Monday, October 20, 2008

On economic thought - 1

(Finance will come soon enough, but for now, economics)

Most introductory courses in economics split the discipline into microeconomics and macroeconomics. Very crudely, microeconomics deals with markets, while macro deals with the entire economy. Government policy spans the entire spectrum, for eg. product market regulations on the micro front, fiscal and monetary policy on the macro.

Microeconomics is a set of assumptions, assertions, observations and models on which the foundation of economic thought is built. While a fair bit of it (especially in its mainstream form) is mathematical, it is essentially just a modeling of human behaviour, action and interaction. On the other hand macroeconomics is highly mathematical, deals with huge amounts of data, employs complicated econometric models and often deals at an uncomfortable level of abstraction. To be sure, there are assumptions, assertions and comments on human behaviour galore. However, at all points of time, the attempt is to analyse the cumulative sum of all agents in a given economy.

Therefore, microeconomics tends to be easier and much more intuitive than macro. For example, to assert that 'government inspection of schools is debilitiating' requires only a certain level of knowledge and competence. To claim that 'the correct way for India to fight inflation is to sell its dollar reserves' takes a wholly different level.

Most non-academic thinkers and commentators miss this fact. As ordinary citizens, what influences us most is government policy, and that straddles both micro and macro. Somehow, the average commentator on economic policy tends to assume that if he is able to, say, critically evaluate the regulatory aspects of tax, he is also able to make very informed comments about the ideal fiscal policy. In the past, it has often amused as well as irritated me to see inflation-is-a-monetary-phenomenon-explained-for-dummies type of posts floating around in the blogosphere. However, I have always reserved comment, for I was one of the dummies myself.

To be sure, the basic relationships between macroeconomic variables can be broadly understood by a single course in macro, or even casual reading. What I am refering to here are the prominent macroeconomic debates. Many of these tend to very fine-grained and extremely non-trivial in nature. While one side of the debate may seem intuitively more appealing if explained properly, criticism of the other side should typically be left to the experts. Most dilletante commentators are only projecting their policy biases when they take sides. Uninformed macroeconomic analysis mixed with policy bias makes for a terrible concotion.

Another key point that we often miss out is that many economic (micro and macro) debates are academic in nature, centred on a theoretical contention or on interpretation of avaliable data, and may not have any policy or ideological implications. For example, neo-classical economics (mainstream microeconomics as it is taught at most places) assumes that technology is exogenous to all firms in the economy. The macro-level implication is that technology can be treated as an exogenous variable to the economy and changes in technology lead to 'shocks' or transitions between different 'equilibrium' states of the economy (more on equlibriums later). I find this assertion to be patently absurd on the micro-level. Of course, no neoclassical economist lives or dies by this theory and it is only a model-simplification. However, I find this simplification extremely distortionary. Sure enough, it has been criticized on many fronts by many economists who also find it absurd. But does this criticism have any policy implications? Most probably not.

If I was to argue that this flaw in neoclassical economics means that the capitalist economic system that it serves as the foundation of is principally flawed, it would be a stupid argument. Yet, often enough, people believe that by finding out one flaw with a system of economic theory they have destroyed the credibility of the policy implications of that system. More commonly, one finds people trying to place their own understanding of a purely academic debate on a simplified policy spectrum of left and right, socialism and capitalism.

Of course, there are many other tenets of economic theory that have direct policy implications. A blow to one of these tenets would lead to genuine policy debates. One prominent example is that of the ridiculous idealization of perfect competition. But more on imperfect competition and other such things later.

(this is the part 1 of an n-part series, n is as yet undecided)

20 comments:

tanuj solanki said...

two questions:
1)
microeconomics is less mathematics and more modeling. What qualifications make u make such absurd comments, comparing the mathematical basis of micro and macro (U seem to be measuring the degree of maths by what was taught to us here!)?
2)
the second is less vitriol ;) Please explain how the extension of the concept of technology as an exogenous variable is flawed at the micro level...

Good post. I like the considerable decline in criticism of alien thought!

zen babu said...

Tanuj,

1) Well, my economics qualifications are limited to my postgraduate education and a host of non-course related reading.

However, in what I have read (limited, but not too less), the central questions in micro are often about expected utilities, theory of values, convex preferences. While these are operationalized mathematically, many of them are essentially just assertions about human behaviour.

IN macro, by contrast, the biggest debates are about theories of business cycles and effectiveness of fiscal and monetary policy. Large amounts of data are crunched using complex econometric models to analyse lead-lag relationships between inflation, GDP growth, unemployment rates, interest ates and the like. Indeed, if you read more about the Keynesian-Monetarist debate, for about 30 years these dudes kept digging up data to try and establish just how vertical the LM curve was!

Think about inflation data. Can you think of just how much measurement and statistical crunching goes into coming up with it. Ditto for GDP measurement. But leave the measurement, if you were to try and establish a relationship between those variables, can you just assume an easy function between the two? Contrast this with say modeling concave utilities using the square root function or the logarithm function. Do you still find my assertion absurd?

2)Actually, I find the idea of technology being exogenous absurd at the macro-level as well. It's just that I did not want to be talking about Solow residuals in the first post, and I doubt if I will do a good job of talking about Solow residuals anyway.

At the micro-level, however, the reasoning is simplistic enough. Technology is usually treated by management literature (as opposed to economics theory) as a resource. Some technologies are commoditized, but many more are patented, or put to use in unique ways. Even when technology is not unique, the level of skill of different peopel on the same technology is different.

The whole idea of 'learning by doing' presents a very stark challenge to the idea of technology being exogenous and same for all firms.

tanuj solanki said...

Response to Response

1) hmm...
provided the necessary tickle :)

I would have said the same thing based on what I have read. Just wanted to see what your scientific method of justification would be. I agree with what you say.

2)
You didnt say much here! Slight disagreement

Would have liked you to delve further into
> Adoption cycle
> Consumer Behavior (a micro thing as you said)
> Utility curves
> And examples where technology and the above three were not seen for some period!

And yes, behavioral finance

But I think you will need a separate post for that...

Way to go, champ /\/\

Gaurav said...

Technology is usually treated by management literature (as opposed to economics theory) as a resource. Some technologies are commoditized, but many more are patented, or put to use in unique ways. Even when technology is not unique, the level of skill of different peopel on the same technology is different.

Reminds me of a discussion I had with Don Hambrick a few months back. It was in the RBV context. Using Barney's conceptions of VRIN, it is difficult to think of just the abstract concept of "technology" as a resource that can provide a firm with competitive advantage. How the technology is used makes the difference.

So what follows from this, we agreed, was that technology is just part of the landscape. It is as much a VRIN resource for firms (or not) as oxygen, gravity, the ability to think or communicate.

In that sense, technology is too broad a construct to define as exogenous or endogenous. More fine-grained constructs are needed.

zen babu said...

Gaurav,

While I used the example of technology as a resource, criticism of 'technology' is exogenous need not come only from the RBV perspective. Actually, my problem is much simpler.

If one assumes that technology is exogenous, and a change in technology is a 'shock' to the economy, will then where exactly is the shock coming from. Or, who is producing it?

Also, I wonder why you say that technology and skill sets are as broad as 'oxygen' or 'gravity'. They could also be modeled as differentiated capital and differentiated labour.

zen babu said...

Essentially, 'technology is exogenous' + 'static equilibrium' is the combination that kills it for me. But like I said, more on equilibria later.

avataram said...

There are few topics of discussion in India, like the $/Re rate, the level of currency reserves, high inflation or RBI’s monetary policy. Prominent economists have managed to suggest such fantastical policies out of these few that one is appalled. A few examples I remember are using our forex reserves to build out infrastructure projects, selling down reserves to reduce inflation, how India must compete with china on the size of reserves without taking into account the totally different nature of production in these countries and so on.

And of course, I fit right there in your list of bad economists with some (not all) of my criticisms of neoclassical economics.

But sometimes, what is the point? Some five guys read me, maybe the same five read you. And the guy who is responsible for half these myths starts a new series on myth-busting himself. Create myths on Monday, bust them on Tuesday.

India is a good example of Gresham’s law in Ideas. Eventually, bad economic ideas and bad economists will drive out good ones. Then all the bad ones will band together and publish another edition of Pragati.

To prevent n from being = 1, why don’t you write about Paul Romer, Grossman and Helpman, Aghion and Howitt and their endogenous growth theory? At least someone has created a nice theory by making technology endogenous.

tanuj solanki said...

"But sometimes, what is the point? Some five guys read me, maybe the same five read you"

For this avataram, I will be your fan for life :)

zen babu said...

Avataram,

You are right, some of those ideas have indeed been terrible, and it doesn't even require too much macro knowledge to criticise some of those ideas.

All I'm saying is, if you claim that selling dollar reserves to fight inflation is a bad idea, then while your logic for claiming so may be strong and intuitive enough, that would not be enough. A little data is needed - on our reserves, on our deficit, on the daily value of forex traded, etc. Many of Ajay Shah's macro proposals also seem absurd to me but I wouldn't dare criticise them without data. That is the way I look at things.

And your hatred for neoclassical economics is partly due to your hedge fund going bust. So I make exceptions for you!

I don't know too much about Paul Romer, bu trust me, n will not be just 1.

doubtinggaurav said...

You are boring.

avataram said...

Better data does not necessarily make for good economics.

A fine counter-example is Mr Shah himself. He started CMIE, and it was the only source that collected government data from various sources, and when data was suspect, got CMIE to design better data series and published them as well.

The problem was, he thought he could create an in-house group of economists with Ph.ds who would use this data and do some good research as well.

You see the result. I read papers by the likes of Ila Patnaik only to laugh.

So, the next time someone like Ravikiran quibbles about your data, simply ignore him. He doesnt know any economics. Your problem is that you take everyone seriously.

zen babu said...

Better data does not make for good economics, but macroeconomic assertions without data often seem very hollow.

Which was, more or less, my original point. Anyway, on macro, I take you more seriously than any of the other pop-commentators.

tanuj solanki said...

;)

yeah right

The suggestion is to see how one chandan sapkota blogs about economics.

http://www.sapkotac.blogspot.com


He is a guy who works. May be he is too much news and too little views (or intelligence or knowledge, or whatever the pomposity is about). HE changes things by pointing out merely the things that apply to underdeveloped places on the planet. And he has some following!

If you are going to blog about economics, would it be wise to start from chapter 1 (and get into a debate; or even clearing doubts on 'whether more data is more economics') as a I-am-the-thinker-who-is-so-turned-on-he-could-go-on-forever way?

Your next post will probably be about endogenous growth theory, and avataram will initially try his hardest to find a fault, like me, and then later on find the argument too tough to carry on... and that I believe will make u take n to 3

then 4

till the point where u get bored of it.

Which I think is inevitable. Because all of it will be highly textbook, interspersed with the highest degree of opinion... and will invoke the darker parts of the commentator's brain

You see your blog essentially is all about the comments. Because you just can't leave a question open-ended. And some of it also stems from your view of irrationality.

You seem excited about the fact that irrationality has not been 'factored-in' by anyone... and so the interest in behavioral finance, but that statement assumes irrationality to be exogenous to the whole thought process.

Irrationality IS thought. An acceptance of this fact places all things in order, surprisingly :)
It is a great help in providing the correct importance to word-play in intellectual intercourse...ones that you seem to love starting (and I must appreciate you in your ability to find people like you)

I think with your views (+ action + respect for irrationality) you can change something drastic. You are the most intelligent among the people who have commented here. But easily the stupidest too!

Your economics is all about you. Why?

Except with probably your taxes, none of you dick-heads will help this country. You might make it to some 'forum on policy discussion--is fiscal policy the way to go in market condition like the present'. But not anything else.

You could have done it by

avataram-- starting to write!
& zen-- coming down a little bit from the cloud, and moving beyond the initial chapters

Me, I wont even pay the taxes. I love Michael Jackson too much!

zen babu said...

Tanuj,

Nevermind. Sometimes you're way too vague for me. Vague, I say - not abstract. The two are different.

I think you will like Nilu.

try http://themaanga.com

zen babu said...

Also, you are probably a little unused to this set of people. Here, no one ever admits defeat in an argument:-).

And, comments must be replied to. Else we will all become Amit Varma. Which is, to put it mildly, less than desirable.

tanuj solanki said...

I checked the dictionary...and couldnt really find the difference!

thanks for nilu...
his only problem is he comes here!

haha

bye...

P.S: I tried liking ur blog. but have decided to stay away from commenting from now on! Not my place... But know that I am reading

tanuj solanki said...

I even tried doing things you would have secretly wanted me to do....comment slightly less wisely than you

How sheepish?

zen babu said...

Hmm...I have a feeling you think you know me better than you actually do.

zen babu said...

Abstract - Philosophy
Vague - poetry, esp. free verse

Gaurav said...

Get a room, you two.