Tagged: Economics

Physics Killed The Economics Star

There has been much debate recently about the failings of the discipline of economics and those who practice it. What good are any of them, the critics ask, if they could neither prevent nor foresee a financial crisis of such magnitude? Economists’ responses to this varied in tone from personal exclusion and blame shifting (everyone went digging through their pre-2009 blog posts) to honest soul-searching, also including retaliation that was as non-constructive as the initial critique.

When I personally encountered this debate, I defended the dismal science against all odds. No surprises there: I’ve invested most of my adult education in the field and learned to parrot the remarks of much more brilliant men: blame certain economists, not economics, I began. Hardly anyone in academe does forecasts at all- it is the explanation of phenomena, and not their prediction, that mainly interests economists. And the real knockout, the last refuge of the desperate: what else is there that is better, anyways?

Sociology? Political Science? Psychology? History? It seems difficult to imagine that these fields, with their embrace of complexity, could do better. These disciplines’ rejection of universal principles of behavior as a core makes quantifiable predictions even more difficult. Think of the banker, the manager, the investor, the president. This person does not want to hear about all the contextual elements, the defining minutiae of human idiosyncrasies, the complex power struggles determining the movements of economic aggregates. She wants to know if the number will go up, or if it will go down. And fast.

In this same mental exercise, the late Paul Samuelson turned in practice to mathematics and in spirit to physics. If we cannot state our assumptions and our reasoning in a rigorous manner, he said, the complexity of the issues will drown out everything in our theories but the rhetoric. And with his turning, all subsequent generations of economists marched forward – some with blind enthusiasm, some with trepidation – towards the ideal of economics as an objective, quantitative “social natural science”.

As someone who knew nothing of the emulated fields, I applauded the effort. The elephant in the room, that the object of a social science is fundamentally not the same as that of a natural one, was eventually addressed by the rise of behavioral economics with Kahneman and Tversky. In class, we reviewed contemporary approaches to the seemingly irrational behavior that threatened to wreck two centuries of work. Every day in every way, economics was getting better and better. The critics could wait a little and then be forever silenced.

But then I started reading a little about physics, or rather about its history. I read about Tycho Brahe, who developed the most advanced instruments of his day to collect data on the movements of the stars and planets. I read about his disciple, Johannes Kepler, who waited until the greedy Brahe died and then used his collected data to describe the geometric patterns within. And of course, I read about how Newton took this description of the motions of planets and developed a precise mathematical description of gravitation.

What shocked me was that none of them offered an explanatory (as opposed to a descriptive) theory for planetary motion; it would take until the 20th century (i.e. General Relativity and Quantum Mechanics) to offer explanations as to why gravity existed and thus shaped the motions of the planets. All the work before it was limited to describing the patterns in the data in increasing depth and rigor.

This wasn’t at all like what I’d learned in class. I don’t recall ever reading about any famous economist who simply dedicated himself to collecting data and describing it. Most of the theoretical papers I’d read spent little more than a paragraph in discussing anecdotal evidence, let alone focus entirely on modeling surface behavior. On the other side of a vast chasm, the empirical researchers bent over backwards to find testable implications of these theories, and often failed to confirm them. It was almost as if they weren’t on the same planet, let alone the same department.

I witnessed one of the clearest examples of this divide in the theory of international trade. It is one of the oldest branches of economics, and yet for the longest time it failed miserably to explain or predict the behavior of real-world exports and imports. The eminently rational arguments that motivated trade in the classical and modern theory- comparative advantage, factor abundance, differences in preferences – turned out to be very poor predictors of what trade flows actually look like.

It wasn’t until 1952 that an empirically successful model was proposed: Jan Tinbergen’s “Gravity” equation (an allusion to Newton’s formula). It’s argument was rudimentary: trade would increase with the GDP of trading countries, and decrease with distance and other barriers. If the simplicity of the argument was galling to theorists, its results were even more so – it explained the real world data beautifully. The empirical economists were pleased at this new available tool, and began using it to answer interesting questions about the world, while the theorists simmered.

It was offensive that such a shallow explanation of such a complex reality was preferred to the deeper models. As a student, deriving the equilibrium for Ricardian or Heckscher-Ohlin trade  was mathematically challenging and full of surprising insights, while learning about the pedestrian theory behind the “gravity” model took less than a single lecture. The rest was mostly computation and statistics, and that was a lot less fun, a lot less glamorous.

After reviewing the scientific history of gravity, however, I was ashamed of my initial reaction to this model. If I was really all for getting on the natural sciences bandwagon, then why not do it thoroughly? The minute the old theories of trade failed to make accurate and testable predictions, they should have been dismantled for whatever useful parts they had and then ditched. Instead, despite the fact that they have failed in every honest empirical test for the last 60 years, they continue to be taught and researched.

More importantly, the “gravity” model is precisely the kind of explanation to be looking for at this stage- an accurate description of the data. To accept this doesn’t mean that there aren’t deeper explanations for what it describes, just like Newton’s own law of universal gravitation did not exclude the deeper answer provided by general relativity. What it does mean is that a more humble approach – a gradual deepening of our explanations of reality- is bound to be more successful than writing theory from a vacuum. The problems we face are too urgent to allow such a broad division between the theorizing and verifying branches of the science and the ensuing lag in progress.

Admittedly, the limitations that the domain of economic research imposes are different from those of the natural sciences; laboratory experiments, the ideal environment in which to untangle these complex phenomena, are fairly recent in economics and downright  impossible for many subjects. The other source of data, the “natural experiments” sometimes provided by the real world, is impossible to control and difficult to interpret correctly. These are not, however, arguments that support the current divide between pure economic theory and empirical analysis. If anything, these limitations further motivate a more conservative approach: describe successfully, and only then attempt to explain.

I suppose it is clear that I cannot abandon my defense of economics for long. Like Samuelson, I am convinced that the only path that the discipline should follow is that of the natural sciences. Anything else is sophism, or at best a pre-Copernican notion that humans are somehow exempt from the laws  that rule the universe. However, economists must consciously beware of their tradition as speculative philosophers if they are to become scientists. It is an enormously difficult endeavor, since they must adapt the natural scientist’s method to a different and much more fickle field. But, I believe, there is no discipline that is better equipped or more urgently at task than economics.

Love and Information: The Return

Note: A slightly more technical discussion of some Industrial Organization applications to sociology.

The hold-up problem is caused by asset specificity and absence of a perfect contract in a market transaction. These two elements are so broad and commonplace that they are likely to be found in almost all aspects of life. One of these is the realm of romantic relationships. When two individuals begin a relationship, usually through a “dating” process, this is the first instance of several future decisions that have to be made. These decisions can be analyzed using some very conventional tools of economics.

In a utility-maximizing framework, it is understood that the individuals are making a decision whether to enter a relationship with the other person on a utility-maximizing basis (i.e. all relatively new relationships are understood to be revealed preferred to other available relationships). One could think of this new organization between the two individuals as a firm committed to producing several different outputs: Joint leisure, children, economies of scale (sharing apartments, cars, etc.) and even joint economic output (through division of labor).

One of the things that makes this type of organization special is that, throughout its conception, it is not (usually) governed by an explicit contract. Rather, it is until much later, when the partnership has been judged by both parties to be sufficiently promising, that a formal contractual agreement (e.g. marriage) usually takes place. It is interesting to note that even this contract is much further from theoretical “perfection” than any standard business analog. For its maturing stages then, a relationship will be guided by an informal contract adopted from social norms. For convenience, we will not describe its clauses, trusting that they are familiar to the reader (e.g. sexual exclusivity, joint investment of time and effort, etc.).

It is these beginning stages of a romantic relationship that are most prone to under-investment due to a potential hold-up problem. First, consider the relationship-specific investment in knowledge of the counterpart: For both persons involved, investing in knowledge of the other person’s attributes, likes and dislikes is an essential input for production of joint leisure. This investment, however, is virtually useless (and perhaps even harmful!) in any other potential relationship the person might have.

Note also that the cost of this investment is increased further by the fact that a person’s probability of finding a suitable mate is (generally) decreasing with respect to time (due to a decreasing pool of single potential mates, or decreasing physical attractiveness, for example). Once characterized in this fashion, the situation is that of a classic hold-up problem: Due to the uncertainty of a relationship reaching a point of stability (i.e. marriage or any other barriers-to-exit scenario) in which asset-specific investments will pay off, the realized level of investment that must be sunk previous to commitment is sub-optimal.

In the standard economic theory, we see that it is usually the party which must sink the investment that will stand to lose (and which under-invests as a consequence). In this particular case, since both parties must sink some investment, it is the party whose opportunity cost of investment is the greatest that stands the most to lose. This would suggest that this is precisely the party that would propose a binding contract in order to safely sink the investment, or ask for a lump-sum transfer to compensate for the asymmetry. Since the latter case is trickier to analyze in this context, let us stick with the former.

One instance of this is the added opportunity cost of investment for females due to a smaller window for reproduction. Assuming that both parties in a relationship value parenthood to the same (positive) degree, it will be the female who stands the most to lose from a long “going-out” process that fails to come to fruition. A similar, if less politically incorrect, example is that of a relationship between a high-level executive and an individual living comfortably off an endowment (without any labor involved). One would expect, holding all else constant, that the executive’s higher cost of time would lead to a “pressuring” towards an explicit agreement for mutual investment.

Consider now an additional effect of the investment in knowledge of the counterpart (i.e. besides production of joint leisure): Additional information regarding the expected outcome of the relationship in the long term. Thus, agents invest in “getting to know” the other person not only because it improves the mutual experience, but because it allows them to (eventually) decide if the other person represents an inter-temporal utility-maximizing choice of mate.

It then follows that the impact of this hold-up problem is not only a loss of potential joint leisure production throughout the “dating” period, but also that the decision whether or not to sink investments with a particular individual might be made with sub-optimal information. In general, this would imply a greater chance of choosing to sink an investment when it should have been avoided (e.g. marrying a then undisclosed schizophrenic) or not sinking when it should have been made. Since it is difficult to appraise the cost of the first scenario, the millions of dollars spent in divorce settlements in Canada alone (72,000 divorces in 2004 with costs ranging from $540-$18,900) might help gauge the impact of these suboptimal decisions.

It is difficult to suggest an additional contractual resolution to this hold-up problem since such a solution already exists. The entire institution of marriage is a contractual resolution which raises barriers to exit and reduces the probability of wasted ex-ante investments. Other, less rigid contractual resolutions exist: The engagement ring is an intermediate contract between the beginning and “stable” stages. In some countries, such as Mexico, there are specific laws (albeit old-fashioned ones) that give a woman the right to sue an ex-boyfriend on account of “lost time” if he terminates a long relationship that never made it to marriage. These kinds of intermediate agreements (whether public or private) could “ease” the individuals along their investment paths towards the optimal level.

The most difficult part of this problem seems to rest mainly on the difficulty of extracting accurate information regarding the counterpart’s behavior and reliability in the long term. Given what we know about the effects of uncertainty on investment levels, even perfectly designed intermediate contracts are not likely to solve this issue.

Minutiae

Una anecdota de mi última clase de Matemáticas de este Miércoles.

 

Normalmente no voy a clase de Matemáticas, porque la clase se trata principalmente de ver al profesor S. leer directamente las filminas, que de por sí están llenas de errores de ortografía y notación. El tipo aparentemente es un excelente econometrista pero no mucho más. Además de ello, el material es suficientemente denso cómo para ser muy difícil de digerir oralmente, especialmente cuando se transmite en un solo tono durante dos horas seguidas.

 

Sin embargo, esta vez fui porque se trataba de la última clase. Creo que muchos nos sentíamos igual, porque me dijeron que fue la primera clase llena en mucho tiempo. De cualquier manera, todos siguieron sus patrones comunes. Algunos trataban de escuchar y tomar notas, cayendo poco a poco en un estupor conforme la voz del profesor iba matando a la tarde a cucharadas de aceite. Otros, como yo, abrieron sus computadoras y se pusieron a hacer otras cosas.

 

Al final del tema, el profesor S. quiso dar un pequeño discurso de cierre, y a pesar de su generalmente pésima exposición dijo algunas cosas relevantes. Nos dijo que era claro para él y para los demás profesores que la mayoría del grupo no estaba en sus mejores ánimos, que muchos se veían deprimidos, probablemente por sus resultados mediocres, obtenidos con mucho trabajo. “Si están aquí es porque fueron excepcionales en su carrera, y naturalmente están acostumbrados a ser los mejores entre los demás. Sin embargo, obviamente al llegar aquí la concentración es muy diferente, y la distancia entre habilidades se vuelve mucho más pequeña. Son inteligentes – dense cuenta de esto.”

 

Estas tres observaciones causaron que todo el mundo pusiera atención, inclusive algunas risas nerviosas. S. prosiguió: “Traten de acordarse de por qué vinieron aquí. No vinieron a competir por calificaciones, a menos de que hayan mentido en su ensayo de aplicación. Leí muchos de ellos, y sé que todos vinieron aquí por el contenido y el material. Así que piensen en eso que les interesa, y trabajen para eso – para su tesis al final del año y para aprender de las cosas que querían aprender. No se preocupen por los resultados, porque a fin de cuentas no vinieron para eso. Quizás así no se verán tan infelices”.

 

Hubo un silencio. Todos hablamos de esto, pero la mayoría de nosotros no habíamos hablado con algún profesor al respecto. A pesar de la opinión tibia sobre este profesor en particular, había muchas caras agradecidas – evidencia de la autoridad moral que tienen los profesores en general para nosotros. Faros a través de la niebla, papás, dioses… algo por el estilo. Ese silencio fue lo más cercano a una catársis que nos iba a dar esa clase, y pronto se murió cuando alguien hizo alguna pregunta técnica del examen.

 

Creo que nos hizo bien.