Wednesday, November 23, 2011

Economic models in theory and practice

Michael Woodford has a nice essay at INET where he responds to John Kay’s plea for a changed economics. In it, Woodford presents a number of arguments in favor of economic models that I think are valid and useful, but I don’t think he successfully defends the way economists use models in practice. Instead, he defends a different way of using models that would be more defensible.
Let’s consider his arguments in favor of mathematical models.
Argument 1: Precision
Models allow the internal consistency of a proposed argument to be checked with greater precision;
True, if the argument allows for translation into mathematical form. There’s an old Keynes quote on this:
Much economic theorizing to-day suffers, I think, because it attempts to apply highly precise and mathematical methods to material which is itself much too vague to support such treatment.
Sometimes, surely, the “vagueness of the material” is a shortcoming that makes an argument sound more sensible than it is. In that case, forcing it into mathematical form forces us to clarify what we actually mean and makes it harder to “weasel.” In other cases, however, formal methods force us to “sharpen” assumptions in a way that changes the argument itself. There’s a difference between saying that people have some thoughts on how gasoline prices will be in the future, and saying that people have subjective beliefs about future gas price trajectories that can be defined as a probability distribution over all possible price paths.
Argument 2: Differentiation/clarification
Back to Woodford:
they allow more finely-grained differentiation among alternative hypotheses
This is true – in so far as all the alternative hypotheses can be translated into this common language. For instance, the philosopher Jon Elster has written on Gary Becker’s rational addiction work that
Although I disagree sharply with much of it, it has raised the level of discussion enormously. Before Becker, most explanations of addiction did not involve choice at all, much less rational choice. By arguing that addiction is a form of rational behavior, Becker offers other scholars the choice between agreeing with him or trying to identify exactly where he goes wrong. Whatever option we take (I'm going to take the second), our understanding of addiction will be sharpened and focused.
This sounds fine, until you try to read the literature and discussions and realize that economists rarely find it interesting (or possible?) to discuss the specification of a model taken as a serious hypothesis about a causal mechanism in the world. As Woodford says elsewhere in his essay, when you want to conduct economic analysis with a mathematical model,
An assessment of the realism of the assumptions made in the  model is essential --- not, of course, an assessment of whether the model literally describes all aspects of the world, which is never the case, but an assessment of the realism of what the model assumes about those aspects of the world that the model pretends to represent. It is also important to assess the robustness of the model’s conclusions to variations in the precise assumptions that are made, at least over some range of possible assumptions that can all be regarded as potentially of empirical relevance. These kinds of critical scrutiny are crucial to the sensible use of models for practical purposes.
However, in many parts of economics, this kind of discussion is seen as irrelevant or silly. If you persist in trying to discuss “the realism of what the model assumes about those aspects of the world that the model pretends to represent” you’ll just be a person who doesn’t “get” economics.
Consider the rational addiction model of Becker and Murphy and the others that followed in its wake. As I’ve written with a colleague here,
The core of the causal insight claims from rational addiction research is that people behave in a certain way (i.e. exhibit addictive behavior) because they face and solve a specific type of choice problem. Yet rational addiction researchers show no interest in empirically examining the actual choice problem – the preferences, beliefs, and choice processes – of the people whose behavior they claim to be explaining. Becker has even suggested that the rational choice process occurs at some subconscious level that the acting subject is unaware of, making human introspection irrelevant and leaving us no known way to gather relevant data
In addition: Trying to examine whether the causal mechanisms described are at all plausible or consistent with evidence, is seen as irrelevant or weird. It’s an exercise only philosophers like the above quoted Jon Elster and oddballs like myself seem to be interested in (I first wrote on this in an article called “Taking absurd theories seriously”). “Real” economists seem content to wave their hands and say “as-if” or “these are just standard assumptions.”
Argument 3: Enables complexity
[Models] allow longer and more subtle chains of reasoning to be deployed without both author and reader becoming hopelessly tangled in them.
This claim by Woodford is similar to Krugman’s claim in “Two cheers for formalism” (a piece originally published in the Economic Journal):
Most of the topics on which economists hold views that are both different from "common sense" and unambiguously closer to the truth than popular beliefs involve some form of adding-up constraint, indirect chain of causation, feedback effect, etc.. Why can economists keep such things straight when even highly intelligent non-economists cannot? Because they have used mathematical models to help focus and form their intuition.
This sounds sensible: One could argue that individuals face relatively simple problems (“how much milk do I feel like drinking now?”), but that we need formal tools to understand what happens when they interact in markets or firms or whatever. However, this wouldn’t really be true. The argument is particularly off if you’re into rational expectations – in which case you want to impose the requirement that the agents in the model understand the model they are in and optimize in light of the real constraints they face. In that case, they need the same tools you do.
The argument is also off in other contexts. As I’ve argued elsewhere, it is actually an argument against all sophisticated, mathematical theories of individual choice. If mathematical modeling is a tool necessary for economists to reason their way through, say, rational addiction theory, how on earth do they expect “even highly intelligent non-economists” to discover that becoming a junky is their best shot at happiness? You might want to avoid the question by saying that they are able to do this “subconsciously”, but even that is a testable claim (hint: it’s empirically false). Also – if we really did solve such problems easily in our subconscious – wouldn’t these models seem intuitive and in line with our gut feelings? Put differently, it seems odd to develop a tool to overcome human cognitive frailty and then claim that this tool used at “full power”
Argument 4: Enables critical evaluation
Woodford’s essay again:
Often, reasoning from formal models makes it easier to see how strong are the assumptions required for an argument to be valid, and how different one’s conclusions may be depending on modest changes in specific assumptions. And whether or not any given practitioner of economic modeling is inclined to honestly assess the fragility of his conclusions, the use of a model to justify those conclusions makes it easy for others to see what assumptions have been relied upon, and hence to challenge them.
Here I’ll just refer back to the discussion on argument 2. Once again, I agree with Woodford in principle – but would argue that this is descriptively inaccurate in terms of how academic discussions in economics are actually conducted. When I examined the justification of specific assumptions in rational addiction theories (in “Taking absurd theories seriously”), I found that this was a lackadaisical affair: The most weird and unbelievable stuff was left uninterpreted in the model, other weird assumptions were justified by telling whatever anecdote would support it, or by giving loose evidence that would support a different but related assumption. The models, to sum up, were
poorly interpreted, empirically unfalsifiable, and based on wildly inaccurate assumptions selectively justified by ad-hoc stories.
Conclusion
Time to wrap up.
I realize that I’ve sounded critical of Woodford, but hope the “in principle”/”in practice” distinction is clear. My problem with his essay is that it’s framed as a defense of current economic practice. Evaluated in that regard, the arguments fails: He actually defends a form of “best practice” in modeling that is neither widespread nor widely recognized as such in economics today (as far as I can tell).

Monday, November 21, 2011

Hamermesh: Macro is rubbish, but the academic market is working and selecting for usefulness. It selected for Gary Becker, didn’t it?

Labor economist Daniel Hamermesh is interviewed at the Browser and asked for five books showing that economics is fun. At one point, the following exchange occurs:
With the economics profession, in the aftermath of the financial crisis, being somewhat in disrepute…
Stop! Stop, stop, stop. The economics profession is not in disrepute. Macroeconomics is in disrepute. The micro stuff that people like myself and most of us do has contributed tremendously and continues to contribute. Our thoughts have had enormous influence. It just happens that macroeconomics, firstly, has been done terribly and, secondly, in terms of academic macroeconomics, these guys are absolutely useless, most of them. Ask your brother-in-law. I’m sure he thinks, as do 90% of us, that most of what the macro guys do in academia is just worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.
I’m not sure most people in the outside world would make a distinction between macro and microeconomists.
I know. It’s up to us to educate them. I got this line from a friend in architecture the other day. He said exactly the same thing. I went through the same litany, trying to disabuse him of this notion. It’s like pushing a stone up a giant hill. It’s not going to get me very far, I agree. But nonetheless it is the case that most of us, and most of what we do, remains tremendously useful, tremendously relevant, and also fun!
He also names names. While Sargent, for instance, is a good guy, 
Not all the macro guys who won the Nobel are good. The guy who won it in 2004 was one of the main culprits in the nonsense, Ed Prescott.
At the same time, Hamermesh is an optimist, in that he believes the academic market selects, over time, for usefulness:
I do believe in markets. We had some useless macro guys here who just left, thank God, and we’re now looking for replacements. I do think the failure of these people is conditioning how we search for a replacement. I’m quite sure the journals in academe are going to reflect this too. People are interested in being useful in this profession. It doesn’t mean the people who were the bad guys from the last 20 years in macro are going to be doing anything different. They’re incapable of doing anything different! But markets do work and the dead and useless get shoved aside by the young and useful. I’m a tremendous optimist. I do believe markets work and that people run to fill niches. There’s an obvious niche here, and you’re already starting to see it being filled.
I think this is interesting: Macroeconomics the last few decades has basically been run by guys that Harmermesh charges with doing mostly “worthless rubbish. Worthless, useless, uninteresting rubbish, catering to a very few people in their own little cliques.” These are the guys who’ve dominated top journals and top economics departments and who have won Nobel Prizes for their macro work. Yet he still sees the academic market as a well-functioning mechanism selecting for usefulness.
There’s a second thing I find interesting about this: The “top economists” that Harmermesh mentions to show that micro (as opposed to macro) is useful, is the same economist that I trot out to show how absurd nonsense is accepted in economics.
Together with Hans Melberg, I recently argued that there is a “market failure” in (at least a large part of) the academic market for economists: If you have a model that is theoretically consistent and in line with “standard theory” (rational choice, equilibrium, etc.), and if the model matches some stylized facts and can reproduce regularities in market data – then you’re more or less given free reign to make causal claims and say that the “theory” can support strong and important claims regarding the welfare effects of actual real world policies.
In this work, Melberg and I looked at the kind of claims made in the literature on rational addiction theory. We argue that this is a literature featuring claims so obviously unsupported (we call them “absurd”), that their acceptance into good journals is a clear indication of a “broken market.”
The funny thing is: The whole literature on rational addiction theory – which we see as a clear example of how the “academic market” in economics allows policy-useless nonsense claims to rise to the top - is based on the work of Gary Becker. This same economist is one of two economists that Hamermesh mentions as examples of good economics that, presumably, show how well-functioning the market is.
There have been some great economists since then, in the last 30 to 40 years. [..] There’s Gary Becker, who in my view is the top economist of the last 50 years. His notions of family bargaining and how families behave are terribly important, and affect how, in the end, we all think.
To me, the rise of Gary Becker and his theories does not illustrate the usefulness (in the sense of credible, well-supported insights into the real world and the effects of actual policy choices on real people) of his work, but more that it “opened new markets” for economists: He showed them ways to build theories of the kind they were familiar with within a host of new areas (education, family, crime, addiction), in ways that seamlessly fit the criteria of “rational choice” and standard micro-economic practice. He provided innovative, creative, exciting strategies for economic imperialism. His work allows you to interpret all sorts of things using the universal acid of economic theory. Some of it may be truly useful and correct, some of it is very clearly not, yet all of it has been very successful within the discipline. To me, that makes it unlikely that “usefulness” was the selection criteria involved.

UPDATE: Came across a nice blogpost by Daniel Lemire who also doubts that science is successfully self-regulatory, though he argues from a different angle (he asks: how well does peer-review filter out bad research? To what extent does citation levels reflect quality?). I could also add this post which discusses a recent result that rebuttals don't affect how often a paper is cited, nor how well it is regarded.

Friday, November 18, 2011

The invisible hand is everywhere… you just need to notice every little detail!

In the book “Darwin’s Dangerous Idea” the philosopher Daniel C. Dennett called Darwin’s theory of evolution a form of “universal acid”:
it eats through just about every traditional concept, and leaves in its wake a revolutionized world-view, with most of the old landmarks still recognizable, but transformed in fundamental ways.
The same thing is true of economic choice theories: The logic of equilibria based on rational actors making marginal adjustments started as a description of the market, ate its way into “above market”-institutions such as regulatory agencies (regulatory capture) and government (public choice), as well as “non-market”-institutions such as families and – in a nice little satirical Ourobos-move – the discipline of economics:
The way I would describe Academic Choice theory is that it is “the sociology of economists, without romance.” Is this right? What an insightful comment. As you say, Academic Choice theory is a descriptive project, with no normative orientation. We apply a critical approach in order to counterbalance pervasive earlier notions of economists as scientific heroes struggling against popular ignorance in order to serve the common good.
What would you identify as the central insights of Academic Choice theory? The theory begins by identifying three principal ways in which economists try to maximize their utility. First, they receive salaries from universities, which can be increased if their course enrollment increases. Course enrollment is primarily driven by students with future careers in business and the financial sector, so an economist has an incentive to propound theories that CEOs and financial institutions find attractive. Even if adoption of these theories leads to substantial public costs, these costs will not be shouldered by the economist personally. Second, by developing such theories an economist can open the door to future wealth as a lobbyist or consultant. Third, the support of economists is critical to creating and maintaining special privileges for the financial services industry and for top corporate officers. By threatening to withdraw this support, economists can engage in rent-seeking. I call this last practice academic entrepreneurship.
The post is wroth worth reading in full. Remember – no matter what objection someone raises, you can always turn the firehose of economic acid on them and reduce them to yet another selfishly motivated rational agent. And when the economic worldview has eaten its way through everything and laid bare the underlying logic and structure of the world in all its stark, brutal detail? Then, perhaps we’ll all meet up in the “Invisible Hand Society” of Robert Anton Wilson’s novel “Schrodinger’s Cat Trilogy”:
Dr. Rauss Elysium had summed up the entire science of economics in four propositions, to wit:
1. Find out who profits from it.
This was merely a restatement of the old Latin proverb-a favorite of Lenin's-cui bono?
2. Groups never meet together except to conspire against other groups.
This was a generalization of Adam Smith's more limited proposition "Men of the same profession never meet together except to defraud the general public." Dr. Rauss Elysium had realized that it applies not just to merchants, but to groups of all sorts, including the governmental sector.
4. Every system evolves and expands until it encroaches upon other systems.
This was just a simplification of most of the discoveries of ecology and General Systems Theory.
4. It all returns to equilibrium, eventually.
This was based on a broad Evolutionary Perspective and was the basic faith of the Invisible Hand mystique. Dr. Rauss Elysium had merely recognized that the Invisible Hand, first noted by Adam Smith, operates everywhere. The Invisible Hand, Dr. Rauss Elysium claimed, does not merely function in a free market, as Smith had thought, but continues to control everything no matter how many conspiracies, in or out of government, attempt to frustrate it. Indeed, by including Propositions 2 and 3 inside the perspective of this Proposition 4, it was obvious-at least to him-that conspiracy, government interference, monopoly, and all other attempts to frustrate the Invisible Hand were themselves part of the intricate, complex working of the Invisible Hand itself.
He was an economic Taoist.
The Invisible Hand-ers were bitterly hated by the orthodox old Libertarians. The old Libertarians claimed that the Invisible Hand-ers had carried Adam Smith to the point of self-contradiction.
The Invisible Hand people, of course, denied that.
"We're not telling you not to oppose the government," Dr. Rauss Elysium always told them. "That's your genetic and evolutionary function; just as it's the government's function to oppose you."
"But," the Libertarians would protest, "if you don't join us, the government will evolve and expand indefinitely."
"Not so," Dr. Rauss Elysium would say, with supreme Faith. "It will only evolve and expand until it creates sufficient opposition. Your coalition is that sufficient opposition at this time and place. If it were not sufficient, there would be more of you."
Some Invisible Hand-ers, of course, eventually quit and returned to orthodox Libertarianism.
They said that, no matter how hard they looked, they couldn't see the Invisible Hand.
"You're not looking hard enough," Dr. Rauss Elysium told them. "You've got to notice every little detail."
Sometimes, he would point out, ironically, that many had abandoned Libertarianism to become socialists or other kinds of Statists because they couldn't see the Invisible Hand even in the Free Market of the nineteenth century.
All they could see, he said, were the conspiracies of the big capitalists to prevent free competition and to maintain their monopolies. They, the fools, had believed government intervention would stop this.
Government intervention was, to Dr. Rauss Elysium, just like the conspiracies of the corporations, merely another aspect of the Invisible Hand.
"It all coheres wonderfully," he never tired of repeating. "Just notice all the details."

Thursday, November 17, 2011

Rational models are NOT more constrained than irrational ones

One more comment on the Raquel Fern├índez conversation at the Straddler that I mentioned in a previous post. I thought she had several good points that she formulated well, but there was one comment that I’ve often seen economists make and that I think is wrong or at least misleading:
There is a beauty to the models in and of themselves. You assume, for example, that people are rational. I don’t think any really good economist thinks that people are perfectly rational, but, on the other hand, if you want to model people as not rational, all of a sudden it’s not clear what choice you should make. There are a million and one ways to be non-rational; there’s only one way to be rational within the confines of a model. Rationality means one thing: you’re maximizing your welfare subject to constraints. Now, if you say people don’t always maximize, and they’re beset by this and that, then all of a sudden you can have a million models. And that’s a little bit unsatisfactory too.
Yes, “there’s only one way to be rational within the confines of a model,” but so what? Within the confines of a specific model of irrationality there would be only one way to be irrational too. And  yes, “there are a million and one ways to be non-rational,” but there’s also a million and one ways to specify a utility function – and this gives us a million and one ways to act that are all rational.
There are actually three points (at least) here:
  1. Strictly speaking, “utility maximization” is empirically empty. We start with a preference relation that summarizes observed choice between pairs of consumption bundles, and which is “rational” in the sense of being complete, reflexive and transitive. We can then represent this with an ordinal utility function constructed to capture the choices described by this preference relation. Any preference relation – that is, any systematic set of choices fulfilling these conditions – can be represented by such a utility function. If you always did what hurt you the most, your choices could still be captured by such a utility function – and saying that you “maximize utility” means nothing more than saying that you “choose the one option within the choice set that would be selected no matter what other alternative in the choice set you set it against in a pairwise choice”. This makes no claims concerning why this option is selected – it may be because it benefits you, is best for the world (but not for you selfishly), is the most brightly colored, was most recently advertised or whatever.
  2. Economists then commonly make the “great leap of welfare economics” by assuming that all choices actually made aim to maximize the welfare of the choosing agent. “Utility” now measures “welfare” in some way.To be “rational” means to be “smart and selfish” – and arguments about whether or not A or B or C “is rational” quickly becomes a tiresome exercise in discussing psychological egoism. “Yes, he gave away his money to the beggar – but this gave him a warm glow which was the most welfare-maximizing item he could purchase for that sum of money”
  3. People are obviously not 100% selfish in terms of money and goods for themselves, so such utility functions need to be defined over non-observable goods as well as observable goods. This means that the “one” model of fully rational choice is actually a million models, due to the many degrees of freedom within the model. You do what maximizes your “utility,” but that can be anything. Take Gary Becker’s work: In his work, your utility function can be defined over “capital stocks” that refer to addictive capital, imagination capital, human capital etc. Looking at the different variants of rational addiction theory that have been developed within Becker’s framework, economists are happy to assume different numbers of such stocks and different cross-derivatives between stocks and other goods. Out, as a result, comes “rational consumption” that is rising, falling, cyclical, chaotic, or involves cold-turkey quitting.
I really don’t understand why (some) economists think “utility maximization” is such a “hard constraint” on theorizing in light of this. If you think it is – let me know one consumption pattern or human behavior that if it were observed repeatedly would be inconsistent with “rationality” or “utility maximization”. If it’s a hard constraint this should be simple – there should be long lists of possible, observable behaviors that could not occur if people were actually rational and maximized utility in some substantive sense and that would not occur if the hypothesis of “rational selfish maximization” was correct.
In actuality, I think you’ll find that there is no behavior weird enough to make rational choice economists doubt there being some rational utility-maximizing explanation out there provided we look long and hard enough. As Stigler and Becker wrote in their De Gustibus Non Est Disputandum article:
On our view, one searches, often long and frustratingly, for the subtle forms that prices and income take in explaining differences among men and periods. […] we are proposing the hypothesis that widespread and/or persistent human behavior can be explained by a generalized calculus of utility-maximizing behavior, without introducing the qualification “tastes remaining the same".
Put differently: If you see human action that doesn't look rational - doubt not! Rationality works in mysterious ways... Believe, think, pray and tinker with your model - and if you are wise enough all will be revealed and the Invisible Hand will publish your paper in a top-ranked journal...

Wednesday, November 16, 2011

The “canonical model” and the importance of default models

A Google+ post from Al Roth alerted me to an interesting conversation at The Straddler with Raquel Fernández. She has some great ways of making some nice points, such as her statement that a:

problem [in economics] is that methodology frequently trumps the question. Once you have a way to model things, much of the research becomes very self-referential; that is, it becomes more about how the model  behaves and less about the question. I think the question really matters, but a lot of economists believe the methodology matters more than the question. And this leads to very elaborate models of very many things without much of an outside reality check.

Another interesting impression I get from her talk, which is not explicit and may be a misreading on my part, flows from this point and concerns the importance of default models: The “default” or “canonical” model of economics describes a perfect-competition well-functioning market. We know that this is an incorrect description of the world, but it frequently shapes our “gut reaction,” and because we understand it fully we feel more comfortable arguing about this model than about the world. As a result, economists who give policy advice are treated more leniently by fellow economists if their advice is consistent with the standard model.

[…] the people who go and give advice usually end up with a very bad rap in economics. I am amazed at how much hatred—and I will say hatred—Paul Krugman evokes from some fellow economists. But one of the reasons for this is that he says things for which there is not “scientific” support and which go against what these people believe is "good" economics. Now, people on the other side also say things for which they do not have "scientific" support incidentally, and they don’t get the same amount of hatred.[…]

Take the argument we’ve been having recently. Should we be trying to increase aggregate demand or should we be reducing the deficit? […] Well, a model is not going to give you the answer because it depends on whether you write the model in such a way that getting aggregate demand up is a good idea, or whether you write it in such a way that people are really worried about future deficits that are coming around the road and they won’t invest because they know that taxes are going to be high in the future.

These things are rigged into the model from the beginning when it’s such an unsettled question, and we don’t really have an exact science-based way to answer it, which is why we argue about history. […]

Economists don’t have to be free-marketers. But that ends up being the canonical model, and then everything else ends up being a departure from the canonical model, which you’ve then got to explain why you’re departing from. It’s not because the canonical model is right, it’s because you ask most economists and they’ll say, “At least we understand how that economy works very, very well. So you want to tell me that we’re going to move away from this one and move to something else, that’s fine, but you have to explain why you’re putting in all of these imperfections.” So it’s not that you can’t write those things down, it’s just that there is less of a standard way of doing it.