Sunday, August 3, 2014

Against human-centric macroeconomics

"Gravity might not be explainable in terms of any broader, more general phenomenon. But we know for a fact that macroeconomics is the result of a whole bunch of little economic decisions by individuals and companies."
Noah Smith
Do we really know this? For a fact? To be specific, I'm not questioning the idea that an economy is made up of humans making decisions with money (of course it is) -- I'm questioning the idea that observed macroeconomic relationships (price level and money supply, RGDP and employment) are the result of humans making decisions with money. This blog posits that macroeconomics is just about the large quantity of things (money, people in the labor force, goods and services) and human thought has a peripheral role. In that list we don't care what goods or money think, so why are humans so special?

I also have another question: is the idea of including human decision-making in economics a byproduct of our own human sense of agency rather than, say, solid reasoning or empirical justification? I think the answer is yes, it's a byproduct. Modern economics grew out of ethical philosophy and morality (it's all over everything: utilitarianism, the "Puritan work ethic" and macroeconomic "austerity", Adam Smith's The Moral Theory of Sentiments, the perceived morality of debt) and has therefore always been about human thought. It didn't grow out of natural philosophy (or science as it is known today) or accounting where it might have arisen from observation ("I noticed that everything seems to get more expensive on our books with each passing year, but also prices don't rise when business isn't good and we aren't hiring more people.").

In one of my early posts, I mention that my approach to economics has been that of an alien observer who has good enough instruments to see how nighttime lights are increasing and CO2 is increasing on Earth, land is cleared and posits the idea of a "civilization" on Earth that operates under a theory of "economics" ... analogous to Boltzmann positing atoms operating under a theory of statistical mechanics.

Macroeconomics does not take this approach, but instead started at the very beginning assuming that human behavior was important. Modern economics has some of its origins in physiocracy, and in that economic theory sits the 17th century analog of expectations (quoting from wikipedia, emphasis mine):
Pierre Le Pesant ... advocated less government interference in the grain market, as any such interference would generate "anticipations" which would prevent the policy from working. For instance, if the government bought corn abroad, some people would speculate that there is likely to be a shortage and would buy more corn, leading to higher prices and more of a shortage.
and incentives:
Le Pesant asserted that wealth came from self-interest and markets are connected by money flows (i.e. an expense for the buyer is revenue for the producer). Thus he realized that lowering prices in times of shortage – common at the time – is dangerous economically as it acted as a disincentive to production.
All that can be said (from the information-theoretic point of view) is that a price control changes the information transfer capacity of a particular channel detected by that price (relative to other channels). An incentive (i.e. the knowledge people are willing to pay way more for your goods and/or services than it costs to produce them) is just one piece of information transferred from demand to supply. So is irrational fear. So are speculative hedges ("I may pay top dollar for your goods now, but by the time you build the capacity, I won't"). So is random lack of knowledge ("I guess bacon just costs 50 dollars per pound"). The correctness (or content) of these ideas are not (to first order) important. This was part of the revolution of information theory (see the overview at that link) -- the human meaning of the message is irrelevant. It may be that human thought is very important to a description deviations from the underlying trend:


But in not looking at a human-independent baseline, we don't really know what the real economic fluctuations are (see here and here). Have we been led astray because we as humans were too close to the problem?

Tom Brown asks in a comment (that I can't seem to find right now, update: Tom found it, thanks!) if the information transfer model would apply to non-human economies. I don't know the answer to that. However, macroeconomics as conducted today has an answer: no, it doesn't apply. There are no economic laws that are independent of human thought. Even supply curves depend on expectations of future prices and demand curves depend on consumers' tastes and preferences (and diminishing marginal utility). Recessions might not happen among Klingons and the Ferengi Phillips curve might be perfectly stable. It would be an act of hubris to think an alien civilization thinks the same way we do ... e.g. would risk premia be the same? Some economists do this already with different human cultures, and I touched on it in an earlier post. Maybe this is the correct approach. If it is, then economists should completely abandon any pretense to universality and instead become a sub-discipline of history (the chapter on the period when economists thought universal laws existed would be entertaining).

I believe there is at least a major component that is independent of human behavior, not only because of the successes of the information transfer model but because one of the most successful economic predictions ever assumed that human behavior, on average, summed up to noise:
Suppose that there are a whole ton of different behavioral biases, and that these vary across time, across people, and across situations so much that even with a billion lab experiments we couldn't find them all. Only once in a while will the forces be aligned to make one behavioral bias dominate; most of the time, the net effect of all the biases will be unpredictable by the outside observer. When you have an unpredictable mishmash like that, you have to model it as a stochastic process. In other words, if it's too complicated to explain deterministically, then you treat it as randomness.

So what if psychology usually just ends up injecting randomness into our decisions?
That was from Noah Smith again. It is exactly the theory behind information transfer economics.

PS (added 8/4/2014, 9:28pm MDT): The thrust of this post is opposition to human-centric macro, and not saying human behavior has no role whatsoever (the third sentence says "of course" an economy is made of people, the graph in the middle is quite literally me calculating the impact of expectations, and I kept the piece of the quote of Noah's post that says "once in a while will the forces be aligned to make one behavioral bias dominate").

19 comments:

  1. Jason, I enjoyed this post. Here's my previous question you were looking for I think:

    http://informationtransfereconomics.blogspot.com/2014/07/notes-from-ben-bernanke-and-p-model.html?showComment=1404767903653#c3710617198842574707

    I didn't even try your search box because it only works on the contents of the post I think. (Sometimes I think it even excludes the title!... which would be weird for a google product... though it is useful). Instead I did a google site search:

    site:http://informationtransfereconomics.blogspot.com/2014/ chimps

    I remembered I used the word "chimp"

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    1. Thanks, Tom. I updated with the link.

      I also changed the sentence to "... and human thought has a peripheral role" in order to remove some ambiguity, added an "e.g." before the risk premia line and added a parenthetical "(relative to other channels)", hopefully making it a bit more clear.

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  2. I think this post really gets to the philosophical heart (w/o using any math) of what's different (perhaps revolutionary?) about the ITM.

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    1. I wouldn't say it is necessarily that revolutionary; the early quantity theories of money headed in this same direction ... until the Great Depression.

      Irving Fisher said in his 1892 thesis (on page 3):

      "To fix the idea of utility the economist should go no farther than is serviceable in explaining economic facts. It is not his province to build a theory of psychology."

      And then writes down on page 5:

      A/B = dA/dB

      for the exchange of two quantities. That is exactly the same as the information transfer model, except there is a log a/log b = 1/k factor out front.

      http://informationtransfereconomics.blogspot.com/2014/03/apples-bananas-and-information-transfer.html

      His thesis advisor was Gibbs, of thermodynamics fame.

      Here's a link

      Fisher then introduces utility, where he goes astray. It is pretty amazing if you just take utility to be another quantity of some good or service, then his page 28 looks remarkably like http://informationtransfereconomics.blogspot.com/2014/06/towards-arrow-debreu-mckenzie.html

      (Also, the book is free from Google. I may do a post on this because I didn't realize the magnitude of the similarity between Fisher's Mathematical Investigations and the ITM until now.)

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    2. This is very surprising to me! Thanks.

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  3. It also get's to the core of what I find attractive about the ITM. Whenever I imagined using the scientific method to investigate macro before, I often came back to a unrealistic reductionist approach: essentially let's built "The Matrix" but w/o any biological humans at all... then we can repeat experiments exactly, etc. The other thought I kept having was "let's build a massive multiplayer online game" ... as a means of trying to control for the economic environment a bit better. The former is unrealistic. There still may be a place for the online game, but what I like about the ITM as apposed to the "reductionist" approach of building The Matrix is exactly what you describe in this post. Maybe the reductionist approach would be as wasteful and inefficient and unnecessary as it would be to discover the ideal gas law by running a high fidelity simulation of 6x10^23 individual molecules bouncing about in a container.

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    1. Although given the deeply ingrained idea that human behavior is a major force in macro, the simulation might be more helpful in convincing people :)

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  4. Jason:

    Scenario: You and I are the only people left in the world. We talk, produce, trade, and argue about stuff.

    In this scenario, there will be "macro-economic" phenomena. We could add up our total spending over the course of a year. We could add up the number of hours we worked to produce stuff over the course of a year. We could add up how much total money we each own.

    Question: If your thesis concerning macro stats is correct, then it must be possible for you to know, and for me to know, how it is that these "macro" statistics came to be that isn't a result of what you and I did individually with our bodies and/or material things.

    If we debate this, and after many hours of debate and analysis, you remain convinced that something other than our individual behaviors is responsible, then A. How could we learn of what (who?) is responsible, and B. How it is different from a non-falsifiable God?

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    1. Much the same way there is no temperature in a system with two particles, there is no macroeconomics in a system of two people. This model is only valid for N >> 1 (i.e. the reason for the macro in macroeconomics). But let's look at the small economy limit anyway ...

      In the limit of a small economy, human behavior has a large impact (you need N >> 1 people in order for their "psychology" to cancel out on average). However, if we buy and sell stuff to each other, then our total nominal output in any given year would be approximately log NGDP ~ k log M + c + ε where M is the quantity of whatever it is we're using for money (and c and k are constants). The error term ε would be large, because as one person, you control half the economy, and your psychology wouldn't necessarily cancel mine. You may overvalue my assets by a large fraction of the economy or for whatever reason a large portion of the money M may go unused in transactions (a recession).

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  5. Follow on questions here:

    http://pragcap.com/forums/topic/against-human-centric-macroeconomics#post-70541

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  6. Started to reply but it got too long =)
    http://realfreeradical.com/2014/08/06/taking-the-people-out-of-economics/

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    1. I think my comment on your post got too long too (but I left it anyway) :)

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  7. O/T: Jason, have you seen this?

    http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/08/the-quantity-theory-and-neutrality-of-money-when-money-is-endogenous.html#more

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    1. I have -- I actually reference it in my as yet unpublished post.

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  8. The claim that human behavior may not be involved in macroeconomic seems odd, since buying and selling appear to be distinctive human (well, conscious-agent if we include animals) behavior. If you can show me an example of stars or electrons buying or selling, I'd be interested to see it.

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    1. This is different. Yes, we observe humans buying and selling things, but do the various decisions made matter to the aggregate data?

      No one has ever built an empirically accurate model that showed this mattered, so we technically don't know that it does.

      Think of it this way: a not very good model of a human agent has say 1000 parameters. There are 100 million agents in the US. That is a 100 billion dimensional problem.

      In macro, there are maybe a few hundred variables at best that we think describe an economy (interest rates, unemployment rates, GDP).

      That means either a) the complexity of those human agents pretty much vanishes in the aggregate, or b) there are millions of additional macro aggregates that can be measured.

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  9. OTOH if what you're getting at that the Rational Expectations Theory in economics is probably bogus since people aren't well modeled as rational agents, then I'm on board with that.
    The Noah Smith quote is typically ignorant twaddle, since it's not true at all that complex systems always reduce to ergodic stochastic ensembles. Curie point, anyone?

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    1. We actually have no idea if an economy is a "complex system" as one has never been successfully described by any model.

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