jamesz

The forecaster as a storyteller

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Paul Krugman explaining the IS-LM model:

[T]he first thing you need to know is that there are multiple correct ways of explaining IS-LM. That’s because it’s a model of several interacting markets, and you can enter from multiple directions, any one of which is a valid starting point.

Which beautifully illustrates this point:

There seem to be two ways of understanding things; either by way of a metaphor or by way of a story, …[and] the metaphorical and narrative explanations answer to each other.

The metaphors McCloskey refers to are what we commonly term ‘models’; the narrative is the story that justifies the model’s existence. The metaphor provides a framework for the narrative, as the narrative provides a context for the metaphor. The importance of this interdependence is that models are empty without a narrative to explain why they exist. Equally, a historical narrative is of little help if it doesn’t give rise to a generalisable metaphor that we can use to simulate counterfactual worlds.

Krugman’s introduction to IS-LM (a macroeconomic metaphor) illustrates not only the importance of the narrative but also the fact that multiple narratives can support the same metaphor. This ties in really well to Matt’s discussions of the value of economic forecasting. The value in forecasting is not in the predictions that our models make about the future, but in the usefulness of the narrative the forecaster tells. That narrative varies across forecasters depending upon the relative importance of various actors in their story, despite the fact that they all have pretty much the same model of the economy in mind. That may help explain why they all tell a different story and yet profess to largely agree about all the important issues.

jamesz

Morality in sport

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NYT:

On Tuesday night at the London Games, some of the world’s best badminton players hit some of the sport’s worst shots. Sad serves into the net. Returns that sailed far wide. …On Wednesday, four women’s doubles teams — two from South Korea and one each from China and Indonesia — were disqualified. …The eight players were found to have tried to lose their matches intentionally, apparently because they had determined that a loss would allow them to play a weaker opponent in the next round.

I don’t really understand the moral outrage over this. The competition is set up such that winning it is easiest if you lose some matches, but there are also sporting norms that say you have to do your best to win every game. Obviously, when the rewards to winning the competition are high, those incentives will over-ride the norms of sporting conduct. It’s no surprise that teams would try to throw a match, although I am surprised that they did it so obviously: you’d think they’d practice this sort of thing a lot if most competitions work this way.

There’s a more technical discussion of incentive compatibility constraints in the design of the competition over at Cheap Talk.

Matt Nolan

“Sluggish” credit growth, where does NZ fit in?

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Via Tyler Cowen on Twitter was this article, combined with the comment “credit growth sluggish”.  The view here is that the 4% growth in private sector credit is too weak when compared with historic averages – and that the goal of the Fed should be to focus on the “quantity of credit” here, rather than target the price.

Now in New Zealand we have similar data here.  According to this, private sector credit growth was 2.3% year-on-year (or 3.2% if we exclude repurchase agreements – which is preferable IMO).  This compares to a decade-long average of 7.3%pa (8.3%pa), and if we were solely quantity focused this would seem insufficient.  [Note:  I did decade instead of history, as the implicit inflation target moved significantly over the decades – a factor that pushes this figure around.  Would be best to look at “real growth” for a longer-term focus]

I’m not concluding anything from this per se – it is just interesting that NZ analysts are running around getting concerned about inflation and rising credit growth, while analysts in the US, who are observing stronger credit growth than we are, are generally complaining that more needs to be done.  Tbf, their unemployment rate is a lot higher, and their output gap is correspondingly larger (presumably).

But with underlying inflation in the lower end of the RBNZ’s target, credit growth numbers objectively soft, and the unemployment rate undeniably elevated I feel that the inflation calls may be a touch overplayed.  [Note:  A relative price lift in construction due to a rebuild in Canterbury is not inflation – it is a signal of scarcity, as prices are supposed to be].

Matt Nolan

The issue of assumptions

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In a recent post, James recently raised an essential, and fascinating, point on assumptions.  To borrow his own words:

Assumptions are often made for tractability, rather than realism, yet still influence our conclusions. It isn’t possible to control for the unrealistic assumptions; if it were we wouldn’t have made them. That means our conclusions will be biased by assumptions we’ve made only for convenience and we need to bear that in mind when considering the policy implications of our models.

This reminded me of an essay by Maki which can be found in “New Directions in Economic Methodology“.  The essay was title “Reorienting the assumptions issue“.

In this essay, Maki does a number of interesting things – but in terms of this specific issue his key insight was to differentiate between “core” and “peripheral” assumptions.  This is an insight we have borrowed many times when talking here on the blog.

A core assumption “constitutes the theory” while a peripheral assumption does not.  What does this mean?  Well it means that the “core” makes up the central set of necessary assumptions required to achieve a certain result!

It is these core assumptions that need to be “realistic” in some sense of the word – while peripheral assumptions are merely there to increase tractability, or make a result easier to interpret.  Fundamentally, our core result should only rely on our core assumptions.

Core assumptions in econometrics

For those who are statistically inclined, this also fits neatly inside our view of econometric theory.  Fundamentally, the assumptions we make about error terms in a regression in econometrics are akin to checks regarding whether we have all the appropriate “core” assumptions for the econometric model and the question we are asking with that model.

For example, we may be trying to explain some independent variable (y) with a set of (presumed to be) exogenous dependent variables (x).  However, it turns out one of these x’s turns out to be correlated the error term – so that this variable is “endogenous“!  If we wanted to estimate the impact of this dependent variable on our independent variable through typical OLS, our estimate will be biased (this is the justification for instrumental variables).  In this case, the model is likely underspecified in some way – such as having missing “core” variables (omitted variable bias), or a missing “causal relationship” (reverse causation between the independent and dependent variables).

A conclusion

As the above example hopefully showed, what dictates a “core” assumption in a model depends strong on what question we are trying to answer with the model!  An analysis of what constitutes “core” assumptions for our analysis, and then a discussion regarding whether these core assumptions correspond to a realistic set of assumptions, should be an essential component of all model building exercises in economics.

jamesz

Behavioural economics and policy

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Stephen Gordon applies the Lucas critique to behavioural economics and nudges:

A key insight of behavioural economics is that people don’t always and everywhere re-optimise whenever their environments change. Instead, they will often – or even usually – make use of various rules of thumb and/or passively accept the default option. …This the idea behind ‘nudges’: you can alter people’s behaviour by making minor changes to the frames in which people operate…

But this only works if the change is subtle enough to not attact the full, direct attention of the decision-maker. If the change is big enough, people will haul out the full artillery of their rational selves in order to try figure out what optimal decision is. This means that behavioural economics is unlikely to be of much use in policy-making.

What he’s saying is a policy that takes advantage of people’s rules of thumb relies on them using the rules of thumb. If the policy is a big enough change in the circumstances they face then they might change their rule of thumb, which changes the effect of the policy. Unless you know how people form their heuristic, you can’t target it with policy.

For example, setting organ donation schemes to be opt-in by default may increase the level of donation because people don’t have a strong preference over whether they donate after death. If you applied the same reasoning to a decision that people care deeply about then it might have no effect because people will make the effort to choose their preferred option.

It’s an interesting point but I think Gordon goes too far by suggesting that it invalidates the targeting of behavioural heuristics. Read more

Matt Nolan

The attempt to make everything a “generation war”

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Via Blaise Drinkwater (on Google+ of all sites!) was this link from Marginal Revolution.  The generational war component comes through this:

By speeding the flood of less expensive imported products into Japan, the strong yen is contributing to a broader drop in the prices of goods and services, known as deflation, that has helped retirees stretch their pensions and savings. The resulting inaction on the yen, according to a growing number of economists and politicians, reflects a new political reality, with already indecisive leaders loath to upset retirees from the postwar baby boom who make up nearly a third of the population and tend to vote in high numbers.

To me, this comment is relatively nonsensical for two reasons.

Firstly, The Yen has “strengthened” from an incredibly weak level in 2007 – incredibly weak by historic standards!  Yes the Yen is now strong against the US dollar, but if you compared it to a wider basket of currencies this is hardly the case.

When talking about currency, historical context isn’t particularly useful.  Instead we need to ask things such as “what is purchasing power parity like” and “are they running a trade surplus”. It turns out that Japan is still running sizable trade surpluses, suggesting that (if anything) the Yen may still be too weak …

My second complaint is this view of the Yen and inflation – inflation is the growth in the general price level over time, a “high Yen” is a one-off price level shock … it doesn’t change the rate of growth in the general price level it merely knocks down the level as a one-off.  The endemic deflation in Japan isn’t a result of “fiddling with tradable prices”, it is the result of persistent deflation expectations feeding into the wage and price setting behaviour in the country.

Now if there is a generational war in this context, it relies on Japan’s pensions not being inflation adjusted.  Is this the case?  If not, this is much ado about nothing.