Friday, October 24, 2014

Optimization and Its Discounts

Trying to reconcile cost shifting with the discounting of future climate change costs and benefits has taken me on some unexpected detours. I was initially thinking about bills of exchange and their role in the early modern era of concealing church-outlawed "usury" in the guise of a more palatable commercial transaction. Discounting was an arithmetical accounting exercise that arose out of the discounting of bills of exchange.

Both compound interest and discounting partake of the same exponential function -- from different ends of the calculation -- so it is easy (and misleading) to think of the discounting of a bill of exchange as a kind of loan. Discounting a bill of exchange is a sales transaction. The credit involved is commercial credit extended from a supplier to a purchaser. The bank then buys the bill of exchange from the supplier at a discount from its face value.

If one insists on seeing a loan from the banker in the transaction, it would only be an indirect loan to the purchaser of the goods, not to the supplier who sold the bill of exchange to the bank. But that loan would be secured by the goods that were the original object of the transaction that originated the bill of exchange... (Unless, that is, the bill of exchange was only speculative, a circumstance that Marx labeled a swindle.)

The important point is that bills of exchange originated in real transactions of goods, not in purely financial transactions. This has serious implications for the use of "discounting" in cost benefit analysis of public investments.

If the discount rate is meant as a metaphor it is a peculiarly bad one. The goods in question -- costs and benefits of climate change mitigation, for example -- have both negative and positive values but more importantly they have not been contracted for by the interested parties -- there is no "bill of exchange" to be discounted. Furthermore, the beneficiary of the discounted price is not society but the polluting firm who has shifted part of its costs to society and the environment. This perverse distribution of costs and benefits (and incentives) is concealed by the aggregate generality of the climate economy models that construe everything as one big happy economy.

Put it this way: discounting the future costs and benefits of greenhouse gas emissions provides a subsidy to the most prolific emitters of greenhouse gases that they can then reinvest at compound interest. This is hardly a matter of being "neutral" on questions of distribution. Nor is it a question of generational equity. This is simply taking the bankers' perspective on financial accumulation and proclaiming it "socially optimal."

The Passing of Fred Lee: An(other) Old Wobbly Bites The Dust

Last night (Oct. 23) at 11:20 PM, CDT, prominent heterodox economist, Fred Lee of the University of Missouri-Kansas City, died of cancer.  He had stopped teaching during the last spring semester and was honored at the 12th International Post Keynesian Conference held at UMKC a month ago. While I do not know if he was a card-carrying member of the IWW, as was a friend of mine, Bill Grogan, who died over a month  ago and about whom I blogged here then; on more than one occasion, including at this conference at UMKC last month, I heard Fred called an "old Wobbly," and I never heard him dispute this description. For any who do not know, "Wobbly" has always been the nickname for a member of the Industrial Workers of the World (IWW), a pro-working class universal union anarcho-syndicalist group.

Whatever one thinks of heterodox economics in general, or of the views of Fred Lee in particular, he should be respected as the person more than any other who was behind the founding of the International Conference of Associations for Pluralism in Economics (ICAPE), and also the Heterodox Economics Newsletter.  While many talked about the need for there to be an organized group pushing heterodox economics in all its varieties, Fred did more than talk and went and organized the group and its main communications outlet.  He also regularly and strongly spoke in favor of heterodox economics, the unity of which he may have exaggerated.  But his voice in advocating the superiority of heterodox economics over mainstream neoclassical economics was as strong as that of anybody that I have known.  I also note that he was the incoming President for the Association for Evolutionary Economics (AFEE), and they will now have to find a replacement.  He had earlier stepped down from his positions with ICAPE and the Heterodox Economics Newsletter.

It was both sad and moving to see Fred at the PK conference last month in Kansas City.  He was in a wheelchair with an oxygen tank, with his rapidly declining health condition stunningly apparent.  There were several sessions honoring his work.  However, at one of the major ones, he spoke at the end. Although he was having trouble even breathing and could barely even speak, he rose and made his comments, at the end becoming impassioned and speaking up forcefully to proclaim his most firmly held positions.  He declared that his entire career had been devoted to battling for the downtrodden, poor, and suffering around the world, "against the 1% percent!" and I know that there was not a single person in that standing room only audience who doubted him.  He openly wept after he finished with those stirring words, as those who were not already standing rose to applaud him with a standing ovation.

Fred's own research agenda focused on developing a heterodox microeconomics, one based on the idea of markets being dominated by oligopolistic firms with price-setting powers and more.  In the Post Keynesian camp he drew heavily on the work of Alfred Eichner as well as Michal Kalecki, although he was also influenced by American Institutionalists such as Gardiner Means, hence his Presidency-Elect of the Old Institutionalist AFEE.  He wrote on many other topics as well, and in more recent years on the broader issue of the meaning and application of heterodox economics and how to develop a coherent alternative heterodox economics.  But his most famous work was and will probably remain his work on a heterodox, arguably Post Keynesian, approach to micreoeconomics.

At this point I must note that while we were always friends, and I knew Fred for a long time, we had some fairly strong differences of opinion in recent years.  A decade ago, I with David Colander and Ric Holt, wrote a book and an article, followed up by another book and some other articles, the first book being _The Changing Face of Economics: Conversations with Cutting Edge Economists_ (2004, University of Michigan Press) and the first article being "The Changing Face of Mainstream Economics" (Review of Political Economy, 2004).  We argued that "mainstream" is a sociological category, those running the show in the profession (top departments, journals, etc.), while "orthodox" is an intellectual category, the hardline version of which is widely called "neoclassical economics."  We argued that "heterodox" was both: not running things and also intellectually anti-orthodox.  This opened the door for a category of "non-orthodox mainstream economists," with people like George Akerlof being possible examples.  Several heterodox economists disagreed with this argument and viewed us as weakening the criticism of "the orthodox mainstream" with this sort of divisionist argument, and quite a few of those expressed their disagreements in print, with there actually being an entire book dedicated essentially to reading the riot act on us as a bunch of namby-pamby wafflers or worse.  Fiercest of all in this crusade, both verbally and in print, was good old Fred Lee, who saw us as undercutting and undermining and demoralizing the movement for a unified and strong heterodox economics battling that "orthodox mainstream."

I note that at the meeting in Kansas City I stood up to speak about this and to praise what I considered to be the strong and principled position held by Fred, despite our disagreements.  I also spoke to him privately afterwards, and we parted on friendly terms.  However, I note that he laid out in his public remarks a distinction between a "heretic" and a "blasphemer," both of these terms positives for him.  A heretic is someone who questions orthodox doctrine, but still at some level believes it, while a blasphemer is someone who utterly and totally rejects it.  He told me in our final private conversation that he viewed me as being a mere heretic, while he was a true blasphemer.

RIP, Fred.

Barkley Rosser

Addendum:  The book criticizing Colander, Holt, and me is "In Defense of Post-Keynesian and Heterodox Economics: Responses to Their Critics," ed. by Fred Lee and Marc Lavoie, 2012, Routledge.   In effect the bottom line may boil down to our saying that the heterodox can be the source of cutting edge ideas that the mainstream sometimes adopts, such as behavioral economics, whereas they say that any idea that can be accepted by the mainstream is simply being coopted, and that the heterodox must overthrow the mainstream orthodoxy root and branch.  This may be what separates "heresy" from "blasphemy."


Been Discounted So Long It Seems Like Up To Me

The monks ascending the steps on the outside of the wall are growing the GDP, while the monks descending the steps on the inside are abating carbon dioxide emissions. Climate change mitigated -- emissions decoupling accomplished!

"Business profit," Schumpeter tells us, "is a prerequisite to the payment of interest on productive loans... The entrepreneur is the typical interest payer." There are three cost-reduction strategies that firms may pursue to maximize profits. The most opportunistic is cost-shifting, in which some third party, society or the environment gets stuck with the cost rather than the firm. The cost doesn't go away, it just becomes external to the accounting entity's balance sheet and thus is an "externality." Greenhouse gas emissions are such an externality. They are a cost-shifting success for the profit maximizing firm.

Carbon trading schemes and Pigouvian taxes are supposed to "internalize" those externalities so that the users of fossil fuels, for example, are made to pay the full cost -- or at least a larger proportion of the cost -- of their production processes or consumption preferences. Assessments of the costs and benefits of such policies typically discount the present value of future costs and benefits. The appropriate discount rate, it is often argued, should reflect market interest rates or else it may result in spending that is less efficient than would occur through the market. William Nordhaus in A Question of Balance:
The choice of an appropriate discount rate is particularly important for climate-change policies because most of the impacts are far in the future. The approach in the DICE model is to use the estimated market return on capital as the discount rate. The estimated discount rate in the model averages 4 percent per year over the next century. This means that $1,000 worth of climate damages in a century is valued at $20 today. Although $20 may seem like a very small amount, it reflects the observation that capital is productive [S'man: no, it reflects the assumption that capital is "productive"]. Put differently, the discount rate is high to reflect the fact that investments in reducing future climate damages to corn and trees should compete with investments in better seeds, improved equipment, and other high-yield investments. With a higher discount rate, future damages look smaller, and we do less emissions reduction today; with a lower discount rate, future damages look larger, and we do more emissions reduction today.  
Update:  But... if profitability is a function of cost shifting, the market interest rate a function of profit, the discount rate a function of the market interest rate and cost/benefit optimization of GHG abatement a function of the discount rate, doesn't said optimization embed a circular reference? No, this is both too simple and too forgiving an interpretation of the relationship between discounting and cost shifting. More on this soon...

Nordhaus, again:
In thinking of long-run discounting, it is always useful to remember that the funds used to purchase Manhattan Island for $24 in 1626, when invested at a 4 percent real interest rate, would bring you the entire immense value of land in Manhattan today. 
Professor Nordhaus here simply updates and tones down the hallucinations of Dr. Richard Price, who exclaimed in 1774:
One penny, put out at our Saviour's birth to 5 per cent compound interest, would, before this time, have increased to a greater sum, than would be contained in a hundred and fifty millions of earths, all solid gold. 
As Marx began the chapter in Capital in which he cited Price's dazzled fancy:
The relations of capital assume their most externalised and most fetish-like form in interest-bearing capital. We have here M — M', money creating more money, self-expanding value, without the process that effectuates these two extremes. 
In his discussion of discounting, Nordhaus doesn't distinguish between compound interest and the process that brings about the apparent productivity of capital that he extols. What makes this lack of distinction particularly telling is that he is supposedly discussing solutions to a problem that results from the very process that makes capital productive of profits sufficient to sustain interest payments on money capital. It is as if the greenhouse gases are unrelated to the industrial processes that emit them.

Compound interest does not emit greenhouse gases. What people do to make the profits to pay the compound interest does. Money capital does not compound itself. The discount rate is no more independent of the cost-shifting that engenders it than it is of the greenhouse gas emissions whose costs are being shifted. D.I.C.E. thrown will never annul chance.

Wednesday, October 22, 2014

Helicopter Money in the Midst of a PLOG

Mark Thoma and his readings have pulled together a nice collection of writing on a concept known as “helicopter money”. To be honest, as I read all the links I decided to fire off my own comment which needs a little refining. My opening line is simple:
Helicopter money means using fiscal stimulus with easy money to overcome one awful shortage of aggregate demand noting the following well established ideas.
PLOG is a Paul Krugman term for prolonged large output gap, which has been the current situation since 2008. This period has also been described as a liquidity trap where fiscal stimulus is clearly needed as traditional monetary policy has done all it can do and we still are in a PLOG. This naturally leads to my first well established proposition: We should be using fiscal policy that maximizes the bang for the buck. Which leads me to the rest of my rant:
(1) Transfer payments for the poor does so by giving income to people most likely to spend it; (2) Payments to the rich or tax cuts for the rich have no bang but a lot of bucks (Barro-Ricardian equivalence); (3) We could this with public infrastructure investments; (4) The Republican dorks running Congress are trying to cut (1) and (3) while emphasizing more of (2); which is why (5) We need to take fiscal policy out of the hands of these Republican dorks who run Congress.

Monday, October 20, 2014

Pension Funds and Private Equity

There is a fascinating piece by Gretchen Morgenson in today’s New York Times about the large investments public pensions have made in private equity funds.  The focus is on the secrecy of these deals, but the question also comes up as to whether these investments are proper given the fiduciary role that pension fund managers are supposed to play.

One thought that occurs to me is this: pension funds by their nature should position themselves overall toward relatively lower risk portfolios.  Yet pension funds pay a management fee to private equity firms, and then the first 20% or so of investment profits go to private equity as well.  For these fixed costs pension investors receive rights to the residual returns, which may be positive or, as in the case that leads the article, negative.  Present and future pensioners are paying for the opportunity to play a lottery.

It should really be the other way around.  General partners like private equity funds should pay pension funds an initial percent on investment for access to capital along with returns up to some specified level.  The private equity folks, being more risk-loving (in theory) would then grab what’s left.  In this way the risk would be allocated according to levels of fiduciary responsibility.  Why should wealthy speculators load the risk onto working class retirees?

Sunday, October 19, 2014

"From him exact usury whom it would not be a crime to kill."

The truth about usury lies somewhere beyond St. Ambrose's condemnation and Jeremy Bentham's cavalier apologetics. In a very brief but valuable essay, Francis Bacon counselled,
It is good to set before us the incommodities and commodities of usury, that the good may be either weighed out or culled out; and warily to provide, that while we make forth to that which is better, we meet not with that which is worse. 
Strictly speaking, compound interest is usury. Discounting is compound interest, ergo discounting is usury.  Bentham, who upheld usury in a series of letters addressed to Adam Smith, also was a pioneering proponent of cost-benefit analysis for public investments. Considering that usury has both incommodities and commodities, a proper cost-benefit analysis would need to evaluate the costs as well as the benefits that arise from the discounting of future value.

The typical way of handling traditional objections to usury is to cite scripture and the interpretations of it offered by religious authorities. This was the method followed by Benjamin Nelson in The Idea of Usury, whose analysis was taken up by Lewis Hyde in The Gift and by David Graeber in Debt: the first 5000 years. But the biblical injunctions are laconic and subsequent interpretations may partake more of rationalization than impetus. Bentham was right when he observed,
It is one thing, to find reasons why it is fit a law should have been made: it is another to find the reasons why it was made: in other words, it is one thing to justify a law: it is another thing to account for its existence. 
Bentham's defence of usury, though, was as verbose and meandering as the infamous passage from Deuteronomy about brethren and strangers was terse. His account of the grounds for the prejudice against usury was frivolous and dismissive. "To trace an error to its fountain head," Bentham cited Lord Coke, "is to refute it." What Bentham meant by "trace" was "assert." According to him, the prohibition of usury was motivated by the perverse asceticism of early Christians, foolish abstractions of Aristotle and ill-tempered envy toward the wealthy by the profligate debtors.

More concisely and substantively, Francis Bacon presented, in one paragraph, a catalogue of seven disadvantages arising from usury. A second paragraph elaborated on three advantages. Bacon's fourth criticism of usury is of particular interest:
…it bringeth the treasure of a realm or state into a few hands; for the usurer being at certainties, and others at uncertainties, at the end of the game most of the money will be in the box; and ever a state flourisheth when wealth is more equally spread…
In favour of usury, Bacon's second point is his most compelling:
…were it not for this easy borrowing upon interest, men's necessities would draw upon them a most sudden undoing, in that they would be forced to sell their means (be it lands or goods), far under foot; and so, whereas usury doth but gnaw upon them, bad markets would swallow them quite up.
In modern parlance, Bacon's most compelling arguments, both for and against usury, refer to what Marshall called the "external economies" -- or positive and negative externalities -- of the loan transactions. For better or worse then, compound interest is a vehicle for the shifting of costs and benefits. It is well to remember, in this connection, Joan Martinez-Alier's observation that "one can see externalities not as market failures but as cost-shifting successes."

One doesn't need to assume that cost shifting is necessarily a bad thing. Insurance, including social insurance, is a form of cost shifting. But when the project being evaluated in a cost-benefit analysis has the overt purpose of internalizing the cost of externalities -- such as in the analysis of abatement of greenhouse gas -- it is disingenuous to overlook the role of compound interest in enabling the social cost shifting in the first place and of perpetuating it over the period being analyzed. In other words, part of the value allegedly being "added" by capital in the analysis is not in fact being produced but is merely being appropriated by capital through social cost shifting.

(See also "Why Is the Discount Rate So Important?" page 9 in "More than Meets the Eye: The Social Cost of Carbon in U.S. Climate Policy, in Plain English.")

Saturday, October 18, 2014

The Biggest Nonlinearity in the Short Run Cost of Mitigating Climate Change

David Roberts, bless ‘im, has another fine post in which he sums up a pair of recent journal articles that cast doubt on estimates of the cost of stabilizing greenhouse gas concentrations.  The two main points he emphasizes are both quite sensible.  First, long-term economic prognostication is a fool’s errand.  He highlights a telling quote from one study by Rosen and Guenther:
[G]iven all the uncertainties and variability in the economic results of the IAMs [integrated assessment models] … the claimed high degree of accuracy in GDP loss projections is highly implausible. After all, economists cannot usually forecast the GDP of a single country for one year into the future with such a high accuracy, never mind for the entire world for 50 years, or more.
Precisely.  Or as Keynes put it,
The sense in which I am using the term [uncertainty] is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth owners in the social system in 1970.  About these matters there is no scientific basis on which to form any calculable  probability whatever. (The General Theory, 1937)
The second point is that economies are complex interdependent systems whose interconnections can’t possibly be modeled by analysts who know only the world as it is now, not the world as it will become.  One disturbing factor, of course, will be climate change itself, which will likely have deep, and mostly impossible to foresee, effects on many aspects of the economy.  Similarly, different technological and institutional configurations of the future economy of the planet can’t be captured by models that consider them separately, or only in light of their market connections.

Now I’d like to add two further observations to the mix.  The first is that the long run economic costs of climate change mitigation, the ones that will show up over the course of 50 or 100 years, are really irrelevant.  The case for taking action doesn’t depend on them, and future people will have to figure out how to cope with them when the time comes.  It’s the short term costs, the ones that will make themselves known during the first years of serious policy implementation, that matter.  They matter for policy, because if we can anticipate them we can take actions to minimize their impact.  Crucially, they matter for political economy, since the opposition to action on climate change is ultimately about short run costs: who bears them and how big they are expected to be.

The second observation is that the biggest nonlinearity is hiding right under our nose: the potential for writing off a portion of the capital stock.  All existing models assume that capital goods are employed until they fully depreciate, with reduced productivity of the stock related smoothly to more rapid depreciation: if a change in relative prices means a unit of capital is a bit less productive, its lifespan will be a bit shorter.

This assumption rules out a fundamental nonlinearity: each unit of capital has a tipping point, a critical balance of revenues and operating costs that separates utilizing it from abandoning it.  Consider a simple example: an airplane.  A large passenger airplane is a significant piece of capital investment.  Its profitability depends on the cost of providing air travel and the willingness of travelers to pay for it.  If the cost of fossil fuel rises due to a carbon tax or cap, airline companies have to raise prices and cope with the resulting loss of demand.  This can mean somewhat fewer flights and more empty seats.  But there is a level of price increases at which the plane is simply taken out of service: it’s no longer profitable to operate it.  Indeed, an entire company may liquidate, going from a substantial capitalization to scrap.  There is almost certainly some fuel price that triggers this discontinuity, although we don’t necessarily know what it is in advance.  The same point likely holds for many investments in transportation, shipping, real estate and fuel-intensive manufacturing.

If this view is correct, economists should put research into the short run effects of fossil fuel prices on the capital stock into high gear.  The cumulative effect of such writeoffs will be macroeconomic disruption, which we can offset through policy if we can see it coming.  Above all, identifying the investments most at risk from climate policy will tell us more about the political barriers we face than a thousand surveys about public attitudes toward science.

For more on cost, see this post from The Road from Carbonville.

A Tipping Point for Sexual Harassment

I have nothing to add to this important piece about sexual harassment and the dependence of restaurant servers on tips.  Read it yourself.  The practice of holding servers hostage to the emotional fluxes and fantasies of customers is barbaric.  Visitors from Europe, at least the ones I know, are appalled.  Surely one of the reasons for working for a living is to not have to depend on alms.

Voting in Texas

The Texas voting law just upheld by the US Supreme Court requires voters to show a picture ID at the polls and specifies what kinds qualify.  A gun permit is OK, a college ID isn’t.

Amity Shlaes and Cliff Asness Are Not Economists

Now that I have the obvious – can Brad DeLong explain why he wastes his precious time with these two? OK – we have this nonsense to deal with:
Even if what the Fed is doing is not inflationary, the arbitrary fashion in which our central bank responds to markets betrays a lack of concern about inflation. And that behavior by monetary authorities is enough to make markets expect inflation in future.
These two sentences convinced more than ever that no one should ever take Amity Shlaes seriously, but why we are at it, here is what I wrote over at Mark Thoma’s blog:
I'm not sure why anyone wastes time with her or this Cliff Asness person. Neither know anything about economics. My proof? The utter stupidity of their writing as noted in this quote. Hey Amity - we are far below full employment. With nominal interest rates at rock bottom and with the fiscal austerity that your idiot Republican masters have imposed on us - what is left? Oh yea - higher expected inflation might lower real interest rates in spite of the zero interest rate bound. And you think this is a bad thing? Stupid!

Friday, October 17, 2014

Nightmare in the Eurozone: Is OMT Going to Be Put to the Test?

Nothing fundamental has changed in the Eurozone.  The region is sputtering, alternating between sluggish growth and outright recession.  Inflation is below target and trending ever downward.  Imbalances between surplus and deficit countries remain unsustainable.  European banks are still stumbling along with unknown equity buffers, and it falls on the fiscally strapped governments of the periphery to backstop their own institutions.  Austerity fails to deliver on debt reduction, since moribund economies can’t generate enough tax revenue, and the denominator in the debt/GDP ratio refuses to grow.  So it has been, and so it is.

The only barrier standing between the current mess and a return to the sovereign debt crises of a couple of years ago is Draghi’s pledge to do whatever it takes to keep the bond vigilantes at bay.  What has always been unknown is the extent to which this promise (Outright Monetary Transactions) is a false front.  If there were new runs on the weakest sovereigns, would the ECB go on a buying binge to keep prices up?  Germany has been explicit in its opposition to OMT, which it regards as illegal and, in its version of macroeconomic moralism, sinful.  Still, financial markets were reluctant to take on the ECB for fear that Draghi would do what he said, and that bets against the sovereigns would not pay.

Nevertheless, the longer the bleeding continues in the EZ, the more likely it is that OMT will be tested.  Greece, with SYRIZA spooking the moneyed class, is already seeing a runup in its interest rates, and contagion is not out of the question.  The problem of the hour, however, is that the credibility of OMT hinges on Germany backing down in the confrontation over austerity.

Here’s why.  Throughout the zone, governments are challenging the 3% cap on fiscal deficits.  In the face of a potentially devastating triple dip recession, they have no choice.  Moreover, the steady rise in the popularity of Euroskeptic parties aligns the politics with the economics.  Bond issues will expand, and as they do, markets will wonder whether the rising debt still has Draghi’s backing, particularly since it will be in explicit defiance of Germany’s demands—and Germany, in theory, has the power to prevent Draghi from carrying out OMT.

Put this way, it all seems rather obvious: the cost of permitting a renewed run on the debt of weaker sovereigns is so great that surely Germany would have to back down, implicitly if not overtly.  So one would think, and I hope this happens.  But sometimes political commitments can take on a life of their own.  Germany has clearly drawn a line in the sand, and the domestic credibility of Merkel—and her coalition partner, the SPD, as well—would collapse if she were seen to do an about-face.  Up to this point, domestic German politics has entirely dominated external relations in German policy-making.

Given enough time and further economic deterioration in Germany itself (which will persuade business interests to demand a change in direction), I expect Germany to accede.  The problem is one of timing.  Here is the scary scenario:

1. Talks between Germany and the expansionistas break down.  France and its Mediterranean allies begin expanding their fiscal deficits, while Germany publicly rebukes them and indicates that it will not permit the ECB to support “irresponsible” deficits with bond purchases. There is a temporary surge in support for Merkel within Germany, as she shows herself to be principled and tough.

2. Investors, sensing new weakness on the part of the ECB, start shorting sovereign debt, first in Greece, then perhaps again in Spain and, crucially, Italy.

3. The moment of truth for OMT, delayed for two years, now arrives.  Either Draghi follows through or he doesn’t.  To back up his pledge he needs Germany to go along.  But Merkel has drawn a line in the sand, one which has overwhelming popularity at home, and if she allows Draghi to go forward she faces a political catastrophe.  Moreover, neither the CDU nor the SPD wants to be the party that breaks ranks and allows the other to play the role of the steadfast defender of economic virtue.  Germany says “no” and......

You can take it from there.

If you think such a disaster ought to be kept at as great a distance as possible, what you should hope for is that Germany backs down now, before a crisis materializes, and that serious attention is given to the underlying structural and institutional factors that make Eurozone finances so precarious in the first place.

Wednesday, October 15, 2014

Utility and Happiness

Utility is a hypothetical measure of well-being used by economists (and others) to construct models of individual choice.  It is whatever motivates people to make the choices they make.  It cannot be seen or measured directly, only inferred from those choices under the assumption that there is a single “something” behind them.

In recent years the concept of utility, along with the claim that individuals act to maximize it, has come under attack.  Other aspects of well-being, like self-reported happiness or satisfaction, certain types of brain activity, and indicators of physical and emotional health are directly measurable, and it’s been found that people often, and systematically, make choices that fail to optimize these substantive benefits.  In fact, there has been a lively and complex debate, kicked off by the Easterlin Paradox, over whether and under what conditions increases in real income correspond to increases in directly measurable well-being.

So today I notice a new post on Vox by Glaeser, Gottlieb and Ziv that defends utility against the claims of self-reported life satisfaction.  The big name here, for those who don’t know, is Ed Glaeser, perhaps the most prominent urban economist working today.  They say, we’ve found new evidence that people’s choices don’t maximize their happiness: they could move to a different location and become happier but they don’t.  Hence there’s a conflict between utility, the invisible whatever that causes people to choose what they choose, and measurable happiness.  And this shows that policies geared toward increasing happiness are misguided, because utility is what should be maximized.

Tell me if I’m missing something here, but what I see is this: (1) We have a theory that people’s choices maximize something called utility. (2) But we have evidence that measurable well-being is not maximized by these choices. (3) Therefore we conclude that measurable well-being is a bad proxy for “true” well-being.

Of course, any single measurable dimension of well-being is likely to be incomplete.  We really do need, as Stiglitz et al. said, a dashboard of indicators.  But surely the shortcomings of any one measure can only be assessed against other measures.  And my having chosen A over B is not in itself a substantive measure of how well off I am basking in my subsequent A-ness.  The question, after all, is whether the economic choices people make maximize their well-being.  To test this we go out and gather various independent measures of well-being.  When we find out they diverge in significant ways from revealed preferences, it is weird to use this as a demonstration that the evidence can’t really show what it seems to show, since our hypothesis about utility maximization has to be right.  And for “weird” you can also substitute “ideological”.

Tuesday, October 14, 2014

David Cameron leads Britain into the 19th century

Cameron ridicules France's 'nonsense' 35 hour working week, Daily Mail: "Mr Cameron launched his attack on the French employment model while responding to questions from pensioners and older workers at Age UK's London head office.":
The idea - economists would call it the lump of labour fallacy - the idea that there is just a fixed number of jobs and all you have got to do is try and divide them up between young people, old people, males, females - I think it's nonsense.
Very dangerous to ever point a finger at another European country but I sometimes think the French, with their obsession with the 35-hour working week, they are falling into the danger of a lump of labour fallacy, where ‘if only everyone just worked 35 hours there would be more work to go round.
Also at Guardian Politics live blog.

"Why economists dislike a lump of labor," Tom Walker, Review of Social Economy, 2007, vol. 65, issue 3, pages 279-291

Abstract: The lump-of-labor fallacy has been called one of the “best known fallacies in economics.” It is widely cited in disparagement of policies for reducing the standard hours of work, yet the authenticity of the fallacy claim is questionable, and explanations of it are inconsistent and contradictory. This article discusses recent occurrences of the fallacy claim and investigates anomalies in the claim and its history. S.J. Chapman's coherent and formerly highly regarded theory of the hours of labor is reviewed, and it is shown how that theory could lend credence to the job-creating potentiality of shorter working time policies. It concludes that substituting a dubious fallacy claim for an authentic economic theory may have obstructed fruitful dialogue about working time and the appropriate policies for regulating it.

Good silliness vs. bad silliness

Paul Krugman, October 14, 2014: Jean Tirole's New Industrial Economics "made it safe to be strategically silly, to the great benefit of economics."

Paul Krugman, October 7, 2014: "the rigorous-sounding but actually silly notion that you can’t produce more without using more energy."

Weitzman's Burden: do we dare to question economic growth?

Do we dare to question economic growth? asks Warwick Smith in a Comment is Free op-ed at the Guardian:
We live on a finite planet. 
That’s it. How, you might wonder, can such a simple statement of obvious fact undermine the tenets of modern society?
According to Paul Krugman, though, "there’s a lot of room to reduce emissions without killing economic growth. If you think you've found a deep argument showing that this isn't possible, all you've done is get confused by your own word games."

O.K., let's play some serious "word games," then, and try not to get confused.

Actually, these are word games about pictures. One of them is Wittgenstein's discussion of the duck-rabbit picture. The other is Keynes's discussion of the newspaper beauty contest in which contestants are asked to guess which pictures the most contestants think are prettiest.

But let's start with another quote from Paul Krugman, "So what I end up with is basically Martin Weitzman’s argument: it’s the nonnegligible probability of utter disaster..." What the probability of utter disaster does in Weitzman's argument is render the standard cost-benefit analysis, based on a market-based discount rate, inoperative. What's a discount rate? It's an interest rate, or more specifically, according to Investopedia,
The discount rate also refers to the interest rate used in discounted cash flow analysis to determine the present value of future cash flows. The discount rate in discounted cash flow analysis takes into account not just the time value of money, but also the risk or uncertainty of future cash flows; the greater the uncertainty of future cash flows, the higher the discount rate.
So a discount rate is an interest rate. What is an interest rate? In the retrospective, "From Usury to Interest," Joseph Persky explained,
Our modern word 'interest' derives from the Medieval Latin interesse. The Oxford English Dictionary explains that interesse originally meant a penalty for the default on or late payment of an otherwise legitimate, nonusurious loan. As more sophisticated commercial and financial practices spread through Europe, fictitious late payments became an accepted if disingenuous way of circumventing usury laws. Over time, 'interest' became the generic term for all legitimate and accepted payments on loans.
A discount rate is an interest rate is a (formerly) usurious charge on a loan. Now, if I were to say next that "economic growth is another aspect of compound interest" or that "usury is what propels growth and what makes it imperative" an economist would insist that I am some kind of a crank. I won't say that.

I won't say it because what we're dealing with here are not economic growth and interest rates but accounts of economic growth and interest. These accounts are like pictures and here is where Wittgenstein can be of help. Paul Krugman, and EconoSpeak's own Peter Dorman, are fond of reminding us that critics of growth "mistakenly" identify GDP with "stuff." They point out that it is value, not stuff, that gets added up in the national income accounts. This is a bit like saying the duck-rabbit picture is a picture of a rabbit, not of a duck.

GDP certainly is not stuff. It is an account of something. And it is most definitely an account of something that many -- possibly most -- people perceive of as stuff. The question then arises whether the "value" that economists attribute to GDP would continue to carry the same weight if the people who formerly perceived of GDP as accounting for stuff stopped having that perception. This is another way to pose the question, "what is liquidity?"

What is liquidity? Clearly Keynes thought that liquidity-preference resulted from uncertainty and that changes in liquidity-preference are implicated in slumps to the extent that the rate of interest required to induce people to not hoard liquid assets exceeds the expected rate of return on productive investments. In other words, while GDP is indeed not stuff, whether it is perceived to be an account of stuff may well have a bearing on private investment decisions.

Furthermore, whether an individual investor does or does not believe that GDP is an account of stuff doesn't matter as much as what that investor believes is the average perception of investors. Keynes illustrated this condition with his beauty contest story.

In conclusion, Weitzman presented a compelling case for the inappropriateness of using market interest rates as a discount rate for cost-benefit analysis of policies for abatement of GHG emissions. There are no grounds for assuming that capital markets would react benignly to such policies, however prudent and appropriate they may be.

Is there "a lot of room to reduce emissions without killing economic growth?" as Paul Krugman asserts or "do we dare to question economic growth?" as Warwick Smith wants to know.