Thursday, July 10, 2008

"Folk Economics"

So I started reading... and someday will finish reading... this article in the Southern Economic Journal called "Folk Economics", by Paul Rubin. It was highlighting "folk economics" - what Rubin suggested were "inaccurate" understandings of how the economy works that were contrary to basic economic theory. As Rubin explained it, most folk economics revolves around the idea of wealth distribution, rather than wealth creation (which economic theory is primarily based on). For example, when a "folk economist" sees a price increase they only interpret it as a decrease in their piece of the pie. They don't understand that a price increase is a market signal that reallocates goods and services in an optimal way. In other words, "folk economists" don't understand how price increases can actually increase their wealth by increasing the productive efficiency of the economy - they only consider how it decreases their wealth by eliminating purchasing power.

Fair enough. I, like most economists, have always been uncomfortable with the knee-jerk aversion to free trade or immigration. This is the zero-sum game mentality that argues that if a job goes to an immigrant it is denied to a native, or that if we import our steel we are automatically losers. Of course I don't buy into that silliness. But I also don't buy into the knee-jerk reaction of economists (we'll call these guys "trained economists" as opposed to the aforementioned "folk economists") - that free trade or open immigration is always desired.

Now, not all economists make this mistake - but usually those that do resist the knee-jerk "trained economist" reaction do so in an incomplete way. They'll say something like:

"Free trade will create losers, but it's still best because the economy as a whole benefits enough to compensate the losers using the gains of the winners - so it's what's called an "Edgeworth Box" problem - the only issue is how to divide the spoils between the winners and the losers".

Again, that's fair enough. I buy that completely. But trained economists haven't really addressed their underlying difference with "folk economics": in all of their models, economists maximize utility and only utility. Sometimes its expressed as an income level or a profit level, or it's expressed in terms of a nebulous unit that's actually called "utility" - but there is always, always, always the assumption that you want to maximize your personal gain and you don't really care what others get. And yes - economic theory shows us that under these assumptions "folk economists" consistently produce the wrong results.

But hold on a second - economics is the science of human decision making, production, and resource allocation. It is true that "folk economists" could be doing a really bad job of "knowing thyself" - but it's also possible that the "trained economists" should take a cue from them about what human beings actually try to maximize when they make decisions, produce, and allocate resources. We always assume that humans try to maximize utility - but what if they also try to maximize something like "status" (this would certainly be conceivable to a sociologist!). We can define an agent's "status" as the ratio of the agent's own utility to the utility of another agent. Averaging all "statuses" with respect to all other agents in the economy would then provide the agent's "status level". Let's say that agents try to maximize two things - their status level and their utility level - and that each agent has their own marginal rate of substitution between status and utility.

Now, I haven't worked this out for an international trade model or anything like that - but conceivably this could drastically change the results. Mercantilism in imperial England suddenly starts making sense if instead of comparing "England in 1775" to "England in 1875", Lord North and King George III placed more value on the comparison between "England in 1775" and "France in 1775," or even "England in 1875" and "France in 1875". This isn't a justification for mercantilism - but it does suggest that when we say mercantilism is "flawed" we must be careful to state the metric we are using to evaluate it.

Think about economic policymakers in the U.S. today. Let's say by choosing one economic policy trajectory (we'll call it the "libertarian wonderland policy") we could be flying in jet packs by 2050, and by choosing another economic policy trajectory (we'll call it the "beleaguered Keynesian pseudo-market policy") we would only have clean hydrogen fuel cell cars by 2050. Let's also say that the "libertarian wonderland policy" would result in a technologically-inclined India emerging as the dominant global power, while the "Keynesian pseudo-market policy" would keep the U.S. as top dog.

Would you really miss the jet pack you never knew you could have had? Would you really be disappointed to drive around in hydrogen powered cars? Probably not - ignorance is bliss! And national policy-makers (and I'm sure most citizens) certainly wouldn't have trouble picking where they would want to be in the global pecking order! It's no wonder, then, that economic policymakers consistently choose something akin to the beleaguered Keynesian pseudo-market policy over the libertarian wonderland policy! Wealth creation - the focus of modern economics - is important and desireable, but when wealth creation occurs in the future, it will necessarily be hazy and uncertain. Wealth distribution, however, is crystal clear and in our faces every day (think Thorstein Veblen and conspicuous consumption). How can the "trained economists" have missed wealth distribution as a primary economic motivator???

I have my suspicions as to why - since the "status level" variable I introduced earlier would be a function of the "utility" variable, the math would start to get a lot more complicated. But I think it's more than that. Ever since Adam Smith, we have had an aversion to mercantilism and the zero-sum mentality (and probably rightly so). In the modern world, we also strongly emphasize the individual.

Now I'm all for individualism, but we need to understand the context in which the individual exists. We assess value based on how we measure up to our peers. Think about a little kid with a rubber ball. It's the greatest thing in the world - a very valuable commodity that the kid would pay a steep price to keep. Then another child comes along with something even cooler - like a squirt gun! Is the first kid willing to pay the same price to maintain rights to the rubber ball? No way. The first kid wants the second kid's squirt gun! The value of the rubber ball instantly plummets to next to nothing - not because of future expectations, not because of changes in the level of supply or the number of kids who want that ball. The ball loses value because it is not as good as something else that is now available - specifically, something else that the first kid doesn't have (if the first kid has a squirt gun and a ball when the second kid walks by, the ball probably won't lose any value).

I use this children's example to illustrate my point because the reaction is so visceral and essential to the human experience! "Folk economists" definitely err on some important points... but I think they've tapped into something that mainstream economists have come up woefully short on. Behavioral economists and experimental economists are starting to take up these issues (in a nutshell, experimental economists found that subjects would actually pay to punish "defectors" in a cooperative game... something that is attributed to "rule maintenance" and institution formation. I think it goes a lot further than that, but the point is it's not predicted by mainstream theory) so hopefully more will be done soon. Maybe I'll take it up and try to run a trade model that justifies mercantilism.

We should never discount what sociologists call "local knowledge". Of course folkways have been displaced by modernization for a reason. That reason is that in a huge number of cases folkways are inadequate or just plain wrong. But that doesn't mean we can't take cues from folkways and local knowledge. This knowledge evolved over centuries - it's bound to have useful insights into the human condition.

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