A Tale Of Baby-sitters, Ketchup, And Economists

krugman

Paul Krugman’s article in this past weekend’s NYT Magazine:

The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.

To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive. But this evidence was of an oddly limited form. Finance economists rarely asked the seemingly obvious (though not easily answered) question of whether asset prices made sense given real-world fundamentals like earnings. Instead, they asked only whether asset prices made sense given other asset prices. Larry Summers, now the top economic adviser in the Obama administration, once mocked finance professors with a parable about “ketchup economists” who “have shown that two-quart bottles of ketchup invariably sell for exactly twice as much as one-quart bottles of ketchup,” and conclude from this that the ketchup market is perfectly efficient.

But neither this mockery nor more polite critiques from economists like Robert Shiller of Yale had much effect. Finance theorists continued to believe that their models were essentially right, and so did many people making real-world decisions. Not least among these was Alan Greenspan, who was then the Fed chairman and a long-time supporter of financial deregulation whose rejection of calls to rein in subprime lending or address the ever-inflating housing bubble rested in large part on the belief that modern financial economics had everything under control. There was a telling moment in 2005, at a conference held to honor Greenspan’s tenure at the Fed. One brave attendee, Raghuram Rajan (of the University of Chicago, surprisingly), presented a paper warning that the financial system was taking on potentially dangerous levels of risk. He was mocked by almost all present — including, by the way, Larry Summers, who dismissed his warnings as “misguided.”

[...]

babysitters-club

I like to explain the essence of Keynesian economics with a true story that also serves as a parable, a small-scale version of the messes that can afflict entire economies. Consider the travails of the Capitol Hill Baby-Sitting Co-op.

This co-op, whose problems were recounted in a 1977 article in The Journal of Money, Credit and Banking, was an association of about 150 young couples who agreed to help one another by baby-sitting for one another’s children when parents wanted a night out. To ensure that every couple did its fair share of baby-sitting, the co-op introduced a form of scrip: coupons made out of heavy pieces of paper, each entitling the bearer to one half-hour of sitting time. Initially, members received 20 coupons on joining and were required to return the same amount on departing the group.

Unfortunately, it turned out that the co-op’s members, on average, wanted to hold a reserve of more than 20 coupons, perhaps, in case they should want to go out several times in a row. As a result, relatively few people wanted to spend their scrip and go out, while many wanted to baby-sit so they could add to their hoard. But since baby-sitting opportunities arise only when someone goes out for the night, this meant that baby-sitting jobs were hard to find, which made members of the co-op even more reluctant to go out, making baby-sitting jobs even scarcer. . . .

In short, the co-op fell into a recession.

O.K., what do you think of this story? Don’t dismiss it as silly and trivial: economists have used small-scale examples to shed light on big questions ever since Adam Smith saw the roots of economic progress in a pin factory, and they’re right to do so. The question is whether this particular example, in which a recession is a problem of inadequate demand — there isn’t enough demand for baby-sitting to provide jobs for everyone who wants one — gets at the essence of what happens in a recession.

Forty years ago most economists would have agreed with this interpretation. But since then macroeconomics has divided into two great factions: “saltwater” economists (mainly in coastal U.S. universities), who have a more or less Keynesian vision of what recessions are all about; and “freshwater” economists (mainly at inland schools), who consider that vision nonsense.

Freshwater economists are, essentially, neoclassical purists. They believe that all worthwhile economic analysis starts from the premise that people are rational and markets work, a premise violated by the story of the baby-sitting co-op. As they see it, a general lack of sufficient demand isn’t possible, because prices always move to match supply with demand. If people want more baby-sitting coupons, the value of those coupons will rise, so that they’re worth, say, 40 minutes of baby-sitting rather than half an hour — or, equivalently, the cost of an hours’ baby-sitting would fall from 2 coupons to 1.5. And that would solve the problem: the purchasing power of the coupons in circulation would have risen, so that people would feel no need to hoard more, and there would be no recession.

Krugman offers a few notes on the article on his blog:

First, to anyone who wishes I’d given credit — yes, I was helped by reading many sources (especially Justin Fox), but it’s a magazine article, not a book with room for an acknowledgments page; I couldn’t even acknowledge the editing work done by my wife, Robin Wells, which played a big role. Some fairly extensive sections had to be taken out — for example, I wanted to include material about Paul Samuelson’s 1948 textbook, which reads very well in the current crisis, but had to cut it. Hyman Minsky also got crowded out. Sorry.

Second, on whether the pretty good response of policy-oriented economists in the crisis undercuts the thesis — I don’t think so. I mean, yes, my colleagues are smart people, and some of them are highly flexible and quick on their feet. But the fact remains that many of these responses have been completely ad hoc; there just wasn’t the theoretical development in advance there would have been if the profession hadn’t been chasing the neoclassical dream.

Third, on an interesting point raised by Discover (via Mark Thoma): won’t we eventually have a true theory that’s as beautiful as the full neoclassical version? Well, one thing’s for sure: we don’t have that beautiful final theory now, so the current choice is between ideas that are beautiful but wrong and a much messier hodgepodge. But my guess is that even in the long run it won’t be all that neat. Discover suggests general relativity versus Newtonian physics; but a better model may be meteorology, which as I understand it starts from some simple basic principles but is fiendishly complex in practice.

sign

A couple posts from Matthew Yglesias, here and here. Yglesias:

Since I alluded to Larry Summers’ paper on “ketchup economics” from the mid-eighties earlier today, I may as well quote the funny part:

“Ketchup economists reject out of hand much of this research on the ketchup market. They believe that the data used is based on almost meaningless accounting information and are quick to point out that concepts such as costs of production vary across firms and are not accurately measurable in any event. they believe that ketchup transactions prices are the only hard data worth studying. Nonetheless ketchup economists have an impressive research program, focusing on the scope for excess opportunities in the ketchup market. They have shown that two quart bottles of ketchup invariably sell for twice as much as one quart bottles of ketchup except for deviations traceable to transaction costs, and that one cannot get a bargain on ketchup by buying and combining ingredients once one takes account of transaction costs. Nor are there gains to be had from storing ketchup, or mixing together different quality ketchups and selling the resulting product. Indeed, most ketchup economists regard the efficiency of the ketchup market as the best established fact in empirical economics.”

I was actually inspired to do some research into the ketchup market and discovered that at my local Safeway, a 20 ounce bottle of Heinz sells for $0.13 an ounce. If you go up to a 32 ounce bottle, the price falls to $0.11 an ounce; meaning in effect your extra 12 ounces cost only $0.77 cents per ounce. Thus, we can use the Efficient Ketchup Markets Hypothesis to back-calculated the exact nature of the transaction costs and so forth that justify these prices volume discounts.

A couple of posts at The Motley Fool. Anti-Krugman throwerw:

First of all, you would have to be an idiot or an academic to believe that the market is efficient.  I’m 22 years old, and I’ve been actively investing for about a year.  From the moment I started , I’ve understood that the market is irrational.  It’s not hard to see, and it’s very easy to prove.

The funny thing is, we have a school of economics, the Austrian school, that works very well and that has done a much better job of explaining what is happening than all of this other used dogfood economic theory.  Krugman has never admitted in any of his columns that this school of thought even exists.  That’s how he can continue to ignore the real problem, a lack of savings and excessive debt, and continue to champion increased deficits and wasteful government spending.  How about instead of trying to create a new theory of everything that will ultimately fall apart again, we just use some common sense?

Pro-Krugman (at least on this) TMFMmbop:

I’ll man up and compliment his lucid, well-written short history of modern economics — How Did Economists Get It So Wrong? — in this week’s NYT Magazine (hat tip to Otto kid). The first part of that ultimate conclusion, specifically that “[economists] have to face up to the inconvenient reality that financial markets fall far short of perfection, that they are subject to extraordinary delusions and the madness of crowds” is exactly right.

But I will defend the reality of reverse incentives — those provided by the government that spur consumers to make choices that shouldn’t be in their best interest.

Scott Sumner at Wall Street Pit:

What’s my point? I completely distrust an economist who talks about a promising new area of research that will soon yield all sorts of insights. In my view when a new area is discovered, most of the really useful insights are almost immediately obvious. The only exception that comes to mind is the huge gap between the development of externalities theory, and the discovery of the Coase Theorem. Perhaps others can find some other exceptions. So one implication of this line of reasoning is that I will never live to see the day when behavioral economics and behavioral finance finally revolutionize economics and finance. I probably don’t know enough about these fields to have an intelligent opinion, but my hunch is that if the standard model that we teach in our textbooks has not yet been revolutionized by behavioral economics, it will never be revolutionized. That behavior economics will always be on the fringes, providing interesting anomalies.

And I think this is the problem with Krugman’s agenda. If we knew how to “incorporate the realities of finance into macroeconomics” we would have done so already. We haven’t done so, because we don’t know how. And I think there are good reasons why we don’t know how. Almost any proposal to do so must somehow, at least implicitly, assume the policymakers are smarter than highly paid investment bankers. And even with all the bizarre bubbles we have seen in recent decades, I think that assumption is just too much for most economists to swallow.

Krugman is a very persuasive writer. I keep telling right-wingers that if we have deflationary monetary policies, policies that reduce NGDP, the free market will be blamed. I don’t see any persuasive rebuttals to Krugman from those on the right. I don’t know if my arguments are persuasive, but at least I’m trying.

James Kwak at Wall Street Pit:

His history of post-Depression macroeconomics goes through roughly three phases: Keynesianism; Milton Friedman and monetarism, which, he argues, was relatively moderate compared to the positions of some of his self-styled followers; and the period from the 1980s until 2007, which he describes as the conflict between the Saltwater (coastal, pragmatic, New Keynesian) economists and the Freshwater (inland, efficient markets, neo-classicist) economists. According to Krugman, these two schools had differences on a theoretical level, but those differences were papered over by practical agreement on government policy: namely, monetary policy was superior to fiscal policy at managing the economy.

This false peace was exploded during the financial crisis by the zero bound, something Krugman has invoked often. The agreed-upon way to stimulate the economy in a recession is to lower interest rates. When interest rates hit zero, they can’t be lowered anymore (rather than lend you money and expect to get less back in the future, I should put it under my mattress), and then the policy question is what if anything else should be done. This provoked the fallout between people who favored the stimulus as a way of propping up demand and those who thought that for theoretical reasons a stimulus could not possibly have any positive impact.

Gwen Robinson at FT Alphaville

Justin Fox at Time:

Beyond that, the one big issue I have with the piece is that, while economists certainly got lots of things wrong before the crisis (as did almost all of us), many members of the profession have acquitted themselves pretty well since things turned really ugly last year. Krugman goes on and on about the “freshwater” economists (at the Universities of Chicago, Rochester and Minnesota) and their crazy ideas about perfect markets. But what’s telling is that the hardcore freshwaterites have had almost no impact on economic policy for the past year—neither in the Bush months or the Obama ones. Sure, Nobelist Ed Prescott, a former freshwater economist who now teaches in Phoenix and thus should probably be described as a no-water economist, made the statement that:

“I don’t know why Obama said all economists agree on [the need for a stimulus bill],” Prescott said. “They don’t. If you go down to the third-tier schools, yes, but they’re not the people advancing the science.”

Unless you believe that pretty much anyplace other than Arizona State University is a third-tier school, this is patently untrue, evidence of the extreme isolation of the remaining true believers in rational expectations and real business cycles and other such elegant but profoundly unhelpful macroeconomic theories developed since the 1960s. Even some of the true believers seem far more aware than Prescott that the past year’s events have challenged their theories—as the University of Chicago’s Robert Lucas told me last fall, “everyone is a Keynesian in a foxhole.” Among economists with actual influence on policy over the past year—Philip Swagel in the Paulson Treasury, Larry Summers and Christina Romer and Austan Goolsbee and etc. in the current White House—there’s been a great willingness to experiment and accept that markets don’t always deliver optimal results. The result: an economic recovery that seems to be gaining strength. So don’t totally count the economists out.

Jane Smiley at HuffPo

Donald Marron at iStockAnalyst

UPDATE: Will Wilkinson

Rod Dreher

UPDATE #2: Steve Verdon

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1 Comment

Filed under Economics, The Crisis

One response to “A Tale Of Baby-sitters, Ketchup, And Economists

  1. Pingback: What We’ve Built Today « Around The Sphere

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