War of the economists

War - Or why the public cannot trust economists redux:

Matt Yglesias has a very good post on Robert Barro's latest. Brad DeLong seems to agree with Matt. Paul Krugman uses the word "boneheaded" to describe the Barro piece.
This exchange is a good micro-cosm of how the stimulus debate has proceeded. A highly respected anti-stimulus economist puts up some anti-stimulus evidence in a highly imperfect test (in Barro's defense, he did cover more than just WWII). The anti-stimulus economist is attacked by pro-stimulus economists. But the pro-stimulus proponents are focused on attack. They are not putting up comparable empirical evidence of their own for the efficacy of fiscal policy and there is a reason for that, namely that the evidence isn't really there.

The pro stimulus economists have already put up their evidence. The anti-stimulus economists just don't like it. Likewise the pro stimulus pack don't like the evidence of their opponents. There is great uncertainty over the evidence on both the tax cut advocates and the fiscal stimulus advocates. There is some sense that we might want to try both (Scroll down to see that Mark Thoma does not object to tax cuts per se but he feels that spending in public projects is way overdue, for instance, tax cuts won't build schools). Unfortunately, this approach can divide resources to the point that neither is effective. (I'm in the both camp even though it may end up being ineffective.)

For instance, Warren Buffet via MR: "All you know is you throw everything at it and whether it’s more effective if you’re fighting a fire to be concentrating the water flow on this part or that part. You’re going to use every weapon you have in fighting it. "

Being in the "both" camp then requires us to find projects that are beneficial. Why build schools if they are not needed? In this case, the paper by Linda Bilmes is relevant. Corruption can become a problem. However, if I were in the pro-stimulus camp I would consider the findings of this paper to be interesting but tangential. Whether or not fiscal funds are put to "good" use is irrelevant as long as it gets recycled into the economy. Digging holes and then filling them up again is a Keynesian presciption out of a liquidity trap.

The pro tax cut camp also wants to use tax cuts to spur investment. Seeing that we had almost a decade of "spurred" residential investment that accompanied the housing bubble I question the need to "spur" more investment unless the pro tax cut advocates are proposing that the government "cause" another investment bubble in public works type projects. Perhaps in this case companies like Bechtel, Siemens and various construction companies will become beneficiaries. And "hopefully" we'll have another bubble that will lift us out of the recession. After all during the dot-com bubble there was a lot of IT "investment" e.g. laying down fiber optic cables, etc. (At least I think there was. I need to find a reference for this.)

Update: Menzie Chinn has some diagrammatic expositions of fiscal policy analyses which I found useful. Again these are theoretical arguments and as far as I can tell there are no empirical estimates of the slopes of IS-LM models.

Update: This is getting fun!
Rodrik seems to be anti-stimulus but what he says here makes sense as well (emphais mine):
And if I am right on the remaining source of disagreement, we can say two things. First, there is in fact a reasonable consensus about the economics of the situation (as described by both Cochrane and Krugman, although they do use different words). And second, the remaining disagreements are largely philosophical, political, and practical--revolving around the role of government, the extent of rent-seeking and public-choice concerns in government programs, and the right mixture of prudence and boldness that the situation requires.
It wouldn't be the first time that economists are discussing such questions--for which their PhDs have done little to qualify them--in the guise of discussing economics. But it would be too bad if disagreements on the second score obscure the apparent convergence on the former.

My argument against Cochrane's piece:
We are experiencing a strong portfolio and precautionary demand for government debt, along with a credit crunch. People want to hold less private debt and they want to save, and they want to hold Treasuries, money, or government-guaranteed debt.

Is this an assertion, assumption or something based on evidence? It sounds plausible but if there is any movement by economics toward 'evidence-base' this is not one of its finer moments. See also Brad Delong's claim that Cochrane is making "an elementary, freshman mistake."

Economic indoctrination

One of Ariel Rubinstein's dilemmas was depicted in the Layoff Survey where respondents (mainly students) were asked how many people to layoff in a hypothetical situation. He found that Econ students were more likely to respond to the profit maximizing solution (and hence laying off more) than either Philosophy or MBA students. He concludes:

The interpretation of the results cannot be separated from one’s personal views regarding the behavior of economic agents in such a situation. If you believe that the managers of a company are obligated morally or legally to maximize profits, then you should probably praise economics for how well it indoctrinates its students and be disappointed that so many of them still do not maximize profits. On the other hand, if you approach the results with the belief that managers should also take into account the welfare of the workers, particularly when the economy is in recession and unemployment is high, then you probably feel uncomfortable with the results.

I think that this is one of the problems with using students. It is possible that once the students are out of school the effects of indoctrination might be ameliorated. Having come from the economics department from Rochester (a very free market school) and having been out of economics for almost 10 years I have no problems entertaining the following seriously (whereas I would have not in the first few years out of school):
1. Nationalization of the financial industry
2. Health care is a right, not a privilege (Bumper Sticker)
3. Living wages
4. Free trade is over rated

It is also possible that the Econ students were not responding truthfully but responding in a way that they think the questioner would want them to respond. For instance, they may have viewed the survey as a "test" of how well they had learned economics. This may be an instance of where asking a question might be distorting.

Bottom line: I'm not as worried about indoctrination as Prof. Rubinstein as long as Econ students don't remain in academia. This is when they move from being indoctrinated to being idealogues.

Solving the financial crisis fictionally

Is it possible for the government to solve this crisis by engaging in a massive attempt to fool the public? These caught my eye:

1. Accounting Standards Wilt Under Pressure (From WaPo) In October, largely hidden from public view, the International Accounting Standards Board changed the rules so European banks could make their balance sheets look better. The action let the banks rewrite history, picking and choosing among their problem investments to essentially claim that some had been on a different set of books before the financial crisis started.
The results were dramatic. Deutsche Bank shifted $32 billion of troubled assets, turning a $970 million quarterly pretax loss into $120 million profit. And the securities markets were fooled, bidding Deutsche Bank's shares up nearly 19 percent on Oct. 30, the day it made the startling announcement that it had turned an unexpected profit.

2. ShadowStatistics (debunked).

Voting and rationality

Andrew Gelman had a series of posts on voting and rationality: here, here, here, and here for instance. Wading into very unknown territory for me is the following question: Why isn't the Nash equilibrium in a voting game to vote?

Consider an N-person game with two pure strategies of vote or not vote over two candidates.
1. Suppose nobody votes. This cannot possibly be a Nash equilibrium since any one person can vote and the vote will be decisive.
2. Thus the NE must be to vote.

Consider the N1+N2=N person game where N1 supports candidate 1 and N2 supports candidate 2.
1. Suppose no one from either or N1 or N2 votes. Again any one player from the N1 or N2 coalition will deviate from this strategy of not voting and the vote will be decisive.
2. Again the NE must be to vote.

Unfotunately, I have not been able to find out whether my reasoning is correct in this simple game. The economics literature is full of papers on costly voting where each voter incurs a cost C of voting (either uniformly distributed or not), imperfect information on the size of N1 and N2, strategic voting, coalition formation, stability of the core, etc.

I find the above simple and straightforward enough for me to explain why people vote. Why do economists have to cloud the issue? I guess it must make for fancier math and more publications.

Causality and cure

This Econbrowser post states: "How you think we might get out of our current economic problems has something to do with how you think we got into them in the first place."

This implies that the cure is determined by its cause (or causes). So if there are multiple causes we would treat all of them. But by some accounts e.g. Acemoglu/Johnson there are various contributory factors (not necessarily causes) e.g. the Great Moderation made policy makers complacent that also should be considered. When there are many factors and causes do we address them all equally or are some more important than others? How do we determine the size effect of these factors/causes? Should contributory factors get a smaller weight than "causes"?

And what if there are feedback effects, for instance, if mark to market were a feedback effect, should we "short-circuit" this feedback loop? Or what if credit downgrades caused feedback effects, for instance as in AIG?

Finally, how do we model all these when models have been discredited? Do we return to structural equation models?

Update: Eswar Prasad and Brad Setser explore the global roots of the current financial crisis. If global imbalances are a proximate cause that created the liquidity for the subprime bubble then is capital controls the answer?

Inauguration Day

Can't helped but be moved by the pictures of the thousands of people turning out for the Inauguration. K1's piano teacher said she never thought she would see the day that an African American would become president. Neither did I. I thought that conservative America would never vote for an African American and that the liberals could talk the talk but when it came down to it they would even choose Hilary Clinton rather than an African American.

The hardest road is still ahead. What legacy would Obama leave if he fails? Would it lead to a backlash against blacks? Or is this really full steam ahead for equal rights?

There is so much hope today and it is such a great contrast to the feelings I had on 9/11.

Update: Elizabeth attended and gave us a view of what she got to see (barely anything!) but I agree that it was more the look on people's faces, the feel of the crowds and the sounds of the cheering and the sense of hope that mattered more. If we were before kids I might have been tempted to shlep down to the Washington Monument myself.

VAR numbers as road signs

In a previous post there was mention of the notion that seeing a VAR number too often can cloud the judgement of the user and lead him to accept it as truth. One can make the same analogy to road signs - from this article ("Distracting Miss Daisy") by John Staddon.

...the overabundance of stop signs teaches drivers to be less observant of cross traffic and to exercise less judgment when driving—instead, they look for signs and drive according to what the signs tell them to do. ... But this is emblematic of the sort of signage arms race that has become necessary in the U.S. When you’ve trained people to drive according to the signs, you need to keep adding more signs to tell them exactly when and in what fashion they need to adjust their behavior. Otherwise, drivers may see no reason why they should slow down on a curve in the rain.

Do more road signs make roads safer or prevent more accidents?

In 1949, a British statistician named R. J. Smeed, who would go on to become the first professor of traffic studies at University College London, proposed a now-eponymous law. Smeed had looked at data on traffic fatalities in many different countries, over many years. He found that deaths per year could be predicted fairly accurately by a formula that involved just two factors: the number of people and the number of cars. The physicist Freeman Dyson, who during World War II had worked for Smeed in the Operational Research Section of the Royal Air Force’s Bomber Command, noted the marvelous simplicity of Smeed’s formula, writing in Technology Review in November 2006: “It is remarkable that the number of deaths does not depend strongly on the size of the country, the quality of the roads, the rules and regulations governing traffic, or the safety equipment installed in cars.” As a result of his research, Smeed developed a fatalistic view of traffic safety, Dyson wrote.

So should we abolish VAR numbers?

A few European towns and neighborhoods—Drachten in Holland, fashionable Kensington High Street in London, Prince Charles’s village of Poundbury, and a few others—have even gone ahead and tried it. They’ve taken the apparently drastic step of eliminating traffic control more or less completely in a few high-traffic and pedestrian-dense areas. The intention is to create environments in which everyone is more focused, more cautious, and more considerate. Stop signs, stoplights, even sidewalks are mostly gone. The results, by all accounts, have been excellent: pedestrian accidents have been reduced by 40 percent or more in some places, and traffic flows no more slowly than before.

What I propose is more modest: the adoption of something like the British traffic system, which is free of many of the problems that plague American roads. One British alternative to the stop sign is just a dashed line on the pavement, right in front of the driver. It actually means “yield,” not “stop”; it tells the driver which road has the right of way. Another alternative is the roundabout. ... A “mini-roundabout” in the U.K. is essentially just a large white dot in the middle of the intersection. In this form, it amounts to no more than an instruction to give way to traffic coming from the right (that would be the left over here, of course, since the Brits drive on the left). ... most right-of-way signs are informational: there are almost no mandatory stops in the U.K. (The dominant motive in the U.S. traffic-control community seems to be distrust, and policies are usually designed to control drivers and reduce their discretion. The British system puts more responsibility on the drivers themselves.)

The above quote leads to the suggestion that banks use their own VAR numbers to set their own capital requirements which was indeed what they did and did not prevent the crisis. A 99 percent chance that Bank A will not lose more than 50 million itoday without accounting for the overall economic condition (or correlated risk) is essentially meaningless. Perhaps financial authorities should spend more time providing direction on whether daily VARs need to be adjusted to account for economic conditions than to the numbers themselves. For instance, if an economy shows signs of some stress then authorities need to provide direction as to how VAR numbers should be adjusted.

However, this suggestion is subject to the same criticisms of whether the Fed should pop asset price bubbles. But rather than use interest rates, setting VAR limits or making VAR adjustments can trigger an overall audit of the financial sector where participants can disagree on whether the VAR limit makes sense in the same way that BCS ratings are dissected. This way the authorities are in some sense ahead of the game without causing the disruption of an increase in interest rates.