Tag Archives: Economics

Winston Churchill on the economics consequences of the Treaty of Versailles

the-gathering-storm

 

The economic clauses of the Treaty were malignant and silly to an extent that made them obviously futile. Germany was condemned to pay reparations on a fabulous scale. These dictates gave expression to the anger of the victors, and to the failure of their peoples to understand that no defeated nation or community can ever pay tribute on a scale which would meet the cost of modern war.

The multitudes remained plunged in ignorance of the simples economic facts, and their leaders, seeking their votes, did not dare to undeceive them. The newspapers, after their fashion, reflected and emphasized the prevailing opinions. Few voices were raised to explain that payment of reparations can only be made by services or by the physical transportation of goods in wagons across land frontiers or in ships across salt water; or that when these goods arrive in the demanding countries they dislocate the local industry except in very primitive or rigorously-controlled societies. In practice, as even the Russians have now learned, the only way of pillaging a defeated nation is to cart away any movables which are wanted, and to drive off a potion of its manhood as permanent or temporary slaves. But the profit gained from such processes bears no relation to the cost of the war. No one in great authority had the wit, ascendancy, or detachment from public folly to declare these fundamental, brutal facts to the electorates; nor would anyone have believed if he had. The triumphant Allies continued to assert that they would squeeze Germany “till the pips squeaked”. All this had a potent bearing on the prosperity of the world and the mood of the German Race.

In fact, however, these clauses were never enforced. On the contrary, whereas about £1,000 million of German assets were appropriated by the victorious Powers, more than £1,500 millions were lent a few years later to Germany principally by the United States and Great Britain, thus enabling the ruin of the war to be rapidly repaired in Germany. As this apparently magnanimous process was still accompanied by the machine-made howling of the unhappy and embittered populations in the victorious countries, and the assurances of their statesmen that Germany should be made to pay “to the uttermost farthing”, no gratitude or good-will was to be expected or reaped.

Germany only paid, or was only able to pay, the indemnities later extorted because the United States was profusely lending money to Europe, and especially to her. In fact, during the three years 1926 to 1929 the United States was receiving back in the form of debt-instalments indemnities from all quarters about one-fifth of the money which she was lending to Germany with no chance of repayment. However, everybody seemed pleased and appeared to think this might go on for ever.

History will characterise all these transactions as insane. They helped to breed both the martial curse and the “economic blizzard”, of which more later. Germany now borrowed in all directions, swallowing greedily every credit which was lavishly offered her Misguided sentiment about aiding the vanquished nation, coupled with a profitable rate of interest on these loans, led British investors to participate, though on a much smaller scale than those of the United States. Thus Germany gained about fifteen hundred million pounds sterling in loans as against the one thousand millions of indemnities which she paid in one form or another by surrender of capital assets and valuta in foreign countries, or by juggling with the enormous American loans. All this is a sad story of complicated idiocy in the making of which much toil and virtue was consumed.

References:

  1. Churchill, Winston. The Gathering Storm. Boston: Published in Association with the Cooperation Pub. Houghton Mifflin, 1948. Print. 6-9.

 

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Economic Equality vs Efficiency

99cents

“Equality vs efficiency” is a classic debates in economics. Moralizing liberals pout about the poor, while those cold conservatives wave around their economics textbooks. Both sides are usually talking about completely different issues and they always talk past each other. It doesn’t get much more left vs right than this.

Take Bernie Sanders’ statement about economic growth:

If 99 percent of all the new income goes to the top 1 percent, you could triple it, it wouldn’t matter much to the average middle class person. The whole size of the economy and the GDP doesn’t matter if people continue to work longer hours for low wages and you have 45 million people living in poverty. You can’t just continue growth for the sake of growth in a world in which we are struggling with climate change and all kinds of environmental problems. All right? You don’t necessarily need a choice of 23 underarm spray deodorants or of 18 different pairs of sneakers when children are hungry in this country. I don’t think the media appreciates the kind of stress that ordinary Americans are working on.

This is probably the clearest expression of the typical liberal position on inequality I’ve ever seen. If you actually sit down to consider it, and not scoff at the fact that Sanders is a socialist, I think it’s a pretty reasonable position. Yet the media still managed to botch it. They thought he was literally talking about how 23 choices of deodorant causes poverty. Or they thought he was advocating central planning Soviet style. Or they thought he hated economic growth or something. This is all completely wrong.

I’ll illustrate my point with numbers, because I find that numbers make everything much clearer. Let’s consider two cases.

  • In case 1, we have a simple economy made up of units of “economic benefits”. These benefits are things like wealth, innovation, and whatever else you would consider good for the economy. Let’s assume that this economy has legal structure A. After a year of economic activity, there are 100 more “economic benefits”. This legal structure causes pre-tax distribution to go disportionately, say 80%, to the top 20%. It might look something like this:
Top 1% 50
19% 30
50% 12
20% 7
Bottom 10% 1
Total Benefits 100
  • In case 2, we have the same simple economy, but with legal structure B. This results in more equitable distribution, but we only get 90 units of “economic benefits”. It might look something like this:
Top 1% 30
19% 20
50% 18
20% 13
Bottom 10% 9
Total Benefits 90

It’s obvious from Sanders’ statement that he would prefer case 2 to case 1. That’s what he means when he says “you can’t just continue growth for the sake of growth“. He’s not “opposed to growth”, he’s just thinking about the “trade-off” between growth and equality. It’s a moral issue that he thinks is important. If the economy is growing but the poor are only getting 1%, that doesn’t really help them much. It’s a simple, but reasonable argument and none, literally none, of the pieces I’ve read addressed it.

Of course his point is nothing new and it’s heavily disputed. Perhaps economic growth will falter because of the distortions caused by redistribution, which would hurt the poor even more. Dismantling the welfare state could result in economic gains beyond our wildest dreams. You might even dispute the ethics. These are all possibilities, but extraordinary claims require extraordinary evidence. Unfortunately, most of the debate on inequality is rhetoric, and not the good kind (1).

Personally, I think the whole “equality vs growth” dichotomy is utter nonsense, a mischievous framing device. Just off the top of my head, I can think of several things that cause inequality and hurt economic growth:

  • Occupational licensing artificially restricts the supply of labor and raises the wages of that profession. This is form of economic rent. While necessary on some level, there are major costs when the practice is taken too far (2). And lo and behold, the percentage of US workforce that is licensed has increased dramatically since the 1960s:

licensing2

  • Bad incentive schemes used in the finance sector not only inflate the incomes of CEOs, but also provide horrible incentives. When compensation increases with stock prices, CEOs and management will want to increase the value of those stocks. Unfortunately, there’s a lot of dishonest ways to do this, e.g. excessive risk taking, deceptive accounting, etc. (3). Given these incentives, it’s no wonder that these schemes played a role in the recent financial crisis.
  • Subsidies that have long outlived their usefulness also contribute to inequality. Farm subsidies , stadium subsidies, and many others are a pernicious form of rent-seeking.

This is just a small list. Some of these things are caused by the government, some by the market and getting rid of all of them would improve economic growth. They also have one thing in common, i.e. a contempt for the rule of law. Major legislative efforts to reduce inequality won’t mean a damn thing if we continue to see pervasive levels of rent-seeking in our economy. Our problem of inequality won’t be solved until we are serious about the rule of law. Unfortunately, I don’t think any of these presidential candidates care about that, except, ironically enough, Bernie Sanders.


Footnotes:

1. There’s also a problem of bad data. That will probably change in the near future and maybe we can get some more definitive answers. But that doesn’t mean they’re aren’t some great debates going on. There’s stuff in the dark corners of the econ-blogosphere. You’ll have to do some digging, but it’s definitely there.

2.

The most obvious social cost is that any one of these measures, whether it be registration, certification, or licensure, almost inevitably becomes a tool in the hands of a special producer group to obtain a monopoly position at the expense of the rest of the public. There is no way to avoid this result. One can devise one or another set of procedural controls designed to avert this outcome, but none is likely to overcome the problem that arises out of the greater concentration of producer than of consumer interest. The people who are most concerned with any such arrangement, who will press most for its enforcement and be most concerned with its administration, will be the people in the particular occupation or trade involved. They will inevitably press for the extension of registration to certification and of certification to licensure. Once licensure is attained, the people who might develop an interest in undermining the regulations are kept from exerting their influence. They don’t get a license, must therefore go into other occupations, and will lose interest. The result is invariably control over entry by members of the occupation itself and hence the establishment of a monopoly position. (Friedman 1962: 148)

3. Joseph Stiglitz has written at length about the problem of poorly constructed incentive pay schemes. See his book, The Price of Inequality, pages 108-114 and his congressional testimony on January 22, 2010 for the clearest expression of this position.

Links:

Bernie Sanders’ ‘deodorant’ comment ignores realities of economic growth by Jeff Jacoby

Sorry, Bernie Sanders. Deodorant isn’t starving America’s children by Jim Tankersley

Bernie Sanders’s Dark Age Economics by Kevin D. Williamson

Bernie Sanders’ Fossil Socialism by Matthew Continetti

Economists and Rhetoric: Defending McCloskey by Alex Lenchner

Why Conservatives Should Care About Occupational Licensing by Adam Ozimek

Incentives and the Performance of America’s Financial Sector by Joseph Stligliz

References:

1. Baker, Dean. The End of Loser Liberalism: Making Markets Progressive. Washington, D.C.: Center for Economic and Policy Research, 2011. Print.

2. Friedman, Milton. Capitalism and Freedom. Chicago: U of Chicago, 1962. Print.

2. Stiglitz, Joseph E. The Price of Inequality:. New York: W.W. Norton, 2012. Print.

4. Weeden, K. A., and D. B. Grusky. “Inequality and Market Failure.” American Behavioral Scientist. 58.3 (2013): 473-91.

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Economists and Rhetoric: Defending McCloskey

deirdre mccloskey

When I read history books, I tend to focus on the major themes, and not so much on the smaller stuff. When historians get bogged down with details, reading their books becomes tiresome. Things just don’t click. All I see are a bunch of names, dates, and academic terms. There isn’t a coherent story. After reading through some of these turgid books, I realized that it’s no coincidence that many of the best historians are also fantastic writers. Ron Chernow, Richard J. Evans, David Herbert Donald, and many others are great writers. They understand how to tell a story that conveys the facts and narrative they want to present. They don’t use jargon. They don’t just list a bunch of names and dates. It makes reading their 800-1000 page tomes a little easier and their arguments much clearer.

Here comes Noah Smith skewering Deirdre McCloskey. First, let me say that I’m a provisional fan of McCloskey. I haven’t read any of her major works, but I have read several of her essays, which are fun and informative reads. Contrary to the grumblings of her critics, she’s a very entertaining writer and I find that her style doesn’t distract from her arguments. She appreciates the art of writing and thinks that our use of language is important. See this excerpt from her essay, Keynes was a Sophist, and a Good Thing, Too:

“Sophistry” in Plato’s sense means “mere verbal trickery,” as against Really Knowing, the sort of ting a true philosopher Knows. True, how one would really know that one Really Knows is a detail the philosophers have not quite worked out in 2400 years of trying, but they are agreed that mere opinion created by exchange of words is to be loftily sneered at.

The contrary view, that of the sophists themselves (including arguably Socrates himself, Plato’s teacher), is that we humans must get along on exchanges of words, and had better learn to use them well. Democracies and courts of law depend on an art of persuasion exercised in the here and now, not on a doctrine of Really Knowing established by an aristocracy with time on its hands. The sophists were, so to speak, professors of law. In later classical times the great Roman sophist Quintilian defined the ideal law student as “vir bounus dicendi pertius,” the good man skilled at speaking. You don’t have to believe this characterizes many law students, or economics students, to recognize it as an ideal, which recommends honest rather than dogmatic Truth.

When I read McCloskey (and many historians for that matter), I read her as a sophist. I don’t take everything she says too literally, especially her rhetorical flourishes (1). They certainly add to the narrative, but you can ignore them. It rarely takes away from the central argument being made. It’s what makes reading people like McCloskey enjoyable.

So when people critique someone’s work by obsessing over rhetoric, it usually turns out bad. This is essentially what Noah Smith did. He tried to pick apart every statement McCloskey wrote, and it made for a unconvincing post. Some of his points are wrong. Others are nitpicks that have little to do with McCloskey’s review. He simply couldn’t get past her style. I wonder if he applies that same standard to journalists or historians who frequently use rhetoric. The War Nerd, whom I know he reads, makes statements like McCloskey’s all the time. It’s what makes him so damn interesting! Unfortunately, economists like Noah Smith don’t appreciate that style of writing and it’s why, I think, many social scientists simply don’t understand the art of good writing. They don’t understand the art of rhetoric.


1. For example, when McCloskey is talking about economist theorists and “existence theorems”, I pretty sure she’s exaggerating:

With such and such general (or not so general, but anyway non-quantitative) assumptions A there exists a state of the imagined world C. A typical statement in economic “theory” is, “if information is symmetric, an equilibrium of the game exists” or, “if people are rational in their expectations in the following sense, buzz, buzz, buzz, then there exists an equilibrium of the economy in which government policy is useless.”

References:

The Trouble with Mathematics and Statistics in Economics by Deirdre McCloskey

Keynes was a Sophist, and a Good Thing, Too by Deirdre McCloskey

Deirdre McCloskey Says Things by Noah Smith

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Static vs Dynamic Equilibrium

Equilibrium is a poorly understood term on the internet, especially when applied to economics. Consider these examples:

  1.  Imagine an object lying on a table in a room. The external forces on the book (gravitational force) are equal to the normal force provided by the table. Assuming we’ve left the system unchanged, the properties of the system (microscopic and macroscopic) will remained unchanged as time goes on. This is called a static equilibrium.
  2. Now imagine a reversible chemical reaction. When this system reaches equilibrium, reactants are converted into products and products are converted into reactants at a constant rate. So while there is no net change in the system, chemical reactions are constantly taking place. The properties in the system are still moving/changing as time goes on. This is called a dynamic equilibrium.

equib-for-rev-reaction

In economics, equilibrium can be applied in a similar fashion as in the natural sciences. For example:

  1. Static equilibrium for a specific model is where there is a lack of tendency to change. In a basic supply and demand model, equilibrium is where quantity demanded and quantity supplied are equal. No agent in the system has an incentive to change it’s behavior. The endogenous variables in the system will remain at those values until the system is perturbed.
  2. Dynamic equilibrium in economics is a little bit trickier to define. First let’s look at what we mean by the word “dynamics” in economics. There are several definitions of economic dynamics (1), but they all seem to have one thing in common, the concept of time. Economic dynamics basically gives a continuous picture of the economy over a period of time. A dynamic equilibrium is when the endogenous variables change at the same rate over time. Consider a model of inflation. Over time, the price level, nominal money supply, and other nominal values increase at the same rate. However, the real price level has remained unchanged.

Now these are just two simple examples of how equilibrium is used in economics. Depending on the model, the word “equilibrium” might mean something else.

When people criticize economists for assuming equilibrium in their models, they are typically only talking about static equilibrium.  But this is a very, very narrow definition of the word “equilibrium” that ignores decades of economic research. So while the criticism occasionally hits the mark (sometimes the assumption of equilibrium is just wrong), it usually reveals an ignorance of a very deep and complicated field.

Footnotes:
1. Some examples:

“Economic Dynamics those parts where every quantity must be dated.” – Hicks

“Economic dynamic is the study of economic phenomenon in preceding and succeeding events.” – Bamoul

Links:

  1. Colds, strokes and Brad Delong
  2. Dynamic Equilibrium
  3. Chemical Equilibrium: A Dynamic Concept
  4. What is an economic equilibrium?

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The Broken Window Fallacy is trivial

In his essay, What is Seen and What is not Seen, Frédéric Bastiat wrote his famous parable, the Broken Window Fallacy (BWF). A boy breaks a shop keeper’s window and the shop keeper is forced to replace it. Townspeople sees that the broken window caused a boost in economic activity, which they think is good for the economy. But no, says Bastiat, the town is wrong. What we are ignoring is the unseen, i.e. if the shop keeper’s window wasn’t destroyed, he might have spent his money elsewhere; “It is this third person who is always in the shadow, and who, personifying what is not seen, is an essential element of the problem.” Destruction, though it may increase economic activity, ultimately results in a net loss in the stock of wealth. The resources used to replace destroyed capital could have been used elsewhere for more productive purposes:

From which, by generalizing, we arrive at this unexpected conclusion: “Society loses the value of objects unnecessarily destroyed,” and at this aphorism, which will make the hair of the protectionists stand on end: “To break, to destroy, to dissipate is not to encourage national employment,” or more briefly: “Destruction is not profitable.

Bastiat doesn’t just talk about broken windows. He also talks about taxes, the military, protectionism, and many other economic issues. Sometimes Bastiat’s lucid writing and colorful analogies shed light on the importance of opportunity cost. Other times, particularly his discussion of public works, Bastiat is prone to hand waving (1). Either way, it’s a fun essay that does a wonderful job of talking about opportunity costs, better than any modern economic textbook.

But for some reason, Libertarians view the BWF as some sort of magic bullet. They obsess over Keynesians’ supposed ignorance about the unseen and frequently use the parable on a variety of policy issues.  This is complete nonsense. In reality, the BWF doesn’t really shed light on any policy issues that Keynesians emphasize. At best, the analogy provides a trivial piece of insight that has been known by economists for decades.

I’m going to borrow an analogy from Gene Callahan to show this, except I’ll use some figures to convey the point better. I’ll also relax some of the assumptions in Bastiat’s original essay. Consider two scenarios.

In Scenario One, there’s an isolated valley. In the valley lives a wealthy landowner who lives in a mansion worth $100. There is also a large number of poor subsistence famers who live on farms worth a negligible amount. The farmers were prosperous when the landowner was constructing his estate, but now he is done and there is no other work around. The wealthy owner is sitting on $1000 dollars of idle capital while the farmers are barely surviving.

Let’s say a tornado comes along. It completely destroys the landowner’s mansion and he is forced to rebuild. He now has a need to employ all of those poor subsistence farmers, the flow of economic activity increases, and a year later, the mansion is rebuilt. Visually, it will look something like this:

Year 1 House Idle Resources Total Wealth
$100 $1,000 $1,100
Year 2 House Idle Resources Total Wealth
$100 $900 $1,000

In Scenario 2, we have the same exact circumstances, but there is no tornado. Instead, 3 years later (on Year 4), the wealthy landowner decides to build a large addition to his mansion. It costs $100 to build, but will be worth $200 when finished. He again has a need to employ all of those poor subsistence farmers, the flow of economic activity increases, and a year later, the addition is built. Visually, it will look something like this:

Year 1 House Idle Resources Total Wealth
$100 $1,000 $1,100
Year 2 House Idle Resources Total Wealth
$100 $1,000 $1,100
Year 3 House Idle Resources Total Wealth
$100 $1,000 $1,100
Year 4 House Idle Resources Total Wealth
$100 $1,000 $1,100
Year 5 House Idle Resources Total Wealth
$300 $900 $1,200

Stocks vs. Flows

In debates over the merits of the BWF, Libertarians tend to emphasize stock of wealth, i.e. the value of all wealth in the economy measured at a specific time, while Keynesians tend to emphasize flows, i.e. the measure of economic activity over a period of time (e.g. GDP or investment per unit time). So in my example above, it’s obvious that Bastiat’s fallacy holds true. The second case has a larger stock of wealth than the first case. In fact, I would argue that Bastiat’s parable holds true in any scenario where resources or capital is destroyed. Libertarians would argue that this is unequivocally a bad thing. But this isn’t exactly obvious.

Whether stocks or flows matter at any given moment all depends on the context. In my example, while the stock of wealth decreases in scenario 1, we could say the economic flows are more important. Those poor subsistence farmers need an income to alleviate their suffering. Meanwhile, the landowner is sitting on a huge amount of idle resources. So Scenario 1 is better for farmers because they are employed earlier, thus alleviating their suffering earlier. Claiming that resources are allocated from more efficient uses, I think, completely misses the point here.

Whether or not the BWF really matters is ultimately an empirical question. Unless you can effectively demonstrate 100% crowding out, then it might not matter if the BWF holds. The economic flows could outweigh the net loss in economic wealth.  To determine that, we need to look at things like the distribution of wealth, employment, comparisons of utility, and host of other “unseen” variables, not just the stock of wealth and economic activity. “Destruction is bad” is not an a priori truth.

The Broken Window Fallacy is a straw-man

Another problem is that the BWF is often employed as an blatant straw-man. When Keynesians are advocating for fiscal policy during a recession, that do not mean we should break windows. Analogies about alien invasions or digging holes (2) are colorful metaphors. What Keynesians really mean by fiscal policy is increasing employment by using idle resources on things that we would consider productive, e.g infrastructure or R&D. This has absolutely nothing to do with the BWF unless you assume 100% crowding out, which doesn’t apply during a recession.

You could dispute this and emphasize the importance of the “unseen”, but that’s an empirical question. Preaching the BWF gets you nowhere and you have to actually show that employing idle resources in the short run is worse than the alternative. Of course, that’s really hard to do, which is why we continue to have debates over fiscal policy.

It’s obvious the BWF is at best a trivial insight. Destruction of resources and capital is (almost always) bad for the economy. Great to know, but no serious economists advocates destruction as a solution to our economic woes. And while the “unseen” is the main focus of Bastiat’s original essay, it’s something that economists have written about for literally centuries. Citing the BWF without some sort of empirical evidence adds nothing to the conversation and handwaving doesn’t refute any Keynesian argument about macroeconomic policy.


Notes:

1. It’s worth noting that Bastiat allows for the use of public works and counter-cyclical policy during a crisis in his essay:

As a temporary measure in a time of crisis, during a severe winter, this intervention on the part of the taxpayer could have good effects. It acts in the same way as insurance. It adds nothing to the number of jobs nor to total wages, but it takes labor and wages from ordinary times and doles them out, at a loss it is true, in difficult times.

However, it’s still quite obvious that he’s relying on the assumption of full employment when talking about the unseen.

2. The frequently cited quote from Chapter 10 of the General Theory:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is. It would, indeed, be more sensible to build houses and the like; but if there are political and practical difficulties in the way of this, the above would be better than nothing.

Links:

Stocks, Flows, and Bastiat by Daniel Kuehn

Yglesias on Broken Windows: couldn’t have said it better myself by Daniel Kuehn

Correcting the Keynesians on the Broken Window Fallacy by Robert Murphy

Goodnight, Irene by Gene Callahan

The Broken-Window Fallacy by Robert Murphy

A Word on Economic “Fallacies” by Unlearning Economics

Debunking the Broken Window Fallacy by Robert Nielsen

Hazlitt, Keynes and the glazier’s fallacy by John Quiggin

The Real Problem with the Broken Window Fallacy by Unlearning Economics

Actually, Breaking Windows is Good by Matt Bruenig

References:

1. Bastiat, Frédéric, and W. B. Hodgson. What Is Seen and What Is Not Seen: Or Political Economy in One Lesson .. London: W.H. Smith and Son, 1859. Print.

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Thomas E. Leslie on the use of mathematics in Economics

In a review of William Jevon’s The Theory of the Political Economy, economist Thomas E. Leslie has some interesting thoughts on the use of mathematics in economics:

Within that narrower field can we proceed, as Mr. Jevons contends, not only by simple deduction, but by mathematical process?  “There can be,” he says,  “but two classes of sciences those which are simply logical, and those which, besides being logical, are also mathematical. If there be any science which determines merely whethera thing be or not, whether an event will or will not happen, it must be a purely logical science ; but if the thing may be greater or less, or the event may happen sooner or later, nearer or farther, quantitative notions enter, and the science must be mathematical in nature, by whatever name we call it.” Nevertheless, it can hardly be contended that Adam Smith’ s reasoning respecting the nature and causes of the wealth of nations is in its essence, and ought to be in actual form, mathematical ; or that the process by which his main propositions are established is anything more than logical. We might add that they rest in good part on inductive, and not simply on deductive, logic; but the question before us is whether mathematical methods could properly be applied to their demonstration. That wealth consists, not of money only, but of all the necessaries and conveniences of life supplied by labour, land, and capital; that man’s natural wants are the strongest incentives to industry ; that the best assistance a government can give to the augmentation of national opulence is the maintenance of perfect liberty and security ; that the division of labour is the great natural organization for the multiplication of the products of industry ; that it is limited by the extent of the market; and that the number of persons employed in production depends in a great measure upon the amount of capital and the modes of its employment—these are the chief propositions worked out in the ‘ Wealth of Nations,’ and it can hardly be said that mathematical symbols or methods could fitly be used in their proof. We need not controvert Mr. Jevons’ proposition that ‘ pleasure, pain, labour, utility, value, wealth, money, capital, are all notions admitting of quantity ; nay, the whole of our actions in industry and trade depend upon comparing quantities of advantage or disadvantage.’ But the very reference which Mr. J evons proceeds to make to morals militates against the assumption that ‘ political economy must be mathematical, simply because it deals with quantities,’ and that ‘ wherever the things treated are capable of being greater or less, there the laws and relations must be mathematical.’ The author instances Bentham’s utilitarian theory, according to which we are to sum up the pleasures on one side and the pains on the other, in order to determine whether an action is good or bad. Comparing the good and evil, the pleasures and pains, consequent on two courses of con duct, we may form a rational judgment that the advantages of one of them preponderate, that its benefits are greater, its injurious results, if any, less; but it by no means follows that we can measure mathematically the greater or less, or that the application of the differential calculus would be appropriate or possible in the matter.

Leslie was a famous Irish historicist who in the late 19th century made significant theoretical contributions to the development of historical economics in England. Math was never really used in economics during this time (at least not on the level like what we see today), so it’s understandable that he would be tentative in embracing the use of mathematical modeling in economics. But aside from that, he has a point here. How can we use mathematical symbols to properly model economic phenomenon like the division of labor, the invisible hand (spontaneous order), market organization, and a bunch of other important things that shape the economic system we live in? When does economic modeling go beyond solving elaborate “chess problems” (to borrow from Deirdre McCloskey)? Based on my current knowledge of economics (which by most standards is very limited), most of the current models used rest on dubious assumptions that render the model almost useless when applied to any real market system. Because of the complex math being used, many of the major problems in these model are obscured by an elaborate “superstructure” of mathematical symbols. Leslie made a similar point:

We regret that so much of Mr. Jevons’ own reasoning is put into a mathematical form, because it is one unintelligible or unattractive to many students of considerable intellectual power and attainments. On the other hand, we not only concede that a mathematical shape might have been given to a great part of Ricardo’s system, but we regret that it ever received any other, because his theory of value, wages, profits, and taxation is misleading and mischievous. Assume that the products of equal quantities of labour and abstinence are necessarily of equal value and price, and that exertions and sacrifices of different kinds are commensurable, and a number of mathematical equations and calculations can be based on those assumptions. But since the basis is false, the more the superstructure is hidden the better; and we should be glad to see it obscured, in every treatise in which it is put forward, by a liberal use of the calculus.

That’s not to say I completely embrace Leslie’s position. I’m not against the use of mathematic in economics and it can be a very useful tool*. But mathematical modeling is no substitute for studying actually economic systems, i.e. history, institutions, social relations, evolutionary systems, division of labor, and many other phenomenon.

*See this post by Noah Smith on why we should use mathematic in economics. There is another fantastic post on the blog Magic, Maths, and Money. Also see this post by Paul Krugman. There has been extension discussion on the econblogsphere on this topic and if you search around a little, you’re bound to find some interesting commentary.

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Why Economics Needs History

When economics was becoming it’s own subject in the late 18th and early 19th century, one of the common themes of what we now call classical economics was it’s approach to argue from universal assumptions. Take this famous passage from Adam Smith’s Wealth of Nations:

The division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequences of a certain propensity in human nature, which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.

Wether this propensity be one of those original principles in human nature, of which no further account can be given, or whether, as seems more probable, it be the necessary consequences of the faculties of reason and speech, it belongs not to our present subject to inquire. It is common to all men, and to be found in no other race of animals, which seems to know neither this nor any other species of contracts….Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog.

Here Smith assumes that the ability to make contracts and exchanges was created by a “propensity in human nature”, not by historical or cultural circumstances. You can also find in the writings of Ricardo and Malthus the view that the economy tends towards some “natural state” (Classical theory of growth and stagnation) based on a set of universal laws on wages, rent, and population that held throughout time. However, some economists, most notably Marx, criticized this idea. In a letter to journalist Pavel V. Annenkov, Marx heavily criticized Pierre-Joseph Proudhon’s approach to economics, claiming that:

He fails to see that economic categories are but abstractions of those real relations, that they are truths only in so far as those relations continue to exist. Thus he falls into the error of bourgeois economists who regard those economic categories as eternal laws and not as historical laws which are laws only for a given historical development, a specific development of the productive forces. Thus, instead of regarding politico economic categories as abstractions of actual social relations that are transitory and historical, Mr Proudhon, by a mystical inversion, sees in real relations only the embodiment of those abstractions. Those abstractions are themselves formulas which have been slumbering in the bosom of God the Father since the beginning of the world.

Although Marx is considered a classical economist by most standards (or at the very least, his economics was heavily informed and influenced by his classical predecessors), his stance underlies an important methodological difference between him and other classical economists. To him, universal economics laws and categories do not capture the important features of a particular social-economic system. He recognized the importance of historical development within an economic context.

This problem, what we might call the problem of historical specificity*, is a problem that has been ignored by a number mainstream economists. In all of the academic and internet debate over complicated economic models, we abstract away the institutions that should dramatically change our analysis of any given economic structure or phenomenon. When we talk about individual preferences, we neglect how institutions and culture can mould individual preferences.

Too much history is missing from the current debates on economics. Yes, there have been many fantastic mainstream economic historians over the years. Peter Temin, Barry Eichengreen, Kevin O’Rourke, and many others have all written insightful books, created valuable datasets, and produced useful empirical studies. But what’s lost in many of these empirical studies are the social and institutional realities that shape any social-economic system:

As I inspect current work in economic history, I have the sinking feeling that a lot of it looks exactly like the kind of economic analysis I have just finished caricaturing: the same integrals, the same regressions, the same substitution of t-ratios for thought. Apart from anything else, it is no fun reading the stuff any more. Far from offering the economic theorist a widened range of perceptions, this sort of economic history gives back to the theorist the same routine gruel that the economic theorist gives to the historian. Why should I believe, when it is applied to thin eighteenth-century data, something that carries no conviction when it is done with more ample twentieth-century data?

Robert Solow

Economic debates, especially ones over the “econ-blogsphere”, need to be more historically informed.

*From Geoffrey Hodgson’s fantastic book How Economics Forgot History

References:

1. Chang, Ha-Joon. Globalisation, Economic Development, and the Role of the State. London: Zed, 2003. Print.

2. Hodgson, Geoffrey Martin. How Economics Forgot History: The Problem of Historical Specificity in Social Science. London: Routledge, 2002. Print.

3. Hodgson, Geoffrey Martin, and Geoffrey Martin Hodgson. The Evolution of Institutional Economics: Agency, Structure, and Darwinism in American Institutionalism. London: Routledge, 2004. Print.

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