Saturday, July 26, 2014

How to beat Russia

Geostrategic analysis is so easy, anyone can do it. Just make some historical analogies, lean a little too heavily (but subtly!) on national stereotypes, and try to sound smart. Anyone can get into this game! So why not Yours Truly?

OK, so what is Russia up to in Ukraine, and what can we do about it? Let's think about this.

Thought 1: Historically, Russia is a cautions nation. After their initial burst of expansion, they have made relatively few territorial acquisitions, even after their victories in WW2 and the Napoleonic Wars. Caution makes sense for a big country - you already have a lot, so you have more to lose. Smaller countries, like Germany and Japan and France, have been more tempted to throw the dice.

Thought 2: If Russia is going to expand, it's going to expand to the west. To the east, there are A) some sparsely populated Central Asian countries that Russia already dominates, and B) China, which is now Russia's ally. Russia already has so many resources that further resource-grabbing is much more trouble than it's worth - the only kind of expansion that would really change Russia's status is to absorb some of the populated lands of East Europe. (Why Russia would want to take over these places is not clear, but back to that later).

Thought 3: Russia has a pretty simple strategy for dominating places in Eastern Europe. Basically, take advantage of ethnic divisions (if necessary, stirring them up), and just be by far the biggest, most unified, most powerful ethnic bloc in the area. The weaker ethnic group in any local conflict will naturally look to Russia to be their patron. You can see this strategy at work in South Ossetia, Abkhazia, Transdniestria, and now in Ukraine. It's a slower, more cautious variant of a very old, very effective imperial strategy used by the Mongols and British, among others. It probably explains why Russia is so keen to keep Russian-speakers in the region from abandoning the Russian language.

Thought 4: Russian institutions are just not that effective. Russia's economy has never been that good. They have never had a smooth system for transferring power. Their property rights are weak, their infrastructure is poor, their industries are uncompetitive, they have poor health, etc. Most importantly, Russia suffered massive political collapses twice during the 20th century, and no one really knows if Putin has built anything more durable than the Romanov and Soviet systems.

So what can we do to stymie Russia's expansion into Ukraine and (in the future) elsewhere? First, the current strategy of creating high and uncertain costs for Russian intervention seems to have worked OK - Russia has so far refrained from sending troops into East Ukraine, despite Ukrainian successes against the rebels. Increasing our military forces in Poland and the Baltics may also be necessary.

Second, we should try to boost the economies of countries surrounding Russia, in the hope of encouraging greater popular solidarity with the central governments of those countries. The way for us to boost their economies is to implement free trade agreements between the U.S. and those countries. Ukraine, unfortunately, is already too chaotic to do this, but Romania, Poland, and the Baltic countries are perfect candidates. Also, countries traditionally allied with Russia, like Serbia, Belarus, and Armenia, are good targets for FTAs. (Update: As a commenter pointed out, we're actually not allowed to negotiate bilateral FTAs with EU countries, so we really just have to conclude an FTA with the EU itself as fast as possible.)

But third, and most importantly, what we should do is just wait. Russia's system is not robust to shocks. Putin will grow older and die, leaving no robust, stable system in his wake. Energy prices will fluctuate, wreaking havoc on Russia's economy. Low fertility will put a massive strain on the government's finances. And as Russia absorbs the costs of newly acquired satellite states and territories, without reaping any economic benefit, additional strain will be put on the Russian economy. Even if Russia takes half of Ukraine, reabsorbs Belarus, and slices off a couple pieces of Georgia, it will just collapse again before it ever becomes a real threat to the core of Europe.

And in the meantime, we should of course try to destabilize Russia by creating disruptive cheap energy technologies. Another option is to welcome mass immigration from Russia, thus decreasing the size and power of the Russian ethnic group in the long term.

I think Obama has realized the wisdom of the basic "just wait" approach, and is carrying it out. The key is not to worry - unless you're part of one of the tiny squabbling impoverished ethnic groups on Russia's intentionally chaotic border, you're safe from the bear.

Friday, July 25, 2014

Why doesn't the finance industry use DSGE models? (cont.)

(This post originally appeared at Bloomberg View. It's sort of a mass-market version of this earlier post.)

If you care at all about what academic macroeconomists are cooking up (or if you do any macro investing), you might want to check out the latest economics blog discussion about the big change that happened in the late '70s and early '80s. Here’s a post by the University of Chicago economist John Cochrane, and here’s one by Oxford’s Simon Wren-Lewis that includes links to most of the other contributions.
In case you don’t know the background, here’s the short version: Around 1980, macroeconomists abandoned the models they had been using and switched to something very different. The old kind of model was called structural econometric modeling (SEM), based on equations for economic aggregates -- investment in office buildings, consumption of cars, etc. These models were also called “Keynesian,” because they usually included some assumptions that were loosely based on the writings of economist John Maynard Keynes. The new type of model was called dynamic stochastic general equilibrium (DSGE), and it tried to account for the individual decisions of consumers and producers. Everyone, and I mean everyone in academia, abandoned SEMs in a very short period of time, and many switched over to DSGEs.
Why did DSGE models take over? Two reasons. The first was the stagflation of the 1970s. The Keynesian SEMs predicted that when the Federal Reserve lowered interest rates, it should have given the economy a boost; instead, all it did was create useless, harmful inflation. This made a big impression on economists. About a year ago I asked a group of economists whether the Fed should temporarily adopt a higher inflation target. Robert Lucas, who probably has more claim than anyone to being the father of modern macroeconomics, thundered: “We tried (stupid) inflation! It didn’t (dang) work!”
Now, it was possible to tweak the old Keynesian SEM models to explain why inflation didn’t boost the economy. But at the same time, the aforementioned Lucas and some other heavyweights such as Tom Sargent were revealing that there was a very deep reason those SEM’sshouldn’t work. It boils down to the famous saying that “correlation doesn’t equal causation.” Suppose economists noticed that businesses where people wear Star Trek T-shirts are more productive than others. Simple -- just have everyone wear a Star Trek T-shirt, and you’ll boost national productivity, right? Wrong.
In the same way, Lucas showed that trying to boost gross domestic product by raising inflation might be like the tail trying to wag the dog. To avoid that kind of mistake, he and his compatriots declared, macroeconomists needed to base their models on things that wouldn’t change when government policy changed -- things like technology, or consumer preferences. And so DSGE was born. (DSGE also gave macroeconomists a chance to use a lot of cool new math tricks, which probably increased its appeal.)
OK, history lesson over. So why is this important now?
Well, for one thing, the finance industry has ignored DSGE models. That could be a big mistake!
Suppose you’re a macro investor. If all you want to do is makeunconditional forecasts -- say, GDP next quarter – then you can go ahead and use an old-style SEM model, because you only care about correlation, not causation. But suppose you want to make a forecast of the effect of a government policy change -- for example, suppose you want to know how the Fed’s taper will affect growth. In that case, you need to understand causation -- you need to know whether quantitative easing is actually changing people’s behavior in a predictable way, and how.
This is what DSGE models are supposed to do. This is why academic macroeconomists use these models. So why doesn’t anyone in the finance industry use them? Maybe industry is just slow to catch on. But with so many billions upon billions of dollars on the line, and so many DSGE models to choose from, you would think someone at some big bank or macro hedge fund somewhere would be running a DSGE model. And yet after asking around pretty extensively, I can’t find anybody who is.
One unsettling possibility is that the academic macroeconomists of the '70s and '80s simply bit off more than they could chew. Modeling a big thing (like the economy) as the outcome of a bunch of little things (like the decisions of consumers and companies) is a difficult task. Maybe no DSGE is going to do the job. And maybe finance industry people simply realize this.
There are signs that some academic macroeconomists are starting to come to a similar conclusion. In another post, Cochrane talks about attending a recent macroeconomics conference, and how researchers are abandoning big, all-encompassing theories in favor of simpler, more targeted models designed to explain specific ideas rather than predict the whole economy. And at the Fed, academically trained economists have flat-out refused to abandon their old-style SEMs. That seems like a strong sign that the Fed hasn’t found any DSGE model that convincingly explains the business cycle.
So it seems to me that industry people and academics need to have more of a conversation than they’re having. If industry simply missed out on the big intellectual revolution of the '80s, academics need to help them get on board. On the other hand, if academics have set themselves an impossible task, they need to think hard about what to do instead.


This James Heckman quote from 2010 is sort of the converse of my post. He asks: If old-style "Keynesian" SEM's are so bankrupt, why is Wall Street still using them exclusively?
What struck me was that we knew Keynesian theory was still alive in the banks and on Wall Street. Economists in those areas relied on Keynesian models to make short-run forecasts. It seemed strange to me that they would continue to do this if it had been theoretically proven that these models didn’t work.
The standard answer to this is that the "Keynesian" models are OK at unconditional forecasting, but not at policy-conditional forecasting. But since DSGE models should, in theory, be the best models for policy-conditional forecasting, Heckman's question leads naturally to mine...

Thursday, July 24, 2014

Why I like Frequentism

My post about "Bayesian Superman" wasn't actually intended to be a knock on Bayesianism - it was just about a quirk of rationality. I certainly don't think Bayesianism is a "dangerous religion that harms science"!

But reading this Andrew Gelman essay made me think about Bayesian inference in science, which then got me to thinking about Frequentist inference, and why I think Frequentism is a bit underrated these days.

Frequentist hypothesis testing has come under sustained and vigorous attack in recent years. It's arbitrary, it doesn't obey the likelihood principle, it throws away information, it can lead to silly results. All this is true. But there are a couple of good things about Frequentist hypothesis testing that I haven't seen many people discuss. Both of these have to do not with the formal method itself, but with social conventions associated with the practice. These are:

1. The unwritten rule that you "don't protect the null hypothesis" (or that you "penalize type I errors relative to type II errors"), and

2. The implicit three-valued logic of "hypothesis rejection".

The first of these is about what kind of prior (to use Bayesian language) the scientists should start with. It basically says that you should bias your conclusions against your own hypothesis. This is in contrast to, say, using flat or "uninformative" priors.

The second social convention is more amorphous and difficult to define. It's about what conclusions you draw from the hypothesis test. If you don't protect the null, and you reject the null in favor of your own hypothesis, Frequentism says you've found something interesting, and you should follow up on it. If you fail to reject the null, though, it doesn't mean you believe in the null any more than you did before - it means you shrug and move on. Frequentism implicitly assigns results to one of three categories: 1. "interesting evidence against a hypothesis", "interesting evidence for a hypothesis", and "nothing interesting". It's sort of like three-valued logic, in a way. Compare this to the implicit logic of the likelihood principle, in which you compare alternative hypotheses directly.

Why do I like these social conventions? Two reasons. First, I think they cut down a lot on scientific noise. "Statistical significance" is sort of a first-pass filter that tells you which results are interesting and which ones aren't. Without that automated filter, the entire job of distinguishing interesting results from uninteresting ones falls to the reviewers of a paper, who have to read through the paper much more carefully than if they can just scan for those little asterisks of "significance". Naturally, this filter also has a downside - it creates publication bias against "negative results" that may in fact be interesting. But that may be a small price to pay to avoid the flood of paper submissions that would result if everyone just wrote up and sent in the results of any estimation exercise.

Second, the discipline of the Frequentist social conventions acts against scientists' natural tendency to favor and promote and believe in their own theories. It tries to enforce the idea of scientific honesty. Feynman talks about this in his famous speech, "Cargo Cult Science":
It's a kind of scientific integrity, a principle of scientific thought that corresponds to a kind of utter honesty--a kind of leaning over backwards. For example, if you're doing an experiment, you should report everything that you think might make it invalid--not only what you think is right about it: other causes that could possibly explain your results; and things you thought of that you've eliminated by some other experiment, and how they worked--to make sure the other fellow can tell they have been eliminated. 
Details that could throw doubt on your interpretation must be given, if you know them. You must do the best you can--if you know anything at all wrong, or possibly wrong--to explain it.
The kind of integrity Feynman is talking about concerns systematic error. The Frequentist social conventions are an attempt to do something similar for random error. This provides a natural defense against "scientific trolling", which is a term I just invented to mean "the tendency of unscrupulous researchers to report weak results to advance some ulterior agenda." Scientific trolling means that ulterior-motivated researchers will submit a flood of weak results, while scrupulous, scientifically-motivated researchers will voluntarily restrain themselves from reporting equally weak results that go in the opposite direction. That sort of reporting bias will tend to contaminate the beliefs of a neutral observer. (I can think of at least one very good real-world example of this, but I will be polite and not discuss it on a blog.)

Now, of course, the Frequentist social conventions are weak, inadequate defenses against subjectivism and noise. They have drawbacks, like discouraging the reporting of negative results. And they are subject to being gamed by unscrupulous researchers. But at least they are something.

Bayesian inference seems to me like a perfectly fine and good method of inference. It's more appealing in many ways than classical Frequentism. But I think that Bayesianism might want to get some standardized social conventions similar to (and hopefully superior to) the Frequentist ideas of "not protecting the null" and "statistical significance" (note: it may already have these, and I'm just not aware of them). These conventions would unavoidably be arbitrary, and would throw away some information in many cases. But they would help lean against the natural incentives of the scientific reporting and publishing process. Maybe there could be more than one set of conventions, for use in recognizably different situations.

Classical Frequentist hypothesis testing is probably on its way out in the long term. But the fact that it has survived and dominated scientific publishing as long as it has, in spite of all its well-known problems, might be a testament to the usefulness of the unspoken social conventions associated with it.

National unity sure is helpful

(This post originally appeared at Bloomberg View.)

These days, many people tend to dismiss anything Pat Buchanan says. But in a recent column in WorldNetDaily, Buchanan raises an important point: America could use a bit of nationalism. By “nationalism,” I don’t mean jingoistic sentiment and aggressive militarism. I mean a sense of national cohesion, of being one unified people instead of just a collection of unrelated individuals who happen to live in the same geographical space. Here’s Buchanan:
Will America remain one nation, or are we are on the road to Balkanization and the breakup of America into ethnic enclaves?...
We were not a nation of immigrants in 1789. They came later. From 1845-1849, the Irish fleeing the famine. From 1890-1920, the Germans. Then the Italians, Poles, Jews and other Eastern Europeans...From 1925 to 1965, the children and grandchildren of those immigrants were assimilated, Americanized. In strong public schools, they were taught our language, literature and history, and celebrated our holidays and heroes. We endured together through the Depression and sacrificed together in World War II and the Cold War.
By 1960, we had become truly one nation and one people...But we are no longer that “band of brethren.” We are no longer one unique people “descended from the same ancestors, speaking the same language, professing the same religion.”
We are from every continent and country. Nearly 4 in 10 Americans trace their ancestry to Asia, Africa and Latin America. We are a multiracial, multilingual, multicultural society in a world where countless countries are being torn apart over race, religion and roots.
We no longer speak the same language, worship the same God, honor the same heroes or share the same holidays. Christmas and Easter have been privatized. Columbus is reviled. Stonewall Jackson and Robert E. Lee are out of the pantheon. Cesar Chavez is in...
If a country is a land of defined and defended borders, within which resides a people of a common ancestry, history, language, faith, culture and traditions, in what sense are we Americans one nation and one people today?
Buchanan is right to be worried about American people’s sense of national unity. A famous 1999 paper by William Easterly, Reza Baqir, and Alberto Alesina documented that in places with more ethnic divisions, the government was worse at providing public goods -- things like infrastructure, public health and other goods and services that the government is usually the best at providing. A substantial body of research supports this conclusion. Although people still argue about the reason, it seems clear that when the people of a country don’t consider themselves to be “one people,” the government becomes less effective.
America may be suffering somewhat from this problem. Since the '70s, elements of the Republican Party have exploited ethnic divisions to reduce support for government spending, especially in the South where racial tensions run high. Basically, a large number of poor and middle-class white people seem to have become (wrongly) convinced that government spending only benefits black or Hispanic people. In practice, cutting government spending usually doesn’t mean cutting redistributive transfers like Medicare -- it means cutting things that offer small benefits to large numbers of people, such as infrastructure and scientific research.
Has immigration exacerbated this problem? Maybe, but I think Buchanan is seriously overstating the danger. If Hispanic immigration led to the Southwest turning into a Spanish-speaking region -- America’s version of Quebec -- then there might be cause for alarm. But that is just not happening. Hispanic immigrants are becoming English speakers even faster than the earlier waves of European immigrants that Buchanan cites. Hispanics are rapidly increasing their educational attainment, and mixing socially with other groups at high rates. Intermarriage between Hispanics and other races is extremely high. And all of these trends are even more pronounced for Asian immigrants, who have recently taken over from Hispanics as America’s biggest group of new immigrants.
So on the language, education and marriage front, there is nothing to worry about. But what about the cultural and historical front? The continued existence of anti-immigrant sentiment on the political right is reminiscent of the “know-nothings” who resisted German and Irish immigration in the 1800s. Are lower-class conservative Americans going to continue to refuse to see the new immigrants as their fellow countrymen?
Buchanan suggests that the Depression and the World Wars, along with a unified history curriculum in public schools, were responsible for the assimilation of the last immigrant wave. Well, we are just now emerging from the closest analogue to the Depression that we are (hopefully) likely to see. And our history curriculum, while it has changed in substance, doesn't seem to vary from state to state more than it used to – in fact, it may vary less, given the influence of national tests like the advanced-placement history test. Stonewall Jackson and Robert E. Lee, for their part, probably don’t mind being written out of the “pantheon” of the nation from which they fought so hard to secede.
As for world wars -- well, let’s just hope that those aren't necessary for national unity.
Overall, things look good for immigrant assimilation. The main threat to Buchanan’s cherished ideal of national unity comes from nativist elements of the political right, and their refusal to accept Hispanic immigrants as legitimate Americans. Let's hope the pro-immigration wing of the conservative movement, typified by Ronald Reagan, George W. Bush, and Marco Rubio, will win out.

Tuesday, July 22, 2014

Bayesian Superman

Consider Proposition H: "God is watching out for me, and has a special purpose for me and me alone. Therefore, God will not let me die. No matter how dangerous a threat seems, it cannot possibly kill me, because God is looking out for me - and only me - at all times."

Suppose that you believe that there is a nonzero probability that H is true. And suppose you are a Bayesian - you update your beliefs according to Bayes' Rule. As you survive longer and longer - as more and more threats fail to kill you - your belief about the probability that H is true must increase and increase. It's just mechanical application of Bayes' Rule:

P(H\mid E) = \frac{P(E\mid H) \cdot P(H)}{P(E)}

Here, E is "not being killed," P(E|H)=1, and P(H) is assumed not to be zero. P(E) is less than 1, since under a number of alternative hypotheses you might get killed (if you have a philosophical problem with this due to the fact that anyone who observes any evidence must not be dead, just slightly tweak H so that it's possible to receive a "mortal wound").

So P(H|E) is greater than P(H) - every moment that you fail to die increases your subjective probability that you are an invincible superman, the chosen of God. This is totally and completely rational, at least by the Bayesian definition of rationality.

If you think this is weird, consider a closely related question: Suppose H was true, and you were an invincible God-protected superman. How would you know? Simple: you'd go get in a bunch of dangerous situations, and when you failed to die, you'd gradually realize the truth. The more dangerous the situations you chose, the faster the truth would be revealed - if you jumped in front of a train and failed to die, that would be stronger evidence than if you just drove to the store without a seat belt and made it back safely.

But nevertheless, every moment contains some probability of death for a non-superman. So every moment that passes, evidence piles up in support of the proposition that you are a Bayesian superman. The pile will probably never amount to very much, but it will always grow, until you die.

So does this mean that any true Bayesian will eventually accept invincibility as his working hypothesis? No. There are other hypotheses that explain your failure to die just as well as H does, and which are mutually exclusive with H. The ratio of the likelihood of H to the likelihood of these alternatives will not change as you continue to live longer and longer. But this gets into a philosophical thing that I've never quite understood about statistical inference, Bayesian or otherwise, which is the question of how to choose the set of hypotheses, when the set of possible hypotheses seems infinite.

Anyway, it seems to me that "Bayesian superman" is not just a prescriptive definition of how a rational person reacts to his own failure to die, but also a description of the observed behavior of teenagers. Teenagers - especially boys - are commonly described as "thinking they're invincible." Often this belief noticeably decreases when a young man sustains a major injury, witnesses a major injury or death, or has a close call with death. This, I suspect, is because most people's belief in their own invincibility is a little more complex than the "Proposition H" I've written above - it includes things like "God is looking out for my friends," and "God will stop me from getting the s*** kicked out of me," etc. A lot of people seem to start life with a non-negligible belief that this kind of special protection is watching over them. Sadly, they all eventually learn otherwise.

Monday, July 21, 2014

You'll get no edge with Zero Hedge

(This post originally appeared at Bloomberg View.)

I can’t tell you that gold is a bad investment. Even after the recent plunge, if you bought gold in 2004, your investment would have earned you an annualized rate of about 10.4 percent, after accounting for inflation. That is darned impressive. If you bought in 1994, it would have earned about 3.9 percent per year -- not too shabby. Even if you bought all the way back in 1984, you would have earned 1.8 percent in real terms. (Of course, this assumes that is wrong, and that inflation hasn’t been massively understated.)
In addition to delivering decent long-term returns, gold has been a way to spread or offset investment risk. As my co-blogger Yichuan Wang showed last year, gold’s return is somewhat negatively correlated with interest rates, so that a bet on gold is to some degree a bet on lower rates. This is actually the prediction of some old economic models, which also indicate that gold should have a positive rate of return over the long term. But a lot of the variance in the price of gold isn't explained by such factors, meaning that some small amount of gold is a valuable addition to any well-diversified portfolio.
But there are two big words of caution with respect to gold. The first is that you shouldn’t believe the standard story for why gold will go up. The second is that you should be very wary of websites and media outlets that constantly push you to buy gold.
The standard story for why you should buy gold is that it’s a hedge against the inherent weakness of the fiat money system. Unfortunately, it isn’t. For example, gold is a poor hedge against inflation. The correlation is very weak. Remember that gold had its huge bull run in the 2000s and a long slide in the '80s…but inflation was higher in the '80s than in the 2000s!
A more speculative and extreme version of the story is that the whole fiat money system is destined for collapse, and that after this happens we’ll go back to using gold as money. If that did happen, you’d want to own a lot of gold at that moment. Unfortunately, there are some big problems with this story, too. Technology has advanced to the point where we can use things like Bitcoin instead of heavy, easy-to-steal physical commodities like gold. And if civilization collapsed to the point where we couldn’t even use computers anymore, I’d advise you to invest in guns, ammunition, seeds and antibiotics instead of gold.
A bigger problem with the gold story is the question of why you should expect it to earn a good return. For gold’s price to keep rising steadily due to the failure of the fiat money system, it has to be the case that more and more people will steadily realize that the story is true. So a bet on this gold story is a bet that your macro perspective is way, way ahead of the macro perspectives of most other investors. That’s a highly speculative, risky bet.
So you should beware of media outlets that constantly push this story on you. The most important such website is probably Zero Hedge. If you read Zero Hedge, you’ll see this story about gold and fiat money being promoted again and again and again, often mixed with a healthy dose of political ideology and references to “Austrian economics.”
If you actually take Zero Hedge’s constant gold-flogging to heart, you could lose a lot of money. Since gold hit a peak in 2011, it has lost about 33 percent of its value in real terms. Zero Hedge kept touting gold all the way down. For example, in November 2011, Zero Hedge ran an article saying that gold could be “on its way to infinity.” In March 2012, Zero Hedge urged its readers to “stay long gold.” An October 2012 article made the same recommendation. As the price fell, Zero Hedge assured us that the collapse was only in “paper” gold, not the physical commodity. Needless to say, if you took Zero Hedge’s advice at any of these points, you would have lost a lot of money.
Now, if the gold crash is only temporary, and someday gold heads toward infinity, then losing money on paper is no problem…unless, of course, you have to sell to cover retirement expenses or pay some medical bills.
A lot of finance people seem to treat macro stories, like the one Zero Hedge pushes, as entertainment rather than actionable information. That’s a healthy attitude. And it’s true that Zero Hedge occasionally does some excellent reporting, or publishes other good information. So maybe you can read the site just for those tidbits, and either ignore or just smile indulgently at the huge volume of gold-flogging politics-tinged macro-propaganda that the site hurls at you day after day. But then you’re like one of those rare people who really does read Playboy magazine for the articles.
Zero Hedge is still pushing gold. It’s still pushing Austrian economics. But should you be listening? Only if you’re very good at separating bedtime stories from reality.

Sunday, July 20, 2014

Are liberals rescuing marriage?

(This post originally appeared at Bloomberg View.)
When we think about the issues of family, sex, and morality there’s a standard story that frames our thinking. Ross Douthat, writing back in January, did a good job of telling that story:
[Liberals might want to] acknowledge the ways in which liberalism itself has undercut the two-parent family — through the liberal-dominated culture industry’s permissive, reductive attitudes toward sex, and through the 1970s-era revolution in divorce and abortion law.
It seems obvious that sexual permissiveness discourages marriage. In the old days, marital sex was the only socially acceptable kind of sex, so if you wanted to have sex, you had to get married; allow people to have sex outside of marriage with no social sanction, and you take away a big part of the impetus to get married. Liberal values, therefore, are corrosive to families.
But is this true? Last year, I read a book that changed my outlook on American society: Charles Murray’s ``Coming Apart: The State of White America, 1960-2010.” In that book, Murray convincingly argues that a class divide has emerged in America, between educated people (“Belmont”) and uneducated people (“Fishtown”). The surprising thing is that Murray finds that the educated Belmonters, despite being much more socially liberal than their Fishtown counterparts, actually have more traditional family values -- they get married more, get divorced less and pay more attention to their children. After a period in the '70s and early '80s when educated people dabbled in single parenthood and high divorce rates, they went back to a traditional-family structure. Uneducated Americans, on the other hand, are abandoning marriage and two-parent child-rearing in droves.
It isn't just Murray finding this. Richard Reeves of the Brookings Institution has identified something very similar. In a landmark article in Atlantic magazine, he gave a detailed, data-driven case that educated Americas are rebuilding the institution of marriage:
[C]ollege graduates in the United States are reinventing marriage as a child-rearing machine for a post-feminist society and a knowledge economy. It’s working, too: Their marriages offer more satisfaction, last longer, and produce more successful children.
The glue for these marriages is not sex, nor religion, nor money. It is a joint commitment to high-investment parenting…Right now, these marriages are concentrated at the top of the social ladder, but they offer the best—perhaps the only—hope for saving the institution.
How can this be? How can the people who preach sexual license be the same ones who have rebuilt their families, while lower-class people who profess more conservative values are seeing their families crumble?
Social conservatives have a few hypotheses. One is that high-investment parenting is only for the wealthy -- that in our stratified society, lower-income people know that investing a lot of effort in the kids won’t pay off, so they just don’t bother. A variant of this is the idea that lower-class men are too risky for lower-class women to marry.
In his book, Murray implies that educated liberals are a bit hypocritical. He calls on them to “preach what they practice,” in the hope that they can spread their newly recovered family values to the Fishtown masses. But a thought occurs to me: What if that’s exactly what they’ve been doing all along? What if sexual permissiveness and feminism, instead of being toxic to the institution of marriage, are the key to saving it?
That might sound crazy, but here’s the case in a nutshell. If you wait until marriage to have sex, you’re taking an enormous risk. What if you’re not compatible? Or what if you regret not having shopped around?
Sexual permissiveness means that sex isn’t about marriage. But that means that marriage isn’t about sex. Most of the upper-class liberal educated Americans I know who are in stable, happy marriages had their share of premarital sex. Knowing what that lifestyle is like -- and realizing that they wanted more -- allowed them to be more content in their marriages, and more realistic about what marriage is all about (i.e., lifetime companionship and raising kids).
Feminism may be even more important for families. With traditional gender roles, only a man who can be a sole breadwinner is a worthwhile mate. That rules out a lot of men, and it might be a reason why less-educated Americans’ conservative values are holding them back from getting married. Feminism, on the other hand, rewards fathers for sharing child care and housework, and frees them from the heavy burden of antiquated expectations.
In other words, maybe liberal morality is simply better adapted for creating stable two-parent families in a post-industrialized world. Maybe conservative family values are hard but brittle, like diamond, while liberal family values are strong like titanium -- able to bend without breaking.
If this is true, then I feel hopeful about American families. In many cases, educated and upper-class Americans are social trend-setters, while less-educated Americans catch up eventually. Perhaps America’s “Fishtown” class is simply doing the same thing the “Belmont” class did 30 years ago -- experimenting with single parenthood -- and will eventually learn how to do gender-equal marriage and high-investment parenting.

Thursday, July 17, 2014

Austrianism, wrong? Inconceivable!

I see that Robert Murphy of the Mises Institute has taken the time to pen a thoughtful critique of my gentle admonishment of followers of the school of quasi-economic thought commonly known as "Austrianism." Robert deserves a response, so here is one.

First, Robert takes pains to point out that the image I included in my original blog post was not a picture of an Enterprise crewmember who had been subverted by Khan's "brain worms" (actually "Ceti eels"), but rather of a minor character in an unrelated episode of the original Star Trek series. This is correct, of course. Searching for an image to use in my post, I found the pictures of the actual Ceti eels too visually unappealing, while the pictures of the subverted Enterprise crewmen did not look particularly out of the ordinary (much as a devotee of Austrianism may appear, when encountered in a bar or on a trading floor, to be a normal human being in full possession of his faculties). So I instead chose an unrelated picture that I thought would better convey the general idea of the post, rather than remaining faithful to the canon of the original Star Trek series. Robert might also have noted that the picture used by Bloomberg was not of a Ceti eel, but of a handful of garden-variety earthworms. I apologize for this canonical inaccuracy as well. And before anyone starts giving me a hard time, let me note that the image at the top of this post is actually not a picture of Robert Murphy; it's actually an image of the alien "Balok" from the original Star Trek series episode "The Corbomite Maneuver."

So now that that's cleared up, let's examine Robert's critique. Much of my original article discussed the failed Austrian prediction that QE would cause inflation (i.e., a rise in the general level of consumer prices). Robert reiterates four standard Austrian defenses:

1. Consumer prices rose more than the official statistics suggest.

2. Asset prices rose.

3. "Inflation" doesn't mean "a rise in the general level of consumer prices," it means "an increase in the monetary base", so QE is inflation by definition.

4. Austrians do not depend on evidence to refute their theories; the theories are deduced from pure logic.

This is sort of an intellectual defense-in-depth. Each argument, if true, obviates the need for all the former arguments. For example, if asset price rises really are the same as consumer price rises, who cares if consumer prices rose more than the official statistics suggest? And if QE really is defined as inflation, why does one need to point out rises in asset or consumer prices? And if Austrian theory is not vulnerable to falsification by data, then why bother citing any evidence at all?

In other words, the fact that Robert is making all of these arguments at once seems to me like a tacit admission that each one of the arguments, on its own, is very shaky.

But be that as it may, all of the arguments are either unsupported assertions or deeply flawed. Let's go through the list.

1. Robert:
2) "prices are rising much faster than anyone thinks" There are plenty of people who think the “cost of living” is a lot higher now than it was in 2007. No, I’m not saying we’re living amidst hyperinflation but the government is hiding it; but I do think the official Consumer Price Index is understating things.
Rebuttal: There are plenty of people who think the "cost of living" is a lot lower than it was in 2007. No, I'm not saying we live amidst deflation but the government is hiding it; but I do think the official Consumer Price Index is overstating things.

See what I did there?

2. Robert:
UCLA giants Alchian and Klein argued in a 1973 paper that asset prices should be included in a proper measurement of monetary policy. By that criterion, the Fed definitely has been “loose” and “inflationary” since 2008; indeed that was the whole point. People look at soaring stock prices and say, “Good job Bernanke!”
Rebuttal: Imagine yourself saying this: "Oh, no, the price of stocks is going up! Jeez, how will I be able to afford my weekly purchase of 100 shares of my favorite ETF? I better ask my boss for a raise!" You can't, right? Because when stocks go up, that's good.

Now an Austrian may be tempted to retort: "But this price rise is only temporary; it's going to crash later!"

OK, even if that were the case, it would be the crash, not the rise in stock prices, that would be the bad thing. Whereas if you're worried about increases in the price of say, TVs, your chief worry is not that the price of TVs will subsequently crash - in fact, you probably hope that it does, so you can get a cheap TV.

So you see, stock price rises are not actually good to include in inflation. (Homes are more complicated, of course, since they involve a consumption component.)

3. Robert:
Noah [argues] that the Austrians in response to the modest CPI hikes of 2009-2013 attempted to redefine inflation. No, Noah, this is not some new position. Here’s Mises on page 420 of Human Action:
...What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency toward a rise or a fall in commodity prices and wage rates...
Now that was originally published in 1949, so I’m pretty sure Mises wasn’t providing cover for Peter Schiff and me in light of CPI after various rounds of QE. 
If Noah doesn’t trust such a dodgy source as Mises, maybe he’ll heed the statements of an official Federal Reserve publication? Joe Fetz provided me with this 1997 Cleveland Fed paper, which says: 
Today, we commonly hear about different kinds of inflation. Indeed, the word inflation is often used synonymously with “price increase.” But there is also a different, more specific, definition of inflation–a rise in the general price level caused by an imbalance between the quantity of money and trade needs. This “inflation” has but one origin–the central bank. It is the latter definition that drives many of those advocating an anti-inflationary policy for the Federal Reserve, and that more closely conforms with the word’s original meaning. 
Oops, sorry Noah. Maybe next time you should do some research before writing on a topic. 
Historically the word “inflation” did indeed mean what (some) Austrians currently insist is a better definition–namely an increase in money rather than an increase in prices[.]
Hmm. First, note that the Cleveland Fed paper defines inflation as "a rise in the general price level caused by an imbalance between the quantity of money and trade needs." For that to exist, you need the general price level to rise. If it doesn't, then by the Cleveland Fed's 1997 definition, there is no inflation. So by the Cleveland Fed definition Robert cites, there has also been very low inflation since QE began.

Let me humbly suggest that perhaps Robert should actually read his own sources before writing on a topic.

But in any case, yes, it is true that Ludwig von Mises also wanted to define "inflation" as an increase in the monetary base (note, however, that the rise in prices that he considered to be an "inexorable" result is looking less inexorable by the day). But so what?

Here's the real point: Defining QE as inflation, no matter who came up with the idea and when, is merely a distraction from the fact that QE has not led to a rise in consumer prices. What kind of prediction is it to say that "QE is inflation, therefore of course QE causes inflation, HA!" No prediction at all.

But this brings us to Austrian Defense #4...

4. Robert:
But Noah’s claim that my prediction about CPI movements has something to do with Austrian theory is nuts. Notice that the mainstream economists like to mock Austrians (Misesians in particular) on two different counts: In the first place, they mock us because we adhere to “praxeology,” which says that pure economic theory is deduced a priori, rather than through empirical observation. (Here’s Noah admitting he knows this, in point #2 of a February blog post.)
This is basically saying "Noah, you can't use evidence to disprove our theories, because you know very well we don't care about evidence!"

Which is sort of the whole problem, isn't it? Austrians are looking at real events and saying "Inconceivable!", make that "Inexorable!" But I do not think that word means what they think it means.

See, most people do care about the evidence, very much. They do not care if Austrian theories were logically deduced from the Human Action Axiom. They care whether their financial portfolios increase or decrease in value. And if they bet on the Austrian predictions that inflation (the real kind) would go up as a result of QE, they lost money. Praxeology might be logically satisfying, or it might not, but it's cold comfort when extant reality is kicking you in the head.

(Incidentally, people also mostly don't care about whether "inflation" means the rate of change of the monetary base or whether it means the rate of change of the CPI. What they care is whether the former causes the latter. Word games are even less comforting than logical syllogisms.)

My article was not intended to point out that Austrian theory failed its own test of validity following QE. It can't possibly fail its own test - it designed the test so that it could not fail it.

My point was that Austrian theory has failed other people's test of validity.

Now, that's obviously not enough to convince a lot of Austrians to abandon Austrianism - once you have accepted a belief system that creates its own criteria for success, you're very unlikely to change (that's what I meant by calling Austrianism a "brain worm"; it is by no means unique in having this Ceti eel-like property). But from where I'm standing, failed empirical predictions are a big deal. And it's not just inflation, either - it's gold, the dollar, etc.

Anyway, there are some other miscellaneous points I could make about Robert's critique (For example, he blatantly overlooked the one point at which my rant was actually charitable to Austrian ideas! Can you find it?). But this is the main thrust. In any case, I thank Robert again for taking the time to write a response to my article.

Monday, July 14, 2014

How are macro methods evolving?

I realized long ago that I'm much more interested in the philosophy-of-science issues of macroeconomics than in the subject matter itself! So when John Cochrane came back from the NBER Summer Institute with a big post about the latest trends in macro methods, I was understandably excited. I don't have a heck of a lot to add, but here are the highlights:

Math as Storytelling

Back in 1991, Larry Summers complained that macro models create the illusion of science-y-ness by pretending that the parameters in their model represented real things instead of stylized allegories. In 2010, Ricardo Caballero argued something similar, saying that the crisis had exposed the faults of the overly-precise "fully-specified DSGE" approach.

The argument is really not about the content of models - it's about the use of math itself. One way to use math is the way physicists and chemists use it - to make quantitative predictions of stuff. The other, less ambitious, way is to use math to be precise about your ideas, to check your logic, and to explain your ideas in a universal language. The latter way isn't bad; what's bad is when you mistake the latter for the former, and take your models "too seriously."

The crisis and recession seemed like it should have told macroeconomists that they were taking their models a bit too seriously. And in fact, that seems like exactly what has happened. Cochrane:
Most of the theory papers had some "motivating" facts...Not one paper wrote down a model, estimated or calibrated its parameters, and compared that model to data...This isn't a complaint, really, it's just where we are. The kinds of things people want to investigate are just too hard to write down models rich enough to take to the data... 
[B]oth of the macro theory papers stopped well short of serious confrontation with data. We didn't see anything like the standard fully specified models...compared to, say, impulse-response functions. The models are so stylized you can't begin to quantify them...This too is not really a criticism. I've been working with simpler and simpler models, as I find it hard to keep the intuition and quantitative parable aspect alive as models get more complex.
So mainstream macro people seem to have converged on the Caballero idea. This also provides yet more evidence that modern mainstream macroeconomics is very much alive and kicking as a research program.

More stylized models doesn't necessarily mean simpler models, though:
Sam [Kortum] gently chided Ufuk et al. for presenting 24 pages of complex model all to "motivate" some regressions.
It will be interesting to see whether the move toward stylization will be followed by a move toward simplicity in model-making. Maybe macroeconomists, groping for big ideas to explain the unprecedented events we've just seen, will go back to telling the kind of simple stories that Milton Friedman used. Or maybe even "24 pages of complex model" is so simple compared to the real thing it's trying to model that to make it even simpler would lose too much of the logic.

Growth vs. Business Cycle Theory

The idea that growth and development econ were two completely different fields always struck me as a little weird. I mean, sure, maaaaaaybe you could use an endogenous-growth model to tease a couple extra bips of growth out of a mature economy for a few years, if you had enough data to really find the best endogenous-growth model, which (let's be honest) you don't. Endogenous growth theory is very kewl and interesting, but it just doesn't seem that important relative to development econ, which deals with the monumental challenge of boosting poor countries to middle-income level. (Robert Lucas seems to agree.)

I don't follow growth theory much, but according to Cochrane, the top growth people are indeed becoming more interested in development issues, and adopting the methods more commonly associated with development econ:
Economic Fluctuations merged with Growth in the mid 1990s. At the time there was a great confluence of method as well as interest. Growth theorists were studying growth with Bellman equations, dynamic general equilibrium models of innovation and transmission of ideas, thinking about where productivity shocks came from... 
That confluence has now diverged. I enjoyed spending an hour or two thinking about how religion has blocked or adapted to ideas over the centuries, and Paul [Romer]'s view on social norms or neuroeconomics. But I don't really have any expertise to contribute to that debate...[W]hen Daron Acemoglu, who seems to know everything about everything, has to preface his comments on macro papers with repeated disclaimers of lack of expertise, it's clear that the two fields really have gone their separate ways. Perhaps it's time [for] growth to merge with institutions and political or social economics.  
Cool. Though this may not sit well with Japanese macro people, a lot more of whom do growth econ rather than business-cycle theory.

Verbal Arguments and the Wisdom of the Ancients

Probably the most striking sentence in Cochrane's post was the following:
In my 30 years as an economist, our field has become much more literary and less quantitative.
That's interesting. I had thought it was the opposite. Was there a U-shaped pattern, where things became more quantitative leading up to the mid-80s, and then trended back toward literary-ness?

In times of uncertainty, we humans have a natural tendency to reach for the wisdom of the ancients. Cochrane isn't such a fan of this, but recognizes that he may be swimming against the tide:
The use of ancient quotations came up several times. I  complained a bit about Eggertsson and Mehrotra's long efforts to tie their work to quotes from verbal speculations of Keynes, Alvin Hansen, Paul Krugman and Larry Summers. Their rhetorical device is, "aha, these equations finally explain what some sage of 80 years ago or Important Person today really meant."  Ivan Werning really complained about this in Paul Beaudry's presentation. What does this complex piece of well worked out "21st century economics" have to do with long ago muddy debates between Keynes and Hayek? It stands on its own, or it doesn't... 
Physics does not write papers about "the Newton-Aristotle debate." Our papers should stand on their own too. They are right or wrong if they are logically coherent and describe the data, not if they fulfill the vague speculations of some sage, dead or alive... 
Sure, history of thought is important; tying ideas to their historical predecessors is important; recognizing the centuries of thinking on money and business cycles is important. But let's stand up for our own generation; we do not exist simply to finally put equations in the mouths of ancient economists. 
But...perhaps I'm just being an old fogey. Adam Smith wrote mostly words. Marx like Keynes wrote big complicated books that people spent a century writing about "this is what they really meant." Maybe models are at best quantitative parables. Maybe economics is destined to return to this kind of literary philosophy, not quantified science.
My instincts are with Cochrane on this issue. There is nothing more annoying than when you argue with some idea, and then some guy comes along and says "Go read Ludwig von Mises, then you'll understand everything." No you won't. You'll just get a warm glow of understand-y-ness, and you'll end up parroting words and phrases from the Old Master without being any better able to think critically and originally about the issues.

Then again, a lot of those old folks were really smart, and there are probably insights embedded in their writings that are too vague or complex to be translated directly into math, but which contain information, the way the priors of a portfolio manager carry valuable information in a Black-Litterman model. But the flip side of that is that you probably have to be a really, really smart person to extract that deep-buried insight. Economic history, in other words, seems like very dangerous sauce to me - in the right hands it can be useful, but it is usually in the wrong hands.

But that's just my thought. I feel like I may annoy Brad DeLong with this thought...

The Upshot: Halfway Back to the Drawing Board

So from what Cochrane saw at the NBER macro meeting, the field is becoming more literary, more stylized in its modeling, and more eclectic in its approach. To me, these all seem like manifestations of one single, underlying process: Macroeconomists are going back to the drawing board in the wake of the crisis and the recession. Not all the way back, but part of the way back. They are searching for new ideas, by making their models more conjectural and conceptual, by bringing in a mix of techniques and "out-there" ideas, and by picking through ideas from the past.

It seems to me that this is exactly what good scientists do. If you are one of the people who thinks that macroeconomics is utterly compromised by dogma, politics, or non-scientific thinking, Cochrane's report should cause you to update your priors somewhat.

One More Thought: The Impact of Blogs

I suspect that blogs have played a largely helpful, though marginal role in the evolution of macro since the crisis - encouraging macro people to realize that something big was broken and needed fixing, tossing around ideas and brainstorming, etc. But I've come to think that blogs have also injected too much contentiousness and aggression into the discussion. For example, Cochrane writes:
[Paul Romer] pointed to my use of "paleo-Keynesian" to describe the static models from the 1960s, guessing nobody would remember anything else from my discussion. When I complained that Paul Krugman invented the term, he pointed out (correctly) that such borrowing just made its use more rhetorically effective. There go the cortisol levels.
When I started blogging a few years ago, I took a very confrontational and sometimes even insulting tone. That was because I thought A) this is the internet, B) everything on the internet is a joke, and C) everyone gets that it's a joke. I guess I had spent too much time in the bowels of the net. I always meant it as a joke, and I never imagined that top academic people would read, much less care about, my blog.

Turns out I was naive. Over time, fellow bloggers like Tyler Cowen and Adam Ozimek convinced me that more civility was needed, so I try to confine my chain-yanking to those who are more used to getting their chains yanked. Academics need to be able to think clearly and objectively, without their cortisol levels being spiked.

Basically, in the wake of the crisis, blogs have fulfilled the same role as the verbal debates between Keynes, Hayek, Sraffa, Robinson, etc. during the Depression. But like those debates, it has generated its fair share of acrimony.