MICROECONOMISTS are wrong about specific things, Yoram Bauman, an economist and comedian, likes to say, whereas macroeconomists are wrong in general. Macroeconomists have borne the brunt of public criticism over the past decade, a period marked by financial crisis, soaring unemployment and bitter arguments between the profession’s brightest stars. Yet the vast majority of practising dismal scientists are microeconomists, studying the behaviour of people and firms in individual markets. Their work is influential and touches on all aspects of social policy. But it is no less fraught than the study of the world economy, and should be treated with corresponding caution.
For decades non-economists have attacked the assumptions underlying economic theory: that people are perfectly informed maximisers of their own self-interest, for instance. Although economists are aware that markets fail and humans are not always rational, many of their investigations still rely on neoclassical assumptions as “good enough” descriptions of the world. But this “101ism”, as Noah Smith, an economist and journalist, calls it, is less prevalent than it was in the 1950s and 1960s, when researchers like Gary Becker reckoned everything from crime to marriage could be described in terms of rational self-interest. Since the 1970s, as Roger Backhouse and Béatrice Cherrier describe in “The Age of the Applied Economist”*, a new collection of essays, the field has taken a decidedly empirical turn.
Most influential economic work today involves at least some data from the real world. Many economists made their names by finding unique datasets containing “natural experiments”, in which a change in policy or conditions affects only parts of a population. This allows researchers to tease out the effect of the change. In a famous example, published in 2001, John Donohue and Steven Levitt used variations in abortion laws across states to conclude that legalising abortion had been responsible for as much as half of the decline in crime in America in the 1990s. Other economists used randomised controlled trials (RCTs) to generate experimental data on the effects of social and development policies. In RCTs randomly chosen subjects are given a “treatment”, such as a microloan or a school voucher, while those in a control group are not. The behaviour of the two groups is then compared.
These developments have led to better, more substantial research. Yet they have also exposed economics to the problems bedevilling most social sciences, and some hard sciences, too. Researchers can tweak their statistical tests or mine available data until they stumble on an interesting result. Or they read significance into a random alignment. Economics, like other social sciences, is suffering a replication crisis. A recent examination in the Economic Journal, of almost 7,000 empirical economics studies, found that in half of the areas of research, nearly 90% of those studies were underpowered, ie, that they used samples too small to judge whether a particular effect was really there. Of the studies that avoided this pitfall, 80% were found to have exaggerated the reported results. Another study, published in Science, which attempted to replicate 18 economics experiments, failed for seven of them.
Even when a study is perfectly designed and executed, the result is open to interpretation. Environmental factors such as changing institutions or social norms inevitably play some role, but researchers cannot fully account for them. The results of an experiment conducted in one country might not be relevant in another, or in the same country at a later date. Research may suffer from more than one of these problems. Critics of the paper by Messrs Donohue and Levitt reckon, for instance, that the authors’ computer code contained an error, that they used a measure of crime that flattered their results, and that they neglected the possibility that differences in the change in crime across states were caused by differences in factors other than abortion laws. (The pair conceded an error, but responded that taking better account of confounding factors did not weaken their conclusion.)
Small wonder that economists struggle to answer seemingly straightforward questions, such as how minimum-wage laws affect employment. In 2017 two teams of researchers released assessments of a change in Seattle’s minimum-wage laws within days of each other. Each came to wildly different conclusions (continuing an established pattern of such research).
New techniques could help. Machine learning, in which computer programs comb through vast datasets in search of patterns, is becoming more popular in all areas of economics. A future beckons in which retailers know virtually everything about every transaction, from the competing products buyers considered before their purchases to their heart rates at the moment of payment. That could mean better predictions and policy recommendations without a smidgen of economic analysis. But pitfalls are already apparent. The algorithms used are opaque. And getting access to the richest data will require researchers to work with, or for, giant tech firms which have their own interests.
Read the small print
Economics enjoys greater influence over policy than other social sciences. Striking new findings are publicised by researchers and their institutions, promoted by like-minded interest groups and politicians, and amplified by social media. Conflicting results and corrections are often ignored. Being alert to the shortcomings of published research need not lead to nihilism. But it is wise to be sceptical about any single result, a principle this columnist resolves to follow more closely from now on.
“The age of the applied economist: the transformation of economics since the 1970s“, Roger Backhouse and Beatrice Cherrier, November 2016.
“The impact of legalised abortion on crime“, John Donohue and Steven Levitt, Quarterly Journal of Economics, May 2001.
“The impact of legalised abortion on crime: comment“, Christopher Foote and Christopher Goetz, Quarterly Journal of Economics, February 2008.
“Measurement error, legalized abortion and the decline in crime: a response to Foote and Goetz“, John Donohue and Steven Levitt, Quarterly Journal of Economics, February 2008.
“The power of bias in economics research“, John Ioannidis, T.D. Stanley and Hristos Doucouliagos, Economic Journal, October 2017.
“Evaluating replicability of laboratory experiments in economics“, Colin Camerer et al, Science, March 2016.
“Seattle’s minimum wage experience 2015-2016“, Michael Reich, Sylvia Allegretto and Anna Godoey, June 2017.
“Minimum wage increases, wages, and low-wage employment: evidence from Seattle“, Ekaterina Jardim et al, NBER working paper 23532, June 2017.
Japan still has great influence on global financial markets
IT IS the summer of 1979 and Harry “Rabbit” Angstrom, the everyman-hero of John Updike’s series of novels, is running a car showroom in Brewer, Pennsylvania. There is a pervasive mood of decline. Local textile mills have closed. Gas prices are soaring. No one wants the traded-in, Detroit-made cars clogging the lot. Yet Rabbit is serene. His is a Toyota franchise. So his cars have the best mileage and lowest servicing costs. When you buy one, he tells his customers, you are turning your dollars into yen.
“Rabbit is Rich” evokes the time when America was first unnerved by the rise of a rival economic power. Japan had taken leadership from America in a succession of industries, including textiles, consumer electronics and steel. It was threatening to topple the car industry, too. Today Japan’s economic position is much reduced. It has lost its place as the world’s second-largest economy (and primary target of American trade hawks) to China. Yet in one regard, its sway still holds.
This week the board of the Bank of Japan (BoJ) voted to leave its monetary policy broadly unchanged. But leading up to its policy meeting, rumours that it might make a substantial change caused a few jitters in global bond markets. The anxiety was justified. A sudden change of tack by the BoJ would be felt far beyond Japan’s shores.
One reason is that Japan’s influence on global asset markets has kept growing as decades of the country’s surplus savings have piled up. Japan’s net foreign assets—what its residents own abroad minus what they owe to foreigners—have risen to around $3trn, or 60% of the country’s annual GDP (see top chart).
But it is also a consequence of very loose monetary policy. The BoJ has deployed an arsenal of special measures to battle Japan’s persistently low inflation. Its benchmark interest rate is negative (-0.1%). It is committed to purchasing ¥80trn ($715bn) of government bonds each year with the aim of keeping Japan’s ten-year bond yield around zero. And it is buying baskets of Japan’s leading stocks to the tune of ¥6trn a year.
Tokyo storm warning
These measures, once unorthodox but now familiar, have pushed Japan’s banks, insurance firms and ordinary savers into buying foreign stocks and bonds that offer better returns than they can get at home. Indeed, Japanese investors have loaded up on short-term foreign debt to enable them to buy even more. Holdings of foreign assets in Japan rose from 111% of GDP in 2010 to 185% in 2017 (see bottom chart). The impact of capital outflows is evident in currency markets. The yen is cheap. On The Economist’s Big Mac index, a gauge based on burger prices, it is the most undervalued of any major currency.
Investors from Japan have also kept a lid on bond yields in the rich world. They own almost a tenth of the sovereign bonds issued by France, for instance, and more than 15% of those issued by Australia and Sweden, according to analysts at J.P. Morgan. Japanese insurance companies own lots of corporate bonds in America, although this year the rising cost of hedging dollars has caused a switch into European corporate bonds. The value of Japan’s holdings of foreign equities has tripled since 2012. They now make up almost a fifth of its overseas assets.
What happens in Japan thus matters a great deal to an array of global asset prices. A meaningful shift in monetary policy would probably have a dramatic effect. It is not natural for Japan to be the cheapest place to buy a Big Mac, a latté or an iPad, says Kit Juckes of Société Générale. The yen would surge. A retreat from special measures by the BoJ would be a signal that the era of quantitative easing was truly ending. Broader market turbulence would be likely. Yet a corollary is that as long as the BoJ maintains its current policies—and it seems minded to do so for a while—it will continue to be a prop to global asset prices.
Rabbit’s sales patter seemed to have a similar foundation. Anyone sceptical of his mileage figures would be referred to the April issue of Consumer Reports. Yet one part of his spiel proved suspect. The dollar, which he thought was decaying in 1979, was actually about to revive. This recovery owed a lot to a big increase in interest rates by the Federal Reserve. It was also, in part, made in Japan. In 1980 Japan liberalised its capital account. Its investors began selling yen to buy dollars. The shopping spree for foreign assets that started then has yet to cease.
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