I’m starting now on what will I think be the hardest and most controversial chapter of my book – the argument that the search for a macroeconomic theory founded on (roughly) neoclassical micro, which has been the main direction of macro research for 40 years or so, was a wrong turning, forcing us to retrace our steps and look for another route. As always, comments and criticisms accepted with gratitude.
Refuted doctrines
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Micro-based macro
We are now all Friedmanites, Lawrence Summers, (former US Treasury Secretary, now Director of the White House’s National Economic Council, and prominent New Keynesian economist) and
At the end of the 19th century, British Liberal politician Sir William Harcourt observed “we are all socialists now”. Harcourt was referring to a radical land reform measure that had been denounced as socialist when it was introduced, but was generally accepted by the time he was speaking (a couple of years later). Harcourt’s point was applicable to the whole trend of economic and social policy, in Britain and elsewhere, from the 1867 Reform Bill that gave millions of working class men the vote (women had to wait until after World War I) to the crisis of the 1970s. From progressive income taxes to publicly-owned infrastructure services (both prominent items in the 10-point program of the Communist Manifesto)) ideas that were unthinkable in mainstream politics became issues of political contention and then established institutions.
As a pithy summary of the way ideas that were once radical become acceptable, and are ultimately embodied in conventional wisdom, Harcourt’s quip has never been bettered. As a result, it has been reused many times over.
One of the most notable adaptations of Harcourt was that of Time Magazine in 1965, which noted, following the successful use of fiscal policy to stabilize the economy that “we are all Keynesians” now. This statement was made by Keynes’ greatest modern critic, Milton Friedman (though he later said it had been taken out of context). Even more famously, it was repeated by Richard Nixon in 1971.
But whereas Harcourt was speaking at the beginning of a nearly a century of reform that did indeed take economic policy in a socialist, or at least social-democratic direction, Nixon’s statement marked the end of the era of Keynesian dominance.
In fact, Nixon was citing Keynes’ aversion to the gold standard (a “barbarous relic”) as a justification for abandoning the pegging of the US dollar to gold, which was a central feature of the Bretton Woods system of fixed exchange rates that had underpinned Keynesian economic management since World War II. The outcome was not a system of stable exchange rates backed by a basket of commodities rather than gold, as Keynes had proposed, but the complete breakdown of Bretton Woods and a shift to the floating exchange rate system advocated by the greatest critic of Keynesian economics, Milton Friedman.
In the course of the 1970s, Friedman and his supporters, centred on the University of Chicago, won a series of political and intellectual victories over the Keynesians. Following the failure of attempts to stabilise the economy using Keynesian fiscal policy, governments around the world switched to Friedman’s preferred remedies based on controlling the growth of the monetary supply. Even though this did not work particularly well, and was later replaced by policies based on managing interest rates, the resurgence of the Chicago School was not reversed. Their case against government intervention, both to stabilise the macroeconomy and to address market failures in particular industries, was widely accepted.
The Keynesians conceded Friedman’s central points: and that macroeconomic policy can affect real variables, like the levels of employment and unemployment, only in the short run. They sought to develop a ‘New Keynesian’ economics, by showing that, given small deviations from the competitive market assumptions of the basic neoclassical economics model, it would be possible to explain the recurrence of booms and recessions and to justify the modest stabilisation policies pursued by central banks during the Great Moderation. Because prominent representatives of this group were located at Princeton and Harvard on the East Coast of the US, and at Berkeley on the West Coast, they were sometimes called the ‘saltwater school’ as opposed to the ‘freshwater school’, located in the lakeside settings of Chicago and Minnesota.
Members of the freshwater school sought to push Friedman’s conclusions even further, arguing that macroeconomic policy could not be beneficial even in the short run. They tried to show that government intervention could only add uncertainty and instability to the economic system, and that, in the absence of such intervention, economic fluctuations like booms and slumps were actually good things, reflecting economic adjustments to changes in technology and consumer tastes. The resulting models went by various names, but the most popular was ‘Real Business Cycle Theory’.
Despite their often heated disagreements, saltwater and freshwater economists were in agreement on one fundamental point: that macroeconomic analysis must be based on the foundations of neoclassical microeconomics. And, although they disagreed about economic policy, these disagreements could be contained within a very narrow compass. With a handful of exceptions, both schools took it for granted that macroeconomic management should be implemented through the monetary policies of central banks, that the only important instrument of monetary policy was the setting of short-term interest rates and that the central goal of monetary policy should be the maintenance of low and stable inflation. Granting these premises, saltwater economists argued that stability could only be achieved if central banks paid attention to output and employment as well as inflation, while the freshwater school favored an exclusive focus on price stability.
The global financial crisis did not so much confirm or refute the elaborate arguments of the competing schools as render them irrelevant. The saltwater school could claim vindication for their view that the economy is not inherently stable, but their models had little to say about the kind of crisis we have actually observed, driven by an interaction between macroeconomic imbalances and massive financial speculation.
The freshwater-saltwater disputes were similarly irrelevant to the policy debate which was conducted in terms that would be familiar to someone who had not looked at an economics book since 1970. (In fact, the freshwater side of the dispute rapidly reverted to arguments from the 19th century, which had been debunked by Keynes and Irving Fisher).
As Gregory Clark of UC Davis observed ‘ The debate about the bank bailout, and the stimulus package, has all revolved around issues that are entirely at the level of Econ 1. What is the multiplier from government spending? Does government spending crowd out private spending? How quickly can you increase government spending? If you got a A in college in Econ 1 you are an expert in this debate: fully an equal of Summers and Geithner.’
If we are to develop a macroeconomic theory that can help us to understand, and hopefully prevent the recurrence of, crises like the current one, and help us to improve policy responses, economics must take a different road from that it has followed since the 1970s. The appealing idea that macroeconomics should develop naturally from standard microeconomic foundations must be recognised as a distraction. In its place, we must accept, in the language of systems theory that macroeconomic phenomena are emergent, arising from complex interactions of behaviors we do not fully understand, but must nevertheless respond to.
John Quiggin 
Michael,
There are over 30,000 registered financial institutions in the United Kingdom.
The UK government has effectively nationalised two large banks and about three or four smaller banks/mutuals.
If an investment banker at RBS can’t get a bonus, there are a lot of other places he can go to get it.
SocGen can agree on bonus caps – their investment banking and trading is headquartered in London and their private bank is split between London and Geneva. To give one example.
Dutch banks are not that large. Capping bonuses at 100% – well I am not about to say that is unfair. A 100% bonus is pretty f**king good.
SeanG, read widely don’t put the cart before the horse.
Michael,
I don’t need to read it – I live it.
SeanG, really.
JQ-There’s a huge gap there. You’ve got background more policy-oriented than theory-oriented, and then note that things have gone weird, and then jump into, “If we are to develop a macroeconomic theory…”
You might be right. It might be (as metaphor) we want to use quantum physics for the small stuff and relativity for the big stuff, and not worry too much about how they connect. But what you’ve written here so far definitely doesn’t make that case.
In the framework of systems theory, large-scale behaviors might be emergent, but knowing how the small particles interact is a good way to understand how the large system will work, you just have to be willing to make the connection.
There’s various places the microfoundations project could have gone wrong. It could have gone wrong in the micro-micro things which we think we can afford to overlook (likely things now in the “behavioral economics” bin) much of the time might “emerge” into things we can’t afford to overlook at the macro level. It could have gone wrong in connecting the micro and the macro, we may have simplified somewhere we shouldn’t.
I am wary of a macro without micro foundations. It seems like that way lies fuzzy intuition (which the occasional brilliant mind might intuit correctly), or purely empirical study without any theoretical grounding, in which case, I think we’re in for trouble because macro’s a pain to study empirically even with a theoretical framework.
@Michael of Summer Hill
I am being serious.
You talk about banking issues in Europe and the US. However, Summer Hill ain’t the City of London and Sydney is not New York. Australia’s banks have held up pretty well, it was not like the US and UK where the banks were about to collapse.
Yes SeanG, but maybe APRA has got something to do with promoting a stable financial system.
But SeanG, is ‘meta-regulations’ the answer?
There is no real “answer” because volatility, the business cycle, whatever the terminology – it is going to happen again. What matters is the structure surrounding the system. Do you have a strong structure, like Australia, where financial companies can collapse eg. Babcock, without causing systemic meltdown. Or do you have weak structures so one small fault becomes a gaping hole?
APRA – world’s best.
Now SeanG, if ‘meta-regulations’ are lax are you suggesting more government intervention?
SeanG, if you keep up all this reasonableness, logic, and empirical strength, you’re going to make them mad 🙂
Jarrah, SeanG is correct for the State is the main actor in ‘systems theory’.
@SeanG
You are also missing the point of Monetary policy Sean – yes it lowers the interest rates but as GDP expands interest rates rise anyway (yes, producing crowding out). It just happens that the net interest rate movement is down but again, that may not be the result if the increase in the Money supply is inflationary. Fiscal policy supposedly raises interest rates causing crowding out (again maybe and maybe not – depending on what the appetite for debt is like – it wont have that affect at all in a liquidity trap when people have little demand for additional debt). You also forget entirely that interest rates are not the only determinant of investment. Recall the accelerator Sean. Rising GDP caused by a fiscal expanion will add to demand and profits and give firms the wherewithall to invest from their own equity. Debt is only part of how firms fund expansion and a much overemphasised part by the “anti fiscal policy, lower taxes” minions out there.
Its about balance Sean, not tribalism. The shame of it all is, I even read the extremist nonsense and scaremongering anti fiscal policy in some textbooks now. Im not there to teach people a one eyed view of policy (this policy very very good that policy very very bad) and I wont. We have both if we need them. Do you only want one lifejacket in a boat? (Dont answer that you want none at all) I hope my students understand both policies, not just well, but really well.
Alice,
I am more than aware of the drawbacks to monetary policy. Although I did not mention it, it does not mean that I do not know about them.
Fiscal policy does impact both short-term and long-term yield curves and depending on the risk appetite at the time, the size of the deficit and government debt along with confidence in that specific country etc the size of crowding out is not constant. That is why I am not upset about the fiscal stimulus in Australia. Unlike the UK and Europe where it can lead to a crowding out stage, Australia has a different set of circumstances.
A company, say in software engineering, is not going to really benefit from the fiscal stimuli. It will be affected by interest rates because interest rates are cheaper than equity. The problem with the idea of fiscal stimulus is that it automatically assumes that everyone wins – this is wrong. Some win, others lose out.
I do not know your background (other than being a lecturer/tutor (?) and working for NSW Treasury (?)) but if you look at financial accounting and how investment decisions are made, you’ll see just how important cheap debt is for private firms.
@Michael of Summer Hill
State intervention is not the only answer because it is the means that differ. If you get the basics right – capital adequacy, risk management expertise, shareholder participation. Then you can have a crisis in one area of finance which will not lead to contagion across the entire system.
If you look at Germany and France with far more regulations than the US or UK, you note that neither country comes out smelling like roses. The German banking system is being propped up with massive amounts of government backing. French banks have been very badly hit in this crisis but because the French consumer banking sector cannot afford to purchase their own homes, they did not suffer from an erosion in their lending book and their insurance businesses i.e. French banks have survived because French society cannot take out too many loans because of stagnant wage growth.
Massive governent involvement does not automatically equate to financial sector perfection.
Australia is a good model. I’ll adopt it any day.
SeanG, not sure your analysis is correct for the French & German economies grew last quarter whilst the UK economy seems to be going down the slippery slope.
The German banks managed credit flows because they were backed by the German government. The French and German economies are less based on banking and finance than the UK. The German economy shrank by 5% p.a. but this is because they are export-orientated.
Maintaining credit flows, smaller banking sector vs. US/UK/Ireland/Iceland, investment-focused government stimulus packages have all contributed to having a comparatively short recession.
Their banking system is not broken like the US and UK but that is not to say that they are not damaged. I was not trying to make a negative comparison between the US/UK on one hand and France/Germany on the other. I just wanted to dispel the idea that their banking systems were brilliant when the Australian system is far better than other developed nation’s financial sectors.
@SeanG
Cheap debt has also impacted negatively on the private sector Sean G – who are leveraged to the hilt. What happened in Iceland ?? Cheap debt everywhere and one morning they woke up to a mortgage that doubled overnight. Cheap debt may be important for cheap businesses, Sean but there is absolutely nothing wrong with keeping debt manageable at higher interest rates….when the stronger businesses will survive and perhaps households dont go out and whack everything on the cheap debt credit card at Harvey Normans. No one can ignore the level of private sector debt we have now…and this must correct.
Cheap debt is part of the problem. I dont want businesses to survive if they can only survive on cheap debt. Cheap debt causes bubbles which must burst Sean. I purchased my first property on interest rates at 11%. I didnt notice the economy imploding around me – because it wasnt – and in many ways it held more opportunity for young people (better jobs, and cheaper housing).
So lets not talk too much about cheap debt shall we? Its not all about cheap debt which has its own pitfalls. Its about strong businesses who can survive higher interest rates and likely because have something decent to sell.
Those who need cheap debt and very cheap labour have no appeal to me (marginal businesses Sean – call in the creative destruction).
SeanG, the UK does have a very big problem attracting foreign investment, but you are correct our regulatory framework is superior.
@SeanG
Sean – you say
“State intervention is not the only answer because it is the means that differ. If you get the basics right – capital adequacy, risk management expertise, shareholder participation.”
Just tell me please…which major banks have got capital adequcy right? Risk management right? and shareholder participation right???
lately?
Very few and far more have got it all wrong. Australia may have done better precisely because of teh 4 pillar policy but even our banks didnt get these criteria of yours right…
So the basics arent right and more state intervention is needed (stating the bleeding obvious – financial sector regulation has apparently been on vacation in Butlins holiday camps for some time…).
@Michael of Summer Hill
This has been a long-term problem for the UK.
Considering the historical weakness of the pound, there is a wonderful arbitrage opportunity in the FX markets if you want to play a long-term game.
@Alice
I agree on the scale of consumer debt. It is very scary.
The big four and some of the smaller retail banks have got that right. Many of the Spanish banks had huge capital buffers so that despite the Spanish property market and economy virtually collapsing, they are still solvent.
The financial markets can spread huge amounts of risk to different banks. 4 Pillars is important, but if you look overseas with comparable competition policies – such policies are not the key determinant as to whether or not a bank survives.
If you want, Alice, you can interpret my comments about regulatory framework as advocating a good dose of discipline to the marketplace from government.
SeanG, I let Alice carry on for tonight but check the % drop in foreign investment over since last year and your jaw will drop.
@SeanG
Sean – I really worry about your loguc when you say ” Many of the Spanish banks had huge capital buffers so that despite the Spanish property market and economy virtually collapsing, they are still solvent.”
I really dont care about the Spanish banks being solvent when the Spanish property market has collapsed and the the economy has virtually collapsed.
Do you hear what you are saying Sean – the rest of the Spanish economy is in dire straits and peoperty has collapsed but the banks are OK??
Something wrong with this picture Sean.
Ill bet the banks now own the property and likely much of the economy. This is not good. Its unhealthy.
@Michael of Summer Hill
Moshie – you are gentleman! Im going to bed though though – so you take over!
@Michael of Summer Hill
I know exactly how much the Pound has lost vs AUD/EUR. If we are looking at a trend analysis we will see it at near-historical lows. Now the UK economy has sticky inflation so with QE at £175bn and massive government borrowing over the medium-term then interest rates have to eventually move back up to stem the potential for high inflation. So what we are looking at is the potential for Sterling to risk relative to Euro and AUD.
Now if one were to borrow in AUD, convert to Sterling and sit on that conversion for two years, then there is a good probability that the Sterling will be stronger than it’s current weak position. Convert back to AUD and reap the capital gains. Same thing with Euro.
It comes down to how long you want to keep the trade open and whether it is floating or fixed rates.
@Alice
18% unemployment, hundreds of thousands of houses empty… but the banks are still intact. You asked the question Alice, I gave an answer.
@SeanG
Sean – thats the problem. When the economy is apparently just the banks. That was Icelands problem as well.
My friend Bill K just phoned to read out an article in the Fin. An article about one Amory Lovins
http://en.wikipedia.org/wiki/Amory_Lovins
…but the article is worth reading as it refers to 1977 and what Lovins proposed at the time.
Talk about missed opportunities and false directions. Bloody hell!!!
@Alice
The issues are completely different. Iceland was massively overindebted – both banks and large corporates precepitating a collapse in the wider economy.
Spain has based on an unsustainable housing boom and tourism. The banks had nothing to do with it.
So who lent the money for the housing boom Sean?
Banks, finance companies, surprisingly large amount of pension funds and individual retirement accounts.
The construction firms cannot flog off the houses to British investors and capital dried up. Such is life.
John
I am not sure what the scope of the book you are planning is, but here is a two pennies worth from someone who is not an economist.
The single characteristic of economic theory that I have heard of (macoro, micro, whatever) that generates the most immediate, whiplash, saywhat!!! reaction from me when ever I have heard it is the description of human behaviour that seems to be the basis of economic’s theroretical structure – human being are full rational, well informed utility maximisers (or other formulations along the same lines).
Some professors from the Economics department should take the trip across campus to the Psychology department and run this idea past a Psychology Professor. After they have picked themselves up off the floor amid gales of hysterical they will proceed to show how this description of the human psyche has about 1 in a millions relevence to actual human nature
To use simplistic high school set theory terminology, Venn diagrams etc, Economics strikes me as being fundamentally the discipline that exists at the intersection between the Physical Sciences and the Psychological Sciences. Essentially what happens when the human psyche intersects with the physical world.
Now obviously analysing such a complex intersection is horrendously difficult, thus the need for macro theory, looking for emergent behaviour from the aggregate of vast numbers of components. But as a fundamental reality check, all economic theories need to be able to pass the reality check tests of ‘Do these conclusions conflict with our understanding of how the physical world works?’ and ‘Do these conclusions conflict with our understanding of how the human psyche works?’. And if the answer is no, the theory is wrong. Ultimately Economics is subordinate to Physics and Psychology.
So, when you start to use simplifications to try and make a theory usable, one of the key things you need to look out for is when the simplifications produce a reasonable approximation and when the produce total crapolla.
A classic example of how apparently reasonable simplifications can lead to wildly invalid outcomes is in Fluid Mechanics. The Navier Stokes equation is one of the most fundamental of equations describing the behavious of a fluid. It is a partial differential equation with several terms related to different properties of the fluid. And the equation cannot be solved analytically – it can’t be solved with pen & paper. It has to be solved computationally using computer grunt. And as my old Fluid Mechanics professor said (this was the 1970’s), for any serious problem, smoke comes out of the computer.
So people looked at the equation and realised that one term, the term referring to the viscosity of the fluid was, in virtually all flow situations, negligable. And if you removed the viscosity term from the equation, lo and behold, it was now pen & paper solvable – you bewdy.
When the simplified equation is applied to various flow situations, the result is nice regular, symetrical, smooth and even flow. Which bears absolutely no similarity to real flow, all swirls, vortices, turbulence, water hammer and all sorts of things.
So how could an insignificant term actually have such a huge impact. The answer lies in the phrase ‘virtually all flow situations’. In the tiny set of flow conditions where viscosity is significant, what happens is that the impact of the viscosity term generates effects that then cascade out through the bulk of the flow, generating mass disruption and rendering the simplified analysis totally null & void.
What has this to do with Economics? When you are trying to aggregate many components to determine the macro behaviour of something, you need to be aware of situations where aggregate behaviour can’t be determined by some average of the micro behaviour because the micro behaviour can be wildly variant, chaotic and just plain weird.
And since Economics is based on the human psyche, irrationality, and just plain weirdness will often prevail; inaccuracies in how we model that psyche can have vast consequences – Lehmann Brothers found that out.
Another small point. The economic concept of defining something as ‘an Externality’. Until Economics addresses the reality that its models are wildly incomplete while somethings are regarded as external, Economics will continue to generate consequences such as Global Warming, Species Extinction. The Tragedy of the Commons in all its many forms. A theory that has ‘Externalities’ is a wildly incomplete theory.
Obviously attempting to build a theory that can encompass all these complexities is one of the most complex undertakings imaginable. But I get the sense that too much of Economic thinking does not adequately recognise how wildly inaccurate simplified theories can be. Any theory must be tested against the real world, and in particular looking for whether the theory will produce reasonable approximations to actual reality, or wildly innaccurate outcomes.
As with any therorising, test against the evidence or its just speculation and sophistry. And if it fails the test, bin it.
Glenn Tamblyn,
You misunderstand the term ‘externality’.
The best definition I found is in Blad and Keiding*. An externality occurs when the action of one agents reduces (negative externality) or expands (positive externality) the choice set of another agent. In short, if the potatoe growers decide not to sell to psychologists then those psychologists who want to eat potatoes can’t do that anymore. Now you will say this hasn’t happened and therefore, by your methodology, my ‘theory’ should be rejected. I’ll say, well we have the institution of a market, which works for potatoes (sellers of potatoes don’t – as yet – ask for the professional background of potential customers). This institution has a philosophical (and psychological) basis. But this institution, a market, does not work for air, water, soil and acoustic pollution.
Perhaps the foregoing is sufficient to indicate that your statements about economics are possibly an example of ‘bounded rationality’ (due to information asymmetry) on your part.
*Reference will be supplied upon request.
Glenn Tamblyn’s arguments makes a lot of sense. Ernestine, Glenn can be read as essentially pleading (in the legal sense) for negative externalities to be included in the cost structure of the market. Obviously, this requires legislation (a regulated market) as free markets tend to cost goods but not “bads” (as I inelegantly term them.)
What Glenn might or might not understand is that the term “externality” is often used academically in a descriptive sense and not in a normative sense. It is an expression of “that’s how it is by current default” but not necessarily an expression of “that’s how it should be”.
Mind you, standard capitalist economics (I’ve avoided saying neoclassical) has pretty much swept the negative externalities issue under the carpet for about 150 years. It has been convenient and possible to ignore it up to now. We no longer have that luxury. In fact, we lost that luxury about 30 years ago but ignored the warning signs. Now we are in the “Age of Consequences”.
Ikonoclast, I completely agree that legislation is required to ‘internalise the costs of externalities’. However, I believe it is up to the public to express a demand for such legislation. Incidentally, I find JQ’s blog interesting and useful because of the many different intellectual inputs. As such I believe it helps to reduce the information gaps which have developed with specialisations of specialisations.
@Ernestine Gross
Externality – according to the stock standard def taught to first years – is a cost or benefit of production imposed on a third party who is not a party to the transaction between buyer and seller that gives rise to the externality. In short its a blind spot in the pricing mechanism because some costs of production are not included in the price and are being carried by some external hapless individuals (negative externality) – such as disposing polluted by product into a river system and ruining the rivers productive capacity for others result in lower prices for polluting firm (than if correct costs of responsible environmentally friendly by product disposal included). So, the poor fisherman downstream loses his catch to the sneaky river polluting woodchip plant.
But according to Ikono modern capitalist economics (those neo whatevers) refuse to acknowledge that market failure even exists. The source of the great divide. Of course, if market failure exists its an argument for intervention but as long as we continue to deny the existence of market failure, the pollution problem gets worse and no one is obliged to produce or bear any regulation to fix it. Find me an exec in big Coal or big Oil who believes in market failure and Ill pay a $10 spotters fee immediately. Im am pretty sure though we could find the Tasmanian tiger first.
Alice, true, the text by Blad and Keiding is an advanced economic theory text rather than first year undergraduate. I find their definition of the idea of an externality better because it does not exclude externalities in consumption (eg, drinking, eating and smoking in a lecture theatre). Further, I found the Blad and Keiding definition easier to work with in my own work on the ‘internalising transport noise externalities’ (ie to derive a measurable variable). The Blad and Keiding definition is clear and well defined in the conceptual framework of mathematical economics. This helps to derive measurable variables.
@Ernestine Gross
Yes – I dont like those sort of examples either Ernestine. Ive seen some dreadful examples given of externalities in undergrad texts that leave the students even more befuddled (along the lines you mention – smoking in a lecture theatre etc).
@Ernestine Gross
An externality occurs when the action of one agents reduces (negative externality) or expands (positive externality) the choice set of another agent.
This is not at all the normal definition of externality in economics. It appears to make everything an externality with there even being externalities in a two person world. If X sells to Y at a price P* then there is an externality relative to the sale having taken place at a different, even if mutual beneficial and agreed on, price. Changing choice sets can be irrelevant as far as externalities go, in economics, when individuals are indifferent between the changed choice sets. Have you got the word for word quote from Blad and Keiding?
Freelander @40
Here is the quote from Blad and Keiding:
“The fundamental common feature of all types of externalities is that the acts of one agent affects the set of feasible acts of other agents. The result may either be that the other agents obtain a larger set of possible choices – in this case we speak of a positive external effect – or they experience a reduction in their possibilities of choice, a negative external effect”. Blad and Keiding (1990, pp 253-4)
The Blad and Keiding definition allows a distinction to be drawn between ‘costless’ externalities (I ignore positive externalities for convenience)and ‘clostly’ externalities. Only those reductions in an individual’s set of possible choices are ‘costly’ which are excluded from the set of ‘at least as preferred as’ possible choices. For example, if i prefers to sleep until 7:00 am but can’t because transport noise wakes i at 6:00 am then his set of feasible choices is reduced and it is costly to i. But if i leaves the house at 6:00 am when transport noice starts, then the ‘reduction in the choice set’ is not costly to i.
Ikonoclast, Ernestine, Alice (& JQ if you are listening in)
When I used the term Externality I was in a sense referring to what I see as one of the core objectives of Economics – the development of tools to help prevent The Tragedy of the Commons. We are coming to the end of the first decade of what I believe is the make or break century for Humanity, our Crisis of Survival, for a whole host of reasons. And the Tragedy of the Commons is at the heart of our predicament
What matters here is what I see as a problem with setting system boundaries. If I make a decision to undertake some act, purchase something or whatever, I will have some scope or domain over which I consider the ramifications of my possible choice. Having made my choice and acted, there may well be a different scope over which the consequences of my choice are played out. For example, if I am an American who likes driving my SUV, I might buy biofuel for my car. That fuel may be derived from Palm Oil plantations in Indonesia (one of the all time dumb ways of producing biofuel by the way), grown on land that has been cleared of rainforest, destroying habitat for the Orangutan, possibly contributing to its extinction.
The scope of my decision may extend to whether I think that using biofuels is a good idea, but the consequences of my choice reaches out further to the ethical, aesthetic and existential costs of a species extinction.
If I drop some litter, that is a tiny example of the Tragedy of the Commons, but one I have engaged in knowingly. The appropriate response is laws to punish me or actions to modify my behaviour. But the cost of a species loss as a consequence of driving my car may be something I am unaware of. Both are the Tragedy of the Commons, but in the second case I am a quite unwitting participant.
As a basic guiding rule for running our affairs, if I make a choice that has consequences over some domain, my consideration of my choice needs to extend over the same domain – us continuing to make choices for narrow reasons that have broad consequences is going to be suicidal for our societies.
Yet so much of how our societies, businesses, laws and economies function allows, if not encourages, this. This is what I meant by Externalities. I get the benefit and some unknown external ‘other’ pays the bill. And I am not even aware it is happening. Or I can run a business, shift costs to an external party and my customers don’t even know that I have done so.
Economics as a discipline is one of the essential toolkits we need to bring to bear on our problems, and in particular how to solve the Tragedy of the Commons. It is a life & death issue for humanity.
Therefore the quality of the theoretical underpinnings of Economics is of paramount concern. Thus my earlier comments regarding Economics without a sound psychological underpinning to its theoretical structure and the extreme non-linearity of errors in analysis arising from some simplifications.
Through the course of the development of our understanding of the Physical Sciences there have been a series of major transformations. The knowledge of the Ancient Greeks etc, through India and the Arab World, the development of the ‘great Clockwork’ from Copernicus through Newton & Descarte to the end of the 19th Century. Then the transformations of the 20th century – Relativity, Quantum Mechanics, Chaos Theory, Watson & Crick, Freud & Jung, Goeddel’s Incompleteness Theorem. These transformations often involved fundamental re-thinking of the theoretical foundations of the sciences, often complete paradigm shifts.
Is Economics in need of such a major rethinking of its foundations? A world view of ‘fully informed, rational utility maximisers’ and ‘agents’ just doesn’t seem an adequate description of reality to base
anything on.
Secondly, to your comment
Ernestine … “I completely agree that legislation is required to ‘internalise the costs of externalities’. However, I believe it is up to the public to express a demand for such legislation”.
Yes, you are right to some degree. It is obviously not within the remit of Economics to impose this upon society. However I would suggest that it is within Economics’ remit to ensure that every man woman and child cannot avoid knowing that they are doing it. To at least make herculean efforts to ensure that if the TOTC happens, it is at least never unwitting. And in particular, that policy makers, politicians, business people have absolutely no wriggle room, that Economics has the tools to continually pound on their heads so they cannot avoid the TOTC..
Consider Astrophysics. This is an example of what I would call a ‘descriptive’ discipline. It seeks to understand stars, galaxies etc. But only to further our general knowledge. Medicine on the other hand I would describe as a ‘prescriptive’ discipline. Not only does it seek to understand how our bodies & disease works, it offers prescriptions for what we should do about it – take this pill, apply this lotion, go under this knife.
Perhaps a key question for Economists is: ‘to what degree is our profession descriptive or prescriptive?’. And how would your clients, those policy makers, politicians, business people etc answer the same question? Even working as opposed to academic Economists? My personal suspicion is that your clients see your discipline as more ‘prescriptive’ than you do. That annoying psychology stuff again. Your clients want you to tell them what to do. And like most people, they aren’t good at hadling qualified and nuanced opinions.
So, in the same way that a Doctor has a Duty of Care to their patient to ensure that they are warned of the possible consequences of a medical procedure, and that this is conveyed to them in the most understandable way possible; so to I would argue that Economics has a Duty of Care to its clients to warn of the possible consequences of actions taken. Because your clients will take your advice and apply it in the real world.
So in that sense avoiding at least the unwitting aspects of the TOTC is the responsibility of Economics. No one should ever be able to ‘litter’ without being forced to at least recognise they are doing it.
Which brings me back to my question about the theoretical underpinnings of the discipline and whether they are adequate to the task.
Earlier in this thread, someone referred to things being categorised in the ‘behavioral economics bin’. Is ‘Behavioural Economics’ actually what Economics needs to be?
As an interested outsider I sense that your profession is still waiting for its ‘Quantum Mechanical Revolution’, its great paradigm shift. I can’t even begin to say where you might find that, but psychology will probably be at the heart of it. But there is a lot riding on the outcome of such a quest. Economics is one of the true Life & Death disciplines because it must be seeking to answer, at least in part, the question ‘How are we to live so that we can keep living?’
Glenn Tamblyn,
@Glenn Tamblyn
Glen says “When I used the term Externality I was in a sense referring to what I see as one of the core objectives of Economics – the development of tools to help prevent The Tragedy of the Commons.”
In agreement Glen. It is more my understanding than the altered choice sets of individuals definition given by Ernestine but I can see Ernestine’s rationale in the example provided above. Guess Im just suspicious re the entire choice vocabulary that has prevailed in economics in recent decades, as if the individual’s choices should be given more weight than the outcome for the whole tribe or group or society etc (and if the sum of individual choices is even thought to be the basis for a measure of the best choices for an economy – now wouldnt that fallacy of composition?).
@Glenn Tamblyn
And Glen,
You are right. Economists DO have a duty of care to be prescriptive and to advise their clients. The entire problem is that economists are becoming increasingly inward, communicating in many cases only to their esteemed colleagues in language that is utterly incomprehensible to their clients. In addition many economists have turned their tools of trade to the pursuit of rewards from the finance world or business world, and less to the problem of how we should live so that we can continue to live (the heart of the economic problem).
That is a tragedy no less than the tragedy of the commons.
@Ernestine Gross
I had a look at an old mathematical economics text (Takayama) which takes the same line as Blad and Keiding. I can see that it is convenient to define externalities this way, for mathematical purposes. Neverthelesss, I would say that a costless externality is no externality at all, which would mean that the definition would provide a necessary condition for an externality and the sufficient condition would be that the change in the choice set either excludes the current optimal set of choices or provides a more preferred optimal set. This gets the utility function or preferences into the picture which is important because, after all, externalities are in the eye of the beholder. You could also have a model where various agents had no choice and were force fed. This would nevertheless admit the possibility of their suffering or enjoying externalities; their ‘meal’ could change as the result of others actions.
Update, Update, Update, it has been reported today that Treasury deputy secretary David Gruen blames US and European banks for the global financial crisis because their sophisticated models were badly flawed and unrealistic.
@Michael of Summer Hill
Oh here we go Moshie – the campaign to blame the GFC on bad computer models…..when its really lousy economics they mean? Blame the robots they invented?
Freelander @ 45,
I see, Freelander, given your notion of ‘mathematical convenience, the length of a piece of string lies in the eyes of the beholder. By contrast, this so-called ‘mathematical convenience’, applied in economics, would lead me to the conclusion that the eyes of the beholder determines whether a given length of string is long enough for his or her wants. The length of a piece string can be determined by a non-economist.
To be frank, I am a little surprised by your response.
You write:
Please edit out “You write:” in #48, p 3.
@Ernestine Gross
The important thing making something an externality is often the individual’s attitude toward the action or activity. For example, some human rights abuse takes place overseas and results in people here being less happy, the action overseas is has a negative externality. Charity for example has positive externalities because by helping a poor person, the action makes others also happier because they were less happy because that person was poorer. This is not simply something I dreamed up. Hence, the eye of the beholder. An important component in the whole thing is preferences. Of course, you can have technological externalities impacting on the production processes of other goods or services but if these goods or services were not valued by anyone then the impacts would be irrelevant.