Does reality have a closed-form solution?

Yesterday I listened to a very good talk by Boris Gershman of American University as part of George Mason's Public Choice Seminar Series. The title of his paper is "The Two Sides of Envy", basic premise being that envy can be either productive ("keeping up with the Joneses") or destructive, causing malicious destruction of others' property. He then outlines a mathematical model using parameters like quality of property rights enforcement and cultural feelings about inequality to explain how either productive or destructive equilibria can come about.

A good paper, I would say. But, the part that inspired me to write this blog came at the very start, when Dr. Gershman was describing his assumptions. He said something like (paraphrasing) "assume that production as a function of time is linear and increasing. This allows us to find a closed form solution."

In mathematical jargon, "closed form" basically indicates an expression in the form of some equality:

Y = (whatever)

which can be complex, but in practical terms, is solvable and can produce some tangible answer. Closed form expressions are nice when you're writing a research paper because then you can derive some optimum or equilibrium (whichever you happen to be interested in) and therefore have a nice clear result to present at the end. If a problem lacks a closed form solution then it requires some sort of computer modeling or other difficult method in order to analyze it, which is a lot less satisfying.

These simplifying, closed-form-generating assumptions are all very well and good for the realm of pure theory. But we know that in the real world, production clearly is not linear with respect to time: going from 0 to 1 hour of work produces much more than going from 8 to 9 hours of work. The production function is concave for pretty much every industry in existence:

So what does this do to the model? Suddenly there are no closed form solutions. Everyone's optimum becomes incredibly difficult to calculate, and the existence of any equilibria much more difficult to prove. And this is just one example: introducing non-linearity into other parameters as well creates an even more tangled skein for the theorist to unravel.

For the most optimistic Neo-Classical economists, ideally economics would be a science like physics, which can express and predict human behavior with a set of equations. In the last 50 years that goal has been shown to be increasingly unrealistic but many brave micro-theorists still persist to this day, although their hopes have no doubt been tempered with experience.

So, although the paper by Dr. Gershman is very nice and the technique is strong, I wonder how much it helps us understand human motivation beyond saying envy can be either productive or destructive - a fairly intuitive result which hardly needs mathematics to express it - when the quest for a closed form solution makes its assumptions so divisive with reality.

Broken Window Fallacy: Beijing Edition

It seems like the media finds new ways to be wrong about economics every day, but really, they've been recycling the same fallacies for hundreds of years now. Bastiat's "broken window" fallacy seems an especially popular one, particularly when there's a natural disaster of some sort.

To summarize the fallacy: a punk kid throws a rock through a store-owner's window. The public disapproves, but a few "wiser" souls look on the bright side: "well, now the owner has to buy a new window, which creates business for the glazier, so it's actually good for the economy that the window was broken." Quick, someone give that kid a medal!

Of course, what this ignores is that the money which could have been spent on something else (a new suit, a nice dinner...) for the store-owner is instead spent on a new window, plus society has lost the value created by the window before it was destroyed. Destruction of useful property is just that -- destruction -- and cannot be good for the economy.

And this brings us to Beijing, where record air pollution has forced many to stay inside, grounded flights, and otherwise disrupted daily life and public health. But, as the FT is quick to point out, it has a "silver lining" for one part of the economy: companies which produce air filters.

To the FT's credit, it does not suggest that this will boost the GDP for Beijing, and the "silver lining" rhetoric is forgivable... An article titled "Beijing smog offers nothing of value, causes great inconvenience" might not inspire so many clicks. They also emphasize the adverse distributional effects:

...anger is exacerbated by the fact that China’s unelected leaders provide themselves with modern air purifiers that each cost about 1½ times the per capita annual income of Chinese urban residents.
For those who can afford the purifiers, the toxic air has sent them running to buy such machines, leaving most vendors out of stock until the end of February.

Almost sounds like a broken window corollary: when everyone's window gets broken, those with the most power and influence get theirs replaced first.

Hardly a phenomenon unique to China of course... I would guess that a thorough investigation of rebuilding after Hurricane (wait, Tropical Storm?) Sandy might find the same pattern in which buildings got the fastest response. In this respect, cynicism about political economy is the great equalizer.

Social media debacle for ALDO Shoes

Yesterday ALDO featured an online sale, with a promotion code giving $10 off any order plus free shipping. Today, apparently, they're rethinking that decision after seeing the predictable result: the code was distributed on a deals site, and lots of people ordered items in the $12-$15 range to get them for $2 to $5.

I'm guessing about 10,000 people just got a terse note like this one: "we unfortunately realized the promotion code you applied was only valid on footwear and was not valid on accessories or handbags. As a result, we regretfully had to cancel your order." Unfortunately, indeed.

Obviously a clever web developer could have set up their shopping cart system so that the coupon code could only be used in the "Shoes" category, but they didn't. So now a bunch of hopeful consumers are having their hopes of a good deal dashed the day afterwards. I wonder how much money ALDO stood to lose from this technical screw-up to justify committing such a customer service faux pas?

Here's a snapshot of the carnage on ALDO's Facebook right now:

...And it continues. The entire page reads like a social media strategist's nightmare.

The bland, "sorry for the inconvenience..." boilerplate replies don't help much either. It's not an "inconvenience" -- that would be something that happened by accident. The decision to cancel everyone's order was clear and deliberate, so some genuine contrition might be in order for wasting lots of people's time and energy.

Social Media 101: own up to your mistakes. Right now people just aren't buying it. My own impression of ALDO as a company, while non-existent before, is now purely negative. On the plus side, if I ever publish on social media strategy again, I've got another "what not to do" example ready and waiting.

A Tribute to "Hard Green"

Popularized by Peter Huber, "Hard Green" is the title of a book as well as somewhat of a mental paradigm combining great optimism for future technology mixed with great disdain for traditional environmentalists. I'm no biologist so I won't go into the science of it, but it's worth reading for the rhetoric alone.

In particular, this passage cracks me up every time I read it:

We can go it alone. We need energy, nothing more, and know how to get it from many more places than the plants do. We don’t need the forest for medicine; as often as not we need medicine to protect us from what emerges by blind chance from the forest. We don’t need other forms of life to maintain a breathable balance of gas in the atmosphere or a temperate climate. We don’t need redwoods and whales at all, not for ordinary life at least, no more than we need Plato, Beethoven, or the stars in the firmament of heaven. Cut down the last redwood for chopsticks, harpoon the last blue whale for sushi, and the additional mouths fed will nourish additional human brains, which will soon invent ways to replace blubber with olestra, pine, and plastic. Humanity can survive just fine in a planet-covering crypt of concrete and computers. (Huber 2000)

Quality of life inside a "crypt of concrete and computers" aside, I'm sympathetic to this view. The greatest resource is still human ingenuity; nearly everything else can be replaced. However, lots of people seem to enjoy looking at or interacting with nature, so it's probably worth saving for its consumption value, at least. Deep ecologists, gnash your teeth.

Immigration and median income

Reading The Progress Paradox: How Life Gets Better While People Feel Worse. I'm only two chapters in but I already like it a lot. Gregg Easterbrook is very insightful and rather pithy ("if you torture numbers long enough, they will confess to anything.") He also has an interesting perspective on the debate over "stagnating median income" in America.

He writes:

for each of the last twenty years, the United States has accepted more legal immigrants than all other nations of the world combined, along with a huge influx of illegals... The result of wide-open borders is that today 11 percent of the United States population is foreign-born, the highest proportion since the 1930s. Immigrants start at the bottom of the income bell curve, and in statistical terms their main impact is to pull down the numbers for the median household...
Among the 89 percent of the American population that is native-born, inequality is declining, not increasing - a trend driven in no small part by the rising incomes of African Americans, most of whom are native born and whose family median incomes are currently rising twice as fast as family median income for the United States as a whole.
...if the existence of an inequality gap is an indictment of the American economy, then the solution is to forbid immigration. Such a policy would impose grave hardships on poor immigrants. If inequality statistics are bad and the solution is a policy that would impose grave hardships on the poor, the point of absurdity has been reached - which shows how weak the whole inequality-gap objection is in the first place. (pp. 10-12)

Lamenting the death of the middle-class is an easy way to make political hay, but unsurprisingly, its relation to reality is tenuous at best. Easterbrook does an excellent job of exposing why this argument is so fallacious.

The general message: life in the developed world is getting better for almost everybody, at varying degrees of speed. The overall goal of Easterbrook's book is to explain why people continue to feel their situation is bad when it is measurably improving by all objective measures. I may return with another post more directly regarding that topic soon.

Is a revolution in economic policy coming?

I'm reading The Soulful Science: What Economists Really Do and Why It Matters by Diane Coyle. I think it's a successful book in overviewing many interesting aspects of contemporary economics. The goal is to increase public understanding and access to the economics profession, although unfortunately, I suspect that most of its readership will be economists...

The part I particularly like is toward the end, when Coyle is discussing the advances in econometric technique over the last thirty years. She goes on to boldly say

I predict that during the next ten years the astonishing mapping of our societies taking place now, using modern econometric techniques and new data sets, will start to have a revolutionary impact on public policy. The availability of solid empirical evidence on an array of social issues is, however, going to make economics very controversial... A lot of sacred political cows are heading for the slaughterhouse. The buzz phrase in policy wonk circles these days is "evidence-based policy"... What if the evidence suggests you should overturn your old policy? 

She continues:

...the "what works?" agenda of empirical economic research is one of the most pressing challenges facing the modern world today.

I wholeheartedly agree, and its this belief which has driven me to graduate school and various efforts to increase my ability with econometric technique (although the prospect of vast future wealth doesn't hurt, either). However, I'm a little more pessimistic about the role of "evidence-based policy" in overturning current policy.

It seems to large extent, politicians (and by extension, voters) don't care whether policy achieves its stated ends. Rent control has not made apartments more accessible in NYC; foreign aid has not overcome the trap of poverty in Africa; various restrictions on immigration have not improved the prospects for American jobs. Instead, these policies make people feel good because it seems that we are confronting the problem.

Basically, I'm arguing that policies are expressive rather than functional. The challenge then is not just for economists to provide better evidence for what works and what doesn't, but also to shift the way that policies are evaluated so that the "what works?" agenda is even on the radar. Technocracy seems to be unpopular, for some reason...

Capital Gains Taxes -- Impediments to Growth

Part of the recent debt deal has involved an increase on capital gains rates, and the arguments raised by conservatives against this plan are decidedly lackluster. They should go back and read George Gilder's Wealth & Poverty (1981).

Gilder argues the biggest division in society is between entrenched industries and the competitors who will eventually replace them with newer and more efficient technologies. Regarding capital gains, he says

Although large companies naturally will benefit most in absolute terms, cuts in the tax on capital gains are a redemptive boon to companies that expect to grow fast, that is, new and innovating companies. Capital gains are the chief source of new wealth in a capitalist economy... This tax constitutes a big business protection act - a defense of large companies against small, old wealth against new, the past against the future. But so-called progressive politicians bitterly resist its removal from stocks... Yet most real wealth originates in individual minds in unpredictable and uncontrollable ways. 

I think this is much more convincing than the double-dipping argument we hear so often instead, which has largely become a red herring. Only 54% of Americans own stocks (a historic low) and most of them are in retirement accounts, where double-dipping is largely avoided anyways.

The real damage done by capital gains taxes is deterring risk taking in young companies, which represent most of the wealth-creation in a capitalist economy. Sometimes it pays to go back to the classics. Apparently Reagan gave copies of Wealth & Poverty to Senators and Representatives regularly; maybe the G.O.P. leadership should revive that practice. It might liven up their press conferences a bit.

From Brian Z. Tamanaha's "Failing Law Schools"

The book is a pretty scathing indictment of current law school practices from tuition, to faculty work loads, to the quality of education offered.

One passage I found especially interesting, under the heading "The Unexpected Parallel Between Liberals Today and Elites of Yesteryear":

Liberal law professors today would doubtless condemn the elite-dominated ABA at the turn of the twentieth century for raising the cost of legal education in a way that restricted access by the poorer classes to the profession. Economic barriers to the legal profession are once again a central issue in a fight over the regulations that govern legal education. This time liberal law professors, in the name of high-quality legal education and fairness to colleagues, are the ones staking out the higher-cost position. Both then and now, arguments were couched in claims of being for the public good. One difference is that the elite bar then was consciously aware that they were restricting access (for what they thought were legitimate reasons), whereas law professors today apparently have blinders on that prevent them from seeing this consequence.

Strong stuff!

The Multiple Political Selves Model of the "Fiscal Cliff"

Back in 2011, the deal for raising the debt ceiling was supposed to make Congress compromise on a budget before 2012. But why expect a more reasonable Congress to materialize just because a year has passed?

This reminds me of a model from the behavioral economics literature: multiple selves in intertemporal choice. Its purpose is to explain various anomalies in consumer choice. For example, why do people so often buy a gym membership, and then never attend? Why do various self-disciplining devices, like "Christmas clubs" or collaborative diet plans (e.g. Jenny Craig) exist?

Basically, the theory goes, people treat a future version of themselves as an entirely different person, a person which (typically) is much more far-sighted and self-restrained than the person they are today. This explains why procrastination is so common: present-me doesn't want to do the work, but certainly future-me will! Of course, when the future becomes the present, the exact same logic causes the unpleasant task to be shifted forward even more.

It seems that in American politics we suffer from a multiple political selves problem. Current Congress may be too divided to reach any reasonable deal, but surely future Congress will be wiser and more restrained... But it's not.

This is why the fiscal cliff "deal" involves a two-month delay on the funding cuts which have everyone so up in arms. Sadly, we'll still have all the same nincompoops in Congress when that deadline rolls around as well.

Personal procrastination is a bad habit, but political procrastination is even worse. There's a case to be made that Congress should just pass some budget deal, even if it's not the best one, just to quiet market uncertainty. Unfortunately, continued delay seems the most likely outcome. The year changes, the politicians still stay the same.