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.

Prof Mankiw's "convenient agnosticism"!

Greg Mankiw is one of my favorite economists. His hugely popular text book is arguably the second-best window to learning the principles of Economics. His superstar blog has surely played a major role in enriching the debate on many political economy issues.

But his recent post explaining his ambivalence and agnosticism on extending unemployment insurance dismays me. In fact, it comes across as specious and positively disingenious, bordering on misleading and mis-directing the debate. Here is why

1. For a start, there is now enough literature on the pros (reduces household income uncertainty and props up aggregate demand) and cons (budgetary costs and lowers job search costs) raised by Prof Mankiw.

There is now ample evidence that extending the duration of UI does little to lower the marginal incentive to search for re-employment. Alan Krueger and Andreas Mueller have found that the time devoted to job search is fairly constant regardless of unemployment duration for those who are ineligible for UI.

Further, a recent study by the San Francisco Fed found negligible impact of UI extension on increase in unemployment rate - about 0.4 percentage point of the nearly 6 percentage point increase in the national unemployment rate since 2008.

2. The cases for and against any policy instrument varies depending on the broader macroeconomic environment. There cannot be a single applicable-for-all-conditions reasoning in favor or against a policy.

Consider this. The US economy is still recovering very slowly from a deep recession. Unemployment rates are on the rise and private sector job creation remains anemic. Inflation is low, aggregate demand is weak. Household balance sheets remain battered and will require more repairs. Monetary accommodation may have limited further traction. There is limited fiscal space available.

In the circumstances, doing nothing for lack of compelling quantitative evidence (of the success of the proposed intervention) and thereby letting the economy continue its present course has several dangers. The dismal macroeconomic conditions and prospects mean that the economy risks falling into a deep recession, from which recovery will be even more painful and long-drawn out. In fact, without recovery taking hold (and there is no evidence of this happening), the shares of debts and deficits will continue to grow.

The limited fiscal space available means that any stimulus spending should be directed at areas delivering the greatest bang for the buck. Money should be delivered to the hands of people who are likely to spend it immediately. A number of studies clearly indicate that among the various stimulus options, UI is among those with the largest multiplier.

3. The argument against any action on the grounds of conclusive enough evidence is all the more misleading since the inherent nature of an economy precludes any conclusive enough evidence on any reasonably complex economic policy intervention. Do we invoke this excuse to let a system take its own course, even when it is hurtling down into an abyss? Or do we weigh the relative probabilities of possible policy options and respond with the most cost-effective and most-likely-to-succeed option?

No one disputes that budget deficits and public debts should be lowered. The relevant question is whether this is the time to do so? What are the costs of contraction at this point in time? What is the cost of not doing anything and letting UI expire? Is there enough evidence in favor of the stimulative impact of UI?

In other words, the choice is between risking a deflationary recession with rising shares of debts and deficits and untold pain for the vast majority of people, and stimulating a recovery by running up short-term deficits. Reasonable people would choose the later as the lesser evil.

4.

"So when I hear economists advocate the extension of UI to 99 weeks, I am tempted to ask, would you also favor a further extension to 199 weeks, or 299 weeks, or 1099 weeks? If 99 weeks is better than 26 weeks, but 199 is too much, how do you know?"

This too has echoes of the first point. Prof Mankiw surely knows that there cannot be a not-too-high, not-too-low, and just right magic figure for the duration of UI applicable for all situations. In fact, the issue to be discussed here is not whether UI duration is too-high or too-low, but the benefits of its extension as opposed to costs. At issue is not what constitutes the optimal duration of UI, but whether fiscal stimulus is required and what is the most effective form of stimulus. If we assume that the moral hazard of UI is negligible and that we need fiscal stimulus, then the case in favor of extending UI is pretty strong.

5.

"It is also conceivable that the amount of UI offered in normal times is higher than optimal and that a further extension would move us farther from what is desirable."

On this, there is already enough evidence that US stands on the negative side of the optimum UI duration scale to Europe's positive side. So the argument on the possibility of deviating farther away from the desirable may be superfluous.

6. Prof Mankiw's argument is based on lack of "compelling quantitative" evidence on the optimum period of UI. He gives the impression that he is unable (or unwilling) to take a decision on UI till he has "compelling quantitative analysis" about "how generous the optimal system would be". Unfortunately, by setting his conditions in so comprehensive a manner, he has virtually ensured that he will never need to take a decision to support extension of UI. In any case, how much evidence is "compelling" enough?

He knows all too well that it is impossible to conclusively quantify the optimal duration of UI - not now, never in future too. In the circumtances, this logic is a convenient excuse for not doing anything. This naturally translates into letting the UI benefits expire. In other words, you vote against extension without appearing to directly oppose it!

And such reasoning has now become the convenient excuse for conservative economists to recuse themselves from supporting government interventions in many areas. The pathological opposition to tax increases too works on similar lines. Once again, it is impossible to conclusively prove whether the system falls on the upward (left) or downward (right) side of the Laffer curve.

Similarly, conservatives point to the persistent high unemployment rates and weak economic growth and argue that the fiscal stimulus measures failed. The difficulty of estimating the counterfactual condition (without stimulus) means that an argument set on such terms of reference cannot be easily refuted.

Taken to its extremes, such reasoning can be used to justify almost any position. In social sciences like economics, it is impossible to conclusively quantitatively prove that a proposed intervention or policy is required. Decisions on whether fiscal stimulus is necessary and what types of spending is required, will never be proved in a universally compelling manner.

The role of social theories

Superb post from Daniel Little, who draws the distinction between the relative predictability (arising from reasonably high level of conformity to the laws of nature) and simplicity (so "that we can aggregate the effects of the relevant component processes into a composite description of the whole") of natural sciences and the complex and unpredictable path and context-dependent world of social sciences. He argues that there is little "real knowledge to be gained by applying social theories to a set of empirical circumstances",

"My general inclination is to think that "applying" general social theories to specific social circumstances is not a valid way of creating new knowledge or understanding. This is because I believe that social ensembles reflect an enormous degree of plasticity and contingency; so general theories only "fit" them in the most impressionistic and non-explanatory way. We may have a pure structural theory of feudalism; but it is only the beginning of a genuinely knowledge-producing analysis of fourteenth-century French politics and economy or the Japanese samurai polity. At best the theory highlights certain issues as being salient -- the conditions of bonded labor, the nature of military dependency between lord and vassal. But the theory of feudalism does not permit us to "derive" particular features or institutions of French or Japanese society. "Feudalism" is an ideal type, a heuristic beginning for social analysis, rather than a general deductive and comprehensive theory of all feudal societies. And we certainly shouldn't expect that a general social theory will provide the template for understanding all of the empirical characteristics of a given instance of that theorized object...

allow Marxism, or Weber or Durkheim or Tilly, to function as a suggestive program of research for empirical investigation. Let it be a source of hypotheses, hunches, and avenues of inquiry. But be prepared as well for the discovery of surprising outcomes, and don't look at the theory as a prescription for the unfolding of the social reality. Most importantly, don't look to theory as a deductive basis for explaining and predicting social phenomena."

Daniel Little's post should be a must read for all social scientists who often elevate theories to a pedestal and engineer social explanations and predictions to fit the underlying theories. No where is this more ubiquituous than in the field of economics.

Social science theories should function as enabling methods of research rather than act as all encompassing and comprehensive theories. They should be employed to help find explanations for past events and help predict future ones, instead of becoming blanket explanations and predictions themselves.