Methodology – Page 23 – artdiamondblog.com

Progress of Economic Science on Central Banking

The passage below is a comment by former head of the Fed, Paul Volcker.

(p. 25) . . . I recently commented to some of my economist friends that I’m not aware of any large contribution that economic science has made to central banking in the last 50 years or so.

Our ability to forecast is still very limited. The old issues of the relative role of fiscal and monetary policies are still debated. Markets are certainly more complex, and some of the old approaches toward monetary control seem less relevant. Recent events have certainly illustrated limitations in our understanding of the economy.
The advent of floating exchange rates, which partly reflects a shift in academic thinking, has certainly been important, but the underlying problems of policy seem familiar.

Stern, Gary H., interviewer. “Paul A.Volcker in Conversation with Gary H. Stern.” The Region (September 2009): 18-29.
(Note: ellipsis added.)

Econometrician Leamer Argues for Methodological Pluralism

(p. 44) Ignorance is a formidable foe, and to have hope of even modest victories, we economists need to use every resource and every weapon we can muster, including thought experiments (theory), and the analysis of data from nonexperiments, accidental experiments, and designed experiments. We should be celebrating the small genuine victories of the economists who use their tools most effectively, and we should dial back our adoration of those who can carry the biggest and brightest and least-understood weapons. We would benefit from some serious humility, and from burning our “Mission Accomplished” banners. It’s never gonna happen.

Source:
Leamer, Edward E. “Tantalus on the Road to Asymptopia.” Journal of Economic Perspectives 24, no. 2 (Spring 2010): 31-46.

Econometric “Priests” Sell Their New “Gimmicks” as the “Latest Euphoria Drug”

The American Economic Association’s Journal of Economic Perspectives published a symposium focused on the thought-provoking views of the distinguished econometrician Edward Leamer.
I quote below some of Leamer’s comments in his own contribution to the symposium.

(p. 31) We economists trudge relentlessly toward Asymptopia, where data are unlimited and estimates are consistent, where the laws of large numbers apply perfectly and where the full intricacies of the economy are completely revealed. But it’s a frustrating journey, since, no matter how far we travel, Asymptopia remains infinitely far
away. Worst of all, when we feel pumped up with our progress, a tectonic shift can occur, like the Panic of 2008, making it seem as though our long journey has left us disappointingly close to the State of Complete Ignorance whence we began.

The pointlessness of much of our daily activity makes us receptive when the Priests of our tribe ring the bells and announce a shortened path to Asymptopia. (Remember the Cowles Foundation offering asymptotic properties of simultaneous equations estimates and structural parameters?) We may listen, but we don’t hear, when the Priests warn that the new direction is only for those with Faith, those with complete belief in the Assumptions of the Path. It often takes years down the Path, but sooner or later, someone articulates the concerns that gnaw away in each of (p. 32) us and asks if the Assumptions are valid. (T. C. Liu (1960) and Christopher Sims (1980) were the ones who proclaimed that the Cowles Emperor had no clothes.) Small seeds of doubt in each of us inevitably turn to despair and we abandon that direction and seek another.
Two of the latest products-to-end-all-suffering are nonparametric estimation and consistent standard errors, which promise results without assumptions, as if we were already in Asymptopia where data are so plentiful that no assumptions are needed. But like procedures that rely explicitly on assumptions, these new methods work well in the circumstances in which explicit or hidden assumptions hold tolerably well and poorly otherwise. By disguising the assumptions on which nonparametric methods and consistent standard errors rely, the purveyors of these methods have made it impossible to have an intelligible conversation about the circumstances in which their gimmicks do not work well and ought not to be used. As for me, I prefer to carry parameters on my journey so I know where I am and where I am going, not travel stoned on the latest euphoria drug.
This is a story of Tantalus, grasping for knowledge that remains always beyond reach. In Greek mythology Tantalus was favored among all mortals by being asked to dine with the gods. But he misbehaved–some say by trying to take divine food back to the mortals, some say by inviting the gods to a dinner for which Tantalus boiled his son and served him as the main dish. Whatever the etiquette faux pas, Tantalus was punished by being immersed up to his neck in water. When he bowed his head to drink, the water drained away, and when he stretched up to eat the fruit hanging above him, wind would blow it out of reach. It would be much healthier for all of us if we could accept our fate, recognize that perfect knowledge will be forever beyond our reach and find happiness with what we have. If we stopped grasping for the apple of Asymptopia, we would discover that our pool of Tantalus is full of small but enjoyable insights and wisdom.

For the full article, see:
Leamer, Edward E. “Tantalus on the Road to Asymptopia.” Journal of Economic Perspectives 24, no. 2 (Spring 2010): 31-46.

Coase: “Firms Never Calculate Marginal Costs”

Source of YouTube video:
http://www.youtube.com/watch?feature=player_embedded&v=ZAq06n79QIs#!

(p. 257) You can watch a 99 year-old Ronald Coase speaking in December 2009 for 25 minutes on the subjects of “Markets, Firms and Property Rights.” “One of the things that people don’t understand is that markets are creations. . . . In fact, it’s very difficult to imagine that firms act in the way that is described in the textbooks, where you maximize profits by equating marginal costs and marginal revenues. One of the reasons one can feel doubtful about this particular way of looking at things is that firms never calculate marginal costs . . . I think we ought to study directly how firms operate and develop our theory accordingly.” From the conference “Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase,” held at the University of Chicago Law School by the Information Economy Project at George Mason University School of Law. The webpage also includes video of seven panels of prominent speakers, along with PDF files of a dozen or so papers given at the conference. Available at 〈http://iep.gmu.edu/CoaseConference.php〉.

Source:
Taylor, Timothy. “Recommendations for Further Reading.” Journal of Economic Perspectives 24, no. 3 (Summer 2010): 251-58.
(Note: ellipses in original.)

Reality Is Not Always “Elegant”

Source of book image: http://images.betterworldbooks.com/067/Ordinary-Geniuses-Segre-Gino-9780670022762.jpg

(p. C9) In the summer of 1953, while visiting Berkeley, Gamow was shown a copy of the article in Nature where Watson and Crick spelled out some of the genetic implications of their discovery that DNA is structured as a double helix. He immediately realized what was missing. Each helix is a linear sequence of four molecules known as bases. The sequence contains all the information that guides the manufacture of the proteins from which living things are made. Proteins are assembled from 20 different amino acids. What is the code that takes you from the string of bases to the amino acids? Gamow seems to have been the first to look at the problem in quite this way.

But he made a physicist’s mistake: He thought that the code would be “elegant”–that each amino acid would be specified by only one string of bases. (These strings were dubbed “codons.”) He produced a wonderfully clever code in which each codon consisted of three bases. That was the only part that was right. In the actual code sometimes three different codons correspond to the same amino acid, while some codons do not code for an amino acid at all. These irregularities are the results of evolutionary stops and starts, and no amount of cleverness could predict them.

For the full review, see:
JEREMY BERNSTEIN. “The Inelegant Universe.” The Wall Street Journal (Sat., August 13, 2011): C9.

The book under review is:
Segrè, Gino. Ordinary Geniuses: Max Delbruck, George Gamow, and the Origins of Genomics and Big Bang Cosmology. New York: Viking, 2011.

Paul Samuelson, in 2009 Interview, Says Economists Should Study Economic History

Clarke Conor interviewed Paul Samuelson in the summer of 2009. Since Samuelson died in October 2009, the interview was one of his last.
Samuelson was a student of Joseph Schumpeter at Harvard, and Schumpeter worked to get Samuelson financial support and a job. Near the end of his life, Schumpeter was ridiculed when he warned National Bureau of Economic Research (NBER) economists that they should not neglect economic history.
It took Paul Samuelson a long time to appreciate Schumpeter’s truth.

Very last thing. What would you say to someone starting graduate study in economics? Where do you think the big developments in modern macro are going to be, or in the micro foundations of modern macro? Where does it go from here and how does the current crisis change it?

Well, I’d say, and this is probably a change from what I would have said when I was younger: Have a very healthy respect for the study of economic history, because that’s the raw material out of which any of your conjectures or testings will come. And I think the recent period has illustrated that. The governor of the Bank of England seems to have forgotten or not known that there was no bank insurance in England, so when Northern Rock got a run, he was surprised. Well, he shouldn’t have been.
But history doesn’t tell its own story. You’ve got to bring to it all the statistical testings that are possible. And we have a lot more information now than we used to.

For the full interview, see:
Clarke, Conor. “An Interview with Paul Samuelson, Part Two.” The Atlantic (2009), http://www.theatlantic.com/politics/archive/2009/06/an-interview-with-paul-samuelson-part-two/19627/.
(Note: bold indicates Conor question, and is bolded in original.)
(Note: the interview was posted on The Atlantic online website, but I do not believe that it ever appeared in the print version of the magazine.)

No Amount of Econometric Sophistication Will Substitute for Good Data

(p. 234) Using a powerful method due to Singh, we have established a relationship between God’s attitude toward man and the amount of prayer (p. 235) transmitted to God. The method presented here is applicable to a number of important problems. Provided conditional density (1) is assumed, we do not need to observe a variable to compute its conditional expectation with respect to another variable whose density can be estimated. For example, one can extend current empirical work in a variety of areas of economics to estimate the effect of income on happiness or the effect of income inequality on democracy. We conjecture that this powerful method can be extended to the more general case when X is not observed either.

For the full article, from which the above is quoted, see:
Heckman, James. “The Effect of Prayer on God’s Attitude toward Mankind.” Economic Inquiry 48, no. 1 (Jan. 2010): 234-35.

Reference Point Ignored Due to “Theory-Induced Blindness”

(p. 290) The omission of the reference point from the indifference map is a surprising case of theory-induced blindness, because we so often encounter cases in which the reference point obviously matters. In labor negotiations, it is well understood by both sides that the reference point is the existing contract and that the negotiations will focus on mutual demands for concessions relative to that reference point. The role of loss aversion in bargaining is also well understood: making concessions hurts. You have much (p. 291) personal experience of the role of reference point. If you changed jobs or locations, or even considered such a change, you surely remember that the features of the new place were coded as pluses or minuses relative to where you were. You may also have noticed that disadvantages loomed larger than advantages in this evaluation–loss aversion was at work. It is difficult to accept changes for the worse. For example, the minimal wage that unemployed workers would accept for new employment averages 90% of their previous wage, and it drops by less than 10% over a period of one year.

Source:
Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.

Kahneman Grants that “the Basic Concepts of Economics Are Essential Intellectual Tools”

(p. 286) Most graduate students in economics have heard about prospect theory and loss aversion, but you are unlikely to find these terms in the index of an introductory text in economics. I am sometimes pained by this omission, but in fact it is quite reasonable, because of the central role of rationality in basic economic theory. The standard concepts and results that undergraduates are taught are most easily explained by assuming that Econs do not make foolish mistakes. This assumption is truly necessary, and it would be undermined by introducing the Humans of prospect theory, whose evaluations of outcomes are unreasonably short-sighted.
There are good reasons for keeping prospect theory out of introductory texts. The basic concepts of economics are essential intellectual tools, which are not easy to grasp even with simplified and unrealistic assumptions about the nature of the economic agents who interact in markets. Raising questions about these assumptions even as they are introduced would be confusing, and perhaps demoralizing. It is reasonable to put priority on helping students acquire the basic tools of the discipline. Furthermore, the failure of rationality that is built into prospect theory is often irrelevant to the predictions of economic theory, which work out with great precision in some situations and provide good approximations in many others. In some contexts, however, the difference becomes significant: the Humans described by prospect theory are (p. 287) guided by the immediate emotional impact of gains and losses, not by long-term prospects of wealth and global utility.
I emphasized theory-induced blindness in my discussion of flaws in Bernoulli’s model that remained unquestioned for more than two centuries. But of course theory-induced blindness is not restricted to expected utility theory. Prospect theory has flaws of its own, and theory-induced blindness to these flaws has contributed to its acceptance as the main alternative to utility theory.

Source:
Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.

Models Often “Ignore the Messiness of Reality”

Source of book image: http://www.namingandtreating.com/wp-content/uploads/2011/04/SuperCooperators_small.png

(p. 18) Nowak is one of the most exciting modelers working in the field of mathematical biology today. But a model, of course, is only as good as its assumptions, and biology is much messier than physics or chemistry. Nowak tells a joke about a man who approaches a shepherd and asks, ”If I tell you how many sheep you have, can I have one?” The shepherd agrees and is astonished when the stranger answers, ”Eighty-three.” As he turns to leave, the shepherd retorts: ”If I guess your profession, can I have the animal back?” The stranger agrees. ”You must be a mathematical biologist.” How did he know? ”Because you picked up my dog.”

. . .
Near the end of the book, Nowak describes Gustav Mahler’s efforts, in his grandiloquent Third Symphony, to create an all-encompassing structure in which ”nature in its totality may ring and resound,” adding, ”In my own way, I would like to think I have helped to give nature her voice too.” But there remains a telling gap between the precision of the models and the generality of the advice Nowak offers for turning us all into supercooperators. We humans really are infinitely more complex than falling apples, metastasizing colons, even ant colonies. Idealized accounts of the world often need to ignore the messiness of reality. Mahler understood this. In 1896 he invited Bruno Walter to Lake Attersee to glimpse the score of the Third. As they walked beneath the mountains, Walter admonished Mahler to look at the vista, to which he replied, ”No use staring up there — I’ve already composed it all away into my symphony!”

For the full review, see:
OREN HARMAN. “A Little Help from Your Friends.” The New York Times Book Review (Sun., April 10, 2011): 18.
(Note: ellipsis added.)
(Note: the online version of the review has the date April 8, 2011, and has the title “How Evolution Explains Altruism.”)

The full reference for the book under review, is:
Nowak, Martin A., and Roger Highfield. Supercooperators: Altruism, Evolution, and Why We Need Each Other to Succeed. New York: Free Press, 2011.

Sticking with Expected Utility Theory as an Example of “Theory-Induced Blindness”

(p. 286) Perhaps carried away by their enthusiasm, [Rabin and Thaler] . . . concluded their article by recalling the famous Monty Python sketch in which a frustrated customer attempts to return a dead parrot to a pet store. The customer uses a long series of phrases to describe the state of the bird, culminating in “this is an ex-parrot.” Rabin and Thaler went on to say that “it is time for economists to recognize that expected utility is an ex-hypothesis.” Many economists saw this flippant statement as little short of blasphemy. However, the theory-induced blindness of accepting the utility of wealth as an explanation of attitudes to small losses is a legitimate target for humorous comment.

Source:
Kahneman, Daniel. Thinking, Fast and Slow. New York: Farrar, Straus and Giroux, 2011.
(Note: bracketed names and ellipsis added.)