Category: Equitablog

Ed Glaeser et al.: Unhappy Cities: “There are persistent differences in self-reported subjective well-being…

…across U.S. metropolitan areas, and residents of declining cities appear less happy than other Americans. Newer residents of these cities appear to be as unhappy as longer term residents, and yet some people continue to move to these areas. While the historical data on happiness are limited, the available facts suggest that cities that are now declining were also unhappy in their more prosperous past. One interpretation of these facts is that individuals do not aim to maximize self-reported well-being, or happiness, as measured in surveys, and they willingly endure less happiness in exchange for higher incomes or lower housing costs. In this view, subjective well-being is better viewed as one of many arguments of the utility function, rather than the utility function itself, and individuals make trade-offs among competing objectives, including but not limited to happiness…

I have always understood expected-utility decision theory to be normative, not positive: it is how people ought to behave if they want to achieve their goals in risky environments, not how people do behave. One of the chief purposes of teaching expected-utility decision theory is in fact to make people aware that they really should be risk neutral over small gambles where they do know the probabilities–that they will be happier and achieve more of their goals in the long run if they in fact do so. Thus the first three things to teach people are:

1. That they are not risk-neutral over small gambles.
2. That elementary considerations of rationality in the sense of finding means to achieve one’s ends require risk-neutrality over small gambles.
3. Hence they should be risk-neutral over small gambles.

Then, of course, there is the fourth thing to teach people:

(4) When they are betting against other human minds, you should not be risk-averse over even small amounts–the fact that another mind is willing to take the opposite side of the bet tells you that your subjective probabilities are biased, and expected-utility decision theory based on your subjective probabilities does not incorporate that information about your biases, and so leads you astray.

Still open, however, is:

(5) Should you act as if you are risk-neutral for small gambles against nature if doing so makes you anxious and hence unhappy?

My view is that you owe it to yourself to train yourself not to be anxious and unhappy with respect to small gambles against nature, and thus train yourself to be risk-neutral with respect to small gambles against nature.

And then there is:

(6) Given that people aren’t rational Bayesian expected utility-theory decision makers, what do economists think that they are doing modeling markets as if they are populated by agents who are? Here there are, I think, three answers:

• Most economists are clueless, and have not thought about these issues at all.

• Some economists think that we have developed cognitive institutions and routines in organizations that make organizations expected-utility-theory decision makers even though the individuals in utility theory are not. (Yeah, right: I find this very amusing too.)

• Some economists admit that the failure of individuals to follow expected-utility decision theory and our inability to build institutions that properly compensate for our cognitive biases (cough, actively-managed mutual funds, anyone?) are one of the major sources of market failure in the world today–for one thing, they blow the efficient market hypothesis in finance sky-high.

The fact that so few economists are in the third camp–and that any economists are in the second camp–makes me agree 100% with Andrew Gelman’s strictures on economics as akin to Ptolemaic astronomy, in which the fundamentals of the model are “not [first-order] approximations to something real, they’re just fictions…”

Andrew Gelman: Differences between econometrics and statistics: “Economists seem to like their models…

…and then give after-the-fact justification. My favorite example is modeling uncertainty aversion using a nonlinear utility function for money, in fact in many places risk aversion is defined as a nonlinear utility function for money. This makes no sense on any reasonable scale… but economists continue to use it as their default model. This bothers me… like… doing astronomy with Ptolemy’s model and epicycles. The fundamentals of the model are not approximations to something real, they’re just fictions…

Andrew Gelman (1998): Some Class-Participations Demonstrations for Decision Theory and Bayesian Statistics: “5. Utility of Money and Risk-Aversion…

…To introduce the concept of utility, we ask each student to write on a sheet of paper the probability p₁ for which they are in different between (a)a a certain gain of $1, and (b) a gain of $1000000 with probability p₁ or $0 with probability (1-p₁)…. The students are then asked to write down, in sequence the probabilities p₂, p₃, p₄, and p₅, for which $1=p₂$10 + (1-p₂)$0; $10=p₃$100 + (1-p₃)$1; $100=p₄$1000 + (1-p₄)$10; and $1000=p₅$1000000 + (1-p₅)$100. One of the students is then brought the blackboard to get his or her answers to questions. The probabilities are checked for coherence… The questions involving piece to p₂ and p₃ or combine field comparison between $1, $100, $0. For example, suppose p₂=0.1 and p₃=0.15…. Then… U($1) = 0.064(U($100))+0.9836(U($0)). We then repeat this procedure using… p₄ to determine the utility of $1 relative to $1000 and $0, and then once again using p₅ to determine the utility of $1 relative to $1000000 and $0. finally, this derived values compared to the student’s original value of p₁. is will disagree, meaning that the students preferences are incoherent. The students in the class then discuss with the student that the blackboard how… To give coherent unreasonable answers….

A related demonstration…. a person is somewhat risk-averse and is indifferent between a certain gain of $10 and a 55% chance of $20 and a 45% chance of $0. similarly he or she is indifferent bring a certain gain of $20 and a 55% chance of $30 and a 45% chances of $10; and, in general, different between a certain gain of $x and a 55% chance of $10+x and a 45% chances of $x-10.

Is this reasonable? The students assent….

Then answer the following question: For what dollar value $y is this person in different between a certain game of $y and a 50% chance of $1000000000 and a 50% chance $0? The answer, surprisingly, is that Whitlers is between $30 and $40…. Setting U($0)=0 and U($10)=1… and evaluating… yields U($20)=1.818, U($30)=2.487…. U($40)=3.035…. U($1000000000)=5.5…. $y must be between $30 and $40.

The student believes each step of the argument but is unhappy with the conclusion. Where is the mistake? It is the theory uncertainty is not the same as “risk-aversion” in utility theory: the latter can be expressed as a concave utility function for money, whereas the former implies behavior that is not consistent with any utility function (see Kahneman and Tversky 1979). This is a good time to discuss cognitive illusions, many of which have been demonstrated the context of monetary gains and losses…. Is decision descriptive? Is it normatively appropriate?

John Maynard Keynes (1926): The End of Laissez-Faire: “The disposition towards public affairs…

which we conveniently sum up as individualism and laissez-faire, drew its sustenance from many different rivulets of thought and springs of feeling…. Locke and Hume… founded Individualism…. The purpose of promoting the individual was to depose the monarch and the church; the effect–through the new ethical significance attributed to contract–was to buttress property and prescriptions…. Suppose… individuals pursuing their own interests with enlightenment in condition of freedom always tend to promote the general interest at the same time! Our philosophical difficulties are resolved…. To the philosophical doctrine that the government has no right to interfere, and the divine that it has no need to interfere, there is added a scientific proof that its interference is inexpedient….

Yet some other ingredients were needed to complete the pudding. First the corruption and incompetence of eighteenth-century government…. Material progress between 1750 and 1850… owed almost nothing to the directive influence of organised society…/ The Darwinians could go one better than that–free competition had built man…. Socialist interferences became, in the light of this grander synthesis, not merely inexpedient, but impious, as calculated to retard the onward movement of the mighty process by which we ourselves had risen like Aphrodite out of the primeval slime….

These reasons and this atmosphere are the explanations, we know it or not–and most of us in these degenerate days are largely ignorant in the matter–why we feel such a strong bias in favour of laissez-faire, and why state action to regulate the value of money, or the course of investment, or the population, provokes such passionate suspicions in many upright breasts. We have not read these authors; we should consider their arguments preposterous if they were to fall into our hands. Nevertheless we should not, I fancy, think as we do, if Hobbes, Locke, Hume, Rousseau, Paley, Adam Smith, Bentham, and Miss Martineau had not thought and written as they did. A study of the history of opinion is a necessary preliminary to the emancipation of the mind. I do not know which makes a man more conservative–to know nothing but the present, or nothing but the past.

Should-Reads:

1. Carter Price: Marriage Won’t Cure Poverty: Single Mother Emphasis Obscures Issue: “Conservative policy researchers have recently been pushing marriage as the solution to low economic mobility, high poverty, and even domestic violence…. The first red flag for the single-mothers-cause-poverty claim should come from the fact that the variation in levels of mobility apply to all children in the community, not just for the children from single-parent households… other factors … like inequality, growth, and unemployment… segregation by race and income…”

2. Joshua Brown: A quick lesson on market tops: “This stock market recovery has now just about lapped the one that followed the 2000-2002 recession, 190% vs 101%…. Although we are currently selling at the same PE ratio as we were at the market’s top in 2007, there is one very important difference–we’re at about half the yield on the 10-year treasury versus back then…. We’re nowhere near the PE ratio the S&P 500 printed at the height of the dot com boom. I would also remind you that–forget the S&P–at the top of the market in 2000 it was really the Nasdaq that was the focal point for stock investors, and that motherf*cker was trading at 96 times earnings…. You can remind the next bubble-screamer you come across of the following three takeaways: a) US stocks are nowhere near as overvalued now on an absolute basis as they were in 2000. b) US stocks are nowhere near as overvalued now on a relative basis (think bond yields) as they were in 2007. Plus, we’re actually getting more in today’s dividend yield versus back then. c) during the prior two tops, stocks got cut in half from both absurd valuation levels (2000) and from reasonable valuation levels (2007)–so valuation levels alone are not ever going to be your tell.”

3. Henry Aaron: The Deficit Isn’t a Big Problem Right Now: “There is no particular reason to worry about one year’s budget deficit…. But if the government runs consistently high deficits, even when the economy is strong, there are two very real dangers…. One is financial…. If debt is growing faster than the economy as a whole… the government will have to raise taxes, cut spending, or borrow still more just to cover the interest. The other danger is that deficits can slow economic growth… [by] mak[ing] it harder for companies and individuals to finance new investments…. Interest rates are abnormally low just now, which means that borrowing is unusually inexpensive. When interest rates are low is the best time to undertake long-lived investments. Carrying out those repairs and improvements would put people to work now and improve productive capacity in the future. So would increased support for scientific research and increased spending to support post-high-school education of those who cannot now afford it. These measures would promote economic recovery right now and boost U.S. productivity in the future. Steps to lower future deficits could also be undertaken now…. Closing the anticipated gaps in Social Security and Medicare would effectively prevent debt from growing faster than GDP…”

Should Be Aware of:

• Glenn Greenwald: NBC News Pulls Veteran Reporter Ayman Mohyeldin from Gaza After Witnessing Israeli Attack on Children
• Harold Meyerson: Why Democrats Need to Take Sides in America’s Class War
• Tim Carmody: A People’s History of Tattooine
• Xavier Marquez: The Good Tsar Bias
• Cory Doctorow: Cold Equations and Moral Hazard

And:

1. Shane Ferro: The Abenomics arrows: “Bloomberg has just put out a new report on the state of Japanese prime minister Shinzo Abe’s project to revive his country’s economy and concludes that ‘the record is mixed’. ‘Inflation is up, though import prices rather than wages account for the bulk of the increase. A skeptical public remains unconvinced that long-term prospects are brighter’. Japan is a little over 18 months into Abenomics, and two of the three “arrows” — fiscal stimulus and monetary easing — have been deployed. Barry Ritholz thinks they’ve already been pretty successful so far: ‘deflation is being replaced by inflation; profits and investments are both increasing for Japanese companies; and the Nikkei 225 is up considerably’. However, there’s plenty to be worried about…”

2. Paul Krugman: Understanding the Crank Epidemic: “James Pethokoukis and Ramesh Ponnuru are frustrated. They’ve been trying to convert Republicans to market monetarism, but the right’s favorite intellectuals keep turning to cranks peddling conspiracy theories about inflation. Three years ago it was Niall Ferguson… here comes Amity Shlaes, making the same argument and citing the same source…. Why this lack of progress? The answer is that inflation paranoia isn’t a simple misunderstanding that can be corrected by pointing to evidence. It’s deeply embedded in the modern conservative psyche. Government action must, by definition, have disastrous results; and whatever market monetarists may try to say, their political comrades will continue to lump monetary policy in with fiscal stimulus and Obamacare. And fiat money can’t work–Francisco D’Anconia said so, and it must be true. So it’s always the 70s, if not Weimar, and if the numbers say otherwise, they must be cooked. Evidence has a well-known liberal bias…”

3. Daniel Kuehn: Hayek and the Lykourgan Dictator: “Perhaps the biggest problem with libertarianism (and I’m talking about the more extreme minarchist and anarchist range of the spectrum, not Greg Mankiw saying he’s largely a libertarian) is that it is a political philosophy which probably more than any other fails to engage its own unintended consequences and robustness. When problems do emerge the true Scotsmen close ranks…. Andrew Farrant & Edward McPhail: ‘Commenting on the Pinochet regime, Friedrich Hayek famously claimed in 1981 that he would prefer a “liberal” dictator to “democratic government lacking liberalism”. Hayek’s defense of a transitional dictatorship in Chile was not an impromptu response. In late 1960, in a little known BBC radio broadcast, Hayek suggested that a dictatorial regime may be able to facilitate a transition to stable limited democracy. While Hayek’s comments about Pinochet have generated much controversy, this paper neither provides a blanket condemnation of his views (he did not advocate dictatorship as a first-best ‘state of the world’) nor tries to excuse his failure to condemn the Pinochet junta’s human rights abuses, but instead provides a critical assessment of Hayek’s implicit model of transitional dictatorship…'”

Already-Noted Must-Reads:

1. Paul Krugman: Debt Shall Have No Dominion: “Nick Bunker notes an important point about the CBO…. The budget office has marked down its estimate of long-term interest rates, reflecting the growing evidence for a secular downshift in the ‘natural’ rate… [and] declared an end to the debt spiral…. Change in debt/GDP = (debt/GDP)*(interest rate – nominal growth rate of GDP) – primary surplus/GDP…. We turn to Table A-1 on page 104 of the CBO report, and we learn that for the next 25 years CBO projects an average interest rate on federal debt of 4.1 percent and an average growth rate of nominal GDP of 4.3 percent. And this means no debt spiral at all…. I don’t want to say that debt doesn’t matter at all. But it clearly matters a lot less than the fearmongers tried to tell us…”

2. Tahmi Lubby: America’s Middle Class: Poorer than You Think: “Americans’ average wealth tops $301,000 per adult, enough to rank us fourth on the latest Credit Suisse Global Wealth report. But… Americans’ median wealth is a mere $44,900 per adult… only good enough for 19th place, below Japan, Canada, Australia and much of Western Europe. ‘Americans tend to think of their middle class as being the richest in the world, but it turns out, in terms of wealth, they rank fairly low among major industrialized countries,” said Edward Wolff…. Super-rich Americans skew average wealth upwards. The U.S. has… 49% of those with more than $50 million in assets…. This schism secures us the top rank in one net worth measure–wealth inequality…. Americans… are having trouble building wealth because wages have stagnated for more than a decade. Median household income was $51,017 in 2012, compared to $56,080 in 1999…. There are many reasons why middle class incomes are suffering, including the decline of unions’ power, the shift of jobs overseas and the increasing use of technology in the workplace, said Kenneth Thomas, professor of political science at University of Missouri, St. Louis. Also, Americans have to pay more out of pocket for basics…” Citing: Giles Keating et al. (2013): Credit Suisse Global Wealth Report 2013

John Fernald: Productivity and Potential Output Before, During, and After the Great Recession: “U.S. labor and total-factor productivity growth…

…slowed prior to the Great Recession. The timing rules out explanations that focus on disruptions during or since the recession, and industry and state data rule out “bubble economy” stories related to housing or finance. The slowdown is located in industries that produce information technology (IT) or that use IT intensively, consistent with a return to normal productivity growth after nearly a decade of exceptional IT-fueled gains. A calibrated growth model suggests trend productivity growth has returned close to its 1973-1995 pace. Slower underlying productivity growth implies less economic slack than recently estimated by the Congressional Budget Office. As of 2013, about 3⁄4 of the shortfall of actual output from (overly optimistic) pre-recession trends reflects a reduction in the level of potential.

But when I look at this graph:

I see, from 2003:I to 2007:IV, a healthy growth rate of 3.2%/year according to Fernald’s potential-output series. Then after 2007:IV the growth rate of Fernald’s potential-output series slows to 1.45%/year. The slowdown from the late 1990s era of the internet boom to the pace of potential output growth prior to the Lesser Depression is small potatoes relative to the slowdown that has occurred since. Thus Fernald’s claim that the “timing rules out explanations that focus on disruptions during or since the recession”. As I see it, the timing is perfectly consistent with:

• a small slowdown in potential output growth that starts in the mid-2000s as the tide of the infotech revolution starts to ebb, and
• a much larger slowdown in potential output growth with the financial crisis, the Lesser Depression, and the jobless recovery that has followed since.

I say this with considerable hesitancy and some trepidation. After all, John Fernald knows and understands these data considerably better than I do. Perhaps it is simply that I spend too much time down in Silicon Valley and so cannot believe that the fervor of invention and innovation that I see there does not have large positive macroeconomic consequences.

Nevertheless, I have come to believe that macroeconomists think that their assumption the trend is separate from and independent of the cycle are playing them false. This assumption was introduced for analytical convenience and because it seemed true enough for a first cut. I see no reason to imagine that it is still true.

Economists Dim Their Growth Views

The policies that enabled the creation of our Second Gilded Age were born at the end of the 1970s out of a particular reading of the political economy of that moment.

Were the ideologues and the intellectuals of the right correct back when they claimed in the late 1970s that the economic problems of the 1970s were the result of “too much government” or of “an excess of democracy”? I think not. But in order to evaluate the argument we need to remember what it was. So here are the particulars of the claims that the U.S. in the late 1970s suffered from too-large a government and too-strong a democracy set forth by Martin Feldstein9 and Samuel Huntington10, with 1-17 from Feldstein and 18-31 from Huntington:

1. “Real GNP growth slowed from an annual rate of 3.9% between 1947 and 1967 to only 2.9% between 1967 and 1979… productivity per man-hour in… private business… 3.2% during 1947-67 to less than 1.5% since 1967 and less than 1% since 1973…”
2. “The average unemployment rate rose from 4.7%… to 5.85%…”
3. “The average rate of… CPI inflation jumped from 2% to 6.7%… with an acceleration to an average of nearly 9% since 1973 and over 13% in 1979…”
4. “Stock prices… rose sixfold between 1949 and 1969…. In the decade since… in constant dollars fell nearly 50%…”
5. “A falling share of national income devoted to net investment and to research and development…”
6. “Increasing pressures and risks in the financial sector…”
7. “Low profitability and an aging stock of plant and equipment in many specific industries…”
8. “A deteriorating performance of United States exports…”
9. “Expansionary monetary and fiscal policies… in the hope of lowering the unemployment rate but without anticipating the higher inflation rate that would eventually follow…”
10. “High tax rates on investment income were enacted and the social security retirement benefits were increased without considering the subsequent impact on investment and saving…”
11. “Regulations were imposed to protect health and safety without evaluating the reduction in productivity that would result or the effect of an uncertain regulatory future on long-term R&D activities…”
12. “Raising the amount and duration of unemployment benefits to the current high levels to avoid hardship among the unemployed would encourage layoffs and discourage reemployment…”
13. “Medicare and Medicaid… lead[ing] to an explosion in health care costs…”
14. “Welfare programs… weaken family structures…”
15. “Federal aid through the tax laws and through special credit programs to encourage homeownership would have such adverse effects on the cities…”
16. “The high rate of unemployment, the lack of investment demand, and the low rate of personal income tax constituted an environment in the 1930s in which the side effects of social security and unemployment compensation would be relatively innocuous. Today’s tight labor market, capital scarcity, and high personal tax rates imply that these programs now impede employment and capital formation…”
17. “Personal and business tax laws were designed for an economy with little or no inflation. The interaction of this tax structure with the current high inflation rates causes extremely high effective tax rates on capital income, a discouragement to saving, and a distortion of investment away from plant and equipment toward housing and consumer durables…”
18. “The democratic surge of the 1960s raised again in dramatic fashion the issue of whether the pendulum had swung too far…”
19. “The vigor of democracy in the United States in the 1960s thus contributed to a democratic distemper… the expansion of governmental activity… and the reduction of governmental authority…”
20. “Across the board, the tendency was for massive increases in government expenditures to provide cash and benefits for particular groups within society rather than in expenditures designed to serve national purposes vis-a-vis the external environment…”
21. “During the 1950s and early 1960s… governmental expenditures normally exceeded… revenue… but… the gap.. was not large…. In the late 1960s… after the… Welfare Shift… the overall government deficit took on new proportions… obviously one major source of the inflation which plagued the United States…”
22. “The beneficiaries of governmental largesse coupled with governmental employees constitute a substantial proportion of the public. Their interests clearly run counter to those groups in the public which receive relatively little in cash benefits from the government but must contribute taxes…”
23. “In the family, the university, business, public and private associations, politics, the governmental bureaucracy, and the military services, people no longer felt the same compulsion to those whom they had previously considered superior to themselves… discipline eased and difference in status became blurred…”
24. “The commandments of judges nd the actions of legislatures were legitimate to the extent they promoted, as they often did, egalitarian and participatory goals. ‘Civil disobedience’, after all… implied the moral value of law-abiding behavior depended upon what was in the laws, not on the procedural due process by which they were enacted…”
25. “The major expansion of unionism in the public sector… add[ed] still further to governmental deficits and to the inflationary spiral…”
26. “The imposition of ‘hard’ decisions imposing costs on any major economic group is… particularly difficult in the United States…”
27. “Domestic problems… become intractable…. The public develops expectations which it is impossible for the government to meet…”
28. “Politicians… [seek] achievement which may have an immediate payoff but which they and, more importantly, their country are likely to regret… giv[ing] to dictatorships (whether communist party states or oil sheikdoms)… a major advantage…”
    29 “An ‘excess of democracy’…. The effective operation of a democratic political system usually requires some measure of apathy and non-involvement on the part of some individuals and groups…”
29. “Marginal social groups, as in the case of the blacks, are now becoming full participants in the political system…. Less marginality… needs to be replaced by more self-restraint…”
30. “Democracy is more of a threat to itself in the United States than it is in either Europe or Japan where there still exist residual inheritances of traditional and aristocratic values…”

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