Which economic theories are especially widely misunderstood?

A lot of them are, actually.  The efficient markets hypothesis might be one, as I’m not sure I understand it myself!  (Would the existence of just one investor “beating the market” disprove it?  Probably not, but then how many are needed?  How many of them have to beat the market “for the right reasons”?  And for how long?  How many dimensions exactly does this problem consist of?)

But today I’ll nominate Rudi Dornbusch’s exchange rate overshooting model.  When I see it cited, and I mean by professional economists or economics writers, more than half the time  people seem to get it wrong.  They use it to refer to all sorts of back and forth exchange rate movements, whereas the Dornbusch logic requires that the overshooting be in line with covered interest parity and thus the subsequent adjustment of the exchange rate is both expected and predicted by interest rate differentials in advance.  That’s hardly ever how it happens.

What else?  How about real balance effects and price level determination, as analyzed by Patinkin, Pesek and Saving, Harry Johnson, and others in the 1960s and 70s?  Most people get the right answer, but if you push them on it they fall apart, quivering and begging for mercy.  “Hey bud, that explanation sounded nice!  How about applying it to the difference between inside and outside money?  How does that shake out?”  Talk about microaggression.

Most economists do pretty well stating the Modigliani-Miller theorem.  They do less well when you ask them how it relates to the infamous “spanning condition,” which indeed it does.

Paul Krugman has remarked a few times on how many economists seem to get Ricardian Equivalence wrong.

At least half the time, in casual conversation, economists seem to forget that for a normal indirect utility function consumers are not risk-averse in terms of prices.

How about a Fisher effect question:? “If people expect prices to go up in the future, why don’t a lot of those prices go up right now?”  Thereby removing much of the inflation premium from the nominal interest rate.  Oops.

Or try this one: “Why is the interest rate a market price which can be expected to rise (fall) in the future, without rising (falling) now in anticipation of the future change? After all, liquid cash doesn’t have much of a storage cost.”  Unpack all of that in two sentences or less and set it straight.  Deadly.

Most economists who don’t do finance don’t know much finance.

Can one economist in forty properly define the “independence of irrelevant alternatives” axiom behind the Arrow Impossibility Theorem, taking care not to confuse intra- and inter-profile versions of the theorem, the latter of course being canonical?  Me thinketh not.  Wikipedia gets pretty close but is not fully clear.  The typical mistake is to think it is about “taking something off the menu,” and a resulting invariance of choice, when in fact the pairwise ordering alone should contain all of the relevant information.  Ah, but how exactly are those two conditions related?

How many people can define “rational expectations” correctly?  Is it: a) the market forecast is right on average, b) individual errors are serially uncorrelated over time, c) market forecast errors are serially uncorrelated over time, d) individual errors are normally distributed, symmetric around the mean, or e) individuals know the “correct model” of the economy (with what specificity?  That of God in the Quran?).  Maybe all of the above?  Some of the above?  Let’s put this one on the SAT.

Time consistency vs. subgame perfection anyone?

Sometimes economists confuse “the law of large numbers” with the potential risk benefits from subdivision of a gamble into many smaller parts.  Arrow himself made this mistake at least once.

How many people can get all of those right?  And how many other common but frequently misunderstood propositions in economics can you think of?  Nothing partisan or policy-based please, and please leave macroeconomics aside, let’s stick to analytics for this exercise.  I’ve already covered the Heckscher-Ohlin theorem.

I am sure this post contains several errors.

Comments

"The efficient markets hypothesis might be one, as I’m not sure I understand it myself!"

It would be better for all concerned if it had a name like the Agile Markets hypothesis.

I prefer "nimble" Very woody word, "nimble".

Nimble Markets Hypothesis would be good.

The basic idea is that markets react quickly to the obvious. If, say, you open up your newspaper and read an article that iPhones have been found to cause brain tumor and you think to yourself, "You know, I should call my broker and have him sell my Apple stock," well, you're probably too late.

Or if you look up old stock prices and notice that stocks tend to go up on the Tuesdays after three day weekends, well, you're probably too late, too.

Now, there are all sorts of potential extensions of the observation that markets are nimble, and some of them might be true. But it would be a lot better if we had a more specific adjective than the vague "efficient" to explain the basic insight.

The various forms of the EMH have been patiently explained, and that is indeed the "weak form", which is operationalized by saying that index funds (or something like them) give better returns. The EMH does have an unfortunate name, though, because it lends itself very easily to strawmen.

Right, this weak form of the EMH is an incredibly useful conceptual tool to have in your head, but even most smart people don't have it because they interpret "efficient" as meaning "good," and thus get hung up their moral opinion of whether markets are good or bad.

A major problem with the EMH is that it is not very well specified. It certainly doesn't seem well specified enough to be testable.

Just what does "reflect" mean in "markets reflect information"? They've thought about it? Some degree of accuracy? Something else?

That markets adjust to news should be obvious. is there someone who thinks they don't? It is not a very formal theory.

EMH often translates to a statement that we don't live in Lake Wobegon.

EMH fails to simply ask the linked question: how much will one more x (say google) cost to create compared to the sunk labor cost in google, and if the labor cost of one more google is less than the market cap of google, what government policy prohibits creating a new search engine based ad seller.

Replace x=google with house, pets.com, strip mall, abandoned oil well, burning coal mine, polluted recreational river, smog choked Beijing luxury condo,...

A related question is why is a car different from a house? Why doesn't the value as measured in price always increase over time if capital gains are assured? After all, god is not creating more steel any more than god is not creating more high rise condos.

Nope. Tyler's problem is framing the question as: 'are markets efficient?' which calls for a yes/no answer.

The correct question is: how efficient are markets? And the answer is: pretty damn efficient, but less efficient from Warren Buffet's viewpoint than yours.

I think TC is referring to the Egotistical Orangutan Coin-Flipping Contest as proposed by Warren Buffett (Google this). This was supposedly a refutation of the EMT, especially when all the 'winning apes' came from the same region (Omaha, NE). However, it is possible these coin-flipping apes were just lucky and came from the same zoo (highly improbable, but theoretically possible). That's TCs question on EMT.

As for TC making mistakes and us mere mortals in the peanut gallery criticizing him, heed this: "When chess masters err, ordinary wood pushers tend to derive a measure of satisfaction, if not actual glee." - I.A. Horowitz from http://www.chessquotes.com/topic-mistakes

Buffett's point wasn't that they came from Omaha, but that the winning apes were all value investors in the Graham & Dodd tradition. Not sure that's devasting to EMH. There are winners and losers in efficient markets, and winning and losing strategies that may persist for a long time. It doesn't posit that individual returns will tend towards the mean.

Between your fawning over TC and your non-stop trolling of Sumner, I honestly don't know what you are up to, and I suspect you don't either.

I understand that from a sufficiently large starting population, SOMEBODY will flip fifty straight heads. If you think this explains Warren Buffett, good for you.

@BD - wow, you just lost credibility in my eyes Brian. I thought you were a PhD in economics. @Savage-right but somewhat wrong. Both of you: the fact that the winners of the coin flipping contest were from Omaha and all subscribed to the B. Graham tradition was specifically cited by Buffett and is considered evidence of non-random behavior. You can explain this as 'monkey see, monkey do' (or drop the 'k', same thing), which is NOT random behavior, but they are following Buffett/Graham, not chance. You can explain this as a breakdown of EMH, and, further, as evidence that inside trading is present (either legal inside trading such as understanding from sitting on many boards what companies will do, as Buffett clearly practices, or, illegal inside information). Brian you have no credibility, and, worse, you're not even entertaining.

Aw Ray, I can survive a loss of credibility in your eyes, but i'm a little entertaining, no?

You're all over the board here, as usual. I've read Graham and I understand what value investing is, and I understand from Buffett's perspective it feels like buying a dollar for 40 cents.

Have you done it? Just read through a bunch of 10Ks and buy the bargains, right? Piece of cake. That way, you can stop wringing your hands about 2% inflation chipping away at your pile of filthy lucre.

Considering that most economists-- and most mathematicians-- don't really understand the Central Limit Theorem or the Law of Large Numbers when it comes to abstract probability on well-defined probability spaces, much less on exactly what confidence intervals mean or the underpinnings and implications of frequentist and Bayesian statistics (along with some of the weirder "paradoxes" in probability and statistics), I would not expect people anywhere to have a grasp on the EMH, which is considerably more complicated at applying it to the real world.

I would expect that most economists would fail to give a concise and correct explanation of the interpretation of the set of multiple priors in the Maxmim Expected Utility model of ambiguity aversion (also called the multiple prior model). Hint: The set of priors is NOT a set of beliefs.

I also expect that the epistemic foundations of Nash (see Aumann and Brandenburger) are often misunderstood. Providing a cogent explanation of Rubinstein's email game is probably highly correlated.

The efficient markets hypothesis might be one, as I’m not sure I understand it myself! (Would the existence of just one investor “beating the market” disprove it? Probably not, but then how many are needed? How many of them have to beat the market “for the right reasons”? And for how long? How many dimensions exactly does this problem consist of?)

It probably depends on time-scale, and even then you'll get weird flukes who manage to get unlikely streaks (I remember Scott Sumner saying that Warren Buffet could be that person, and his main talent is that he doesn't waste that). The longer you go, the less likely it is that you'll beat the market, in the same way that you lose to the house when gambling over time. But in the mean-time, those short-term opportunities draw potential searchers looking for opportunities in.

I think it gets a lot of crap because of the "efficient" adjective. If it was just named the "Public Markets Hypothesis", it'd be more accepted.

There is actually plenty of work on questions like this within statistics. It's good to recognize that such questions are subtle, but they are not unanswerable, as long as one is willing to clarify the question.

The hypothesis says that prices reflect all available information. That is a very large caveat. What if the information is disseminated over time, allowing arbitrage? Or the market is opaque where information is hidden by complexity, or simply that no one bothers to look? Or if you create the information by purchasing not an asset but a company, put your managers in charge, invest your capital and make it viable, which I believe describes what Buffet does.

One of the interesting factoids from the financial crisis was the opacity of the investment prospectus' for the tiered mortgage investment structures. Some people actually read them and managed to do well shorting them. But they ran into an opaque market where prices were not open or public. Eventually the prices and quality of the assets became clear as information about them was disseminated.

But is Warren's success really a two part history? First part he got lucky and then in the second part he is profiting from the Buffet Effect that he has so many followers that the success of what he does is heavily affected by his followers copying what he does. Nothing succeeds like success.This would put us in a whole other ballpark theory wise. Does the observer affect the outcome and how efficient is that?

'I am sure this post contains several errors.'

Self-recommending.

1. The deflation trap. Even central bankers fail to understand that households DO NOT postpone purchases in the anticipation of falling prices.

2. The effect of very low interest rates. Households, in fact, do not react by spending more. Households actually save more, because the very low rates make it more difficult to achieve planned financial goals.

3. Spurious correlations of all sorts. Economic research is stuffed with wrong causations based upon random correlations.

+1 for your #1. It happens because many economists ignore "model 'disclaimer'"...

On #3, people studying economic development and poverty are kings of elaborated but stupid correlations

Now that's a stupid generalization if I've ever heard one. These days development people are kings (and queens) of RCTs, which suffer more from lack of generalizability than anything else.

Everyone knows the true king of spurious correlations will always be macroeconomics.

4. Macroeconomists don't understand that their baroque models are overfit. Any idiot can come up with a theory that "explains" some cherry-picked collection of observed regularities. The true test of a model is how it performs out of sample. Failing that, you should at least aim for realistic assumptions. I don't think anyone would confuse a DSGE model for meeting either of these criteria...

#1 has frustrated me ever since high school, i still don't understand where it comes from or why so many people believe it

My father lived through the first great depression and he was (and is) a great procrastinator on spending/consumption. I'm sure it comes from he experience frmo those days living in a world where income generation was very challenging and saving (even hoarding to an extent) the game.

I think people's experiences and general view on "rational behavior" in economic settings has changed a good bit since then.

To the extent that those without much of a disposible income will by definition be spending on necessities their spending will not change much -- but marginally it may still do so in the way suggested as prices fall and the given income (if that does stay constant) for the household increases in real temrs they will find they have a nominal surplus if they simply consume the same basket of good as before due to the price drops. While this is slightly different it is a situation where nominal agrigate demand is falling due to the declining price level. (Whether that's bad for the individual or the economy as a whole is a different question I think.)

That is a good point, i guess its lost on most of our generations who can't really fathom how you would think in a deflationary/depressionary world.

The last paragraphs instantly raises a question in my mind; in that mini-model consumers are reacting to changes in real income, saving the increased nominal surplus they get from a falling price level. Ignoring that there are other expectation factors at play here (ie, i imagine people in a depression want to save as much as possible given the massive economic insecurities they face), can you not flip this on its head and consider what happens when real income is rising due to increased nominal income, and not a decline in the price level?

IE, is this not saying that is nominal income was rising, people will save more and AD is falling due to the increase in nominal income? Which seems contradictory

What about the late, great, Al Frank, who beat the S&P 500 for 25 consecutive years until he died, with an average annual return of 23%? Yet he never bragged and remained modestly out of the limelight.
http://www.nytimes.com/2002/06/01/your-money/01iht-mglass01_ed3_.html

Indeed, he seems to have given away his secrets for a modest subscription fee. But I think he was lucky and it was due to his advocating small caps, which are riskier than the S&P 500 and return more.

Lucky for 25 consecutive years?

2^25 is only 33 million. I don't find it that unusual that someone would be that lucky.

If you take the efficient market hypothesis seriously, it suggests that a lot of popular rich guys are guilty of insider trading. So not that many people take it seriously.

No it does not. It suggests that the market is wary of some people having superior information (or info analysis skills), and thus reacts quickly to seeing them trade. It would suggest that these individuals would thus be smart to try to hide their trades. Which they mostly do. And it would suggest that mimicking their trades once they have been conclusively revealed, has little promise of success, as the market has already tried its best to incorporate what it can learn from observing their trades. To make money on average from mimicking, the market would have to be *systematically* wrong in how it observes/interprets trades from such informed traders.

Like I said, not many people take seriously the EMH's implication that a sizable fraction of guys who get rich beating the market do it via insider trading.

Not sure what 'like I said' means to imply here, but your conclusion does not follow from the point I made. EMH mainly implies that anyone who has superior information (whether legitimately or illegitimately gained) has to be the first to act on it - or at least one of the first - to gain from this information. You can get rich by exploiting insider information, or you can get rich by being better at interpreting and filtering the massive amount of information everyone gets blasted with. EMH itself has nothing to say on which type you are. Unless you also add the condition that all market participants have the same priors and the same skills; then I would agree that getting rich is very difficult unless you have insider information. In any case, I do have the impression that a decent number of people consider consistent outperformance a sign of insider trading...

Many years ago, when I was a tech, I was installing a quote system in the Key Largo home of a man who'd done quite well. I asked him, in jest, "What's the secret to making money in the stock market?" His serious reply, in Kentucky gentleman voice, was "You don't often get real inside information. When you do, you should act on it."

+1 LOL. Good one. When I was working as a white-collar professional I got inside information, and did not act on it, and it was often accurate. But sometimes if too many people knew the secret, it was already discounted by the market and not tradeable. I am convinced, as SS says upstream, that many rich folk got rich from inside information (including Onassis the Greek shipping tycoon, this is a documented fact when he was a telephone switchboard lad in Argentina eavesdropping on rich businessmen, like a tyler opposed cowan http://www.urbandictionary.com/define.php?term=cowan ("An old English term adopted as a Masonic term for an outsider who listens secretly to the proceedings of a Masonic lodge outside a lodge building. synonym for eavesdropper. The duty of the tyler is to keep out all cowans and eavesdroppers in order to maintain the secrecy of the meeting."))

What about the EMH would suggest that? What is the base probability for beating the market?

And if the Pigou effect worked, why would we have the current panic about deflation ? And why would Japan have any problems at all ?

Japan's problems are caused by a major banking crisis which still has not been fully resolved even after 25 years. Europe has the same problem. Price deflation is just a consequence of credit stagnation and very slow monetary inflation.

Japan's other major problem is that its population is melting down, and extremely low immigration suggests that the problem will not be fixed.

Also, Japan is a healthy, safe, prosperous (but aging) country, I'm not entirely sure there's a 'problem'. And it may be how the whole world looks late this century.

Perhaps, but considering the decline in the working-age population (faster than the overall population of Japan), Japan's GDP is cut by roughly 1-1.5% each year simply by standing still. So it's going to be "in recession" quite often.

Sure, but what does 'recession' mean in that context? If everyone is still healthy and living a long time and fairly prosperous, does it matter? Serious question, because demographically the whole world is likely to be turning Japanese some time down the road. Macroeconomics might have to make some major adjustments in that kind of world.

@ John T & msg,

Yup. Nothing to see here.

Scott Sumner (Ray Lopez' favorite economist) covered this recently:

http://www.themoneyillusion.com/?p=28030

4. Oh, yes, the EMH. Unpredictability of stock market returns is NO PROOF OF MARKET EFFICIENCY, although many economists seem to think so.

5. Speaking of stock markets, long term returns are no reward for risk. Long term trends - usually growing in most markets - are just an artefact of persistent money supply expansion. Monetary inflation, if you like the term.
http://www.devilsdictionaries.com/blog/the-dow-inflation-adjusted

6. Shiller's CAPE. A good idea in essence, but with one major flaw. This is why CAPE has worked poorly since 2009:
http://www.devilsdictionaries.com/blog/shillers-cape-and-its-hidden-flaw

re 6.: how is CAPE an economic theory? I always considered the fact that PE (of whatever variation or adjustment) has predictive power for stock returns is an unexplained empirical artefact, not a theory (much less analytics as set out in the post). So it seems unsurprising that it is not understood by many - it is not explained.

CAPE, or more precisely, using earnings yield to predict returns, makes sense on a theoretical level. The more you pay for earnings, the lower your return is likely to be. The problem is we don't know future earnings, just past earnings. However, past earnings seem a reasonable predictor of future earnings.

Think about bonds. Does it make sense that yield is a good predictor of returns?

imo to qualify for an economic theory, it needs to reflect some kind of idea of how people make decisions and how that is reflected in prices. "The more you pay for earnings, the lower your return is likely to be" is just solving the static equation P=E/R for R. And lacking a good estimate of future earnings, we substitute an accounting number from the past and declare this to be the "theory". Dubious.
If we ignore expectations and more importantly, changes in expectations, discussing finance theories is mostly futile, they are all based on expectations. A "theory" needs to explain *why* people are (supposedly) paying more for $1 of earnings in stock A than for the same earnings just because they are earned by stock B and whether that tells us anything about how they build their expectations.

"past earnings seem a reasonable predictor of future earnings" - in the short run, maybe. But AMZN still has a positive stock price, with a rather large number of negative earnings in its history. Someone must be hoping for something at some point.

Bond yields are exactly the same, still solving P=E/R keeping E constant. Not very enlightening. Yields are a good predictor IF you hold it to maturity, and IF there is no default. Greek bonds have very high yields. Returns, less obvious (imo). A theory needs more than algebra. It needs a story on how (changes in) expectations of E relate to (changes in) R, thus leading to P.

Labour Theory of Value - many people think that is a normative model about the "fair price" of a product, when it is supposed to be a positive model explaining (probably bad, but this is not the point) the existing price of a product.

More specifically, Marx's LTV is generally misunderstood to state that the price of something is determined by the number of hours' labour taken to make it. This is actually closer to Ricardo's LTV which Marx spends plenty of time criticising.

Some sort of LTV was needed to support his theory of the exploitation of the workers, right? Workers are exploited because the value of the product is the value of their labor, but capitalists make money off of the product of their labor, therefore the workers are not being paid the full value of their labor.

I think most economists understand the rational expectations hypothesis but some fail to understand that in real life “level of rationality” is not homogeneous… can we capture it through stats?

I wish I understood signaling better. I just had Econ 101, but I've tried to educate myself by looking it up on Google and on Wikipedia, and am not sure I get it.

Judging from what most economists who don't specialize in studying immigration have to say about immigration policy, the concept of supply and demand is not well understood.

Not sure how exactly to interpret the sentence linking Miller & Modigliani (prop.1?) to markets being spanned, so I guess I am not disagreeing with Tyler's point.
But maybe it's worth mentioning that markets don't need to be spanned (complete) for MM to hold. A static Long-Short arbitrage position has to be possible, but dynamic replication is not necessary (like e.g. with options), so the whole thing can indeed hold in an incomplete market.
The (slightly weird / artificial) assumption is that you can freely trade both the equity, the debt, and the "underlying assets" of the company (this latter assumption is the elephant in the room). If any of these is mispriced vis-a-vis the others, you can create a long-short strategy to arbitrage these. Arbitrage is often linked to spanned markets, but in some situations is more important than in others.
Whether markets in which ALL of these three (equity, debt, assets) are priced are complete or not is not critical. In a sense, you could say that the prices of all three assets can be "wrong", MM only say they have to be wrong in "exactly the same way" if they can all be traded.

I am not sure many economists could honestly dispute these 3 facts :

i) Economists, particularly academic economists (who don't blog), know very little outside of one or two areas. After they get tenure and age a bit they suddenly become experts on areas unrelated to their tenure status or academic reputation. Most pretend to experts on anything related to economics. There are a few exceptions (Amartya Sen has often acknowledged that he knows very little about stock markets and monetary economics, and Ariel Rubinstein has been very humble on various fora), but most economists are fakers.

ii) Journalists and policy makers do not understand point (i).

iii) This is very common in other areas. Have you heard Elon Musk talk about economics or even AI. This is a version the Halo effect.

I suspect successful people in finance and banking understand the economy (as opposed to the academic field of economics) better than most tenured economists at Harvard or MIT. Their success depends on being right, not publishing in arcane economics journals.

ever hear of the 2009 bailouts?

I have heard of many bailouts but only one failure. Success, for some people, means making a lot of money understanding the constraints and incentives that are part of the system.

@(iii): I feel this way whenever Peter Thiel opens his mouth about energy.

I'm not sure if you are specifically referring to hydrocarbons or the O&G industry, but Peter Thiel's take on Clean Tech/Green Energy has been spot on-especially in Zero to One.

If "success" means getting paid I think they only have to be right about their customers' psychological biases.

TC quoting Quine, wonderful!

The "Coase Theorem." Almost everyone forgets about the importance of transactions costs in the conclusion to "The Problem of Social Cost."

Back in the 1990s there was a multiple choice test about this topic and supposedly 1 in 5 economists got opportunity cost wrong.

Makes me think of Buchanan's small monograph "Cost and Choice" which is about the same confusion. Price is also a confused are it seems in much discussion -- the there really is not a single market clearing price in the economic sense for economic participants (they pay in real terms that include all the non-pecuniary aspects of the economic price and are often a bit unigue to the person for any given action) but we often hear the discussion proceed based on some list price.

Actually 4 out of 5 got it wrong (was a four answer multi choice - worse than chance)

http://www2.gsu.edu/~wwwcec/docs/ferrarotaylorbep.pdf

Thanks for linking to that.

I just read the paper. Unbelievable. I thought the question was straightforward and the answer obvious. Hard to believe that so many Ph.D economists have such a hard time with one of the core concepts in the field.

"Or try this one: “Why is the interest rate a market price which can be expected to rise (fall) in the future, without rising (falling) now in anticipation of the future change? After all, liquid cash doesn’t have much of a storage cost.” Unpack all of that in two sentences or less and set it straight. Deadly."

Seems simple to me, but maybe that means I'm missing something. Here goes:
Interest rates represent the cost of renting capital over a specific period of time, with a specified start date and specified end date. If you know capital will be scarce in 2017 (because the Chinese plan to build an exact replica of Paris on the moon that year?), it does you no good to borrow money due in 2016; only rates for periods inclusive of 2017 will rise in that situation.

@louis - but if everybody knows that in 2017 there will be no capital (since Paris' Hiltons will be built on the moon by the Chinese in anticipation of lunar space tourists), then everybody will rush to borrow money due in 2016, and this will cause interest rates to rise today?

Note tyler was talking about the storage cost of "liquid cash". Yes you may accelerate physical investment in 2015-2016 if capital will be scarce in 2017, but this is not a riskless, costless business.
Additionally, you could argue that less capital will be spent in 2015-2016- if rates will be high in 2017, the value of cashflowing assets built in 2016 and cashflowing in 2017 will fall. People may hoard capital in 2016 so they have the opportunity to lend to the Chinese at higher returns in 2017.

" please leave macroeconomics aside, let’s stick to analytics for this exercise. I’ve already covered the Heckscher-Ohlin theorem." - I guess I would nominate the theory of free trade as being confused with the reasoning behind the Heckscher-Ohlin theorem by laypeople. That is, most laypeople assume free trade can only exist if a country is "good at something" like Saudi Arabia is with producing oil. But in fact, the theory of free trade says that countries should engage in free trade so long as there are relative differences in costs between tradeable goods, that is, if there is a difference in cost/price between Widgets X,Y in countries A, B (within each country), then there should be free trade between countries A, B, even if country A can produce both widgets X,Y cheaper than country B. Counter-intuitive. Next might be how unilateral free trade is good for a country, even if other countries have closed borders and refuse to engage in free trade, but instead just dump their exports on that country (as largely is often the case for the USA vs the rest of the world)

EMH is directly linked (i.e., if and only if) the most important unanswered question in Computer Science, namely, are the computational complexity classes P and NP equal. Most computer scientists believe that they are not, but no proof has been found. Few economists understand why this means that the snart bet is on EMH being false

Maybe because it means no such thing.

Could you expand on this a bit more? I've come across P NP before but i'm not a computer scientist and cannot see the link with the EMH.

I've read more than one econo-blogger misstate the diminishing marginal utility of the dollar as a justification for progressive taxation. It's a mathematical error. It's only a justification if you're taxing only the marginal dollar which is never the case.

Don't all changes in tax affect wealth on the margin? If I say "anyone with wealth over $10 mm must pay a $10k surtax" that doesn't tax "the marginal dollar" but the reduction in wealth of $10k happens completely at the margin. I would imagine the reduction in utility from such a tax would be tiny, because the change in wealth happens at a margin where the dollars are worth very little. Meanwhile if you applied the same tax to someone with $20k of savings, the disutility would be far greater. I'm not advocating for such a policy, but I don't understand your point about "mathematical errors" at all.

You properly compared $10k for a millionaire vs $10k for someone making $20k. That sort of head tax would be regressive because of diminishing utility. However, when people mention the diminishing marginal utility of the dollar, they invariable use it to justify a progressive tax over a flat tax, not a head tax. The comparison then is not $10k for each but 10% for each. Does someone making $1m derive less utility from $100k than someone making $20k does from $2k? The law of diminishing marginal utility doesn't answer the question.

If you must raise a certain amount of tax revenue that equals 10% of GDP, you can take 10% from everyone as the base case. Adding any progressivity (take more $ from the rich and offset directly by raising less from the poor) will always be utility maximizing, as long as you don't tax the rich so much that they end up poorer after-tax than the poor. With diminishing marginal utility and a fixed pot of income, a purely equal division of wealth is the utilitarian optimal. Redistribution wins all else equal in the simple model because every Robin Hood act increases utility.
Of course you need to take into account incentives (why USSR didn't work), and the morality/fairness of a utilitarian approach. But you are wrong about the math.

A lot of econ bloggers use "comparative advantage" when they mean "competitive advantage."

Folks who speak of trading in a market like the S&P generally don't understand that a strategy of "buy low, sell high" is no better than one of "buy high, sell low," "buy on Monday, sell on Friday" or even DCA.

Is public choice an economic theory? If so, I'd nominate it. It's taken me a long time to get a hint of an understanding. Maybe government allied economists just disagree with the theory and that's why they don't ever seem to consider it?

The Coase Theorem is another obvious one. I think McCloskey's old claim that only twelve people understand it is too pessimistic even if you don't take her literally, but certainly people bumble through it - particularly in casual discussions.

I...I'm bad at economics. =(

Monetary economics takes the cake, as the current confusion spectacularly illustrates.

My vote is for Complexity Economics. It seems clear that the economy behaves as a Complex Adaptive System, but i think very few economists have wrapped their heads around what that implies and what it means for General Equilibrium Theory.

This is made worse by the fact that complexity theory does not use the same mathematical toolset that economists are comfortable with, and requires research techniques such as agent-based modeling that are unfamiliar to many economists.

The other reason it isn't getting traction is because it implies that the economy is not a machine that can be efficiently tuned by economists. The Paul Krugmans of the world will not stand for that.

I think there might be excess volatility in forex markets because economic thinking is wrong in that case ... an idea which can lead to 'Dornbusch-like' overshooting:

http://informationtransfereconomics.blogspot.com/2014/11/is-market-monetarism-wrong-because.html

And the EMH is probably widely misunderstood -- it seems to be a maximum entropy statement: prices are maximally uninformative in equilibrium. That's maximally uninformative, not completely uninformative. Market prices contain information that is consumed like free energy, rendering, at equilibrium, prices that are essentially random.

http://informationtransfereconomics.blogspot.com/2014/02/ii-entropy-and-microfoundations.html

This is the most resounding issue I see:

Most economists who don’t do finance don’t know much finance.

Absolutely yes. In my view there is a large subset of economists who see little value in finance either, and deliberately and willingly ignore it.

A class I wanted to take was full so I tried to make a Coasian bargain by offering $300 for someone to drop it. While I knew from individual discussions that many people were just 'shopping classes' and on the fence about being in it, that public offer of money caused them to retrench. In short, compensating variation and related concepts are made infinitely more complex by the fact that my willingness to pay directly alter others willingness to accept.

great one data point study! Not a snark...excellent post.

Specialization and the division of labor. If every economist new all of these and other theories considered canonical, then that would imply that few economists were specializing.

I admit, I am confused after reading this stuff - if not before. I find Efficient Markets very hard to state. The "beat the market" comments seem to have some discount-rate model or risk adjustment model in mind that is not specified. Yea wrt Rudi's overshooting, but the same result holds in models with a risk premium. The cool thing , i think is the jump from Le Chatelier to overshooting needed rational expectations. On the so-called HO Thm, I remember, Rybcznski, Stolper Samuelson and Factor price equalization as thms. The trade implication, however, requires an assumption abt tastes - then the result is obvious. Like efficient markets, rational expectations are hard/impossible to specify outside a model. When you think you have it pinned down - like with survey data - you think back and realize you are making all sorts of learning/information assumptions.

I dunno the definition of full ricardo equivalence, but I know perfect foresight. If government spends 100 billion in taxes for two years then the consumer pays exactly that, by definition. If government spends 100 billion with debt for a couple of years, then the consumer pays exactly the equivalent net present value, with full ricardo equivalence. net present value is exactly offsetting according to my high school math.

Krugman still needs multipliers if he assumes the full ricardo.

The change in the future of market prices or inflation work just like uncovered interest parity. Distance in time or environment between money discounting and interest be be offsetting. Same with the overshooting model.

All of these can be incorporated in a rate/term mismatch in a finite system, time is an unnecessary variable. In fact, the expectation operator is not needed, all of the disequilibrium effects are explained with the finite model assumption and term/rate matching. All you need is separation of the monetary regimes.

“rational expectations”

The agent knows the model but accepts a constant uncertainty. Again a result from the assumption of finite systems. If you include a perfect Weiner process (no arbitrage) the the agent knows the local, finite environment only and adaptation time is longer.

Time consistency and game consistency is fundamental. If you have a complete and closed game, you have a minimum redundancy graph. That means you have a finite log equivalent which supports an ordered number line, other wise known as time. The ordering implies a Lebesque integral exists.

The key is that minimum redundancy (maximum entropy) implies, in all finite systems, the existence of a path for summing the Lebesque integral. This idea is fundamental to the theory of everything, and requires the Poincare group must exist. I think this implies a matching between the definition of 'prime' within the game and the rules of the game.

All of these are explained as part of Schramm-Loewner evolution, which is now required reading.
http://www.statslab.cam.ac.uk/~james/Lectures/sle.pdf
A good introduction to the theory of everything. This theory is extended by finding systematic maps between graph and groups.

On #1...what about the role "benevolent" government in making markets inefficient?? The distortions that government creates changes the way market perceives value of goods, erases the structure for a pricing system. I mean, government have "good" intentions, markets obtain bad outcomes due to artificial value of goods.

This may just be a typo in your post, but the Dornbusch model is making use of the assumption of uncovered (not covered) interest parity.

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