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Feed the Beast

July 31, 2013
the Economy: Home and the World
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Mark Thoma asks a question:

Why should government spending as a percentage of GDP stay constant as GDP grows? It seems that, as we grow wealthier as a society, we would want relatively more of the kinds of goods government provides, e.g. social insurance.

I think the answer is a whole lot simpler than that. Thoma’s speaking on the normative – that, as we become a richer society, we ought to spend more on social services for the poor. I agree with that. But in fact one doesn’t need to share my progressive views to see that G/GDP must rise unless we tempt a catastrophically – yes, catastrophically – amended social contract. In other words, the answer is positive.

Conservatives are right. Government sucks at providing most goods and services. Here’s a list of some things with which Uncle Sam should never involve himself:

These are all left better to the private sector. On the other hand, due to economies of scale, monopsony advantage, and network effects, the government has a comparative advantage in the provision of:

  • Medical care.
  • Retirement.
  • Defense.
  • Infrastructure.
  • Education.

Government’s comparative advantage above derives in part from standard economic analysis, but also a public, bipartisan conviction that these services should be provided by a robust public sector. This is not only a liberal consensus.

Now, the real gross domestic product is modified from its nominal counterpart with what economists call a “GDP deflator” from a given base year. It broadly tracks inflation. If price levels increase 10% in a given year, a 12% increase in nominal GDP isn’t too impressive. However, it is the broadest measure of inflation on the aggregate of (C + I + G). But take a look at individual price indices:

fredgraph

The above graph destroys any hope of a smaller government. Since 1988 education (purple) has increased almost seven fold. Healthcare (red) five fold. Food and beverage prices have only doubled, apparel costs have flatlined, while technology and entertainment prices have plummeted. Basically prices for everything the government is good for have a positive slope and everything it’s bad for have a negative slope. I don’t think any other graph could more clearly explode hopes for a smaller, or even flatlined, government.

The past thirty years has not been kind to the median worker. But all inflation isn’t created equal. It all comes down to relative prices. Items consumers spend on (C/GDP) benefit most from rapid globalization and technological change (Netflix… iTunes… Moore’s Law… etc.) and have experienced either incredibly slow inflation or even deflation. Things government can and should spend on (G/GDP) has experienced a disproportionately higher inflation. We can talk about “bending the cost curve” or whatever but a) nothing will bend it near consumer inflation and b) nothing will stop America from aging.

Fact of the matter is – as hard as evidence might be for the right-wing to swallow – so long as medical and educational price inflation outpaces the GDP deflator, G/GDP must rise to maintain the real value of government provision. That is to say that if we maintain a small government – forever at 20% of GDP – its real, inflation-adjusted value will continue to decline.

This is the level at which we must discuss the size of government. Once we fall into the realm of normative, conservatives will stress the inefficiencies of bureaucracy and ideals of free markets. But even at the positive, nothing can halt growth of government. This scares me because one of America’s flagship political parties is hell-bent not only on preventing growth of G/GDP, but also shrinking government despite hugely inflationary pressures to the contrary.

That scares me because I see no way to reconcile our current social contract with the demands of a smaller government. Needless to say, part of the inflation is secular and will ebb as the population ages into an equilibrium. It will ebb as technology moves from entertainment to medical care. It will ebb as online education revolutionizes the university. But it will ebb at a higher level than 1988 – and the size of government must reflect that fact of nature.

Without feeding the beast we will be starving ourselves. And it doesn’t take a progressive ideologue to see this. 

Preparing for Peak Peasant

July 30, 2013
the Economy: Home and the World
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A lot has been said of China’s profoundly imbalanced, investment-driven growth strategy. Paul Krugman thinks that China’s eaten its free lunch and will face its “Minsky Moment” anytime now. Stephen Roach dissents that “doubters in the West have misread the Chinese economy’s vital signs once again”. In fact, while Krugman’s borderline-Austrian language is too harsh, he’s far closer to reality than Roach. And both of them are off mark.

The best way to think about China is an economy that’s about to exit the (in this case very long) Keynesian short-run into a Classical long-run. Hear me out. China is today an industrialized economy with the world’s best supply-chain infrastructure placing it at the forefront of international manufacturing. But it wasn’t always – and understanding this is key to observing the inherently Keynesian dynamic.

China was in – more or less – a Classical long-run with rather underwhelming growth at the time of the Xiaoping Reforms. The agrarian infrastructure supported a rural, labor-intense workforce and there was no excess capacity. However, after supply-side reforms, China’s infrastructure advanced far more rapidly than its labor force. There are many reasons for this, but the most compelling may be an extension of Paul Krugman’s strategic trade theory – emphasizing the importance of economies of scale in international trade. Suddenly, with respect to potential output, there was a huge excess supply. Of labor. To reiterate – this is not a vanilla Keynesian argument of excess supply of roads and factories. Rather, for the first time, the potential output of the average Chinese laborer has increased exponentially, because of the roads and factories. Therefore it is the excess capacity of human and not physical capital. Without this distinction the somewhat unorthodox interpretation that follows is lost.

There is no such thing as an absolute supply of labor. If the United States could tolerate wages measured in pennies and majority people involved in the production of rice we would have no unemployment because of labor-intense comparative advantage. But given our vast social, economic, and physical infrastructure capital-intensity reduces the absolute demand for labor.

The past two decades have been kind to China not only because aggregate supply has been expanding, but also because aggregate demand has been catching up. One, very perverse, way to think about it is that there was a discrete time period at which China entered a deep recession – with its future self – and has been in a frantic, Keynesian catchup ever since.

Having millions of peasants not introduced to its urban economy meant that what was once a Classical long-run in a crappy growth trajectory became a Keynesian short-run with an excess supply of workers relative to new infrastructure. Recoveries – Keynesian and otherwise – provide a period of above-trend growth. This dramatically changes how we might understand the last few years: much like how advanced economies (used to) climb out of economic slumps.

But excess supply can only last so long. In this case China is about to hit what we should colorfully call “Peak Peasant”. That implies the following:

  • There will be – further economies of scale aside – diminishing returns from the marginal unit of labor.
  • Wage inflation will be significantly emergent as the aggregate supply – vis a vis a once future economy – becomes inelastic.
  • China’s growth rate will mean revert: not to its historical mean but back to a trend defined by the expansion of long-run aggregate supply.

That, mostly, supports the Krugman interpretation which, however, wildly misses the mark here:

The need for rebalancing has been obvious for years, but China just kept putting off the necessary changes, instead boosting the economy by keeping the currency undervalued and flooding it with cheap credit. (Since someone is going to raise this issue: no, this bears very little resemblance to the Federal Reserve’s policies here.) These measures postponed the day of reckoning, but also ensured that this day would be even harder when it finally came. And now it has arrived.

Nope.

There is no day of reckoning. That would imply China has – for some period of time – been in a Classical long-run and increases in aggregate demand fueled by cheap credit and an undervalued Renminbi are reflected only as an increase on short-run aggregate supply whose coincident growth will be eaten by inflation.

But China is only now entering the Classical long-run. Until now, Chinese growth has been entirely real without any money illusion.

That means there’s no big “reckoning” coming. If our framework is a China that’s been in (conceptual not technical) recession due to excess supply relative to a discretely improved infrastructure, we are now entering normal times where growth won’t be nearly as rapid.

This means Roach himself has misdiagnosed China’s position. While he’s right that a sectoral shift to tertiary, service-oriented industries is an important component of China’s future, his reasons are wrong:

Why are services so important for China’s rebalancing? For starters, services are far more labor-intensive than the country’s traditional growth sectors. In 2011, Chinese services generated 30% more jobs per unit of output than did manufacturing and construction. This means that the Chinese economy can achieve its all-important labor-absorption objectives – employment, urbanization, and poverty reduction – with much slower GDP growth than in the past. In other words, a 7-8% growth trajectory in an increasingly services-led economy can hit the same labor-absorption targets that required 10% growth under China’s previous model.

That might have been great with a hugely untapped reserve of peasant labor. Like the Keynesian China of yesteryear. Roach’s writing is slightly misleading. He thinks of it as higher employment created per unit of GDP. I think of it as higher employment required per unit of GDP. Without a perfectly elastic labor supply, this means China will rapidly tempt inflationary pressures.

It’s like someone telling you the 18th century model of American farming – where one hundred men with plows do as much as one man with a tractor today – is better because of its labor intensity. While it “absorbs” more labor, it will also push us against a much harsher supply curve.

Also note, an “excess supply” of labor is very different from what we normally think of as excess capacity (empty factories, unfarmed land, or unemployed PhDs). Excess capital is part of the business cycle, and an intimate component of Keynesian philosophy. It is perennial and hence mundane.

But a country will have excess labor only once. We only shift from labor-intensity to capital-intensity once. In other words, China’s quantum expansion of aggregate supply will be unique in its economic history. It cannot sustain the growth rates it has by any wide margin.

In this sense, the Chinese slowdown will only approximate a “Keynesian” explanation. This is the time for China to pursue sensible, capital-oriented policy. Liberalizing its financial market, privatizing state-owned enterprises, and instituting a rule of law will be chief among any such policy.

It is obvious that corruption and absence of law are what will most lethally damage China’s supply-side future, and hence its economy. Until now China’s excess labor held its aggregate supply so high that anti-supply policies – like authoritarian government – were not felt in the numbers. This will not any longer be the case.

The economic future of the world will be dictated not by how China handles a demand-side rebalancing from investment into consumption, but how it handles a supply-side rebalancing from authoritarian management to liberal democracy.

The Fine Rawlsian Line

July 29, 2013
the Economy: Home and the World
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While policy action may not justify the rhetoric, there’s a strong and historic bipartisan consensus that we ought to strive for equality of opportunity, if not equality itself. Liberals think of this as everyone’s right to a fair chance – a shot at the “American Dream”. (Unfortunately, I feel like an idiot typing that phrase without scare quotes). Conservatives write in terms of just deserts – everyone getting what they deserve. But – at least rhetorically – both sides are reaching for the same item: meritocracy.

There’s been some discussion of its inherent contradictions, but the critique stretches as far back as John Rawls Theory of Justice, whose criticism may best be captured from Ben Bernanke’s recent speech at Princeton:

The concept of success leads me to consider so-called meritocracies and their implications. We have been taught that meritocratic institutions and societies are fair. Putting aside the reality that no system, including our own, is really entirely meritocratic, meritocracies may be fairer and more efficient than some alternatives. But fair in an absolute sense? Think about it. A meritocracy is a system in which the people who are the luckiest in their health and genetic endowment; luckiest in terms of family support, encouragement, and, probably, income; luckiest in their educational and career opportunities; and luckiest in so many other ways difficult to enumerate–these are the folks who reap the largest rewards. The only way for even a putative meritocracy to hope to pass ethical muster, to be considered fair, is if those who are the luckiest in all of those respects also have the greatest responsibility to work hard, to contribute to the betterment of the world, and to share their luck with others. As the Gospel of Luke says (and I am sure my rabbi will forgive me for quoting the New Testament in a good cause): “From everyone to whom much has been given, much will be required; and from the one to whom much has been entrusted, even more will be demanded” (Luke 12:48, New Revised Standard Version Bible). Kind of grading on the curve, you might say.

Andrew Gelman’s more (conceptually, not temporally) antecedent criticism of the subject is the instability of meritocratic regimens. That is meritocrats will naturally help their friends and family who will then earn more than they deserve thereby undermining meritocracy’s governing tenet of just deserts. But for sake of discussion, let’s simply assume this point away by stipulating permanently equal opportunity.

John Rawls fundamental concern is that meritocracy suggests the smarter, more attractive, or more charming individuals – deriving these characteristics entirely from genetic luck – deserve more and that this is not a just society. Indeed, the Rawlsian critique is reductionist to an extreme: even a man’s work ethic is luck, not virtue. For this reason, it is alien to the American psyche: we culturally idolize the rags-to-riches story of a boy working two shifts to put his way through college to happen upon a brilliant idea to take risks to become a billionaire. So he famously (though, in my opinion, tautologically and somewhat trivially) argued that the justest society is that in which we constituted a world without knowing our station therein – behind the proverbial Veil of Ignorance. Rawlsians augment said Veil with the “Difference Principle” asserting that inequality ought only to be tolerated to the extent that it benefits society’s poorest members (never mind how that’s defined).

Let’s assume the Rawlsian will is instituted through progressive taxation and social spending: without concerning ourselves with the specific – 39% or 35%? Income or estate? – details. Let’s further introduce IQ as some undefined variable that is a stand in for intelligence, charm, looks, character, work ethic, and basically everything else genetic  but relevant. Finally, let’s consider how our policy’s must differ along some heritability factor of IQ between 0 and 1. In the former a child’s IQ is entirely uncorrelated with his parents, and in the latter it is of direct consequence.

At the lower extreme, it’s very clear progressive taxation and spending is morally just. If we assume an initial level of inequality of outcome at some previous point, the natural extension without social programs as an inequality of opportunity for the next generation. However, we believe it is immoral for children of the poor to suffer for being born in the wrong home. Furthermore, because IQ is entirely uncorrelated with parental genetics, we know that kids from poor families are as likely to succeed as those from rich families, therefore we must equalize the environment to the greatest extent possible. We must equalize inputs, but never outcomes. 

At the upper extreme, it’s also very clear that progressive taxation and spending is morally just. Because IQ is perfectly predictable and we think in a rich society like ours one must not suffer for his genetic composition. That is to say, we must let someone with an IQ of 90 – low, but by no means disorderly – to suffer for his station no more than we let autistics on the streets. Both, obviously, are the result of genetic forces that conspire beyond individual agency. We must equalize outcomes, but never inputs.

Aside from the fact that optimal economic regime within either is brilliantly untenable (“From each according to his ability, to each according to his needs”, anyone?) the key argument here is the tradeoff between equalizing inputs on one end to outcomes on the other.

But this speaks only of the quality not quantity of redistribution. The crucial point is that if we can somehow, abstractly, quantify “redistribution”, the optimal level would be maximum globally at the upper end, minimum locally at the lower end, and bimodal throughout.

Why? At low levels of heritability, you don’t care about normalizing the outcome – only the initial environment (say we can discretely define childhood). At high levels of heritability, you don’t care about normalizing the opportunity. Note, this is a very different thing from saying we shouldn’t spend on education. All it says is that we shouldn’t care about educational inequality. Other things equal, more education is still better.

But redistributing opportunity naturally redistributes outcome more than redistributing outcome redistributes future opportunity. Therefore, the total quantity of redistribution needed increases from 0, but theoretically may fall in between. Diminishing returns on current opportunity along with activities that mutually redistribute both (public infrastructure, for example) cause a decrease in total redistributive spending necessary before it tends towards absolute socialism at absolute heritability.

The conceptual question then is a) in our society does the heritability-redistribution curve ever fall to zero – in other words is redistribution always required – and if so is heritability of the abstractly defined IQ at that point. (Note that the curve can never really fall below zero since redistribution is defined in terms of some percent of income from the top n% of the country, “top” and n selected arbitrarily).

The interesting result here is that – even within pretty liberal and Rawlsian assumptions of what ought to be – there can exist many states where redistribution isn’t important or necessary. I don’t have any way of judging this framework against empirical reality, but it is still pretty intriguing that the radical normative stipulations of Rawlsian thinking do not necessarily imply redistribution as an optimal policy.

Immiserizing Bangladesh

July 25, 2013
the Economy: Home and the World
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When Jagdish Bhagwati – the outspoken free marketer – isn’t sparring with Amartya Sen on India’s future, he’s writing editorials savaging worker safety laws imposed on Bangladesh. Some may be surprised that Bhagwati, almost 80, was among the first to recognize Paul Krugman’s deep prodigy as his grad advisor – though the two are now probably rivals on regulating Bangladesh.

I’m not going to dispute the standard economic line that sweatshops and cheap labor are better for everyone involved. But Bhagwati’s pristinely hands-off approach to international working conditions leaves open room for important questions.

A theoretical dispute emerges from a 1958 paper, Immiserizing Growth: A Geometrical Note, written not by Naomi Klein but by a certain Jagdish Bhagwati. Before I detail the theory, it’s critical to note the mathematical conditions under which it’s derived are extreme but, like so many other brilliant models, helps illuminate a thematic dynamic. Bhagwati suggested that an increase in economic activity and output does not necessitate a coincident increase in standard of living:

The effect of economic expansion on international trade has been receiving increasing attention from economic theorists since the publication of Professor Hicks’ stimulating analysis of the “dollar problem”. It has, however, been insufficiently realized that, under certain circumstances, economic expansion may harm the growing country itself. Economic expansion increases output which, however, might lead to a sufficiently deterioration in the terms of trade to offset the beneficial effect of expansion and reduce the real income of the country.

As I understand, the primary conditions under which Bhagwati’s conclusion holds qualitatively stated are for countries:

  • That have market leadership on the international market.
  • Has experienced heavily export-biased growth.

Bangladeshi export of cheap garments are a forceful example of both predications. Like all other economic theories, immiserization of growth is not binary. For some increase in export-driven output, the nominal increase in income outweighs the deteriorating terms of trade and hence elevates real wages and standards of living.

However, Bhagwati here details an effect which may be framed as a countervailing tension between two abstract poles. Indeed, few of us will suggest that Bangladesh today is in a position where the marginal increase in export revenue is decreasing its real wage rate: but we may say that it is closer than most countries to reaching this threshold, and hence a fall in exports per se may not be as damaging to employment as Bhagwati has suggested in this recent column.

Another, more readily plausible, theoretical challenge emerges once we consider that it is unlikely international garment markets are perfectly competitive – at least not at the national level. (That is, the fact that within Bangladesh it might be difficult for firms to earn supernormal profits speaks little of competitiveness across borders with China or Cambodia). This is a critical assumption that Bhagwati only implicitly acknowledges. Rather, Bangladesh has both a natural and strategic comparative advantage in the garment market. The former derives from labor intensity and a previously untapped female labor market. The latter – very important here – from the specialization of international supply chains and infrastructure around a Bangladesh-dominated garment market.

To the extent that Bangladeshi firms – as a group – earn supernormal profits from this uncompetitive and scaled enterprise, the idea that slightly higher regulations will provoke disemployment is unfounded. Since such profits are ipso facto elevated from the level at which firms would keep all factors of production in their current use, it is difficult to accept that artificially, but minimally, inflated unit-labor costs will reduce output or exports.

Finally, an adaption of basic public choice theory suggests better working conditions need not fall on factory owners. Mancur Olson’s famous “dispersed costs, concentrated benefits” explains the preponderance of wasteful farm subsidies across the developed world. Let’s consider a converse of “dispersed benefits, concentrated costs”. Americans have thoroughly benefitted from extremely cheap garments resulting from similarly cheap labor. Let’s say this consumer surplus comes at the “cost” of better, basic safety in a Bangladeshi factory (I don’t like this terminology, but that aside). A regulation that increases Bangladeshi unit-labor costs represent a much higher percent of Bangladeshi incomes than the resulting fall in garment costs – accounting for rents accrued – helps the American consumer, especially accounting for the vastly higher income across the sea. That is to say, garment costs are a relatively small percent of American expenditure, and the change thereof is more irrelevant still. The elasticities of this relationship suggest incidence of basic regulation falls on interim rents and American consumer surplus, rather than employment of Bangladeshi workers, so long as the American government uniformly requires such working conditions for all countries and not just Bangladesh.

At this point we’ve established, from fairly standard theory, that a) there may not be an increase in unit labor costs, b) such a rise may not cause a fall in export-driven output, and c) such a fall may not precipitate a proportional fall of living standards. Bhagwati must believe, then, that none of the above hold true and this would be an extraordinary claim. At least the answer to the debate isn’t as clear cut as the Financial Times column suggests.

There are also practical benefits to an America requiring higher working conditions for exports from all countries. The current foreign aid model, with apologies for Jeffrey Sachs, is rife with corruption and rent-seeking behavior that is better overcome with a market proposition. This is to say that the United States can stratify various countries by bands of development and require a slightly increasing quality of working conditions – up to a reasonably sane point – by band. That means China faces more stringent restrictions to be eligible for an American export market than does Bangladesh.

Let’s say we do this instead of funding the humanitarian-industrial complex of foreign aid. That destroys a market fundamentalist argument, which is “factories will just go to China which has far higher productivity [output/hr] than Bangladesh”. Unfortunately, countries with higher productivity requirements will likely be at a farther stage of development and hence face more stringent requirements.

Rather than unfairly giving random subsidies to certain countries, the poorer countries will be allowed to develop by facing a lower protectionist standard – with fair minimums and maximums – than their richer brethren. Foreign aid works because its “effective” disposal requires no market power, hell I can remit some money to India too.

On the other hand, few countries have the market power to successfully levy international restrictions – counterintuitively, as I suggest, a more market-oriented proposal than the alternative of foreign aid. The United States is one of the few countries, especially in concert with the European Union and Australia, that commands a sufficient share of the import market to increase worker welfare through such means. Indeed it means that America must hold itself and Europe up to the highest standards so as not to provide our unions an unfair advantage, as Bhagwati worries.

This post isn’t about Bangladesh. It’s about the importance of considering alternative methods of guided development that may seem, at first approximation, paternalistic are, on second thought, fairer to international markets as a whole. Bhagwati’s own theory provides fertile ground on which to question the rather uncritical statement that any and all regulation will increase business uncertainty, curtail investment, and increase disemployment.

We should not overreact because  a building burned or fortress crashed. Rather, we must rigorously evaluate our currently flawed method of development. This, I suggest, is a golden opportunity.

There’s a Version of “Libertarian Populism” That Might Work: It’s Called “Libertarian Elitism”

July 23, 2013
the Economy: Home and the World
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Nick Gillespie from Reason.com recently thrashed Paul Krugman’s remarks on the hot topic among the Republican intelligentsia – “Libertarian Populism”. As described by Krugman:

The idea here is that there exists a pool of disaffected working-class white voters who failed to turn out last year but can be mobilized again with the right kind of conservative economic program — and that this remobilization can restore the Republican Party’s electoral fortunes.

Gillespie cites a rather excellent column from Tim Carney suggesting that libertarian populism is not only viable, but also necessary. Unfortunately there’s a big problem with this theory. By the time intellectuals like Carney chip away at the idiotic kind of populism they dislike – known to some as “social conservatism” – we have a whole different beast altogether. It’s called libertarian elitism.

Here’s the rub. People like Carney and Gillespie, both of which write in publications frequented by decidedly elitist characters – can get all riled up about those awful farm subsidies and that are pumping corn oil through our stomachs. Or about corporate welfare which is basically a fancy term for legalized corruption. Or about bad immigration laws. In fact, they can even enlist support from liberals like myself about the excesses of wasteful government.

Except corn subsidies cost an average American a mere ten dollars a year. Except every poor, working-class white guy is convinced Pedro is going to take his job. But Carney has already anticipated my comment:

Also, offer libertarian policies that have acute benefit to the working class, such as drastic cuts in the payroll taxes. Maybe let people buy whatever kind of light bulb they want. Don’t force them to buy health insurance. Allow them to buy prescription drugs from Canada.

Unfortunately, this isn’t true. Payroll tax cuts are supported by liberal Keynesian elitists like Paul Krugman and Brad DeLong to libertarian elitists like Scott Sumner or Bryan Caplan. It’s not like this is a new or uniquely populist position. And then ask yourself how much your run-of-the-mill working class white cares about the individual mandate, energy regulations, or prescription drugs? Sure, most polls say that people don’t like Obamacare. But they sure as hell doesn’t think it’s the biggest thing holding  life back. Polls tell us he’s most worried about jobs, wages, and retirement.

The libertarian populist wants to imagine the hard-working man who comes home from a job worried about electricity and gas prices from liberal environmental regulations and a Barack Obama pilfering moolah from the middle to the connected elite. You might say that this man is ideally unideal.

But actually the ironic consequence of deep inequality and political divide is most Americans – aside from those of us with our ear to the news – don’t care about corporate welfare and Obamacare. Maybe Fox News has convinced them that the individual mandate is the root of all evil on Earth. But given an Obamacare repeal or a steady retirement he would surely choose the latter. Given a choice between freeing trade and a protected labor market at home he would surely choose the latter.

You can have no libertarian without having elitist. I mean take a look at what Gillespie says:

Unsurprisingly, Carney’s libertarian-populist policy agenda has precious little to do with starving poor people to death or stoking white working-class resentment against dusky hordes (Carney is pro-immigration). Unless by dusky hordes, you mean Wall Street banksters and well-tanned pols such as Speaker John Boehner.

For better or for worse, it’s filled with prescriptions such as “cut or eliminate the payroll tax” (that’s the one that hurts low-wage earners the most); “break up the big banks and/or place stricter safety and soundness rules on them” (hmm, how does that help the Rothschilds again?); and “end corporate welfare” (Carney specifically name-checks the awful Export-Import Bank and subsidies to Big Sugar, which both receive bipartisan congressional support).

You know, there was a group of people, I recall, that made their name on “breaking up big banks”. Except they were mostly young liberal hipsters that wore Converse sneakers. Actions speak louder than words, and while the Tea Party rhetoric – especially the stray segments intellectual observers love to capture – may have said a thing or two about the fat cat bankers that isn’t near the primary message of the group. And it’s certainly not what made them popular among working class whites.

Because, as Cory Robin here notes, the populist sort of libertarian – from the mythmakers at Ludwig von Mises Institute in Auburn to the goldbugs at Paul Manor in Texas – cannot be divorced from its old, confederate memory. We are talking about a people who question the value, if not absolutely oppose, the Civil Rights Act.

Gillespie and Carney will try to ignore this line of conversation, because it is a socio-historical dynamic that is orthogonal to their economic persuasion. At the end of the day, the libertarian populist can never make it in the American South without forsaking everything that it means to be a libertarian.

Here’s what the libertarian agenda – rightly – supports:

  • Ending wasteful subsidies like the Farm Bill.
  • Reducing distortive barriers to trade that hurt, yes, the average American.
  • Freeing borders to immigrants: high skilled or not.

Except none of that appeals to the working-class white. As Carney puts it, a cunning politician might be able to coat it in attractive “campaign fodder”, but in the short run they don’t really give two hoots about trade liberalization and corporate welfare. The Ghost of Richard Nixon teamed with the Ghost of Mancur Olson spellbinds America to the point where only the ugly sort of populist can ever win the crevices of the South.

The libertarian may find his reaping ground among educated – otherwise would-be liberal – college graduates with a quiet Galtian complex. But they have no place in an America too poor to save for emergencies or retirement. After all the populist is angry that liberals are debasing the sacred American greenback harming the humble saving man. But of what savings?

Radically Centrist Education: A Thought Experiment

July 22, 2013
the Economy: Home and the World
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This one’s heavy on the “radical” and light on the “centrist”. 

I knew I had a bit of Marxist in me somewhere. There are remarkably few instances where elimination of private services can have any benefit. Some recent (broadly unrelated) findings from Raj Chetty, Nathaniel Hendren, Patrick Kline, and Emmanuel Saez, to me, suggests otherwise. But I’d argue my following proposal for education reform is also sufficiently centrist as – given certain important caveats – it will heavily diminish the Department of Education’s driving mandate.

Consider a country where the federal government didn’t fund any educational institutions. It levied no redistributive taxes to help the poor catch up with their richer brethren. We could well be living in a night watchmen state. It did, however, institute one law: private education is banned at the primary and secondary level, and federated states must randomly allocate children into schools across a reasonable geographic distribution. Another way to think about it is all privately established institutions (aside from a select, grandfathered few) must offer entry by lottery (this would also deal with a few adverse selection effects of which I speak later).

Socioeconomic cohesion is a natural argument in favor of this proposal. But the potential upsides run a little deeper than that. Take a very divided city like Chicago, with a rotting inner-city populated by blacks and gentrified suburbs with private and what-might-as-well-may-be private schools catering to the affluent. In Chicago, like the United States around it, the merely middle class and affluent do remarkably well. In fact, for families earning over $50,000 – a healthy, but definitely not incredibly high, sum – Americans are amongst the most educated internationally, contrary to stereotypes otherwise.

Lagging education in America derives largely from a large number of poor immigrants and a historically impoverished underclass. (Apologists of our system rightly note that adjusting for ethnicity, Americans are the amongst the best-educated youth in the world).

Here’s the immodest proposal. We know that middle class and affluent schools are doing something right. We don’t know what, and we certainly haven’t been able to export that know-how into success at the inner-city and rural areas. Throwing money, by itself, hasn’t helped either. There’s good reason to believe a lot of it has to do with community engagement which thrives when parents can afford to take a lot of time off to hold the school accountable, and have the confidence to fight against a bad administration.

But let’s say all kids in Chicago were randomly allocated to a school within suitable distance – long enough that rich kids might have to go to poor areas, and vice-versa. The large number of affluent plus families in the area would be compelled to ensure all schools are up to snuff, lest their poor kid end up in a bad program.

This might mean that the rich would voluntarily raise property taxes to finance local education – because private schools are illegal it’s, to their chagrin, the only way to increase financing. It might also mean that schools cut back on wasteful or unnecessary programs. Whatever the case there’s little reason to believe resource scarcity will be a serious problem in a country as rich as the United States.

Because public education is a very localized process in the United States, we might say there’s a “wisdom of the market” that lets good schools succeed. That is to say we don’t know exactly what they do, but if we align those with resources to the right incentives it’s not hard to replicate. We can bank on the fact that America’s extremely successful upper middle will never let their children go to a shoddy school. Today, because richer districts pay well and offer better working conditions, the affluent schools also crowd out the labor market for teachers leaving less motivated and competent teachers for the poor. This proposal would paralyze that competition.

The big caveat is that if states randomly allocate kids across a narrow geographic area, adverse selection processes will compel the rich to select themselves out into their own little cove to a greater extent than today. This isn’t a light issue, but there’s no reason to believe that geographic residence “markets” are perfectly competitive and that people want to gentrify beyond a certain extent (the allure of living in exclusive neighborhoods is probably as conspicuous as it is utilitarian).

We haven’t seen high taxes in richer, bluer states like New York – Rick Perry’s Texas campaign be damned – drive out the best and brightest. In general, it’s a lot easier to move within a locale than between locales, and the evidence that we might have broad, cross-regional assortative effects is extremely weak. (Otherwise California and New York would be poorhouses, by now).

I think this would elevate educational attainment and lower expenditure as a percent of GDP, at the same time. Aside from paying teachers more – which richer districts do quite well – a lot of the money we’ve thrown at education has been for naught (many, much poorer, countries do better for the poor than we do). By getting government out of any and all educational subsidy, the random allocation mandate would force an efficient utilization of scarce resources – something that economists would love.

Naturally, this is a truly radical proposal that murders any resemblance to our deeply unequal, yet government-dominated, educational system of today. I’m not even sure I support it but, given a few caveats, it could offer important insight into making education work. It’s a deep abridgment of personal agency and liberty. But it’s also liberating. Whether we like it or not we live in a society with a strong government omnipresent in most activities. It’s unclear whether this is any the more illiberal than taxation or regulation, but it has potentially grander benefits.

Wealth Taxes and Immigrants

July 21, 2013
the Economy: Home and the World
8 Comments

Tyler Cowen’s new column for the New York Times concerns the rising wealth-to-income ratio in rich countries, and the opportunities thereof. While you’ll always find a lonely voice calling for wealth taxes, economists have largely ignored the possibility for the greater part of the last fifty years considering the strong theoretical challenges they pose. But as Cowen notes, the divergence between capital and income has become too remarkable to ignore: that agnosticism to this dynamic is no longer an option.

This is a long conversation, but I want to highlight something that very few (if any, aside from legalese) have mentioned as a positive to taxing wealth instead of income: its effect on skilled immigration. Indians, as an annual ritual, open the pages of The Hindu to see offers made by American giants to IIT “toppers”. Last year it was Facebook at over $100,000.

This is to say that if skilled wages in India aren’t already at parity, they will be rapidly. This isn’t surprising, educated and entrepreneurial folks are far more geographically mobile, and we would expect factor price equalization to occur more rapidly. Anecdotally, mid to senior management level positions also seem to pay almost 80% of American salaries.

Immigrants very rarely have any wealth. Those from developing countries might be entitled to old land, but by and large not much more. In this sense, income taxes are deeply inegalitarian compared with wealth taxes. We’re essentially putting the high-income, but poor, immigrant on the same level as established families with inordinately higher net worth, but a similar income.

This is economically, and depending on your justification for taxation morally, inexpedient. The most probable form of wealth taxation is likely to take the form of imposing the necessary wealth tax only after a relatively high entry level. For example, I’ve shown that it’s possible to eliminate much of the income tax with a wealth levy on estates greater than $250,000 in value. This addresses a bulk of the standard economic argument against wealth taxes:

  • An overwhelming number of Americans don’t have near $250,000 in wealth, and most live paycheck to paycheck. Since the $250,000 barrier is out of reach, there will be no real disincentives to save (and can hence be glued with a progressive consumption tax to encourage savings).
  • Those that do “qualify” for the tax are likely to have a relatively low marginal propensity to consume anyhow.

If a wealth tax replaced income taxes, it basically tells high-end immigrants “please come over, we won’t tax you immediately”. No doubt, skilled programmers (especially those with six-figure starting salaries) will eventually be subject to wealth taxes – whether they start at $250,000, $500,000, or likely even more – but not the second they get there. It’s basically an affirmation of the stereotypical American dream “we’ll let you make it before we tax you”.

There are many high-end immigrants today wondering why they should go to the United States (forget Europe) for marginally higher salaries, only to be taxed at relatively high rates, when they can stay home – where they have land wealth and family – instead.

Over a period of the immigrant’s lifetime – especially if he or she is successful – there’s a good possibility a wealth tax will extract more revenue. But this is deferred to the future. Hyperbolic discounting will attract many young, high-potential but poor immigrants to come today. At six-figure incomes if national, state, and local taxes eat between 30 and 40% of my salary in Silicon Valley that – whether liberals like it or not – is a disincentivizing factor. And not one in America’s favor.

Now a small detour on the moral case. A common justification for taxes is thus:

  • It is necessary for social rebalancing and investment in infrastructure, education and, when applicable, war.
  • It is the “repayment” for “using” social infrastructure as manifest in schools, roads, and employment opportunities.

But immigrants haven’t “used” American public education or services. In fact, foreign institutions have subsidized their education, only for the taxes to be paid in the United States. This weakens the moral justification for income taxes insofar as immigrants are concerned. Wealth taxes are immune from this critique, as buildup of wealth from saving in the United States represents the extent to which I “used” American services to earn that wealth.

Much of this argument can be extended to high-earning individuals originating from low-income families. It seems unfair – at least initially – to tax the “rags to riches” engineer at the same rate as we do the blue-blooded investment banker (or, for that matter, the blue-blooded engineer as we do the “rags to riches” investment banker). There’s a pretty deep lack of recognition that wealth plays an important socioeconomic role.

There is a lot to be said about progressive taxation. And there’s reason to believe in certain circumstances a wealth tax is preferable given behavioral idiosyncrasies with respect to the discount rate. To the extent we pride ourselves as the nation of immigrants or – more importantly – the “American Dream” it’s important we consider this dimension of the conversation.

Money Printer General: Larry Summers or Janet Yellen?

July 18, 2013
the Economy: Home and the World
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That’s the debate of the moment, folks. Evan Soltas tells us Brad DeLong and Miles Kimball – both accomplished Summers’ colleagues and collaborators – think he’s the way to go. Matt Klein, also for Bloomberg, thinks Larry Summers’ bet on interest rates in 2004 disqualifies both his competence and humility. Barry Ritholtz thinks Summers’ pro-dergulation politics were a train-wreck and would prefer “anyone but Larry Summers”. Whatever the case, I’m sad this debate doesn’t include Christina Romer, but I’ll bitch and moan somewhere else. (Edit: Actually, that’s a lie, I want Paul Krugman. And a billion dollars, too).

The debate (as stated by others) can be captured almost totally by this matrix:

Larry Summer Janet Yellen
Pros Dominating, cutting brilliance, superstar Monetary credentials, dovishness, brilliance
Cons Dominating, unflinching, arrogant, deregulator Not dominating, not an alpha male

A few months ago, I wrote that Janet Yellen has the edge. I wrote that Larry Summers had what Walter Isaacson said of Steve Jobs: a “reality distortion field” – an uncanny ability to use his rhetoric and excellent debating skills to bend those around him to his view. Much of this view is informed by Ron Suskind’s Confidence Men, what everyone epithetically says of Summers – he is beyond human brilliant – and a personal experience.

I was once (not all too long ago) in a very small room, with a very small number of people and Larry Summers was at the center. I think it was off the record, or something to that effect, but it was basically Larry Summers vs. 2007. I entered that room with Inside Men fresh in my mind. But I left with an unmistakably altered view, both on the man and the matter.

Suskind tells us he had a similar effect on Obama. But when I wrote that Summers’ dominating presence was overrated, I thought that Ashok Rao and Barack Obama were very different from the Open Market Committee. We were educated lay people without PhDs in economics. I’m also sure I can convince someone sufficiently dumber than myself that austerity is a good thing. That doesn’t mean shit. I firmly believed that Larry Summers would face far stronger competition – from Yellen included – in the hallowed halls of Harvard the Federal Reserve. I wrote:

So clearly I think Summers is a gifted scholar. For one, it’s kind of funny Yellen’s experience in the central banking system is taken as a bygone conclusion, with far more emphasis on Summers’ “intellectual leadership”. The question is “to whom”. You take a few smart and relatively well-educated people. You put Larry Summers and Janet Yellen in a room with them. There’s probably a very good chance Summers would come out as the “more impressive” character.

But you take two, highly-competent economists, and I’m willing to bet they’re equally confident in Yellen’s intellectual leadership. Now let’s actually talk policy, for a second. I won’t dwell on this because Yellen’s monetary credentials have been discussed in great depth for a while. She’s the rare Fed Official who actually seems to realize that inflation targeting is a disaster, and has endorsed a nominal spending target in all but name. (Christina Romer, my preferred option, has explicitly supported the same).

Miles Kimball tweeted me that I underestimated how much Larry Summers can dominate a room of economists. Based on what I know, I can’t help but doubt this. But Kimball and I agreed that I probably face a severe selection bias exposed mostly to the econ bloggers who are decidedly firmer in their beliefs than the median economist. And Summers’ ability to sway the FOMC is something both Kimball and DeLong cite as Summers’ relative strength to Yellen, and I’ll cede to that judgement.

But I can’t help but worry about the trajectory of this conversation. There’s basically no talk of Larry Summers’ monetary policy beliefs (and he even mentioned in passing something funny in the Financial Times about low interest rates and bubbles. Ugh.) That’s because the pro Larry Summers crowd writing op-eds are insiders. Brad DeLong is a frequent collaborator, Miles Kimball a colleague, and Ed Luce was his former speechwriter. Miles Kimball tweets me “I would expect Larry Summers to have similar views on monetary policy to those expressed by @delong on his blog”.

But I have no basis on which to understand that expectation. Perhaps I’m not privy to privileged information among elite economists. Maybe I just don’t know Larry Summers’ beliefs well enough. Whatever the case, I have no way of forming an opinion on what Larry Summers will do as a Fed chair. Sure we know that he’s expressed discontent with certain aspects of financial regulation, but it’s unlikely his private beliefs are unrevised. And what about his position on the zero interest rate policy? Quantitative easing? Nominal income targets?

On the other hand, while Larry Summers might be a academe-political superstar, Janet Yellen is a monetary genius. I think I sum it up well here:

It almost goes without saying that Yellen is far more established as a academic and policymaker insofar as monetary policy. All we need is a quick Google search to see the extent to which this is (perceived to be) the case. As former Treasury chief and NEC chairman – and in general a brilliant academic – Summers is the more eminent personality: yielding 6,310,000 search hits to Yellen’s 467,000.

But change the query to “[Larry Summers/Janet Yellen] monetary policy”, Yellen comes ahead at 206,000 to Summers’ 131,000. Now I’m not suggesting this is a particularly smart way to judge scholarship on a subject, but it gives a very visceral sense of Yellen’s online footprint insofar as monetary policy is concerned. Moreover, Yellen’s hits are almost entirely pages that are really concerned with relevant policy.

Deriving from his comparative fame, even Larry Summers’ “monetary policy” search hits are of no relevance. At the top are links to his Wikipedia entry, a brilliant profile comparing Larry Summers and Glen Hubbard, something about healthcare, and firelarrysummers.blogspot.com. Now please don’t get me wrong. Summers’ is probably one of the smartest economic policymakers alive today and would make great choice for central banker. But Yellen’s history and deep erudition in this subject – as well as a functioning understanding that “full employment” is 50% of the Fed’s mandate, not just scribbles on a paper – are unquestionably in her favor.

Larry Summers has without doubt engaged in private deliberations to which Barack Obama is privy. That means, ultimately, I have to resign my opinion to Obama’s judgement on monetary policy. History tells me this is not good. To the contrary, I know with excellent confidence that Janet Yellen knows her monetary policy, and rightly believes that dovish expectations will lead to higher employment. I even think she secretly supports a nominal income target.

Google “Larry Summers monetary policy” – tell me what you can get.

The asymmetry of this debate has shifted the conversation entirely from concrete monetary positions – on which I can inveigh my unsolicited opinions – to a sidebar about personality. I’m sorry but that’s just not the most important thing for a Fed chair. We’re not talking about a Treasury Secretary embroiled in politics, here.

And that’s why this conversation still gives Larry Summers the edge. When it comes to personality, academics tend to like the cutting alpha male. Genius associates itself subconsciously with everything Larry Summers represents. But the discussion on policy is vacuous. It’s taken as a foregone conclusion that his good analytical command implies that Larry Summers will follow the right monetary policy. In 2005 I would have said the same thing about Ben Bernanke – the analytical god of unconventional monetary policy. Come 2013, I don’t think Bernanke has lived up to his mandate, and many of us have updated our priors.

That said, I think Ritholtz, Klein, and friends levy an unfair criticism of Summers. It’s always something about his choice of deregulation, or a bet he made at Harvard. Unfortunately one micromotive (an interest rate swap) correlates nothing to his macrobeliefs. That he’s “pro Wall Street” says little of his command of monetary mechanics. That he’s arrogant says nothing of his private maturity in leading the world’s most important institution.

Here’s a heuristic. Larry Summers has – for many people – been a hated man for a long time. But the criticism this time is just a carbon copy of everything that’s been said before. You would expect that there would be specific concerns for a specific job. But there aren’t.

That’s a two way street. The pro-Summers commenters also offer little in his support that couldn’t have been said in service of his appointment to the National Economic Council in 2009. That says a lot about the ambiguities of the rhetoric in his favor, and we need more recognition to this effect.

Larry Summers is an arrogant, Bob Rubin acolyte? What is new? Larry Summers is a brilliant man and an even better debater. What is new?

I would rest easy that we can’t go wrong either way, but I do not trust Barack Obama’s monetary acumen.

The End of Employment? Yeah, Just Like “The End of History”

July 18, 2013
the Economy: Home and the World
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Brad DeLong sends us to another hush warning about mass disemployment and future inequality, this time from the excellent Jim Tankersley. As frequent readers know, I don’t think we’re in for some techno-dystopian future and, while I fall on the right (ish) side of Marc Andreeson’s dichotomy – “The spread of computers and the Internet will put jobs in two categories: People who tell computers what to do, and people who are told by computers what to do.” – I think there’s a lot of cognitive dissonance in this conversation.

Let’s be clear. It is theoretically possible – yet improbable – to have either a fall in median standard of living or natural rate of employment. It is, in every way, impossible to have both. Understanding why isn’t all too complicated, and requires only a simple knowledge of supply and demand. Let’s think of the future utopian society operating within a three-class system: unemployed masses, educated technocrats, and the rich capital owners.

Tankersley points to work from Frank Levy and Richard Murnane suggesting that America isn’t in a great position to educate people in the would-be “unemployed masses” to the “technocrats”. That’s a red herring. While in the realistic framework from which they argue – the medium term – more education of the poor is exactly what we need, in the long-run the demand for technocrats is likely to be low.

But let’s take a moment to think what a fall in the standard of living means? Forget my dollar income, for a minute. A stereotypically middle class American derives his high quality of life from free public education, good shelter, incredible consumer choice, copious quantities of food, and access to cheap but effective consumer durables. Americans also enjoy excellent public services like parks, free roads, cheap energy from other institutional arrangements.

Americans own these goods and services  because – by and large – Americans are involved in the production and distribution of these goods and services. (No, not the direct assembly, but most everything else). But let’s say we enter a robot future. (Interlude: have you seen the Tesla factory?) Let’s say minimum wage workers in McDonalds are replaced with wage-free robots and truckers are replaced with automated engines.

The Neo-Luddites tell us that all these middle class workers will overtime be disemployed and hence observe a crash in their standard of living. Notwithstanding the fact that redistribution mechanisms solve this problem (which does not make it theoretically impossible, per se) – this cannot happen. If robots replace workers who are in the service of providing mass market goods – toys, teaching, everything we listed above – that means those goods are being produced, and hence exist. Of course, we get the Keynesian problem of overproduction if for a time period there is excess supply. But if robots keep producing these goods there is no way they will not find their way into the hands of American masses.

Okay, you say, “what if robots don’t keep producing these goods”. When Kevin Drum linked my previous article on Mother Jones, I found all kinds of liberals (a group with which I otherwise identify) telling me that I’m naive for not knowing that the bad capitalists will hog all the robots, that they won’t share their wealth, that political redistribution is impossible, and such. That means the goods aren’t being produced. But let’s say there’s a town – Detroit? – of the “mass unemployed”. If robots supposedly “replace” their jobs and somehow they don’t get the rewards, two agents aren’t just going to sit and go “oh. shit. I’m unemployed. Too bad”.

No. It’s not like the demand for consumer goods vanished. The mass unemployed will create their own economy. That means since I don’t have a car – because of, you know, “robots” – and you don’t have a microwave, I’ll specialize in microwave production and sell you microwaves and trade you for a car. And before you know it, unemployment solves itself, because demand for goods creates a demand for labor creates employment.

Of course, this situation is highly unlikely to arise. There will be some disemployment, but it will not be associated with a falling standard of living. That’s impossible. This situation is unlikely to arise because:

  • It’s sad. It’s like a hark back to an older economy. We should be using robots to consume more, and that should be the dream of every technologist: not the exclusive ownership by a capitalist minority.
  • The first situation, where we have disemployment, but higher standards of living – indeed, “post scarcity” – is more probably. Profitable corporations need a large consumer base. The mass market is the best and, indeed, only such market. While some commenters tell me that “the rich will own the robots for their own uses”, there’s not much profit if all the one percenters create goods only for other one percenters. For one, there would be a huge excess capacity of robots, compounded by the fact that rich people like artisan work. Not crappy, mass-market Tupperware.

The former point is my philosophical belief and I hold it as axiom. The latter has good empirical foundations. The 2000s – a decade of globalization, capital-biased technical change, and rising income inequality – was actually accentuated by a fall in consumption inequality. Over the past four decades, income inequality increased 237% as much as consumption inequality. And even this is just a first derivative of my point, that is lower-quintile consumption increased far more than income. (Many also suggest we overestimate consumption inequality as it fails to capture surplus deriving from the Internet and other free goods).

I think I’ve somewhat convincingly argued (if only to myself) that both a fall in broad living standards – or even a deceleration in the rate of change thereof – is unlikely to be coincident with disemployment. But this leaves open the possibility of either happening exclusive of the other. Let’s consider the first pair, “fall in living standards, but no disemployment”. I think this is the trickiest possibility, because I can’t really see a way in which this can happen, but also can’t see a way in which it’s impossible – outside of political-democratic institutions which, quite honestly, are failing. All I can argue is that technology is definitely going to increase the consumption from the wealthy which almost certainly will translate into higher wages – if at a far, far lower rate – to the poor. A decrease, or even stagnation, then seems improbably: just a substantial disconnect between capital and labor.

The second case, “disemployment without any fall, and perhaps even increase, in living standards”. Everyone fears this. But we think about unemployment in the narrow sense of U3. But Americans are one of the most “overworked” countries in the world. We’re the richest country not only because of our incredibly high “output per hour” [productivity], but also just “hour” [work ethic]. This works well for some people. Doctors who slave it out as residents and then earn a criminally-unfair killing later in life. (Oh what I’d give to replace every damn doctor sucking money from the American middle class with a robot!)

But think of the single mother working two jobs just to have heat in the winter. Disemployment without a fall in living standards will do her well. She can spend more time with her family. In a previous iteration of this post, I wrote that we’d have a “cornucopia of thought”, or something. I still think I got the principle right, but I was fairly bashed by a bunch of readers for being an idealistic idiot. (“Not everyone has a high IQ”, etc.) Regardless, there are a plethora of studies showing engaged parents are crucial for someone’s future success, in society as well as in the economy. Today this works in advantage of the affluent (if not the ultra-rich). But in the future I do hope that a middle class worker can live very comfortably on 6 hours of work, getting more time to spend time with his family – whether reading books or at a barbecue – and sleep, relax, and ponder. Oh shit I’m getting “idealistic” again.

That’s not to say that economic mobility or condition for the poor in America today is anything great. Only that a sharp fall, or even an absence of elevation, of living standards is very, very unlikely. That is the fundamental dissonance inveighed by the anti-technologists. They assume a utopia in which robots provide everything, but at the same time a dystopia in which they provide nothing.

“The Signal and the Noise” by Nate Silver

July 7, 2013
the Economy: Home and the World
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Subtitled “Why so many predictions fail – but some don’t” Silver’s book is probably one of the only good “pop” statistics book out there. Silver has an engaging style that keeps even the informed reader alert, and brings philosophically profound concepts – like Bayesian reasoning – to the lay man. I put “pop” in scare quotes because I want to deter immediate comparisons to Freakonomics or Blink. In the sense that the book is written by the veritable master of a field – rather than engaging writers dabbling in curious, mind-bending topics – I’m more inclined to compare Silver with Thomas Schelling in Micromotives and Macrobehavior.

As this book has been thoroughly reviewed, I want to frame my response in the context of remarks from Kaiser Fung, Cathy O’Neill, both through a post by Andrew Gelman (who, at least as far back as December last year, had not read the book).

In short, the book is an investigative journey through fallibility of human prediction: from economics and earthquakes to the environment. The thesis is at its core hopeful; and draws a silver lining to human error in the form of: humility, doubt, and above all Thomas Bayes. But he never sells any such heuristic as a panacea to chaos and uncertainty, and is himself very measured about his promotion of a metasolution. I would say he follows his own rules on his 450-page forecast for forecasting.

Since I’m overall very positive about the book, let me start with the cons. Fung (and many others) note that Silver does a wonderful job bringing attention to the Bayesian worldview. They go on to suggest he might have oversold the concept; I see it in another way. He knows that most statisticians would be furious if he started with the tautological identity “p(a|b) = p(a)*p(b|a)/p(b)” which in its simplicity, to a lay person, desalinates Thomas Bayes’ philosophical leap into sterile mathematics. But he takes the abstraction a little too far. While we see the extended formula – through a women updating her priors that her husband cheated – there’s next to nothing in an explanation of why it is the case (we never see the simple form, or hear about the Law of Total Probability). In fact, I’m not sure that removing every reference to Bayes would take so much from his thesis – as the idea of “updating a prior” is not, per se, contingent on probability.

For a book that purports (and for the most part does) tell us why the ghost of Thomas Bayes’ rules the world, the dearth of precise explanation into the mechanics is damaging. Indeed it is crucial to understanding why holding (near) absolute priors makes further revision against evidence (near) impossible which indeed is the bane of every failed forecaster.

Another minor quibble – which is in all honesty dominated by Silver’s clarity and style – is the book doesn’t at all times feel very “together”. With the exception for a few stray remarks, each chapter can be read independently of another as they each tell the story of forecasting in a wide range of disciplines. The story behind Bayes’ is then relegated to Silver explicitly reminding us of its power rather than a natural flow throughout. Again, this is minor and included mostly so that you form a prior in favor of my impartiality!

Let me start with O’Neill’s review. The analytical counterpart of missing the signal for the noise is loosing the forest for the trees (or twigs), and I think accounts for a large part of the review. Don’t get me wrong – I respect her and love her blog – but I just can’t understand how O’Neill concludes that “Nate Silver confuses cause and effect [and] ends up defending corruption”:

The ratings agencies, which famously put AAA ratings on terrible loans, and spoke among themselves as being willing to rate things that were structured by cows, did not accidentally have bad underlying models. The bankers packaging and selling these deals, which amongst themselves they called sacks of shit, did not blithelybelieve in their safety because of those ratings.

Rather, the entire industry crucially depended on the false models. Indeed they changed the data to conform with the models, which is to say it was an intentional combination of using flawed models and using irrelevant historical data […]

In baseball, a team can’t create bad or misleading data to game the models of other teams in order to get an edge. But in the financial markets, parties to a model can and do.

This just doesn’t make sense to me because Nate Silver a) shows that the models are so ridiculously stupid that a child could find their flaws and b) accepts that Wall Street financiers are smart. The only conclusion thereof is the only reason to keep playing fool to these models is to “keep the music playing”, so to speak. No sane reader could finish the first chapter without feeling disgust towards the rot in the financial system. Nor is Silver happy about the bank bailouts that let AIG get away with murder and more.

The purpose of chapter one wasn’t even to “excuse” finance in any meaningful way, just to explain the fallibility of human models and, yes, exuberance. Silver is explaining why the models suck. O’Neill is getting angry that people were using models that suck. It’s not like his “expertise” in finance is – in writing a layman’s book – any less than his intuition of earthquakes or the environment, so O’Neill’s dismissal of his knowledge seems unfair. Especially divorced from the point of his book, which has nothing to do with finance to begin with. Reading the review, one may not be so sure.

Anyway, Silver’s basic point seems to be the criminality of using bad models, and having confidence in their success – so tautologically it seems he hates the way Wall Street worked. I get the feeling O’Neill wanted him to bring his emotions, and other completely irrelevant topics into the discussion thereof, but that misses the point of the book entirely.

And I’m not sure about how other readers feel, this is up to interpretation and I fully believe that O’Neill got this sense, but for what it’s worth I don’t think this is right:

I’m not criticizing Silver for not understanding the financial system. Indeed one of the most crucial problems with the current system is its complexity, and as I’ve said before, most people inside finance don’t really understand it. But at the very least he should know that he is not an authority and should not act like one.

Personally, I never got the sense that Silver was an “authority” in the field, nor did he ever claim to be. Again, a lot of this is up to subjective reading, but I can’t see how someone can reach this conclusion concretely; especially when the chapter is merely an introduction to the way in which models can be used in the real world. Much of his explanation of the failures even derive from a professor at the University of Chicago who teaches a course on the financial crisis; a veritable expert. I can’t help but feel that O’Neill and others feel distaste from the start because Silver introduces Larry Summers without a string of qualifying epithets.

Though of all the subjects discussed in the book, economics was the most familiar. (Which is not saying much for a kid right out of high school, to be fair). And perhaps not surprisingly, I did have the most problem with his discussion of economic forecasting, particularly predicting recession: Chapter Six – “How to Drown in Three Feet of Water”. He mentions several times that professional forecasters failed to predict recession as a serious possibility even after the United States officially was in a downturn and considers this mostly as a flaw of overconfidence or bad modeling; much in tune with the rest of his book.

But I think there’s a disservice in not considering the epistemological impossibility of forecasting recession, quite to the contrary of this passage:

In September 2011, ECRI predicted a near certainty of a “double dip” recession. “There’s nothing that policy makers can do to head it off,” it advised. “If you think this is a bad economy, you haven’t seen anything yet.” In interviews, the managing director of the firm, Lakshman Achuthan, suggested the recession would begin almost immediately if it hadn’t started already. The firm described the reasons for its prediction in this way:
“ECRI’s recession call isn’t based on just one or two leading indexes, but on dozens of specialized leading indexes, including the U.S. Long Leading index…. to be followed by downturns in the Weekly Leading Index and other shorter-leading indexes. In fact the most reliable forward looking indicators are now collectively behaving as they did on the cusp of full-blown recessions.” There’s plenty of jargon, but what is lacking in this description is any actual economic substance. Theirs was a story about data – as though data itself caused recessions – and not a story about the economy.

Silver gets one thing absolutely right. This ECRI firm seems to be staffed of knaves, fools, and worse: a stupidly overconfident chief. That said, Silver’s dismissal of the emphasized text shocked me: because that is precisely the reason a recession is impossible to predict.

Now, Silver agrees that the best forecaster is one who gets it right. Rationally, the goal of any good forecaster is to be trusted and serve as an important source of information for clients. As far as economic predictions go, the client is of course the free market. Here’s the problem, let’s say I’m a trusted forecaster and I publish a report stating that the American economy will shrink by 4% next quarter. If people trust me, my report will have caused a recession. Why? Because business operations across the country will note that consumer demand will crash in three months, and halt expansions and disinvest from the economy into safer instruments like US Treasuries. The fall in investment will precipitate a contraction of nominal spending and hence aggregate demand. Therefore, the market cannot believe that we are on the cusp of recession without actually being in recession at that point.

Of course, when an idiotic firm makes such a prediction no one will bat an eye, because no one trusts that firm: but that isn’t Silver’s point. I think readers loose a gem of an example here because few times is a prediction so intellectually contradictory as in forecasting a recession. Now, Silver does talk about self-fulfilling prophecies in another context entirely, and notes that fear of an epidemic might result in more precautionary measures which undo such a fear.

But that’s not an epistemological flaw. We can’t possibly know that a recession is coming without actually being in one. Single individuals can, but they can’t be trusted by the market as a whole ipso facto. It’s not self-fulfilling at all, it’s like asking “are we there yet” after you’re in the hotel.

The rest of the book is a smooth ride. Silver consistently packs the book with anecdotes from interesting interviews as well as a slew of useful data, and a trove of fascinating references. I suppose many readers would have been thrilled to learn about Knightian uncertainty in the context of climate change, and was somewhat surprised this was absent, but Silver does a lovely job of coordinating various viewpoints with all the important data there is.

Unfortunately, we can’t have too many books on one topic. That’s why reviewers like O’Neill think Silver – for reasons right or wrong – has done a disservice to his audience. I judge a book not by how good it is; but against how well it could have been written. On careful read, I don’t think Silver misses the gold standard by far. I consider myself to be fairly knowledgeable about these topics, but still learned a ton. Most importantly, this book will (hopefully) inspire a new generation of toy forecasters and model tinkerers to approach the world with a probabilistic mindset and to relish in uncertainty. Because it’s a fun book, and doesn’t sellout on substance to get there. Even if Silver isn’t an expert on finance, he has a unique window into that world vis-a-vis the general public, for whom this book is intended.

Oh, and the most important take away is that KPMG should have fired Nate Silver a long time ago.

Five stars, and I’d be hard pressed to update my prior.