Monday, January 3, 2011

The "Big Questions" in economics?

Food for thought for the new year. Late last year, the US National Science Foundation (NSF) invited social scientists to document the grand challenges facing their discipline in the coming years. The purpose was to channel research interest into these areas for the larger benefit of the society. Many economists responded and here are a few interesting white papers

1. William Nordhaus points to arguably the biggest global political economy challenge - how to get sovereign nation states to act in co-ordinated manner to address global public goods? Global warming, cross-border capital flows, commodity price shocks, over-fishing, terrorism, nuclear proliferation etc are all issues whose effects are global and whose solutions go beyond both markets and individual national governments. He frames the challenge succintly,

"Because nations are deeply attached to their sovereignty, the Westphalian system leads to severe problems for global public goods. The de facto requirement for unanimity or broad consensus is in reality a recipe for inaction. Particularly where there are strong asymmetries in the costs and benefits (as is the case for nuclear non-proliferation or global warming), the requirement of reaching consensus means that it is extremely difficult to reach universal and binding international agreements. Not only does each nation face a powerful incentive to free-ride off the public-good efforts of other nations, but each is likely to perceive the costs and benefits of cooperation through a biased cognitive lens that justifies free-riding...

The grand challenge for economics, political science, international relations, and associated social sciences is to devise mechanisms that overcome the bias toward the status quo and the voluntary nature of current international law in life-threatening issues."

2. Alberto Alesina argued that poverty can be addressed only with greater understanding of why certain countries, (nations, regions) have successfully developed and others are lagging. He advocates greater research at the intersection of economics with political science, sociology, anthropology, psychology, and law. In particular, he draws attention to the role of cultural economics in atleast partially explaining many cross-country differences.

Accordingly, specific cultural traits determine (or play a major role in determining) macroeconomic environments and governance systems - lower geographical mobility is a cause for less flexible labor markets; closer family ties creates less demand for insurance products; deeply entrenched savings habits and aversion to debts comes in the way of development of full-fledged financial markets; less-trust to non-family members dilute compliance with contractual obligations and weakens contract laws; lower civic participation reduces social capital and engenders rigidity in laws, and so on. These correlations or causations are critical to understand various aspects of the economic structure, growth potential and poverty reduction policies.

3. Esther Duflo advocates a massive extension of field experiments to obtain empirical findings that can be used to better understand how poverty shapes individual options and construct more effective development policy actions. She proposes a three stage approach - develop a micro-founded testable theoretical framework, test its empirical relevance and develop theories, and incorporate microeocnomic models into a coherent macroeconomics framework that can be replicated.

She argues in favor of testable frameworks that seek to explore the role of behavioural psychology in keeping people poor. She writes about the challenge of developing a testable theoretical framework with the illustration of how poverty affects individual choices,

"Poverty affects behaviour even if the decision maker is 'neo-classical'. He is more likely to be preventeed from borrowing, for example, because he cannot pledge much collateral. He is also more likely to be risk-averse if he has limited access to insurance, since shocks are particularly painful if one has very little to buffer them. He may thus not be an 'efficient' farmer, because the efficient choice would be too risky. He may also never learn what techniques work the best, because experimenting is risky, and he may want to wait for his neighbour to do it for him."

4. Kenneth Rogoff points to three challenges facing macroeconomics in the light of the sub-prime meltdown and Great Recession,

"The first is to find more realistic, and yet tractable, ways to incorporate financial market frictions into our canonical models for analyzing monetary policy. The second is to rethink the role of countercyclical fiscal policy, particularly in the response to a financial crisis where credit markets seize. A third great challenge is to achieve a better cost‐benefit analysis of financial market regulation."

Conventional theories had assumed that unlike product and labor markets, financial markets did not have any large and meaningfully relevant frictions. Fiscal policy has to grapple issues like relative merits of tax cuts and direct government spending, multipliers on various spending choices, the extent to which economies can run up debts, and so on. The challenge with financial regulation involves managing the micro-level incentives of actors, systemic risk management, pro-cyclical nature of regulation etc.

5. Given the fact that human beings are the central focus of all social, behavioral, and economic sciences, Andrew Lo proposes a search for the final answer - a complete theory of human behaviour. He writes,

"Can we develop a complete theory of human behavior that is predictive in all contexts?... By 'all contexts', I mean all situations in which humans may find themselves, including economic, social, cultural, political, and physical. By 'predictive', I mean an empirically validated and repeatable cause-and-effect relation. And by 'complete theory', I mean a theory that is consistent with all known facts of human behavior, and which is sufficient for making correct predictions of human behavior in novel contexts."

6. Alvin Roth draws attention to the exciting field of 'market design' in complex markets, both to fix them when they are broken and to prevent them from breaking. Market designs can more efficiently capture consumers' differential willingness to pay and the subtle differentiation within the same product. Such complex markets which have been "designed" include auctions of spectrum licenses, organ exchanges, advanced academic positions, school choice systems etc. He writes,

"These markets differ from markets for simple commodities, in which, once prices have been established, everyone can choose whatever they can afford. Most of these markets are matching markets, in which you can’t just choose what you want, you also have to be chosen. One of the scientific challenges is to learn more about the workings of complex matching markets, such as labor markets for professionals, college admissions, and marriage."

Designing effective markets require addressing the issue of efficient market clearing. For example, any market should be thick enough but does not result in congestion.

7. Daron Acemoglu argues for greater research into the fundamental institutional (as opposed to the proximate) causes of development. He asks "why some countries have less human capital, physical capital and technology and make worse use of their factors and opportunities". He answers,

"Institutions have emerged as a potential fundamental cause, contrasting, for example, with geographical differences or cultural factors (even as we recognize that cultural factors are central for understanding the evolution, and the persistence, of institutions). Institutional differences, associated with differences in the organization of society, shape economic and political incentives and affect the nature of economic equilibria via these channels. There is now vibrant theoretical and empirical research documenting the importance of institutions for economic outcomes. But the next stage, which requires an understanding of which specific configurations of institutions are most likely to encourage growth in the decades to come, why institutions differ across countries, and why they change, and why they often fail to change, is more challenging...

We do not know which combinations of property rights, financial institutions, judicial institutions, education and various dimensions of social institutions are most conducive to economic development."

He uses Douglass North's famous definition - "Institutions are the rules of the game in a society or, more formally, are the humanly devised constraints that shape human interaction". He outlines its three important features - it is "humanly devised" (as opposed to factors outside human control like geography and history); they set "constraints" on human behaviour; and they work through incentives. Institution determine the "constraints on and the incentives of the key actors".

More are available here.

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