What do we mean by ‘hot’?

One of the unexpected benefits of having worked on projects to design and implement government policy is a greater appreciation for words. We take words for granted and we don’t often give them much thought. That’s a mistake.

Take the word ‘hot’ (no, not that ‘hot’). ‘Hot’ has been in the news recently, in the UK, as a result of the budget. The problem is that there are different rates of VAT for food that is ‘hot’ and food that is ‘not hot’.

For most foods this is not a problem. Fish & chips are ‘hot’ so VAT applies. Sandwiches are ‘not hot’ so VAT does not apply.

What about pasties though? Pasties are prepared freshly in bakeries and then offered for sale. However, the pasties may cool down before they are sold. When is a pasty ‘hot’ and when is it ‘not hot’? If you visit a bakery and there are some pasties fresh from the oven should you buy the pasties and pay VAT, or should you wait half an hour until the pasties are ‘not hot’ and save yourself some money? What do we mean by ‘hot’ anyway? In summer, the ambient temperature will be higher so pasties will cool down more slowly. A ‘not hot’ pasty in summer will be ‘hotter’ than the same pasty in winter. Should VAT apply more in summer than in winter?

Of course, this is complete nonsense, but it arises because someone decided it would be a good idea to have different VAT rules for ‘hot’ and ‘not hot’ food. We elect these people so it is really our fault.

When governments make laws using terms such as ‘hot’, there are always examples at the boundary where the distinction is dubious. This means that these examples are then ‘unfair’. ‘Unfair’ is another word which takes on a life of its own when associated with government policy. ‘Incentives’ is a further example.

Take income tax. If we introduced income tax today, we might create a few simple rules. A flat tax is clearly ‘unfair’ so we might settle for a fixed non-taxable allowance for each individual plus a fixed percentage of all income above that point. Some politicians would then decide that this was still ‘unfair’ while other politicians would decide that the system could be improved by introducing ‘incentives’. Over time, politicians would introduce new rules corresponding to their views of ‘fairness’ and ‘incentives’. Unfortunately, ‘fair’ taxes often result in ‘perverse incentives’, and taxes which promote ‘incentives’ are often ‘unfair’. Redistribution is ‘fair’ but discourages wealthy people from working. Reducing the tax on capital gains is an ‘incentive’ to invest but is ‘unfair’ to those whose income comes only from their labour.

Over time, by introducing these new rules, the politicians would create a tax system which was not particularly ‘fair’ and which did not do much for ‘incentives’. However, it would be very complex. The same politicians would then react to the problems in this complex system by introducing more rules to correct the anomalies arising from the ‘unintended unfairness’ and ‘perverse incentives’. This would result in even more complexity but would still not be very ‘fair’, nor would it produce more effective ‘incentives’. What it would do is to spawn an industry of accountants who would offer to help reduce tax bills by exploiting the many loopholes in the system. Of course, the only people who could afford these services would be large businesses and rich individuals. And that would not be ‘fair’.

‘Fair’ is a word whose meaning is in the eye of the beholder. Child Benefit is a universal benefit. For some reason, that is deemed to be ‘fair’ even though it involves paying government money to millionaires who don’t need it. In most other contexts, using government money to make rich people even richer would be deemed ‘unfair’. Yet, in the case of Child Benefit, we make an exception. Perversely, the current centre-right government has plans to stop paying Child Benefit to millionaires while the left-wing opposition protests that this is ‘unfair’. Imagine if the policy were being implemented in reverse. Suppose that Child Benefit were not currently paid to millionaires and that the government proposed to extend it to millionaires in the middle of our extended recession/depression. I am certain that this would be seen as ‘unfair’ on the Left, so we have two polar opposite policies both of which are seen as ‘unfair’ by the same people.

Actually, there is a germ of logic in the Child Benefit criticisms. The government needed a practical mechanism to decide who should be eligible to receive the benefit. It decided to use the income tax system. The income tax system taxes individuals rather than ‘families’. As a result, the proposed new rules discriminate against ‘families’ with one ‘high’ wage earner and a stay-at-home non earner. ‘Families’ with two ‘lower’ wage earners can avoid losing the benefit even when, in some cases, their combined ‘family’ income is higher than the income of the ‘high’ wage ‘families’.

You’ll see that I have used quotes for ‘family’ and for ‘higher’ and ‘lower’ wages. That’s because these words have their own issues. For example, the ‘lower’ wage earners in my example have incomes which are substantially ‘higher’ than the average national income. As for ‘family’, well that would need an entire post to itself.

Tim Harford wrote a funny article on the subject of the pasty tax this week. He also mentioned last year’s Mirrlees Review (and at BBC and The Guardian) which put forward proposals for a more rational tax system.

These issues are not specific to the UK. Gregory Mankiw wrote an article in The New York Times last month on the problems of defining ‘ordinary income’ and ‘capital gains’ ‘fairly’ in the US.

How did economists get it so wrong?

In 2009, Paul Krugman wrote an article for The New York Times entitled How Did Economists Get It So Wrong? It is an excellent summary of mainstream economic thinking from Keynes to the present day (albeit from a very US-oriented perspective). It is also very good on the deficiencies of the economics profession in predicting the current economic crisis. I particularly like his analogies about baby-sitting and the price of ketchup.

Wanted – useful economists

There seem to be few hard and fast rules in economics. Take the concept of division of labour. We are all better off when we each take a specialist role and then trade with each other. This works well almost everywhere for all manner of goods and services. However, it doesn’t work when asking and answering big questions on economics.

Suppose I want to know the likely impact on inflation of current government policies. As it happens, I have been asking this question and doing some internet research. Economists are the specialists in this area and they have been working on this question for some time. According to economists, the answer is that hyperinflation is likely; or mild inflation; or no inflation; or prolonged deflation. The economics professional does not speak with a single voice on this question. I am left with the task of deciding for myself which, if any, of these answers is correct. Of course, in order to do this, I will first need to teach myself economics to the level of a Nobel prize-winner and then work through the pros and cons of the arguments for each answer. I may be some time.

I’m being a little unfair here, but only a little, so I have a dilemma. In order to make any progress, I need to use the knowledge of ‘the best’ economists, but it’s not at all clear to me which economists are ‘the best’. I need some criteria.

I have set out some criteria, including basic reasoning, below. I have not made any attempt at balance in these criteria. I do not know enough about the many schools of economic thought to achieve political, ideological or methodological balance.

Criteria for 'useful' economists

Criterion	Description
Mainly macroeconomics	Economics is made up of top-down macroeconomics and bottom-up microeconomics. The questions I want to answer seem to be mostly macroeconomic questions.
Prediction track record	Economists who predicted the current crisis are more likely to have mental models that are consistent with the facts. Of course, they could have predicted the crisis through luck, so a longer track record is desirable.
Recognition of failings	Economists who have acknowledged openly the economics profession’s failings are more likely to be open to identifying problems and making improvements.
Good communications	Economists who talk in plain English are easier to understand than those who use abstract jargon.
Flow diagrams	Economists who use diagrams to demonstrate the flows of goods, services, information and money between the various stakeholders in the economy, are likely to be easier to understand than those who use only words.
Complex systems	Economists who use the language of complex systems are more likely to fit my own beliefs.
Trial and error	In the face of a complex system which demonstrates unpredictable behaviour, economists who advocate the use of experimentation, trial and error, and controlled experiments, are more likely to fit my own beliefs.

I’ve been looking for economists who meet at least some of these criteria for a while. Here is my initial list of the economists from whom I’m hoping to learn:

First cut set of 'useful' economists

Name	Country	Website/Blog	Wikipedia	Twitter	Other
Ha-Joon Chang	South Korea	Website/Blog	Wikipedia
Tim Harford	UK	Website/Blog	Wikipedia	Twitter	More or Less
John Kay	UK	Website/Blog	Wikipedia	Twitter
Steve Keen	Australia	Website/Blog	Wikipedia	Twitter
Richard Koo	Taiwan		Wikipedia
Paul Krugman	USA	Website/Blog	Wikipedia	Twitter
Paul Ormerod	UK	Website/Blog	Wikipedia	Twitter
Joseph Stiglitz	USA	Website/Blog	Wikipedia

As most of these economists have blogs and use Twitter, it’s easy to find their views. Some of them have boisterous arguments with their ideological and methodological opponents, so it’s easy to find alternative views as well.

There are lots of financial blogs on the internet. Here is Time magazine’s list of the 25 best financial blogs.

The Pleasure of Finding Things Out

One of the main complications in economics is finding the correct balance between scientific (or empirical) thinking and decision-making, and philosophical (or moral or political) thinking and decision-making.

The current economic crisis has shown us that the economics profession doesn’t know enough about how the economy works to help us define clear rules for how the banking system should work, or how a multi-country currency like the Euro should work, in order to prevent these things from threatening the stability of the entire economic system. Perhaps a few economists know enough to help us develop appropriate rules but how would we go about identifying them?

In practice, we determine the rules for these systems by electing politicians, and their advisors, to set the rules on our behalf. However, if economists don’t know the appropriate rules then why should we expect politicians to be able to set such rules? Also, if we want stable banking and currency systems then what logic should we use in casting our votes in elections?

Some people vote on a moral basis: people should be more self-reliant, or society should be fairer, or we should be more careful with the environment. Other people vote for selfish reasons: they want a promised tax cut or benefit increase. Yet more people vote simply to get rid of an incompetent or corrupt government and replace it with something (anything) different. Perhaps, we can rely on the wisdom of crowds. More likely, we just have no choice but to rely on this type of decision making.

Nobody votes for anyone who has a scientific understanding of how banks and currencies actually work. Of course, that’s because no-one seems to have this understanding. Nevertheless, it’s difficult to understand why we don’t appear to think it’s important to know how these things actually work. There is no relationship between a moral choice, such as a vote for a fairer society, and an understanding of relatively apolitical truths relating to banking systems and currencies. How do we expect these things to work out well?

Somehow, the balance between scientific thinking and philosophical thinking feels wrong. Perhaps, politicians are better salesmen than scientists? Perhaps, scientists confuse the rest of us by using complex jargon and mathematics? Perhaps we just don’t trust people who look like an archetypal ‘nutty professor’? Perhaps we find it difficult to distinguish ‘scientific method’ and ‘scientists’? Perhaps science is just too much effort?

I don’t have heroes but, if I did, one would be Richard Feynman. Feynman was a Nobel prize-winning physicist. He was also a good talker, he used plain English rather than jargon, and he didn’t look like a nutty professor. He understood that scientific method was more important than the ego of any scientist. He was a great ambassador for the virtues of scientific thinking such as curiosity, open-mindedness, rigour, perseverance, humour and humility in the face of observed practical evidence.

Feynman was featured in a number of BBC documentaries. In particular, he discussed his views on scientific thinking in The Pleasure of Finding Things Out. He discussed the pleasure of finding things out about a remote country in Asia called Tannu Tuva in The Last Journey of a Genius. Some of Feynman’s greatest hits are also featured in a number of shorter YouTube videos.

Watch a selection of Feynman’s thoughts after the jump.

Economics, seismology and meteorology

Economics and seismology have some similarities. Both subjects involve the study of complex systems which are stable for much of the time, but which are capable of causing great damage when they become unstable. Both subjects are in their infancy – neither has the capability to prevent catastrophic instabilities and neither has the capability to predict such instabilities.

So why do we seem to have a problem with economists but not seismologists.

Meteorology also has major limitations. Again, it involves a complex system which is stable for much of the time, but which can cause massive destruction when it becomes unstable. Weather forecasters can make accurate predictions for a few days ahead but are less good over longer periods. They can predict major events such as hurricanes but can’t predict their precise paths. They can’t prevent hurricanes from occurring and they can’t change their paths when they represent a major threat to life and property.

So why do we seem to have a problem with economists but not meteorologists.

One answer is that seismology and meteorology study complex natural systems whereas the economy is a complex system with a man-made design. Our expectations of what seismologists and meteorologists can achieve are limited by our shared understanding that we are merely trying protect ourselves from forces which are more powerful than us. Our expectation of economists is that they should help us design and control the economy, rather than just try to understand it and forecast major instabilities. We expect economists to be able to run before they can walk.

A second answer relates to the frequency of instabilities. Earthquakes and hurricanes occur many times a year, whereas major economic depressions may happen only once or twice in each lifetime. We expect earthquakes and hurricanes, but are surprised when the economy becomes unstable.

A third answer follows on from the first two. Our common understanding of the limitations of seismology means that we can take collective actions to protect ourselves against earthquakes:

• Design buildings to withstand the shocks of a major earthquake
• Design walls to hold back related tsunamis
• Design early warning systems to flash messages about impending earthquakes and tsunamis into television and radio broadcasts
• Educate the general population on how to protect themselves during an earthquake
• Design and implement disaster recovery plans.

Our common understanding of the limitations of meteorology also means that we can use daily weather forecasts in a reliable way, and protect ourselves from extreme events.

No such common understanding seems to exist regarding what reliable services we can expect from economists, or whether the rest of us would find such services useful. Imagine that meteorologists always predicted that tomorrow’s weather would be very similar to today’s weather, and imagine that many of them said that their models showed that hurricanes could not occur. They would be correct much of the time but that service would not be useful. This is compounded by the apparent inability of the economics profession to speak with a single voice on anything. As a result, when a major economic crisis occurs, we are each left to our own devices to determine the appropriate course of action, and that action tends to involve panic.

A final answer relates to politics. We ask our politicians, and their economic advisers, to design an optimal economy for us. An honest politician would point out the limitations of our current abilities to do this. Of course, no-one would vote for a politician, or listen to an economic adviser, who expressed this type of humility. We are nevertheless surprised when successive sets of politicians and economists fail to live up to their unrealistic promises.

We have only ourselves to blame.

Economics 101: Hayek and Keynes

One of the consequences of the entanglement of the empirical and political aspects of economics is that the subject has created a number of god-like figures. Certain economists are treated almost as though they were infallible by the followers of the political ideologies which they inspired.

As these economists are all long dead, it is interesting to speculate about what they would say regarding the followers who interpret their words and turn those interpretations into political actions. I doubt that they would be pleased.

Irrespective of the merits of their original ideas, Adam Smith (1723-1790) and Karl Marx (1818-1883) seem to have suffered particularly badly in this respect. However, it is probably the later pair of Friedrich Hayek (1899-1992) and John Maynard Keynes (1883-1946) who exert most influence in modern economics and politics. Hayek is seen as a founding father of many free-market and libertarian ideas championed on the Right of modern politics, while Keynes has the equivalent position regarding the mixed economy championed on the Left.

EconStories has made a couple of videos humanising Hayek and Keynes by depicting them as rappers and as flawed individuals. The videos are entertaining and informative. They also introduce some of the key economic terms used in debates on the current economic crisis e.g. boom and bust, crony capitalism, paradox of thrift, liquidity trap and malinvestment.

I’ve been looking at a number of quotes attributed to Hayek and Keynes. My feeling is that they’d both be sceptical about many of the simplistic answers advocated in their names.

The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.
Friedrich Hayek

We shall not grow wiser before we learn that much that we have done was very foolish.
Friedrich Hayek

The progress of the natural sciences in modern times has, of course, so much exceeded all expectations that any suggestion that there may be some limits to it is bound to arouse suspicion.
Friedrich Hayek

If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid.
John Maynard Keynes

Economists set themselves too easy, too useless a task if, in tempestuous seasons, they can only tell us that, when the storm is past, the ocean is flat again.
John Maynard Keynes

The difficulty lies not so much in developing new ideas as in escaping from old ones.
John Maynard Keynes

Watch two Hayek and Keynes raps after the jump.

Economics 101: The Story of Economics

The BBC radio programme The Story of Economics provides a clear and simple introduction to the subject for a layman like me. I like it because it is presented by a non-economist (economists are part of the set of problems I’m trying to solve) and because it doesn’t try to present a black or white view.

The programme has three half-hour episodes, each dealing with a different perspective on the subject:

1. Gods: economics as a morality tale
2. Cogs: economics as a clockwork machine
3. Monsters: economics as a study of human behaviour.

Even at this entry level, economics splits into empirical (simple and mechanical Cogs augmented by more complex Monsters) where the purpose is to figure out the ‘scientific truth’ about how the economy works, and political (Gods) where the purpose is to promote and justify specific philosophical ideologies.

My objective is to understand the empirical aspects of economics. However, one of the problems is that it’s very difficult to disentangle the empirical and political aspects. The economy is a complex system where there are few black and white ‘provable’ rules. It is very difficult to run controlled experiments. As soon as an empirical economist makes a policy recommendation, it becomes almost impossible to distinguish the empirical economist from the politician.

Yet there are some economic outcomes, such as the collapse of a currency or a banking system, which are in no-one’s political interest. The fact that such catastrophic outcomes still occur, or threaten to occur, suggests to me that our empirical understanding is fairly limited.