A misguided attack on Land Value Taxes

The idea of a Land Value Tax (LVT) is to tax the value of land independently of the value of improvements on that land (e.g. buildings, farms, or mines). Separating the value of a plot of land from the value of the structure built on top of it is a very difficult thing to do, since you can't usually observe the value of a piece of land both before and after the improvement is made. This implementation issue is the main problem with the LVT.

Periodically, people make criticisms of the LVT, and they usually boil down to this measurement problem. For example, Zac Gochenour and Bryan Caplan go to great lengths to show that a tax on the value of unimproved land reduces the incentive to search for better improvements. But under a true LVT, improvements would receive a tax credit, which would remove this problem entirely - if, of course, you can measure the value of the improvement. (Actually, in the case Gochenour and Caplan describe, the measurement of the value of the improvement would actually be easier than usual, since you could do a before/after observation.)

Adam Ozimek of Forbes has another argument against the LVT, which he claims doesn't boil down to the measurement problem. But I think his argument is mistaken. Adam writes:

[T]here are a significant amount of spillovers in local real estate investment. Land value is not just capitalized value of publicly provided public goods, but of nearby privately provided positive spillovers. It’s widely recognized that when individuals clean up a property, or open a popular business, there are often spillover values in the neighborhood. Urban economists recognize that the collective value of these spillovers is huge, and in fact makes up a significant amount of land value. 

The fact that private amenities have positive spillovers suggests that they will be underprovided by competitive markets. However, by allowing some of the value of spillovers to be captured, higher land values provide real estate developers, businesses, and even households with incentives to create them. 

The value of unimproved land does increase with improvements on neighboring land. But this does not mean that land value allows a landlord to capture the value of the spillovers created by his own investment. It does not.

Suppose there are two adjacent plots of initially undeveloped land, A and B. A is owned by Andy and B by Barbara. Andy pays for a nice house on plot A. This raises the value of plot B, and enriches Barbara. If no Coasean side payments are made, then Andy fails to capture the value of his investment in the nice house. Barbara gets a windfall from Andy's investment.

Now suppose there is a 100% LVT. When Andy builds his house, he pays no additional tax. But Barbara pays some tax - she pays the full value of the windfall she received from Andy's investment. Andy's incentive to build the house on plot A is unchanged under the LVT. And Barbara's incentive to build a house on plot B is likewise unchanged. 

So I think Adam's critique is just mistaken. 

But, you may ask, what if there is a spillover not to the value of Barbara's land, but to the value of her potential future improvements? Adam raises this possibility later in his post:

Real estate developers who move into neighborhoods with high vacancies, low demand, and high crime are often hoping that positive spillovers from their investment will spur additional investments from others, which will in turn make their investment more valuable.

This is easy to fit into the example above. Suppose the value of a house on plot B is 1.5 times as high if there is also a house on plot A. That's realistic, since a plot of undeveloped land may make a neighborhood less attractive. In this case, isn't Andy overtaxed by the LVT?

No. His incentive to build the house is exactly the same as it would be without the LVT, since without the LVT he would also fail to capture the spillover benefit on Barbara's improvements. There is an uncompensated positive externality, but it's no bigger with the LVT than without it.

In other words, the problem of neighborhood externalities is a thorny one, but the LVT does not make it worse (or better). The big problem with the LVT remains the measurement problem. Of course, that problem cannot be waved away.


Updates

Just to formalize the above intuition a little more, here's the Andy-Barbara example as a 2-person game. Define:

H_A = the value of a house on plot A when there is no house on plot B
C_A = the cost of building a house on plot A
L_A = the increase in land value of plot A when there is a house on plot B
N_A = the increase in the value of a house on plot A when there is a house on plot B
Without loss of generality let the value of a plot of land be 0 when there is no house on the other plot.

Each player decides whether to build a house or not. With a land value tax, L_A=L_B=0. Here are the games with and without a land value tax:

You can easily see that the condition for (Don't Build, Don't Build) to be a Nash equilibrium in the first game is the same as in the second game - namely, that H-C < 0 for both players.

You can also see that the condition for (Build, Build) to be a Nash equilibrium in the first game is the same as in the second game - namely, that H-C+N > 0 for both players.

Therefore, the presence of an LVT won't affect the outcome of which houses get built. This outcome also doesn't change if you make the game sequential.

On a related note, people on Twitter read this post and started bugging me to cite empirical work, which I had previously failed to locate. But I looked again, and this time I found a couple things. For instance, there was a 1997 study in National Tax Journal that examined Pittsburgh's experiment with an LVT in 1979-1980. The study found that the LVT increased building activity. A 2010 study in the Journal of Urban Economics found similar results when examining a number of LVTs implemented in cities in Pennsylvania; not only did LVTs increase the supply of housing, they also increased density.

Affirmative action for conservatives?

Yesterday it was my pleasure to hang out with Jonathan Haidt, a social psychologist working at NYU Stern. Many interesting things were discussed. Much yummy Japanese food was eaten.

One thing we briefly discussed was Haidt's complaint that social psychology has been hijacked by political interests. This is interesting, because a lot of people say that about economics, but in social psych the political types seem to have made much more headway (though politicization probably matters a lot less in social psych, because the fates of millions of jobs and trillions of dollars don't hinge on psych policies the way they hinge on economic policies).

Anyway, the question is what to do about it. Haidt recommends "affirmative action for conservatives":

I'd like us to set a goal for [the Society for Personality and Social Psychology] that we become 10% conservative by 2020. Yes, I am actually recommending affirmative action for conservatives. Set aside any moral arguments; my claim is that it would be good for us. 

Just Imagine if we had a true diversity of perspectives in social psychology. Imagine if conservative students felt free enough to challenge our dominant ideas, and bold enough to pull us out of our deepest ideological ruts. That is my vision for our bright post-partisan future.

This is an interesting idea. But I have a couple of problems with it:

1. Unlike, say, race, political affiliation is a matter of choice. If we start giving preferential treatment to people who say they're conservative, won't people just pretend to be conservative in order to get a leg up in the brutal academic job market? Incentives matter.

2. Affirmative action type programs never perfectly cancel out bias. Instead, they partially counteract bias in some ways and create bias in others. If you start giving jobs preferentially to conservatives, it seems like you could end up with a lot of low-skill conservatives. Conservative researchers might be quietly ignored and disrespected, with the assumption that "he checked the box to get in". This is one of the big problems with race-based affirmative action, and it seems like it would work for political affiliation just as strongly.

3. What are "conservative" ideas anyway? In econ, "conservatives" (or "libertarians", as economic conservatives insist you call them) want to cut government intervention in the economy. In social psych, it seems like "conservative" means something totally different. What if the "conservative" ideas in a field just suck? Shouldn't we be afraid of permanently enshrining bad ideas?

Academia is about ideas. If you treat a package of ideas as if it were an identity group like race or gender, and offer it permanent shelter within academia, I feel like you're restricting the ability of ideas to improve.

But that leaves the question of how to fight against political hijacking of an academic field. Maybe the best way to do it is simply to fight ideas with ideas. If conservative ideas aren't getting enough play in social psych, start giving them play. Write some papers on conservative topics - if you're famous, who cares if no one publishes them, just post them as working papers on your website. Or start a blog, like Scott Sumner did in econ. Gather like-minded academics, using tools like the internet and human networks. Eventually, people will read your ideas and join your movement. If that group reaches critical mass, you can start new conventions, new societies, new journals, etc. As Gandhi said, "Be the change you wish to see in the world."

In fact, this is exactly why academia has tenure in the first place. It's so you can speak out against consensus and not be afraid for your career. The system isn't broken - just use it!

A case where RBC works

I am a fan of John Cochrane because of his intellectual honesty. He's always very up-front and clear about what his priors and his politics are. But he almost never lets that make him tendentious (the one exception being when he is talking directly or indirectly about Paul Krugman). He goes out of his way to acknowledge alternative interpretations and the limits of knowledge.

This post on news shocks is a good example of what I mean. Cochrane reports on a paper by Arezki, Ramey, and Sheng that uses a very simple macro model to explain the economic response to big oil discoveries. Cochrane notes that the paper doesn't need a lot of the fancy friction-mining and utility-mining that are common in macro these days:

My comment was something to the effect of "this paper is much more important than you think. You match the dynamic response of economies to this large and very well identified shock with a standard, transparent and intuitive neoclassical model. Here's a list of some of the ingredients you didn't need: Sticky prices, sticky wages, money, monetary policy, (i.e. interest rates that respond via a policy rule to output and inflation or zero bounds that stop them from doing so), home bias, segmented financial markets, credit constraints, liquidity constraints, hand-to-mouth consumers, financial intermediation, liquidity spirals, fire sales, leverage, sudden stops, hot money, collateral constraints, incomplete markets, idiosyncratic risks, strange preferences including habits, nonexpected utility, ambiguity aversion, and so forth, behavioral biases, nonexpected utility, or rare disasters. If those ingredients are really there, they ought to matter for explaining the response to your shocks too. After all, there is only one economic structure, which is hit by many shocks. So your paper calls into question just how many of those ingredients are really there at all."

Cochrane himself has done a little utility-mining, in his famous habit formation model of asset pricing with John Campbell. But in general, as an opponent of government intervention in the economy, he would (I am guessing) probably rather that the economy work according to a simple RBC-style model where there are no big market failures that would necessitate countercyclical policy.

The Arezki et al. paper is a victory for that kind of simple RBC-type model. But it's a limited victory, since the fluctuations produced by oil news shocks don't look like most business cycles, and because simple models like this don't explain things like the Great Recession. Cochrane, unlike someone making a lawyerly case, goes out of his way to point this out:

Valerie, presenting the paper, was a bit discouraged. This "news shock" doesn't generate a pattern that looks like standard recessions, because GDP and employment go in the opposite direction... 

Thomas Philippon, whose previous paper had a pretty masterful collection of [complex elements], quickly pointed out my overstatement. One needs not need every ingredient to understand every shock. Constraint variables are inequalities. A positive news shock may not cause credit constraints etc. to bind, while a negative shock may reveal them. 

Good point. And really, the proof is in the pudding. If those ingredients are not necessary, then I should produce a model without them that produces events like 2008. But we've been debating the ingredients and shock necessary to explain 1932 for 82 years, so that approach, though correct, might take a while.

Quite true. And many bloggers or op-ed writers would not go out of their way to point this out.

Anyway, to touch on Cochrane's actual point, it's very interesting that simple RBC-type models should be so good at explaining something like an oil shock and so bad at explaining things like big recessions. This fact could lead economists toward something incredibly valuable: an understanding of the scope conditions of RBC-type models.

Scope conditions are the conditions under which a model works well. (**Physics analogy alert**) For example, we know that a model of frictionless motion works pretty well on an ice skating rink and pretty badly under the ocean. And we know exactly why. In decision theory, I personally think that experiments are starting to teach us the scope conditions of super-basic econ 101 demand theory: it works well for one-shot decisions, and not very well for dynamic situations with lots of uncertainty.

But for macro, it's inherently very hard to identify scope conditions, because there's so much going on at once that you can't get a clean comparison between the cases when a model works and the cases when it fails. That's what makes this Arezki et al. paper so interesting - it gives us a clear case (oil discovery shocks) when a mostly frictionless, very forward-looking, perfectly rational representative agent model with Econ 101 type preferences really works. That, in turn, lets us look at cases where RBC models don't work, and ask "How is this case different from an oil discovery shock?" For example, it might be a negative shock as a opposed to a positive one. It might be a shock to a different sector of the economy. It might be an immediate productivity shock instead of a news shock. Etc. Having a case where RBC models actually work helps us narrow down the list of possible reasons why they usually fail.

There will inevitably be many such differences, but they narrow down the types of models we want to consider. If a model fits the Great Recession but doesn't reduce to the Arezki et al. result when applied to an oil discovery shock, we should be skeptical that that is the right model of the Great Recession. As we accumulate more clear-cut cases like the one in Arezki et al., we increase our list of limiting cases that macro models should reduce to in well-defined limits. That in turn moves us closer to what we really want - a model that really explains why big recessions happen, and what can be done to prevent or combat them.

In other words, having a bunch of limiting cases like Arezki et al. lets us throw away macro models. I personally think that's the real problem in the macro literature - the profession lets a thousand flowers bloom, but the flowers never get cut. Clear results like this one give macroeconomists a pair of scissors.

Why did rich-world deficits start exploding around 1980?

The U.S. federal deficit, which had been decreasing since the end of WW2, began to trend upward beginning around 1980:

Why? Well, the proximate cause was big tax cuts, without any offsetting spending cuts. The beast was not starved, and tax cuts did not pay for themselves.

But what was the political-economic cause? I have a theory.

Economists have studied mechanisms by which a government might pay for public goods (i.e., things that the market won't provide enough of on its own). All the mechanisms basically boil down to either a Vickrey-Groves-Clarke mechanism or an AGV mechanism (AGV stands for some French names). These are ways of determining how much each taxpayer pays for the public goods.

The VCG mechanism, which is similar to what Google uses to sell ads, can't balance the budget. Deficits grow and grow. The AGV mechanism, on the other hand, balances the budget on average. It does this by taxing rich people a lot. However, the AGV mechanism doesn't satisfy something called "individual rationality" - it taxes the rich people so much that they'd like to leave entirely.

If the rich people can't leave, you can tax your captive rich people a lot and balanced the budget. But once they get the ability to leave, you have to cut taxes, and then you can't provide public goods without big deficits.

So one story of the explosion in U.S. government debt is that around 1980, globalization (i.e., European and Asian catch-up growth) progressed to the point where rich people - or companies, which are not explicitly dealt with in the VCG or AGV mechanisms - could threaten to leave unless we cut their taxes. So we did cut the taxes - we switched from AGV to VCG, and could no longer balance the budget.

Now a big caveat is that lots of the things our government pays for aren't public goods, they're transfers. Their level is set not by some consideration of economic efficiency, but by some more complicated political mechanism. So this mechanism-design-based story doesn't fully explain why we failed to cut government spending. It also leaves out the distinction between corporations - whose taxes were cut mostly by loopholes rather than tax rate reductions - and individuals. And it doesn't explain why U.S. deficits stopped expanding as a percentage of GDP in the 1990s, and again since 2011.

So the story isn't entirely satisfying. But it's really striking that deficits started trending upward all over the rich world around the same time. And, via Marginal Revolution, here's some evidence that rich people do sometimes move around to take advantage of lower tax rates - probably a lot more in Europe and Asia than in the U.S.

Anyway, I think the mechanism design story could an overlooked part of the explanation for why rich-world governments have borrowed so much money since the 1980s.

"Race and IQ": a brain-eating memetic parasite

"Almost got me with a weaponised meme."

  - from The Quantum Thief

In nature, there are a number of brain parasites that control their hosts' behavior, turning them partially or fully into zombies. Many of these are fatal. Humans are mostly safe from these threats, but I believe that we face an analogous threat from memetic "brain worms" - ideas that crawl inside our heads, hull out a little portion of our brains, and begin steering our thoughts toward intellectual self-destruction. For example, there's "Austrianism," which convinces people that loose monetary policy is the source of all macroeconomic problems. But that is hardly the worst.

Perhaps the most potent and deadly memetic parasite I know of is called "Race and IQ". This is the belief that average differences in measured IQ across different consensus-defined racial groups are really, really important to society. 

That's the core belief, but there are some associated ones. 

The first is a persecution complex. "Race and IQ" people believe that they are oppressed rationalists/empiricists fighting the good fight against mainstream/liberal culture, which is engaged in a massive effort to deny or cover up The Truth. This can cause severe perceptual distortions, e.g. the notion that people who deny that race is an important or interesting correlate of IQ are denying the validity or existence of IQ itself, or the partial heredity of cognitive abilities. Like most persecution complexes, it also tends to cause aggressive, paranoid behavior.

The second is the certainty that the aforementioned average IQ gaps are due entirely to deep, fundamental (but always unspecified or hypothesized) genetic differences between broad racial ancestries, rather than to things like selective immigration.

The third is the belief that "Race and IQ" is responsible for many or even most of the economic phenomena in the world - the wealth and poverty of nations, growth rates, savings rates, bubbles, etc.

Furthermore, "Race and IQ" seems to act as a sort of gateway drug. Once people's brains have been infected with this parasite, they become more susceptible to stereotypes of all kinds. Soon, they will believe every stereotype about women, about gays, about Jews, about "Latin lovers," about Germany and Greece - about anything and anyone. The older the stereotype, and the more associated with right-wing politics it is, the more likely they are to believe it. They will start inventing new stereotypes about population genetics to explain almost any phenomenon they see - they become addicted to stereotyping. This may be a side effect of the persecution complex - once you think that the mainstream is engaged in a big cover-up effort against one stereotype, why not all of them? And not only do the "Race and IQ" zombies believe in stereotypes, they start trying to apply them in daily life. You know a meme is a brain-eater when it makes people incapable of distinguishing between statistical significance and goodness-of-fit!

In fact, this brain parasite has been around for a long time. In The Great Gatsby, a character suddenly starts spouting the "Race and IQ" canon:

“Civilization’s going to pieces,” broke out Tom violently. “I’ve gotten to be a terrible pessimist about things. Have you read ‘The Rise of the Colored Empires’ by this man Goddard?” 

“Why, no,” I answered, rather surprised by his tone. 

“Well, it’s a fine book, and everybody ought to read it. The idea is if we don’t look out the white race will be — will be utterly submerged. It’s all scientific stuff; it’s been proved.” 

“Tom’s getting very profound,” said Daisy, with an expression of unthoughtful sadness. “He reads deep books with long words in them. What was that word we ——” 

“Well, these books are all scientific,” insisted Tom, glancing at her impatiently. “This fellow has worked out the whole thing. It’s up to us, who are the dominant race, to watch out or these other races will have control of things.”...

“This idea is that we’re Nordics. I am, and you are, and you are, and ——” After an infinitesimal hesitation he included Daisy with a slight nod, and she winked at me again. “— And we’ve produced all the things that go to make civilization — oh, science and art, and all that. Do you see?” 

There was something pathetic in his concentration, as if his complacency, more acute than of old, was not enough to him any more...Something was making him nibble at the edge of stale ideas as if his sturdy physical egotism no longer nourished his peremptory heart.

If this describes someone you've interacted with, or read on the internet, well, now you know what it is.

If you read blogs, you've probably seen a few "Race and IQ" zombies infesting comment sections. But the scary thing about this memetic parasite is that it has shown an ability to (occasionally) infect even the most intelligent minds. It ate James Watson's brain. It might or might not have eaten William Shockley's brain. It has probably eaten the brains of one or two economists over the years. It's sad and scary to see a once powerful mind reduced from exploring the mysteries of the Universe to exploring this lazy, tired, mostly-irrational worldview.

Why is the human brain so vulnerable to this parasite? Here are a few conjectures:

* There is innate pleasure in being the iconoclast - the one guy who's right while all of society is wrong. "Race and IQ", with its persecution complex and its veneer of science-y-ness, lets you play at being Giordano Bruno.

* When smart guys get old they usually lose their edge. Being smart has been part of their self-image all their lives, and now that's being taken away from them by nature. Imagining oneself as part of a naturally intellectually superior race is a way of substituting group pride for individual pride.

* Tribalism and racism, of course, are deeply rooted. People want a reason to believe they have some giant gang out there that will back them up. "Race and IQ" feeds this desire.

In any case, "Race and IQ" is a worrying parasite because I don't know of a cure. Memetic parasites cannot be cleansed with logic and facts, but often there is a sort of anti-parasite agent available - a benign alternative belief system that the infected can be diverted towards. Austrianism, for example, can be cured with MMT. But I don't know of any equivalent "halfway house" belief system that is effective in getting people off of the "Race and IQ" train.

I think finding a cure for this brain parasite would yield substantial rewards for public health.

Americans are better behaved than ever

David Brooks thinks Americans - in particular, less educated, less affluent Americans - are losing their morality. He blames this on the death of collectively enforced social norms:

We now have multiple generations of people caught in recurring feedback loops of economic stress and family breakdown, often leading to something approaching an anarchy of the intimate life...It’s not only money and better policy that are missing in these circles; it’s norms...In many parts of America there are no minimally agreed upon standards for what it means to be a father. There are no basic codes and rules woven into daily life, which people can absorb unconsciously and follow automatically...These norms weren’t destroyed because of people with bad values. They were destroyed by a plague of nonjudgmentalism, which refused to assert that one way of behaving was better than another. People got out of the habit of setting standards or understanding how they were set.

I think David Brooks should look at the statistics on American behavior.

• Crime is way down and continues to fall.

• Teen drug and alcohol abuse is way down and continues to fall. 

• Teen pregnancy is way down and continues to fall.

• Domestic violence is way down and continues to fall.

• Child molestation is way down and continues to fall.

In other words, Americans are becoming better and better behaved in almost every way. 

So David Brooks is cooking up off-the-cuff sociological theories to explain SOMETHING THAT ISN'T EVEN HAPPENING. And then he is recommending big changes in American culture and society, based on his off-the-cuff sociological explanation for SOMETHING THAT ISN'T EVEN HAPPENING.

(So of course we also don't need to invoke poverty to explain the nonexistent "increase in bad behavior"!) 

Yes, Americans - especially lower-class Americans - are suffering from family breakdown and social isolation. These seem like problems of loneliness, not of loss of morality. They're obviously not leading to increases in violence or drug abuse.

You see, the problem with being a grumpy old guy scanning the media for negative anecdotes and grumbling about the world going to hell in a handbasket, and how the only solution is to somehow revamp society to bring back old social norms is that someone might actually listen to what you say.

The pincer attack on macro models

I don't do much macro-dissing these days, but this Brad DeLong post makes me unable to resist putting in a quick dig.

DeLong quotes Robert Lucas from a 2011 panel on rational expectations:

[Using behavioral economics for macro] is like saying that we ought to build it up from knowledge of molecules or--no, that won’t do either, because there are a lot of subatomic particles.... We’re not going to build up useful economics in the sense of things that help us think about the policy issues that we should be thinking about starting from individuals and, somehow, building it up from there.

DeLong responds:

[When Lucas] builds his models he is aggregating up the behavior of 310 million American individuals, having made certain assumptions about what things cancel out when that aggregation is made...
Lucas does say that economists definitely should not:

• Model humans as they actually behave.
• Model their economic interactions as they actually happen.
• Aggregate up.
• And look for emergent patterns to fit to the data.

Instead Lucas says economists should:

• Do what macroeconomists currently do.
• This is, assume one infinitely-lived hyper-rational representative price-taking agent.
• Assume that all equilibrium-selection and coordination problems are automagically solved.

The second, Lucas says, is "science"! The first, Lucas says, is not--even though the first is a strict superset of the second.

DeLong is exactly right. Also, I like the word "automagically".

Anyway, Lucas' ideas about modeling are pretty typical of modern macro defenders (possibly because he had a big part in inventing those ideas). Modern macro methods commonly face attacks from two other groups of economists:http://newmonetarism.blogspot.com/2015/03/lucas-and-his-critics.html

Attacker Group 1: "Old Keynesian" economists who want to use aggregate-only models.

Attacker Group 2: Decision theorists and other micro theorists who want to make macro use more realistic models of agent behavior.

The modern macro defenders' typical response to Attacker Group 1 is: "No, we need to model agents' decisions, because only then can we be confident that these are structural (and, hence, policy-invariant) models. Simply matching aggregate data is not enough."

The modern macro defenders' typical response to Attacker Group 2 is: "No, we don't need to model agents' decisions realistically, because the only measure of whether a macro model is successful is whether it matches the aggregate data."

This leaves modern macro defenders in the odd position of saying that it's crucially important to model agents' decisions, but totally unimportant to model them in a realistic way.

The natural next question for a macro troll to ask is: "If the agent's behavior isn't being modeled in a realistic way, how can we be confident that the preference parameters are really structural?"


Updates:

As usual, Robert Waldmann beat me to the troll.

Steve Williamson responds. He writes:

[W]hen we say that macroeconomic theory has "microfoundations," what we mean is not that it is built up from theory that explains the behavior of individuals. For a lot of economic behavior, we're not going to do very well in explaining the behavior of an individual. And, as Lucas notes, behavioral economists can't do it either. Rather, what "microfoundations" is about is finding the model elements - optimizing behavior, constraints, information - that explain the behavior of large (that's large in the "larger than one but much smaller than 280 million" sense) groups of economic agents from first principles. Then we can make predictions about the effects of policy on the behavior of really large (i.e. 280 million for example) groups of people.

I guess I don't really get this. So there are some intermediate-sized groups of people - much bigger than 1 but much smaller than 280M - who collectively behave like the "agents" that we see in macro models. But these intermediate-sized groups - let's call them "clumps" - don't behave anything like the individuals that comprise them. But we can still treat the parameters that describe the tastes of the clumps as structural. Why? Because of "first principles." Individuals don't have a disutility of labor parameter, or a coefficient of relative risk aversion. But clumps do. And we know that from first principles.

I must be missing something, because this doesn't sound like anything I've read in a macro paper or book. It also doesn't really make sense, but that's a topic for another day...

Meanwhile, in the comments, Tore Ellingsen asks me what I would work on if I were doing macro theory. A great question. I gave some responses, including extrapolative expectations and firm-side frictions and constraints (e.g. borrowing constraints). I also think there's a lot out there to mine from the I/O and the banking theory literature, but here my knowledge is just way too inadequate to name specifics. In terms of things people are doing now, I like the learning models of Evans, and the dispersed-information models of Angeletos, though I'm not sure if either of those were actually inspired by micro research.

In the comments, Steve Williamson says:

Your rewording of what I was trying to say makes no sense to me. That's not what I'm getting at...So, what are microfoundations? That's not building up a macro model from theory that predicts the behavior of individuals, as we don't have theory that does that. It's taking the best available economy (sic) theory we have - that somehow makes sense of average behavior - and we incorporate that in our macro model.

I'm a little relieved that I got Steve wrong at first, since the "clumps" thing indeed made no sense. But unfortunately, this explanation still doesn't make sense to me. What is "the best available economy theory"? Best by what criterion? And what does it mean to "make sense of average behavior", if not matching macro facts? What else could it mean to "make sense of average behavior"? So I'm still confused.

(Discussion continues in the comments.)

Andrew Gelman smacks me down on social science rivalries

Somehow I missed it when it first came out, but back in December Andrew Gelman wrote a great smackdown of a Bloomberg piece by yours truly. I had written that the reason economists get paid much more than sociologists was that they have more technical skills, especially statistics. Gelman retorts:

Smith writes a bunch of things I disagree with — but then, as a political scientist, I guess it’s no surprise to see me disagreeing with an economist!... 

Freudian psychiatrists got a lot of money and a lot of prestige back in the 1950s, and they didn’t know any statistics at all. But they had one useful skill, and that was the ability to convince rich people that their services were personally valuable. In the national discourse, psychiatrists were taken seriously. They were mocked, but they were a central part of the culture and their pronouncements were respected. And they managed to do so without following Smith’s advice to “stop whining and tech up.” 

So perhaps a better piece of advice, if sociologists (and psychologists and political scientists?) want to join economics at the big boys’ table and up their salary and their influence, would be: Stop whining and make your work more appealing to rich people.

Gelman is right. My post left out some big, important things.

First of all, yes, teching up is not necessary for an academic field to get paid big bucks in the private sector (and hence, bigger bucks in the academic sector). Freudian psychology shows that sometimes you can pull off the feat without technical skills.

Second of all, as others have also pointed out since I wrote my post, teching up is not sufficient to get money in the private sector. Your techniques also have to have applications. Gelman terms this "making your work appealing to rich people", but I think usually it's just making your techniques appealing to business (Freudian psychology, with its direct marketing to rich individuals, is the exception rather than the rule). This is why operations research profs get paid more than stats profs. Pretty similar skills, but stats profs would have to pay a higher transaction cost to jump to the private sector - they'd have to learn how to do private-sector stuff. Operations research people already know that stuff, and could switch really quickly. 

Usually, when you have profs with business-related skills, they are in business schools or engineering schools. The less applied disciplines housed in the "literature, science, and arts" schools - physics, math, econ, etc. - are usually paid a lot less. Econ is the biggest exception, and it is not only because of economists' technical skills. 

It's also because economists have figured out ways to make the private sector purchase their techniques directly, without the need for too much retooling. These include, but are not limited to:

1. Legal consulting

2. Macroeconomic forecasting

3. Various assorted other kinds of business consulting

4. Market design (this is new!) 

These, of course, are in addition to at least one hugely important area where economists can apply their skills with retooling: Management consulting.

For sociologists to emulate this financial success completely, it would require that they find ways to get paid for doing sociology. This seems unlikely to happen (though by all means, go for it!). But if they improve their stats techniques so that with a bit of retooling the average sociologist could go to work at a management consultancy or similar firm, they will raise the value of their outside option. At the same time, if they put more stats and applied math in the undergrad sociology curriculum, they will make sociology graduates more appealing to the business world, thus raising demand for the sociology major and probably making it more inelastic at the same time. This was another big thing my Bloomberg post left out.

Whether sociologists want to do this, of course, is another question.

But it's interesting to note that Andrew Gelman's field, political science, has teched itself up a great deal in recent decades, including with game theory (a technique that first found purchase in economics), and with statistics (as Andrew Gelman's own career demonstrates). So even though my prescription for raising sociology salaries is incomplete, it does describe the path that poli sci has chosen to take, and that Gelman himself has chosen to take within poli sci! So that's something.

Gelman's point about Freudian psychology also raises another interesting question. He seems to think that Freudian psychology is (and I am using my own words, not his) basically a bunch of bullshit that rich people were tricked into paying for - a belief that seems very widespread nowadays. But if economists are getting paid to dish out bullshit, what's the bullshit that they're getting paid to dish out?

Gelman claims that Gary Becker's "imperialist" econ stuff is obviously wrong:

Gary Becker’s writing doesn’t scare me, but a lot of it strikes me as wrong, indeed so obviously wrong that it causes me to question how it gets so much respect within the field of economics. I’ve talked with some economists whom I know and respect, and they in turn respect much of Becker’s work, so the story here is far from simple. But let me say this again, my concern about work such as Becker’s — and, I believe, the concern of many other social scientists — is not fear of imperialism, it’s disquiet at such extreme ideas being treated as mainstream.

That's harsh! But even if it were true, I don't think it would be that relevant, since economists don't really get paid to do Beckerian stuff in the private sector.

If economists are getting paid to bullshit, a la Freudian psychologists, who is paying them? Management consultancies might make economists use a teensy tiny little bit of econ theory, but mostly they're just running regressions and doing other stats stuff. As for market design, that ain't bullshit.

That leaves 1. Law and economics, 2. Macroeconomic forecasting, and 3. Various other forms of business consulting.

Law and econ seems like it will inevitably contain some big element of bullshit, because all legal stuff contains large amounts of bullshit. Lawyers are legally obligated to fling whatever bullshit they can fling. But economic considerations are important in legal matters. There's no way around that, really. You could say that the economics being done in legal cases is not the right economics, or not the best, but it's very hard to make an argument that economics in general should just be kicked out of the courtroom.

As for macroeconomics forecasting, that is indeed mostly bullshit, but it's bullshit for which the source of demand - the desire to know the future of the economy - is deep and fundamental. There's no getting rid of this one, I don't think.

That leaves the nebulous 3. Various other forms of business consulting. This is way too nebulous and diffuse to characterize. Some - I have no idea how much - is probably very valuable and useful. But then you have stuff like the corporate shilling in Inside Job. Anyway, if you are pissed at the econ profession, and you think that economists are getting overpaid to do economics for the private sector, it is probably somewhere within this category that you want to look. Good luck with that!


Updates

In the comments, Ryan Decker writes:

Probably one of the bigger components of the last category is transfer pricing. I think it would be hard to argue that economists bring nothing of value to that process (though it involves lots of collaboration with accountants and lawyers).

I didn't even realize that economists did much of this, actually! All the people I know who work in transfer pricing are, indeed, accountants and lawyers. But it makes sense that a lot of economists would be hired for this. And yes, I think this is a pretty clear case of creating real value ("real" as opposed to a fleeting fad, an artifact of imperfect institutions, etc. - yes, I know there's no good definition for "real value").

Another chunk of (3) might be strategy consulting by industrial organization economists. It seems like there should be a lot of that, but I have no idea how much there actually is, or how well it actually works.

Handing the baton to the next hyperpower

No blog has influenced me so much as that of Brad DeLong. I agree with DeLong with a frequency that is almost disturbing. I have often called myself a Brad DeLong sock puppet, mostly in jest.

However, for as long as I've been reading DeLong, I've believed that he is wrong about one big thing - the U.S.-China relationship. Brad thinks we need to do more to bend over backwards to convince the Chinese populace that we are their friend. I think we could not possibly do more than we have done.

Here's Brad's latest expression of the thesis:

In 1846 British Prime Minister Robert Peel accepted the U.S. proposal to draw the border between British Columbia and the Oregon Territory...As a result, when 1916 came, Americans perceived Britain as their friend. Americans perceived the British Empire as by and large a force for good in the world... 

The willingness of the United States to [fight for Britain in the World Wars was] powerfully motivated by America’s affinity with Britain...[Britain had] created a world in which the 20th century’s hyperpower would use its muscle to make the world comfortable for Britain to live in... 

Is the United States using its soft power now with the same skill and foresight? Not really... 

[A]t least one of India and China–perhaps both–will become late-twenty first century superpowers. And so we have an interest in building ties of affinity now: it is very important...that, fifty years from now, schoolchildren in India and China be taught that America is their friend that did all it could to help them become prosperous and free. It is very important that they not be taught that America wishes that they were still barefoot, powerless, and tyrannized, and has done all it can to keep them so.

Now actually, I think most of this is correct. It would be great if India and China thought that America was on their side, and had always been on their side.

And with India, I think there is a great chance that this will happen - in fact, it shows every sign of happening. The first major diplomatic step toward making the India-U.S. relationship similar to the U.S.-Britain relationship was the nuclear cooperation deal forged by the George Bush administration, which de facto legitimized India as a great (i.e. nuclear) power, and reversed decades of damage that the Clinton administration had done by trying to ostracize and punish India for its 1998 nuclear tests, and more decades of damage that previous administrations had done by trying to maintain a ludicrous false parity between India and the neighboring dysfunctional hostile failing state of Pakistan. So I think that, thanks in part to George W. Bush, but thanks more to the natural linguistic and institutional similarities between the two countries, and thanks even more to their shared geopolitical interests, we have a good chance of having a positive, enduring, mutually beneficial special relationship with India.

But then there's China.

Let's review a quick list of the ways that the U.S. has gone to bat for China over the last century or so.

First, through the Open Door policy, we prevented China from being colonized by various European and East Asian imperialist powers. U.S. power was the reason that China appears in light blue ("Partial European control or influence") on this map instead of in green ("Colonized or controlled by Europe"). Had the U.S. not done this, Europe might well have expended its energies carving up and dominating China instead of fighting World War 1.

Then, in the late 1930s and early 1940s, when Japan was conquering large portions of China, the U.S. put an oil embargo on Japan, simply for the purpose of saving China from conquest. This forced Japan to choose between halting their conquests and fighting the United States. It chose the second, and the resulting war cost the United States hundreds of thousands of lives. In other words, we got into the most costly international war in order to save China.

Then, in 1969, after the Sino-Soviet split, the USSR was considering a massive preemptive nuclear strike on China. The United States stopped this attack only by threatening to nuke Russia if they went through with the plan - which would have then resulted in a U.S.-Russia nuclear exchange that would have destroyed both countries. In other words, the U.S. threatened nuclear war, and risked its own total destruction, in order to save China.

Then, in the 1990s and 2000s, the U.S opened its markets to Chinese goods, first with Most Favored Nation trading status, and then by supporting China's accession to the WTO. The resulting competition from cheap Chinese goods contributed to vast inequality in the United States, reversing many of the employment gains of the 1990s and holding down U.S. wages. But this sacrifice on the part of 90% of the American populace enabled China to lift its enormous population out of abject poverty and become a middle-income country.

So again and again, the U.S. has gone to bat for China, harming our own workforce, risking our own death, and sacrificing hundreds of thousands of our young people in brutal combat. It is in part thanks to us that China is a hyperpower today, rather than A) a mishmash of European fiefdoms, B) a mismash of Japanese and Russian fiefdoms, C) a radioactive parking lot, or D) an insular, indigent economic backwater.

And has this caused China's government to teach its children that the U.S. is on its side, and supported its development every step of the way, as Brad would like? No. The government of China continues to teach its people that the West is their enemy. The state-controlled Chinese media continues to spout copious anti-Western rhetoric. The Chinese government continues to commit itself, in public and in private, to resisting Western ideas and culture.

Does this mean that the Chinese people despise the U.S.? No, they do not. They mostly like us. But the Chinese government, which holds the power and decides on geopolitical strategy, is implacably opposed to the United States.

So my question for Brad is: What else would he have us do in order to convince China's government that we are their buddy? What more could we do, in addition to the four aforementioned times that we saved China's bacon? Force Taiwan to join the mainland? Firebomb Yasukuni shrine? Recognize China's claim to the entire South China Sea?

Brad's parallel with the British cession of the Pacific Northwest is not an encouraging parallel. In the light of China's current territorial claims and aggressive actions toward its neighbors (including India), it seems to me to be an ominous parallel.

I counter-suggest that instead of trying to placate China's government by forcing our allies to make territorial concessions to China, that we take our case directly to the Chinese people, by increasing Chinese immigration, by building more cultural and academic links to China, and by continuing to have our leaders praise the Chinese people and culture in high-profile speeches. Will this be enough to make the Chinese government our buddy? No, it won't. But governments don't last forever.

Passive management vs. saving more

So, Eduardo Porter wrote an article, with large excerpts from John Bogle, telling people they should switch to passive management. Here's an excerpt:

On average, a typical working family in the anteroom of retirement — headed by somebody 55 to 64 years old — has only about $104,000 in retirement savings, according to the Federal Reserve’s Survey of Consumer Finances...The standard prescription is that Americans should put more money aside in investments. The recommendation, however, glosses over a critical driver of unpreparedness: Wall Street is bleeding savers dry [with fees for active management].

Ryan Decker does not like this. Bogle and Porter, he says, are "straightening the deck chairs on the Titanic". The real problem, he says, is not that people are paying too much in fees, but that they aren't saving enough in the first place. Ryan writes:

So people are approaching retirement with $104,000, and "a greater part of the problem is the failure of investors to earn their fair share of market returns."...Do Porter and Bogle really want us to believe that the main reason people are trying to retire on $100 grand is that they haven't made sufficient use of passive funds?... 

I'm as big a fan of passive management as anybody, but this is totally absurd...What would the average nest egg be if everyone had chosen the right fee structure and asset allocation? Whatever it is, it's not going to get anyone very far in retirement, particularly if they're accustomed to spending money at the kind of rates that lead to having such a small stash at that age... 

By all means, don't throw your money away on active management, and don't waste your time trying to pick stocks. That stuff matters at the margin. But that particular margin is insignificant compared to the problem of low savings rates.

Ryan is right, and he's also wrong.

Ryan is right that saving more of your income is capable of supporting a lot more retirement spending than saving money on management fees.

But Ryan is wrong to say that this makes Bogle and Porter's argument invalid. Actually, Bogle and Porter have a good argument. Here is why:

If you consume less today in order to consume more during retirement, you have to give something up (today's consumption). Thus, Bogle and Porter are recommending something that gets you more total consumption, while Ryan is recommending something whose main effect is just to move around your total consumption. Reducing fees is no substitute for saving more when it comes to increasing retirement consumption. But saving more is no substitute for reducing fees when it comes to increasing lifetime consumption.

Let's make that concrete. Suppose I save $1000 more when I'm 30 and consume $1000 more when I'm 65. And suppose my per-period utility is u(c_t), and the discount rate over 35 years is B. Then my utility gain from saving more is u(c_30 - 1000) - u(c_30) + B*u(c_65 + 1000) - B*u(c_65), where c_30 and c_65 were the amounts I would have consumed, before I decided to save more. The first part, u(c_30 - 1000) - u(c_30), is going to be negative. The second part, B*u(c_65 + 1000) - B*u(c_65), is going to be positive. In other words, the utility gain from saving more is only the utility gain from more consumption smoothing. And if people are already doing the optimal amount of consumption smoothing, that utility gain is zero.

Just for fun, let's think about that point a little more deeply. We should ask Ryan: Why do we think people aren't doing the optimal amount of consumption smoothing already? What sort of behavioral bias is keeping them from making the right choices for themselves? Do they have hyperbolic discounting? Do they have self-control problems? What's wrong with these people? If nothing is wrong, then saving more would actually be bad for them.

(The same, of course, could be true of active management. Maybe people are choosing active management, and paying the fees, because they get some utility out of doing so. It's certainly possible. Of course, if you take that position, you should then explain why more and more people are switching to passive management, just as Bogle has been urging. Preference shift? Seems unlikely.)

But anyway, the point is that you can't simply compare saving more with paying fewer fees in terms of the increased retirement spending the two are capable of supporting. That's like ridiculing people for picking up a $10 bill by pointing out that they could get a lot more than $10 if they sold their car.

Japan is not a collectivist society

As I prepare to get an Airbnb reservation for my upcoming trip to Japan, I am reminded of this article that came out about a week ago in the New York Times. The article is very good, the reporting is very good, but I did notice this bit from the Hofstede Center:

Dutch social psychologist...Geert Hofstede...developed a matrix of cultural dimensions by which one country could be viewed against another....[H]e came up with six measures...These include individualism versus collectivism, indulgence versus restraint, power distance (a group’s acceptance or rejection of hierarchy) and, perhaps most important for Airbnb, uncertainty avoidance...The center’s portrait describes Japan as a pragmatic culture that emphasizes collectivism and hierarchy and as “one of the most uncertainty-avoiding countries on earth.” (emphasis mine) 

Now, I wouldn't be surprised if the Hofstede Center makes good money dishing up this stuff to American businesses eager to "understand" Japan before they invest there. There's just one problem: this isn't what Japan is actually like.

Don't take my word for it. Go by the data. Grab a copy of David Matsumoto's 2007 book The New Japan, and skim through it - it'll take you maybe half an hour. Matsumoto, a Japanese-American social psychologist, rounds up data from a bunch of cross-cultural studies that use Hofstede's measure and others to measure individualism, collectivism, and a number of other cultural traits.

What they find, in short, is that Japan is not very collectivist. On the individualism-collectivism scale, Japan ranks about the same as the United States (which has consistently measured near the top of the individualism scale). Actually, Japan measures as slightly more individualistic than the U.S. Some of the studies also include Russia and South Korea. Russia is more collectivist than Japan or the U.S., and South Korea is the most collectivist of the four, at least when the studies were done (15-20 years ago).

Now, what's interesting is that this apparently used to not be true! Until the 1980s, Japan really did measure much higher than the U.S. on the collectivism scale. Then in the 80s, something changed, and Japan went individualist in a big way.

Now, Matsumoto is actually upset about this. He really likes traditional Japanese values, and he's actually sad that Japan has become more individualistic. The second part of the book is Matsumoto recommending policies that he thinks will restore Japan's old collectivist values. The policies are fairly silly, and this part of the book can be safely skipped.

Anyway, the data in Matsumoto's book shows two things:

1. Western stereotypes of Japan as a collectivist place are wrong, wrong, wrong.

2. Japan's culture probably underwent rapid change in the 80s, indicating that A) Japanese culture is not the eternal, unchanging thing that some people think, and B) economic changes really do have the power to cause big and sudden cultural changes. When countries get rich they become more individualistic. (I predict Korea measures much more individualistic now than in the 1980s. There's some evidence that China may be moving in the same direction as well.)

I don't expect the Western stereotype of "collectivist Japan" to die overnight. Stereotypes are actually more persistent than the cultures they claim to describe. But eventually, if you keep hitting a stereotype over the head with the hammer of data, it has to cry uncle.