The state of economics

This week's Economist has some articles on the credit crunch and the science of economics. It is fairly critical of both macroeconomics andfinancial economics. My feeling is that it is a bit harsh to half-blame economics, particularly financial economics, for causing the crisis. There are a number of reflections on the Economist articles in the blogosphere by Stephanie Flanders here, Paul Krugman and Brad DeLong. Krugman is partly defensive, but DeLong isn't:

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

China bounces back

China's economy grew at an annual rate of 7.9% between April and June, up from 6.1% in the first quarter, thanks to the government's big stimulus package. The country's quickening economic expansion comes as most nations in the West continue to experience recession. Beijing now expects China to achieve 8% growth for 2009 as a whole, which compares with a predicted contraction of between 1% and 1.5% in the US. (BBC News; click figure to enlarge.)

Everyone seems surprised that the Chinese economy has recovered so quickly. This is being ascribed to the stimulus package announced in last November, but it is surprising that it could come through so quickly.

Unemployment rising rapidly

UK unemployment rose by a record 281,000 to 2.38 million in the three months to May, the Office for National Statistics has said. (See BBC report here.) This is according to the ILO (survey) approach to measuring unemployment. In fact those claiming jobseekers' allowance did not increase in number last month very much, so there seems to be a discrepancy. It may simply be that many of the new unemployed are not bothering to apply for the allowance, which isn't very much (around £65 a week). Everyone expects unemployment to carry on rising until at least early next year as changes in unemployment usually lag output changes.

The paradox of thrift — for real

If you don't understand the paradox of thrift - and every self-respecting first-year economics student upwards really should (I know we don't teach this stuff any more!) read this recent post by Krugman.

UK Inflation falls (a little)

UK annual inflation fell in June as the Consumer Prices Index (CPI) dropped to 1.8% from 2.2% in May, the Office for National Statistics (ONS) said. This is below the Bank of England's target of 2%, but it is surprising perhaps that it is only now below target given general defaltion fears. This is the year on year rate, so measure price changes over the last 12 months, rather than how prices have changed just over the last month or so.

The Retail Prices Index (RPI), a key inflation figure which includes mortgage interest payments and housing costs, became even more negative, falling to -1.6% from -1.1%, the lowest figure since the statistic has been collected in 1948! However given that monetary policy has pushed interest rates down so much, this is perhaps not such a good measure of inflation.

See this page from the BBC for an explanation of inflation and how the statistics are calculated.

Markets and Morals

This year's Reith Lectures were given by Michael Sandler of Havard (rumoured to be the person on whom Montgomery Burns of the Simpsons was modelled!). I liked the first lecture which was on the morality of markets and can be listened to here (or click for transcript). Should we have markets in immigrants, body parts? Should we pay children who do well in test scores? What about carbon trading?

Market triumphalism has given way to a new market scepticism. Almost everybody agrees that we need to improve regulation, but this moment is about more than devising new regulations. It’s also a time, or so it seems to me, to rethink the role of markets in achieving the public good. There’s now a widespread sense that markets have become detached from fundamental values, that we need to reconnect markets and values. But how? Well it depends on what you think has gone wrong. Some say the problem is greed, which led to irresponsible risk taking. If this is right, the challenge is to rein in greed, to shore up values of responsibility and trust, integrity and fair dealing; to appeal, in short, to personal virtues as a remedy to market values run amuck...

Inspiring Green Innovation

There was an excellent programme this week in the BBC's Analysis series by Tim Harford, The Undercover Economist, who examines the economics of different ways to inspire the creators and inventors who will lead the way in this field. Is innovation best left up to the market (with price incentives supplied by the state) or is this issue too big to leave the private sector to its own devices? This can be listened to by going here or play directly (not sure how long the BBC keeps this available).

Don't tighten policy yet!

There is an interesting article in this week's Economist by Christina Romer (chair of the Council of Economic Advisors in the US) in which she explains that errors were made late on during the Great Depression when policy was inadvertently tightened (by cutting back various items of government spending and the ending of some tax reductions) and unemployment shot up again (from 15% to 19%). Her point is: We shouldn't repeat the same mistake now.

Lord Stern on Climate Change

Anthropogenic climate change is one of the major problems facing the planet. It also raises a host of interesting and challenging economic issues, from the selection of policy instruments (command and control regulation, carbon taxes, cap-and-trade, and hybrid schemes), through the analysis of risk, uncertainty and irreversabilities, to the global political economy of reaching an effective international environmental agreement which adequately addresses equity and development issues. The scale and potential impact of climate change on global well-being puts the current, but temporary in nature, financial crisis in perspective. Lord Nick Stern, whose 2007 Review of the Economics of Climate Change (link) did much to raise awareness of the urgency of the problem, has recently published a new book updating his views - A Blueprint for a Safer Planet. An audio file of the informative and very accessible LSE lecture by Nick Stern, to launch his book, can be downloaded at: link). It is well worth listening to both as an economist and as a responsible citizen.

Miscellany from Krugman

A couple of quite interesting columns by Paul Krugman in the New York Times this week. In "Reagan did it" he argues that it is all Reagan's fault: the financial deregulation during the Reagan era set the stage for people in the States to run up very high levels of debt (with the savings ratio--the fraction people save out of their disposable income--falling from around 10% to around zero) and financial institutions to likewise have high borrowing relative to capital. In "The big inflation scare" he argues that fears of inflation are grossly exaggerated - there is no reason to believe that the monetary policy being pursued (including quantitative easing), which is pumping large amounts of money into the economy, will lead to rising prices. The time to be careful, he argues, is once we are coming out of recession.

1931 and all that

(Click to enlarge.) As Stephanie Flanders points out, so far output is tracking fairly closely the fall in the great depression in the UK. That's the bad news. The good news perhaps is that the depression between 1929 and 1934 actually wasn't that bad in the UK. Output only fell by 4.6% in the worst year (compare that with 10% in the US). The graphic shows that the Thatcher period (1979-83) was quite similar to the Great Depression period.

Irrationality, salad and chips - failure of the independence axiom

One of the basic tenets of our approach in economics is that the mere presence of an extra possible choice in the options available to a rational consumer should not affect the decision taken, as long as the consumer does not choose the extra choice itself. This is a version of the "independence of irrelevant alternatives" assumption that crops up in pretty much all rationalchoice theories. However, it seems that the mere presence of a salad on a menu, even if not chosen, makes diners more likely to opt for chips. See this article.

"Investigators asked college students to choose foods from menus that differed in only one feature; one menu offered a salad and the other did not. The point? To find out whether the presence of a salad on the menu influenced what else the students ate. It did. The students choose French fries more often from the menu with the salad."

Why do people like trams so much?

Tyler Cowan in Marginal Revolution asks "why do people like streetcars so much?" Actually I have yet to meet anyone who is enthusiastic about the Edinburgh tram project (other than TIE's supremo), although admittedly many of my conversations on this topic were with taxi drivers, who may have vested interests in the matter. One of my colleagues argues that buses simply dominate trams - they are much cheaper and more maneuverable. But it is a mystery why they apparently remain so popular with many people.

According to Eichengreen and O'Rourke: "globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations." Krugman calls this "half a Great Depression" becuase the fall in manufacturing output in the US is not as bad as it was in 1929. But they point out that looking at global data, things don't look so good. On the bright side, the policy response (monetary and fiscal) looks a lot better now, so there is still hope...

Inflation not falling as fast as expected

The latest (February 2009) inflation figures were a bit of a surprise in that the CPI rate actually increased from 3.0 to 3.2% while the RPI rate which includes mortgage interest didn't go below zero--it fell from 0.1 to 0.0%. The CPI means the Governor of the Bank of England may have a write another letter explaining why inflation is too high. A bit ironic given that everyone is terrified about deflation. The graphic from the BBC shows what's going up and what's going down (click to enlarge).

More on the American bank plan to get rid of toxic assets

For anyone interested, the debate still rumbles on. Here is a summary of the different sides, and here is Krugman's response. The gist of what he says is that the plan, to allow the toxic assets to be bought up with most funding coming from the government, by driving prices of these assets up, will benefit not only those banks who are in trouble, but also many others, so it is basically a waste of a lot of money. He favours a much more targeted approach. This is a well argued counter view by a fund manager.

Gentlemen Prefer Blands; or it all depends on the elasticities.

Simon Clark comments on the posting below by Santi Sanchez-Pages (Gentlemen Prefer Dumbs)

My colleague Santi sets out a very interesting analysis. As any good economist will tell you, it all depends on the elasticities. If v (value of match) = pq, and p depends on q, then write p = p(q) (with p' < 0) so v = p(q)q. Then dv/dq = qp' + p is positive if p'q/p, the elasticity of breeding probability with respect to female quality, which we label as e, is greater than -1 (recall that p' < 0).

If e > -1 (e.g. if p is constant) then the higher quality is not offset by the reduction in probability, so we would still have positive assortative matching (PAM). If e < -1, we get negative matching (NAM); high quality men will want to avoid high quality women as they are too unlikely to have children.

But e may be variable. Suppose q lies between 0 and 1 and p = 1 - q. Then v = q-qq (I can't do squares in Html!); simple calculus, or graphing v against q, shows that the highest value women have q = 0.5 and the worst 0 or 1. Women can be ranked by the absolute value of (q-0.5), so q = 0.25 is as good as q = 0.75. Then we would see NAM between the highest quality women and a representative half of the men (of all types) and PAM between the lowest quality women and the other half of the men. More like 'Gentlemen prefer blands'.

With equal numbers of men and women, whether some agents remain unmatched depends on whether they have a 'reservation quality' (as in 'I'm not that desperate!'). In the set-up above, if men will not accept v less than v*, single men will be low quality, and single women will have q outside the interval bounded by the two solutions to q - qq = v*. So we would observe spinsters who are either successful professional women too busy to breed or women ready to breed but too uneducated; an interesting area for empirical research.

As Santi says, it is true that we have a lot to learn from other disciplines, but the concept of elasticity can also be useful outside economics. Note the resemblance between v = pq ,and revenue = pq = price x quantity. If a man has a cost per unit of quality of c of providing 'satisfaction' to a high quality woman then v = (p - c)q, which can be thought of as total revenue less total cost. So maybe there are further parallels to be explored.

Degree Exam

A number have asked about the format of the exam.  It will be the same as last year's, so you just have to look at past papers on WebCT.

Gentlemen Prefer Dumbs

A few days ago, during a nice dinner at The Vaults, two friends of mine, let's call them K and M, an economist and an anthropologist respectively, and myself, we were talking about the possible effects of the economic crisis on the marriage market. At some point we discussed whether the crisis was going to alter in any way the assortative matching that typically arises in that market. From your own experience, you should have noticed that people tend to match with people of roughly their same socioeconomic status and/or physical attractiveness. The explanation is simple. Suppose that the value of a person can be measured in a universal scale, like the genetic fitness of their potential offspring or the resources they can provide to that offspring. Suppose also, for the sake of the argument, that there is the same number of people in each side of the marriage market. Therefore, everybody in one side of the market (let's say the males) share exactly the same preferences over potential partners, and the same happens in the other side (i.e., the female side). If that is the case, the only pairwise stable matching is assortative: the best male matches with the best female, the second best male with the second best female, and so on. Suppose that that were not the case. It would imply that at least one person in each side of the market is matched with someone with a lower ranking that him/herself. These two "unhappy" people could improve their situation by breaking their previous match and being together.

Then my anthropologist friend M raised a question: We observe that males tend to go for females that are not more intelligent or successful than themselves. Why? After acknowledging that there was a certain truth in that, K and I looked for an answer. The simplistic model of matching that I proposed above assumes that females will have offspring for sure. But that may not be the case in reality. More successful and intelligent women will typically have better outside options to childbearing so they are less likely to agree to reproduce. So if that probability is Pi and the value of female's i offspring is Qi, the value of matching with that female is just PiQi. Hence when going for more intelligent females, men may be trading off higher quality offspring with a lower probability of reproduction. Notice that the same argument applies if Pi represents the men bargaining power within the household against female i and Qi is the quality of the relationship or a measure of some other type of investment made by the female. This assumption can be enough to generate a non-assortative matching in which men have a positive optimal level of female “dumbness." And implies, if we maintain the assumption of equal number of males and females, that that some very intelligent and successful females may remain unmatched.

The moral of the story for you should be that we can try to apply that economic thinking to shed light on any question, phenomenon or puzzle you may encounter. And also that we have lot to learn from listening to other disciplines. That is, unless you are too busy chasing a dumb enough partner out there.

US Banks

There is a heated debate in the US blogosphere about whether Treasury Secretary Geithner's plan to, essentially, buy up toxic assets, is the best way forward to stabilise the banks (the alternative is roughly to guarantee bank debts). If you are to read one thing on this, it should be this article by Krugman which puts the issues over in a beautifully clear way. What he doesn't say in that post, but elsewhere in an earlier post however, is that the reason why he is so against the current plan to buy up the assets is that:

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized.