jamesz

Size matters

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The Economist thinks that the prevalence of small firms in Greece is a problem.

A bias to small firms is costly. The productivity of European firms with fewer than 20 workers is on average little more than half that of firms with 250 or more workers (see right-hand chart). …If the best small firms were able to grow bigger, Greece and the rest might solve their competitiveness problems…

This is pertinent to New Zealand since we also have a small number of very large firms, although we may not have the prevalence of very small firms that Greece does. Beyond the arguments over data issues, it’s interesting to ask whether we might agree with The Economist that this poses a problem for growth. Certainly, New Zealand’s growth might be higher if firms grew, but then why haven’t they already? Not because the owners don’t want to reap the rewards of growth, surely.

Of course, what we need to ask is why the proportion of small firms/large firms is the way it is. The Economist points to tax and labour laws in Greece that punish large firms. In New Zealand it is hard to point to similar legal barriers to growth in firm size, as far as I know. It may be that New Zealand firm owners prefer smaller firms, or that it is difficult for firms to find local, skilled labour (random speculation, not to be taken too seriously). What this highlights is the importance of understanding the differences in countries, as well as their similarities, before rushing to emulate them. Are we the next Ireland/Singapore/Finland? Well, no, we’re a bit different from all those countries and we can’t replicate their successes without understanding those differences.

Matt Nolan

Weekend reading

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This post from mainly macro combines my favourite (although getting dated) book on macroeconomics, my preferred methodological statement for economic modeling, and tackles the idea of microfoundations in macroeconomics.

One of my favourite blog posts in a while – I suggest you have a peek at it.  One thing I would note is that, for applied macro, one day we will realise that microfoundations provide many potential paths to a single macro relationship – and in order to get anything policy relevant we will need to come up with an idea of what is “plausible” in order to narrow this set.

This involves not just working with data, but having to make subjective calls – and that is the area where things get hairy fast.

I’d also note that microfoundations are a huge part of academic economics as they are currently doing the technical work of creating micro models that provide potential explanations of macro phenomenon.  This is an essential task, even if much of the work ends up with potential explanations we view as “not plausible” in the end.

jamesz

Always ask why: Chesterton’s Gate

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Peopl just love to think that they’re smarter than everyone else. They look at a problem they’re not familiar with for two minutes and then say, “Oh, but the answer’s obviously…” Matt will recognise this phenomenon from all the times he’s been told that macro forecasting is a waste of time and the people buying it must be idiots. Economists generally get it from physicists who think Brownian motion solves half the problems in economics. Economists themselves are terrible at it: they look at almost any policy debate and claim that if only X were properly priced then everything would be rosy.

If all these things are so obvious then the question is, why haven’t they been dealt with already? And, “because nobody else is smart enough to see the solution” is unlikely to be the correct answer. More often, the person with the ‘solution’ just doesn’t understand the complexity of the problem and the reasons why things are as they stand.

Now, that isn’t a new insight, but I’m sure I’m not the only one who’s been bothered by the lack of a snappy name for it. After all, it isn’t a real proposition until you can name it after someone. So I was very happy to come across this article by Megan McArdle discussing Chesterton’s Gate. I’m not sure if the name is widespread, but i’m already a fan. Apparently GK Chesterton gave a fairly eloquent description of the problem:

In the matter of reforming things, as distinct from deforming them, there is one plain and simple principle; a principle which will probably be called a paradox. There exists in such a case a certain institution or law; let us say, for the sake of simplicity, a fence or gate erected across a road. The more modern type of reformer goes gaily up to it and says, “I don’t see the use of this; let us clear it away.” To which the more intelligent type of reformer will do well to answer: “If you don’t see the use of it, I certainly won’t let you clear it away. Go away and think. Then, when you can come back and tell me that you do see the use of it, I may allow you to destroy it.”

This paradox rests on the most elementary common sense. The gate or fence did not grow there. It was not set up by somnambulists who built it in their sleep. It is highly improbable that it was put there by escaped lunatics who were for some reason loose in the street. Some person had some reason for thinking it would be a good thing for somebody. And until we know what the reason was, we really cannot judge whether the reason was reasonable. It is extremely probable that we have overlooked some whole aspect of the question, if something set up by human beings like ourselves seems to be entirely meaningless and mysterious. There are reformers who get over this difficulty by assuming that all their fathers were fools; but if that be so, we can only say that folly appears to be a hereditary disease. But the truth is that nobody has any business to destroy a social institution until he has really seen it as an historical institution. If he knows how it arose, and what purposes it was supposed to serve, he may really be able to say that they were bad purposes, that they have since become bad purposes, or that they are purposes which are no longer served. But if he simply stares at the thing as a senseless monstrosity that has somehow sprung up in his path, it is he and not the traditionalist who is suffering from an illusion.

Matt Nolan

Neuroeconomics is exciting, and scary

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Great article from Shiller on neuroeconomics.  The more justification, and more positive side, of neuroeconomics is mentioned here:

Under Samuelson’s guidance, generations of economists have based their research not on any physical structure underlying thought and behavior, but only on the assumption of rationality.

As a result, Glimcher is skeptical of prevailing economic theory, and is seeking a physical basis for it in the brain. He wants to transform “soft” utility theory into “hard” utility theory by discovering the brain mechanisms that underlie it.

This is cool.  Economists want to be reductionist, but we were unable to boil down our theory quite far enough and had to settle on some underlying assumptions of human nature – assumption that were based on “conducting experiments in our own heads”.  Neuroeconomics provides a route for us to actually push the ontological envelope and create a more objective, mechanistic, way to describe the underlying elements of human action.

However, the risk is that we allow this view to cloud our thinking on choice – no matter how far neuroeconomics evolves we will never clearly decipher whether actions are the result of determinism or free will.  By describing action in a deterministic way, we may treat human action as “too deterministic”, leading to a bias towards excessive control and meddling.

Matt Nolan

Rationality and scope in economics

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Whenever someone is busy attempting to have a heart-to-heart with me, I have one catch all statement I always pull out:

Hold yourself to a high standard that you can feel proud of, but never base your expectations or judgments of others on that standard

The usual resp0nse to this is “that’s f’ing obvious”, “no shit, do you think you’re adding anything”, and “congratulations you’ve made the obvious sound pretentious”.

Now this is fine, I agree that the point is obvious and not particularly exciting.  But at the same time this is one of the key reasons why economic theory builds up from basic rational expectations – and yet many of the same people that would call my advice overtly simply when looking at their daily life, would turn around and imply that this sort of assumption is inappropriate when trying to understand the tendencies in the world around us.

What are you saying?

When we assume people act “rationally”, we are assuming that individuals make choices based on the costs and benefits put in front of them.  As an individual I know I make choices, and those choices are on the back of my implied view on the costs and benefits of my actions, so using this view of the individual makes sense to me as a firm prior.

Now, when I look within myself I can see issues with my choices – but given that they are my choices I also know that I have the ability to change them.  Furthermore, my ability to recognise my own faults and poor choices, and still not change my choices, seems to imply that the cost of making “better choices” is seen as too high in my own eyes.  As a result, the policy I enforce often just lets me make my own choices.

In this context, when we look at other individuals we should be LESS judgmental of their choices.  We cannot observe the costs and benefits they face, we cannot determine their inner monologue for justifying and discussing choice, we have only a biased external view of how they think and feel.  Presuming that we can tell them what their choices should be is the height of arrogance, a belief in the supreme superiority of us above them – and assuming the direct irrationality (that they do not make choices based on costs and benefits) of people in this context just has no basis.

This is not to say that we can’t identify areas where individuals have biases, or may want help with choices.  We can look inside ourselves and observe present biases, addictions, and areas where we are short on information – however, this is no irrationality, but merely constraints to our own decision making.  Providing institutions that help individuals move past these biases is the right sort of solution – rather than prescribing choice.

Conclusion

Irrationality is the rally call of people who have a policy they want to put in place, and they need to find “a reason” to do it.  Everyone thinks that people around them are irrational, but a mere moment of introversion suggests that we are too quick to judge the actions of others – given our inability to look through their eyes, or feel the desires that drive their action.

Economic theory is based off the idea that individuals have the best understanding of their own minds, and that policy must be based off a clear market/institutional failure.

Calling for policy based on irrationality just plays on our prejudice against other people based on their “intelligence”, a perception that relies on poor information  is biased by our own desire to make ourselves feel more important in our own lives.

Matt Nolan

The trouble with desiring change for the sake of it

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In a good post by Doug Reich (ht Not PC) he discusses why the current protests appear to have a great deal of “protesting for the sake of it” rather than having explicit – or testable – desires.

The dangerous thing with such protests is the ability for someone to capture the crowd with a false goal – coming up with a solution that is not good just because it can be sold via an underlying urge of the protesters to do something that makes them look altruistic … or more generally makes them look like they were part of some change.

Unlike Doug, I am not willing to call this a problem of the left – instead, this is what I view as a problem of holism – something that exists among all political groups.  For example, the “right” in New Zealand have their measurable goals – meaningless targets that are not based on anything, targets that give them the satisfaction of thinking that are causing progress (here, here, here).

Before we can really say what change in desirable, we need to understand WHY things happen and HOW changes to organisation and policy have an impact on them.

Doing this is hard – it is costly.  People want the satisfaction that comes from “feeling like you are progressing society” without taking on the cost of actually thinking about the policies – as a result there is an incentive to demand change more often, and with a smaller amount of understand, than is actually “optimal”.  This is obvious, it sounds obvious, people will tell me its obvious – and yet the logical conclusion of actually trying to have a real argument before pushing change is IGNORED by both the left and right.

Now some will say “its not ignored, there are studies/evidence”.  But 99% of the time the studies or evidence that are used are either cherry picked, poor research, or were set up with the conclusion already in mind – forcing change down peoples throats in the face of this type of evidence is just as bad as protesting for no real reason.

When it comes to policy, the best changes we can make are in areas where we have the best understand and information – it just happens that we have the best understanding and information about ourselves.  As a result, as a person our main focus on “change” and “fairness” should be within ourselves and related to our own actions.  What’s that saying … be the change you want to see.

We all want to – and should – fight the inequity around us.  But we can’t do this until we understand why it occurs and how it can be influenced.  However, we can only get to this point by doing the hard yards and playing in the “lab in our minds” (and in conjunction with the research of other on these issues) and discerning what can be called “tendency laws“.

A willingness to work out these tendencies, and implicitly treat other people on the same intellectual level as ourselves, is the way to understand the need for change – not overwrought simplifications of what defines “others”, which appears to the basis of both the 99% protests and the push for a measurable GDP target for NZ.