Category: Economics

Anti-market bias, unemployment and immigration

Economist Bryan Caplan discusses the important topic of market-clearing wages. Why are wages not falling during the recession in order to establish equilibrium and full employment? Caplan gives an answer that seems common sense but receives little attention from professional economists and politicians.

Is labor market rigidity a market failure?  I’m afraid so.  But strangely enough, this market failure is largely caused by anti-market bias!  The main reason workers hate wage cuts is that they imagine that wage-cutting employers are satanically “unfair.”  If workers saw wage cuts for what they are – a full-employment mechanism – they’d sing a different tune.  While they wouldn’t be happy to see their wages cut, they’d grudgingly accept that a little wage variability is a fair price to pay for near-total employment security.  Once this economically enlightened perspective took hold, employers would eagerly cater to it – and the market failure would largely go away.

Bryan Caplan’s position may have implications that he may be reluctant to acknowledge. If the absence of widespread anti-market bias is a necessary condition for the proper function of the price mechanism, arguments that immigration can alter the cultural prerequisites for sustainable capitalism (let alone laissez faire) can no longer be dismissed as “nationalist” or “collectivist.” The potential for capitalism will become a function of the genetic and cultural traits of a population.

Theodore Dalrymple on the culture of inflation

In the Summer 2009 issue of City Journal Theodore Dalrymple  discusses the cultural effects of inflation:

asset inflation—ultimately, the debasement of the currency—as the principal source of wealth corrodes the character of people. It not only undermines the traditional bourgeois virtues but makes them ridiculous and even reverses them. Prudence becomes imprudence, thrift becomes improvidence, sobriety becomes mean-spiritedness, modesty becomes lack of ambition, self-control becomes betrayal of the inner self, patience becomes lack of foresight, steadiness becomes inflexibility: all that was wisdom becomes foolishness.

As a general rule, economists do not feel comfortable with cultural arguments. Often, this is not necessary because cultural arguments can be rephrased in technical language that economists do feel comfortable with. In the case of government-induced  currency debasement, the effects of these policies can be evaluated from an economic point of view by studying how inflation alters the incentives and behavior of economic agents. If Dalrymple is correct, the behavioral micro-effects (or even “pico-effects”) of unpredictable changes in the value of money deserve a lot more attention from economists than has been given so far.

Ironically, the cultural effects of inflation have received little attention from empirically-minded  progressive commentators but are increasingly discussed by conservative-leaning Austrian economists. For example, Jörg Guido Hülsmann writes:

The spiritual dimension of these inflation-induced habits seems to be obvious. Money and financial questions come to play an exaggerated role in the life of man. Inflation makes society materialistic. More and more people strive for money income at the expense of personal happiness. Inflation-induced geographical mobility artificially weakens family bonds and patriotic loyalty. Many of those who tend to be greedy, envious, and niggardly anyway fall prey to sin. Even those who are not so inclined by their natures will be exposed to temptations they would not otherwise have felt. And because the vagaries of the financial markets also provide a ready excuse for an excessively parsimonious use of one’s money, donations for charitable institutions will decline.

Similar observations can be made about Keynesian policies to stimulate “the economy.” With the exception of a handful of libertarian socialists, progressives do not appear to be bothered at all by economic doctrines that treat consumption for consumption’s sake as a remedy for economic ills.

Carl Menger and the exact science of economics

In Significance and Basic Postulates of Economic Theory (1938) Terence W. Hutchison presents a logical-empiricist perspective on economic methodology and takes specific issue with Austrian economists who believe that economic theories cannot and should not be falsified through empirical testing. In the chapter “The Application of Pure Theory” Hutchison criticizes Carl Menger’s view of what constitutes an “exact” science:

Menger contributed a further precision to this concept of economic laws, emphasizing what he and subsequent writers called their exactness, exceptions to them being inconceivable, and that “it involved a misconception of the foundations and postulates of the exact method” to test them empirically…To-day one can hardly help concurring with Schmoller that any worker in a chemical laboratory who proclaimed Menger’s conception of exactness would be ejected forthwith.

He also quotes John Elliott Cairnes on the methodology of economics as saying, “The economist starts with a knowledge of ultimate causes. He is already, at the outset of his enterprise, in the position the physicist only attains after ages of laborious research…”

Hutchison responds to his claim as follows:

It is possibly very encouraging for the economist to hear that compared with the natural scientist the psychological method saves him “ages of laborious research”, but it is curious and a pity that this huge start has not enabled him to formulate any considerable body of reliable prognoses such as the natural sciences have managed to achieve.

Hutchison does not completely dismiss the role of  a-priori reasoning in economics but objects to the idea that such reasoning exhausts the subject of economics. He quotes Ernst Mach on “laws” being “a limitation of what is possible.” If a law does not exclude or forbid any conceivable type of empirical occurrence than it  is not telling us anything about the world and, therefore,  such a science should be considered a pseudo-science. A similar complaint has been raised by Karl Popper about the all-accommodating nature of Marxism. The logical positivist writer Otto Neurath was of the opinion that, historically, metaphysical and anti-positivist thinking go hand in hand with the justification of oppression.

Much ink has been spilled over the question of whether the methods of the natural sciences are suitable for the study of economics. But even after 70 years since the publication of  Hutchison’s classic, economists who  have completely rejected empirical testing have contributed little of substance to the science of economics.

Keynes and the efficient market hypothesis

Over at The Money Illusion, Scott Sumner has posted a number of blog entries about John Maynard Keynes as an investor and how it informs the debate about efficient markets:

Far from refuting the efficient markets hypothesis (EMH), the story of Keynes’ investments actually supports the buy and hold recommendations of those who adhere to the efficient markets view, “stocks for the long run.” He did best when he didn’t try to time the market, and did poorly when he engaged in fancy speculative gambles during 1928-29.

It seems to me that one of the errors that many people (including some academics) make when discussing market efficiency is to assume that the hypothesis requires that all participants in the market are rational. Since this postulate so obviously contradicts empirical reality, it is argued that economic approaches associated with market efficiency (such as New Classical Macroeconomics and Real Business Cycles) must be flawed as well. But does the efficient market hypothesis really require such a strong postulate? Is it not enough to propose that rational individuals take advantage of the profit opportunities created by those who make mistakes?

Another flaw in discussions about rationality and efficient markets is that little attention is being paid to the question whether it can be rational to be irrational. As Bryan Caplan has argued in his book The Myth of the Rational Voter: Why Democracies Choose Bad Policies, the average  voter in a mass democracy does not have a strong incentive to be rational because irrationality is basically costless. Thus Caplan writes “irrationality, like ignorance, is sensitive to price, and false beliefs about politics and religion are cheap.” Linking rationality to incentives in this fashion offers the prospect for a reformulation of classical economics that can lead to improved insights into the observation that we see so much variability in the applicability of the strong rationality postulate.

Of course, the case against efficient markets is of little practical interest unless it can be argued that something meaningful can be done about it. Government intervention seems to be of little use if the incentives that shape and maintain irrational behavior apply to collective choice as well; instead, we should expect them to be worse for reasons that are unique  to government (monopoly, the absence of price mechanisms, the prospects of redistribution etc.)

Animal spirits in public policy

In the Summer 2009 issue of the Independent Review, Arnold Kling reviews George A. Akerlof and Robert J. Shiller’s new book Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism. Reading his review, one wonders how it is still possible for a serious scholar to make a case for more government intervention by simply documenting all the ways in which actual human behavior differs from the (strong) rationality postulates of classical economics. As Arnold Kling points out, and this must be getting quite tiresome, why assume that these same “animal spirits” do not inform and shape public policy as well? It is not hard to imagine a book that uses politics and government policies as illustrations of irrationality, conformity, and unfair decision making. As a matter of fact, current government responses to the financial crisis should provide a wealth of examples for numerous volumes about “politicians in panic.”

What might be more illuminating from a scholarly perspective is to investigate how different incentives and institutional environments produce lesser and greater diversions from the postulates of rational choice. A focused contribution to investigating these topics has been made by the economist Bryan Caplan, culminating in his excellent, and courageous, book, The Myth of the Rational Voter: Why Democracies Choose Bad Policies.

Of course, purists will rightly argue that the case of Akerlof and Shiller is dead on arrival because no prescriptive statements can be derived from their detailed descriptions of irrational behavior without accepting the authors’ own outlook, in their case expressed in the metaphor of society as a family in which the government behaves as the parents. The use of this metaphor sheds an interesting light on how some modern liberals view society as an extended family.