Thursday, October 16, 2014

Nessun Dorma Part 2

A few days ago there was a review by Steven Pearlstein of several books, one of which, “We Are Better Than This” by Edward D. Kleinbard,  I have already ordered from Amazon because of this quote in the Pearlstein review:

“Both our native talents and our good fortune are distributed through processes that we cannot fathom and do not ‘earn.’ Our loud proclamations that what we take from the market is our just deserts is just noise made against the darkness, trying to still the voice inside that asks, why me and not them?”

Yes!!  Exactly.

In my last post I wrote about the limits of information, the fact that because information is widely distributed and always changing, and because human beings are constantly striving and pushing and working toward their own ends, unexpected and unpredictable change is not the rare departure, the “exogenous shock”, that is envisioned by modern model-bound economists, but instead is the steady, constant economic norm.  Because of this shoving and pushing we can’t really make long run economic forecasts, and that the agents in our models cannot predict the future any better than we can.  They can’t know their own futures with any security: all of what I called the “the restless magma of human dedication” is bubbling under them, and it can bury them or it can push them to great heights.  They can’t really know which it will be.  They have to live their lives to find out.

 And that should form at least part of the ground on which our economic models stand; the agents in our models should not be rational agents who trade present against a simplistic future in which all possible outcomes are known to them well enough to attach probabilities to each, because in the real world all possible out comes are not known at all, to anyone, and in small or large ways the future will always be something we haven’t even imagined until it gets here.   I don’t know how to create models like that, but if we want our economic models to depict the way the real world works it has to be done.

And that brings us to a dangling thread that needs to be tied up from my last post.  It ended with the sense that economic models can’t be used to forecast very far into the future.  So we might ask: what good are they?  What are they for?  And this relates to a question that I have to answer from time to time, when I admit in some social setting that I do sometimes read the economic blogs.  People ask: what are they forecasting, what are they saying will happen?  Because, of course, that’s what everyone really wants to know, probably because it’s what no one actually can know.  And I have to tell them: they aren’t.  The economics blogs, and economists in general, usually don’t make forecasts.  Oh, just before the release of some new economic statistic, they’ll play the forecast game about what the new release will say---but that’s actually “forecasting” what has already happened, which is what those statistics report.

So if economists don’t forecast the long run, except for those few courageous people who make their living doing nothing else, what on earth do they do?  Why study economics at all?

The answer, I think, is that that we create economic models for at least three purposes.  First, We should recognize that our simple models are parables only, and like any parables they present basic ideas to help us understand the world we find ourselves living in, as humanity has tried to do for thousands of years.  They help us know how people are able to work together, in a sense as cooperative strangers, in a country or in a culture, or on a planet, to provide (or fail to provide) a good standard of living for everyone.  Perfect competition doesn’t exist in the real world, but understanding how it would work tells us some very powerful things about some of the forces that act on us and around us.  Second, models help us figure out the less obvious implications of assumptions we make, or simple things we believe to be true: by embedding those assertions in mathematics, and in models, we can derive implications that we would never find by just contemplating the assertions on their own.  And third, while we may not know what the long run future will be we know what the present is and what the recent past has been.   We can, if we are successful in understanding something about how the world works, still make strong arguments about what will make the near future in some way better, and even what will make the more distant future better or keep it from getting worse, no matter what its exact features will be.  We can do this in the same way that we can say that providing oil will make your car last longer and run better, but adding too much oil can damage seals.  I can’t really forecast what will happen to your car in the future.  You might run over a nail, or get a dent in a parking lot, or there might be some deeper mechanical problem waiting to emerge next week or next month or next year. But I can make conditional predictions about the impact that certain actions might have: put oil in, or the situation will get worse; don’t put in too much or the situation will get worse in a different way.  Similarly in economics we can make conditional forecasts: policy X will have impact Y.  In my view, stimulus will stimulate, which may be good or bad depending on the situation (stimulus during a boom is bad; stimulus in a recession is good).  Austerity will depress, which may be good or bad depending on your situation.  Investing in infrastructure will make the future economy more affluent, in part by making future businesses more productive and perhaps even more profitable.    In making these predictions about the impact of various policy actions, simple economic models help if they depict something true about the world. And if they depict something false, they may mislead us into policy actions that are dangerous, or outright harmful.  That’s why there are so many arguments about the foundations of economic theory: it matters, and our future welfare depends on finding simple models that are true, and avoiding simple models that are false.

And similarly, in each “agent’s” life, he or she has to accept the fact that his or her future can’t be known exactly, and that the farther away the future period is they’re looking at the less can possibly be known about it.  But we do all care about the future, and so the agent in our models still has to make choices about actions in the present that may impact the unknown and unknowable future.  So the agents have to decide what they believe about the future, and they have to decide what present actions will give them the best chance to prosper, or at least survive.  We may not know what the future will be, but we know we’ll have more flexibility to deal with it if our debts are all paid and current, and if we’ve saved something.  We will be better able to deal with whatever comes along if we are more educated, or we have good friends and a strong family to help us through, than if we aren’t or don’t. 

But no one makes present decisions based on any real knowledge of what their taxes will be in some imagined distant future.  They have no idea what their taxes will be, partly because they have no idea what their income will be in that future, and they have no idea what the whole country’s income will be either: their share of future taxes will depend on both.  People save to give themselves a better future, period.  It makes no sense to build a simple economic model, as, for example, the modern version of Ricardian Equivalence does, that assumes that people save today in order to pay taxes in the future, taxes that they can’t know will ever be imposed, and can’t know, even if the taxes are imposed, what portion of those taxes will fall on them.   That is a simple model that seems to me to be false, and so I think that depending on it will lead us to national actions that might cause actual damage to the future we are trying to achieve.

I once read an interview with a multimillionaire who (of course) was asked how others could achieve wealth.  His very honest response was: “I don’t know”.  But later he did amend that.  He said something like this: “Save your money.  Everyone gets a couple of opportunities in their life.  If you have money saved you have one more tool you can use to pursue an opportunity when it comes.  Who knows?   It might succeed, and make you richer than you are.”

Doesn’t that sound more like the life we all lead than the models that assume we all can calculate our expected futures with mathematical precision?

Friday, October 10, 2014

Nessun Dorma

This post will be long, partly wonkish, and partly just odd.  I have to work up a little courage to write this, because in a way it’s a minor assault on the dominant economic paradigms of recent decades.

I’ve been trying to figure out how to comment on a quick exchange that took place a few weeks ago that included blog posts by Mark Thoma, Simon Wren-Lewis, Paul Krugman, Robert Waldmann and David Glasner, among others. It’s over an issue that has come up before, and which I think will come up again and again over the next few years, because I think we’re at a shifting point in economic theory, partly due to the complete failure of macroeconomists to foresee the severity of our recent mini-depression, and partly due to the disastrously wrong predictions that flowed in rivers from the neoclassical economists about the possible impacts of macroeconomic policies.  Investors will flee from U.S. debt soon, soon, soon!! Hyperinflation is just around the corner!!  Interest rates through the roof!! Austerity will solve all of our problems!!  Really?  Well---no. Not really.  The real world did not behave anything like that. 

The question in this blog exchange is: what the heck happened forty years ago when the old Keynesian economics many of us older folks were taught in school more or less vanished from the journals and conferences and textbooks, and was replaced by rational expectations and neoclassical micro-founded macro models?  In this now forty-year-old counterrevolution to Keynes, macroeconomics starts with agents at the micro level who rationally, with infinite mathematical precision, select a present action that maximizes their overall welfare by trading off their welfare in the present time with their expected welfare in future times.  This trade of present against future is an absolute in these models: it has to be there, or the model is suspect.  All of the bloggers above see this wholesale expulsion of meso-Keynesian theory from the academic respectability as a bad thing, although some seem to approve at least part of the neoclassical vision.  Simon Wren-Lewis, for example, starts by saying that “intertemporal theory is the right place to start in thinking about consumption, and exploring the implications of time inconsistency is very important to macro policy.”  Waldmann disagrees, and to some extent I do too, for reasons I’ll talk about below.  But it was Glasner, whose blog posts are almost as long as mine, who wrote openly and eloquently what I have been feeling for forty years, but was too intimidated to say out loud:

the New Classicals chose to use microfoundations as a methodological justification for the extreme unrealism of the rational-expectations assumption…
Meekly and unreflectively, modern macroeconomics has succumbed to the absurd and arrogant methodological authoritarianism of the New Classical Revolution. What an embarrassment.”

Wow.  And yes, exactly.

There is one point I want to add to the excellent blog exchange from a few weeks ago, but I’ll start obliquely, because it was this personal experience a few days ago that reminded me of it:

From time to time, when I find myself idly staring at the walls in the evening, too groggy to write a blog post or even read one but still too awake to retire altogether, I wander to YouTube to see what I can find.  Usually I’m looking for some kind of classical guitar music, or old acoustic blues, but the column of related videos down the right hand side of the YouTube web site is a grand choose-your-own-adventure book.  Once I lose control and click on one of those links, because it seems to point to something adventurous, I end up spending an hour or two following link after link.  (Be patient.  I know the wait is making you fidgety, but I’ll get to the economics of all this in a minute.)

I try to avoid anything that has the phrase “got talent” in the title; I’m not a big fan of watching people embarrass themselves in public, and that’s what those shows display much of the time.  But every now and then I slip, and end up watching the YouTube versions of a “got talent” performance.  And so, late in the evening, in a quiet and pleasant mood after a glass or two of Sauvignon Bordeaux at dinner, I ran across a video from 2007 of the very first session of the very first winner of Britain’s Got Talent.  His name is Paul Potts.  Since I don’t follow these shows I had never heard of him; maybe you have. 

The performance was astounding.  But I don’t really want to talk about Mr. Potts.  I want to talk about the reactions of the judge named Amanda.  Because the point of all of this is to comment on her description of Mr. Potts once he had finished performing.

So here’s the link.  Take a look, and watch Amanda.

What did you think of her, and how she acted and what she said?  She was clearly enormously moved by him; it was all she could do to keep her eyes dry toward the end.  She had to breathe heavily during the last phrases of the aria that he chose to sing, Nessun Dorma (“no one sleeps”) from Turandot, and finally she had to press her cheeks with her palms to keep the tears from launching from her eyes, flooding the desktop and ruining her TV makeup. I don’t blame her.  Sitting ten feet from a voice like that must feel like standing at the far end of a jetty when the typhoon hits.

And when she said what she said---that he was “a little lump of coal that is going to turn into a diamond”---I could hardly do anything but completely agree.  (I don’t know if you’re an opera fan, but if not, trust me: that was an awe-inspiring performance for a Welsh mobile phone salesman, as you could see toward the end when the entire panel of judges was staring open mouthed at the stage.) 

Later in the video she talks about finding frogs that are going to turn into princes. 

It was not for half an hour, and another few links down the evening’s chain of music---and I admit, a few returns to watch Mr. Potts perform again---that I finally thought: wait a minute.  Turn into a diamond?  He already was a diamond, wasn’t he?   She was visibly moved by the voice he already had, the performance he could already give.  What was she thinking was going to change?  Was she forecasting that his performance that night would bring him fame and fortune, and that those things, fame and fortune, would make him a diamond or a prince?  No.  I don’t really believe that.  I don’t think she had really thought through what she meant.  If presented with this argument, I think she would agree that he might have been a frog at some point, but he had already turned himself into a prince long ago.

Because that voice didn’t just emerge from his mouth that evening by spontaneous generation. Somewhere along the road, probably in his early childhood, he fell in love with opera, and spent long, long hours working at it, working at it, and yes, performing.  He had to have had training, as well.  Lots of it.  Years of it.  He may have been the lead in his high school musical, and sung in choirs, and done some community theater musicals or something, and probably been part of an amateur opera company.  Amateur: for free!  I think the rules of entry to the “got talent” shows is that you haven’t made money with your talent in the past.  But even without being paid for it he sang, and sang, and sang, and trained and trained and sang scales and sang arpeggios, and sang phrases, again and again, to achieve that voice.  Some of the singing was undoubtedly fun for him, but much wasn’t; it was hard practice, and he did it when he was tired.  He did it after long days at Carphone Warehouse.  Doing all of that, and having the driving desire in him to stick with all of that, made him a prince long before he entered “Britain’s Got Talent”.  That show was just the first time the rest of us had been given an opportunity to notice that there was a prince living among us, selling mobile phones in Wales.

And that, of course, is why there are competitions like Britain’s Got Talent: we know that the world is full of things we haven’t seen, and full of people working hard, alone, often for free, to do things that may someday amaze us.  This hidden world of dedicated work is like a current deep under the surface of the ocean, like magma deep under the ground, invisible to us, but moving and pushing until, sometimes, it breaches the surface and changes everything.

Which made me think about the nearly universal assumption in labor-leisure trade-off models that we are all so abysmally lazy that we can only be induced to work by offering us a wage that is worth more to us than our leisure time.  Leisure time?? How do these models explain Paul Potts, and the fact that he worked so hard for so long, working to exhaustion without ever being paid, and training at his own expense?   Why did he do that?  But more relevant to this post, it also made me think about the distribution of information in a market economy and about Hayek and the role of prices, and, yes, about the ubiquitous, insistent use of macro models based on every agent’s ability to rationally, precisely, trade present and future welfare.  If we are all so good at seeing the future, and basing present actions on their present and future impacts, how do we explain the fact that Mr. Potts could suddenly appear in front of us fully trained, a magnificent opera singer?  You understand that in order to form a present expected value of future outcomes we have to be able to define all the possible future outcomes, and attach a probability to each of them.  Where is Mr. Potts in our rational deliberations?  How can we attach a probability to something we don’t even know could ever exist?  Did the price system really convey to us all the information that we could possibly find useful about his existence? 

I don’t mean to dismiss Hayek here; just the opposite.  As far as it goes, his paper is right.  He explained his point very well in the link above.  Hayek was trying to compare a price mechanism in a competitive economy with a central authority that simply imposed an answer.  His point was that the economy is so complicated, and the actors so local, that no central authority could possibly know enough to solve the complete problem of proper behavior, proper production and consumption, by every possible consumer and business, and of every possible resource and product.  Importantly, it’s not just that the problem is too big for us to calculate.  Maybe a bigger computer could fix that.  It’s that the required information is just too obscure and far too widely distributed, and constantly changing.  No individual, and no central authority, can possibly weigh one change against another, and allocate resources to accommodate them all, simply because only the few people involved in the changes are really aware of them.  A price mechanism manages to convey just exactly enough information, if we want to call it that, or enough incentive, so that each local actor everywhere will react in more or less the right way to adjust current demand and supply to distant changes he or she cannot possibly know about, simply because scarcity causes prices to rise, and so induces each actor to use less or produce more, and abundance causes prices to decline, and so induces each actor to use more or produce less of whatever it is.  We never have to know why a scarcity or abundance has happened.

And I agree with that completely---in the instant.  Paul Potts is an opera singer who was hidden from almost all of us until he performed in Britain’s Got Talent, and to the extent that his long solitary efforts to achieve his skill made some resources more scarce or abundant, we, in some infinitesimally small way, all helped to adjust the economy to that change, even though we had no idea he existed.  But we couldn’t predict his skill.  The price mechanism may help us adjust in the instant, but it can’t help us adjust to the long run emergence of something we can’t foresee.

Our inability to forecast Mr. Potts’ skill may not strike you as important.  If not Mr. Potts, then some singer will come along; we can forecast that.  Right?  But Mr. Potts is not the only person out there working from sheer dedication to something, and far from our awareness.  There are people who are inventing new technologies, or new methods, or new science that will change not only what is, but what is even possible; or new methods of attack or destruction (not all invisible change is good).  We may not need to know what they are doing to adjust our consumption or production to materially accommodate them, but when their efforts suddenly thrust their way into our worlds they will transform us.  And because their activities are hidden from us we cannot possibly predict their impact on our lives.  Seemingly from out of the blue one technology is tied to another, the clunky text based internet is enhanced with hyperlinks, and then with a print media markup language, and the World Wide Web explodes into a tech bubble in the 1990s.  From out of the blue an obscure group of discontents across the world decides to use commercial airliners as a weapon of terror, and crashes them into towering buildings in New York and squatty pentagonal buildings near Washington DC, and our political world is transformed utterly.  We can’t possibly plan “rationally”, in the way that many microfoundation-based macroeconomic models use that word, for a future filled with events like these that we can’t predict, at least partly because things from distant places or distant minds, things that Hayek’s paper says we don’t ever need to know about, will appear to us like miracles or catastrophes when they finally reveal themselves to us fully formed.

There are undoubtedly events in the future that no one on earth can predict, at least not yet: acts of God or human genius, sheer incalculable accidents, chaotically emergent “shocks” to our economic system.  But there are thousands upon thousands of events, huge and tiny, that are created by human effort, events that are part of the solid ground of economic life, but that only a few, only those that are working on them directly, can really predict; and because there are so many of them there is no one who can predict all of them.  And because there are so many of them, it’s absurd to act, as the modern models require, as though each “representative agent’s” economic future were stochastic but subject to predictive calculation, and dully reducible to “rational” expectations. 

Defenders of the modern economic faith will reply that the models may not incorporate them, because they can’t, but everyone is aware of the possibility of rare “external” economic shocks---external to their models.  But I’m saying that these shocks are not rare, not unusual, that they are part of the core and constant fabric of economic life, and that everyone who is not steeped and vested in economic theory knows it.  Can we predict 6 months out?  Possibly, unless there is a major “external” shock in the next 6 months.  But we expect to be at least a little wrong, in part because there will, without any question, be a vast array of minor external shocks that no central planner, and no economic forecaster, can possibly predict.  And our forecasts out 5 years, or 10 years, are the best we can do, but they will, with absolute certainty, be wrong. 

Our economics should acknowledge this fact: the general public doesn’t try to make forecasts out that far, because unlike us they understand that it’s an impossible task.  Even those who are working hard on one of these hidden things can’t be sure what the reaction will be, how it will interact with other things happening at the same time, how it will really impact the world.  And they can’t predict what reactions their ambition will cause, creating new ambitions in others.  The world is busy.  Nessun dorma, nessun dorma, no one sleeps.  Or rather, more accurately, we don’t all sleep at the same time; there is always someone awake.  Twenty-four hours a day someone, somewhere on earth, is devoting long dedicated hours to creating a future event, large or small, that will astonish the rest of us when it emerges.  We see the economic surface, but far under that the magma flows, the restless magma of human dedication, for good or evil, presses against the world, and when the world cracks to release it all of our prior expectations are scattered across the ground, and a new future covers them.  And that, among many reasons, is why the perfect-world, rational-expectations, Euler-equation dominated macroeconomics that assumes a stochastic general equilibrium future that we can reduce to a current expectation, simply doesn’t work, and never will work no matter how much we refine it.    Others out there are awake, and moving and working, invisible to the workaday wage economy, and they are creating a future the representative agents in these models can’t even imagine, much less assign a probability to and reduce to some bland “present value”.

Nessun dorma: and for economic forecasts, including the forecasts we attribute to the representative agents that we embed in our models, that ground truth matters.