Thursday, August 21, 2008 60 Comments

De gustibus non computandum: or, economics needs a divorce

Most people believe that there is something called "economics." But this is just not so.

When we use the word "economics," we are conflating two completely distinct disciplines. Worse, at most one of these disciplines is right - each despises and condemns the other. It's as if English had one word stellatry, which meant both astronomy and astrology.

Our first discipline is literary economics. Literary economics is what the word economics meant in English until the 1870s or so. It is Carlyle's dismal science. It was also practiced in the 20th century, under the name Austrian economics, by figures such as Mises, Rothbard and Hazlitt. Our second is quantitative economics. Quantitative economics was invented in the late 19th century and early 20th century, by figures such as Walras, Marshall, Fisher, Keynes and Friedman. It is also practiced today, under the name economics.

Observe, for a moment, the suspicious evolution of this terminology. Astrology and astronomy have a similar temporal relationship - as do alchemy and chemistry. Ie: astronomy replaced astrology, and made it clear that its predecessor was nonsense. Chemistry replaced alchemy, and made it clear that its predecessor was nonsense.

But when Robert Boyle replaced alchemy with chemistry, he chose a new name to make it clear that he was separating the sheep from the goats and classifying himself among the former. Astronomy is separate from astrology for much the same reason, and in much the same way.

Whereas in economics it's the other way around. The new name has replaced the old one in situ, forcing its predecessor to decamp to a label which, like all labels, was originally pejorative. It's as if chemistry had decided that it was the only true alchemy, and forced the original alchemists to rebrand their field as, I don't know, Swedish alchemy.

Of course, this doesn't prove anything at all. But isn't it slightly weird? You'd think that if you discover that Field A, which has been taught in all the best schools and universities since Jesus was a little boy, was so misguided in its methodology that it is useless to continue its work, and instead people should study the far superior Field B, you'd call your glorious new B a B, rather than insisting that you had discovered the one true A.

I'd say this anomaly is, if nothing else, a reason to investigate the obvious alternative that this question suggests. Which is that it's actually the new field, Field B, which is a crock. And which has chosen to hitch a ride on the good name of Field A, devouring it in classic parasitic style. In other words, it is actually the Swedish alchemists who are the real chemists, and whose field has been invaded and annexed by a horde of canting, zodiac-wielding transmutationists. Oops.

You may or may not agree with this proposition. But it is surely prudent to consider it fairly. And the only way to do so is to hold the disputed marital property, economics, in escrow, leaving the respondents with their own separate and equal names. Ideally, the noun would be estopped from both parties, giving us not literary economics but something like econography, and not quantitative economics but something like economodeling. (Or perhaps, if you want to be nasty, econogy - practitioners, econogers.) However, some may be too conservative for these bold linguistic innovations.

Let's briefly establish the distinction between these fields. It should be obvious that whatever their respective merits, they are different things and should not be conflated under one name. To indulge in a little Procrustean generalization:

The method of quantitative economics - including both econometrics and neoclassical macroeconomics - is to construct mathematical models of economic systems, ie, systems of independent, utility-maximizing agents. The purpose of quantitative economics is to predict the behavior of these systems, so that central planners can manage them intelligently.

The method of literary economics is to reason clearly and deductively in English about the behavior of economic agents. The purpose of literary economics is to construct and convey an intuitive understanding of causal relationships in economic systems.

Clearly, these fields have nothing in common, either in methodology or purpose. It is true that some quantitative models can be explained in literary terms. However, they cannot be justified in literary terms. And if they can, no quantitative methods are necessary. Indeed, successful quantitative methods often hold up quite poorly when judged by literary standards. Two good examples of this phenomenon are Henry Hazlitt's Failure of the New Economics - a line-by-line response to Keynes' General Theory - or Murray Rothbard's abusive treatment of Irving Fisher's equation of exchange.

And by the standards of quantitative economics, which considers itself a predictive, falsifiable, inductive science, literary economics is simply a nothing. At best, a popularization. It makes no testable predictions. Why anyone would study it in the 21st century is a mystery.

Ergo: there is no possibility of reconciliation. Papers should issue. Custody of that little brat, economics, should be delayed for further consideration. Perhaps he can be sent to Antartica and eaten by a leopard seal.

Consideration of the merits and demerits of contemporary literary, or Austrian, economics is off-topic for this brief, off-week UR. (I know I promised not to post again until the 28th. But your host is not really known for keeping his promises.) Rather, I want to use the tools of literary economics to explain why quantitative macroeconomics is, to put it quite bluntly, fraudulent. The argument that economics needs a divorce is not dependent on this point, but it certainly ought to help seal the deal.

The point is unusually accessible because of an article this week in the NYT Magazine, on the economist Nouriel Roubini. Brad Setser, Roubini's old sidekick and now at the CFR, expands. (I used to post a lot of comments on Setser's blog, but that was before little Sibyl showed up.)

Roubini and Setser are certainly not Austrians. Which makes their reinvention of literary economics all the more interesting. The great lie, after all, is always one cohesive monolith, whereas great truths seep in from every pore. Roubini is trained in modeling, whereas Setser is not. Personally, I prefer Setser. But Roubini is more flamboyant and more credentialed, and he gets the press. As the Times flack puts it:
Roubini’s work was distinguished not only by his conclusions but also by his approach. By making extensive use of transnational comparisons and historical analogies, he was employing a subjective, nontechnical framework, the sort embraced by popular economists like the Times Op-Ed columnist Paul Krugman and Joseph Stiglitz in order to reach a nonacademic audience. Roubini takes pains to note that he remains a rigorous scholarly economist — “When I weigh evidence,” he told me, “I’m drawing on 20 years of accumulated experience using models” — but his approach is not the contemporary scholarly ideal in which an economist builds a model in order to constrain his subjective impressions and abide by a discrete set of data.
Indeed. Setser puts it this way:
But the outcome of most such models seem determined by the assumptions used to create the model more than anything else. [...] I am biased, but I think it is possible to be analytically rigorous (and to use real data to inform your conclusions) even in the absence of a formal model.
And the commenters, as usual, repeat and reinforce the point in various interesting ways. (If you want to participate in a productive discussion about international monetary economics, Setser's blog is still the place to go.)

Moreover, even leading quantitative economists are happy to admit that in the century or so of its existence, quantitative economics has displayed little if any predictive power. For example, consider this cri de coeur from Greg Mankiw, or this European reminder that none of the DSGE models in use every day at the highest policy level includes anything like a plausible theory of what is surely the most salient issue in economic prediction - the business cycle. And Axel Leijonhufvud is brutally direct:
I conclude that dynamic stochastic general equilibrium theory has proven itself an intellectually bankrupt enterprise.
Of course, I'm sure many other economodelers disagree with this epitaph. If nothing else, few scholars display such Diogenesian honesty as to pronounce the death of their own field. Nor are Mankiw and Leijonhufvud really saying that it's time for all the economists in the world to clean out their cubicles and consider new careers in the lawn-care industry.
I'm sure they are quite confident that, with redoubled effort, the profession can redeem itself. But, considering the age of the endeavor, the rest of us should feel free to be skeptical.

One of the most interesting intellectual phenomena of today is the fact that we can read the words of professionals whose jobs it is to actually predict macroeconomic systems. Ie: fund managers. My favorites are three blogs I've mentioned before - Macro Man, Cassandra Does Tokyo, and CT Oysters. Frankly, these guys are just mensches, anyone who reads their blogs for five minutes can see it, and if I had any money I would find a way to give it to them.

The first thing you notice about financial professionals is that they have almost no interest in the work of academic quantitative economists. (In fact there is a species of fund manager called a quant, but quantitative financial engineering has essentially nothing to do with the quantitative economics of Marshall, Keynes, Fisher and the like.) I discovered this world through Brad Setser's blog, and the likes of Setser and Roubini do interact with the pros - giving them considerable respect, indeed, which says a lot for Setser and Roubini.

But as we've seen, they are exceptions. In general, the relationship between the financial industry and the academic field of quantitative economics strikes me as quite comparable to the relationship between the software industry and the academic field of computer science. Ie: what relationship?

When you look at the methodology of the world's Macro Men - this post is a fine example - they seem to operate mainly on the basis of their noses. Their specialty is integrating a wide variety of perspectives and arguments and judging the soup by intuitive gut feel. Nothing farther from the work of Keynes and Fisher, or even from the methodology of the 21st-century central banker (who is often looking at the same problem from the other side) could be imagined. They are not practicing strict Austrian economics, although they are often influenced by it. But their approach is certainly in the literary category. Yet another strikeout for the econogers.

What I want to explain today is why quantitative economics doesn't work. My refutation is certainly not the only possible one - you can find a whole bushel full here. However, since only one refutation is required to refute anything, I have chosen one I find particularly ripe.

The task of econogy is actually remarkably similar to that of astrology. The astrologer maintains a model whose inputs are past measurements (star and planet positions, comets, eclipses), and whose outputs are future events (the death of a prince, the winner of a battle, the sex of a baby). Using signs, symbols and simulations, he maps the one to the other. His results are dispatched directly to the king, who uses them to set monetary policy.

Why do we know astrology doesn't work? We know it in two ways: inductively and deductively. Inductively, we see no past track record of successful astrological prediction - just as Professor Mankiw sees no past track record of successful econogical prediction. But this tells us very little, really. It could just mean that past astrologers were bad astrologers. However, radical new theories of astrology may indeed allow us to predict the deaths of princes, etc.

The deductive argument is far more brutal. We know that astrology doesn't work because we know that astrology cannot work. We know that astrology cannot work because we know physics, and we know that there is no plausible mechanism by which comets, planets, etc, can cause the deaths of princes. (Unless the comet actually hits the prince - a contingency which boring, zodiacless astronomers are perfectly competent to predict.)

Similarly, if you are an American, you've probably had the experience of watching a baseball game and hearing the commentator produce some egregious abuse of statistics, such as "Rodriguez bats .586 against Clemens on prime-numbered Tuesdays." You know that this number is (a) not statistically significant, and even if it was it would still be (b) a product of data dredging, ie, overfitting. And you know this not just because sports commentators are nincompoops, but because you know that the numerical properties of the calendar cannot possibly affect the batting of Rodriguez.

Is there an equivalent for econogy? As it so happens, there is.

Here is a question: how much better a car is a (new) 2008 Mustang than a (new) 1988 Mustang? Is it twice as good? Three times as good? 5.7 times as good? 1.32 times as good? How much better a computer is the MacBook Pro than the Mac Plus? 75 times as good? 1082.1 times as good? And who was a better Bond, Sean Connery or Daniel Craig?

Surely the form of the question is nonsensical. There is no objective way to quantify the quality of a car, or a computer, or a Bond. We might as well ask: what temperature is love? What is the weight of March? Which is better, a cat or a dog? We can express all of these as numbers. We can even produce formulas which output these numbers. But we cannot describe them as measurements.

Actually, however, econogers (econometricians, to be precise) solve these problems on a regular basis. They do so when computing the mysterious quantity known to econogers - and to readers of fine newspapers everywhere - as inflation.

The implicit proposition assumed by the word inflation, at least in its 20th-century meaning, is that changes in the value of money over time can be measured quantitatively. The 20th-century concept of inflation is largely due to one Irving Fisher, who is surely one of the century's most distinguished charlatans. Professor Fisher's work is online, and certainly worth reading, if only from a forensic point of view.

Consider the phrase "value of money." What is the "value" of money? Money, at least your modern fiat currency, has no particular direct utility, unless you need to snort a line of coke or find yourself "caught short." We desire money because we desire the things that money can be exchanged for, such as 2008 Mustangs, plasma TVs, crude oil, etc. Thus we speak of the "purchasing power" of money.

To be more concrete, let's look at a specific currency - the dollar. At any moment, we observe a vast set of prices, which are exchange rates between the dollar and other goods - 2008 Mustangs, euros, tickets to Bond films, and so on.

These prices are measurements - hard numbers. For any time T at which the market is open, we have a precise measurement of the dollar-to-euro ratio. We also have a precise measurement of the dollar-to-crude-oil ratio, and even a fairly precise one of the dollar-to-2008-Mustang ratio. (Though the bid-ask spread on this last is quite wide.)

If we want to speak clearly, however, we cannot speak of the "value of the dollar." We cannot say "the dollar is strong" or "the dollar is weak" or even "the dollar rose today." We can say all these things about the US Dollar Index. But we could construct another index which was a weighted average of the exchange rate from dollars to zinc, dollars to Malaysian ringgit, and dollars to Bond-film tickets, and this number would have just as much (and just as little) right to be described as "the dollar" as does the aforementioned index (which is usually what people mean). But our two numbers might well be quite different.

When we speak of the dollar, we have surrendered our souls to the fallacy of objective value. We have constructed a unitless number out of a set of measurements in incompatible units. The result is a mathematical solecism, like saying "my car is 60 miles fast." There is no such thing as value, only price, and every price has both numerator and denominator units.

But saying "the dollar is strong" is a peccadillo next to the flagitious concept of inflation. The Irving Fishers of the world claim, quite seriously, to be able to measure the "value" of 2008 dollars in 1988 dollars. Let's look a little more closely at how this feat is accomplished.

Clearly, this number is not a price. There is no exchange rate between 1988 dollars and 2008 dollars, as there is between 2008 dollars and 2008 euros. Due to our lack of reliable and effective time machines, there is no market on which 1988 dollars and 2008 dollars can be exchanged. (We can measure the 20-year interest rate in 1988, but by definition this cannot be affected by any events after 1988, unless 1988 has a time machine which can observe the future.)

Time is confusing, so we can think of the problem in another way. Suppose we build a powerful telescope by which we observe economic activity on Alpha Centauri. It so happens that the Centaurians call their currency the "dollar." What is the exchange rate between Earth dollars and Centauri dollars? There is none, because Earth and Centauri cannot exchange any goods, monetary or otherwise.

However, we note that some goods are exactly the same on Earth and on Centauri - the laws of physics being equal. Earth zinc and Centauri zinc, for example, are both zinc. Earth water and Centauri water are both water. So if we measure the prices of these invariant goods in Earth dollars and Centauri dollars, we obtain - presto - Professor Fisher's "commodity dollar."

But there are two problems with this approach. One, we have no reason to expect the Earth-Centauri price ratio in zinc to be the same as the ratio in water, or methanol, or gold, or any other intergalactic commodity standard. Two, while we can average them, but we have no objective procedure with which to define the weight of each commodity in our average. By mass? By energy content? By number of protons? By total price of annual product on Earth? By total price of annual product on Centauri? Each method produces a different result.

And three, we have no reason at all to measure goods that are identical on both Earth and Centauri ("commodities") and ignore items that vary, such as cars, movies, pizza, etc. An Earth Mustang costs E$30,000; a Centauri Mustang costs C$10,000. This suggests that 1 C$ equals 3 E$. On the other hand, Centaurians weigh 500 pounds and have eight legs, which requires a much heavier grade of suspension and a completely different style of seat...

Human anatomy in 1988 is quite similar to its descendant in 2008. Otherwise, the relationship between 1988 and 2008, at least as far as prices are concerned, is precisely identical to the relationship between Earth and Centauri: 1988 and 2008 cannot trade, and consumers in each have a completely different set of preferences and a completely different set of goods they can purchase to satisfy those preferences.

The diligent gnomes at the BLS, of course, have thought of all these things. For example, they have no problem in telling you how much better a car a 2008 Mustang is than a 1988 Mustang. Every year, for a month or two, both the new year's model and the old's are on sale at the same time. In the fall of 1988, you could buy either a 1988 Mustang or a 1989 Mustang. The latter was more expensive - say, 5% more expensive. Therefore, it must be 5% better, dollars to dollars. Compute this number every year, multiply it out, and we have our ratio. Here is a fine illustration of the sort of numerology involved. (Yes, "Fisher" is our dear old Irving, he of the "permanently high plateau," the eugenics, the prohibition and the intestinal butchery.)

This gives us an objective procedure to calculate the quality improvement in Mustangs. Here is another objective procedure: subtract 1900 from the year, and divide. This tells us that the 2008 Mustang is 108/88 better than the 1988 Mustang, ie, 22% better. Which of these procedures produces a number closer to the actual ratio of the value of a 2008 Mustang to the value of a 1988 Mustang? Obviously, to evaluate them, we would have to know said ratio. Back to square one.

Do you still believe that the ratio between 1988 Mustangs and 2008 Mustangs, or the ratio between 1988 dollars and 2008 dollars, or the ratio between Earth dollars and Centauri dollars can be calculated objectively, and should be assigned to the same category as actual numerical measurements, such as the ratio between 2008 dollars and 2008 euros?

If so, I recommend a visit to John Williams' Shadow Government Statistics. Williams combines the formulas used in the Carter era with the data sets of 2008 to compute a rather different set of numbers. A look at the graph tells all. As Williams puts it:
Inflation, as reported by the Consumer Price Index (CPI) is understated by roughly 7% per year. This is due to recent redefinitions of the series as well as to flawed methodologies, particularly adjustments to price measures for quality changes.
Needless to say, 7% is a rather huge number in the world of inflation statistics.

Is Williams right? Is he wrong? I think it goes beyond this. The problem is that Williams is operating under exactly the same assumption as those he criticizes: that there is an objectively calculable number called inflation. No doubt for perfectly justifiable reasons, he favors one (old) method of calculating this number, whereas the government's experts (also for perfectly justifiable reasons) favor another (new) method. Presumably there are many other methods which did not find favor either with the 1978 gnomes or the 2008 gnomes.

All of these figures are stuffed to the gills with subjective fudge. Whether the gnomes evaluate the products and weight the averages using their own personal taste (don't forget the Bond films - entertainment is a significant percentage of consumer spending), or whether their subjective taste is kept at the level of algorithmic choice, the problem is the same: different gnomes, different numbers.

Of course, there is nothing wrong with subjective estimation for purposes of illustration. If an auto reviewer says something like "the 2008 Mustang is three times the car of its 1988 ancestor," one might find it a little odd. If the number is not three but 3.47, a troubling Aspergery feel begins to emerge. But this is the reviewer's judgment, and judgment is why we read reviews. As a reader one may prefer adjectives to numbers, but the numbers are certainly no less expressive.

And this even holds true for "inflation." A historian may find it useful, in explaining the economics of the Roman Empire, to postulate an exchange rate between modern dollars and the denarius of Diocletian. Wheat prices, or labor costs, or precious metals, or any commodity or basket thereof, so long as the same good is obtainable in both 308 and 2008, may serve.

Illustrations, however, are one thing. Equations are another.

Quantitative economics can be refuted simply by observing that almost all its models rely on inflation-adjusted numbers. Figures such as "real interest rates" - ie, actual or "nominal" interest rates minus "inflation" - are everywhere. Other headline statistics, such as "growth," are calculated using the same kinds of spurious pseudo-prices. (And others, such as "unemployment," are consequences of different subjective choices.) Needless to say, an inflation discrepancy on the order of 7% is enough to throw most of your macroeconomic models into a completely different galaxy.

The key observation is that the relationship between the identity of the gnomes who produce the "inflation" number, and the prediction of the model (such as "unemployment"), is in exactly the same class as the relationship between the position of Saturn and the batting of Rodriguez. The latter cannot possibly depend on the former.

In other words, there is no conceivable causal mechanism by which the subjective taste of the gnomes can affect the variable which the model is designed to predict. It is just as erroneous to introduce the BLS's opinion of antilock brakes - whether produced by the judicious conclusion of grizzled auto reviewers, or by an algorithm which is simply encoding the details of Ford's model-year transition strategy - into a model designed to predict unemployment, as it would be to introduce the phase of the moon. Neither the phase of the moon or the stopping power of antilock brakes can either cause or cure unemployment, and any formula which implies otherwise can be discarded without any empirical evidence whatsoever.

Thus we can say: de gustibus non computandum. In matters of taste there is no computing. It is not necessary for us to examine the empirical results of models which purport to predict future events from a mixture of price measurements and subjective quality assessments. We know deductively that no such model can be accurate. We cannot be surprised to learn inductively that they do not, in fact, appear to work. Deduction trumps induction, though it's always reassuring when the two agree.

This analysis leaves two questions open.

One, we have demonstrated the worthlessness of economodeling, but we have not demonstrated the worth of econography. Perhaps both are worthless. In that case, do they need a divorce? Maybe they're more like one of those couples which deserve each other.

Two, we have failed to explain why, if economodeling is such obvious nonsense, it became and has remained so popular.

Perhaps these questions call for a sequel. The next UR post will appear on August 28, 2008. It will probably be about something completely different.


Blogger Votes or Semen said...

I hope the music keeps playing at least until I die. I don't think this great collectivist experiment that has been the 20th and 21st centuries has seen its bloodiest days yet.
Many people expect the singularity to save us from ourselves, but I don't think technology can save us if we use it to further inherently destructive policies.

August 21, 2008 at 3:00 AM  
Anonymous Anonymous said...

I sincerely apologize for not having the time this morning to read the entire article before having the need to reply. I wanted to point out a key bit of evidence from the financial world (in some sense my own professional experience) that might help in finding where the clash between these two halves is leading. I want to note specifically the lines of research or performance data that show how, with mutual funds, fund managers are being outperformed by strategies that are passively managed and rely on formulas to filter down stocks and keep costs lower. I don't know how much that sense about the "gut feeling" goes into designing the strategy, but my feeling is that quantitative tools are largely behind it.

I hope this is not obtuse, coming as it does without the knowledge of the second half of your expose.

However, one of the things that trips me up about the method of the non-quant economics is that the layering of assumptions creates, from a purely probabalistic standpoint, a scenario in which the more detailed they try to be in their reasoning, the least likely those outcomes would be. I only imagine this is a much subtler and more potent demon in the form of reasoning that does not utilize however-crude mathematic benchmarks.

I really must go. Keep thinking.

August 21, 2008 at 7:26 AM  
Blogger Macro Man said...

Moldy, I am honoured by both your mention and your approbation.

I would take slight issue, however, with your characterization of practioners' methodology as "gut feel", which to my mind sounds a bit wishy-washy. I think that the best of the practitioners approach markets in a more scientific method: identify what you are trying to analyze, gather facts, and base your conclusion on an unbiased weighing of the evidence.

Implicit in this is some sort of model of how the world works, which allows one to reach a logical conclusion based on the available evidence.

There is a marked difference between this and true 'seat of the pants' trading, which I have observed at close quarters and can confirm yields, ahem, erratic results.

August 21, 2008 at 7:39 AM  
Anonymous zanon said...


I see no reason why your distaste of modern macroeconomics (in all of its guises) and econometrics (which has a long history of being mangled -- see here: but that's no reason to throw the entire profession of quantitative economics under the bus.

I think it was paul krugman, of all people, who best articulated the benefit of models: whenever you make an argument about something you make assumptions, and writing that argument down in a model forces those assumptions to be 1) consistent, 2) transparent, and 3) precise. This makes it easy for other people to see exactly what you are saying. Without it you have all the old assumptions, but they are 1) inconsistent, 2) opaque, and 3) imprecise. Not a clear improvement.

But as you say, having an equation does not tell you anything about its wrongness or rightness. While macro has demonstrated its rubbishness, and econometrics is regularly abused, classical microeconomics has done a remarkably good job predicting outcomes of everything from rent control, to labor restrictions, to hoarding during times of emergency. There is no inflation measure in micro, so it does not have one of the key issues you discuss in your post today.

Finally, holding up the best of literary economics and comparing it to the worst of quantitative economics is not quite on the up-and-up. There are plenty of other literary economists out there (Naomi Klein?) who don't make the comparison look quite so one sided.

As for your vaunted professional investors, most of them are comparable with darts thrown at a board. If you want to highlight true astrology, the mutual fund industry is a good place to start, with the hedge fund industry coming a short second.

Macro Man: I really enjoy your blog, but you are a chartist, and that is the equivalent of reading bird entrails. I follow and enjoy how you share your thinking, but I'd also be fine pitting your risk adjusted, net-fee performance against a diversified global basket of ETFs and index funds across a 20 year time period. It's nothing personal, but the professional money management industry is as efective as (much of) quantitative economics.

August 21, 2008 at 8:00 AM  
Blogger Alrenous said...

I have a small question.

First let me say I generally agree and I'm glad you wrote the piece.

What about supply and demand? This is clearly a very numerical thing, and as far as I know, actually informs pricing decisions at large corporations. (Of course measuring expected demand is an art, but after that...)

In any case it explains prices extremely well.

Is this somehow not what you're talking about under econogers?

August 21, 2008 at 9:49 AM  
Anonymous c23 said...

MM: Here is a question: how much better a car is a (new) 2008 Mustang than a (new) 1988 Mustang? Is it twice as good? Three times as good? 5.7 times as good? 1.32 times as good?...Surely the form of the question is nonsensical. There is no objective way to quantify the quality of a car, or a computer, or a Bond.

Better: (adj) better ((comparative of `good') superior to another (of the same class or set or kind) in excellence or quality or desirability or suitability; more highly skilled than another

The keyword there is "desirability." Desirability is in the eye of the behold. So just ask some people to rate it on a scale of 1 to 10 - like for cars, or computers, or James Bond. Your results will have larger error bars than, say, measuring air pressure - maybe if you plot the results for a MacBook and a Thinkpad there will be a lot of overlap - but you will find that both of them handily beat an old 386 (and that a new Accord beats an '88 Yugo, and that Connery beats Roger Moore). It would be fair to say that a new Mac or Thinkpad is better than a 386.

Or you could just use a combination of market share and price to measure consumer preferences more directly.

Similarly, given that some things are actually better than others in the way that is relevant here, desirability, and that this can be quantified (albeit somewhat fuzzily), you can make a guess about how much better an item from 2008 is compared to an item from 1988. You could look at the market for used items, or just ask either customers or retailers, who should know roughly how much they would pay or could get for something. The government's policy of looking at discounts on year-old cars is not reasonable since cars drop in value logarithmically, so it would tend to overestimate the value of modern cars - it's as if they're trying to fool us, eh?

The question then becomes, are the fudge factors small enough that the numbers we get are actually useful over a given period of time? I'd use wikiality again. Let different teams of economists, using independently developed (preferably secretly to avoid herd behavior), come up with different models, and if their ideas about what 1988 stuff is worth relative to 2008 stuff matches, they're probably right. You used a similar argument showing that the Shadow Statistics site's numbers don't match the official ones - but the government may be trying to fool us. They have a direct financial interest in understating inflation, which is nothing more than a sneaky tax.

Would honest economists come up with consistent answers? I have no idea. But I think you'd have to try it to find out.

Of course, in practice it would be damned near impossible to get the economists to be honest. They would try to make their numbers match each others so their work would look useful and important. I don't have a solution to that problem, other than to hermetically seal the teams in underground offices with nothing but internet connections to the outside world, which are ruthlessly censored so that they don't know what the other teams are doing.

August 21, 2008 at 9:57 AM  
Anonymous zanon said...

ALRENOUS: Supply and demand *are* very real, and they set prices.

But, this is in the microeconomic realm of quantitative finance, an area that Mencius does not touch on in his essay, and therefore lumps (I believe absentmindedly) with the macroeconomic realm of quantitative finance, which is bunk for all sorts of reasons, the inflation calculation being just one.

c23: Your focus is on the wrong side of the argument, because, as you say, "desirability is in the eye of the beholder". It is easy to compare the worth of a 1998 Mustang with a 2008 Mustang. See how much each sell for *today*. That reveals, in wonderful, quantitative terms, the relative desirability of them both. Don't let Mencius fool you -- in the real of micro, economics does quite well.

The problem is inferring something about the value of money between 1998 and 2008 by comparing mustangs (or any other good). As Mencius points out, money *has* no intrinsic value, so talking about the value of money is the same as talking about the speed of car, it makes no sense.

We could talk about the quantity of money supply in 1998 vs 2008 -- how many dollars (both notes and credits) there are in the world and, instead of talking about inflation talk about monetary dilution.

August 21, 2008 at 10:36 AM  
Blogger Macro Man said...

Zanon, I am not a "chartist"...or at least not just a chartist. That appellation is best applied to those who use charts as their sole criterion for making investment decisions, and would happily trade Centauri zinc futures as readily as the S&P 500, as long as they had a chart for it.

That having been said, charts do provide some information....namely, a literal representation of where prices have been in the past and how they have moved.

This information is not completely without utility; how, for example, in a world of imperfect information, can one render judgement on whether factors A, B, and C have been adequately discounted? I would submit to you that a useful place to look is a chart demonstrating price movements since the factors came to light.

There is also, of course, a behavioural issue as well; if one does not believe in charting, but knows that everyone else does believe in charting, it might still behoove one to be familiar with the techniques so that one can understand (and indeed participate in) potentially profitable price action.

In my line of work, results are the only thing that matter, and charts are a tool that improve the investment performance of my economic judgements by allowing me to time my trades more profitably.

Under ordinary circumstances I would be happy to take your bet, but in 20 years' time I plan to be well shot of the business of looking after other people's money.

It seems to me that you are confusing the median money manager with the entire cohort; as in any other population, there is a lot more mediocrity than there is quality, but that doesn't mean that it is impossible for quality to exist, Nicholas Taleb's own failed fund management efforts notwithstanding.

August 21, 2008 at 11:34 AM  
Anonymous zanon said...

MacroMan: I apologize if my comment came across as a slight -- truly it was not meant that way. When I said I did not mean to be personal, I meant it!

I was also being 100% honest when I said I enjoyed your blog, I read it every day, and I find your comments interesting.

Finally, you are correct, charts are just ONE thing you look at, not the ONLY thing you look at, and who am I to say whether or not that additional source of data is helpful. Certainly, given that others also look at that same information, it certainly must have some impact on trading patterns.

Ultimately, as you say, performance is what matters. Of course I understand that you classify yourself as above average.

Would you agree, though, that the median money manager would lose in my contest?

If so, then all we need to do is having average, and below average money managers identify themselves so we can avoid them!


August 21, 2008 at 12:04 PM  
Blogger Macro Man said...

Ah yes, there's the rub. Unfortunately, one needs to perform a substantial amount of due diligence before one can sniff out the quality. From a retail investor's perspective, your basket of low-cost funds do indeed make a sensible choice.

At the institutional level, which is after all, where the big fish swim (and, it must be conceded, the biggest charlatans reside), such due diligence is all part of the process; my own experiences of institutional "real money" clients is that they tend to be very heavily focused on the investment process, which is after all a requisite foundation for generating superior long-term risk-adjusted returns.

And glad you enjoy "the other MM".

August 21, 2008 at 12:20 PM  
Anonymous zanon said...

MacroMan: Yes, MM suggesting both MacroMan and Mencius Moldbug has confused more than one thread.

I have some connections in the institutional investor space, although less than you I'm sure, as well as the firms who advise said institutional investors on where to put their money. The recent hedge fund boom has certainly been linked to that becoming an accepted asset class in the IM world.

The best information I have on that move is that it will end up being an expensive way to hold equity (as mentioned on Cassie's thread)


August 21, 2008 at 12:25 PM  
Anonymous Michael S. said...

The analogy to astronomy/astrology is a good one, but requires some refinement. That to chemistry/alchemy does even more so. Boyle did not separate chemistry from 'alchemy' (i.e., chrysopoeia or gold-making) - he was a lifelong devotée of chryopoeia, as Larry Principe makes clear in his biography of Boyle, "The Aspiring Adept."

It is more appropriate to say that astronomy and astrology were once one and the same body of knowledge - Kepler, after all, was employed by Rudolph II to cast horoscopes. A good command of astronomy is necessary to establish the position of the stars and planets at the moment of a subject's birth for purposes of genethliacal astrology. As Kepler and his contemporaries practiced it, this was a difficult and complicated art requiring a good deal more precise calculation than is involved in looking up one's sign as one does in today's daily newspaper astrology columns. What happened was that around about the end of the seventeenth century, the parts of the combined body of knowledge we now know as astrology ceased to be practiced by serious people, who devoted themselves to the remaining parts we now know as astronomy.

Alchemy/chymistry/chemistry were similarly one body of knowledge - see L. Principe and W.R. Newman, "Alchemy Tried in the Fire," and their essay "Some Problems with the Historiography of Alchemy" (in "Secrets of Nature: Astrology and Alchemy in Early Modern Europe," eds. W.R. Newman and A. Grafton). They likewise involved great operative skill and precision. An example of this is seen in the gravimetric quantitative analysis of precious metals (assaying), the techniques of which were already well developed by the middle ages.

What happened, again toward the end of the seventeenth century, was that chrysopoeia began to be distinguished from the rest of the discipline. One of the earliest examples of this I have in my library is J.C. Barchusen's treatise "Pyrosophia" (1698), which was used as a textbook at the University of Utrecht. The first two parts of the work discuss the metals, acids, salts, oils, and other materials one might encounter in such practical operations as the preparation of medicines, the extraction and purification of metals, etc. The last division is entitled "pars tertia de Alchimia sive arte transmutatoria" - i.e., chrysopoeia. Barchusen thus exhibits an awareness that this was somehow different from and stranger than the mundane activities he described earlier, but he was nonetheless a believer in it. This is exactly the attitude displayed by Boyle, Newton, Locke, and other contemporaries. The possibility of transmutation was not thoroughly discredited until well into the eighteenth century.

The belief that transmutatory alchemy was feasible lasted longer in Germany than any place else, and it was directly related to the economic circumstances of the German princelings, who ran their little domains on mercantilist/cameralist lines, and were often short of the gold with which they so desired to fill the Schatzkammer. See, for example, Tara Nummedal's "Alchemy and Authority in the Holy Roman Empire." Indeed it exerted an influence on German thought into the nineteenth century - see Glenn Alexander Magee's "Hegel and the Hermetic Tradition."

The chrysopoietic alchemist of the 16th-18th centuries, along with the genethliacal astrologer, occupied roughly the position with respect to the ruler that economic advisors do to presidents and congresses today. The role of the alchemist was to engineer 'economic stimulus,' and that of the astrologer to predict the future. The princely practice of hanging such people (from gilded gallowses) when their schemes and forecasts failed to bear fruit might profitably be reinstituted for the economic advisors our rulers retain today.

August 21, 2008 at 12:26 PM  
Anonymous Blode said...

Moldbug, I dig your blog and wish I had a framed picture of you next to my oil-painting of the great chemist Orsted, but I can't digest the way you use "literary" to refer to history and economics that you approve of. You really need an adjective form of "the humanities" rather than an inflection of "literature". I'm not saying I know the word exactly ... something to do with English not being a completely synthetic language, I think ... but "literary" still sounds like you're talking about fiction.

Crap, what was that word you used to describe the common-sensical, non-quantitative approach to good government before the advent of public policy analysis? I liked that word. Wrote it down. It's in my other pants.

August 21, 2008 at 5:04 PM  
Blogger Victor said...

This comment has been removed by the author.

August 21, 2008 at 8:50 PM  
Blogger chairmanK said...

Mathematical models are useful for physicists, so why do you complain about the use of mathematical models by economists? What you call "literary economics" provides useful intuitive insights, but those insights can be validated and refined using mathematical formalism and computer simulations. Quantitative economics ought not be any different from quantitative neuroscience or quantitative condensed-matter physics (indeed, economics is the statistical mechanics of ensembles of brains).

I agree with you that macroeconomic policymakers are talking pseudoscientific nonsense when they attempt to measure inflation or the "value" of a dollar. And everyone knows that macroeconomists have failed at making consistent, non-trivial predictions. But I don't think that the proper remedy is to abandon quantitative economics altogether. It just needs to be done better.

August 21, 2008 at 8:51 PM  
Blogger Victor said...

As others pointed out, the argument about comparative value of Mustangs from different years is a little odd. Value being by definition that which people hold, how people feel about different model Mustangs defines their relative value; thus, comparing the prices of Mustangs from different years is in fact the very definition of accurate value comparison.

It's more complicated in reality of course, because you would also have to discount for overstock and the novelty factor of the new model; but the principle is sound (which conclusion I reached using the deductive methods you praise).

I think your complaint is comparable to saying that since there is no absolute frame of reference, relativistic physics is crap. In fact, as I was reading your post, I kept thinking about Lorentz transformations. The problem with macroeconomics is not that value is impossible to compare across different contexts, but that we try to come up with a single number reflecting a whole lot of somewhat independent relations.

It's like comparing the values of two subsets of a partially ordered set -- sure, the result won't be very accurate (unless by a stroke of luck you are able to pair the elements in such a way that each element in set A is greater than a corresponding element in set B), not even very meaningful, but they are the best we can do under constrained circumstances. The fact that we choose to use such a result for convenience's sake, does not invalidate the whole field.

You seem to be hell-bent on giving up the very idea of actually being able to give quantitative answers to some very, very important questions -- questions about real issues out there, not the 'how many angels can blog about economics on the head of a pin' kind. That strikes me as, frankly, useless and defeatist.

August 21, 2008 at 9:00 PM  
Anonymous Lawful Neutral said...

Was it also useless and defeatist to give up on making gold from lead? If economics is, in fact, bunk, then pretending it isn't will only lead us to make poorly-informed decisions. That wouldn't be defeatist, but it would be counterproductive.

August 21, 2008 at 10:54 PM  
Blogger TGGP said...

Boyle didn't come up with a new term. "The Sceptical Chymist" like "The Skeptical Environmentalist" referred to an existing type (the good old alchemist) and but demanded more rigor. As others have noted, he continued pursuing transmutation himself. Unfortunately that was before nuclear physics and nanotechnology.

Roubini doesn't seem like a literary economist, just another in the vein of Krugman and Stiglitz. Milton Friedman did popularization for the masses as well. Armen Alchian's textbook contained hardly any equations. The guys at Cafe Hayek are really into economic communication, even righting completely fictional novels to explain economic concepts.

Theoretical model building has been declining in importance in economics for some time, but not because of a revival of "literary" economics (there is no reason that you can't have both a literary-style explanation along with a mathematical model for your theory). It is actually Freakonomics-style investigations into empirical matters, often seemingly unrelated to normal economic concepts, that have pushed it aside. This began with the "natural experiments" investigated by economists like Krueger.

I do think you have a good point about macroeconomics. The trend in the natural sciences is toward reductionism and consilience. The divergence introduced between micro and macro does not seem to be "cutting reality at the joints". Macro looks at things from the perspective of a national economy, but as many economists have argued, there isn't really such a thing as the "American economy".

August 21, 2008 at 11:19 PM  
Blogger MarcWPhoto said...

It is (as you no doubt know, you instigator, you) quite obvious why economodeling is so popular. It has allowed governments to commit the Diocletian Sin and claim that it is, as it ever was and ever shall be, not because they wish to spend more than the populace wishes to give them, but because brilliant men with glasses and tweed jackets have mathematically proved that it is right and proper for them to do so. It allows them to claim ever more power over economic life without argument to Marx, which has proven not to work out so well. And it gives the comfortable illusion of control over that which cannot be controlled, addressing a primal need of the human psyche. Since it did not exist, it was necessary to invent it.


August 22, 2008 at 9:33 AM  
Anonymous Michael S. said...

Blode, the adjective form of 'the humanities' is 'humanist.' This has been distorted by the recent usage 'secular humanist' as a sort of euphemism for atheist.

By itself, the word humanist refers to the study of 'humane letters.' I believe the Oxford university course in classics, colloquially called 'Greats,' is still formally entitled Literae Humaniores. The original humanists were people like Petrarch, Erasmus, Politian, Pico della Mirandola, etc., who read ancient literature for the wisdom it contained rather than for purposes of grammatical and philological dissection or - as is the fashion today - ideological 'deconstruction.'

August 22, 2008 at 11:13 AM  
Anonymous raistthemage said...

I think modeling of complex systems in reality can be useful if the system is simple (ie the growth in grain production of an isolated manor in High Medieval times could probably be accurately modeled for a limited amount of time into the future)... at least until the black death or the hundred years war intervened.

But if you want to model the amount of inflation in the "US economy" this task is impossible. The most reliable indicators of cost of living inflation (energy and real estate prices) are excluded from "core" inflation.

August 22, 2008 at 11:36 AM  
Blogger TGGP said...

not because they wish to spend more than the populace wishes to give them
Long before folks like Walras, critics of democracy like de Tocqueville were warning that the populace would figure out they could vote themselves a share of the treasury. If you surveyed economists and the general public on their preferences regarding public expenditure, I doubt the former would so exceed the latter.

August 22, 2008 at 12:31 PM  
Blogger Victor said...

lawful neutral,

Bad comparison -- there were no decisions riding on being able to transmute lead into gold. You would be better off comparing this to making decisions based on astrological charts; but of course while we know that astrological predictions have nothing to do with the terrestrial events, inflation ratings, for example, have something to do with them. Since inflation rate obviously has some relationship to reality, making decisions based on it is better than making decisions based on astrological charts, which have no relationship whatsoever to that which they purport to predict.

Which is to say, imperfectly accurate information is better than none, and don't make the perfect be the enemy of the good.

August 22, 2008 at 1:50 PM  
Anonymous nick said...

Great article, Mr. Moldbug.

zanon: I think it was paul krugman, of all people, who best articulated the benefit of models: whenever you make an argument about something you make assumptions, and writing that argument down in a model forces those assumptions to be 1) consistent, 2) transparent, and 3) precise. This makes it easy for other people to see exactly what you are saying.

The problem is that more often a blizzard of math and jargon is used to hide bad assumptions. A much better way to unearth assumptions is to insist on clear language, logic, and simplicity.

There is a bad assumption hiding somewhere related to this statement, for example:

There is no inflation measure in micro

Being unable to account for inflation, and in particular changing inflation expectations, creates serious problems for micro because micro is unable to explain price changes due to changes in inflation expectations, and instead ascribes spurious fundamental explanations for these price movements. This makes micro a very bad tool for analyzing many commodities priced in floating currencies, for example. The fact that you can't measure something like inflation objectively does not make it go away -- it just irreparably screws up analyses that either fraudulently concoct an objective measure or, at the other extreme, just assume that the phenomena doesn't exist or doesn't matter for the problem at hand.

August 22, 2008 at 2:14 PM  
Anonymous nick said...

victor: As others pointed out, the argument about comparative value of Mustangs from different years is a little odd...comparing the prices of Mustangs from different years is in fact the very definition of accurate value comparison.

The problem the CPI mongers are pretending to solve is that of comparing a new 1998 Mustang with a new 2008 Mustang. Even if you could identify a bunch of 1998 Mustangs that have done nothing but sit in a garage for 10 years, and then sell them at auction, just sitting in the garage can cause some parts to decay. There can be other problems due to age such as spare parts becoming harder to find, new laws about mileage, pollution, etc. that the old cars no longer comply with, fewer mechanics trained on the old technology, etc.

August 22, 2008 at 2:27 PM  
Anonymous zanon said...

NICK: I'm sympathetic to your point that mathematics and a blizzard of jargon can hide bad assumptions, and bad reasoning, but I assure you that blizzards of words work in entirely the same way.

Insisting on "clear language, logic, and simplicity" is like insisting that people only say that things are true -- it would sure be nice, but isn't going to get you far. Mathematic models are clearer, more logical, and simpler than linguistic models, but this does not make them any more or less right, and an obsession with modeling gets lots of papers published, but tells us nothing about the real world. Which is where academic macroeconomics is today.

My problem with inflation, and it's the same as MMs, is that the term, as it is commonly used, conflates monetary effects (dilution, concentration) with everything else (quantity, quality, etc.) Just as I cannot say whether a $1M house is expensive or cheap (where is it located, how large is it? what condition is it in) I cannot say if a 10% increase in price level means the Fed's running the printing press again, or supply is down, or it's become a fad.

I don't see your problem with micro and commodities. You have a hurricane in Florida, and the price of oranges goes up. This is a pure micro story and it goes just fine.

Also, going through my head of the major micro models, I don't see a term for inflation, or a distinction between real and nominal prices, in many of them, with the exception of labor market models, but those are all in terms of unemployment and now we're pretty close to the Macro world. But maybe I'm not thinking hard enough -- what did you have in mind?

Finally, Nick, we should have an inflation measure and it should track something very simple: how much was money supply diluted (or concentrated).

With that, I would know how much of price change to attribute to a change in the value of money, and how much to attribute to everything else. CPI is meant to do that, but it fails utterly.


August 22, 2008 at 4:04 PM  
Anonymous bnhstbl said...

zanon: I don't see your problem with micro and commodities.

Daily changes in long-term inflation expectations for a currency cause daily (and correlated) changes in commodities as priced in that currency. At high levels of inflation expectations as we've had recently these movements play large roles in many commodity prices, and they always dominate gold and silver prices. I have analyzed this in depth in a number of recent articles at my blog.

Micro models do, BTW, "measure" inflation by making an assumption about it: they assume that it is zero. They assume that the price of a commodity is denominated in some imaginary commodity of fixed value, often called a "dollar." If the dollar price of a commodity changes, micros conclude from this bad assumption that the price change must reflect some change in the fundamentals of the commodity, rather than a change in the currency the commodity is being traded for.

As a result micros are always trying to find a fundamental explanation for large and long-term price movements that have far more likely been caused by changing inflation expectations. Thus to read micro analyses of commodities over the last few years you'd think that the great goddess Mother Earth has visited our civilization with a hundred unique plagues, each just happening to drive up the price of a different commodity for a uniquely awful reason. Occam's Razor, probability, or just plain common sense says that isn't so. If a hundred prices in a given currency move in tandem, we should loook to what they have in common, namely the currency, for the explanation.

I don't have an absolute measure of inflation, but a relative measure of inflation expectations (that is, a measure of by what percent inflation expectations are changing) is fairly straightforward. Gold works well for this, as do broad commodity indices. It should tell us something that these (and TIPS, which measures 10-year CPI-U expectations) all give us roughly the same implied percentage changes in inflation expectations.

August 22, 2008 at 4:59 PM  
Anonymous nick said...

Oops, "bnhstbl" was me. :-)

August 22, 2008 at 5:02 PM  
Blogger George Weinberg said...

A few points:
1) it is simply not true that quantitative models of economics are only of use to central planners and wannabe central planners.
2) It's only Austrians that would divide economics into Austrians and the rest. Keynsians, for example, would probably lump the Austrians, and Chicagoans together as being guys that think the free market is the answer to everything.
3) You seem to be making the mistake of asserting that if a term is not precisely defined then it doesn't mean anything at all. If there were only two commodities of interest, then there would indeed be nothing but their ratio of values, and it would be meaningless to ask whether a change in the ratio represented a rise in the price of gold or a fall in the price of silver. And if there were many commodities, but the exchange rates between every pair fluctuated wildly and unpredictably from one year to the next, it would indeed be futile to talk about anything like a constant measure of value. But neither of these is the case. You can make a list of a large number of commodities and find the exchange rates between most pairs doesn't vary much, and if one suddenly becomes dear relative to the rest it is likely due to a specific cause interrupting the supply, and the cost will likely return to something close to the usual value.

If one says something like "one 2008 dollar is worth the same as x 1950 dollars", this means something like "if I made a list of 100 commodities, I would find that for most items on the list 1 2008 dollar would buy approximately the same quantity as x 1950 dollars". Nobody has ever suggested there could ever be a precise equivalence of the values of money of different times.

August 22, 2008 at 7:39 PM  
Anonymous Blode said...

On further reflection, I think "econography" is a fine term, and no other word-seaching is necessary. I shall begin to use econography in this sense and single-handedly create a revolution. Or maybe not, but at least I have a bigger lexicon.

Moldbug, I never got a sense of your views on monopoly vs. competition. Murray Rothbard seems to support competition among security providers who lack taxing power, you seem to support a single (dare I say it?) state which is only limited in scope and has taxing power. So I guess you're from the non-anarchist wing of the Austrian school, while also being from the non-ordoliberal wing.... But I guess you've already got a term for that too (neocameralism).

So you're an econographically-literate anti-teleological neocameralist Jacobite.

August 23, 2008 at 9:22 AM  
Anonymous randy said...

"The fallacy of objective value"

Exactly. The political class couldn't exist without it, and the non-political class falls for it every time.

August 24, 2008 at 7:47 AM  
Anonymous Libra said...

Anon, Zanon, and Victor-

Modeling can at times be useful. But it's only a small part of good decision making. It's also very easy to use bad modeling and statistics.

At the startup where I work, we do use statistics and models. When the CEO pitches venture capitalists, he uses models, and he uses them for the exact reason Krugman says. They are not meant to predict, but to lay out all the assumptions clearly and consistently, so you can see how they interact.

That said, the model is a very, very small part of why venture capitalists invest. They care far more about the team, their knowledge of the market, the technology, and customer feedback. Almost all of these are impossible to measure with any kind of number.

We also use statistics to find out which part of the product our customers are using. But we know this is a flawed method, and so we only rely on it for a small part of our analysis. Mostly, we go from our own intuition, design sense, user testing, customer interviews, and eating our own dog food. The word Mencius used for this was Phronesis. It's exactly what we do, and that's why we have a successful product.

In summary, about 90% of running our business is non-statistical. For the part that is statistical, the statistics are flawed but we constantly try to improve them.

It's also possible to have just awful statistics that provide mislead into making bad decisions. Mencius's example of batting average on the second Tuesday of the month is one of these. In our business, an example of a terrible statistic is number of lines of code written per week. There are coding shops that have tried to optimize for this number. They did not last long. Productivity in lines of code has nothing to do with creating a product people want to use.

Some of the management at my startup would love to use modeling more than we do. They love to play with their excel spreadsheets. But they are kept in check by the fact that most of it doesn't work, and until they show it works, we are staying with more proven methods. It's not hard for me to see how in the absence of competitive pressure, the econ profession has way over invested in modeling. In fact, in academia, the pressure is not on being right, but on making your job as difficult to obtain as possible, which drives up your own prestige an salary. This has resulted in a massive overemphasis on mathematics.

Thus, the problem with modern economics is two-fold:
1) Instead of the field being 90%
Phronesis and 10% models, it is instead 95% models and 5% econgraphy. The modeling replaced econgraphy even where econgraphy was producing better predictions and better explanations of events.

2) The core statistic - inflation ( and by extension GDP) - is politically constructed nonsense.

For point 1), I just browsed the web site of Harvard's economics department and downloaded a random sampling of papers. Every single one of them was econ-modeling. The papers on growth economics were absolutely ridiculous. They would try and code conditions in a country into variables, and then run regressions to show what caused development. Of course, the regressions fail, and the author concludes with several ways the model could be improved to create better predictions.

An approach based on Phronesis would be to write case studies from actually being on the ground in these countries. The underlying question would be, why aren't people starting businesses and investing capital in order to improve their lives? Maybe the author finds that corrupt local officials steal their profits. Or maybe the people are too malnourished to plan ahead. I don't know what the answer to development is, but I know you're not going to find the answer with models.

For 2) the GDP issue, I think Mencius made a pretty effective debunking. But a few things can be added.

Perhaps an even better example than the mustang - how many times better is a 2002 desktop computer than a 2008 computer? One person may say that the 2008 model is 5 times better, because the processing power is 5 times greater. Another person might say that they are equal, because they only use Microsoft Word, and that works equally well on both computers. A third person might say that the 2008 version is worse, because Vista sucks and crashes constantly. The judgment is entirely subjective. Plausible arguments result in an order of magnitude difference in the result. And yet, this number is actually used to determine the GDP. Every component of GDP is this bad. Which is better an average 1970's house - ( 1,500 ft, 15 minute commute, in a neihborhood with a very high walkability index) or the average 2008 house ( 2,200 square ft, 25 minute commute, have to drive everywhere)? Which is better, Grey's Anatanomy or a Vaudeville Show? Thanks to Napster/BitTorrent/NetFlix, the average person has an infinite supply of music, tv, and movies. Is that an infinite gain in wealth? Of course, Napster and the Internet seemed to have killed the music industry, and no great bands have arrived on the scene since the late 1990's. Since I love guitar rock, this is a terrible loss for me.

For most items comprising the CPI basket of goods, plausible arguments could be made that result in not only order of magnitude difference in growth, but an actual change in direction of growth. Yet magically, the number comes out to consistently be 2-3% a year. It's not a conspiracy, but it's obvious the number is purely the creation of a messy political process.

What happens is that every so often people subjectively feel that the number is wrong. For instance, in 1996, measured inflation was causing social security payouts to go out higher than people thought were necessary. So they found plausible arguments for reducing the inflation number. I am sure that when they figured out all these hedonic and chain-weighting measures, the committee members simply kept adjusting the model until the numbers looked right.

The number is so divorced from reality that our cities can turn into desolated war zones ( the 1970's) or the internet can give us an infinite amount of entertainment for free, and neither makes much of a blip in the GDP number.

It's simply astounding that economists run so many regressions against the GDP number, when it was so obviously designed by a political process to result in 2-3% growth a year. Astrology indeed.

If you really want to track changes in the standard living over time, statistics can certainly play a roll. But you have to use your brain. If I was studying the changes in the standard living, I would look at each part of a person's budget individually. I would make an objective comparison of price of good versus median income. For instance, I'd look at the price of eggs or flour or fish versus median income over time to see how much richer in terms of food we were. I'd then subjectively compare the offerings in a typical super market today versus 1950. I'd look at the price of the median home compared to median income in 1950, versus today. But then I'd also have to subjectively compare the size of the home, location, commute, etc.

Statistics, such as median income or the price of eggs, can be very useful in combination with subjective comparisons. But the models of the modern econologists are patent nonsense, and they need to be shunned by all intelligent people.

August 24, 2008 at 9:10 PM  
Anonymous zanon said...

bnhstbl/nick: I agree with your point -- it's been impossible to tell a good story about recent moves in commodity prices without having a good idea about the future strength of the dollar.

I would also add, though, that the stories that make sense re: the dollar come firmly from the Austrian side of the ledger, not ISLM models.

So yes, here we have a micro-phenomenon that is a manifestation of a macro-economic phenomenon. I would still classify it as an exception that proves the rule, most micro-phenomenon happen over short enough times scales that "inflation=0" does not materially change predictions.

LIBRA: Although I'm a fan of modeling, I also don't believe it substitutes for a brain. Moldbug's point is that, in macroeconomics, it surely has. Spending some time studying modern macro models will make it abundantly clear where he is coming from.

August 25, 2008 at 8:39 AM  
Anonymous Blode said...

Thanks for the link to "phronesis", Libra.

I have a little to add to the discussion about phronesis versus mathy/sciency thinking. While both kinds of thinking are difficult to do correctly, there is a more obvious floor to the abilities required to do the latter. While anyone can say, "Common sense dictates that the correct course of action is ____", not everyone can make a spreadsheet create a stacked bar chart.

This gives the illusion that econometrics, etc., are a more elite undertaking than phronesis, and that people who can convincingly pull off the former have some sort of rare qualifications.

As a college student, it's easy to think of a hundred examples of someone (dim) using (low-quality) phronesis to refute things the social sciences get right. "I don't care what your charts say, I know the death penalty has a huge deterrent effect." I heard that one a few too many times.

That is why I hope we don't confuse good phronesis with common sense. It's uncommon for people to be able to pull off good visceral policy-making. Much less common than proficiency with Excel. What Moldbug and Libra are talking about here is the phronesis of talented, experienced people; I just want to add that talent and experience can be difficult to detect and describe objectively, so we're often left relying on what is essentially an arithmetic test.

August 25, 2008 at 9:21 AM  
Anonymous Michael S. said...

A source of failure on the part of econometric modelling that I have not seen much discussed is the questionable worth of the underlying information.

Most people associate the U.S. Census Bureau with the decennial census of the population, on which the apportionment of congressional districts is based. But the devil makes work for idle hands, and the Census Bureau has to justify its continuing existence during times when it is not carrying out a constitutionally mandated function. One such of the Bureau's activities is the Census of Industry. Businesses in hundreds of industries are periodically canvassed. Each industry has a census form designed specifically for it, and these ask highly detailed questions about each business's operations. Response, just as with the population census, is compulsory.

In my experience, most businesses keep track only of information that is either 1) relevant to their internal needs, or 2) required for IRS filings and compliance with the principal regulatory authorities with which they deal. Much of the information required by the Census of Industry falls into neither class. It might ask, for example, for physical quantities of certain raw materials used by a manufacturer. The manufacturer may not group its raw materials into the classes used in the Census. Furthermore, for most of a business year, it simply keeps track of the costs of its inventories as part of its financial accounting, subject to an annual physical count (which gives only a snapshot on the day it is done). To determine the number of tons of some material used during the course of a year would, without having reference to each invoice paid for it during the period in question to determine the details, might typically involve a calculation to determine that amount from the total paid for the material during the period divided by the then-prevailing average price per ton, The result is a plausible guess subject to some margin of error. How much that margin is depends on how much effort the business puts into the basically unproductive and unwanted task of filling out the census form.

The compilation of what must be, in the case of at least some industries, thousands of census forms filled out with such plausible guesswork, may well and probably does bear very little resemblance to reality. It ought to give one some pause to consider that this information is cranked into econometric models and used by 'experts' for the setting of government economic policy.

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