Wednesday, October 16, 2013

Abusing Models in Economics [Wonkish]

Cameron Murray said some nice, though thoroughly unwarranted, things about me on his blog ‘Fresh Economic Thinking’, so I thought I would add some of my thoughts to his discussion on the use of models in the social sciences. Warning this will get wonkish.

Firstly, I think you need to be specific when discussing the use and abuse of ‘models’ in the social sciences. Economics is a large field and there are thousands of different models, with a large variety of assumptions (realistic and not) and applications. They range from a simple one line OLS estimation to a large set of simultaneous equations. Some are useful, some are not, but making sweeping generalisations about every model in the field only clouds the debate. 

Accordingly, I am going to narrow my part in this discussion to the branch I am most familiar with, and where models are probably most contentious, macro-economics, to talk about what models are used for and how they should be evaluated.

Cameron states that a model “cannot be shown to be of scientific value unless it offers useful predictions”. I think this burden is unfairly harsh – especially when it comes to macro models. There are essentially two types of predictions one could make with a model: forecasts of the impact of a change in policy relative to a baseline scenario, and broad forecasts about future economic outcomes (which usually include some assumption about future economic policy). The former are generally unverifiable. We can make an educated guess about what would happen if, for example, the US were to shut down their federal government, but given the dynamic world we live in it’s impossible to measure the accuracy of this forecast as there is a constant barrage of other events (or shocks) that will affect the US economy at the same time.

Conversely the accuracy of broad forecasts of economy (for example the growth in GDP over the next year) can be measured and compared. However, there is a vast literature that shows that these forecasts are really hard to do. Regardless of which model is used, large-scale DSGE models or small and simple vector auto-regressions (VARs) macro-model forecasts rarely produce informative forecasts. Not only that, but most professional forecasters, groups of highly trained economists using many models coupled with judgement based on years of experience, rarely forecast well either. The point is macroeconomic forecasting is hard. Really hard. I wouldn’t discard a model of the earth’s tectonic plates for falling to predict an individual earthquake, because nobody can predict earthquakes. By the same token it’s ridiculous to expect a macro-model to provide “useful predictions”, because nobody can forecast the economy. It’s an absurdly high standard.

So if a model can’t be used for forecasting then what is it good for? I agree with Cameron that model’s can be useful for telling (hopefully) plausible stories about the economy. Often you need a lot of implausible assumptions to tell these stories, but these assumptions are often necessary to be able to understand a particular mechanism or aspect of how our economy works (the price puzzle is an example of this, where structural assumptions are usually necessary to find the 'correct' casual-link between interest rates and inflation).

There are obviously a lot of commonly used assumptions which are not good representations of how the world really works. Calvo-pricing frictions are not the same as down-ward stick nominal wages, a financial accelerator is not the same as Lehman Brother’s failing, and adjustment costs are not the same as lumpy investment projects.  Each of these assumptions could be improved upon with a more complex approach to better fit reality and the data. However, while this is probably do-able for each assumption in isolation, adding complexity to every aspect of a model at once would quickly make it intractable, and thus useless.

Modelling in the social sciences is not doubt a flawed process. But in areas that don’t lend themselves to experimentation or natural experiments (such as macroeconomics) models are important tool to enable our understanding of the world we live in.

PS Of course if Cameron was referring only to micro-models in his post, then a lot of what I’ve said maybe orthogonal to his point. Though in my experience the controversy over modelling is concentrated in macro.

PPS There are other approaches out there which could handle a more complex set of assumptions, agent-based modelling for example, but these approaches are fairly new and have their own issues.

Friday, September 20, 2013

What is "Economic Reform"?

“Reform” is very sexy word. It is often deployed to cloak policy in feel good vibes and to create an aura of leadership and vision.  So everyone in the policy-sphere wants to think of themselves as reformers and many a complete bastard has appropriated this lovely, but overused, title.  But who are the real reformers and who are the pretenders?  Remember everyone from Lenin, Stalin to the odd Italian Fascist claimed the heroic title of "reformer".  So you should often be very cautious when you encounter people and policies claiming the mantle of "economic reform". 

Economics is a very broad field. There are professional economists working on topics ranging from the economics of wine, food, love, technology, prostitution, video gamescrime as well as the more 'conventional' topics such as public policy or financial markets. As such it's perhaps unsurprising that 'economic reform' is used to describe pretty much any policy that the government wants to sell as a being important for the nation.

But does it really make sense to label policies such as the Gonski reforms (aka Better Schools) or the NBN as 'economic reforms'? Certainly a better education system and a faster broadband network could have an impact on the Australian economy, but that is true of most government policy. If the phrase is to have any meaning at all, it needs to saved for policies that are truly economy-wide, as opposed to policies for individual areas or sectors (in this case the education and telecommunication sectors).

So what would be a sensible definition for economic reform? To answer this question you need to think about two criteria: who does the policy affect, and what does the policy involved changing. More specifically, does the policy affect all sectors and industries, or just one in particular? And secondly, does the policy substantially change the rules of the game, or does it just funnel money around the budget?

I have graphed both of those questions below, and (roughly) plotted a few policies on where they might sit on the spectrum. Up in the top left quadrant you have the economy-wide game-changing economic policies, it's where most of the lionised Hawke-Keating reforms would probably sit. This is what I would define as the archetypal, pure 'economic reform': something that fundamentally changes the way we work as a nation both in the public and private sector for most, if not all, Australians. To the right you have policies that predominantly affect individual sectors, and while they may impact the economy, I think their narrow focus should preclude them from the title. Finally, down the bottom you have policies that either spend or raise money, as opposed to ones that actually change the rules (both legal and cultural) by which our society operates. A classic example of the former is an income tax cut. I don't think these sort of policies should really be described as reforms, they are polices that affect the economy on the margin, but aren't likely to produce fundamental changes in the way it works.

Looking at our list of economic reforms through this lens it becomes apparent that the implementation of 'pure' economic reforms has slowed down over the past decade or so. The most recent reforms have been the GST (which replaced an inefficient and complex wholesale tax system - but doesn't really rise to the level of reforms such as floating the dollar) and the carbon tax (which had a big impact on the mining, manufacturing and energy sectors, but only a limited impact on the services and agriculture industries).

Why might this be the case? Undoubtedly the reforms of the 1980's constituted a lot of low hanging fruit - policies that had large and obvious benefits, and had already been implemented in other countries. But there are still plenty of big ideas out there, many spelt out in the Henry Review. Have our politicians lost their nerve? Or have our economists and public servants lost the imagination necessary to initiate these big reforms? I'm not sure of the answer, but I plan on blogging about potential candidates for the 'Next Big Economic Reform' soon!

PS There is obviously quite a bit of discretion in how I have classified several of the reforms. The reason why I have placed the carbon tax towards the sector specific side, is that for most firms the impact will be quite small (at most a small rise in energy prices). The composition of our electricity production will change, but for most firms and households solar electricity is much the same as the voltage from a fossil fuel based source. This contrasts with, for example, tariff reform which would of affected almost every household and the vast majority of firms.

Thursday, September 12, 2013

Why the Henry Review wanted to scrap the GST

Ken Henry ponders our tax and transfer future.

While barrels of ink have been spilt analysing and reporting on the Henry Review, there remains one key undiscovered gem - its conclusion that the GST should be scrapped.

Tuesday, September 10, 2013

Re-blogging the Henry Review

Australia's Future Tax System

Part of the reason I started this blog is to delve into areas of economics and policy outside of my own narrow field of experience. So as part of an (hopefully) ongoing series I am going to start re-blogging the Henry Tax Review; taking down a box or recommendation at a time and discussing the underlying theory, why they ended up proposing what they did and how things have changed since the report was released.

I think it is fair to say that while the review itself was a great body of work – it’s translation into actual policy has been somewhat lacking. This was probably inevitable. The Henry Review was supposed to be economic roadmap that would guide economic policy over 20 years. But I do think some core elements of it have been missed by both the politicians responsible for it and the media. The first of these posts is going to look at the Henry Review and the GST.

Let me know if you have any specific parts you think deserve a closer look!

Thursday, September 5, 2013

Economics at the Edge - Reflections on the Economics 'Q and A'

Last Tuesday night I was fortunate enough to attend the Economics Student Society of Australia’s Economics ‘Q and A’ night at the Deakin Edge. The event, held in the style of the ABC's 'Q and A', fielded questions from the audience for a top notch panel comprising of Tom Elliot, Judith Sloan, Ian Harper, John Daley and Lynne Williams, with Stephen Koukoulas acting as the moderator.

To kick-start the evening the panel had two prepared topics: ‘The End of the Mining Boom’ and ‘The Economics of Asylum Seekers’.

Wednesday, August 28, 2013

A New Blog


My name is Zac Gross, I'm a (mostly macro) economist about to start post-graduate study abroad. I previously spent a couple years at the Reserve Bank of Australia bustin' cash rate moves - but this blog represents my personal thoughts alone. The plan is to provide unsolicited commentary on the latest and greatest trends in both economics and the Australian public policy arena - but there is a good chance traffic may slow once I start full time study in a month's time.

Until then,feel free to comment below or suscribe on the sidebar! You can follow me on the twitters too.