-year students are assigned an optional reading assignment over the summer. In the spring of 2002, the Dean of First-Year Students asked me if I would assign the book and give a public lecture on it during Orientation Week in September. I was happy to oblige, and, being an economist, I naturally thought of Capitalism and Freedom by Milton Friedman as the one book from my field that I would have all college students read. But I figured that Free to Choose, which was co-authored with his wife, Rose, and covers many of the same insights, would be a more inviting title. So that's what I assigned to the Class of 2006--a primer on how to use basic economic insights to study all manner of social interactions. The slides from the presentation are here.
Of the many topics in the book, the Friedmans' discussion of educational reform in general, and vouchers for primary and secondary school in particular, generated the most interest from the students. I'll share my views on that topic in a later post. To end the lecture, which took place a little over a year after 9/11, I tried to think of how to use the insights from the book to think about the War on Terror.
The core of economics is optimization under scarcity--it is the science of tradeoffs and how markets dictate the relative prices at which those tradeoffs can occur. An economist's analysis of the world after 9/11 would begin by asking, "What aspects of the way our society exists have seen their relative prices increase?" I offered two:
After 9/11, we would have to find ways to go about our business with less congestion and less anonymity. Not zero--but definitely less. To become less congested, we would need to spread out our people and assets more evenly in the country and add some redundancies in our networks. Managing this process would be a job primarily for planners and engineers. I don't follow the relevant sectors well enough to know whether there have been changes in residential and commercial planning since 9/11, nor do we yet have good information on whether there has been a change in migration from more to less densely settled parts of the country.
To become less anonymous, we would need to increase our collection of real-time data and develop stringent privacy standards for how it is handled. Managing this process would be a job primarily for those who manage the access points to networks--whether for electronics, communications, transportation, or finance. And, appropriately, many of the most contentious issues would be adjudicated in courts. The Patriot Act, the creation of the Department of Homeland Security, and the recently passed Intelligence Reform are all attempts, at least in part, to redefine the concept of anonymity.
Some of what we are discovering in this ongoing process is that people differ in how price sensitive they are to changes in the relative prices of congestion and anonymity. Some people are very price sensitive--they would do with quite a bit less of each in response to small increases in their costs. Others are hardly price sensitive at all--they wouldn't change their behavior at all even in the face of large increases in their costs. For ordinary things we consume, a market would accommodate our different preferences. This is possible to some extent with congestion and anonymity, but because we are all interconnected in at least some of the things we do, a large amount of it must be negotiated in the political environment.
Thanks to Roland Patrick for suggesting that the lecture might make for a good post to the blog.