Are centrally planned economies possible?

Pre script:   This may seem like a troll post but it’s not... honest.

There is a very simple way to have an economy with all resources and means of production centrally planned under one authority, only have one person.

Imagine a Robinson Crusoe style Island of Despair economy. All the resources are directed under one single plan to provide for all of the citizens of the Island of Despair, there only being one person.

Under this trivial solution is perfectly possible to have a centrally planned economy. Those who say having a centrally planned is impossible, are simply false.

Now if we introduce a second person, he also comes to the Island through shipwreck, there is Mr. Crusoe goes up to him and they come to an agreement to agree upon and decide the best use of the resources, deciding they can be more productive and prosperous together.

A boat of a dozen colonists arrive on the Island of Despair, Mr. Crusoe and his associate decide as the agreement between them had worked so well they would extent it to these new arrivals. This new agreement works well and they decide the best use of resources through a system of majority voting. There is a growing consensus they should rename the Island of Despair.

As the population of the Island grows larger there is increasing discontent. Those who know more about an issue, argue that they should have greater say than their one vote. They have more information which is only relevant in that specific place and time and the focus on having a single plan for all the resources is preventing them from experimenting and finding new ways of doing things with their expertise.

There is no agreement on how to increase the voting power of specialists and those with more information without it becoming unfair and encouraging vested interests. As the population grows further the time and place specific information larger and larger and becomes harder and harder to process for the authorities. The Island regains it former name.

To conclude, centrally planned economies are possible but as populations grow larger having one organisation grows increasingly harder. To re-work Coase’s point in “The Nature of the Firm” there are costs to operating between organisations and there are costs to operating within one single organisation. The optimal point of size of organisations is when the costs from acting within and outside the organisation are equal. If only there was a system whereby the planning undertaken for the means of production was undertaken by different organisations in some way where they voluntarily offered some sort of medium of exchange to convey their specific interpretation of information in expectation of receiving more of that medium of exchange in return, under some sort of rule of law. If only that this sort of system existed....

Coase, R., H., (1937) "Nature of the Firm"
http://courses.cs.washington.edu/courses/csep590/06au/readings/coase.pdf

Why did the knowledge transmission mechanism fail for austerity?

Simon Wren-Lewis describes a process where academics come up with theories and test them and then through intermediaries that are translated into policies which can be implemented by policy decision makers. He provides the handy diagram below.

So why did this mechanism, which for the most part is usually effective, fail during the macroeconomic crisis? I’m going to link this to a recent econo-blogosphere conversation started by Russ Roberts when he said:
                “Just a curious coincidence that economists who like stimulus want bigger                            government and those who oppose it prefer smaller.”

For context: He is in the camp of opposing fiscal stimulus and smaller Government and many have rightly praised him for persistently trying to identify his own possible biases.

However, in my opinion he’s got it slightly wrong, many of those who want small government also think that austerity is damaging during a crisis, but they stayed quiet during this debate. This is because they knew that in a time of non-crisis they would not have been able to convince people of the benefits of small government, so to achieve the goal of a small state, they let people believe this mistruth.

Due to the fact that academic economists are not the people directly making policy they had plausible deniability and were still able to afterward agree with the macroeconomic consensus, indeed in a recent survey:  “Only 15% [of economists] agreed that the austerity policies of the coalition government have had a positive effect on aggregate economic activity, while 66% disagreed.”

Small state Keynesians from my experience make up a sizeable percentage of economists, and in the 2010 election the only major parties they had to choose from were a larger state Keynesians and smaller state austerian. There was no mass outcry from economists to correct the marcro-media failure because many saw austerity as a necessary falsehood to achieve a smaller state, when constrained by politics. The transmission mechanism failed because of the oldest reason in the economics book: misaligned incentives.

The bias over austerity presented itself not in the content of what was being said but merely in how loudly it was being said. Therefore those small-state Keynesians and large-state austerian (I have never met any but some must exist somewhere), fell quiet and so the argument simply defaulted to the usual large-state vs small-state argument. It became about the minimum wage, benefits, inequality; and traditional left/right lines were drawn for battle. So I think Russ Roberts is wrong to aim the above statement at economists, and instead should aim it at economist when are constrained by political acceptability.

I end with a quote from Kristian Niemitz of the Institute of Economic Affairs who typifies my shy small-state Keynesian:

                “There is some theoretical attraction in the Keynesian idea of running a deficit                  during recessions, and a surplus in boom times, but politics does not work that                    way. I’d rather say, whenever there is a window of opportunity for cutting                        the deficit, politicians should use it. In the medium term, spending will                              increase again anyway, both because of demographic pressure and because of                      the ‘normal’ political pressures. It is absurd to worry about politicians being too                  reluctant to spend.”

Post script: This post is not a comment on the arguments for and against austerity in a downturn but just an explanation about why the transmission mechanism failed to pass the prevailing macroeconomic theory to policy makers.

Moral Lucas Critique


Pre-Script: Sorry it has been so long since the last post.


In my last post I covered how everything in the social sciences is subject to Lucas critique and there are no “deep parameters” on which to base model for our understanding of social structures, only deeper or less deep.

I will now develop this idea to how due to performativity policy actions may alter moral preferences. Performativity is a generalised term for the Lucas critique theory.

Economics policy model often assume that people the utility people receive from monetary incentives is independent of non-monetary utility received. So if you offer money for people to give blood, more blood will be donated, right?

U(non-monetary benefits) + U(monetary benefits) > U(non-monetary benefits)

Therefore introducing monetary benefits it stands to reason more people will donate blood.

Studies have shown when money is offered for blood donation less is donated, as it undermines the non-monetary utility of the action (nef, 2013). The independence assumed in our model is not only wrong but gives the wrong conclusions.  

But if policy actions are introduced which assume non-monetary and monetary utility independence, will people start expecting monetary payment for doing “good” things?

This can be seen in Gneezy & Rustichini (2000) where they investigate the effects of placing a fine on parents who are late to pick up their children from day-care, in hope to deter the behaviour. They find that the introduction of a fine actually increased the rate of late arrivals. Perhaps the introduction of a fine reduced the non-monetary cost of being late to a greater extent than the increased monetary cost. This in the logic of common sense is entirely understandable, people do not rush to get their on-time as they think paying for the luxury of being late. There is no guilt for being late, no group pressure to be on time.

Although, this is a tricky problem for policy-makers it is not the real crux which Gneezy & Rustichini (2000) find. They find that once the fine is removed the rate of lateness does not revert back to the previous lower level. The norm of lateness has been established.

This means that the assumption of independence between non-monetary incentives and monetary incentive has actually changed the revealed preferences in a non-reversible manner. This leads economists to have to expand their work. We not only have to work out the effects of policies on variables such as unemployment and inflation but also we have to work out whether this will have any implications on individuals’ underlying preferences.

This post may sound like a behavioural economist, having a psyco-bable rant to the rest of the profession. But this is actually one of the key criticism levied against behavioural economics. That for example paying students to do well in school has the moral implication of teaching children not to learn to have line up their preference with their meta-preferences. Which subsequently could create a society of instant gratification [insert socio babble].

In the last post I said no model is free of the Lucas Critique, because there are no deep parameters. By a similar argument no policy (or absence of policy) is completely free of a Moral Lucas Critique. Every policy creates an interaction between monetary and non-monetary incentives, this is not a nihilist position that we should not do anything out of fear of changing morality, but that we as a profession need to expand our remit. We need to interact and produce work with the other social sciences more and investigate the possible moral implications of our policies. Then when we present policy options to politicians we need to also include possible moral implications of instituting this policy. This will allow politicians to make more informed and hopefully better choices.

Nef, (2013), New Economics Foundation, “Money and giving: Do financial incentives deter or encourage co-operative behaviour?”

http://b.3cdn.net/nefoundation/2927a207e52f267882_80m6iy5zu.pdf

Gneezy, U., & Rustichini, A., (2000) “A FINE IS A PRICE”, Journal of Legal Studies,       vol. XXIX.

http://rady.ucsd.edu/faculty/directory/gneezy/pub/docs/fine.pdf

The Lucas Critique should be reformed into a scale.

What is the Lucas Critique?

The Lucas Critique refers to Robert Lucas' 1976 paper where he argues that one should not base an economic policy entirely on a pattern observed in historical data because agents will adapt to the policy and the pattern may cease to exist. He summaries it as:

"Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models.”

Lucas, Robert (1976). "Econometric Policy Evaluation: A Critique”

As the story goes, Old-Keynesians thought that the Phillips relationship between inflation and unemployment was a constant rule as such they could base policy upon it. However this lead to the inflation of the 1970s as the policies themselves caused the relationship to break down. Then the Lucas critique was able to convince the profession that it need to move on from Old-Keynesianism and start micro-founding all mainstream models. Now whether you think this is what happened or not (it wasn’t exactly) it is not crucial to the substance of this post.
Now Lucas wasn't the first person to highlight this phenomenon but often in economics (as in life) it is not about saying the right things, it is about the right person, saying the right things, at the right time. The Lucas Critique, is generalised into what is known as performativity.

How do you “pass” the Lucas Critique?

Whenever someone presents a model not part of the micro-founded, DSGE, mainstream set of models, the usual disregarding trope is “this wouldn't pass the Lucas Critique”. So what on earth does it mean to pass the Lucas Critique? Well first presumption would be that it passes if a policy is enacted based on this model, it wouldn't change the statistical patterns. But what ex-ante way do we have of deciding whether a model passes? The usual argument is whether or not the model has micro-foundations.

But do introducing micro-foundations mean that you avoid the Lucas-Critique, what are these preferences, these “deep parameters” so inherent to the human condition that they transcend the social environment? Preferences don't exist in an atomistic manner. Micro-foundations do not avoid the Lucas critique.

When you think about fashions and fads, this is of course obvious. Even with micro-foundations one cannot avoid the implications of performativity.

If you're right and we can't avoid the performativity, what does the whole of the economic profession do?

I by no means want to throw the baby out with the bath water, economics models are not useless. What I wish to happen is the economic profession to expand the tools which they use. As none of the tools which are useful “pass” the Lucas Critique, the Lucas Critique should be redefined as a scale. With this scale if a pattern is found and a subsequent policy recommended by a model, then a Lucas scale sensitivity analysis should occur and observe whether the same result is elicited. Indeed, if the same result is not elicited it would be more interesting to discuss why it has not been in this case, than the result itself.

Economists are not unfamiliar with sensitivity analysis, indeed is an important part. This is just another aspect of sensitivity analysis which should occur before a policy recommendation.

After completing a micro-founded DSGE model, an economist could do an econometric study to see if the estimates of the effect are similar. Then perform an agent based model to see whether in this case the meso casual mechanisms involved do affect the aggregation.

This post is not in itself a criticism of micro-foundations or in fact DSGE models, instead it tries to encourage pluralism of different methodological tools in economics. Additionally, end the instant disregarding on anything that is not DSGE on the basis it does not pass the Lucas Critique, because in the social world nothing does.

Other interesting posts on this issue:

Understanding Society - Issues on micrfoundations: http://understandingsociety.blogspot.co.uk/2013/10/issues-about-microfoundations.html
Facts and Other Stubborn Things - I think it was the Lucas Critique, not stagfltion
http://factsandotherstubbornthings.blogspot.co.uk/2012/12/i-think-it-was-lucas-critique-not.html

Dan Davies - “Microfoundations” ain’t so microfounded       https://medium.com/bull-market/microfoundations-aint-so-microfounded-315b46775432