More (#2) from The Undercover Economist Strikes Back:

...forecasting is not the economist’s main job. Unfortunately, economists have managed to stereotype themselves as bad forecasters because investment firms have realized that they can get some publicity by sending someone called a “chief economist” to the studios of Bloomberg Television, where said chief economist will opine about whether shares will go up or down. Most academic economists don’t even try to forecast, because they know that forecasts of complex systems are extremely difficult — if anything, rather than being overconfident in their forecasts, they’re too eager to dismiss forecasting as an activity for fools and frauds.

Keynes famously remarked, “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!” It’s a good joke, but it’s not just a joke; you don’t expect your dentist to be able to forecast the pattern of tooth decay, but you expect that she will be able to give you good practical advice on dental health and to intervene to fix problems when they occur. That is what we should demand from economists: useful advice about how to keep the economy working well, and solutions when the economy malfunctions.

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When you look at the most exciting, innovative work coming out of economics today, it’s pretty much all from microeconomists, not macroeconomists. Think of Al Roth’s work on market design, in which he uses computer-based algorithms to allocate children to school places, young doctors to their first hospital jobs, and kidney donors to compatible patients. Economists such as Paul Milgrom, Hal Varian and Paul Klemperer are scoring notable successes in auction design, from Google Ads to lucrative spectrum auctions to efforts to support the banking system without giving massive handouts to banks. John List, Esther Duflo and others are designing economic experiments to reveal hidden truths about human behavior. These economists are much more like dentists — or doctors, or engineers. They solve problems.

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Macroeconomic models have become elegant and logically sophisticated, but suffer a serious disconnection from reality. The thinking has been that logical consistency must come first, and hopefully the models will start to look realistic eventually. This is not entirely ridiculous—Robert Lucas’s critique of the Phillips curve and the chastening stagflation of the 1970s showed economists that it wasn’t enough merely to draw conclusions from the data, because the data could change dramatically. But four decades on from the “rational expectations” revolution, there are good reasons to believe that macroeconomics is failing to incorporate some important perspectives.

...Three examples spring to mind: banking, behavioral economics and complexity theory.

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behavioral economics, a kind of fusion of economics and psychology, has made big inroads into economic thought in the past fifteen years... Microeconomists were initially skeptical, and many remain skeptical. But skeptical or not, they have paid attention and either embraced behavioral economics or criticized it.

But macroeconomists? They seem to have ignored behavioral economics almost entirely. Robert Shiller told me that while the microeconomists would show up to argue when he gave seminars on behavioral finance, the macroeconomists just haven’t shown up at all.

More (#1) from The Undercover Economist Strikes Back:

In The Wealth of Nations, [Smith] wrote: “A linen shirt, for example, is, strictly speaking, not a necessity of life. The Greeks and Romans lived, I suppose, very comfortably though they had no linen. But in the present times, through the greater part of Europe, a creditable day-laborer would be ashamed to appear in public without a linen shirt. . . .”

Smith’s point is not that poverty is relative, but that it is a social condition. People don’t become poor just because the median citizen receives a pay raise, whatever Eurostat may say. But they may become poor if something they cannot afford—such as a television—becomes viewed as a social essential. A person can lack the money necessary to participate in society, and that, in an important sense, is poverty.

For me, the poverty lines that make the most sense are absolute poverty lines, adjusted over time to reflect social change. Appropriately enough, one of the attempts to do such work is made by a foundation established by Seebohm Rowntree’s father, Joseph. The Joseph Rowntree Foundation uses focus groups to establish what things people feel it’s now necessary to have in order to take part in society—the list includes a vacation, a no-frills mobile phone and enough money to buy a cheap suit every two or three years. Of course, this is all subjective, but so is poverty. I’m not sure we will get anywhere if we believe that some expert, somewhere—even an expert as thoughtful as Mollie Orshansky or Seebohm Rowntree—is going to be able to nail down, permanently and precisely, what it means to be poor.

Even if we accept the simpler idea of a nutrition-based absolute poverty line, there will always be complications. One obvious one is the cost of living: lower in, say, Alabama than in New York. In principle, absolute poverty lines could and should take account of the cost of living, but the U.S. poverty line does not. A second issue is how to deal with short-term loss of income. A middle manager who loses her job and is unemployed for three months before finding another well-paid position might temporarily fall below the poverty line as far as her income is concerned, but with good prospects, a credit card and savings in the bank, she won’t need to live like a poor person—and she is likely to maintain much of her pre-poverty spending pattern. For this reason, some economists prefer to measure poverty not by what a household earns in a given week, month or year—but by how much money that household spends.

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According to the official United States government definition, 15 percent of the U.S. population was poor in 2011. That was the highest percentage since the early 1990s, up from 12.3 percent in 2006, just before the recession began. For all its faults, you can see one of the appeals of an absolute poverty line: if poverty goes up during recessions, you are probably measuring something sensible.

The European Union doesn’t use a comparable poverty line, but in the year 2000, researchers at the University of York tried to work out what EU poverty rates would be as measured against U.S. standards. They estimated poverty rates as high as 48 percent in Portugal and as low as 6 percent in Denmark, with France at 12 percent, Germany at 15 percent and the UK at 18 percent. Clearly, national income is a big influence on absolute poverty (Portugal is a fair bit poorer than Denmark), but so, too, is the distribution of income (France and the UK have similar average incomes, but France is more egalitarian).