A Brief Defense of Economic Models

In this write up my goal is to convince some Austrians that mathematical models aren't as fallacious as they presume.  Before I get into my arguments I must first make this point and it is something that needs to be kept in mind as the readers works through this brief write up. Mathematics, insofar as it is utilized in economic theory, does not predict human action in a deterministic fashion, rather, it captures the laws of human action such that predictions can be made given the constraints of relevant conditions under examination within the theory.

To sum up the Austrian view of models, one could argue that they believe models use false assumptions and lead to fallacious results.  On the Austrian view, models cannot capture human action. I am not bold enough to claim that mathematical models can perfectly capture human action but I do think models are highly useful.  Consider the standard model of supply and demand.  It gives us proper results, is extremely intuitive and a wonderful teaching tool.  Austrians, on the other hand, believe that the assumed continuity of the supply and demand curves are false.  As far as I can tell, this is their primary objection to using this model. According to them, because supply and demand are not continuous it is much more unlikely to reach equilibrium.  I would just like to point out that adherents of this model do not assume that the supply and demand ever actually reach equilibrium, but rather, prices are always adjusting towards equilibrium.

But I digress.

If what Austrians said about mathematical models were true, I would not need to write this because I would probably agree with them.  However that is not the case.  Consider this quote out of one of the leading graduate school micro theory books:

"Imagine that you are trying to explain a particular phenomenon with one of two competing theories.  Neither fits the data perfectly, but the first does a somewhat better job according to the standard statistical measures.  At the same time, the theory is built on some hypotheses about behavior by individuals that are entirely ad hoc, whereas the second is based on a model of behavior that appeals to your intuition about how people act in this sort of situation.  I assert trying to decide which model does a better job of "explaining" is not simply a matter of looking at which fits better statistically.  The second model should gain credence because of its greater validity, which brings to bear, in an informal sense, other data" (Kreps, A Course in Microeconomic Theory, pg 8)

Does this quote seem to fit the Austrian argument that Chicago school economists are stat chasers and do not care about the validity of assumptions?  Quite the contrary actually.  It seems to me that Chicago School economists are concerned about human behavior/theory first and stats second.  I do not see why any economist should have a problem with this method of economics.  As long as the economist will admit some of the draw backs his assumptions might have, why should we completely throw models out the window? Note that when models are introduced through scholarly journals the author will always point out some of its downfalls but explain why it is still useful.

Another reason why I think models are important was touched on in my second paragraph.  Models are helpful learning tools because they are intuitive insights into real world phenomena.  Consider supply and demand again.  If I were to try and explain to someone why rent controls create housing shortages it is to my advantage to draw supply and demand curves and then show the different implications of keeping rent lower than the market clearing price.  It is much easier for the layman to see the consequences as a picture rather than sorting through all the material in their head.  Same goes for tariffs and minimum wage.  I have a hard time explaining why tariffs are bad even to a relatively knowledgeable audience, but as soon as I draw it out for them it clicks.

The last reason why I believe models are important is because even models that are falsified still help us gain knowledge.  This is because learning what assumptions lead to the false conclusions now gives us insight into why these assumptions won't work for future theories.  As long as the economist is trying to encompass human behavior as much as possible and it is fairly explanatory and predictive, why should anyone reject it? Models can have good explanatory power as to why things happen and to what will happen.

Lastly I would just like to point out this is barely scratching the surface of how much theory and thought goes into what makes a good economic model.  To simply reject these ideas based off of the use of models alone is preposterous

Imaginary Constructs and Regression

One of the methods of doing Austrian economics is imaginary constructions of economic situations.  When utilizing this method, the economist ponders how certain economic factors will affect other economic factors.  For example, I want to think about how the rise in a price of a substitute good will affect the demand of the good in question.  Another way to put it would be, how will a decrease in the price of chicken affect the demand of turkey.  When doing this, the economist has to hold certain variables constant in a thought experiment.  Using the chicken and turkey example, one must hold constant the fact that it is not November.  This is a good tool when constructing economic theory, no one will deny that.  However, the reason why Chicago School economists use regression is to find out the degree of which a price decrease in chicken will affect the demand in Turkey.

Consider how a Chicago School economist will handle this problem.  First, they will make use of the imaginary construct the same way an Austrian economist would.  Obviously, a decrease in the price of chicken should decrease the demand in turkey because they are substitute goods. Unless of course it is November where the demand of turkey sky rockets regardless of substitute goods.  So at this point the Austrian and the Chicago Schooler should have arrived at the same point.  Here is where regression comes in.  The next step for the Chicago schooler is to collect chicken prices and quantities of turkey sold over the same geographical areas and time periods.  This is where they will find the degree of how much price changes in chicken actually affect the demand in turkey.  It might be very large or very small.  What we can do to further test the affects the month of November variable has on this is introduce a "dummy variable," which basically tells us how much November increases the demand for turkey.

Why is this useful?  If a firm selling chicken and turkey has found turkey sales are declining they can now make a better estimate of how much they need to increase the price of chicken in order to increase the demand of turkey.  In my view, the theory is vitally important but the firm is more interested in the results produced by the regression.  Another reason why regression is so useful is because it holds the other variables constant in order to see your imaginary construct as values.  For example, if the price of chicken decreases by 50 cents the demand of turkey will decrease by .5%, holding all other variables constant.

Why Mises would claim that if we were to do a study using regression we learn nothing other than the amount price changes in chicken will affect the demand for turkey in that particular time period and geographical area is misguided at best.  In my view, a firm can gain vast amounts of information by using regression methods.  The firm learns how to change the demand for turkey by manipulating chicken prices, ceteris paribus.  Obviously we cannot change them based on quantitative certainty but it gives important insight insight nonetheless.

Inflation vs. Deflation

Inflation or deflation, which is better?  The answer can vary depending on who you ask.  Consider the question from the position of a worker as an importer or exporter.  If we have inflation, our dollar is weaker compared to other currencies so exporters will be able to sell more while importers will be able to buy less.  From this perspective it is easy to see that each profession, whether an importer or an exporter, will view inflation differently.  The same can be said for deflation.  In addition to the importer/exporter scenario the same principle holds when considering this question from the position of a borrower vs. a lender.

Let me first point out that no economist would argue that mild deflation or inflation is troubling.

Now let's consider some of the things Austrians say about deflation.  They claim it is not something to be feared and it is as silly to fear deflation as it is to think wars are good for the economy.  In a video with Tom Woods and Jeff Herbener they approach the discussion in a very frustrating way.  Tom Woods begins by saying that there are various definitions of deflation and when most economist are talking about deflation they are not referring to a drop in a money supply but rather a decrease in prices.  They go on to talk about the implications of falling prices (you can watch the video here).  One of the implications they falsely represent is that people will delay making purchases indefinitely because of the falling prices.  They laugh at the prospect of people waiting to buy coffee 10 days later because it will be five cents cheaper.  I want to address some of these arguments because they are not handled properly.

First of all, when other economists talk about deflation as a negative for the economy, they are speaking in terms of deflationary policies being implemented by the Federal Reserve.  They are not arguing that an increase in production that causes deflation is bad for the economy.  What is meant by Federal Reserve deflationary policies is exactly what Tom Woods says most economists are not referring to, which is a decrease in the money supply.  So right off the bat this video is misleading the viewer.

The next question you should be asking yourself is, why are deflationary policies unfavorable?  Consider a drastic decrease in the supply of money, say 20% (during the great depression the money supply dropped 33% over three years).  The problem is not that prices will fall eventually, the problem is that inflation/deflation takes around 9-15 months before the economy will start to feel these effects.  With this being considered, within the minimum of 9 months we would have only 80% of the the previous money supply while prices have yet to drop.  This has various implications, but clearly with less money to go around there will be less investment by businesses, less consumption by the consumer, less lending by banks etc.  The economy will slow down because of this.

I want to address the coffee argument because this is an egregious oversimplification of deflation.  First and foremost, no decent economist will ever tell you people will wait to buy coffee ten days because of falling prices nor will they say that people will postpone buying a computer because the prices will fall.  This is a straw man argument.  What needs to be considered when thinking about the economic effects of deflation is whether a businessman wanting to invest $100 million into his company would wait a few months if prices are projected to fall?  Any rational business man would consider waiting because if they were to take out a $100 million loan and prices are falling by 2% each year for 30 years how much extra would they have to pay back?  My investment will have be able to generate more profit than what I am paying back in interest to the bank in addition to having to pay back the amount the dollar has deflated.  This scenario doesn't seem quite so laughable now does it?  A business man with thinking like an economist will not think it is laughable either.

Woods and Herbener do address this issue at around the 7 minute mark but the manner in which they address it is improperly handled.  In America we cannot simply switch money, which is Herbener's solution to this problem.  He claims that in times of mild deflation, historically, this did not happen but I addressed this in argument in previous paragraphs.

What might the monetarist say?

In Milton Friedman's view, he would want a slight increase in a targeted money supply.  He usually argued somewhere between 3-5% with 3% being his best recommendation.  This itself, according to Friedman, would keep inflation or deflation mild.  This is what good economists argue for.  A stable money supply leads to a stable economy.  He argued this because of the evidence Herbener points out.  During the times of great expansion there were small increases in the gold supply.  Friedman wanted to emulate this with the Federal Reserve if our economy is to operate with a Federal Reserve.

The next time you hear an Austrian argue that it is silly to fear deflation you can argue that no economist fears mild deflation.

Debate on Globalism

Recently I got into a debate on open borders with respect to trade and labor.  I am in favor of free trade between countries and also open borders wrt labor, almost all schools of thought are in accordance with this theory.  Monetarists, Austrians and even Keynesians all agree.  In a nutshell, the theory states open borders will lead to increased economic activity and increase the standard of living.

The person I was debating was a fan of Adam Smith and was claiming that Smith was against open borders to trade and labor, or at least as far as I could tell.  He thought that open borders to trade and labor, and commodity backed money would lead to "mutually assured economic destruction".  I have read some Adam Smith, probably not as much as I should have, but I have read a little more since the debate and I found out that the person I was debating had it completely backwards.

I was surprised to hear someone claiming that Smith was against open borders in the first place.  I knew he was in favor of free trade and I could not imagine him being wrong on this.  So I read into his views on borders and one quote sums up his view very well.  "The core of free trade, is the free circulation of labor".  Clearly this implies that Smith opposed any mercantilistic restrictions with regards to not only trade but labor as well.  It makes sense that he would be in favor of open borders, every good economist I have ever read or spoken with is in favor of it.  Furthermore, it is almost all economists pet peeves to hear people talk about why tariffs are good and we can't let immigrants steal our jobs etc. etc.

I had no idea what Marx thought of immigration at the time of the debate but he sent me a link of something that said Marx was in favor of open immigration to reduce national identity.  This sounded like something Marx might say, but my research did not agree with this assessment.  Basically, Marx was against any immigration thinking it was a ploy of the bourgeoisie to bring in cheap labor to drive down the wages and further exploit the labor.  It also makes sense that Marx would be against it.  He is one of the worst economists in the worlds history.

Disclaimer: When economists talk about open borders to trade and labor they are not endorsing letting anyone in the country at anytime.  Rather, they are endorsing making it easier for people to enter a country for jobs if they are demanded.

Is Milton Friedman a Statist?

No.

This claim that Milton Friedman is a statist mostly belongs to Austrian Economists.  They think because Milton Friedman "supported" the federal reserve this makes him a statist.  This could not be further from the truth.

Let me be clear:  Milton Friedman DID NOT support the federal reserve.  Lets look at a quote:

"Any system which gives so much power and so much discretion to a few men, [so] that mistakes -- excusable or not-- can have far reaching effects is a bad system.  It is a bad system to believers in freedom just because it gives a few men such power without and effective check by the body politic --  this is the key political argument against any independent central bank...  To paraphrase Clemenceau:  money is much too serious a matter to be left to the Central Bankers"

This quote does not seem to support the Austrian hypothesis that Friedman was a statist in support of the federal reserve.  If you read enough Friedman or watch enough of his videos you will find him saying he is in favor of abolishing the federal reserve.  He also mentions many times that when he writes or talks about the federal reserve, he is theorizing given that it exists.  Furthermore, in his 1968 paper entitled "The Role of Monetary Policy" published in The American Economic Review he points out the proper way to conduct monetary policy is a "steady rate of growth in a specified monetary total".  This is exactly what we were doing with the gold standard by mining gold in other countries and bringing it to America.  His argument for this is that historically countries with a steady rate of monetary growth have had steady economic activity while countries with wild swings of growth have had wild swings of economic activity.

One other thing to point out is that if you want to learn about basic economic issues from a capitalistic point of view youtube Milton Friedman on whatever subject you wish to see and you will more than likely find plenty of videos all of which will be denouncing the government involvement in markets.

Austrians and Game Theory

My favorite area of economics and mathematics is Game Theory.  It is a fascinating subject with a wide variety of applications.  As someone who used to consider myself an adherent of the Austrian school of economics I know it deals with some of the issues Austrian Economists have with normal General Equilibrium methods of economics. Also, it just so happened to be "co-founded" by an Austrian economist, Oskar Morgenstern.  I knew Mises was not a fan of game theory, however, I was interested to see what current Austrian economists think of it and that is what motivated this post.  Needless to say there is a lack of understanding.

I went searching on mises.org to find as many articles I could, this first led me to the mises.org blog.  People there had varying opinions of game theory but the overwhelming understanding of game theory was completely mistaken.  One person mentioned how game theory is largely based off the prisoners dilemma and therefore is a useless thing to study.  This is very frustrating because game theory has roots all the way back to Emile Borel and other mathematicians, it's most influential work was published in 1944, and the prisoner's dilemma as we know it is credited to Luce and Raiffa in 1957!  This, amongst other fallacious arguments, were very common in these blog discussions.

Okay, so people writing on the blogs misunderstand game theory, but the trained economists couldn't be so drastically mistaken could they?  In an article entitled "The Games Economists Play" by Robert Murphy he attacks the conclusions of game theory in a clearly misinformed fashion.  He analyzes the aforementioned prisoner's dilemma and uses it to claim that because of this we should not accept game theory in general.

In the prisoners dilemma, two players are accused of committing crimes, one minor crime in which their guilt can be proven with out a confession, and major crime for which they cannot be convicted unless at least one confesses.  The confessor will go free but the other will go to jail for 6 years.  If neither confess, they will go to jail for only 1 year.  If they both confess they will go to jail for 5 years.  In this game without communication, the Nash Equilibrium is for each player to confess and hence go to jail for 5 years.  This, to Robert Murphy, is the downfall of game theory because each person could increase their non-jail time time by not confessing.

What Dr. Murphy does not understand is that Nash Equilibrium does not tell you the outcome will be optimal, only the strategies that rational players will make.  The reason the prisoner's dilemma is so famous is because it was the first example of an inefficient Nash Equilibrium (at least that I have found in my research)  Furthermore, he says

"Even here, the game theorists orthodox analysis is not entirely appealing: real world players often do cooperate even in a one-shot prisoner's dilemma"

This made me wonder if he is completely unaware of the study of games with communication?  Or even the study of cooperative game theory.  In the situation described above it is assumed that the prisoner's cannot communicate and have zero way of knowing what the other will do.  Hence, it certainly becomes much more plausible to confess (I have watched enough First 48 on A&E to see that people often do confess).  Also, if we analyze the game properly the outcome makes complete sense.  Since the criminals are not cooperating or communicating in any way, as soon as criminal A thinks criminal B will not confess, criminal A has all the incentive to confess.  His choice becomes either go to prison for one year or zero years.  Likewise for the other criminal.  Now one could argue that many criminals would rather go to jail than be a "rat".  This is where I would like to point out that the focal point effect already deals with this objection.  

Now, if we look at this game through a cooperative game theory lens, the outcome changes entirely.  Through this lens, we can consider any way in which the criminals will cooperate.  Consider the possibility that there is a contract signed before hand in which the criminals agree to not confess otherwise face a punishment worse than prison.  In this game, the person does not have any incentive to cheat because the time he spends free will be worse than time in prison due to the punishment.  Hence, the equilibrium now becomes both criminals not confessing.  

Two more points to consider: first, he mentions people using the prisoner's dilemma to argue for government intervention.  Again, these people do not understand the fact that the criminals have no way to communicate or cooperate.  Hence, their argument is invalid.  Further, the fact that Robert Murphy would actually use this argument to argue against game theory is intellectually dishonest.  He is misrepresenting something he should have studied while getting his PhD.  Any game theorist knows the prisoner dilemma can actually be used to argue for LESS government.

Finally, he gives a formidable representation of "backward-substitution".  Again, I am wondering if he is unaware of the vast literature on the subject of repeated games.  In 1982 Kreps, Milgrom, Roberts and Wilson constructed a way to show that "non-confession" strategy will be employed given an initial certain doubt and actions during the game.  The explanation gets very technical with a lot of game theoretical terms so I will not go into it here, but it is discussed in full detail in "Game Theory: Analysis of Conflict" by Roger B. Myerson in section 7.6.  Also, there are game theorists who study forward induction as well.

In conclusion, it is clear to see Robert Murphy builds up a straw man representation of game theory in order to tear it down.  No where does he address any of the advancements of game theory in the last 20-30 years.  He does not address perfect equilibrium, proper equilibrium, sequential equilibrium, subgame perfect equilibrium, trembling hand perfect equilibrium, the focal point effect, repeated games and the list could go on.  He does however, address Nash equilibrium and the prisoners dilemma, two aspects of game theory developed in the 1950's.  Both of which have been greatly advanced.