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January 15, 2006
David Warsh, Proprietor


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What Has Changed in Economics?

When the American Economic Association met in New York City in December 1965, the sessions were dominated by an interest in the economics of knowledge. As president-elect, Princeton’s Fritz Machlup sought to showcase the latest work in the field that interested him most deeply: Zvi Griliches and Dale Jorgenson and Edward Denison on the measurement of productivity change, Kelvin Lancaster on conceptual issues in the measurement of consumption, Karl Shell on inventive activity, Richard Nelson and Edmund Phelps on education and the diffusion of technology. In his Ely lecture, Kenneth Boulding observed that the commodity aspects of knowledge had suffered from “a certain neglect” by economic theorists ever since Adam Smith. He quoted testimony given before Congress in 1886 by John Wesley Powell, the explorer of the Grand Canyon: “Possession of property is exclusive; possession of knowledge is not exclusive, for the knowledge which one man has may also be the possession of another.”

In the world outside the hotel, the Keynesian synthesis, the “New Economics,” was at the height of its influence and prestige. Inside the hall, Boulding complained, “I get the impression that economists in this country are bathed in a warm glow of self-congratulation, arising out of the long Kennedy-Johnson upswing and the successful tax cut, and they are all climbing onto the bandwagon of the Great Society, waving flags and tooting horns.”  In Washington, Keynesian economists were in control. Indeed, that very week, Time magazine put John Maynard Keynes (who had died in 1946) on its cover (“The Keynesian influence on the expansionist economy”). Seven days later he would be edged out for Time’s “Man of the Year” by General William Westmoreland, then overseeing the build-up of US forces in Vietnam.

On that year’s red-hot job market was a 25-year-old MIT graduate student named George Akerlof.  He had gone to MIT from Yale in 1962, intending to make economics more mathematical. Before long, he developed a conviction that math, while potentially invaluable, often cloaked a lack of knowledge about how markets actually worked. Hired by the University of California at Berkeley, Akerlof quickly began several research projects, including one on the market for used cars, before taking a year’s leave in 1967 to work for the Indian Statistical Agency, in New Delhi, in order to learn first-hand about poverty and caste. Thus he missed the ’67 meetings in Washington D.C., when Milton Friedman’s criticism of the assumption of a permanent trade-off between inflation and unemployment touched off a long, slow re-examination of Keynesian assumptions.

That was forty years ago. When the economists met in Boston earlier this month, it was Akerlof who organized its meetings as president-elect. The meetings are bigger now, more than ever the creature of a program committee, much too complicated to describe as having a simple theme.  But the organizer still gets to make a few distinctive choices.  Akerlof used his to invite four key lectures, by global leaders of new developments. Those four indicated certain ways in which economics had changed.

Andrei Shleifer of Harvard University lectured on the economics of persuasion. Using data on financial image advertising from Money magazine and Business Week during the years of the Internet bubble, Shleifer sought to distinguish between traditional views of advertising and new, psychologically-richer “behavioral” explanations. For George Stigler in the 1960s, advertising had been mostly objective — simply information conveyed about the availability and quality of a product. For Shleifer, his collaborator Sendil Mullainathan, and many young economists, the essence of advertising (and much other commercial communication) is that it tells people what they want to hear. No one who traced the shifting pitches of Wall Street firms during the mania — from reliability to alacrity and back — could doubt that consumer belief-systems are central to understanding the processes of their manipulation, he said, or that understanding cognition was central to understanding economic behavior.   

Ernst Fehr of the University of Zurich summarized a series of papers emanating from his Institute for Empirical Research in Economics.  Using tools ranging from positron emission tomography (PET) scanning of patients’ brains to questionnaires and simple laboratory experiments, Fehr’s group has assembled impressive evidence for the existence of a set of social preferences that in the past have been assumed away by most economists — a preference for mutual cooperation, a dislike for cheating and unfairness, a capacity for trust. They’d even identified a hormone, Oxytocin, as promoting trust among human beings (though not necessarily trustworthy behavior). The inquiry into tastes for reciprocity and punishment had barely begun, Fehr said; “neuroeconomics” promised significant insights into the human capacity to imagine the other, and to show how this ability interacts with one’s own preferences and beliefs.

Alan Krueger of Princeton University described the “new new thing” among labor economists, by which he meant something other than the “natural experiments” that were a vogue in the 1990s. This new tendency Krueger called “tectonic economics,” meaning research that examines seismic shifts in some phenomenon, tracing out the effects on crime of a major shift in policy like Roe v. Wade on crime, for example, or examining the reasons for major shifts such as the rise in wage inequality in the 1980s. A still older approach to empirical work, structural estimation, attaches great importance to the combination of econometrics and theory of a research project;; the emphasis on randomized and natural experiments in the late 1980s and 1990s grew out of frustration that not much was being learned structural estimation, Krueger said.  “I think the field is now shifting to high-importance questions (that’s tectonic economics) because of frustration that the randomized and natural experiments often give us a compelling answer but to a narrow question.”

Finally, Claudia Goldin of Harvard University (as noted last week) explained how women’s increased involvement in the economy had slowly gathered force until it had become most significant change in labor markets of the last century — a tectonic shift of a high order.  Introducing Goldin to the audience as his “ideal as an economist,” Akerlof explained his admiration for her having consistently chosen “the biggest and most important issues” and approached them with great originality.  Her demonstration that the direct costs of the American Civil War had amounted to four times the pre-war GNP anticipated a surge of interest in the costs of the war in Iraq. Her discovery of “the high school movement” in the late nineteenth and early twentieth centuries had shown how the United States had dealt with a surge of immigration, to the great advantage of its workforce.  And her continuing interest in the economic history of women “and the past injustices that had been committed to them” Akerlof said, had led most recently to her demonstration, with Cecilia Rouse, that orchestras will choose more women in blind than in open auditions. “Her work reverses the usual economic methodology of testing hypotheses determined by considerations of economic theory. Instead, Claudia’s theories are based on observation of the facts.  She has a more modest vision of economic methodology than is the norm. She is Charles Darwin rather than Albert Einstein.”

It was this preference for the inductive approach to economics that was on display throughout. Not surprisingly, Akerlof’s own career followed a trajectory of immersion in problems of the real world, too. In a short autobiography he wrote after that paper on used cars and asymmetric information — “The Market for ‘Lemons’” — earned him an eventual Nobel Prize, Akerlof reflected on his tour of duty in the Indian Statistical Office.

“The trip to India was important for my intellectual development. Especially, it confirmed for me that nonstandard analyses were needed to understand many economic transactions. As I have hinted earlier, the fundamental problem I wished to explore in economics, was the reason for unemployment. Unemployment involves, above all, a gap between supply and demand. In India, the caste system for centuries has interposed itself between supply and demand. The gaps between supply and demand in the Indian caste system were then potentially informative as to how similar gaps might exist in labor markets in Western countries. What I learned in India became the keystone for my later contributions to the development of an efficiency wage theory of unemployment in Western countries. This theory unfolded over the next twenty years. Curiously, Joe Stiglitz visited Kenya at about the same time and developed models embodying alternative efficiency wage theory based on his similar observations of the underdeveloped world.”

This preference for the close observation of the relevant facts, variously described as “empirical” or “behavioral” economics (in sharp opposition to the “positive” economics of an earlier day) was not simply a matter of Akerlof’s personal taste. It was pervasive at the meetings. Stanley Engerman of the University of Rochester was named a distinguished Fellow for, among other things, his demonstration Time on the Cross: The Economics of American Negro Slavery, his 1974 book with Robert Fogel, that slavery had been a prosperous economic institution. (Princeton’s Michael Rothschild and the University of Chicago’s Hugo Sonnenschein were similarly honored.) Daron Acemoglu and James Robinson participated in several sessions carved from their new book, Economic Origins of Dictatorship and Democracy, a dominating exemplar of the new political economy. And in “Free Markets and Fettered Consumers,” outgoing AEA president (and Nobel laureate) Daniel McFadden of the University of California at Berkeley catalogued what was known about limitations to self-reliance of the human mind and adduced the implications for the design of the new Medicare pharmaceutical benefit.

Most of the Medicare population would be able to deal satisfactorily the choices offered by the market for prescription plans, despite the complexity of Part D and consumer discomfort with market choices, he concluded. But a significant minority, about 10 percent, are in danger of opting out by default, and a substantially larger fraction may choose the wrong plan or miss the May 15, 2006, deadline, “so there is likely to be considerable churning and grumbling” in the future. A little out-reach, in the form of premium holidays, introductory prices and signing bonus to plan providers, would go a long way towards minimizing the problem, McFadden said.

So what has changed in economics in forty years? In 1966, the field was deeply divided between institutionalists, Austrians and others who shared a vivid interest in the real world, but who possessed relatively few of the models that only recently had come to dominate discourse; and the then-ruling macroeconomists, who had plenty of models, most of them of such great generality as to offer little insight into what was really going on.

By 2006, the gap had narrowed dramatically in most fields, thanks, in large part, to developments in game theory that permitted questions of strategic interaction to be addressed. In all cases, the way ahead was deeper into the math or computation — the disappointments of the 1960s having stemmed more from “economists’ lack of (mathematical) knowledge rather than to the truth of their arguments,” as Akerlof put it in his autobiography. CentrNowhere has this been more apparent than in monetary policy, where progress in understanding the path to price stability has been sufficiently rapid that the Bush administration turned to a university economist, Princeton’s Ben Bernanke, to replace the corporation- and market-trained Alan Greenspan.

Even interest in the economics of knowledge has revived, thanks once again to a student who immersed himself in the details of the real world before turning to formal methods to create simplified formulations that have reanimated the study of economic growth — Paul Romer of Stanford’s Graduate School of Business. Still on the program this year were two under-recognized giants in their fields who, as young men at the meetings in 1965, had espoused the centrality of the growth of knowledge, Ned Phelps and Richard Nelson, both of Columbia University. It was splendid to see their views — and those of Machlup and Boulding, too — confirmed by subsequent events.

* * *

Investigative reporter David McClintick’s story on what happened after Andrei Shleifer and Harvard were found to have committed fraud and breach of contract respectively appeared last week in the January 2006 issue Institutional Investor — “How Harvard Lost Russia: The inside story of what happened when the enormous power and resources of the government of the United States were put in the wrong hands.” You can read it on II’s awkward Web page (but not see the interesting photographs) if, in the left rail, you locate “Institutional Investor Magazine International,” click on it and register for a one-day pass. Its centerpiece is a careful reconstruction of events in the spring of 1997, when the U.S. Agency for International Development blew the whistle on the Harvard team, whose leaders were busily lining their pockets with Russian investments in contravention of the rules. The article bears careful reading.

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