Responses to Reader Questions, 7/29

I answer some and invite others

Paid subscribers can submit new questions in the comments. Here are some earlier questions:

What is the biggest open question in finance that academics have (so far) done a poor job trying to address? (in your opinion)

I think that the biggest issue that has not been addressed well is diversity of investors. It’s much easier to think of the market in terms of a single representative investor. At most, you give a nod toward people having different levels of risk aversion.

But in the real world, people clearly differ in their information sets, beliefs, opinions, and psychological characteristics. Years ago, someone pointed me to some work by Mordecai Kurz trying to model a stock market in which investors had two different outlooks. Other than that, I don’t know of any literature that delves into investor diversity. I suspect that various puzzles concerning market dynamics and trading volume can only be solved by taking investor diversity into account.

if your values became egalitarian but your factual beliefs about econ stayed the same, how would your views about healthcare policy change?

I don’t think my views would change. In my book, Crisis of Abundance, I proposed policies in which government would provide support for the very sick (in terms of cost of dealing with their ailments) and the very poor, but for no one else. I think that approach would be more egalitarian than what we have now and more egalitarian than many other proposals. Other approaches spread government subsidies out to more people, which of course makes those policies more popular than mine.

What are your thoughts on egalitarianism generally?

Probably my most contrarian thought is that political inequality in the U.S. is much, much bigger than income inequality or wealth inequality. I have some numerical justification for this claim in my most widely unread book, Unchecked and Unbalanced. If you think of inequality as being able to carry out a family dynasty, to give your children an advantage over other people’s children, to me it seems to be much more common in politics than in business. I see more Senators who are the children of political leaders than I see business moguls who are the children of other business leaders.

If you had to develop a simple rubric for ex ante rating political candidates’ priorities and policies as reflected in their campaign platforms/agendas, what might that look like?

What I would most like to see is an awareness of the capacity for government to do damage: to intervene overseas in ways that have bad consequences; to have programs corrupted by special interests; and to undertake new initiatives without addressing the failures and mismanagement of older programs. Also, I really wish we had a candidate who had managed an organization larger than a Senate staff. Dwight Eisenhower is the only President of the past hundred years who I think appreciated the strengths and weaknesses of large organizations.

Is central bank policy really as myopic as it seems to be?

James Tobin joked that Milton Friedman described the Fed as acting like an amateur shower-tuner, alternately freezing and scalding. Tobin didn’t see that pattern, and neither do I. The economy does not follow a perfectly smooth path, but (a) I don’t think that the Fed always deserves blame and (b) if they do deserve blame, I don’t think that over-reaction to current news is what is driving their mistakes. The “long and variable lags” proponents have often misread the economy, too, unless you stretch “variable” really far to enable “long and variable lags” to explain everything.

Has writing your series on human interdependence led you to any major updates to your political stances? Or to your model of promoting those stances effectively?

Much of what I have written under that rubric includes ideas about economics and business that I have held for a long time. I am becoming more exposed to ideas that are new to me in psychology, evolution, sociology, and the nature of political beliefs. I think that has made me sadder about politics. The beliefs that worry me seem to grow in strength, especially among people who are highly educated.

What would it take to make an S&T (specialization and trade) school? Could it merge or dominate the Austrian school?

The short answer to the question is that S&T will remain small in the foreseeable future. Just me and a few non-academic disciples. Even if it somehow took over the Austrian school, it would still be small.

The long answer is to look at the recent history of schools of thought in economics. My view of economics in the twentieth century is that there was Communism, left anti-Communism, and right anti-Communism.

On the Communist side, you could include Soviet economists, such as they were. In the West, I would include anyone who defended central planning. I would include Leontief, who was exiled at a young age by the Soviet Union. I would include Abba Lerner or John Kenneth Galbraith. I would include Joan Robinson and some of the other British Keynesians. Maybe it is unfair to describe them as on the Communist side. But I think it is fair to call them on the planning side.

The right anti-Communists would include the 20th-century Austrians. Mises and Hayek, obviously, but there were others. It would include Milton Friedman as well. Think of the whole Mont Pelerin Society (which was not large, although arguably it was influential relative to its numbers). They saw central planning as an inevitable disaster, both for freedom and for economic well-being.

The left anti-Communists would be mainstream American economists, notably Samuelson and Solow. Solow said that when he would read Galbraith, it made him think of all of the advantages of markets. And when he would read Friedman, it made him think of all of the ways markets can fail and that government intervention is appropriate. The left anti-Communists sought a middle ground.

What’s my point? I claim that a lot of mainstream economics of the 20th century can be interpreted as formulating a left-of-center economic program against Communism. Solow, who studied under Leontief, spent a career fighting Leontief’s main contribution, which consisted of input-output tables that could be used by a central planner.

Input-output analysis assume no ability to engage in substitution. You always need fixed proportions of inputs to get to an output. Solow thought that approach was wrong. He and a number of others worked out the neoclassical production function, in which substitution between capital and labor is particularly important. When the Club of Rome promulgated its Limits to Growth thesis, Solow read it as failing to allow for substitution, and he denounced it.

In the 1950s, there was an intense, esoteric debate over “re-switching,” also known as the Cambridge Capital Controversy. Ostensibly it had something to do with the properties of the marginal product of capital in the context of the production function. But the underlying conflict was Solow-Samuelson anti-Communism vs. the more leftist British. Why the re-switching issue took on so much significance in this conflict is hard to reconstruct.

The neoclassical production function was useful in the anti-Communist position because it implies that labor is not exploited. Instead, one can argue that workers are entitled to their marginal product, and under sufficiently competitive conditions that is what they will receive.

Still, the “mood affiliation” of left anti-Communists was with the interventionism of Roosevelt’s New Deal, and with his successors in the Democratic Party. Thus, the concept of market failure came to loom large in the work of mainstream economics. Mainstream economists also wrestled with the concept of a social welfare function, hoping that it would provide a way to justify government intervention and technocratic calculation.

Mainstream economics became very committed to the use of mathematics. Macroeconomics, in particular, became ahistorical, as economists sought mathematical models that could characterize the state of the economy. The mathematical turn proved to be a powerful status move.

As I tried to point out in my book, I believe that viewing the economy through the lens of specialization and trade is better than mainstream economics. For macroeconomics, it is better to treat fluctuations as historical events than as shifts in aggregate demand, which only pretends to be an economic concept. In microeconomic theory, where mainstream economics depicts government as addressing market failures, the specialization and trade perspective correctly predicts that government intervention will subsidize demand and restrict supply.

But will a school of economics emerge around the specialization and trade perspective? I doubt it. Mainstream economics is too entrenched. See my conversation with Pi.