Brad DeLong Says Economic Theory Does Not Exist
In a column that ran today in the Project Syndicate, Brad DeLong said this:
One of the dirty secrets of economics is that there is no such thing as “economic theory.” There is simply no set of bedrock principles on which one can base calculations that illuminate real-world economic outcomes. We should bear in mind this constraint on economic knowledge as the global drive for fiscal austerity shifts into top gear.
Unlike economists, biologists, for example, know that every cell functions according to instructions for protein synthesis encoded in its DNA. Chemists begin with what the Heisenberg and Pauli principles, plus the three-dimensionality of space, tell us about stable electron configurations. Physicists start with the four fundamental forces of nature.
Economists have none of that. The “economic principles” underpinning their theories are a fraud – not fundamental truths but mere knobs that are twiddled and tuned so that the “right” conclusions come out of the analysis.
I am of two minds about this. I certainly feel that the beautiful economic theories that have been created with the help of some serious mathematics in the last few decades have yielded valuable insights. Yet on the other hand, these insights are far from telling us unambiguously important things about economic reality and from giving us good recipes for economic policy. I don't even feel we understand, as economists, how such a basic thing such as economic trade can emerge, based on trust among people. So we have ended up with "theory" as a plaything of political interests. For such reasons, I share DeLong's frustration. Yes, Paul Seabright has written the wonderful book The Company of Strangers, but still we don't have a good grasp of the fundamentals of economic trade at the level of really basic theory! Naturally, I am trying to do something about this in ongoing research with my long-time collaborator, Rob Gilles, or I would not be justified in airing my complaints on this theoretical lacuna.
But is it really beauty and some insights of doubtful empirical relevance versus abandoning all hope of having an economic theory? I sincerely hope not. We have, in game theory, the mathematical theory of networks, and in the technology of simulation, some tools that should allow us to build a better theory. One that, although it will always be subject to criticism and will always create the longing for something better, will not be so easily dismissed as nonexistent by a leading economist.
I understand that DeLong is concerned about macroeconomics and one can read his nonexistence claim in terms of macroeconomic theory. But that is a cop-out. If we had a good theory of economic fundamentals, we would be able to build an, at least existent, theory of macroeconomics, by DeLong's standards. So I addressed my remark here to basic economic theory, not its macroeconomic special case.
Site status update
- The Public Economics page is under construction and I will be filling out the other pages soon.
- I have added to Links I Like (on the right) a new site, A Fine Theorem.
- Regular weekly posts are starting this week.
A good example of the importance of incentives
Well, make this a bad example if you must. It is an example of bad incentives that produce bad outcomes. I am referring to the article by Bebchuk, Cohen, and Spamann in the Project Syndicate web site, in which the authors discuss the compensation of the executives of Lehman Brothers.
The article discusses a report by a court-appointed examiner on the finances of Lehman Brothers prior to the bankruptcy of the company. The report shows that while the shareholders of Lehman Brothers lost plenty of money in the bankruptcy, the executives managed to stay in the black, because of the structure of their performance-compensation pay contracts.
The authors point out that the ability of executives to make lots of money by pursuing highly risky strategies and their ability to avoid losses when their risky strategies lead to financial disaster are very bad news for the shareholders. This is the point I want to emphasize here. The shareholders, the owners of the company, gave bad incentives to their managers, and once a fiscal panic came about, the owners lost big.
But they were not the only ones to lose. The risky actions of executives such as those at Lehman (and they were not the only ones to be overly aggressive in taking risks) magnified the financial panic, once it had started, which resulted in the major recession we are still enduring. All of us lost.
Bebchuk, Cohen, and Spamann conclude that executive compensation schemes should be changed to give executives better incentives. This is certainly correct but it does not go far enough. Since the bad incentives created by such pay structures affect everybody, it is really a general reform of the mechanisms for performance pay throughout the economy that is indicated. Mechanism design theorists have the tools to suggest possible solutions. These tools are not a panacea, but they would certainly result in a safer financial system if applied carefully.
The biggest problem is probably political. As the Democratic administration moves to consider financial reform, after getting health reform passed, the Republicans are likely to resist meaningful reform. This is a basic issue with all mechanism design. Indeed, mechanism design theory starts with the assumption that a plan on how the system should be made to work has been agreed upon by society and the remaining problem is only technical: how to give people the right incentives so that the plan is achieved. This, and the reliance of mechanism design theory on classical game theory with its hyper-rational model of players, are the two biggest hurdles in coming up with mechanisms that deliver optimal incentives.
The degradation of US democracy
Read this post by Daniel Little and weep. If you care about democracy and the public good, that is. This kind of thing is a main reason that standard economics has done a serious disservice to humanity by emphasizing the private motivations of individuals and not studying public mindedness and the "public good" in general very much. We can still hope to make strides to reverse this inattention to publicness in economics and also in the political sphere. At least, I sincerely hope so.
What chess champion Gary Kasparov can teach us
Recently, Gary Kasparov wrote an essay about humans and computers playing chess, under the guise of a book review. Andrew McAfee today published an essay on Kasparov's ideas, with a specific focus on one observation by Kasparov.
Kasparov noted that recent matches have shown that weak human chess players with computers can beat a chess supercomputer, and, in addition, a chess grandmaster with a computer but a weak organization of the human-computer collaboration. In Kasparov's words,
Weak human + machine + better process was superior to a strong computer alone and, more remarkably, superior to a strong human + machine + inferior process.
McAfee starts from this and says that Kasparov may have stumbled upon a better model of business processes. From my point of view, I see Kasparov's insight as one example of the great benefit to be gotten if we can only adapt mechanism design theory to capture the fuzziness of humans and the precision of computers, acting in tandem, better. (I think there are many examples to urge us to change mechanism design towards more human-compatible decision-making models, on which I plan to blog more.)
I am making no grand claim that I know how we can approach this goal. I am simply noting that it seems a very worthy goal, one that I would rather see research in mechanism design aim for. Instead, the current thrust of the mainstream mechanism design research seems to be to get more and more refined mathematical results based on the assumption that the actors in the mechanisms studied, whether human or computer agents, behave with the precision of computers. I am aware of some work that attempts to introduce errors in the decision-making of agents in mechanism design theory, such as work by Kfir Eliaz, but I would certainly love it if more of the very clever mechanism theorists attacked the fuzziness problem head on.
Let us not leave the topic of a better business process to Harvard Business Review articles only. Some Econometrica articles on it, please.
Posting hiatus to end soon
A bit backed up by the semester's start and snow blizzards, but I intend to post more soon and also to expand the pages on mechanisms, public economics, and networks.
Incentives matter and monopolies are terrible
Monopoly (or near monopoly) is always very bad for consumers. Check out this article from OSnews.com about Intel's compiler that goes to some lengths to handicap non-Intel processors. I got more and more thankful for the free software folks (think GNU compiler) and all open source contributors as I was reading this. Yes, I am writing this on an iMac that has an Intel processor. I wish I could fight monopolies effectively on my own...
Academic textbooks and healthcare incentives compared – Boing Boing
The always interesting Boing Boing blog has a long post on the market for academic textbooks and makes explicit comparisons of the incentives in this market and in the U.S. healthcare system. I won't quote from the article, as it is good enough for me to recommend you to read it in whole, along with the comments, several of which are good also. I will say that I am making some progress in this area, having for the first time given students several weeks' notice about the textbooks I am going to use in the upcoming spring semester. Next year, I will try to substitute some creative commons sources for textbooks, but it will be hard, and very hard for my graduate courses.
Lecture Notes on Dominant Strategy Implementation
Rather later than I was hoping, I am posting my lecture note on dominant strategy implementation. The notes are for my graduate microeconomics course at Temple University, and the book referenced is my book A Toolbox for Economic Design, co-authored with Karen A. Campbell, Emina I. Cardamone, Scott Deacle, and Lisa A. Delgado. The book covers this topic in chapter 2.