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Vladimir_M comments on Open Thread June 2010, Part 3 - Less Wrong
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James_K:
Aside from the standard arguments about the shortcomings of GDP, my principal objection to the way economists use it is the fact that only the nominal GDP figures are a well-defined variable. To make sensible comparisons between the GDP figures for different times and places, you must convert them to "real" figures using price indexes. These indexes, however, are impossible to define meaningfully. They are produced in practice using complicated, but ultimately arbitrary number games (and often additionally slanted due to political and bureaucratic incentives operating in the institutions whose job is to come up with them).
In fact, when economists talk about "nominal" vs. "real" figures, it's a travesty of language. The "nominal" figures are the only ones that measure an actual aspect of reality (even if one that's not particularly interesting per se), while the "real" figures are fictional quantities with only a tenuous connection to reality.
It's pretty easy to get this sort of view just reading books. In my (limited) experience, there are a fair percentage of divergent types that are not like this - and they tend to be the better economists.
You may like Morgenstern's book On the Accuracy of Economic Observations. How I rue the day I saw this in a used bookstore in NY and didn't have the cash to buy it..
EDIT: fixed title name
I'm going through Morgenstern's book right now, and it's really good. It's the first economic text I've ever seen that tries to address, in a systematic and no-nonsense way, the crucial question of whether various sorts of numbers routinely used by economists (and especially macroeconomists) make any sense at all. That this book hasn't become a first-rank classic, and is instead out of print and languishing in near-total obscurity, is an extremely damning fact about the intellectual standards of the economic profession.
I've also looked at some other texts by Morgenstern I found online. I knew about his work in game theory, but I had no idea that he was such an insightful contrarian on the issues of economic statistics and aggregates. He even wrote a scathing critique of the concept ot GNP/GDP (a more readable draft is here). Unfortunately, while this article sets forth numerous valid objections to the use of these numbers, it doesn't discuss the problems with price indexes that I pointed out in this thread.
realitygrill:
Could you please list some examples? Aside from Austrians and a few other fringe contrarians, I almost always see economists talking about the "real" figures derived using various price indexes as if they were physicists talking about some objectively measurable property of the universe that has an existence independent of them and their theories.
Thanks for the pointer! Just a minor correction: apparently, the title of the book is On the Accuracy of Economic Observations. It's out of print, but a PDF scan is available (warning -- 31MB file) in an online collection hosted by the Stanford University.
I just skimmed a few pages, and the book definitely looks promising. Thanks again for the recommendation!
I meant personally - I did my undergrad in economics. I'm extremely skeptical of macroeconomics and currently throw in with the complex adaptive system dynamicists and the behavioral economists (and Hansonian cynicism; that's just me). But, to give an example, Krugman has done quite a bit of work in the complexity arena.
Yeah, you're welcome! The first I heard of that book was someone using the example of calculating in-flows and out-flows of gold. Each country's estimates differed by orders of magnitude or something like that, and even signs.
There are a number of reasonably priced copies on amazon.
Oh good, they certainly weren't that reasonable the last I checked.
It's not so much a matter of being overconfident as it is not listing the disclaimers at every opportunity. The Laspeyres Price Index (the usual type of price index) has well understood limitations (specifically that it overestimates consumer price growth as it doesn't deal with technological improvement and substitution effects very well), but since we don't have anything better, we use it anyway.
"Real" is a term of art in economics. It's used to reflect inflation-adjusted figures because all nominal GDP tells you is how much money is floating around, which isn't all that useful. real GDP may be less certain, but it's more useful.
Bear in mind that everything economists use is an estimate of a sort, even nominal GDP. Believe it or not, they don't actually ask every business in the country how much they produced and / or received in income (which is why the income and expenditure methods of calculating GDP give slightly different numbers although they should give exactly the same result in theory). The reason this may not be readily apparent is that most non-technical audiences start to black out the moment you talk about calculating a price index (hell, it makes me drowsy) and technical audiences already understand the limitations.
James_K:
You're talking about the "real" figures being "less certain," as if there were some objective fact of the matter that these numbers are trying to approximate. But in reality, there is no such thing, since there exists no objective property of the real world that would make one way to calculate the necessary price index correct, and others incorrect.
The most you can say is that some price indexes would be clearly absurd (e.g. one based solely on the price of paperclips), while others look fairly reasonable (primarily those based on a large, plausible-looking basket of goods). However, even if we limit ourselves to those that look reasonable, there is still an infinite number of different procedures that can be used to calculate a price index, all of which will yield different results, and there is no objective way whatsoever to determine which one is "more correct" than others. If all the reasonable-looking procedures led to the same results, that would indeed make these results meaningful, but this is not the case in reality.
Or to put it differently, an "objective" price index is a logical impossibility, for at least two reasons. First, there is no objective way to determine the relevant basket of goods, and different choices yield wildly different numbers. Second, the set of goods and services available in different times and places is always different, and perfect equivalents are normally not available, so different baskets must be used. Therefore, comparisons of "real" variables invariably involve arbitrary and unwarranted assumptions about the relative values of different things to different people. Again, of course, different arbitrary choices of methodology yield different numbers here.
(By the way, I find it funny how neoclassical economists, who hold it as a fundamental axiom that value is subjective, unquestioningly use price indexes without stopping to think that the basic assumption behind the very notion of a price index is that value is objective and measurable after all.)
Very true. A good general measure in human economic systems should NOT merely look at the ease of availability of finished paperclips. It should also include, in the "basket", such things as extrudable metal, equipment for detecting and extracting metal, metallic wire extrusion machines, equipment for maintaining wire extrusion machines, bend radius blocks, and so forth.
Thank you for pointing this out; you are a relatively good human.
That is a very poor inference on their part.
Here's a crude metric I use for gauging the relative goodness of societies as places to live: Immigration vs. emigration.
It's obviously fuzzy-- you can't get exact numbers on illegal migration, and the barriers (physical, legal, and cultural) to relocation matter, but have to be estimated. So does the possibility that one country may be better than another, but a third may be enough better than either of them to get the immigrants.
For example, the evidence suggests that the EU and the US are about equally good places to live.
I don't think that's a good metric. Societies that aren't open to mass immigration can have negligible numbers of immigrants regardless of the quality of life their members enjoy. Japan is the prime example.
Moreover, in the very worst places, emigration can be negligible because people can be too poor to pay for the ticket to move anywhere, or prohibited to leave.
But "given perfect knowledge of all market prices and individual preferences at every time and place, as well as unlimited computing power", you could predict how people would choose if they were not faced with legal and moving-cost barriers - e.g. imagine a philanthropist willing to pay the moving costs. So your objection to this metric seems to be a surmountable one, in principle, assuming perfect knowledge etc. The main remaining barrier to migration may be sentimental attachment - but given perfect knowledge etc. one could predict how the choices would change without that remaining barrier.
Applying this metric to Europa versus Earth, presumably Europans would choose to stay on Europa and humans would choose to stay on Earth even with legal, moving-cost, and sentimental barriers removed, indeed both would pay a great deal to avoid being moved.
In contrast to Europans versus humans, humans-of-one-epoch are not very different from humans-of-another-epoch.
Excellent point -- although I would pay a good deal to move to Europa, given a few days worth of air and heat.
A fair point, though I think societies like that are pretty rare. Any other notable examples?
Off the top of my head, I know that Finland had negligible levels of immigration until a few years ago. Several Eastern European post-Communist countries are pretty decent places to live these days (I have in mind primarily the Czech Republic), but still have no mass immigration. As far as I know, the same holds for South Korea.
Regarding emigration, the prime example were the communist countries, which strictly prohibited emigration for the most part (though, rather than looking at the numbers of emigrants, we could look at the efforts and risks many people were ready to undertake to escape, which often included dodging snipers and crawling through minefields).
The basket used is based on a representation of what people are currently consuming. This means we don't have to second-guess people's preferences. Unique goods like houses pose a problem, but there's not really anything we can do about that, so the normal process is to take an average of existing houses.
Which is a well understood problem. Every economist knows this, but what would you have us do? It is necessary to inflation-adjust certain statistics, and if the choice is between doing it badly and not doing it at all, then we'll do it badly. Just because we don't preface every sentence with this fact doesn't mean we're not aware of it.
Just to avoid confusion among readers, I want to distance myself from part of Vladimir_M's position. While I agree with many of the points he's made, I don't go so far as to say that CPI is a fundamentally flawed concept, and I agree with you that we have to pick some measure and go with it; and that the use of it does not require its caveats to be restated each time.
However, I do think that, for the specific purpose that it is used, it is horribly flawed in noticeable, fixable ways, and that economists don't make these changes because of lost purpose syndrome -- they get so focused on this or that variable that they're disconnected from the fundamental it's supposed to represent. They're doing the economic equivalent of suggesting to generals that their living soldiers be burned to ashes so that the media will stop broadcasting images of dead soldier bodies being brought home.
I wouldn't be in a good position to determine if it's lost purpose syndrome since I'm an insider, but I would suggest that path dependence has a lot to do with it.
Price indices are produced by governments, who are notoriously averse to change. And what's worse the broad methodology is dictated by international standards, so if an economist or some other intelligent person comes up with a better price index they have to convince the body of economists and statisticians that they have a good idea, and then convince the majority of OECD countries (at a minimum) that their method is worth the considerable effort of changing every country's methodology.
That's a high hurdle to cross.
On my blog I suggested using insulin prices as a good proxy for inflation. That should be pretty easy for economists to find, even historical data. One economists could find the historical data for one country and use it as a competing measure. No collective action problem to solve there! Just a research paper to present.
(Though I can't find it on google searches, but economists should be able to get access to the appropriate databases.)
The technology to manufacture insulin has been getting a lot cheaper since the late 1970s when bacteria were first used to synthesize insulin (before that it had to be extracted from animals). That process has become even easier since the process for growing E. coli has become much more efficient.
True, that was just one layman's brief pondering of an alternate metric, and I hadn't realized the secular technology trend. I was mainly looking for something that can't be debased because then people will die, but that is also has minimal volatility in demand, supply, and speculation, and requires numerous inputs so as to smooth out the effect of local shocks.
And perhaps I'm running into a Goodhart trap myself -- today, the problem seems to be inflation being hidden via product degradation, but if I pick a metric mainly optimized for that, it will get worse over time. So finding a good or basket that covers all those would require more work -- but product debasement is pretty clearly being ignored today.
(Note that precious metals are sold in a way that prevents them from being secretly debased, but also are heavily influenced by global extraction rates, and are heavily speculated on and hoarded.)
Anything that has numerous inputs will likely be something which is complicated to manufacture and therefore will have increasing efficiency as the technology improves. I can't think of a single good that fits your criteria and hasn'thad substantial technological advancements of how it is made in the last 30 years. This sort of approach might work if one had very steady data for some long historical period with not much technological advancement.
That's making your inflation rate strongly tied to one particular technology. A breakthrough making insulin synthesis easier, or increased diabetes rates, would affect insulin prices but not the rest of the economy.
Would error bars be a bad thing?
Economists could calculate error bars that would say how closely the calculated aggregate figures approximate their exact values according to definitions. This is normally not done, and as Morgenstern noted in the book discussed elsewhere in the thread, the results would be quite embarrassing, since they'd show that economists regularly talk about changes in the second, third, or even fourth significant digit of numbers whose error bars are well into double-digit percentages.
However, when it comes to the more essential point I've been making, error bars wouldn't make any sense, since the problem is that there is no true value out there in the first place, just different arbitrary conventions that yield different results, neither of which is more "true" than the others.
There's an old joke: "How can you tell macroeconomists have a sense of humour? They use decimal points." I'll admit spurious precision is a problem with a quite a bit of economic reporting. Remember that these statistics are produced by governments, not academics and politicians can have trouble grokking error bars.
Actually, that's not really the case. There is an ideal, it's just you can't do it. If you knew everyone's preferences and information and endowments of income, you could work out how people's consumption would change as real incomes and relative prices changed so you could figure out what the right basket of goods is to use for the index at every point in time (the right bundle is whatever bundle consumers would actually pick in a given situation).
But in practice you can't get the information you'd need to do this, and that information would be constantly changing anyway. In practice what statistical agencies do is develop a basket of goods based on current consumption and review it every decade or so. This means the index overestimates inflation (the estimates I've seen put it at about 1 percentage point per year) because when prices rise, people change their consumption patterns and we can't predict how until it's already happened.
This is a flawed procedure, but it's not arbitrary, its an honest effort to approximate the ideal price index as well as we can, given the resources at our disposal.
James_K:
To the best of my understanding, what you write above seems to concede that even under the assumption of omniscience, when we consider different times and/or places, with different prices, incomes, and preferences of individuals -- and different sets of goods available on the market, though this can be modeled by assigning infinite prices to unavailable goods -- there is, after all, no unique objectively correct way to define equivalent baskets of goods. You could calculate the baskets that would actually be consumed at each time and place, but not the ratio of their true values (whatever that might mean), which would be necessary for their use as the basis for a true and objective price index.
Am I wrong in this conclusion, and if I am, would you be so kind to explain how?
I would be really grateful if you could spell out what exactly you mean by "the ideal price index" when it comes to comparing different times and places, given my above observation. Also, you ignore the question of how exactly baskets are "reviewed," which is a step that requires an arbitrary choice of the new basket that will be declared as equivalent to the old.
Moreover, different kinds of "honest efforts" apparently produce very different figures. The procedures for calculating official price indexes have been changed several times in recent decades in ways that make the numbers look very different compared to what the older methods would yield. (And curiously, the numbers according to the new procedures somehow always end up looking better.) Would you say, realistically, that this is purely because we've been moving closer to the truth thanks to our increasing knowledge and insight?
The concept of "true value" is incoherent, at least in my model of reality. The correct price to attach to a good at any time is its market price at that time. If you had the set of information I listed in my last comment, you'd have the market prices, since they're implied by the other stuff.
I think we're using different definitions of arbitrary. To me, arbitrary means that there is no correct answer, and all options are equally valid. I don't accept that as a legitimate description of the process, there are judgement calls, but ambiguity is inevitable in the social sciences, you either get used to it, or find something else to study. Now if you're using arbitrary in the way I'm using ambiguous, then I don't think we disagree, except that I think it's less problematic than I think you do, since as soon as you start dealing with people things get so complex that ambiguity is inevitable.
Now, here you have a point. The Laspeyres Index is biased up, it may be an honest effort, but not one that's Bayes correct. But Bayesian rationality has not penetrated through the discipline at this time, and as such a biased estimate is allowed to remain, primarily because there's no methodologically clean way to remove the bias (you'd need to be able to predict things like quality changes and how people change their spending patterns in response to price changes) and without a background in Bayesian probability theory I think most economists would baulk at adding a fudge factor into the calculation.
It might be valuable to talk about a "true value" of a given good to a given agent. Yes, the correct price to buy or sell a good at is always the market price; but whether I want to sell at that price or buy at that price depends on how much I want the good. If I sell, then the "true value" of the good to me is less than the current market price; and if I buy, then the "true value" of the good to me is greater than the current market price. In general, the "true value" of a given good to a given agent is the price such that, if the market were trading at that price, that agent would be indifferent regarding whether to buy or sell that good.
James_K:
I heartily agree -- but what is a price index, other than an attempt at answering the question of what the "true value" of a unit of currency is? What are the fabled "real" values other than attempts at coming up with a coherent concept of "true value"?
Yes, but even given perfect knowledge of all market prices and individual preferences at every time and place, as well as unlimited computing power, I still don't see how this solves the problem. We can find out the average basket consumed per individual (or household or whatever) and its price at each time and place, but what next? How do we establish the relative values of these baskets, whose composition will be different both quantitatively and qualitatively?
To clarify things further, I'd like to ask you a different question. Suppose the moon Europa is inhabited by intelligent jellyfish-like creatures floating in its inner ocean. The Europan economy is complex, technologically advanced, and money-based, but it doesn't have any goods or services in common with humans, except for a few inevitable ones like e.g. some basic chemical substances, and there is no trade whatsoever between Earth and Europa due to insurmountable distances. Would it make sense to define a price index that would allow us to compare the "real" values of various aggregate variables in the U.S. and on Europa?
If not, what makes the U.S./Europa situation essentially different from comparing different places and epochs on Earth? Or does the meaningfulness of price indexes somehow gradually fall as differences accumulate? But then how exactly do we establish the threshold, and make sure that the differences across decades and continents here on Earth don't exceed it?
Well, if macroeconomists and other social scientists were just harmless and benign philosophers, I'd be happy to leave them to ponder their ambiguities in peace!
Trouble is, to paraphrase Trotsky's famous apocryphal quote, you may not be interested in social science, but social science is interested in you. In the present Western political system, whatever passes for reputable high-profile social science will be used as basis for policies of government and various powerful entities on its periphery, which can have catastrophic consequences for all of us if these ideas are too distant from reality. (And arguably already has.) Macroeconomics is especially critical in this regard.
If some price indexes are "clearly absurd", then they apparently have some value to us - for if they were valueless, then why call any particular one "absurd"? If they yield different results, then so be it - let us simply be open about how the different indexes are defined and what result they yield. The absence of a canonical standard will of course not be useful to people primarily interested in such things as pissing contests between nations, but the results should be useful nonetheless.
We commonly talk about tradeoffs, e.g., "if I do this then I will benefit in one way but lose in another". We can do the same thing with price indexes. "In this respect things have improved but in this other respect things have gotten worse."
Constant:
Sure, but such an approach would deny the validity of all these "real" economic variables that are based on a scalar price index. In particular, it would definitely mean discarding the entire concept of "real GDP" as incoherent. This would mean conceding the criticisms I've been expounding in this thread, and admitting the fundamental unsoundness of much of what passes for science in the field of macroeconomics.
Moreover, disentangling the complete truth about what various price indexes reveal and what they hide is an enormously complex topic that requires lengthy, controversial, and subjective judgments. This is inevitable because, after all, value is subjective.
Take for example two identically built houses located in two places that greatly differ in various aspects of the natural environment, society, culture, technological development, economic infrastructure, and political system. (It can also be the same place in two different time periods.) It makes no sense to treat them as equivalent objects of identical value; you'd have a hard time finding even a single individual who would be indifferent between the two. Now, if you want to discuss what exactly has been neglected by treating them as identical (or reducing their differences to a single universally applicable scalar factor) for the purposes of constructing a price index, you can easily end up writing an enormous treatise that touches on every aspect in which these places differ.