Atanu Dey On India's Development

Understanding Economics — Follow up

November 30, 2012 by Atanu Dey | 17 Comments

Here I reply to some of the comments to my post “Understanding Economics” of a few days ago.

Tanno wrote

Economist regularly fail to predict things like the Housing bubble burst in the US. Back then, some nutcases (like Peter Schiff) who are not economists predicted it exactly. At the same time Nobel prize winning economists completely discarded it on television shows. If economic models can’t even predict such big things, I wonder what are they good for? In other words, isn’t the current economic theory just some mathematical model that has nothing to do with reality?

I would like to have some examples where economic theories have been successful and reasons why they have failed miserably in other occasions.

Economists often fail and so do other professionals, including doctors, engineers, architects and journalists. Humans are imperfect and even under the best of circumstances, bounded rationality and imperfect information don’t make it easy for anyone to predict stuff. Predictions are hard, especially about the future. Those who are foolish enough to do so usually end up badly. But that does not mean that all of economic theory is just stuff and nonsense. You cannot discard advances in, say, medical sciences just because some doctors have made mistakes.

People have put in lots of effort into figuring out how the world works. Yes, they don’t know everything, and perhaps they will never know everything. But even though our understanding of complex systems is incomplete, we still know things that are indubitably true. This core set forms the solid foundation on which we can continue to extend our understanding of the world.

Economic models do predict with surprising accuracy a wide range of behaviors. But like Heisenberg’s uncertainty principle which states that there is a limit to how accurately you can simultaneously know the momentum and location of a particle, there must be limits to how accurately you can predict both the timing and the extent of any particular bubble. Too many factors at play that we have no knowledge of.

Modeling economic phenomena using mathematical models is useful, although it may be hard for non-economists to appreciate their utility. But that does not mean that one cannot go overboard with too much esoteric mathematics.

What the vast majority of us should know about the fundamentals of economics does not involve much mathematics at all. Just plain arithmetic and a bit of high school algebra suffices. If you really want to, you can throw in a bit of differential calculus — but only if you want to manipulate the variables with ease. Add a few simple diagrams, such as supply and demand schedules, and you are fairly well equipped to explain quite a bit of the world.

DJ replied to Tanno thus

@Tanno You’ve asked for economic models that would predict the crisis. Minsky is an economist who had models for ponzi debt cycles which would explain and predict the debt crisis. Schiller has behavioral models which predicted the housing bubble and various bubbles born out of irrational exuberance. Didier Sornette while not an economist, uses mathematical models to predict when asset prices will peak. Schiller is not a good example, he is like a broken clock who will be right eventually at some point in time.

Sambaran wrote

Fiat currency intrigues me. Fiat currency helps us avoid the complications of Barter system, this much is understood.

Hence it seems to me that amount of fiat-currency printed/released by a Fed/RBI should be equal to value of goods that its citizens are going to exchange.

Question1: How can the RBI/Fed print money with such abandon then?
Question2: How does RBI/Fed go about deciding the amount of money to print?
Question3: Excess money printing is a mechanism by government to take money out of the hands of citizens’ savings without explicitly calling it tax. Please confirm.

Abhijat too wants to know “what is money.”

Money is hard to get — in more than one sense. I will try and get around to it eventually. I say eventually because I don’t think it is useful to introduce money into the discussion too early. It just confuses people. We can get a fairly good understanding of the basic principles of economics without reference to money. After that, we can talk about money and it will then become quite clear that money is not all that important.

Yes, money matters but there are others things that matter more. Money matters to accountants but not so much to economists. Money is nominal, not real. Stuff is real. Stuff is wealth. Stuff matters.

The answer to the question 3 above is, “Yes, inflation is a disguised tax brought about by printing money and putting it in circulation.”

Piccolo wrote

I have a question about free-market philosophy. How does the philosophy of free-market or minimum govt justify govt funding of scientific research and primary education?

Good question. Even a brief answer would be fairly long. The answer will have to start with “what is a market?” Then you have to go to “what is a free market?” Then we have to ask how the cost of production of something is recovered. Then we will get to kinds of goods for which it is hard to allocate the costs and the difficulty of recovering the costs of these goods. Then we will figure out that there are other mechanisms for funding such goods, etc.

In exploring that, we will also have to visit the role of governments and why a minimal government is better. All this is worth exploring.

VirtualPresence wrote

I like the idea of a free market and am aware of the advantages of an incentivized system. Looking at the economic disparities in our society i would like to see you explore some policies or “regulations” enacted the government that are consistent with the idea of a free market economy (without any form of redistribution) and provide a better moral ground to justify a greed based system. Such policies, if any, will help us avoid situations like the sub-prime mortgage crisis which was the result of nothing but pure GREED.

Exploring the role of greed is an excellent point. Also economic disparity and what to do about it. All of this has to start with an understanding of what we mean by “government.” The starting point is to recognize that governments are people too. That means that whatever human characteristics you and I have as people, the people who constitute the government also have the same. If we are greedy, so are the people in the government. Therefore it may be asking too much to expect the “government” to fix the problem of greed.

DJ wrote in response to the matter of greed

@VirtualPresence Greed is not a property of a system, but of human beings (at least some large subset of humans). You cannot have a system that does not take that into account. Greed will always exist, no matter what system you come up with. Greed is not bad in a competitive, fair, accountable framework where it can be channeled into productive activities. Markets are the best system of determining when greed goes too far and companies get punished accordingly. Its only when the framework isn’t fair, or if the accountability mechanism is broken, or when there are distortions from regulators or govt that you have a problem. The problem is that greed is usually one step ahead of regulators, or greed can corrupt regulators, then what do you do?

Kumar_N asked about taxation. Among other questions, he asked

What does taxation theory say about the best model to ensure effective disbursal of tax monies across the nation? Thanks in advance.

I am sorry I can’t answer to those questions, only partly because I don’t know much about it. I may get to them if time permits me later on in the work.

Finally Suramya wants to know about “market failures.” That is an absolutely essential topic and it has to be addressed in the book.

Thanks all for the inputs. I will address them as I go along.

  • pravin

    i dont find peter schiff terribly bright on trade etc,but basic ABCT -austrian business cycle theory on which he bases many of his predictions have more serious economists as adherents.peter is an investment manager so dont expect him to dot the is and cross the tees.anyway,it is funny that people who had no clue what hit them -krugman,bernanke,stiglitz etc are still in charge making decisions while schiff is brushed off as a nutcase.
    now that atanu has discovered ron paul,i hope he also discovers ludwig von mises’s regression theorem about money,hayek’s ABCT and their exposition on malinvestment.
    there is lots of stuff out there on mises.org for free.i wonder why study economics at university at all -where all you learn is keynesian and monetarist dogma.or worse,studying econometrics and then using it as a tool to predict the future.the only reason to really study statistics and applying erle granger tests and time series and in the like is to analyse the past.but economists love to use it without a reasonable theory ie their assumptions are bogus.no wonder idiotic welfare functions are taught and development economics is peddled to the unwitting guilt stricken city slickers.
    no mention of why central banking -central planning of money-is subject to the same co-ordination and knowledge problems as producing cars or pencils is ever made.no wonder economists are resorting to running experiments like abhijit banerjee and co or chanelling freud and co in the behaviourists -attempting to nudge people into behaviours they like.
    the whole positivist trend that economics has taken since world war 2 has made it poorer.it is worthwhile examining the espitemological underpinnings of economics that is taught today.sadly the only conlusion is that the entrenched people in academia have too much to lose if they accept that their whole life has been a total waste akin to studying the flat earth theory

    • http://www.deeshaa.org Atanu Dey

      pravin wrote, among other things,

      now that atanu has discovered ron paul,i hope he also discovers ludwig von mises’s regression theorem about money,hayek’s ABCT and their exposition on malinvestment.

      I have not “discovered” Ron Paul. I merely mention him because much of what he stands for is in accord with my way of thinking.

      I don’t worry about complicated stuff — such as “regression theorems” and business cycle theories. My aim is to understand the world from first principles. If and when I have understood those bits, I may if time permits and if my cognitive capabilities are up to it, I may move to the complicated stuff. But for now, I will leave the obviously more competent to weave their complicated theories.

  • Abhijat

    Hi Atanu,

    A couple of more (common man) inputs to ponder on the “Understanding Economics” work.

    1. Various models in Economics, e.g. the “small is beautiful” (Schumacher type), and others, and their connections with the socio-political structure of societies.

    2. I hear that Economics is one of the most mathematised sciences. In what way? This could perhaps go a bit far than the proposed idea, but perhaps directions towards such framework could be put in.

    Thanks.

    Abhijat

    • http://www.deeshaa.org Atanu Dey

      Abhijat,

      Thanks for the inputs in your comment above.

      1. “Small is Beautiful” is not an economic model. Schumacher’s thesis was that we are not capable of understanding large complex systems, and so we should keep it small and simple. Where possible, yes it does makes sense to keep it small and simple. But not everything can be made so. Some things are by their very nature very large and very complex. When dealing with such systems, it is wise to be very careful.

      2. The use of mathematics in various disciplines — from computer science (discrete maths) to medicine to physics to engineering, etc — is required when you want to manipulate the variables involved with ease and compactly. Economics uses maths for the same reason. Some people do go overboard with maths but that is their outlook. There are enough others who use maths appropriately. The world is a large place with lots of people. We have enough to do around the world that there’s a place for everyone to do whatever makes them happy.

  • Zenil

    Hi Atanu,

    Hi have two questions :

    a)
    Whats your take on regulatory bodies like FDA,the recently created Consumer Financial Protection Bureau, wall street regulators, Department of Education etc?

    Free market enthusiasts foam at the mouth when talking about regulation , they say it adds unnecessary cost to the company , its a waste of money and and generally would argue that the “market” will somehow figure it out.

    I am on the side of regulation. A strong regulatory system saves people from getting harmed in the first place. The threat of penalty and being found out results in companies voluntarily recalling defective food products,toys,cars etc. In US I routinely see eggs,milk,meat products being recalled. In India I have never heard of any outbreak resultining in a recall !!

    b) Minimum wage : Corporations are making record profits. To me the salary difference b/w the highest wage earner and the lowest is immoral. Is there a moral argument to be made for forcing companies to pay above minimum wage to their employees ?

    • http://www.deeshaa.org Atanu Dey

      Zenil,

      In reply to your two questions:

      a) I am for free markets. Here I will not define precisely what that means as it can be an article by itself. I hope to cover it in the basics book. Here I will just mention that markets work but there are circumstances under which markets don’t work perfectly.

      Nothing that humans invent — and markets are a human invention — works perfectly. To fix market failures, one mechanism is regulations. They have to be used carefully so that we don’t end up making a bad thing worse. Light-handed regulation often works.

      Note that regulation of markets can be done not just by the government but also by non-governmental organizations. That’s a topic in itself and I should write more about it later.

      b) Minimum wage is a wonderful idea. At least at first glance. Looked at with a little care, it looks entirely different. It is a terrible idea. It harms precisely those who it is supposed to protect. In fact, minimum wages are a prime example of how half-baked ideas cause harm when their proponents probably don’t mean harm.

      If there is enough interest, I will write a short piece on the harm that minimum wages do.

  • Tilopa

    How would you explain that hindu socio-economic model propounded by RSS based on jaati/varnas is anti-capitalist.
    You talk about the small government and maximum economic freedom,values which the RSS resent.
    So would you like to say on how capitalism can be in accordance to hinduism?

    • http://www.deeshaa.org Atanu Dey

      Tilopa,

      I am an economist. I concern myself with matters that pertain to economics and development. What the RSS does it not my concern. If what they propose is contrary to common sense (which is another way of saying contrary to the basic principles of economics), I think they are stupid.

      Hinduism and capitalism belong to different sets. The former belongs to the set of “cosmological beliefs” and the latter to “material beliefs.” The sets are disjoint, much like the set of colors and the set of spanners. What colors are used in a painting has no bearing on what kinds of spanners are being sold in the hardware store in the neighboring city.

  • Ashish

    @Tilopa

    On Capitalism in Hinduism, you can read sanjeev sabhlok’s blog or his book with the same name.

  • Tilopa

    @Ashish

    It’s not only the insignificant people in the RSS who are anti-capitalist but now learned peoples like Subramanian Swamy are also propounding some sort of “hindu economics”

  • Loknath

    Tilopa,
    This is what pains me deep in the heart. Pseudo nationalism and lectures on self reliance

  • pravin

    @zenil – 2 words about regulators: ‘regulatory capture’. who do you think constitutes the regulators? not some omniscient good intentioned angel -but rather lobbyists and former employees of those very entities which it is supposed to regulate.Underwriter labs were in the business of certifying what is good quality long before any recall business started.btw,most of the recalls in the auto sector are anti japan protectionist lobbying.

    second:about minimum wage.if the argument is X can be declared to be the minimum wage,why not 100x? since you are not using supply and demand,why not use pure legislative force to declare whatever salary our noble leaders decree .the only people who benefit from minimum wage are the entrenched employees.they are protected from competition from the new young,cheap labour force .ie it simply increases barriers to entry for those willing to work for less.presumably you want minimum wages to help these new and unskilled vulnerable workers.but it turns out that these are the very folk who lose out.

    • http://www.deeshaa.org Atanu Dey

      pravin, you wrote about minimum wages.

      I will take that up in a separate post. Thanks.

  • DJ

    @pravin About anti Japan protectionism, are you basing your comment on some data? The data I looked up doesn’t seem to support your argument:

    http://www.recallowl.com/interesting_stats.php
    http://www.statisticbrain.com/automobile-recall-statistics/

    Also, I thought many of the Toyota and Honda cars are now made in the US anyway? Are you talking about Europe by any chance?

  • Zenil

    @pravin- you answer is simplistic…Regulatory bodies weren’t created in a vaccum.Each one was created in response to specific market failures. Couple of examples :

    FDA : Was created as a specifc response to widespread food adulteration, misbranding of foods and drugs in USA. Without FDA there would be no labelling of ingredients in food, drugs, missrepresentation of whats in them etc.

    Consumer Finance Protection Bureau : To protect consumers from widespread credit card rip offs.

    Without regulatory bodies, how will free market come up with ways to protect the consumer ?

    Mimimum wage : No one is arguing for 100x..Min. wage is not calculated from thin air. In California, minimum wage is around 11$/hr which is still considered a below poverty line wage…A min. wage establishes a floor,a way for working people to maintain a min. standard of living and prevent them from going broke. In India there is no concept of min. wage..Which means you have kids working basically for food and water and nothing else.They will never work their way out of poverty and will forever remain slaves.

  • Zenil

    Atanu,

    One more question. Since we are both Ron Paul fans wih reservations..:)-

    Ron Paul is a vehement supporter of property rights and at some point he was against abolition of Jim Crowe laws..One aspect of this was a property owner (say a restaurant owner) could freely discminate against people by color of their skin thereby limiting their access to said property and services.. Supposedly Ron Paul was extreme in his belief that property rights has to be respected regrdless of prejudices.

    When most property owners are prejudiced,and such discrminiation is widespread,how will a “free” market solution work ? (You could apply this case to rural India where upper castes use their dominant status to control access to say a school or a well) ..If it were left to “free” market , african americans will still be segregated in buses,schools,restaurants..Without applying some kind of force how will free market correct itself ?

    Feel free to rejig/expand/rephrase/extend this question if it leads to a more complete explanation..:)-

  • pravin

    zenil,

    true,the regulators didnt spring up from nowhere.for example,it was upton sinclair’s investigations into the chicago meatpacking industry that lead to a lot of the labelling regulations.
    while,the notion of market failure is hazy because the market is not a perfect machine -it just represents the views of the people in the society.as people evolve,the markets outcomes change.
    in anycase,appointing govt babus -who are just as human and fallible as the rest of us -is no solution.the better solution is more competition and entrepreneurship to change things so that outcomes are better.
    perhaps you should consider the impact of regulators -they cant anticipate problems because they are not omniscient.they can definitely cause harm -as the FDA regularly does,and they are usually industry insiders who know that it is better to serve the insiders than the consumer (after all they are mere human beings and not angels).
    so while the market does produce bad outcomes,that doesnt automatically make it an argument to fix it by bringing in people with guns and badges (ie the govt)
    i already gave you an example of underwriter labs which existed long before the govt agencies.if you believe that in today’s age companies will not label their products unless a govt babu tells them then you are ignoring the fact that as more information is present in the market,people’s demands change.ie 2010 is not the same as 1910s chicago.
    ditto about property rights and ron paul btw.forcing people to become good people at gun point will not solve any racial tensions.infact the jim crow laws themselves were govt created,so atleast lets not credit the govt for removing racism.
    the market will produce its own ranades and jyotiba phules as society evolves.the nonsensical implication of the civil rights act is that a black restaurant owner CANNOT turn away klan members for example.
    there are enough economic and social incentives to be a racially harmonious society.breaking property laws is no help in that.