Ten principles of economics

Yoram Bauman (and here) is an environmental economist who works at the University of Washington. He is also a stand-up comedian.

Evolution of the wealth of nations

One of the biggest tensions in economics is between a top-down macro view of the economy and a bottom-up micro view of the economy. César Hidalgo (and here) is pursuing a very visual and data oriented approach to economic thinking which allows him to get the best of both worlds.

We have always had this tension of understanding the world, at small spatial scales or individual scales, and large macro scales. In the past when we looked at macro scales, at least when it comes to many social phenomena, we aggregated everything. Our idea of macro is, by an accident of history, a synonym of aggregate, a mass in which everything is added up and in which individuality is lost. What data at high spatial resolution, temporal resolution and typological resolution is allowing us to do, is to see the big picture without losing the individuality inside it. I believe that in the future, macro is going to be something that is going to be in high-definition. You're going to be able to zoom in into these macro pictures and see that neighborhood, and see that person, and understand that individual, and to have more personalized interactions thanks to the data that is becoming available. I think that in some sense, big data can help recover the humanity of a world in which the scientific representations of people have become dehumanized, because of our need to simplify.

César Hidalgo

César talks about his work here. The Observatory of Economic Complexity is here. His TED talk from 2010 is also very interesting. Watch his TED talk after the jump. It's all about lego and putty.

Ceci n'est pas une pipe

René Magritte has some great advice for all modellers of complex systems.

Reclaiming the Laffer curve from the propagandists

The Laffer curve explains why increases in the rate of income tax do not always generate more revenue for the government.

Consider the income tax system:

1. The government is free to set the rate of income tax anywhere between 0% and 100%
2. If the government chooses to set the rate at 0%, it will generate no revenue. 0% of anything is nothing
3. If the government chooses to set the rate at 100%, it will also generate no revenue. If an individual does not profit from working then there is no incentive to work at all. If no-one works then revenue from income tax will be nothing
4. In the real world, governments set the rate of income tax somewhere between 0% and 100%, and they do generate revenue
5. We can conclude, therefore, that there must be one (or more) rate(s) of income tax that will generate the maximum income tax revenue.

This is a great example of a thought experiment in economics. However, it is also an example of why economics is not a science, or at least why most economists (and almost all politicians) do not appear to be scientists.

What is missing from this description of the income tax system is a very obvious question. What is the optimum rate of tax which will generate the largest amount of revenue?

It seems to me that there are four possible answers to this:

1. A specific number. For example, perhaps 42% is the optimum tax rate. We’d need to be clear whether this rate included or excluded related taxes such as National Insurance, but this would be a really useful answer. The government could set the tax rate to this optimum rate and then watch the revenue flow in
2. Two or more specific numbers. For example, perhaps 32% and 52% both generate the same maximum amount of revenue. The government could then choose between these two rates depending on its political beliefs
3. It depends. Perhaps there is no universal optimal tax rate and the optimum depends on circumstances. For example, maybe culture is an important factor; maybe the optimum varies depending on the wider state of the economy; maybe it depends on political and religious beliefs; maybe it depends on age; maybe it depends on the government's spending plans. If this is the case, a scientist would want to explore this further before drawing any conclusions. Without further research, the government would have no clear cut method for using the Laffer curve to set the optimal tax rate
4. We don’t know. Although the Laffer curve is an interesting and useful thought experiment, there is no practical way of knowing the optimal rate in all circumstances.

This defines the dividing line between science and politics. Scientists would ask this very obvious additional question and demand an answer. Politicians would be happy to use the thought experiment to generate political propaganda. I’m not sure where economists sit in relation to this division.

Here is a typical diagram of the Laffer curve.

Laffer curve as political propaganda

This is an example of political propaganda. There is no scale indicating different taxation rates. There is an assumption that there is one peak taxation rate. There is another assumption that the current taxation rate is higher than the peak rate. This is propaganda for a politician who believes in tax cuts. The diagram could equally be drawn with the current tax rate to the left of the peak. With that minor tweak, the diagram would become propaganda for a politician who believes in tax increases.

The Laffer curve originated in the 1970s. At that time, income tax rates in many countries were above 90%. It’s not hard to imagine that this level of tax was a major disincentive. It’s almost certain that 90% is to the right of the optimum tax rate. However, that does not mean that we can conclude that any current tax rate is to the right of the optimum rate.

There are three key points arising from this argument.

Firstly, let’s assume that, when the governments in the 1970s set very high rates of tax, they were being self-interested, intelligent and rational. Mainstream economics assumes that all economic actors are self-interested, intelligent and rational, so that must include these governments. However, at best, these governments were only “intelligent and rational” from their own perspective.

If we increase the rate of tax then we will generate more revenue. Let’s increase the rate of tax as far as we can
An "intelligent and rational" government

The problem with this logic is that tax payers are also intelligent and rational, and many tax payers reacted to the higher rates by leaving the country, by closing their businesses, or by looking for loopholes in the tax laws.

Secondly, the Laffer curve is likely to apply to all exchanges in economics. The peak in the middle arises precisely because it is the most intelligent and rational compromise between the self-interest of the two actors involved. Not all exchanges take place at the peak, though, because it is in the self-interest of both parties for the exchange to take place away from the peak. If I can sell you a sandwich for £1,000 then that is a good deal for me but a bad deal for you. In that case, I have a better self-interest optimising strategy than you, but that doesn’t preclude the exchange from taking place if you are starving and I am a monopoly supplier, or if you are a fool.

Thirdly, economists need to decide where they sit in the science versus political propaganda divide.

In the meantime, non-economists should reclaim the Laffer curve from the political propagandists and challenge the economics profession to become scientists. The smartest people are the ones who ask the best questions, not the ones who think they have all the answers.

Golly and evolution

Anyone who is interested in dynamic, evolving systems (such as biological, economic and political systems) should play with cellular automata (and here) at least once. They’re great fun and very educational. They show that even very simple systems can evolve in unexpected ways due to the interactions of the actors or components in the system.

A cellular automaton consists of a regular grid (or universe) of cells, each in one of a finite number of states. Each state is represented by a colour. The simplest automata use two states: normally represented by black and white. More complex automata use more colours and shades. For each cell, a set of cells called its neighbourhood is defined relative to the specified cell. For example, the neighbourhood may be the eight cells immediately surrounding a cell plus the cell itself. An initial state (time t = 0) is selected by assigning an initial state for each cell. A new generation is created (advancing t by 1), according to some fixed rule that determines the new state of each cell in terms of the current states of the cells in its neighbourhood.

The behaviour of a cellular automaton is dependent on its initial condition and the rule by which the universe evolves from one generation to the next. A wide variety of behaviours can be observed: the universe may evolve into a stable state or it may become unstable; it may live “forever” or die away quickly; it may generate regular or irregular patterns. The automaton can be stopped at any generation in order to manually change the state of one or more cells, in the same way that mutations occur in biological life. When the automaton is restarted, the mutation can change the behaviour of the universe radically or it can die out quickly as the universe reverts to its original behaviour.

Golly is a great computer program for exploring cellular automata. It’s an open source program so it’s free to download. It’s available for a range of computers including Windows PCs and Apple iPads.

Two of my favourite patterns in Golly are Bloomerang which generates a colourful kaleidoscopic pattern, and Wolfram 22 which generates a Sierpinski triangle.

Bloomerang

Wolfram 22

For more information on cellular automata check out the Wikipedia entries for Conway’s Game of Life and elementary cellular automata (and here). John von Neumann, Stanislaw Ulam and Stephen Wolfram were three of the key figures in the development of cellular automata. Check out their Wikipedia entries to get an idea of the provenance of cellular automata.

What do we mean by “economics”?

Paul Krugman is one of my favourite economists. In 1996, he gave a talk entitled “What economists can learn from evolutionary theorists”. During the talk, he gave his own definition of economics. He also talked about how economists could learn from evolutionary theory, using an example about the behaviour of frogs. Here are the relevant extracts.

Paul Krugman on the definition of economics:

Let me give you my own personal definition of the basic method of economic theory. To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the interactions among intelligent, self-interested individuals. Notice that there are really four parts to this definition. Let's read from right to left. Economics is about what individuals do: not classes, not "correlations of forces", but individual actors. This is not to deny the relevance of higher levels of analysis, but they must be grounded in individual behavior. Methodological individualism is of the essence. The individuals are self-interested. There is nothing in economics that inherently prevents us from allowing people to derive satisfaction from others' consumption, but the predictive power of economic theory comes from the presumption that normally people care about themselves. The individuals are intelligent: obvious opportunities for gain are not neglected. Hundred-dollar bills do not lie unattended in the street for very long. We are concerned with the interaction of such individuals: Most interesting economic theory, from supply and demand on, is about "invisible hand" processes in which the collective outcome is not what individuals intended.

Paul Krugman

Paul Krugman on the behaviour of frogs:

William Hamilton's wonderfully named paper "Geometry for the Selfish Herd" imagines a group of frogs sitting at the edge of a circular pond, from which a snake may emerge - and he supposes that the snake will grab and eat the nearest frog. Where will the frogs sit? To compress his argument, Hamilton points out that if there are two groups of frogs around the pool, each group has an equal chance of being targeted, and so does each frog within each group - which means that the chance of being eaten is less if you are a frog in the larger group. Thus if you are a frog trying to maximize your choice of survival, you will want to be part of the larger group; and the equilibrium must involve clumping of all the frogs as close together as possible. Notice what is missing from this analysis. Hamilton does not talk about the evolutionary dynamics by which frogs might acquire a sit-with-the-other-frogs instinct; he does not take us through the intermediate steps along the evolutionary path in which frogs had not yet completely "realized" that they should stay with the herd. Why not? Because to do so would involve him in enormous complications that are basically irrelevant to his point, whereas - ahem - leapfrogging straight over these difficulties to look at the equilibrium in which all frogs maximize their chances given what the other frogs do is a very parsimonious, sharp-edged way of gaining insight.

Paul Krugman

I’ve been looking for a definition of economics for some time. The current economic crisis suggests that there is something fundamentally wrong with economics (or certainly with economists), so I thought it might be a good idea to go back to basics and look for an effective definition. I tried Wikipedia and a number of other sources, but it was Krugman’s definition that struck me as most interesting, and the fact that he gave his definition during a talk in which he contrasted economics with evolution suggested a link with complex systems.

Nevertheless, I have a problem with Krugman’s definition. A one word summary of his strap line is that economics is about “interactions”. His phrase “among intelligent, self-interested individuals” is merely delimiting the interactions. I agree with the focus on interactions. However, he then breaks his definition into four bullet points. The first three of these bullets are about individuals. Only the fourth is about interactions. This balance feels wrong.

When Isaac Newton saw an apple falling from a tree, he had the opportunity to think further about the apple or to think further about the movement of the apple. There are lots of things he could have thought about the apple: the way it grows, its shape, its size, its colour, its taste, the recipes through which it can be transformed into food and drink, how any of these things could be improved. Instead, Newton thought about the movement of the apple. In many ways, it would have been easier to think about the apple. For example, he would not have had to go to the trouble of inventing calculus. However, he thought about the movement of the apple and realised that the apple was not really important to his thinking. It could have been anything falling from the tree: a leaf, a branch, an animal or even Isaac himself. Incredibly, he realised that he could replace the apple with the moon, even though the moon doesn’t fall from a tree and the moon never hits the ground. Newton was smart but one of his most immense skills was the way he framed this problem and defined his area of study.

I don’t think that Newton would have defined his subject with a strap line about movement, and then expanded his definition with four bullet points, the first three of which were about apples.

This is what troubles me about Krugman’s definition of economics. Why are individuals so important that they warrant three bullet points? Surely the individuals are the equivalent of Newton’s apples. Individuals are not even the only actors in the economy. What about businesses, banks and governments? And why do the individuals need to be intelligent? When Krugman discusses frogs, he doesn’t indicate that they need to be intelligent, even though they display “intelligent” behaviour by arranging themselves in groups to protect themselves from the snake. And why does Krugman not say anything interesting about interactions if that is what he thinks economics is about? It would be better if he had said something like this.

Let me give you my own personal definition of the basic method of economic theory. To me, it seems that what we know as economics is the study of those phenomena that can be understood as emerging from the exchanges and interactions among self-interested economic actors. There are really five parts to this definition. Economics is about individual exchanges between actors. For example, I buy a bicycle from you for £20. The exchanges may involve assets, products or services. The actors may be individuals or businesses. Economics is about the exchanges themselves but also about the strategies used by the actors to promote their self-interest Economics is about the money used to facilitate these exchanges and related interactions. This includes physical notes and coins but also credit-based money. The inclusion of money also means that economics is about the banks who issue money and who manage money on behalf of other economic actors. As the banks are themselves involved in exchanges, they are also economic actors Economics is about the emerging properties of the totality of these exchanges and related interactions. When exchanges are viewed from the perspective of assets, products, services and money, we talk about markets. When exchanges are viewed from the perspective of the actors, we talk about wealth and debt, surpluses and deficits, profits and losses, winners and losers. When exchanges are viewed from the perspective of geography and government, we talk about international trade and exchange rates between currencies Economics is about the rules and regulations used in these exchanges and related interactions, and how these rules and regulations impact on the behaviour of the actors. The inclusion of rules means that economics is about the governments and other institutions which set the rules. As these institutions are themselves involved in exchanges, they too are economic actors Economics is about the emerging properties of this entire system, including the study of observed behaviours such as booms and busts of the entire economy; booms and busts in the prices of specific assets, products or services; and economic wealth and debt of individual actors. Economics is about the tools for managing this entire system in order to promote economic well-being, and to prevent and cure observed economic pathologies.

Jamie

Why do I believe that this would be a better definition, and that interactions are so much more important than individuals? There are two main reasons.

Firstly, as Krugman says in the fourth bullet point of his definition, many of the most interesting, and certainly the most destructive, phenomena in economics are about interactions:

1. If an individual buys shares, there is no problem. If everyone buys shares, there is an asset bubble. If an individual sells shares, there is no problem. If everyone sells shares, there is market panic
2. If an individual takes his money out of the bank, there is no problem. If everyone takes their money out of the bank, there is a bank run and the bank collapses
3. If an individual decides to stop spending and instead saves his income, or uses it to pay back his debt, there is no problem. If everyone does this at the same time then no-one is spending their income, so there is no demand for products and services, and the economy collapses. Keynes called this phenomenon “the paradox of thrift”. Why did he see it as a paradox though? It is only a paradox if you start by thinking from the perspective of an individual but not if you start by thinking about interactions
4. When Japan has a major earthquake not only does it disrupt the Japanese economy, but there are contagions to other regions. For example, when the earthquake generates a tsunami which overruns sea barriers and floods a single nuclear power station, Japan turns off all of its nuclear power stations and uses other energy sources instead. As a result of this, world demand for other types of energy increases. This increases the price of energy for everyone. In addition, other countries respond to the Japanese nuclear accident by re-considering their own use of nuclear power. This has further implications for energy prices and also for the employment of people in the nuclear industry in those countries.

Secondly, conventional macro-economic models focus on the behaviour of a single individual: a single, rational, representative agent. How do these models incorporate interactions? If there is only one individual then with whom does he interact? How do these models predict pathologies such as depressions and bank failures when these phenomena relate to interactions? Based on our experience in the current economic crisis, they don’t. Even though Krugman’s strap line emphasises interactions, mainstream macro-economic models seem to focus on the three bullet points about individuals.

One of the problems for a non-economist in trying to understand much of modern economics, and in trying to understand most modern economists, is that a lot of this economic thinking appears to be insane. As a result, a rational non-economist is tempted to conclude that it must be him who is insane. Surely, any sane economist would realise that models based on individual behaviour are unlikely to predict pathologies caused by interactions?

Here is a presentation (and slides) by Joseph Stiglitz, Nobel prize winner, at the 2010 INET conference, making similar points about the limitation of mainstream macro-economic models, particularly from 17:00 to 19:30 in the video. At least it’s comforting to know that if a sceptical non-economist is insane then so is Joseph Stiglitz.

When you start by thinking about interactions then some aspects of economics become obvious. For example, in world trade, when one country runs a trade surplus then some other country must have a deficit. The sum of all imports into all countries must equal the sum of all exports out of all countries. When many countries run a trade surplus at the same time then at least one country must act as “deficit of last resort”. If a country running a deficit decides to close its trade gap then the easiest way to do this is to stop importing goods from other countries. As a result, those countries’ trade surpluses will be threatened. You might suggest that this is obvious. I couldn’t possibly comment except to say that I’d expect to learn this in the first couple of weeks of an elementary economics course if that course were based on interactions. I cannot buy a product unless you sell it. I cannot borrow money unless you lend it. I cannot collect taxes unless you pay them.

What about mainstream economists though? Do they think this is obvious? Here is another presentation (and slides) by Joseph Stiglitz, this time at the 2012 INET conference where he makes precisely these same points. Good man! However, remember this is a Nobel prize-winning economist presenting to some of the world’s leading economists on state of the art economics. Stiglitz does include a number of more sophisticated points in his presentation, including some political points about possible solutions to current problems in international trade. However the key messages, particularly in his slides, are blindingly obvious to anyone who thinks about interactions.

It is a good job that it was Isaac Newton who saw the apple fall from the tree, and not an economist. The economist would have focused on the price of the apple and claimed that its movement was caused by an “invisible hand” which injected “animal spirits” into the apple! If only Newton had decided to sell the apple to a friend and used the proceeds to buy a new notebook. He might then have thought about that as well.

High Anxieties: The Mathematics of Chaos

High Anxieties: The Mathematics of Chaos is a documentary film made by David Malone on the origins of chaos theory and its implications for our political and economic systems. It describes how advances in mathematics and physics have led to an understanding that we don’t live in a Newtonian ‘clockwork universe’ governed by simple rules of cause and effect. It concludes that there are practical limits to our individual and collective abilities to predict and control complex natural systems and man-made systems. Any observed instabilities and breakdowns of such systems may be inherent in the systems themselves and are not necessarily the result of an external shock. The programme was first broadcast by the BBC in 2008.

The programme provides a good introduction to chaos theory and to well-known concepts such as tipping points. It makes a number of good points particularly on economics. However, a few segments seem to push the concept of chaos too far. For example, it suggests that chaos was a major cause of our inability to plan the course of the First World War, and it somehow seeks to relate chaos to the development of nuclear weapons. Also, it ends with some conclusions about the inevitability of disastrous outcomes arising from man-made climate change, which I don’t think are warranted by the preceding arguments. The key point surely is that chaos theory suggests that phenomena such as climate change are unpredictable, and that the risks they represent should be taken seriously, but not that such phenomena will inevitably lead to disaster. Nevertheless, the programme is worth watching.

Watch High Anxieties, split into nine segments, below.

Segment
High Anxieties: Part 1 of 9
High Anxieties: Part 2 of 9
High Anxieties: Part 3 of 9
High Anxieties: Part 4 of 9
High Anxieties: Part 5 of 9
High Anxieties: Part 6 of 9
High Anxieties: Part 7 of 9
High Anxieties: Part 8 of 9
High Anxieties: Part 9 of 9

The programme mentions people such as Henri Poincaré, Aleksandr Lyapunov and Edward Lorenz. Interviewees include David Ruelle, Paul Ormerod, James Lovelock, June Barrow-Green, Peter Cox and Linda Gask.