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.

Predator Politics

So this is a cool report from Slate on how the cast of "Predator" has been unusually prone to maverick bids for public office. I've always said that the Predator pair - Ventura and Schwarzenegger - should run as independent candidates for president (unfortunately, President Schwarzenegger wouldn't be possible due to natural-born citizenship requirements... but there was a discussion about amending the Constitution to do away with this requirement in 2004. That debate could always be revived). There are only two words available to fully describe a Ventura-Schwarzenegger (or Schwarzenegger-Ventura) ticket: "bad" - "ass"

Anyway - this report is on another cast member who is running for the Senate in Kentucky on the Libertarian ticket... against Senate Minority Leader and uber-Republican Mitch McConnell. So unfortunately, this doesn't look like its meant to be. Still, I can't think of anything that would qualify someone more for public office than battling alien warriors in the jungle.

I don't care how silly it sounds to some people and I don't care how goofy Ventura has acted or how erratically Schwarzenegger has governed. We need politicians who are independent, confident, proud, respectful of the people, and not in the pockets of anyone. I've often made the case for Bloomberg's possible presidential run on these grounds, and its the same reason I admire what Ross Perot (or Theo Roosevelt, for that matter) did. If an independent candidate did nothing else right, they would succeed in doing one thing - breaking the toxic grip of the two major political parties on Washington for at least four years. And besides - even on policy issues I bet an independent candidate would do well. Without party affiliation they would have the opportunity to be flexible and explore different options - they would probably pull the best and the brightest from both sides of the aisle to serve in their administration, and most independents in recent years have been fairly moderate - so nothing crazy would be likely to happen. We have only had one truly unaffiliated president in our history - who did not pay fealty to anyone or any party and demonstrated that by staffing his administration with members of both major parties. That was George Washington, and it was damn good eight years if you consider how it could have played out under a Hamilton, a Jefferson, or an Adams (all great in their own right... they just probably would have steered the U.S. in a radically different direction if they had the opportunity to be the first president).

A real oil crisis...

Not to imply that what we're currently experiencing isn't an oil crisis... but the recent bellicosity of Iran got me worried about a real oil crisis that could hit us. If military conflict starts with Iran, they will in all likelihood seal off the Strait of Hormuz from all traffic - particularly oil tankers. Granted, Iran survives based on it's oil exports, but I'm sure they could manage to sell some to China, and my understanding is they already have a pipeline going north to Tehran, and that winds around the Caspian Sea, west to Europe. So the point is, Iran could seal off the Strait of Hormuz from Iraqi and Saudi oil, and as much oil as they could afford to withhold - and then sell what they need to to the West to keep themselves afloat. The Washington Post Express reported today that 40% of the world's oil passes through the Strait of Hormuz... 40%!!!!! If 40% of the world's oil were taken off the market immediately, it would set off a global depression. Granted, our military would probably be well-fueled from refineries in Iraq that don't have to pass through the Strait.

That would also mean that we would be at war in the territory stretching from Iraq, through the Iraqi border with western Iran, into central Iran and the Tehran region, to the eastern border between Iran and Afghanistan, and into Afghanistan and the Pakistani border region. That span of the globe is around 2000 miles across... roughly the distance from Washington, D.C. to Salt Lake City, Utah would be a war zone.

People - this is how empires fall. We cannot go to war with Iran - I'm more and more worried that we absolutely would not recover from it. And maybe we'd by mired in a dogfight for a decade or two before China or the EU reestablished global stability, but the more I think about this, the more terrible of an idea it sounds like. And honestly, it's not just John McCain's off color jokes that I'm worried about. Who cares about those? I'm more worried that Israel is going to fire off a few rockets at Iranian nuclear facilities like they did to Iraq a couple years back.

The startling thing about this scenario that I've laid out is that nuclear weapons don't feature in it at all. Granted, nuclear weapons would make this hypothetical conflict significantly worse (although if we were to use ours, it might bring it all to a swifter conclusion), but even if there were no nukes, or if ther were nukes and we eliminated the program it doesn't matter -the cost we would pay would be enormous.

OK - this post started as a musing on what an Iranian war would do to the price of oil - but its grown a little beyond that. The American people think they are invincible, but they're not. We can fall just like anyone else. People need to understand how starting a military conflict with Iran would tear this nation apart - the economic crisis would probably rival the great depression, we would be fighting a war against both Sunnis and Shias, inflation would sky-rocket, and the food crisis would only grow worse because of fuel shortages, and you can bet that terrorism would be stepped up as a result. Not to mention what it would do to global confidence that the U.S. could pay off it's debts - and if that confidence slips, countries like China and Russia will want us to make good on our Treasury bonds (which we won't be able to afford). Granted - I'm very much setting out a worst-case scenario, but if we get engaged in this there is no way we'll get out with the same power and prestige that we've enjoyed for the last fifty years. I don't mind sitting in Iraq for a little while longer until things cool down... but we need to move out of the region and show some basic respect for state sovereignty there - even if we don't like the sovereign. If this Iran thing gets pushed any further the risk will be too great, and there cannot be a compromise any more - we would need an Obama administration. As much as I respect McCain, it would be too big of a risk.

Wednesday, July 9, 2008

Election Pet Peeves

OK - I have two election pet peeves I want to put out there:

1. Our obsession with "flip-flopping": Ever since the 2004 election and the rise of YouTube, we have been obsessed with catching candidates who switch positions on an issue. Now, I know the root reason for why we do this. In a lot of cases, chameleon candidates suspiciously shift positions depending on who they're talking to - just to get elected. Candidates who were initially idealists (I think Obama and McCain both fall into this category) may cave to vested interests as they spend more time in Washington, etc. Of course this isn't great and we should call them on it when it happens. But what we've created is an environment in which politicians are afraid to re-evaluate their positions, compromise, and remain open-minded. The most infuriating recent example has been Obama - who has been savaged for suggesting that he would actually listen to advisers when setting a time-table for withdrawal from Iraq!!! First, I think Obama is intelligent enough that even when he supported a swift withdrawal he always would have done it in consultation with the experts. But lets hypothetically say that's not true, and that he was initially naive and would have pursued withdrawal with or without the advice of experts. Isn't it a GOOD thing that he changed that position? Shouldn't that re-evaluation be encouraged? I personally see his supposed "flip-flop" as a clarification of a position he's held all along. McCain is a victim of this as well - his positions have most notably changed on Iraq and taxes. What's going on! We want to encourage flexibility in our politicians, not discourage it!

At least they don't call it "waffling" any more... what a stupid term...

2. "The #1 Issue": OK, so this may be counterintuitive that an economist is frustrated that the economy is supposedly now the #1 issue in the campaign - but I'll tell you why I am. Yes, we're going into a recession, and yes it looks like it will be a fairly painful one. But the economy is cyclical, people - it goes up and down. Plus, recessions perform very important tasks. As people are laid off and investments are withdrawn from certain sectors, they are freed up to be reallocated to growing sectors (health care, "green jobs", IT, etc.). The U.S. is blessed to have such flexible labor and capital markets because it makes our economy more nimble than most European or Asian economies. It's painful - and we need to support the losers - but recessions have come and gone for centuries. It's not the end of the world.

That's not to say that there aren't important economic issues to consider. The problem is that none of the candidates are talking about them! The important economic issues are the long-term problems that we need to start working on now - problems that existed before the recession and are still going to be their once we get back into an upswing. Problems like energy independence; budget deficits; spiraling health care costs; international competitiveness; energy independence decaying infrastructure; the aging of the workforce; have I said energy independence? These are the problems that we need to worry about - not the recession. We do have to act on the recession, but we know how to address it, and we know we'll eventually pull out of it.

One thing that is worth talking about that is related to the current recession is the re-emergence of "stagflation" - the coexistence of inflation and recession. We haven't seen that since the 1970s, and (pardon my French), stagflation can be a real bitch. For those who don't know, economic theory predicts that inflation and recession should NOT occur together. In fact, one usually solves the other! The solution to inflation is to slow down economic growth, and the solution to an economic slowdown is to pump cash into the economy, which has the downside of inflating the currency. So, needless to say it scares economists when the two come together. Well folks, it's happening again. We haven't hit double-digit inflation or double-digit unemployment yet (both of which occured in the 1970s and early 1980s), but who knows - we're not out of the woods yet. This is a serious concern, and you do hear the candidates talking about higher prices - but you don't really hear them talking about the paradox of stagflation and what they're going to do about it. And maybe they shouldn't - maybe this is a job for the Fed and the Treasury Secretary, and economists to look into for the time being.

My number 1 issue(s): Terrorism, the Iraq War, infrastructure, health care costs, the budget deficit, and energy. Nobody shines on all of them, but Obama has a strong lead.

Energy: The Good, The Bad, and The Ugly

The Good: T. Boone Pickens - oil man, financier, and the guy who brought down my Dad's former employer, has a simple but interesting plan for reducing our dependence on foreign oil. He essentially suggests taking the natural gas that we currently use for power generation, and replacing it with wind power (22% of electricity production from wind, specifically). As he points out, wind is more plentiful in the U.S. than it is anywhere on Earth. You can think of us as the "Saudi Arabia of wind". The natural gas savings from this move could then be diverted to fueling cars powered by natural gas rather than gasoline. Pickens estimates that this could reduce oil imports by 38%, which would come to $300 billion a year. Even better - both natural gas and wind are cleaner than gasoline, and both are produced domestically. This isn't exactly rocket science here - lots of people have suggested that we move on wind energy - but Pickens has the personal wealth to push this plan (he's airing self-funded commercials promoting it), and he's already made some investments in wind energy in Texas. He may also have the clout to push the next administration in this direction as well. When it comes to major changes like this, the trick isn't just to have the good idea. Usually these "good ideas" are deceptively simple and more or less abundantly available. The trick is to provide the motivation to make it happen. Pickens could help with this. Very encouraging.

The Bad: OK, so it's not really bad - ridiculous is probably a better word. As most have probably already heard, the G8 is meeting in Hokkaido, Japan, and they have agreed to reduce greenhouse gases by 50% by 2050... well... sort of. My understanding (culled from NPR), is that the agreement is not enforceable and conditional on other countries agreeing to the cuts as well. To add to the craziness, I'll remind my readers that 2050 is still 42 years out. The G8 says nothing about a "bridge policy", like the Pikens proposal, that might get us there. OK, so this isn't really "bad", but it is a little discouraging that this is what the G8 came up with. I would have preferred a less declaratory, more modest, but more immediately actionable policy.

Oh - and Mexico, India, Brazil, China, and South Africa threw in their two cents too... they challenged the G8 to reduce emissions by 80%. Thanks guys... you're a real help here.

The Ugly: Crude oil prices have fallen for the last two days! So why is this in my "ugly" column? Market analysts suggest that oil prices have fallen in response to recent reports that experts are worried the recession will be deeper and longer than expected. Softening demand due to a prolonged recession means that prices go down. So there you go! Prices are lower because the economy is tanking!

Here's an idea - lets kill two birds with one stone. Lets actually rebuild our public transportation infrastructure in places like... oh... I don't know - Virginia maybe? That would put people to work (addressing the recession), and help cut our demand for oil (addressing oil prices).