Short blogging hiatus

In Europe for a week, won't be able to blog...

Why do people support austerity? A conjecture.

Paul Romer once said that "A crisis is a terrible thing to waste." A crisis, it is widely believed, gives you the chance to change long-entrenched institutions and make long-needed reforms. It's hard to read that quote without thinking the uncomfortable thought: Doesn't that mean that provoking, or at least allowing, a crisis is the best way to improve your institutions for the long-term?

This thought has been running through my head as I have interacted with three groups of people: 1) Southern European economists, 2) Western "Japan hands", and 3) American opponents of monetary and fiscal stabilization policy.

Regarding South European economists, my evidence is anecdotal, but every single Italian, Spanish, and Greek economist I've talked to has seemed very down on the notion of fiscal stimulus, and highly disdainful of Paul Krugman. Alberto Alesina seems to be an exemplar of their thinking. When discussing stimulus spending, they tend to predict that this spending will be captured by special interests and wasted. Monetary easing receives scarcely more respect. Inevitably, any discussion of the European crisis leads quickly to a discussion of broken institutions in the Southern European countries - poor tax collection systems, over-regulation, sclerotic labor markets, political corruption, and even a poor cultural work ethic.

Now, this could simply be selection bias; the U.S. is considered a bastion of laissez-faire, conservative macroeconomics, so it's possible that the conservative South Europeans are the ones who make it here. But interestingly, I see a very similar attitude among long-time Western observers of Japan (called "Japan hands"), who are mostly very skeptical of Abenomics, and very focused on structural issues. For example, here is Peter Drysdale:

The first two ‘arrows’ [in Abe's quiver] are crude Keynesianism and are controversial, not least because, if they work, they could bring unintended consequences for the currency and the Japanese government bond market... 

The ‘third arrow’ of revitalisation is therefore critical for the success of all these measures. If there is no effective reform program for promoting private sector investment-led growth, the chances of a bond market collapse and a fiscal mess multiply dramatically... 

A return to stable, relatively rapid growth, requires a more flexible and competitive Japanese economy. As Harner explains, ‘restrictions, anticompetitive and onerous laws and regulations, multi-tiered, bureaucratic interference and inflexibility, relatively high taxes — all these obstacles to free market exchange and competition have sapped profitability, international competitiveness, and growth from vast swaths of Japan’s economy’. 

Without getting rid of these burdens, Japan is not going to be able to grow its way out of stagnation and the risks would then be for deepening of the crisis.

As for American opponents of stabilization policy, these include John Cochrane, who pooh-poohs both fiscal and monetary stimulus, saying that we need to get rid of "sand in the gears" of our institutions in order to promote growth. They also include Tyler Cowen, who often disparages Keynesianism (though he sits on the fence in terms of monetary easing), and who often writes about the need to improve our political institutions.

What unites all these and other "austerians"? There are several possibilities. One is that austerity is a good idea, and that these smart people recognize that it is a good idea. Another is that these are political conservatives who are worried that countercyclical macroeconomic policy will redistribute income and regulatory privilege away from themselves or their favored social groups. A third is that the psychological impulse toward austerity - tighten your belt in bad times! - is simply very very strong among all humans. And a fourth possibility, favored by Paul Krugman, is the idea that austerity is perceived as morally virtuous.

I want to suggest a fifth possibility. I conjecture that "austerians" are concerned that anti-recessionary macro policy will allow a country to "muddle through" a crisis without improving its institutions. In other words, they fear that a successful stimulus would be wasting a good crisis.

Consider the perspective of someone who has long advocated institutional reforms. For example, imagine yourself as a Western "Japan hand". For decades, you have watched Japan stagnate. You have seen the revolving door of prime ministers come and go, come and go. You have watched the long-ruling LDP dish out trillions of dollars of taxpayer money to pay politically connected construction firms to pour concrete over every riverbed in the country, even as women were forced into unproductive housewifery by a sexist and hidebound corporate culture and foreign imports were blocked by ever more creative non-tariff barriers.

And as you watched Japan's economy stagnate and its productivity fall behind, you waited. You waited and waited for the day when things would get too dire, and the old system would eventually collapse under its own weight, and Japan would be forced to undergo an economic and social revolution. "One day," you told yourself, "they're not going to be able to muddle through anymore."

In 2011, it seemed that that day had finally come. Japan's economy had taken powerful blows from the 2008 crisis and the 2011 earthquake. The Fukushima nuclear accident had exposed the depths of government corruption. The long-ruling LDP had been replaced by the DPJ, but it was clear that the new guys were cut from the same tattered cloth, and only a massive political "realignment" could restore efficacy to Japan's Diet. And most of all, the Japanese debt continued to skyrocket, until it seemed inevitable that deep cutbacks were coming.

And then came Shinzo Abe, a stalwart of the old LDP, swept into power on a promise to beat deflation and use monetary stimulus to get Japan back on its feet. And Abenomics seemed to be working: the yen fell, inflation expectations budged, and the stock market soared. Suddenly there seemed to be a real possibility that Japan would "muddle through" yet again. Sure, Abe has also promised structural reforms, but - you think to yourself - you've heard that song and dance before. If Japan manages to muddle through under Abe's aggressive recession-fighting policy, there will be no real incentive for the old system to change. The day of reckoning will be pushed back another decade.

I can only imagine that a similar thought process is running through the heads of many South Europeans as they watch the macroeconomic debate. If monetary stimulus (including a euro exit) and fiscal stimulus manage to just barely save Greece and Italy and Spain from their own days of reckoning, won't the euro-sclerosis just deepen before things finally collapse in ten years' time? And I imagine that something similar might be running through the minds of John Cochrane and Tyler Cowen (Update: And Richard Fisher!), as they decry "sand in the gears". Suppose a Krugman-style stimulus really did work! Wouldn't that allow the sand to stay in the gears, reducing our long-term growth rate just to produce a little short-term stability?

In other words, maybe people like the idea of austerity because they think an economic stagnation is our best chance to address what they perceive to be our long-term challenges. Allowing a crisis might be less terrible than wasting it.

Now, when stated that way, the idea sounds kind of silly - why don't we just periodically bomb our own cities, in the hope that governance will improve during the rebuilding? But I find it very difficult to state with any confidence that the idea is wrong. When economists discuss the costs of stabilization policy, they limit their discussion to distortionary taxation, unexpected inflation, and things like that. They almost never bring politics or institutions into the picture. The fact is, we just don't know how institutions really work. So I can't dismiss the idea that anti-recessionary macro policy might, in fact, rob us of our best chances to make needed reforms.

But what I think we should do is to discuss this idea explicitly. If people really do think that the danger of stimulus is not that it might fail, but that it might succeed, they need to say so. Only then, I believe, can we have an optimal public discussion about costs and benefits.

Update: Eerily, the very day after I wrote this post, Steven Pearlstein of the Washington Post made exactly this argument for austerity. Tyler Cowen links approvingly, calling the argument "wisdom".

Science fiction novels for economists

Diane Coyle has a blog post called "Classics for economists," and someone on Twitter requested that I do a companion piece called "Science fiction for economists", so here it is.

Really, most science fiction is about economics. What makes most future visions interesting is not just the technical particulars of the cool new Stuff, but the social ramifications. Here are some of the sci-fi books that I thought dealt with important economic issues in the most insightful and interesting ways. I also chose only books that I think are well-written, with well-conceived characters, engaging plots, and skillful writing.


1. A Deepness in the Sky, by Vernor Vinge



In addition to being quite possibly the best science fiction novel I've ever read, Deepness is also a great meditation on public economics. When Vernor Vinge became famous in the 80s, he was a hard-core libertarian - his novel The Peace War, and its sequel short story "The Ungoverned", are like a Real Business Cycle model come to life, with lone-wolf genius engineers teaming up with private police forces to bring down a fascist technocratic government made up of...university administrators. Ha. But by the 90s, Vinge's views on government and markets had become markedly more nuanced - in the swashbuckling space opera A Fire Upon the Deep, we see private security forces failing miserably when faced with a powerful external threat (in fact, that book made me think of the "Tamerlane Principle"). Security, Vinge realizes, is a public good.

In Deepness, Vinge adds another public good: Research. The narrative of Deepness is split between a race of spider-people with roughly 20th-century technology, and a spacefaring guild of human merchants called the Qeng Ho. On the spider world, the protagonist is a brilliant scientist named Sherkaner Underhill, who is basically a Von Neumann or Feynman type. Sherkaner is the ultimate lone genius, but he ends up needing the government to fund his research. In space, meanwhile, the heroic merchant entrepreneur Pham Nuwen (who is a recurring protagonist in Vinge novels) struggles to decide whether he should turn his merchant fleet into an interstellar government. Governments, he finds, are good at producing really new scientific breakthroughs, but eventually they become unwieldy and stifle the economy and society, then collapse under their own institutional weight. The very very end of the book is - or at least, seemed to me to be - a metaphor for the Great Stagnation and the death (and future rebirth) of Big Science.


2. Makers, by Cory Doctorow



Cory Doctorow is known both for his science fiction and for being the creator of the blog Boing Boing, one of the oldest and best blogs on the internet. In Makers, Doctorow dishes up a near future that is almost spooky in its prophetic vision. The book is all about economics, the death of corporations, the rise of freelance and temp economies, the death of old media and the rise of blogs, and the disruptive impact of technology on people's jobs. It envisions the rise of 3D printing, the startup craze (and the startup glut), and the use of intellectual property as corporations' weapon of choice to fight back against progress. It's incredibly well-written, but also extremely sad, just to warn you.


3. The Dispossessed, by Ursula K. LeGuin



It's incredibly hard to imagine a world without private property, but LeGuin pulls it off. Spoilers: A world without property is pretty boring and fairly poor. But LeGuin also shows us another world, much like our own, where the anti-property anarcho-syndicalist movement was suppressed and tamed, much like Marxism was suppressed and tamed here on Earth. What's interesting is that although anarcho-syndicalism doesn't work incredibly well on the world where it's implemented, the anarcho-syndicalist idea and movement serve as a sort of permanent opposition force on the capitalist world. When I read Robert M. Buckley writing that Marxism has fulfilled a similar role in the West here on Earth, I immediately thought of The Dispossessed.


4. Down and Out in the Magic Kingdom, by Cory Doctorow



Doctorow again. In this book, he examines what a true post-scarcity society would look like. Spoiler: It looks a lot like a bunch of sarcastic bohemian Canadian people. But basically, I think that's probably what the future will look like, at least if we're lucky. Anyway, this book is notable for the concept of "whuffie", an online currency based on peer approval, which arguably inspired Facebook's "like" button.


5. Rainbows End, by Vernor Vinge



Vinge again. Rainbows End is a sad, thoughtful novel about old age and obsolescence (notice that there is no apostrophe in the title). But it's also one of the most visionary novels about future labor markets. In an interconnected world in which skills never stay fresh for long and most value is created through entertainment, old engineers have to go back to high school, and new corporations are started by teenagers collaborating online with strangers halfway around the world. Rainbows End is also famous for envisioning the technology of Augmented Reality; this novel probably inspired Google Glass. Interestingly, Vinge continues his evolution toward a balanced view of public goods, adding education to the list of things that government needs to provide. (Update: In an email, Vinge points out that he never specified that the high school in Rainbows End was government-funded! Touche!)


6. Accelerando, by Charles Stross



Charles Stross, another noted blogger, loves to play with ideas, even if he doesn't believe in them. In Accelerando, he mainly plays with the idea of the Singularity, but he also plays with a bunch of far-out funky future economics. In one part, the main character, impresario and wandering entrepreneur Manfred Macx, uses advanced computer algorithms to successfully implement an optimal centrally planned economy, by predicting what humans will want before they even know they want it. Macx's various disruptive innovations inevitably draw the ire of the law, and he creates a protective cloud of AI lawyers to wage constant "lawfare" against governments and corporations alike. In another part of the book, the entire solar system is taken over by sentient High-Frequency Trading algorithms. But I haven't really spoiled the book for you, since these are only about 0.1% of the ideas contained within. Note: Stross has also written a series called the Merchant Princes series that deals even more with economics, but I haven't read it.


7. Lucifer's Hammer, by Larry Niven and Jerry Pournelle



Lucifer's Hammer is a story about a comet hitting Earth, and the aftermath. It's notable for its quaint Reaganite conservative politics (it came out in 1977), and does make a couple of glaring economic mistakes (for example, a guy trying to build a nuclear power plant is an independent wildcatting entrepreneur instead of a giant government-backed corporation). But it makes up for that with its excellent portrayal of what the economy would be like in the immediate aftermath of an abrupt civilizational collapse. Hint: Farming, containment of contagious diseases, de-specialization of labor, and collective security become very very important.


8. The Windup Girl, by Paolo Bacigalupi



Brutally dark and hopeless, The Windup Girl is a book about peak oil, global civilizational decline, and the (temporary) end of positive-sum economies. In a suddenly overpopulated world, humans are forced into a constant Hobbesian zero-sum game, and most moral norms go right out the window. Warning: This is very tough book to read. But it serves as an important reminder of the Malthusian menace that forever lurks just outside the circle of light provided by the flickering candle-flame of modern technology.


9. The Moon is a Harsh Mistress, by Robert Heinlein



Actually a mythic retelling of the American Revolution, The Moon is a Harsh Mistress contains some very interesting thoughts on colonialism and the Resource Curse. Unsurprisingly, terrorism is used as a way to make resource colonialism too expensive for the occupying power. Unfortunately, we don't get to see the political struggles and despotic regimes that probably arose in the aftermath of lunar independence. But Heinlein also does use the book to play with some interesting libertarian ideas, like a privatized court system.


10. Schismatrix, by Bruce Sterling



Simply one of the most wide-ranging and visionary science fiction novels ever written. Bruce Sterling is like an eternally erupting quasar of creativity, and this is his finest book. None of the economics here makes any sense - or, more accurately, it all takes place in such a funky, crazy future world that it's impossible to know if it makes any sense.


11. Permutation City, by Greg Egan



If there's any sci-fi novel that beats Schismatrix for far-out blow-your-brain-out-the-back-of-your-skull vision, it's Permutation City. If I hadn't already had the idea for D-Mod, this book (written over a decade before I thought of the concept) would have given it to me fully formed. Permutation City is about the ultimate nature and purpose of human consciousness and experience, and yet it has implications for technologies that are being developed right now, as we speak.


12. Reamde, by Neal Stephenson



Most people would recommend Stephenson's Snow Crash or Cryptonomicon, but for economics I like Reamde the best. Although not technically sci-fi, it has that flavor. The hero is an aging tech entrepreneur who owns a game that's a combination of World of Warcraft and Bitcoin (yes, this book predicts Bitcoin). It also deals with the economic incentives of the Russian mob, the challenges facing smart young tech workers in China and Hungary, and lots of other cool features of today's global economy. It's not Stephenson's #1 awesomest book, though; that would be Anathem.


13. The Game of Thrones series, by George R.R. Martin



Actually, I lied earlier...the person who requested a "Sci-fi for economists" list also asked me to include fantasy. But the Game of Thrones books (actually called A Song of Ice and Fire, though few use that name anymore) are really the only fantasy novels I can think of that deal with economics in an interesting way. You get to see a lot of the messed-up economies of medieval times, including feudalism, slavery, anarchy, blood sport, and the difficulty of international trade with poor information and unreliable transportation.


Anyway, there's my list. I haven't read everything out there, obviously - I hear that Ken MacLeod's books have a lot of economics in them, for instance, as well as some of Heinlein's other works. But if you're in the econ field and you want to think big deep thoughts about economics under different technological and social conditions, these books are for you. They're also a lot of fun.

Update: Mark Palko looks at "Crime novels for economists". Diane, looks like you started a meme!

Update 2: Other sci-fi recommendations via Paul Krugman and Tim Worstall.

Of course "hedge funds" lose money

Matt O'Brien, one of my partners-in-crime over at the Atlantic, has a piece criticizing hedge fund managers who go on TV to advocate hard-money policies. (Joe Weisenthal has a similar piece.) I agree with the criticism. But Matt also calls hedge fund managers out for their poor investment performance. As this article from The Economist shows, super-expensive hedge funds have done terribly over the last decade, when compared with a simple low-cost diversified portfolio of stocks and bonds. Matt says: "Hey hedge fund guys, if you can't even beat the market, why should we trust you on policy issues?"

I think this latter criticism is a bit misplaced, for two reasons. The first (and less important) reason is that to evaluate hedge funds - or any investment - you need to look not only at the return, but at the risk. If hedge funds have higher return-to-risk ratios (such as Sharpe ratios) than a passive stock-bond portfolio, then they are a better investment. Why? Because in that case you can borrow money and invest it in hedge funds, and your leverage will increase the returns (and the risk) of the hedge fund investment. If the hedge funds have a higher Sharpe ratio than the passive portfolio, you can leverage up until your risk is the same as the passive portfolio but your return is higher. In that case, you will have beaten the market, even if the hedge funds in which you invested did not beat the market. A number of top hedge funds have earned lower returns than the market since the financial crisis, but with much lower risk.

See?

Now, I said that this is the "less important" reason. This is because even after adjusting for risk, hedge funds as a class probably underperformed the market. And they can be expected to continue to underperform the market, as a class. But that's just because hedge funds as a class are not particularly special, interesting, valuable, or desirable.

What is a "hedge fund"? It's a legal category, like "mutual fund". The "hedge fund" category is basically a "none of the above" legal category, meaning that hedge funds, alone among money management companies, have essentially no restrictions on the kinds of assets they are allowed to trade. To start a hedge fund, all you have to do is be a "qualified investor" with $5 million in capital, or be a "sophisticated investor". That means that as a hedge fund you can be essentially any Tom, Dick, or Harry, and you can try essentially any strategy. You could have macaque monkeys pick stocks and call it a "hedge fund". The catch-all "hedge fund" category attracts many of the best ideas in the investing world, but also many of the worst. And there's a lot more bad ideas than good ones. And you can't just tell which is bad and which is good by looking at size and fame, because many of the bad ones get lucky and get some temporary good returns, which results in people handing them giant wads of cash (which they then proceed to lose, while taking a giant fee).

Thus, just throwing your money at anything that is called a "hedge fund", just because you have heard that some "hedge funds" have managed to earn spectacular returns, is an extraordinarily bad idea.To put it another way: Anthony Scaramucci, organizer of the SALT hedge fund conference in Las Vegas, writes: "Mutual funds are the propeller planes, while hedge funds are the fighter jets." But that's not true. Some of them really are fighter jets. And some of them are beat-up old pickup trucks covered in papier-mache to make them look like fighter jets from a distance. And you aren't allowed to get anywhere near the planes to touch them and see which is which. And you forgot your glasses.

Anyway, I'm sure many rich people do invest in anything called a "hedge fund", but they're just throwing their money away (fortunately they have plenty to spare). But if America's pension funds, mutual funds, and insurance companies are doing this, then we have a problem.

In any case, we shouldn't be surprised that hedge funds as a class have been getting crappy returns of late. In fact, we've seen this sort of pattern before. In the 1990s, "venture capital" firms earned amazing returns, and a bunch of people heard about it and started throwing their money at anything that called itself a "venture capital" fund. New funds flooded the field to take advantage of this inflow of dumb money. Returns subsequently collapsed and have not recovered, though the old established firms continued making outsized returns (but stopped taking new investments, because when you get big it's harder to grow fast). The same thing happened with "private equity" (leveraged buyout) firms, who made a killing in the 00s but have not been doing so well since. And the same thing probably happened with mutual funds, back in the 60s when they became prominent and earned a lot of money.

So there is a very interesting behavioral story going on here. Why do people hurl their money blindly at the flavor-of-the-week money-management company category? Why do they fail to understand that there are good and bad hedge funds, just like there are good and bad architects or doctors or web designers? I don't know, but it's a fertile topic for behavioral finance research.

(And as a final note, the big worry when investing in hedge funds should probably be fees, not past performance. Even the best hedge funds may charge you such high fees that the extra returns they earn you get eaten up. So watch out.)

Back to the original subject, though. Matt shouldn't castigate "hedge funds" as a whole for making crappy returns, because it's just a legal category, not a hive mind. But his basic point stands anyway. You shouldn't trust hedge fund guys on policy issues. In fact, he even understates his case. Even if a hedge fund guy makes more money than God, year in and year out, you shouldn't trust him on policy issues any more than a highly successful physicist or heart surgeon or poker player. A money management company is not a nation-state.


Update: On Twitter, Giorgio Vitale brought to my attention the fact that the graph Matt shows is not actually hedge fund returns (those are often undisclosed), but the returns on an index that tries to track broad hedge-fund performance. That's good to know, though my points all still apply...

If you get a PhD, get an economics PhD

People often ask me: "Noah, what career path can I take where I'm virtually guaranteed to get a well-paying job in my field of interest, which doesn't force me to work 80 hours a week, and which gives me both autonomy and intellectual excitement?" Well, actually, I lied, no one asks me that. But they should ask me that, because I do know of such a career path, and it's called the economics PhD.

"What?!!", you sputter. "What about all those articles telling me never, ever, nerver, nenver to get a PhD?! Didn't you read those?! Don't you know that PhDs are proliferating like mushrooms even as tenure-track jobs disappear? Do you want us to be stuck in eternal postdoc hell, or turn into adjunct-faculty wage-slaves?!"

To which I respond: There are PhDs, and there are PhDs, and then there are econ PhDs.

Basically, I think of PhDs as mostly falling into one of three categories:

1. Lifestyle PhDs. These include math, literature and the humanities, theoretical physics, history, many social sciences, and the arts. These are PhDs you do because you really, really, really love just sitting and thinking about stuff. You work on you own interests, at your own pace. If you want to be a poor bohemian scholar who lives a pure "life of the mind," these PhDs are for you. I totally respect people who intentionally choose this lifestyle; I'd be pretty happy doing it myself, I think. Don't expect to get a job in your field when you graduate, though.

2. Lab science PhDs. These include biology, chemistry, neuroscience, electrical engineering, etc. These are PhDs you do because you're either a suicidal fool or an incomprehensible sociopath. They mainly involve utterly brutal hours slaving away in a laboratory on someone else's project for your entire late 20s, followed by years of postdoc hell for your early 30s, with a low percentage chance of a tenure-track faculty position. To find out what these PhD programs are like, read this blog post. If you are considering getting a lab science PhD, please immediately hit yourself in the face with a brick. Now you know what it's like.

(Note: People have been pointing out that EE isn't as bad as the other lab sciences, with somewhat more autonomy and better job prospects. That's consistent with my observations. But econ still beats it by a mile...)

3. PhDs that work. I'm not exactly sure which PhDs fall into this category, but my guess is that it includes marketing, applied math and statistics, finance, computer science, accounting, and management. It definitely, however, includes economics. Economics is the best PhD you can possibly get.

Why get a PhD in economics? Here's why:

Reason 1: YOU GET A JOB.

Can I say it any more clearly? An econ PhD at even a middle-ranked school leads, with near-absolute certainty, to a well-paying job in an economics-related field. I believe the University of Michigan, for example, has gone many, many years without having a PhD student graduate without a job in hand.

You will not always get a tenure-track job, though there are a lot more of those available right now than in other fields (thanks, I am guessing, to the nationwide explosion in business schools, which hire a lot of econ PhDs, including yours truly). But if you don't get a tenure-track job, you will get a well-paid job as a consultant, or a well-paid job in finance, or a decently-well-paid job in one of the many, many government agencies that hire armies of economists. All of these are what are commonly referred to as "good jobs," with good pay, decent job security, non-brutal working conditions, and close relation to the economics field.

Now, this may be less true at lower-ranked schools; I don't have the data. I imagine it's not as certain, but still far, far better than for lab science PhDs at similarly ranked schools.

Why do so very few newly minted econ PhDs face the prospect of unemployment? Part of it is due to the econ field's extremely well-managed (and centrally planned!) job market. Part of it is due to the large demand from the lucrative consulting and finance industries. And part is due to the aforementioned proliferation of b-schools. There may be other reasons I don't know. But in an America where nearly every career path is looking more and more like a gamble, the econ PhD remains a rock of stability - the closest thing you'll find to a direct escalator to the upper middle class.


Reason 2: You get autonomy.

Unlike the hellish lab science PhD programs, an econ grad student is not tied to an advisor. Since profs don't usually fund econ students out of grants (few even have big grants), econ grad students mostly pay their way by teaching. This means you usually have to teach, but that is not nearly as much work as working in a lab. Even when a professor does support you with a grant, (s)he generally employs you as a research assistant, and gives you ample time to work on your own research.

Compare this to a lab science PhD, in which you basically do the project your advisor tells you to do, and you succeed or fail in part based on whether your advisor chooses a project that works out. Your destiny is out of your hands, your creativity is squelched, and your life is utterly at the mercy of a single taskmaster. In economics, on the other hand, you can start doing your own original, independent research the minute you show up (or even before!). Profs generally encourage you to start your own projects. Unlike in lab science PhD programs (but like in "lifestyle" PhD programs), your time is mostly your own to manage.

This means that as an econ grad student, you'll have a life. Or a chance at having a life, anyway.


Reason 3: You get intellectual fulfillment.

Econ is not as intellectually deep as some fields, like physics, math, or literature. But it's deep enough to keep you intellectually engaged. Econ allows you to think about human interactions, and social phenomena, in a number of different intellectually rigorous ways (e.g. game theory, incentives, decision theory, quantification of norms and values, bounded rationality, etc.). That's cool stuff.

And economists, even if their research is highly specialized, are encouraged to think about all different kinds of topics in the field, and encouraged to think freely and originally. That's something few people appreciate. In a lab science, in contrast, you are encouraged to burrow down in your area of hyper-specialization.

In econ, furthermore, you get exposed to a bunch of different disciplines; you get to learn some statistics, a little math, some sociology, a bit of psychology, and maybe even some history.

Also, as an economist, your status as an intellectual will not disappear when you get a job. Even if you go to work as a consultant or a financier, your thoughts will be welcomed and considered by economists in the blogosphere. And you can even publish econ papers as a non-academic.

In fact, it's also worth pointing out that econ is a field in which outsiders and mavericks are able to challenge the status quo. This is in spite of the econ profession's well-known deference to intellectual authority figures. The simple fact is that econ, you don't need money to advance new ideas, as you do in biology or chemistry. And you don't need math wizardry either, as you would if you wanted to introduce new ideas in physics.


Reason 4: The risk of failure is low.

In economics PhD programs, the main risk of failure is not passing your prelim exams. This happens to a substantial fraction of people who get admitted to econ programs (maybe 25% or fewer at Michigan). But if you flunk out, you get a complimentary Master's degree, which is probably worth the 2 years that you'll have spent in the program. And after you pass the prelims, there is little risk of not finishing a dissertation; unlike in most fields, you do not have to publish to graduate.


Caveats about the econ PhD

Of course, I don't want to make it seem like the econ PhD is an utterly dominant strategy for life fulfillment. There are some caveats that you should definitely take into account.

First, there is the fact that an econ PhD program is still a PhD program. That means, first of all, that you will be in poverty in your late 20s. That is not fun for most people (some "lifestyle PhD" students and bohemian artists excepted). Also, econ PhD programs force you to manage your own time, while giving you very little feedback about how well or badly you're actually doing. That can be stressful and depressing.

Second, be aware that the culture of economics is still fairly conservative, and not in the good way. Econ is one of the few places in our society where overtly racist and sexist ideas are not totally taboo (Steve Landsburg is an extreme example, but that gives you the general flavor). Discrimination against women, in particular, probably still exists, though I'd say (or I'd hope, anyway) that it's on the wane.

Finally, there is the fact that if enough people read and believe this blog post (ha!), it will cease to be true. There's a piece of economics for you: as soon as people become aware that a thing's value is greater than its price, they will start bidding up the price. But information diffuses slowly. Expect the econ PhD to lose its luster in five to ten years, but that still gives you a window of time.


Anyway, despite these caveats, the econ PhD still seems like quite a sweet deal to me. And compared to a hellish, soul-crushing, and economically dubious lab science PhD, econ seems like a slam dunk. There are very few such bargains left in the American labor market. Grab this one while it's still on the shelves.


Update: Here's a 1999 paper documenting that the econ PhD is, economically speaking, a really good deal. Also, here is Bryan Caplan saying some very similar things back in 2005.

Update 2: A grad student friend writes:

[E]ven going to the abysmally ranked [econ]department that I go to I have no worries at all about getting a good job after I graduate. It may not be an academic job, but that's fine by me (or if it's an academic job it might be in a policy department rather than an econ department).

Another anecdote supporting the thesis that even econ PhDs at low-ranked schools don't worry much about employment...

Can "culture" predict economic development?

In this essay, Daniel Altman predicts that China will fall short of the West, because of its "Confucian" culture:

[Unconditional] convergence didn't seem to be happening in many parts of the world [in the last century]...[S]ome countries that appeared to be catching up to the West for a few decades, like Japan, hit a wall before they reached the same standards of living, falling inexplicably short of the target. 

In the very long term, [cultural] factors may turn out to be the most important ones [in China's development]. 

Confucianism is perhaps the leading influence on Chinese business practices...The teachings of Confucius date back centuries, and they are deeply ingrained in Chinese society...Yet some of its central tenets, though they may have benefits at the social level, are not necessarily conducive to economic growth. 

Confucian ethics teach that one should value the collective over the individual...A second and related tenet of Confucianism...encompasses the “respect for elders” that is a hallmark of many East Asian civilizations. In Confucianism, this deference belongs not just in family relationships but also between ruler and subject, master and servant, and employer and employee. 

Together, these tenets of Confucianism — and the way they have been interpreted by the Chinese authorities in recent times — have helped to maintain rigid hierarchies in Chinese businesses... 

There is one other cultural current that runs just as deeply as Confucianism...Chinese people learn a very particular story of the birth of their nation, in which the great struggle through the millennia has been to unite the enormous land mass and diverse ethnicities of China into one nation...The message is clear: to be united and realize the dreams of a great Chinese nation, the Chinese people need strong rulers who brook little dissent. 

The message carries through to the boardrooms of Chinese companies, which tend to concentrate the instruments of power in the hands of a single strongman... 

All of these factors will combine to lower the target for material living standards in China — or, to put it more technically, they reduce the level of per capita income toward which China is converging. With these factors in place, China simply is not in the same convergence club as the United States...

China may just manage to catch the United States and become the world’s biggest economy. But it will hold onto the title for only a few years before the United States, growing more quickly in both population and the productivity of its workers, passes China again... 

[A]s Japan’s example goes to show, holding onto culture — and other deep factors — can keep the limits to growth in place.

This column provides an object lesson in the degree to which using Twitter has limited my vocabulary. I'm struggling to think of a concise description of this essay that does not involve the word "derp".

First, I need to deal with the most glaringly annoying part: the Japan example. Altman claims that Japan failed to catch up with the West. This is laughably false. Here are the 2012 per-capita GDP numbers (at PPP) for Japan and its three closest analogues among the Western nations, the rich, medium-sized, ethnically homogeneous nations of West Europe (source: IMF):

• Germany:   $39,028
• UK:           $36,941
• Japan:      $36,266
• France:      $35,548

In case you wondered, here are the nominal GDP numbers (source: IMF):

• Japan:      $46,736
• Germany:   $41,513
• France:      $41,141
• UK:           $38,589

Hopefully, you are convinced that Japan has fully caught up to the West. Its per-capita GDP is no less than the GDPs of the countries that produced Locke and Hume and Adam Smith, Wittgenstein and Kant, Descartes and Voltaire. +1 for convergence, -1 for "culture". Why Altman feels justified in his casual assertion that Japan "fell short" of the West remains a mystery.

Anyway, let's move on to the claims about China's "Confucianist" culture. Just for fun, here are the GDP (PPP) numbers for two other East Asian countries commonly labeled as "Confucianist" - South Korea and Taiwan:

• Taiwan:      $38,749
• Korea:        $32,272

As you can see, Confucianism has not stopped these countries from rivaling Western ones in wealth. Taiwan, in particular, is populated by people of the exact same cultural heritage as mainland China, and yet has managed to overtake both the UK and France in GDP. Singapore, a city-state populated mostly by Chinese people, is even richer, rivaling the small countries of North Europe.

Anyway, I could sit here and question every assertion Altman makes about China's "Confucianist" culture - "How do you know that's culture and not institutions?" "Where's your data?" "Have you even ever worked in China?" - but I think the Taiwan and South Korea GDP numbers do the trick. I rest my case. +1 for convergence, -1 for "culture".

This clearly illustrates the perils of engaging in what I like to call "phlogistonomics" (a term coined by Matt Yglesias). The method goes like this:

Step 1: Take some hard-to-understand phenomenon, like economic growth. Explain the parts you can explain with standard economics (capital, labor, prices, etc.). What's left - the part that really drives the model - is the phlogiston.

Step 2: Label the phlogiston. Make sure you choose a name that refers to something people in general already believe in. "Culture" is great. "Confidence" works too, as do "institutions", "technology", "power","the true desires of the Fed", and of course, "irrational expectations" (the favorite of us behavioral finance types, hehe).

Step 3: Act like you know exactly how the phlogiston behaves. Predict its effects based on commonly held national/ethnic/gender stereotypes ("Greece is in trouble because Greeks are lazy!"), or your political beliefs ("Obama the Kenyan Muslim socialist is killing business confidence!"), or any plausible-sounding story that plays to popular prejudices, preconceptions, fears, or hopes.

Yes, in the end, conventional wisdom and stereotypes and politics end up driving the model. But along the way, your careful selection of like-minded sources, and your authoritative tone, allow you to seem really wise and sagely in front of an audience of people who were primed to believe your conclusion.

Unfortunately, you may run into a problem: Someone may use the same phlogiston, but different assumptions, to reach the exact opposite conclusion. Scott Sumner, for example, believes that China's culture is precisely what makes its catch-up to the West inevitable:

Like Japan, like Britain, like France, indeed like almost all developed countries, [China] will grow to be about 75% as rich as the US, and then level off.  It won’t get there unless it does lots more reforms.  But the Chinese are extremely pragmatic, so they will do lots more reforms... 

If we want to learn from the Chinese culture, learn from Singapore(or Hong Kong), which is how idealistic Chinese technocrats would prefer to manage an economy; indeed it’s how China itself would be managed if selfish rent-seeking special interest groups didn’t get in the way.  But they do get in the way—hence China won’t ever be as rich as Singapore; it will join the ranks of Japan, Korea, Taiwan, and the other moderately successful East Asian countries... 

I expect China to end up in the “normal” category, mostly based on its cultural similarity to other moderately rich East Asian countries.

Altman, you have met your match. Now all we, the readers, have to do is decide which of these European-Americans has a deeper, subtler understanding of the Chinese culture, and we'll know which one to believe!

(For the record, I'd go with Sumner. Also, Chinese culture seems a lot like American culture to me, but that's mainly based on my students, who of course chose to move here. If I had to predict, I'd say China will reach 50% of U.S. GDP, but that equaling us will be hard because of global resource constraints.)

Of course we could always admit that, well...we don't really know what's going to happen to Chinese growth. But we don't want to admit that. Because we don't like to not know things. Not knowing things is scary. There is safety in derp.


Update: Altman responds, noting that Japan's GDP is markedly less than that of the U.S., Canada, and Austrialia. Of course, I could have pointed out that Singapore, with a GDP (PPP) per capital of $60,410, is considerably richer than any of the countries named. But I thought it more appropriate to compare countries of similar population sizes and resource endowments...

Will Abe address Japan's number one problem after all?

First Abe surprised me by actually following through with his monetary policy promises; he appointed Haruhiko Kuroda to the BOJ, and together they are embarking on the most ambitious attempt at "reflation" ever tried by a central bank. It remains to be seen if this will actually work, of course; Japan remains mired in deflation even after the announcement, casting further doubt on the effectiveness of the "expectations channel" of monetary policy. But Abe is trying, and that is the important thing.

Now, Abe is talking about an issue that I think is far more important than monetary policy - and one which I had even less hope that he would address. I'm referring to the status of women in the Japanese economy.

One of the essential things that differentiates Japan's economy from ours is that in Japan, women still form an economic underclass. Japan's labor market has an infamous "two-tiered" structure, in which there are two kinds of workers: "Real workers" and "contract workers". The former have (theoretically) lifetime employment guarantees, guaranteed yearly raises, bonuses, and full benefits, with the possibility of promotion to top management. The latter have low, stagnant salaries, few benefits, few guarantees, and little if any possibility of promotion. The former are mostly men. The latter are mostly women.

Not only is this a tremendous waste of talent, it discourages women from entering the workforce. For this reason, most Japanese mothers quit work when they have kids, and working Japanese women tend to have few kids. In addition to holding down Japan's GDP, this is often cited as one cause of Japan's low fertility rate.

Many of Japan's peculiarities seem less peculiar once you know this fact. For example, Japan's unemployment rate is famously low. But Japan's labor force participation rate is even lower than ours. Women make up much of the difference (teenagers and early forced retirees make up the rest).

Anyway, it has long been known that women's exclusion from the Japanese corporate system is one of the main things holding back Japan. In addition to boosting U.S. total GDP by getting more people into the formal workforce, women's increased economic equality has thought to have boosted American productivity by quite a lot. Japan has received no such boost. Pretty much everyone knows that Japan needs to make women more equal; everyone from Aung San Suu Kyi to the U.S. Embassy to the IMF harps on the point. A thousand articles have been written on the topic, but not much has changed.

Why has not much changed? Japan's protected economy, heavily subsidized "zombie" companies, and weak corporate governance insulate it from the Beckerian free market forces that probably helped advance gender equality in the U.S. in the 80s and 90s. In the absence of such market pressures, the most proven route to gender equality is the Swedish/French route, in which the government basically just tells companies "Thou shalt hire and promote women." This method has proven successful in those highly regulated, somewhat protected European countries.

However, Japan's politics has long been dominated not by France/Sweden-type social democrats, but by arch-conservatives. These arch-conservatives made their home in the long-reigning Liberal Democratic Party, which ruled uninterrupted for 55 years and squelched most efforts at social reform. Nobusuke Kishi, the founder of the LDP and its most important leader, was Shinzo Abe's grandfather.

During Abe's first term, he appeared entirely uninterested in addressing the problems of women's equality. His foreign minister and right-hand man was the late Shoichi Nakagawa, who once said:

"Women have their proper place: they should be womanly...They have their own abilities and these should be fully exercised, for example in flower arranging, sewing, or cooking. It's not a matter of good or bad, but we need to accept reality that men and women are genetically different."

So you can see why I have been skeptical about Abe's commitment to women's equality.

However, Abe may surprise me again. According to all reports, Abe is contemplating a big push to put more women in corporate boardrooms:

Japanese Prime Minister Shinzo Abe moved Friday to compel corporate Japan to promote more women to executive roles, asking business leaders to set a target of at least one female executive per company... 

“Women are Japan’s most underused resource,” [Abe] said... 

More details are expected in June, when the government is to unveil a “national growth strategy” of deregulation measures and other structural changes designed to make the economy more dynamic.

Just by saying this, Abe has surprised me, actually. But given his party's strongly sexist traditions, it is far too soon to declare a revolution. As he did with monetary policy, Abe must convince me with dramatic, unprecedented, massive action...and more importantly, he must convince Japan itself.

But if he does...then Abe will have outdone even his predecessor and patron, Junichiro Koizumi...and maybe even his own grandfather as well.

Book Review: The Occupy Handbook

This is a book you should read. It's been a year and a half since the Occupy protests, and they've mostly disappeared off of the public radar. Doesn't matter. The Occupy Handbook (edited by Janet Byrne) is a great general guide to a number of the economic problems our country is facing, the solutions people have put forth, and the grassroots movements that have sprung up to vent people's dissatisfaction.

The Occupy Handbook consists of 55 chapters, each chapter written by a different author (though there are a couple repeat appearances). The authors include famous economists, no-name activists, authors and TV personalities, and more. Among said economists are Paul Volcker, Robert Shiller, Paul Krugman, Daron Acemoglu and James Robinson, Brad DeLong, Tyler Cowen, Peter Diamond and Emmanuel Saez, Jeffrey Sachs, Nouriel Roubini, Raghuram Rajan, and others. The topics range from statistics on inequality in America, to the social structure of protest movements, to the history of Marxism, to the nature of third-world informal economies, and more. Almost all of the chapters are brief and to the point, and there are very few that did not teach me something interesting and new.

The overall message of the book is (or should be) that America's problems are complicated and deep, and not confined to a cyclical recession. They are related to our industrial structure, our class structure, our political institutions, and our government policies. And there are lots of people working on solving these problems in a number of different ways, from the halls of academia to the streets of New York to the corridors of government. No person sees all of the problems. Each person has only a piece of the elephant. And no one's solution is completely right. We all have something to learn from each other.

Anyway, some of the chapters really stood out as excellent, even in a very strong field:

John Cassidy asks the question "What good is Wall Street?", a question that (surprisingly!) receives too little discussion in the rest of the book.

Michael Hiltzik gives a great history of protest movements during the Great Depression.

James Miller has a truly excellent discussion of the problems of "consensus" decision-making, and the reason we use majority-rule democracy instead.

Robert M. Buckley writes a history of Marxism that forever changed my thinking about that movement. Specifically, he presents Marxism as a quiet but ever-present underlying threat in Western societies - a spectre that continues to haunt Europe - that forces elites to share power and wealth with the masses. This is quite possibly the best chapter in the whole book.

The incomparable Michael Lewis has two brief, witty chapters whose writing outshines the rest of the anthology.

Martin Wolf's chapter serves as a microcosm for the entire book. It represents one of the most succinct summaries of the West's economic problems that I've ever read.

Felix Salmon has the single most sensible policy proposal in the book, a call for banks to write down the principal on underwater mortgages.

The ideological distribution of the authors is naturally centered on the left, but there is definitely a spread. Tyler Cowen gives a reasonable (if not entirely convincing) conservative rebuttal to many of the complaints about inequality voiced elsewhere in the book. If I were the editor, I would have included one or two more of these, just to make Cowen's piece seem slightly less out of place, but it's not a big problem.

The book does whiff badly a couple of times - with over 50 authors, that's really inevitable. In particular, a guy named Brandon Adams is given three (three!!) chapters, more than any other author, in which he spouts a bunch of derp about how American culture is going down the tubes. These chapters can be safely skipped.

Also, Thomas Philippon really should have had a chapter.

But these are very minor quibbles. Overall, Occupy Wall Street is perhaps the most important, comprehensive guide to America's discontents since...well, I can't even think of another such guide in recent decades, and we haven't had this many discontents for quite a while. Its influence seems likely to outlast the Occupy movement itself. So, go read it, if you haven't already.

KrugTron the Invincible

If you grew up in the 80s you probably remember Voltron. Although the show often had convoluted plotlines, it would somehow always end with Voltron (a super-powerful robot formed from five mechanical lions) facing off against a monster called a "Robeast". Voltron had plenty of weapons, but he would invariably strike the killing blow with his "Blazing Sword". Eventually the show became kind of routine, but to a four-year-old, it was pure gold.

In the econ blogosphere, a similar dynamic has played out over the last few years. Each week a Robeast will show up, bellowing predictions of inflation and/or soaring interest rates. And each week, Paul Krugman...I mean, KrugTron, Defender of the Blogoverse, will strike down the monster with a successful prediction of...low inflation and continued low interest rates. Goldbugs, "Austrians", New Classical economists, and harrumphing conservatives of all stripes have eagerly gone head-to-head with KrugTron in the prediction wars, and have been summarily cloven in twain.

Don't remember? Well here's a quick (partial) episode guide:

Krugman vs. Peter Schiff (see also here)

Krugman vs. Ron Paul

Krugman vs. Robert Murphy

Krugman vs. Niall Ferguson (see also here)

Krugman vs. Allan Meltzer

Krugman vs. a giant hive-mind of goldbugs

It's really kind of amazing. And in case there was any doubt as to KrugTron's prognosticatorial puissance, just ask the experts, who found that he pummeled all other pundits in prediction prowess, getting 14 out of 15 predictions right.

So it's fair to ask: What is KrugTron's Blazing Sword? How does he keep vanquishing the Robeast of the Week?

Well, Krugman himself will tell you that his secret weapon is simple, elementary Keynesian economics - a rough-and-ready IS-LM view of the world, backed up by sophisticated "liquidity trap" models like this one. In those models, low aggregate demand will always keep the economy trapped in a low-inflation, low-interest-rate world.

But I'm not so sure. Keynesian models aren't really used for forecasting the world; they're used as guides for policy. A Keynesian model, be it IS-LM or Liquidity Trap, tells you "If you do fiscal policy, the economy will respond thus." It doesn't tell you how the economy will do in total; that is jointly determined by policy and by the external "shocks" that the Keynesian models (like all macro models) take as given. 

Keynesian models didn't predict that unconventional monetary policy (QE2) would be insufficient to raise expectations of future inflation, and thus would be unable to bust us out of the liquidity trap. Nor did Keynesian models predict that private investors would be willing to ignore the possibility of a U.S. sovereign default, thus allowing the U.S. to avoid a spike in interest rates.

But Krugman did predict both of these things.

And here's the most interesting one. Krugman's earliest prediction victory came at the expense of John Paulson, one of history's most successful investors (although unlike the Robeasts pictured above, Paulson didn't seek out a battle with Krugman; he was set up as the anti-Krugman by a writer at Businessweek). In 2010, Paulson predicted a strong economic recovery. Such a recovery, if it had come, would have busted us straight out of the liquidity trap and allowed monetary policy to cause inflation. Paulson backed up his bet with billions, and rolled snake eyes.

But Paulson is no mere Robeast. He is no inflationista, "Austrian" econo-troll, or conservative ideologue. In fact, he has a large group of very skilled macroeconomists working for him. There is no way his team doesn't know Keynesian econ backwards and forwards.

Nor does Keynesian theory, of the type used by Krugman, insist that an economy will remain mired in recession without a fiscal stimulus to prime the pump. Sure, somewhere out there, there are models in which the economy can fall into a bad equilibrium that requires fiscal policy to kick it out (in fact, Miles Kimball and Bob Barsky are building such a model, but they are severely late in publishing the working paper; so hurry up, guys!). But IS-LM and the Eggertsson-Krugman model don't have this feature. In those Keynesian models, growth can recover on its own.

So how did Krugman know growth would be slow? He didn't (I hope) put his trust in Reinhart and Rogoff's assertion that growth is always slow after financial crises. Maybe he just assumed that the underlying drivers of aggregate demand are sluggish, but I think Paulson's team could have done that just as easily.

No, I think Krugman's real secret weapon is something else: Like Voltron before him, he's borrowing heavily from Japan.

See, I myself am fairly agnostic about Keynesian ideas. But I've expected nothing but low growth, low interest rates, and low inflation since 2008 (though I haven't been as confident about these things as Krugman, and am thus not in his class as a super-robot). I expected these things because of one simple proposition: We are like Japan. 

Since its land bubble popped in 1990, Japan has had low inflation and low interest rates and low growth, even as government debt mounted and quantitative easing was tried. Paul Krugman was there. He watched Japan carefully, and he often states that it deeply affected his thinking. In fact, it might not be an exaggeration to say that watching Japan made Krugman the Keynesian he is today.

Meanwhile, the Robeasts have all used a different example to inform their understanding of the world: America in the 70s and early 80s. That was a time when government intervention in the economy (seemingly) led to high inflation. This taught generations of conservative economists, politicians, pundits, and regular folks that government intervention leads to inflation. And that if you wait long enough (or maybe enact the right structural reforms), growth will come back on its own.

But America 2008-present has not looked like America 1975-1985. It has looked like Japan, 1990-present. The proper comparison was across space, not across time. Assuming that other countries are fundamentally different than ours - that cultural differences, or institutional differences, etc. make cross-country comparisons utterly worthless - has proven to be a losing bet.

So if you want to get into the economic prediction game, and you don't want to be sliced and diced by KrugTron's Blazing Sword, but you can't bring yourself to fully embrace Keynesianism, I have a suggestion: Take a good close look at Japan.

Meanwhile, the Austrians, goldbugs, and other assorted Robeasts will continue to provide us with our weekly entertainment.

Why did Reddit get the wrong guy? (Or: the Wisdom of Crowds vs. the Madness of Mobs)

Short answer: It didn't. Or more accurately, we'll never know if it did, because we don't really have a way of knowing what "Reddit" thinks, only what some people on Reddit seem to think.

Long answer: OK, let's back up. When the Boston Marathon bombing manhunt began, there was a Reddit forum (subreddit) devoted to finding the bombers. A lot of people had high hopes for this effort. But the main "suspect" to emerge out of Reddit was a guy named Sunil Tripathy, who had no relation whatsoever to the bombings. Meanwhile, in about the same amount of time, police found the real guys, Tamerlan and Dzhokhar Tsarnaev. If you're interested in the details of Reddit's epic fail, see here. (And more here.)

Which brings us to the question, which someone asked me on Twitter: Why, exactly, did Reddit whiff so badly?

In recent decades, we've heard a lot about the "wisdom of crowds". James Surowiecki, who wrote an excellent book on the topic, mentions things like the stock market's identification of the reason for the Challenger disaster, or the ability of a group of non-experts to collectively outguess an expert on questions like "How many jelly beans are in this jar?". More recently, we've learned that prediction markets are more accurate than polls at predicting election outcomes, and in fact that they beat sophisticated "expert" forecasts in many situations. Companies have experimented with internal prediction markets to tap the collective wisdom of their employees. In general, we have come to believe more and more in the ability of large groups of non-experts relative to the ability of small groups of experts.

Should that belief be challenged by the Sunil Tripathy fiasco?

Not necessarily. The key is that the "wisdom of crowds" may work very well in some cases, while in other cases it may give way to the "madness of mobs". We don't know exactly which case is which, but we do have a general idea what sets them apart. Surowiecki summarizes it well in his book, in fact.

Basically, when we have a method for aggregating the information of diverse independent individuals, crowds will perform very well. When the individuals in a crowd coordinate, however, diversity and independence breaks down, and crowds can pounce on the wrong answer.

We see this in finance experiments. A number of experiments, including classic work by Charles Plott, have established the ability of financial markets to aggregate the private information of diverse participants to arrive at the "right" price. However, other experiments, e.g. by Colin Camerer, have shown that when people pay attention to the actions of others instead of to their own private information, then information can become "trapped", and markets can arrive at the wrong price. There are a number of different theoretical reasons why herd behavior might take over from efficient information aggregation; some of these are "rational" explanations and others are "irrational", but they all rely on individuals having some reason to ignore their private information and focus on what other people do.

You can definitely see the herding dynamic at work in the case of the Sunil Tripathy fiasco. A few guys started saying "It was Sunil Tripathy!" And a lot of other people on the subreddit started focusing on that name, and looking for information about Tripathy. The Tripathy idea was a wrong idea that was initially concentrated among a small group of individuals, who pushed that idea loudly and confidently. Meanwhile, a large number of people on the subreddit may have had small, weak pieces of information pointing to the Tsarnaev brothers. But since Reddit had no way of collecting and aggregating these dispersed small pieces of information, it might have become "trapped", just like in a Colin Camerer experiment.

So let me return to the "short answer" at the beginning of the post. It's not really right to say that "Reddit" picked Sunil Tripathy. Some people on Reddit picked Tripathy, and their voices emerged loud and clear from the chaos, not because most people agreed with them, but because they were the loudest and most strident minority voice. So anyone paying attention to Reddit picked out a few shrill cries of "Tripathy!" rising above the cacophony, and concluded that this was Reddit's consensus verdict. Meanwhile, the attention of other Redditors was turned toward Tripathy, and they spent their time and effort evaluating the Tripathy hypothesis instead of generating alternative hypotheses.

In other words, because it had no way of aggregating information, Reddit became less like a prediction market and more like a lynch mob.

Would Reddit have done better if people could have voted on who they thought did it? I doubt it, because the set of hypotheses was not properly mapped. In an election prediction market, you know the set of candidates. In a jellybean jar contest, you know the set of numbers of jellybeans that might be in the jar (i.e. the real line). But a "whodunit" poll can't list every human being as a potential culprit; it has to limit the choices to a few popular hypotheses. In Reddit's case, a poll would have included 1. Tripathy, and 2. Someone Else. Not very helpful. A prediction market would have suffered from the same problem.

So is there any hope for crowdsourcing terrorism investigations? I think that there already is such a method: Police tip hotlines. Tips tend to be independent, since people usually don't know who else is calling in a tip. And in a high-profile case like a terrorist attack, people who call in tips tend to be fairly diverse, since so many different kinds of people are paying attention. Finally, police can tabulate the number of similar tips, which is a method of aggregation. So tip hotlines satisfy the loose, general criteria for the "wisdom of crowds" to overcome the "madness of mobs". I think it's no coincidence that in the Boston bombing case, a victim's tip ended up being hugely helpful to the police.

Anyway, it's worth pointing out that these criteria for "crowd wisdom" aren't clear-cut. How do you know how independent and diverse a crowd's members are? What is the optimal method of aggregating their beliefs? This is a large, important, open area of research. So have at it, smart people. Just don't pay too much attention to what others in the field are doing...

The reason macroeconomics doesn't work very well

I don't think it's politics (mostly). I don't think it's the culture of consensus and hierarchy. I don't think it's too much math or too little math. I don't think it's the misplaced assumptions of representative agents, flexible prices, efficient financial markets, rational expectations, etc.

Fundamentally, I think the problem is: Uninformative data.

I was planning to write a long post about this, and I never got around to it, and now Mark Thoma has written it better than I could have. So I'll just steal most of his excellent, awesome post, and add some boldface:

The blow-up over the Reinhart-Rogoff results reminds me of a point I’ve been meaning to make about our ability to use empirical methods to make progress in macroeconomics...it's about the quantity and quality of the data we use to draw important conclusions in macroeconomics. 

Everybody has been highly critical of theoretical macroeconomic models, DSGE models in particular, and for good reason. But the imaginative construction of theoretical models is not the biggest problem in macro – we can build reasonable models to explain just about anything. The biggest problem in macroeconomics is the inability of econometricians of all flavors (classical, Bayesian) to definitively choose one model over another, i.e. to sort between these imaginative constructions. We like to think or ourselves as scientists, but if data can’t settle our theoretical disputes – and it doesn’t appear that it can – then our claim for scientific validity has little or no merit. 

There are many reasons for this. For example, the use of historical rather than “all else equal” laboratory/experimental data makes it difficult to figure out if a particular relationship we find in the data reveals an important truth rather than a chance run that mimics a causal relationship. If we could do repeated experiments or compare data across countries (or other jurisdictions) without worrying about the “all else equal assumption” we’d could perhaps sort this out. It would be like repeated experiments. But, unfortunately, there are too many institutional differences and common shocks across countries to reliably treat each country as an independent, all else equal experiment. Without repeated experiments – with just one set of historical data for the US to rely upon – it is extraordinarily difficult to tell the difference between a spurious correlation and a true, noteworthy relationship in the data. 

Even so, if we had a very, very long time-series for a single country, and if certain regularity conditions persisted over time (e.g. no structural change), we might be able to answer important theoretical and policy questions (if the same policy is tried again and again over time within a country, we can sort out the random and the systematic effects). Unfortunately, the time period covered by a typical data set in macroeconomics is relatively short (so that very few useful policy experiments are contained in the available data, e.g. there are very few data points telling us how the economy reacts to fiscal policy in deep recessions). 

There is another problem with using historical as opposed to experimental data, testing theoretical models against data the researcher knows about when the model is built...It’s not really fair to test a theory against historical macroeconomic data, we all know what the data say and it would be foolish to build a model that is inconsistent with the historical data it was built to explain – of course the model will fit the data, who would be impressed by that? But a test against data that the investigator could not have known about when the theory was formulated is a different story – those tests are meaningful... 

By today, I thought, I would have almost double the data I had [in the 80s] and that would improve the precision of tests quite a bit... 

It didn’t work out that way. There was a big change in the Fed’s operating procedure in the early 1980s... 

So, here we are 25 years or so later and macroeconomists don’t have any more data at our disposal than we did when I was in graduate school. And if the structure of the economy keeps changing – as it will – the same will probably be true 25 years from now. We will either have to model the structural change explicitly (which isn’t easy, and attempts to model structural beaks often induce as much uncertainty as clarity), or continually discard historical data as time goes on (maybe big data, digital technology, theoretical advances, etc. will help?). 

The point is that for a variety of reasons – the lack of experimental data, small data sets, and important structural change foremost among them – empirical macroeconomics is not able to definitively say which competing model of the economy best explains the data. There are some questions we’ve been able to address successfully with empirical methods, e.g., there has been a big change in views about the effectiveness of monetary policy over the last few decades driven by empirical work. But for the most part empirical macro has not been able to settle important policy questions... 

I used to think that the accumulation of data along with ever improving empirical techniques would eventually allow us to answer important theoretical and policy questions. I haven’t completely lost faith, but it’s hard to be satisfied with our progress to date. It’s even more disappointing to see researchers overlooking these well-known, obvious problems – for example the lack pf precision and sensitivity to data errors that come with the reliance on just a few observations – to oversell their results. (emphasis mine)

This is the clearest and based statement of the problem that I've ever seen. (Update: More from Thoma here.)

I'd like to add one point about the limits of time-series econometrics. To do time-series, you really need two assumptions: 1) ergodicity, and 2) stationarity. Mark addressed the ergodicity problem when he talked about trend breaks. As for stationarity, it sometimes matters a lot - for example, if technology has a unit root, then positive technology shocks should cause recessions. But the statistical tests that we use to figure out if a time-series has a unit root or not all have very low power. There are some pretty deep theoretical reasons for this.

Anyway, that's just yet one more reason macro data is uninformative. That problem isn't going to be solved by gathering more accurate data, or by seeking out new macroeconomic aggregates to measure (though we should probably do both of those things anyway).

So what are the implications of this basic fundamental limitation of macro? I think there are three.

1. Beware of would-be prophets from outside the mainstream. There are a number of people, usually associated with alternative or "heterodox" schools of thought, who claim that macro's relative uselessness is based on an obviously faulty theoretical framework, and that all we have to do to get better macro is to use different kinds of theories - philosophical "praxeology", or chaotic systems of nonlinear ODEs, etc. I'm not saying those theories are wrong, but you should realize that they are all just alternative theories, not alternative empirics. The weakness of macro empirics means that we're going to be just as unable to pick between these funky alternatives as we are now unable to pick between various neoclassical DSGE models.

2. Macroeconomists should try to stop overselling their results. Just matching some of the moments of aggregate time series is way too low of a bar. When models are rejected by statistical tests (and I've heard it said that they all are!), that is important. When models have low out-of-sample forecasting power, that is important. These things should be noted and reported. Plausibility is not good enough. We need to fight against the urge to pretend we understand things that we don't understand.

3. To get better macro we need better micro. The fact that we haven't fond any "laws of macroeconomics" need not deter us; as many others have noted, with good understanding of the behavior of individual agents, we can simulate hypothetical macroeconomies and try to do economic "weather forecasting". We can also discard a whole slew of macro theories and models whose assumptions don't fit the facts of microeconomics. This itself is a very difficult project, but there are a lot of smart decision theorists, game theorists, and experimentalists working on this, so I'm hopeful that we can make some real progress there. (But again, beware of people saying "All we need to do is agent-based modeling." Without microfoundations we can believe in, any aggregation mechanism will just be garbage-in, garbage-out.)

After the financial crisis, a bunch of people realized how little macroeconomists do know. I think people are now slowly realizing just how little macroeconomists can know. There is a difference.