An excellent little spot by Noah Smith on who uses what sort of economic model to do their forecasting:

Suppose you’re a macro investor. If all you want to do is make unconditional forecasts — say, GDP next quarter – then you can go ahead and use an old-style SEM model, because you only care about correlation, not causation. But suppose you want to make a forecast of the effect of a government policy change — for example, suppose you want to know how the Fed’s taper will affect growth. In that case, you need to understand causation — you need to know whether quantitative easing is actually changing people’s behavior in a predictable way, and how.

This is what DSGE models are supposed to do. This is why academic macroeconomists use these models. So why doesn’t anyone in the finance industry use them? Maybe industry is just slow to catch on. But with so many billions upon billions of dollars on the line, and so many DSGE models to choose from, you would think someone at some big bank or macro hedge fund somewhere would be running a DSGE model. And yet after asking around pretty extensively, I can’t find anybody who is.

One unsettling possibility is that the academic macroeconomists of the ’70s and ’80s simply bit off more than they could chew. Modeling a big thing (like the economy) as the outcome of a bunch of little things (like the decisions of consumers and companies) is a difficult task. Maybe no DSGE is going to do the job. And maybe finance industry people simply realize this.

And at this point we might be able to work out what’s wrong with academic macroeconomics. It’s not quite economics to simply shout “Follow the money!” but we can adapt that very useful idea of revealed preferences to tell us what’s going on here. That useful idea being that we shouldn’t look at what people say they’ll do but rather at what they actually do. And we can argue that academic economists are trying to successfully predict what is going to happen as a result of changes in government policy if we should so wish to. But combine that with that follow the money idea and we’d expect the financial markets economists to have been subjecting their models to more rigorous testing. After all, real money is at stake, not just whether you manage to get published in one or another journal.

We should admit that this does rather play to our prejudices here. We’re not great fans of macroeonomics at all, agreeing with Keynes that in the long run we’re all dead but adapting that to insist that in the long run it’s all microeconomics. Get incentives and the price system right and pretty much all other economic problems will either solve themselves or shrink to their not being problems that we want or need to worry about.

This of course enrages macroeconomists but as we don’t get invited to their parties anyway we can shoulder this burden well enough.

Underneath that jollity though there is a much more serious point. Macroeconomics is really a very under developed approach of looking at the world. We rather take the Hayekian line that it always will be, given the dispersed nature of information and the impossibility of having enough of it in real time to be able to do anything useful with it. But that there’s pretty much no one macro theory that you could get all macroeconomists to sign up to is another indication that it’s really just not ready for prime time yet.

And if it’s not ready for prime time then we really shouldn’t be using it to try and guide our actions on the economy. We should, therefore, concentrate our efforts on those areas where we do know we’ve largely got the appropriate and necessary knowledge, about those incentives and that price structure.

This story might cause a little pause for thought:

One of the most vivid arithmetic failings displayed by Americans occurred in the early 1980s, when the A&W restaurant chain released a new hamburger to rival the McDonald’s Quarter Pounder. With a third-pound of beef, the A&W burger had more meat than the Quarter Pounder; in taste tests, customers preferred A&W’s burger. And it was less expensive. A lavish A&W television and radio marketing campaign cited these benefits. Yet instead of leaping at the great value, customers snubbed it.

Only when the company held customer focus groups did it become clear why. The Third Pounder presented the American public with a test in fractions. And we failed. Misunderstanding the value of one-third, customers believed they were being overcharged. Why, they asked the researchers, should they pay the same amount for a third of a pound of meat as they did for a quarter-pound of meat at McDonald’s. The “4” in “¼,” larger than the “3” in “⅓,” led them astray.

That story’s too good to want to check if it’s actually true or not. But if it is then why would we continue with an education system that has had more than a century to try to get things right but has manifestly failed to do so?

Quite, Gove and others are onto the right sort of policy, freeing the education system as much as possible from that dead hand of said state.

Last night I watched Mike Judge’s 2006 film Idiocracy. I enjoyed it a lot. It is basically a dystopian science fiction film with an element of (slightly dark) comedy, but it hides its fairly extreme pessimism and conservatism behind a half-hearted satire on modern society.

It imagines what would happen if the less sharp people in society had substantially more kids than the smarter people—and if this trend carried on for centuries. By 2505 the population has an average IQ of something like 60, and society is crude, degenerate and decadent. It limps on only because the last of technological advances went into automating most of the functions needed for basic survival. The personal narrative is that two people, a man and a woman both selected for their extreme averageness in all attributes, get cryonically frozen, wake up in 2505, and are the smartest people in the world. Hijinks ensue.

It’s a fairly enjoyable film on its own merits, but the really interesting question is whether it says anything about the world we live in. While this sort of thing is extremely uncertain and speculative, arguably it does.

Behavioural genetics tells us, as the film suggests, that (variation in) intelligence is 50-90% driven by genes. And the extent to which intelligence is linked to genes increases through life (suggesting the impact of school & upbringing wears off quickly). This is true for any given socioeconomic class (unless they are exposed to lots of lead pollution, malnutrition or similar big negative environmental shocks). This is true across the world.

Indeed, a large fraction of this seems to come identifiably through specific alleles or single-nucleotide-polymorphisms (chunks of genetic code). We also know that intelligence correlates with brain volume, also genetically-driven. We even know that the way brain volume changes is substantially genetic. By contrast shared environment (includes family upbringing, and under certain conditions also the effect of school) has around zero effect on IQ/intelligence.

And so the question becomes: are sharper people having fewer kids than the less sharp? Evidence seems to say “yes”, for the USA, UK, Taiwan, and generally across the world. Though, it certiainly has to be said, that on the models here (estimating a loss of about .8 IQ points per generation, or perhaps 3 per century), it would take substantially longer than 500 years to get to the idiocratic society.

But wait a second—what about the Flynn Effect? Haven’t measured IQs increased massively over the past hundred years? Aren’t we getting smarter? Sadly, the Flynn Effect may not reflect an improvement in intelligence—once you account for the many ways that people have got better at tests, e.g. through learning to guess when they don’t know the answer. In fact, the tests with a lower “g loading”, i.e. the ones less good at accurately reflecting intelligence, are the ones reporting the biggest Flynn Effects.

This shouldn’t be surprising, because random selection into a better school typically has no positive impact on achievement (though it does have strong negative impacts on crime). But even if the Flynn Effect were, say, reflecting greater education making up for lower genetic intelligence, it seems like we’ve pretty much exhausted its benefits—and it is now going into reverse in the Netherlands, the UK, Finland, and elsewhere. And thus even if phenotypic IQ (i.e. as measured by tests), and not genetic IQ, is “what matters”, we can’t hope that extra education will make up for duller genetics in the future.

And we have independent reasons to think that genetic IQ might be “what matters”. While it is phenotypic IQ that correlates with, e.g. homicides, this relationship is seriously confounded by the fact that medical technology has advanced substantially over the period. Without these advances, homicides would be five times higher (on a static analysis—it’s possible that the extra who would have been killed, but survived, would have themselves committed extra homicides).  And it is genetic IQ that appears to be associated with social advances, innovation, science, technology and so on. Were the Victorians smarter than us? Though the linked paper has been criticised, their response to their critics is persuasive enough that we should take the idea seriously.

If this is all true (and certainly that is itself a contested step) should we be worried? This is the most interesting question for me. Thankfully, there are two families of technologies that I see as potentially solving this problem.

The first is artificial wombs. One of the main causes of reduced fertility among the smart, as documented in Idiocracy’s excellent opening third, is the cost of having children. This cost is not just in terms of feeding, clothing and looking after them, nor even buying more expensive houses to get into better schools, but also in terms of labour market potential—much of the gender wage gap appears when women take time out to have & raise kids, and a large fraction of the rest may come because women expect to take this time out (and thus invest less in human capital). We know that people really do respond to things that make having kids cheaper. Technologies that drastically reduce the cost to smart women of bearing kids could be one way of arresting the alarming trend.

The second is genetic engineering in all its forms. If we can pick embryos, or even engineer people’s DNA, then we could feasibly (after lots more research!) make sure that kids are smart even if their parents are not. While Idiocracy does not mention “my” first solution, it dismisses this one, explaining that the remaining smart people in society spend their precious time perfecting cures for hair loss and impotence.

But I’m much more optimistic than Mike Judge (hopefully rationally!)–I have almost unlimited faith in the ability of human ingenuity to overcome big threats to society. I feel confident we’ll either develop the aforementioned technologies, or in their stead something completely different and entirely unpredictable that solves the issue. And if our best minds do spend their time solving erectile dysfunction—as in Idiocracy—who knows, that might help solve the problem!

This time she’s running a conference telling us all how it’s absolutely vital that the UK economy be planned the way that Ms. Mazzucato thinks it ought to be. Which is, if we are fair about it, a plan that rather ignores one of the most basic economic points about economies:

This is encouraging news and shows that the UK is hopefully on the path towards ‘rebalancing’ away from an economy biased towards financial services, towards growth of innovation and productivity in the ‘real economy’.

Hmm. For this to be either true or desirable we’d need to show that we actually have an economy biased towards financial services.

The key problem that he and other international policy makers have is to make sure that such rebalancing tackles finance on two equally important sides. On the one hand, rebalancing so that finance funds the real economy. This means addressing the dire situation that figure 1 shows below, i.e. the degree to which finance has been financing itself leading to the exponential rise in the value added made up of financial intermediation, compared to that of the real economy (everything but finance and agriculture).

Hmm, so, OK, finance has been a greater part of the value added in the economy in recent times. It’s still difficult to understand why this is a bad idea.

The second key issue that rebalancing must address is not just how to get more value added from the ‘real economy’ and less from ‘financial intermediation’ (finance financing finance), but also how to de-financialise the real economy itself!

Hmm again.

So, back to this question of whether the UK economy is in fact excessively financialised. And there’s two parts to that question. In the general economy we’re no more financialised than other advanced economies. We have roughly the same sized pensions industry, insurance and retail and commercial banking industries, mortgages, savings products and all the rest. And we need only invoke Maslow’s Hierarchy of Needs to see why a richer nation might want more of such financial activity. Once the basic needs are met we move on to wanting to have security which is exactly what savings and insurance do for us.

But it is also true that the total financial sector in the UK is larger than it is in most other countries. Almost nowhere else has anything even remotely comparable to The City. but to say that is a problem would be to make the poor departed spirit of David Ricardo cry. For we do seem to have a comparative advantage in being the financial marketplace for the world and that’s an advantage that we should be exploiting.

So if we look at the domestic economy we don’t seem to be excessively financialised. And if we look at the total economy that financialisation is about our successfully selling services to Johnny Foreigner. Neither of which are obviously problems that require solutions. Making Ms. Mazzucato’s conference, and possibly the good professor herself, somewhat redundant.

The Institute has lost a talented and much valued friend, and those who work to spread economic and personal liberty have lost a staunch and effective campaigner. From the ASI’s foundation in 1977, we worked with John, who was then Press & Parliamentary Officer for Federation of Small Businesses. During his spell in that post from 1977 – 1982, he was also a Lambeth Councillor, and combined knowledge of what worked for business with deep insights into the workings of local government. He was a leading figure among the very small band who worked to restore free markets and opportunities to a nation worn down by years of centralism and state planning.

He engineered a joint publication between the ASI and the Federation of Small Businesses in 1979. Called “An Inspector at the Door,” it detailed the various powers of officials to enter premises and seize materials. It was a media sensation, with numerous articles about Britain’s “Society of Snoopers.” Margaret Thatcher expressed her concern in Parliament, and set up a commission to review and curtail some of those powers.

It was an early example of John’s effectiveness and his skills as an organizer and a communicator. Those skills saw him in good stead when he went to the US, where he became President of the Institute for Humane Studies, the Atlas Economic Research Foundation, the Charles G Koch Foundation, and the Claude R Lambe Foundation.

His appointment in 1993 as Director General of the Institute of Economic Affairs was an inspired one. He rapidly reinvigorated the IEA and restored it to its former glory and influence. Assiduously he built up its network of supporters and its range of influential publications. John’s own temperament, outgoing and enthusiastic, helped turn the IEA’s meetings into ones not to be missed. John’s benign presence not only left its stamp on the IEA, but on the numerous outside bodies that he generously helped to build up and support. Internationally he helped to establish other institutes, and was a stalwart of the Mont Pelerin Society, founded by F A Hayek to propagate liberal, free-market ideas.

John had many publications to his credit, including “Waging the War of Ideas” (2003), together with some important works he co-authored or edited. Under his leadership the IEA supported and publicized works by outside bodies, often hosting launches in the IEA’s premises. Those premises were transformed during John’s tenure, giving the IEA the space it needed for its extended tasks.

He was a good friend and a loyal one. We shall miss his huge personality and his wry humour. He made a major contribution to making the world into a better place, and will deservedly be remembered for that.