By Simon Grey, on January 20th, 2012
If you want to feel like the smartest person in the room, often a good way to accomplish this is to be the only economist. Frequently, the one economist will say things that make a lot of sense that no one else would ever come up with. When I am that one economist, I sometimes feel like a genius. Until a second economist enters the room, that is. Because when the second economist shows up, he or she often says all the smart things I was going to say, before I can say them. It turns out, it is not the economist who is brilliant, but rather the training we get as economists which leads us to think differently from non-economists, that sometimes makes us seem smart.
It is true that economists generally think more deeply than most people. They are used to considering tradeoffs and long-term effects of a given policy or decision, which is something that eludes most people.
However, the mindset espoused by Steven Levitt is quite dangerous, and speaks to a tendency towards arrogance that is often seen among economists. Because they are generally wiser and smarter than other people, many economists begin to think that they are absolutely smart and wise. This in turn leads them to rely too much on their own perceived genius, which is why economists generally don’t have an issue with some form of central planning: they really think that they are smart enough to plan an economy.
They are wrong, of course, because they lack one essential ingredient: knowledge. While economists may be pretty smart, and even wise, they simply do not know enough to manage an economy properly. And so, they get so caught up in their brilliance that they never realize they are astonishingly ignorant.
By Rok Spruk, on December 16th, 2009
On Sunday, December 13th, Paul A. Samuelson has died at the age of 94 (link).
He was on the economic giants of the 20th century. His ideas reshaped the economic science and revolutionized the mode of economic thinking around the world. With the mathematical rigour and analytical mastermind, his groundbreaking approach to economic analysis transfored the economic science into a dynamic problem-solving tool. In this short essay, I will present my reflections on the life and contributions of Paul A. Samuelson to the economic science.
I first came across Paul Samuelson in the year before I entered the university. In the first year of the undergraduate class, Samuelson and Nordhaus’s Economics was the assigned reading for the Introductory Macroeconomics. I read the textbook back and forth and I liked it; not because of its simplicity in introducing the analytical framework of economics but rather because of the clarity, intuition and incentives to undertake a rigorous pursuit of analytical economics at the theoretical and empirical level. In addition, Samuelson penetrated the application of linear programming to economic problem-solving.
Together with Milton Friedman, Paul A. Samuelson is the economic giant of the 20th century. Hardly any economist could take the same place in the scope of influence as an economic thinker. He conducted the Neoclassical synthesis. As an interested reader can verify in his Nobel prize lecture (link), Samuelson’s synthesis combined a Keynesian macroeconomics with a rigorous Marshallian microeconomics. In microeconomics, Samuelson extended the Marshallian analysis of partial equilibrium with strong mathematical articulation of demand and supply curves, cost curves and deadweight loss. On the abstract level, together with Abram Bergson, he constructed social welfare functions based on three marginal conditions and extracted from earlier work of Kaldor-Hicks-Scitovsky analysis (link). In macroeconomics, Samuelson further affirmed the dominance of Keynesian macroeconomics with a strong emphasis on the role of fiscal policy in stimulating full-employment output. In addition, he invented the term multiplier and the acceleration, the former relating to the effect of change in exogenous macro variables on endogenous variable (notably, output) and the latter referring to the partial adjustment of aggregate investment to the capital stock. Samuelson-Hansen multiplier-accelerator principles spurred the theoretical foundations of Keynesian economic policy. He also popularized Overlapping Generations Model which later became the corner stone of innovations in the modeling of aging population. In macroeconomics, Samuelson also proposed the so-called “Samuelson-Mishi condition” for the efficient provision of public goods. When the condition is satisfied, it implies that further substitution of private goods provision for public goods will result in a diminishing social utility.
Assuming Pareto efficiency, Samuelson-Mishi condition satisfied the criteria for Lindahl equlibrium. The equilibrium states that when individuals are willing to pay for the provision of public goods according to marginal benefits, it will be Pareto efficient. However, such condition is not compatible with the incentive mechanism since it requires the complete knowledge of individual demand functions for particular public good which could result in the asymmetric distribution of benefits in response to relevation-principled taxation.
As a student of international economics, I came across the influential theoretical work of Paul Samuelson. Modern international economics is a combination of mathematical economics, advanced microeconomics, game theory and international finance. One of the most interesting and penetrating areas of international economics are theorems in international trade. Under particular assumptions theorem postulate axiomatic explanations based on previous statements. Back in 1941, he proposed Stolper-Samuelson theorem together with Wolfgang Stolper. The theorem quickly became a source of academic debate. In its simplest form, the theorem states the following: assuming constant returns to scale and perfect competition, a rise in the relative price of good will lead to higher return on the factor which is used more intensively in the production of the good and to the fall in the return to the other factor. Stolper and Samuelson wrote:
“Second only in political appeal to the argument that tariffs increase employment is the popular notion that the standard of living of the American worker must be protected against the ruinous competition of cheap foreign labor… In other words, whatever will happen to wages in wage good (labor intensive) industry will happen to labor as a whole. And this answer is independent of whether the wage good will be exported or imported.”
The theorem showed that the international trade between two countries could lead to the opposition of international trade since the relative price of labor-abundant good in the high-wage country will be higher than the world price of that good, reflecting the relative abundance of capital or human capital. The theorem quickly became the main theoretical weapon of opponents to free trade. Even today, Stolper-Samuelson is the best explanation of why labor unions in high-wage countries oppose free trade agreements and further economic integration with low-wage countries.
Another important contribution of professor Samuelson is the so called Ballasa-Samuelson effect which states that higher growth productivity growth rate in tradable goods relative to non-tradables will lead to the real exchange rate appreciation. Balassa-Samuelson effect also went through numerous time-series regression. The effect has been tested 60 times in 98 countries. Cross-section regression studies of Ballasa-Samuelson effect were analyzed in 142 countries. In a vast majority, the empirical evidence of Ballasa-Samuelson hypothesis was supported. The main empirical findings emphasize that productivity differential between tradeable and non-tradable sector is positively correlated with differences in relative prices. The empirical evidence also supported Samuelson’s initial proposition that productivity differentials translate into higher purchasing power parity through real exchange rate appreciation.
In finance, Paul Samuelson penetrated the analytical aspects of lifetime portfolio selection. In 1972 he published The Mathematics of a Speculative Price which later became the ground of option pricing. Based on discoveries of Bachelier’s pioneering work, he laid the foundations of stohastic price movements and random forecasting matches. His pioneering work in financial theory of speculation and random walk (stohastic) movements in stock prices became the underlying theoretical foundation in the emerging financial industry. In an article entitled Probability, Utility and the Independence Axiom (Econometrica, 1952), he discussed the role of probability models in measuring the overall utility. In this sense, he relied on Keynesian defence of subjective theory of probability and argued that the subjective perception of probability does not inhibit the proper functioning of financial markets. In 1965, he published A Proof that Properly Anticipated Prices Fluctuate Randomly where he provided the foundation of the efficient market hypothesis that has been further developed by Eugene Fama and other scholars. For a detailed discussion of Paul Samuelson’s contribution to financial economics, see Merton Miller’s contribution in Britannica (link).
In addition to his theoretical and empirical work, he is the founding member of the Econometric Society and its president in 1951. In 1961, he was the president of American Economic Association. In the political sense, Paul A. Samuelson influenced the economic policy of the Kennedy Administration. In 1960, the U.S headed for the recession. President Kennedy, following Samuelson’s advice, enacted tax cuts and a balanced budget. In 1964, when Kennedy tax cuts were enacted, top marginal tax rate was reduced from 91 percent to 70 percent. The economic reasoning behind tax reductions was firmly laid in the Keynesian multiplier (1/(1+c)(1+t)). Paul Samuelson and Walter Heller (Chairman of Council of Economic Advisers during Kennedy Administration) argued that lower tax rate would stimulate consumption spending and boosted output and employment. Throughout the 1960s, the U.S economy experienced one of the longest periods of stable economic growth, favorable employment outlook and balanced federal budget. Here is how JFK, following Samuelson’s advice, supported the tax reduction (link). Also, David Greenberg’s article on Kennedy tax reduction is a worthy source of further information on that topic (link).
On Sunday, the economic titan passed away. He not only revolutionized the field of economic science but also spurred the interest for economics and popularized it in a manner that turned dismal science into a problem-solving science based on theoretical foundations and empirical verification of theoretical postulates. His approach to economic analysis combined Marshallian microeconomics and Keynesian macroeconomics which he joined together after the WW2 in a Neoclassical synthesis. Compared to other economic thinkers, he knew how to formulate theoretical postulates in a manner that stimulates the research interest for further investigation.
He will be missed and remembered as the giant of the economic thought and a titan of economic theory.
By Ajay Shah, on October 6th, 2009
We’ll soon get the announcement. Here are a few possibilities, computed by Thomson/Reuters, using citation analysis.
If I had to vote, it would be a Taylor/Woodford prize. For a sense of this work, see: link, link. While inflation targeting was invented in New Zealand based on the intuition of cleanliness in public administration, Taylor and Woodford had a lot to do with being able to think straight about it.
It’s interesting to wonder how publicly visible citation data can be used to predict the Nobel prize outcome. One would want some kind of model which consumes citation data and comes up with an estimate of the Pr(Nobel prize). E.g. if one strong idea suffices (example: James Heckman) then it suggests certain people who will get through (example: Paul Romer). If they want you to build a broad literature (example: Robert Lucas) then that yields a different profile of those who will get through. Hmm, I can’t come up with an example of another Robert Lucas. Such a modelling effort will yield insights on the usefulness of summary statistics of citation data such as the h-index and the g-index. As an example, it’s easy to test which of the h index or the g index have superior predictive power in a model of predicting the Nobel prize.
Most people in India think of Raghuram Rajan as being the first Indian-born economist who became the chief economist of the IMF. What is not widely appreciated is that in the class of economists of Indian origin who are younger than Amartya Sen, Raghu is the best set of papers, as measured by citations.
By Winton Bates, on March 23rd, 2009
When I first met Jim (that is not his real name) a few days ago he seemed like a fairly harmless businessman. But when he heard that I was an economist, he said that there was something he wanted to ask me.
I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”
I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”
I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.
At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.
Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”
I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.
Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”
I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things – seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.
Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.
Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are rocket scientists!”
By J.D. Seagraves, on July 7th, 2008
“Libertarians are Republicans who smoke pot.” So goes the saying. And most Americans know little else about the Libertarian Party, America’s third largest, or the libertarian political philosophy. So when former Republican congressman Bob Barr announced his candidacy for the LP’s presidential nomination on May 12, the mainstream media assumed he was a shoo-in. After all, he was a Republican and now lobbies for the Marijuana Policy Project—how could someone better fit the popular definition?
But what the media failed to recognize is that many party members don’t consider libertarianism to be a branch of conservatism but, instead, its diametric opposite. These libertarians refused to embrace Barr and, instead, rallied behind the candidacy of party stalwart Mary Ruwart during the Libertarian National Convention on May 25. It took six ballots before Barr was finally able to win the party’s nomination with just over 51% of the vote, and the rift now between the “reformers” who backed Barr and the “radicals” who supported Ruwart is bitter—and largely economics related.
In Brian Doherty’s 2007 book Radicals for Capitalism, which chronicles the history of the libertarian movement, five figures are cited as essential: Ludwig von Mises, Friedrich Hayek, Milton Friedman, Murray Rothbard and Ayn Rand. All but Rand were economists. And if we eliminate Rand, who was a philosopher, from the discussion (both Barr and Ruwart said she was their favorite philosopher during a debate), the four economists can be easily divided among the “reform” and “radical” camps—Hayek and Friedman to the reformers, Mises and Rothbard to the radicals. Monetary theory was the key difference between Hayek/Friedman and Mises/Rothbard, and this difference is a microcosm for the larger ideological divide within the Libertarian Party.
Two Different Sides…of the Same Coin?
Friedman, a hero to the reformers, was critical of the Federal Reserve System but not of fiat currency in general. Fiat currency is money that’s given value by government decree and “legal-tender” status—meaning people must accept it by law. The most popular alternative, commodity-backed currency, has usually been based on gold. Under a gold standard, paper notes may be redeemed for gold coins or bullion, and thus money is valued for the gold it represents. Friedman saw monetary gold as unproductive since resources were expended to mine gold out of the ground in one part of the world only to have it stored in underground bank vaults in another part of the world.
Rothbard, a disciple of von Mises and an early LP “radicalizer,” strongly disagreed. He supported the Austrian economist Carl Menger’s theory of the origin of money which stipulated that money came into being “organically” in the course of prehistoric barter. For example, a shoemaker and a butcher who wanted to make a trade would have a need for money if the butcher already had enough shoes. The butcher would be willing to accept an “exchange commodity” even if he didn’t want the particular commodity for himself because he knew he could trade it to someone else for something he did need.
Gold, in Menger’s theory, became the “most commonly accepted means of exchange” (i.e., money) due to its durability, divisibility, portability and homogeneity or sameness. Butter, by contrast, would not have been a good form of money since it is perishable and significant values of it would be hard to carry in one’s wallet. Diamonds would also make bad money since they aren’t easily divisible and vary widely in quality.
Closing the “Gold Window”
To Rothbard and others who believe in this origin theory, the governments of the world have played a sinister trick on their citizens. People only accept U.S. dollars because they had value yesterday. Trace things back far enough, and you’ll get to August 15, 1971. The day before that, the dollar was convertible into gold. But on that day, President Nixon closed the “gold window,” making the U.S. dollar a purely fiat currency.
People still accept the dollar, according to Rothbard, because they’ve been conditioned to do so. But a fiat currency could never arise naturally in the marketplace. Thus, the U.S. monetary system, based on the fiat dollar, is fraudulent and, according to Rothbard and his followers, designed to redistribute wealth from the poor and working people to the rich and politically connected. This “principled populism” is a far cry from right-wing conservatism which is often labeled as being for Big Business and against the poor and laboring classes.
Ron Paul, the maverick Republican congressman and former 2008 presidential candidate, was a disciple of Rothbard and Mises and was himself the Libertarian Party’s presidential nominee in 1988. Both the reformers and the radicals of the LP claim Paul as one of their own. But he has made a career of criticizing the Federal Reserve and advocating a return to gold as money. With the reform wing’s victory over the radicals this election year, the LP’s presidential ticket will likely be silent on this issue.
Reformers wish to deal with the “practical,” just as Friedman and Hayek, both Nobel laureates, did. The radicals hold fast to principles no matter the political cost, much like Mises and Rothbard. But as the U.S. dollar continues on a seemingly perpetual slide, the radical position of abolishing the Fed and restoring the gold standard is looking more and more like a practical reform.
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