On the value of models

Paul Krugman discusses the value of models.

But he misses an important point:  the value of models is also their greatest flaw.  Models simplify things so everybody can follow the train of thought, but that simplification means they’re always wrong.  In other words, they are excellent tools for communicating ideas and highly flawed when it comes to understanding complexity.

So the problem with models is that they served to hide the fact that this assessment of the Depression is also entirely true.  “Faced with the Depression, institutional economics turned out to have very little to offer, except to say that it was a complex phenomenon with deep historical roots, and surely there was no easy answer.”

As far as I’m concerned the only solution to this problem is to develop competing models and demand that each individual researcher decide for him or herself what weight should be put on each model in explaining a given circumstance.  That is, to acknowledge that there is no easy answer and enjoy the consequent debate.

Thus the task of economics is to encourage and facilitate the development of competing models.  This will require that far more respect be paid to verbal models, as qualitative models are needed to lay the foundations for the development of new formal models.

Economics and complacency

There is a faith amongst some economists that growth will save us — but economists don’t have a good grasp of why economic growth does or does not take place — a fact that most of them will admit.  The current fad is to attribute growth to “institutions” — with the understanding that the specification of what institutions matter to growth, what institutions don’t matter and what institutions hinder growth has hardly been started (with the exception of the importance of property rights).

The foundation of the belief that growth will come seems to be the view that financial crises are just extreme versions of recessions and recessions are followed by recoveries.  This is an extremely ahistoric approach to economics since there are many examples of failed recoveries:  Holland in the late 18th c, Britain in the 1920s, Japan in the 90s.

This is probably related to the fact that most of the research on the Depression of the 30s takes the view that our ancestors made mistakes that we would never make.  Therefore, the outcome of our crisis has to be better than the outcome of their crisis.  However, as someone who has studied the 19th c approach to central banking, I suspect that we have made mistakes that our ancestors would never have made.

For example, about six years ago I corresponded with a researcher at a Federal Reserve Bank.  My question was this:  When tracking monetary data, why does the Fed report the “Non-financial commercial paper” series, but not the “Financial commercial paper” series?

The answer:  Financial commercial paper is used to make loans, so the assets and liabilities of the financial companies will zero out and have no effect on the money supply.

Think about that answer for moment.  The Fed’s policy was literally to ignore the increase in the liabilities of financial institutions because they did not affect measures of the money supply.  The Fed had a policy of ignoring credit growth on the part of financial institutions.  This is an error that 19th century bankers would never have made.  I suspect it grows out of the lazy habit of using Arrow Debreu based models where financial institutions don’t matter.

At the time I pointed out to the Fed researcher that the Fed should be keeping an eye on measures like financial commercial paper, because they were likely to be correlated with the risk of financial instability (and that I drew this conclusion from my knowledge of 19th c central banking).

A theory of publicly listed firms

John Kay’s column today prompted this line of thought:

Here’s a theory that in my view merits consideration.  Although I am sure that it is far from 100% correct and may be as little as 10% correct, I believe that it has as much truth as the view that large corporations are competitive firms in competitive markets.

The rise of stock markets and the ability to finance huge firms that deliberately exploit the benefits of size to undermine competition destroyed the relationship between a free market and a competitive market.  Thus, the presumption should be that industries with publicly listed companies are oligopolies and profits earned by these companies should be viewed with suspicion as they are likely to be rent-seeking profits.

When publicly listed companies are viewed as rent-seeking entities rather than competitive firms in a competitive market, there is a clear role for government in protecting smaller unlisted firms from predatory behavior.  Since it is far too difficult for government to determine what market based prices would be in a environment where publicly listed companies are predominant, remedies for their existence should be at the macro level:  (i) high taxes on publicly listed companies whose profitability is significantly higher than the average in competitive markets (i.e. where non-publicly listed companies predominate) and (ii) high taxes on wages paid to employees of publicly listed companies (that for example are more than double the wages of employees with comparable years of education outside the publicly listed sector) to prevent employees from extracting the rent-seekers surplus.  In addition, all publicly listed companies should be prohibited from spending any money on lobbying, campaign contributions or providing freebies for politicians.

Any other policy can be viewed as a government subsidy to rent-seeking behavior.

The double taxation canard

I’ve never understood the argument that corporate equity is taxed twice.  It seems to be based on simplistic economic models where the owners of the firm are identified with the firm itself, but bankruptcies never take place.

Of course, corporations exist mostly because they grant the owners limited liability in the event of bankruptcy — so it’s pretty clear that any economic model that does not have corporate bankruptcies in equilibrium does not actually have anything to say about corporations.  Limited liability is possible because corporations are persons under the law.  For the same reason corporations have to pay their own taxes and economic models that confound the corporation with its owners fail to capture what a corporation is.  Equity owners who want to avoid “double taxation” have always had the option of forming a partnership.

Double taxation is a canard that exists mainly because economic models don’t capture the costs and benefits of corporations.