Don’t diss the framework

Noah Smith writes a great piece on “what economics gets right” over at Bloomberg View today. In it, he criticizes the view of Alex Rosenberg and Tyler Curtain, who claim in a recent New York Times piece that economics “lacks the most important of science’s characteristics — a record of improvement in predictive range and accuracy.”

To counter their claim, Smith cites micro-level examples of economists making successful predictions: rates of use for public transit in San Francisco, Google’s use of game theory to maximize profits from sale of ad space (specifically, a model refined by microeconomist Hal Varian), and so-called “gravity models” of international trade that Smith says “do a very good job of predicting how much trade will occur between any two countries.”

But Smith also blames economists for Rosenberg’s and Curtain’s faulty perspective. He writes:

Why do Rosenberg and Curtain get it wrong? Part of the fault is their own — they just didn’t bother to do their homework. But part is the fault of economists, who don’t do a very good job of trumpeting their predictive successes to the world. Some economists still defend the idea that economic theory doesn’t need to make predictions in order to be useful, and instead merely has to give people a framework for thinking about the world.

That argument hasn’t carried much water with the general public, and rightly so. Without empirical support, you can’t really be confident that a theory is a good framework for thinking about the world. It’s likely that economists using bad theories will make bad policy recommendations, no matter how organized or internally consistent those economists’ mental frameworks.

The link behind “defend the idea” in the passage above is to a paper by James E. Anderson called The Gravity Model. I’m not about to read this entire paper, so I’m not sure why he linked to it. I actually think it might be a mistake, as it’s the same link as the previous link in the article.

But whether the link is correct or not, I propose that he might as well have linked to Hans-Hermann Hoppe or some other proponent of the praxeological method, which denies, on philosophical grounds, the legitimacy of a criterion for the usefulness of economic science that regards “predictive success” as the ultimate goal. Hoppe writes:

Just recall that according to its very own doctrine, neither a predictive confirmation nor a predictive falsification would help us either in deciding whether a causal relationship between a pair of variables did or did not exist. This should make it appear rather doubtful that anything is gained by making prediction the cornerstone of one’s philosophy.

Instead of predictive success, then, “praxeologists” like Hoppe emphasize a correct application of a priori knowledge toward expanding the analytical framework with which we can think correctly about economic issues or hypothesize about future economic outcomes. Theorists can make predictions on the grounds of that a priori framework, but their predictions’ accuracy—good or bad—doesn’t necessarily inform us of the legitimacy of the framework itself. A bad prediction simply means the principles of the framework have been misapplied.

I’m guessing it’s this type of thinking that Smith is referring to when he criticizes economists who “defend the idea that economic theory doesn’t need to make predictions in order to be useful, and instead merely has to give people a framework for thinking about the world.”

That said, don’t think Smith’s allegation that empirical support is necessary to prove that a framework is correct. I’m not the first one to day this—it’s a well-known criticism of empiricism from practitioners of the alternative praxeological method. While the need for empirical support might be true for the realm of the natural sciences, it’s not true for social sciences like economics.

But I’m not going to rehash that entire argument here. Instead, I simply want to defend the usefulness of refined mental frameworks—ones that don’t have as their object the making of predictions (that is, the type of frameworks Smith refers to)—toward helping people understand economics in the real-world.

To put it simply, even strictly-empirical economists rely heavily on sound mental frameworks that aren’t necessarily empirically provable. They rely on a priori truths from the very beginning of their analysis, when they posit that nothing in reality can be known to be one way or another prior to future experiences which may confirm or disconfirm a hypothesis (in other words, the foundational assumption of empiricism). And as Hoppe points out, economists hypothesizing about possible causes of certain phenomena is almost always colored by some a priori, “framework” knowledge. This is because according to strict empiricism, we cannot know with certainty whether something is a possible cause of something else. So if we want to explain some phenomenon, our theorizing would be unconstrained by a priori considerations of any kind, which leaves us with no starting point from which to launch an investigation. Everything can have some influence on anything. Most economists, then, do their analyses with certain principles or assumptions in mind—rules that have no empirical support, but are undeniable by their very composition (i.e. humans act to satisfy their ends).

Likewise, a proper framework disqualifies a range of propositions as influential. Hoppe writes:

[Praxeological propositions] restrict the range of possibly correct predictions. And it would do this not as an empirical theory, but rather as a praxeological theory, acting as a logical constraint on our prediction-making.19 Predictions that are not in line with such knowledge (in our case: the quantity theory) are systematically flawed and making them leads to systematically increasing numbers of forecasting errors. This does not mean that someone who based his predictions on correct praxeological reasoning would necessarily have to be a better predictor of future economic events than someone who arrived at his predictions through logically flawed deliberations and chains of reasoning. It means that in the long run the praxeologically enlightened forecaster would average better than the unenlightened ones

To say like Smith, then, that economists focused on developing a sound analytical framework through which people can view economic phenomena are misguided is blatantly unhelpful. The framework is a prerequisite for good empirical research. It’s the most “useful” thing about economics, and it’s postulates aren’t necessarily empirically verifiable. It’s the foundation upon which economic reasoning rests. If the mental framework is bad, then even a theory with a thus-far stellar track record of predictive success could lead us wildly astray.

To close, here’s Hoppe again:

To understand the logic of economic forecasting and the practical function of praxeological reasoning, then, is to view the a priori theorems of economics as acting as logical constraints on empirical predictions and as imposing logical limits on what can or cannot happen in the future.

“An ostentatiously prodigious worker”

George Howe Colt writing in Brothers: On His Brothers and Brothers in History about the work habits and many accomplishments of Dr. John Kellogg:

The Doctor was the wizard behind this vegetarian Oz. He was, in his way, no less a visionary than Ellen White, and his goal as no less ambitious: to change the way Americans ate, breathed, dressed, exercised, and defecated. To that end, he churned out nearly fifty books (Rational Hydrotherapy); more than two hundred medical papers (“Surgery of the Ileocecal Valve”); and so many pamphlets for the lay reader (“Nuts May Save the Race”) that even the publicity-conscious doctor couldn’t keep count.

He founded a nursing school, which, not coincidentally, provided the San with a stead stream of low-paid employees. He helped establish more than thirty San franchises across the country. He gave more than five thousand lectures. He made frequent trips abroad: to examine the latest exercise equipment in Sweden; to study advanced surgical techniques in England; to learn about the bowel-cleansing benefits of yogurt in France.

He invented a heated operating table, a vibrating chair that increased blood circulation, an electric belt that massaged the hips, a mechanical exercise horse, a machine that kneaded the abdomen to relieve constipation, a canvas sleeve that brought fresh air into a patient’s bedroom at night without chilling the entire room, a tobaccoless Turkish pipe.

An ostentatiously prodigious worker, the Doctor rose at four a.m. for an enema, a cold bath, and calisthenics before launching into a twenty-hour workday. He bragged of composing between twenty-five and fifty lectures a day (many of them novella-size); of dictating eighteen hours at a stretch (pausing only as one exhausted stenographer gave way to another); of working forty hours straight without nourishment (other than the handful of nuts he hoarded like a squirrel in his coat pocket); of performing as many as twenty-five operations in a day. (Though he made his name promoting fringe medical therapies, the Doctor was an accomplished gastrointestinal surgeon whose precise stitching moved the director of the Johns Hopkins Hospital  to remark, “I have never seen such beautiful human needlework.”)

Fortunately, the Doctor was a skilled multitasker. While taking his morning bath, he listened to staff reports; while dictating, he polished off a few medical journals. Once, on a camel caravan in the Sahara Desert, clad in nothing but a pith helmet and a loincloth, he took advantage of a brief stop at an oasis to dictate an entire issue of Good Health magazine.

And you thought you were a workaholic…

The lowdown on negative interest rates

Here’s my humble attempt to explain the logic of “negative interest rates” over at Enhancing Capital. I’ve found some good stuff written on this topic already, but nothing that I thought was accessible to the average person. Hopefully this report helps to fill that gap.

One highlight I’d like to point out is that negative interest rates on reserves at the central bank aren’t necessarily a “game changer.” They do reverse the logic of interest on reserves (commercial banks pay interest to the central bank instead of the central bank paying interest to commercial banks), but they don’t mean that banks are all of a sudden going to try to get rid of all their reserves. This hasn’t been the experience of banks in the Eurozone, where negative rates already exist on some deposits at the ECB. It won’t be the experience of banks in the U.S. if the Federal Reserve takes similar measures. Finance is all about trade-offs—paying a small fee to hold reserves at the central bank could still be a more attractive option to commercial banks than making more loans to keep their negative interest-bearing reserve balances from growing. What matters is whether commercial banks can identify enough credit-worthy borrowers whose risk of default is low enough to promise a higher return than the negative interest rate charged by the central bank. If not, then banks might very well be content to pay interest to the central bank rather than make more loans.

Finally, I realize this report might seem mistimed. If anything, talk on the town regards when the Fed is going to tighten monetary policy, not loosen it. My explanation is three-fold:

  1. I’m not convinced tightening is as imminent as many analysts are making it out to be, for reasons I’ve explained before.
  2. It’s important for investors to understand the logic of negative interest rates before they happen, not after (no harm in being over-prepared!).
  3. The ECB has already imposed negative interest rates, and the Bank of Japan has toyed with the idea. The policies at these banks, of course, have ramifications worldwide, and investors everywhere ought to understand what negative interest rates are.

Read the full report at EnhancingCapital.com.

The value of expertise

I think respect for common sense is an amiable, humble, and often useful habit for a thinker to have. It reminds a thinker of the complexity of the world. But one can’t articulate anything clearly, or follow any sophisticated chain of logic, or conduct an experiment, without departing somewhat from common sense, and entering the rarefied, elite world of theory and expertise.

Nathan Smith

What happened to Ebola?

The Ebola outbreak was one of 2014’s biggest stories. But now, by the year’s end, we rarely hear about it. So what happened?

For one, the survival rate among patients is improving, at least in Sierra Leone. Among patients admitted since November 4 to a particular clinic in Sierra Leon’s capital, only 24 percent have died.

All this has led to a smaller number of cases than the CDC expected by year’s end. One of its estimates put the January 2015 number at 1.4 million cases—73 times higher than the 19,000 cases reported by December 21 (that’s embarrassing!).

Ebola also failed to show up in the United States after the most recent confirmed case in New York City on October 24, and those Americans who did contract Ebola fared fairly well on average—just one in four died of the disease.

So to sum up, Ebola didn’t turn out to be as big of a deal as either the CDC or some paranoid, alarm-sounding Republicans made it out to be. Those who predicted we’d all die unless government took drastic measures (like banning flights) were wrong.

This raises an interesting thought experiment: Suppose government had banned flights from infected countries. Suppose they did so on October 25—one day after the most recent confirmed case in America. It’s likely we’d credit the lack of any further cases to government’s action. We’d pat ourselves on the back for supporting a flight ban, and we’d have “evidence” to support the use of more flight bans in the future should something like the Ebola outbreak happen again.

This “evidence,” of course, would be faulty. Ebola wasn’t going to spread any further in the United States whether government banned flights or not. This is fact.

But suppose something else. Suppose other actions the government has taken to combat some perceived threat—say, drone strikes of suspected terrorists in the Middle East to combat the threat of terror, or mandating certain vaccines to combat widespread outbreaks of disease—have had the same effect of apparent usefulness but have, in reality, fought a non-existent threat. How many of those roles government assumes are really just big wastes of money?

Don’t have “wolf eyes”

Some inspiration from Jeff Haden.

It’s easy to view even those we know extremely well through the lens of one slice — a mistake, a misstep, a blunder, an ill-chosen word — and then forever view them through the lens of that moment. Yet everyone is the sum of their parts, and when we view people through the lens of that one slice we miss the rest of them: their skills, their strengths, their meaning in our lives….

How often do you fall into this trap? I call it the “wolf eyes.” We can often become like wolves on the prowl, looking under every rock for something he or she said that might discredit his or her testimony. We’ll discount someone’s entire influence because of a controversial Facebook post, an unfortunate off-the-cuff comment, or even speculative reports about his or her private life.

But is this helpful? With wolf eyes, we’ll always find something wrong with everyone. If we keep them on for too long, we’ll run out of people to admire. We’ll find ourselves alone atop the tower we built that hides our own failures from others and gives us a sense of moral superiority over the rest of the world. We’ll lose any sense of urgency or challenge we felt from those we once admired.

People make mistakes, and those mistakes can be worth noting. Sometimes they can even be damning. But they usually aren’t. So instead of looking for mistakes, look for solutions. View failures as problems to be solved—as areas where improvement is needed and can happen. Think of others’ shortcomings as just one chapter among the dozens that comprise their full body of work, and not as a seal of disapproval on the front cover. You’ll be a happier, more inspirational person for it.

Some interesting facts from 2014

Here’s a cool piece from Pew Research. It lists “14 striking findings from 2014.” Here are some highlights (though you really should go check out the whole piece…it’s quite interesting!).

  1. The median wealth of white households is 13 times that of black households and 10 times that of Hispanic households. That’s insane!
  2. 63 percent of Americans say it’s a good thing that states are moving away from mandatory sentences for non-violent drug offenders. This is up from 47 percent in 2001.
  3. 47 percent of “consistent conservatives” cite Fox News as their main source for news about government and politics.
  4. The typical unauthorized immigrant has now been in the U.S. for nearly 13 years, up from 7.4 years in 1995 (does this mean the rate of illegal immigration has slowed?).
  5. The number of Catholics in Latin America has fallen from 92 percent of the population in 1970 to 69 percent in 2014. The number of Protestants, meanwhile, has risen from four to 19 percent over the same period.

I like pieces like this because they help to refine the mental constructs we maintain that color our understanding of the world and the manner in which we interpret current events. It’s easy to think we “get” the world—that we understand the economic, socio-cultural and political factors that shape public opinion because we once read about how this or that influence pervades in this or that cultural setting. But the world is ever-changing. What was true 20, 10 or even just five years ago might not be true today.

In certain contexts, failing to recognize this can be damaging (and sometimes embarrassing). It also frustrates me to hear people reference things like “Christian Europe” and other stereotypes that are founded on grossly outdated information that articles like this help to correct.

What happened to savings in late 2012?

What happened to the personal savings rate in Q4 2012?

Note the huge increase in personal saving in Q4 2012.

I’m not asking why it tanked between Q4 2012 and Q1 2013. The drop simply put it closer to it’s long term trend. I want to know why it spiked so high in Q4 2012. I came across this chart earlier this morning. I looked up “personal savings rate Q4 2012” on Google but found nothing to explain this. It’s a big jump—something like 30 percent. Any ideas?

Dark clouds looming

A good piece from The Economist on “the dark clouds around the silver lining” of Fed monetary policy. A highlight:

…constraining the economy to so low a rate of average inflation is a good way to ensure that very low inflation or deflation becomes a serious threat whenever the next shock hits. That would be nasty in and of itself, given what we have learned about wage rigidity over the course of this business cycle. It is made all the worse by the very high probability that interest rates will quickly fall back to zero during the next downturn. That’s the third reason to pull one’s hair out over the Fed’s preferred approach: the lower the average inflation rate, the lower the nominal interest rate consistent with normal economic growth, and the higher the odds of hitting the zero lower bound whenever trouble strikes.

And the kicker:

…the Fed is the world’s monetary pacesetter, and it is rapidly moving toward tightening at a time when a disinflationary freeze is settling in around the rest of the globe. The Fed may tell itself that its responsibility is to take a very narrow, domestic view. Given the interconnectedness of the global financial system, taking a narrow, domestic view strikes me as a bad idea, even in terms of pure American self-interest.

I think this author is on to something important, but I don’t agree that the Fed is going to be as hawkish as he thinks. I don’t expect a rate hike in 2015 largely for those reasons this author cites. In short, I don’t think the Fed is “rapidly moving toward tightening” right now.

The Fed is frustrating (and won’t raise rates in 2015)

The Editors at BloombergView are spot on with this one:

Here’s the point, and it’s really quite simple: The Fed doesn’t know when it will start to raise interest rates, nor should it have to know, nor should it indulge analysts’ misconceived determination to find out. Interest-rate changes are not, and should not be, on a schedule. They depend entirely on what happens in the economy, and the Fed — like every last one of those analysts — doesn’t know what will happen. What it can and should do is draw attention to the economic indicators it is following — in particular, indications of inflation pressure in the labor market. The rest just sows confusion.

On a related note, I made a public prediction earlier this week that the Fed will not raise rates in 2015. Inflation, as measured by the Fed’s preferred PCEPI, is just too low. Fears of runaway inflation are totally unfounded in the data. Yes, stock values are soaring high enough to scare some investors, but Yellen has insisted that the presence of speculative bubbles is no reason to raise rates. That decision will come, she says, only once the two arms of the Fed’s dual mandate—unemployment and inflation—look good. And right now, inflation looks anything but. Yellen has always been a deflation hawk, anyways.

For more of my views on this topic, see my recent piece at Enhancing Capital. This is the startup I’ve mentioned on my blog before—an investments e-newsletter that “brings market analysis to life.” In this case, that’s more than just a cheesy slogan. They do some pretty cool stuff with data visualization that keeps things simple and straightforward without sacrificing depth of research. Most of my content there regards larger economic trends, but stock picks and sector analyses are their specialty. Check ’em out!