Desire Modification: the ultimate technology

"It's not having what you want/ It's wanting what you've got"

- Sheryl Crow

"We sell you the serenity to accept the things you can't change, the courage to change the things you can, and the wisdom to know the difference."

- advertisement for Metadesire, Inc. in "Utility Functions" (by Noah Smith, in progress)

What is the ultimate technology? Several suggestions have been made. One is faster-than-light travel, which (if allowed by the laws of physics) would open up the entire Universe to human exploitation. Another is self-bootstrapping artificial intelligence, which could (and hopefully would) invent anything humans could invent, and so save us from all further exertions. A third, much discussed in the past decade, is mind upload (sometimes called "brain emulation"), which would allow us to exist in any world of our choosing, and essentially be gods (as long as nobody pulled the plug from outside).

As ultimate technologies go, being a god is hard to beat. And mind upload makes faster-than-light travel look a little silly...why explore strange new worlds when you can just create them? But I think there is an even more ultimate technology out there for the taking - one that is probably a lot easier to create than any of the ones I named. That technology is desire modification.

First, let's imagine the ultimate form of desire modification (or "d-mod" as I will sometimes refer to it). In this ultimate form, each person would have a computer in his or her brain that could change his or her desires, habits, beliefs, personality, and emotions in any conceivable way. Here are some thoughts about what that would imply for the human species:

1. Obviously, the technology would be incalculably dangerous. If the brain computers were hacked, people could be made into slaves, zombies, or worse. So the technology would only be adopted after extreme precautions had been taken and shown to be effective.

2. Such a technology would mean the instant end of economics as we know it. Utility theory assumes something called "local nonsatiation", which means that people always want more of something. With d-mod, local nonsatiation goes right out the window, since you can instantly dial yourself to a "bliss point" where you are just perfectly satisfied and don't want anything else. That's the end of scarcity.

3. Just as personality upload makes FTL travel look a bit silly, d-mod makes personality upload look a little silly. Why bother creating new worlds when you can just like the world you're in? Why "hack the world" when you can just "hack the human"?

4. When we can decide what we want, desire becomes less important than meta-desire. What do we want to want? And what do we want to want to want? Etc. D-mod is like putting the parameters of the utility function in the utility function itself. The result could be very chaotic if people keep changing and changing (because each new change induces a desire for another change). But most people are likely to end up in fixed-points or "cul-de-sacs", where they want to want exactly what they currently want.

5. However, not everyone will end up in the same cul-de-sac. The resultant "clades" of humans will be very, very different from each other, much more different than people are now. This will make human interaction very weird. In fact, in a sci-fi story I'm writing, I refer to the rapid adoption of d-mod as "The Weirdening", and I think the Weirdening would (will?) be even weirder and more important and less predictable than the "Singularity".

6. With humanity divided into clades by motivation and personality type, evolution would be very important. For example, suppose some people just decided to pump up their happiness to ridiculous levels, and eliminate all of their wants or needs - instant nirvana. These "happies" (note the semi-pun) might just sit on sidewalks, letting their beards grow long, until they either died of starvation (which is what rats do when given this option) or were kept alive by altruistic passers-by. Alternatively, imagine people turning themselves into "zipheads" who only care about work (I stole the term from Vernor Vinge). "Happies" and "zipheads" would quickly die off or be switched back to other personalities by concerned family and friends; in the end, they would be survived by clades who want long-term survival and possess more complex, well-rounded sets of motivations.

7. However, after all this talk of zombie slaves and Weirdenings, I should note that I personally think that d-mod will be pretty benign. Most people just want to be happier, more motivated, kinder versions of the people they already are. Although we could conceivably become a planet of bizarre posthumans, I think the more likely outcome is that we'll end up pretty close to where we started. But the extra life satisfaction that we'll get from d-mod, even so, will represent a bigger a boost to utility and happiness than any technology before or after. It will put the lie to the old (and wrong) idea that technology doesn't change human nature.

OK, so hopefully your mind is as blown as mine was when I thought of all this back in the summer of 2010. (Random aside: I did come up with all this on my own, after reading some Charles Stross stories about personality upload and thinking "How come these people have godlike control over their worlds but are still so dissatisfied all the time?" A little while later I happened to read Greg Egan's novel Diaspora, which had already explored most of these ideas and questions decades ago. So, while I can claim originality, I can't claim primacy for these ideas. For other sci-fi books that deal with d-mod technology, see Vernor Vinge's A Deepness in the Sky, George Alec Effinger's When Gravity Fails, and of course Aldous Huxley's Brave New World and Philip K. Dick's Do Androids Dream of Electric Sheep?).

Now, back to reality. Obviously we are a long way from the kind of d-mod I discuss above. But how far away? Rudimentary d-mod technologies already exist, and are already big business. The main examples are antidepressant medication such as Prozac, recreational pleasure drugs such as Ecstasy, and "study drugs" such as Adderall. Deep brain stimulation of the nucleus accumbens, used to combat severe depression, is another example. A third is meditation, which is used to increase calmness and sometimes reduce certain desires (remember, skills and techniques also count as "technologies" - Buddhists and others have been exploring d-mod for thousands of years). Motivational speakers, self-help books and courses, and psychotherapy also partly fall into the d-mod category. So the market is already there; d-mod is a product that sells itself.

The real possibility for the explosion of d-mod technology, and the resultant Weirdening, comes from advances in neuroscience, computer science, and the intersection between the two. Drugs are a blunt instrument; computer chips are precise. So watch this space. The "fourth industrial revolution" of desire modification will be the biggest and most important. And possibly the last. But if it's not the last, will it matter?

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American growth could be higher than the pessimists think!

Robert J. Gordon has a new NBER working paper essay that really should cite Tyler Cowen, since it's all about a Great Stagnation in U.S. growth. Unlike Cowen, however, Gordon believes that the Stagnation will persist into the indefinite future. The paper is really two essays in one - the first part speculates that most of the big discoveries and inventions have already been made, and the second part identifies social and institutional constraints on U.S. growth. (Here are thoughts on the paper by FT Alphaville and Paul Krugman). Although there are some parts of the paper with which I agree, overall I think Gordon overstates the case for pessimism.

First, the technology part. Gordon claims that there have been three big "industrial revolutions" that have driven growth over the past two centuries, but that these bursts of innovation have diminishing returns:

A useful organizing principle to understand the pace of growth since 1750 is the sequence of three industrial revolutions. The first (IR #1) with its main inventions between 1750 and 1830 created steam engines, cotton spinning, and railroads. The second (IR #2) was the most important, with its three central inventions of electricity, the internal combustion engine, and running water with indoor plumbing, in the relatively short interval of 1870 to 1900. Both the first two revolutions required about 100 years for their full effects to percolate through the economy. During the two decades 1950-70 the benefits of the IR #2 were still transforming the economy, including air conditioning, home appliances, and the interstate highway system. After 1970 productivity growth slowed markedly, most plausibly because the main ideas of IR #2 had by and large been implemented by then...

The computer and Internet revolution (IR #3) began around 1960 and reached its climax in the dot.com era of the late 1990s, but its main impact on productivity has withered away in the past eight years. Many of the inventions that replaced tedious and repetitive clerical labor by computers happened a long time ago, in the 1970s and 1980s. Invention since 2000 has centered on entertainment and communication devices that are smaller, smarter, and more capable, but do not fundamentally change labor productivity or the standard of living in the way that electric light, motor cars, or indoor plumbing changed it...

The article suggests that it is useful to think of the innovative process as a series of discrete inventions followed by incremental improvements which ultimately tap the full potential of the initial invention. For the first two industrial revolutions, the incremental follow-up process lasted at least 100 years. For the more recent IR #3, the follow-up process was much faster. Taking the inventions and their follow-up improvements together, many of these processes could happen only once. Notable examples are speed of travel, temperature of interior space, and urbanization itself.

As I always say, we economists don't really know where technology is going. No one really does, and we probably know less than most. I agree with most of Gordon's claims about the three industrial revolutions. But what does that tell us about future revolutions?

There are many hypothetical technologies that have the power to transform the human experience even more profoundly than any that have gone before. Fusion power and self-replicating networked nanotech are two popular ones, but there are others that have the potential to be even more transformational. For example, personality upload (also called "brain emulation"). Why spend all your wealth rearranging the world we live in, when you can just create your own? An even bigger one is desire modification. Why spend all your wealth creating a better world, when you can make yourself like the one you're in? In fact, inventions like this are so transformational that they would call into question the very definition of economic growth, economic value, GDP, etc. The "industrial revolutions" from personality upload and/or desire modification would dwarf anything that has gone before.

But even on a more modest level, there are technological improvements already in the works that will help sustain growth. The fall in solar costs is one of these. Improvements in robotics/automation/A.I. are a second. Genetic technologies are a third, and biomechanical engineering (artificial eyes and the like) is a fourth. These things are real.

After delivering a long discourse on technology, Gordon pivots on a dime and lists six non-technological "headwinds" that will supposedly drag down U.S. growth in the near future. I'll go through these one by one...

(1) The “demographic dividend” is now in reverse motion. The original dividend was another one-time-only event, the movement of females into the labor force between 1965 and 1990, which raised hours per capita and allowed real per-capita real GDP to grow faster than output per hour. 

This is correct. Next:

(2) The second headwind already taken into account in the 2007-27 forecast is the plateau in educational attainment in the U.S. reached more than 20 years ago, as highlighted in the path-breaking work of Claudia Golden and Lawrence Katz (2008). 

This is also correct, BUT, then Gordon turns around and says this:

At the secondary level the OECD PISA test results for 37 nations had the U.S. recently ranked as ranked as 21st in reading, 31st in math, and 34th in science. There is an ongoing achievement gap between whites and Asians on the one hand and Hispanics and Blacks on the other, while the Hispanic percentage of our nation’s schoolchildren keeps increasing, dragging down the national average. Making matters worse is a new and growing gap between the educational preparation and achievement of American girls and boys; the female share of college graduates is now up to 58 percent.

First of all, this paragraph contains the disturbing assumption that Hispanic educational underachievement is something permanent (racial/genetic?). Fortunately the evidence seems to say otherwise.

On a more basic level, this paragraph doesn't support Gordon's contention. Gordon is arguing that growth from educational attainment is finished. As evidence he then points to low educational attainment. But low levels mean more room for growth. Doesn't everyone know this? You wouldn't point to Vietnam and say "Look how little capital this country has; slow capital accumulation will be a drag on Vietnamese growth"...right?

In other words, U.S. educational attainment has little room to grow in terms of quantity (years of study), but has absolutely huge room to grow in terms of quality. That is a potential source of accelerated growth.

Gordon goes on...

(3) The most important quantitatively in holding down the growth of our future income is rising inequality. The growth in median real income has been substantially slower than all of these growth rates of average per-capita income discussed thus far...If what we care about when we talk about “consumer well being” is the bottom 99 percent, then we must deduct 0.55 percent from the average growth rates of real GDP per capita presented here and elsewhere.

This is moving the goalpoasts, to be sure, though I agree with the sentiment. But notice that again, Gordon is claiming that levels are correlated with growth rates, and that's just not right. For example, suppose overall U.S. GDP growth slows to zero, but inequality decreases. By Gordon's own preferred metric, that would speed up growth for the 99%. Presto.

So once again, Gordon implictly assumes that recent trends will continue; if the trends reverse, the "headwind" becomes a tailwind.

And here is yet a third example:

(4) The interaction between globalization and ICT is a daunting headwind. Its effects include outsourcing of all types, from call centers to radiologist jobs. Foreign inexpensive labor competes with American labor not just through outsourcing, but also through imports. And these imports combine lower wages in emerging nations with growing technological capabilities there. This is nothing more than the Hecksher-Ohlin-Samuelson factor-price equalization theorem at work, and it inevitably has a damaging effect on the nations with the highest wage level, i.e., the United States.

I strongly agree with Gordon that factor-price equalization has held down American middle-class income, and contributed heavily to the inequality he discusses in his Headwind #3. But again, there is no certainty that this trend will continue. Chinese wages are rising rapidly, and unless India fixes its political problems, there will be no equally big source of cheap labor to replace it. If factor-price equalization goes into reverse, it will be a big tailwind for America's 99%.

Next we have:

(5) Energy and the environment represent the fifth headwind...India and China are both growing more rapidly than the U.S. and taken together those two nations are responsible for double the carbon emissions of the U.S.

Yes, global warming will probably restrain global growth.

Finally, we have:

(6) The twin household and government deficits represent the final headwind. Already in 2007 U.S. households suffered from an unprecedented overhang of debt equal to 133 percent of disposable income. The government debt was then manageable but has since begun to explode. Consumers have gradually been paying off debt, and this is one reason why the economic recovery has been so tepid. As a matter of arithmetic the ratio of government debt to GDP can be reduced by a mix of higher taxes, lower expenditures, and lower entitlement benefits (including higher retirement ages). But the same arithmetic implies that higher taxes and/or lower transfers reduces the growth rate of real household disposable income relative to that of real GDP.

There are two issues here. One is the "balance sheet recession"/liquidity trap. But that is fixable by policy. Next is the distortionary effect of taxation needed to make the government deficit sustainable. But I don't believe that this is nearly as large as conservatives claim, if the taxes are some combination of income, sales, and property taxes.

So in conclusion, I think that Gordon overstates the pessimistic case. Yes, there are headwinds for American growth, but there also potential tailwinds. These include:

• Improved educational quality
• Slowing factor price equalization
• New technologies like cheap solar, robotics, and biotech
• Increased high-skilled immigration

And farther in the future, there is the potential for further industrial revolutions that will dwarf the ones we've seen in the past.

Addendum: I seem to be the only person talking about Desire Modification as a transformational technology. Greg Egan and Vernor Vinge have written books in which this technology plays a central role. In my "spare time" I'm writing a couple of sci-fi short stories based on the idea. It's a really big deal, and I'll write a post about it soon. (Update: That post is now up.)

Update: John Cochrane makes a similar critique of Gordon's conflation of level effects with growth rate effects.

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China lands

You may have heard someone ask: "Will China have a soft landing or a hard landing?" Those terms aren't well-defined, but the question is still at the very heart of the global economy. Something big is happening in China, and we should all be paying attention.

I think the most useful definition of "soft/hard landing" is whether the thing slowing China's growth is more about supply or more about demand. No country can sustain 10% growth forever. Eventually, the twin forces of Solow catch-up and slowing technology transfer will bring growth down. If China follows the pattern of history, it is due for a moderate slowdown, perhaps to 7% growth, as demonstrated in this paper by Barry Eichengreen and Kwanho Shin. In fact, the more sober economic forecasters have already assumed that 7-8% will be China's "trend" growth rate going forward. 7-8% is not bad at all; hence, a "soft landing".

The soft landing scenario is fundamentally a story about long-run supply. Hence, we should not expect unemployment to result. And indeed, for the past year, even as growth and investment slowed, Chinese unemployment stayed low.

In contrast, a "hard landing" would be the kind of thing the developed world saw in 2008 (and the developing U.S. saw in 1929) - a financial crisis, followed by a general flight to safe and liquid assets, a collapse in bank lending, and a rise in unemployment. This would bring growth down substantially below the 7-8% level. The "hard landing" is basically a gigantic aggregate demand shock.

In the case of China, the danger here is the combination of house prices and local government debt. House prices rose a lot in recent years, and many companies and local governments took out debt using the suddenly-more-valuable real estate as collateral, often making use of a "shadow banking" system (sound familiar?). If these debts default, banks will have to take big losses; since the banks are state-owned, they will certainly be bailed out by the federal government. Although China's federal deficit is low - bailouts will not bankrupt the government - we've seen how even a successful bailout is not generally sufficient to get banks lending again after a financial crisis. China would have to respond by cutting interest rates; if rates hit zero, a liquidity trap would result and the recession would be prolonged. 

The thing is, we just don't know how bad the debt situation is. Maybe nobody does. If the debt problem has been exaggerated by the Western press, then there's not much to fear; China will coast to a 7% growth rate and keep chugging along. But if the debt problem is worse than we think, China's economy may have a heart attack.

So, how do we know whether China is headed for a "hard landing"? It's hard to tell just from the growth numbers, since A) China's growth numbers are year/year numbers, which are harder to interpret than the annualized monthly growth numbers we in the U.S. are used to, and B) China's growth statistics are not reliable (see this Dallas Fed paper for more worrying numbers).

But if the difference between hard and soft landings is all about aggregate demand, then we can look at two other indicators to figure out whats happening: prices, and unemployment. Chinese inflation has slowed. However, prices in developing countries behave a bit differently than prices in developed countries, so this is a pretty difficult number to interpret, especially because it's not core inflation. 

How about unemployment? This is worrying. After looking fine for months, China's job market is beginning to tighten a bit, though not as much as in 2009. All in all, it may be too early to call. In addition, China has been easing monetary policy, and home prices appear to be rising again. So an incipient "hard landing" may have been averted or delayed.

But all eyes are now watching China. In the blogosphere, Tyler Cowen is on the case. He puts the probability of a major Chinese recession - a "hard landing" - at over 5%. My own gut says it's more like 20% - I think problems are often worse than the initial reports say - but I am not an expert. For rapid, high-quality reporting on the situation, see the blog of Also Sprach Analyst.

Anyway, even if my pessimistic take is right, 20% is not a big percent chance, and China's numbers still look mostly kinda-sorta OK. But beware those who tell you that "this time it's different" - that China's authoritarian government, or its high-saving hard-working culture, or some other special feature of its society makes it immune to hard landings. Keep your eyes peeled for increases in China's unemployment rate, waves of defaults on loans, drops in housing prices, and drops in core inflation.

Update: Inventory overhang also a bad sign.

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Niall, the British Empire is over. Accept it.

I have been known to tease a fellow blogger or two, but there is really only one writer who makes me truly mad, and that is British historian Niall Ferguson. I will explain exactly why he makes me so mad at the end of this post. First, though, I want to say a few words about Mr. Ferguson's cover story in Newsweek magazine, entitled "Hit the Road, Barack". I should note that it imposes a heavy psychic cost for me to do so, since it requires that I actually read Niall Ferguson. But the public duty to expose BS and promote truth and intellectual honesty overrides such selfish concerns.

First, Ferguson alleges that Barack Obama has broken a bunch of his campaign promises:

[T]he question confronting the country...is whether the winner [of the 2008 election] has delivered on his promises. And the sad truth is that he has not.. 

[Obama] promised to “build the roads and bridges, the electric grids, and digital lines that feed our commerce and bind us together.” He promised to “restore science to its rightful place and wield technology’s wonders to raise health care’s quality and lower its cost.” And he promised to “transform our schools and colleges and universities to meet the demands of a new age.” Unfortunately the president’s scorecard on every single one of those bold pledges is pitiful.

First, I'll just quickly note that the American Recovery and Reinvestment Act contained substantial funding for infrastructure. So Ferguson, when he says that Obama has not built infrastructure, is simply asserting something that is not true. In the parlance of my generation, he is "spouting BS".

Next, let's examine the hypocrisy of the critique. Paul Ryan, the man about whom Ferguson says many glowing things (almost ignoring Romney), has proposed to cut infrastructure spending fairly dramatically. So Niall Ferguson is criticizing Obama for not promoting infrastructure enough, even as he praises a man who wants to gut infrastructure. Does this make any sense? Only if you accept "Obama must be defeated" as an axiom, which Ferguson does. Otherwise, no.

Next, we come to a pair of enormous, glaring, bald-faced self-contradictions. First, in the following passage, Ferguson derides Obama's stimulus as ineffectual, and lambastes him for increasing the deficit:

By the end of this year, according to the Congressional Budget Office (CBO), [the U.S. federal debt in public hands] will reach 70 percent of GDP. These figures significantly understate the debt problem, however. The ratio that matters is debt to revenue. That number has leapt upward from 165 percent in 2008 to 262 percent this year, according to figures from the International Monetary Fund. Among developed economies, only Ireland and Spain have seen a bigger deterioration. 

Not only did the initial fiscal stimulus fade after the sugar rush of 2009, but the president has done absolutely nothing to close the long-term gap between spending and revenue.

Yet scroll down, and we find Ferguson warning about the upcoming "fiscal cliff":

[B]arring some miracle, the country will hit a fiscal cliff on Jan. 1 as the Bush tax cuts expire and the first of $1.2 trillion of automatic, across-the-board spending cuts are imposed. The CBO estimates the net effect could be a 4 percent reduction in output.

Ferguson is criticizing Obama for allowing the "fiscal cliff" to happen. The fiscal cliff is a series of pre-arranged, automatic spending cuts and tax increases - in other words, things that will reduce the deficit. So Ferguson, who blasted Obama for increasing the deficit, is now blasting him for cutting the deficit.

Additionally, Ferguson warns that this pre-programmed austerity will cause GDP to contract. But if that's true, it must follow that deficits boost GDP - in other words, that stimulus works. I.e., the exact opposite of what Ferguson implies with his "sugar rush" comment and his many previous anti-stimulus writings. But Ferguson either fails to see this implication of his "fiscal cliff" critique, or else sees it and bulls right through it, refusing to sacrifice an Obama-bashing opportunity on the altar of self-consistency.

Backtracking a bit, we find Ferguson criticizing Obama on health care:

His much-vaunted health-care reform will not prevent spending on health programs growing from more than 5 percent of GDP today to almost 10 percent in 2037... the Patient Protection and Affordable Care Act (ACA) of 2010 did nothing to address the core defects of the system[.]

I'm not sure where Ferguson gets his numbers. But surely he can't have failed to notice the health care cost slowdown that everyone is talking about, can he? Now, maybe Obamacare gets some credit for the cost slowdown and maybe it doesn't, but the slowing trend certainly makes Ferguson's portents of doom seem very three-years-ago.

Ferguson sprays out some more random irrelevant stuff, like the fact that China is going to overtake the U.S. in total GDP. He fails to note how impossible it would be to stop that from occurring; if every Chinese person were to get a job flipping burgers at McDonald's (at the U.S. minimum wage), China's total GDP would be bigger than ours. That's how many Chinese people there are. Ferguson expects Obama to work some magic to let us stay ahead of a country 4.5 times our size?

Then we come to Ferguson's criticism of Obama's foreign policy, which veers into absurdism that would make Monty Python proud:

Obama completely missed the revolutionary wave of Middle Eastern democracy—precisely the wave the neocons had hoped to trigger with the overthrow of Saddam Hussein in Iraq. When revolution broke out—first in Iran, then in Tunisia, Egypt, Libya, and Syria—the president faced stark alternatives. He could try to catch the wave by lending his support to the youthful revolutionaries and trying to ride it in a direction advantageous to American interests. Or he could do nothing and let the forces of reaction prevail. 

In the case of Iran he did nothing, and the thugs of the Islamic Republic ruthlessly crushed the demonstrations. Ditto Syria. In Libya he was cajoled into intervening. In Egypt he tried to have it both ways, exhorting Egyptian President Hosni Mubarak to leave, then drawing back and recommending an “orderly transition.” The result was a foreign-policy debacle. 

So first, Ferguson credits Bush's invasion of Iraq with sparking the Arab Spring, and then he criticizes Obama for mishandling said Spring. Ferguson's mind - which I'm sure has an I.Q. above 17! - must be constantly confronting him with the scoreboard: zero new Middle Eastern democracies under Bush, three under Obama (four if Syria's rebellion succeeds), plus substantial democratic reforms in Morocco.

But Ferguson absolutely ties himself in knots with his attempts to turn that scoreboard upside down. Obama was cajoled into intervening in Libya! Egypt was somehow a failure! Let's not mention Tunisia! And let's conveniently forget the fact that Iraq is still not a functioning democracy! Oh, and Obama should have invaded Iran to support the Green Revolution (but drone strikes in Pakistan are illegal)!!!

But the most ludicrous moment in this foreign-policy farce comes when Ferguson says:

Remarkably the president polls relatively strongly on national security.

Oh geez, I wonder why. Maybe it's because, oh, I don't know, Obama killed Osama bin Laden, ended the stupid Iraq War, improved relations with most of our allies, and helped bring about three or more new democracies in the Middle East? Maybe that is why the people like President Barack on national security? Oh, no. Couldn't be. The American people must be fools! Blind, mistaken, misled fools!

...pant, pant...

OK, let me catch my breath...

Anyway, much of the rest of the article is devoted to a hagiography of Paul Ryan, which I will not touch on other than to mention that, surprise of surprises, Ferguson utterly ignores the deficit-ballooning aspects of Ryan's budget plan, repeating the - can I call it a lie? pretty please? - mantra that Ryan is a fiscal conservative and deficit-cutter.

So basically, what we have here is a pedestrian, poorly written, poorly-thought-out, self-contradictory, often counterfactual anti-Obama screed. But it is not enough for me to simply point this out. Instead, I want to examine why Niall Ferguson has thrown away the ancient Western traditions of logic and reason in a frenzy of partisan animus. I submit to you that Ferguson's true motivations are fairly transparent. Witness his ideal of what foreign policy should be:

Meanwhile, the fiscal train wreck has already initiated a process of steep cuts in the defense budget, at a time when it is very far from clear that the world has become a safer place—least of all in the Middle East. 

For me the president’s greatest failure has been not to think through the implications of...challenges to American power...(emphasis mine)

Niall Ferguson wants the United States to be an empire. An historian, Ferguson has always been enchanted with the British Empire of his forebears. He has also long been enchanted with the notion that the United States can and should become the successor to the British Empire, and that we Americans have been shirking our duty by pretending to be just another live-and-let-live nation-state. He seems to have been especially enchanted by that magic moment in 2003 and 2004, when it seemed that under George W. Bush and the neoconservatives, America was finally taking up the mantle of empire. The failure of the Iraqi adventure, and the collapse of popular support for similar adventures, must have felt to Niall Ferguson like something beautiful was being snatched from his hands.

Now, Ferguson hopes, under a Romney/Ryan (or Ryan/Romney?) presidency, America has a chance at completing the mission that George Bush started, and returning to its path to glory as British Empire II.

But - and this is why he makes me so angry - Niall Ferguson badly misunderstands my country. We are a Republic, not an Empire, and we always will be. We rejected the mantle of Anglo-Saxon world domination in the Philippines, again in Vietnam, and again in Iraq. And we will always reject it. We do not want to go forth and educate and enlighten the brown people at the point of our Tomahawk missiles, Mr. Ferguson. We want to invite them here, to live with us, to work for us and hire us, to marry our children, to become part of this country. Even, yes, to lead this country, as Barack Obama, for all his faults, has done. We do not want to conquer the world. We want to become the world.

The British Empire is over, Niall. It had its day. We can debate eternally how much good it did, but now it is done, and it is not coming back. Stop trying to screw up my Republic in your doomed effort to bring it back.

Update: Also see this excellent James Fallows takedown of Ferguson's atrocious piece.

Update 2: Also see Joe Weisenthal discuss Ferguson's disastrous attempts to analyze and predict the economy.

Update 3: And you really must read Matt O'Brien's epic fact-check of Ferguson's article.

Update 4: Here is a good roundup of Ferguson beatdowns from Joe Coscarelli, which unfortunately doesn't include mine, but does include contributions by Brad DeLong, Paul Krugman, and Matt Yglesias. Also see more from Ezra Klein and Mark Thoma.

Update 5: Niall Ferguson responds, mostly to Matt O'Brien. He does not mention me, nor does he address any of the points I make in this post.

Update 6: Here is Paul Krugman with a thoughtful discourse on Niall Ferguson's wrongness.

Update 7: Here is Dan Drezner with a fact-check of Ferguson's foreign policy claims.

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Flinging spaghetti at inequality

Via John Cochrane, I see that Kip Hagopian and Lee Ohanian have written a lengthy article about inequality. It's hard - no, impossible - for me to summarize the thesis of the piece, because it's basically a huge smorgasbord of loosely related, unrelated, and even contradictory reasons why the United States government should not redistribute income. Basically, the arguments of Hagopian and Ohanian can be broken down into the following list:

1. Income inequality isn't important.
  1a. What's really important is equality of opportunity.
  1b. What's really important is consumption inequality.
  1c. What's really important is the level of consumption enjoyed by the poor.
  1d. There's no good measurement of "fairness" when it comes to income.

2. Inequality is mismeasured.
  2a. Prices paid by the poor are mismeasured.
  2b. Government benefits to the poor are not included in inequality statistics.

3. Consumption inequality has decreased, not increased.

4. Increases in income inequality were unavoidable.
  4a. Inequality increased because of globalization.
  4b. Inequality increased because of technology.
  4c. Inequality increased because of low-skilled immigration.

5. America's inequality hasn't increased as much as that of other rich countries.

6. Attempts to reduce inequality by redistribution will lower GDP.

7. Inequality is a good thing.
  7a. Inequality is a result of economic freedom.
  7b. Inequality is a result of an entrepreneurial culture.

(The article goes on to talk about taxes, how the rich pay more than their fair share, how the rich are "job creators" and taxing them will hurt the poor, and how what we really need to do is fix the K-12 education system.)

It seems to me that Hagopian and Ohanian have flung a bunch of spaghetti at the wall to see what sticks. Anyone looking for a reason to oppose redistributive taxation will probably find something to like within this multitude. Indeed, I myself agree with about half of these points (if you're interested, I basically agree with 1a, 1b, 1c, 2b, and 4a).

But that doesn't make the article a coherent argument. Think about these questions:

* If inequality has been mismeasured and/or has gone down, why do we need to say it's irrelevant and/or a good thing?

* If inequality has been mismeasured and/or has gone down, why do we need to explain why it was inevitable that apparent inequality went up?

* If inequality is irrelevant and/or a good thing, why do we need to argue that its rise was unavoidable?

There's no thesis here, other than the idea that "income redistribution is bad." I think this reduces the credibility of the authors. Hagopian and Ohanian clearly started from a policy conclusion  ("income redistribution is bad") and went in search of reasons why this might be true, then went in search of data that supported those reasons. That's exactly the reverse of how I think scientists ought to do things. First you look at the data, then you make sense of it, and then you decide which policy makes the best sense. The fact that Hagopian and Ohanian seem to have done the reverse of this makes me think "Oh, here are another couple of guys who want lower taxes on the rich, and will grab hold of any theory or statistic that seems like it supports lower taxes on the rich."

So even though, for me, some of the arguments were convincing - i.e., some of the spaghetti landed in my mouth, and the rest on my shirt - the scattershot nature of the argumentation makes me less likely to buy into the overall policy conclusion. I don't think this is how economic policy advice should be done.

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What does "consumption-led growth" even mean?

Actually this post was just an excuse to post a picture of T-Pain.

There are a number of terms thrown around in the econosphere that confuse and annoy me. Perhaps they  annoy me because they confuse me? Anyway, one of these terms is "consumption-led growth" (and its evil sister terms, "investment-led growth" and "export-led growth"). This is usually invoked with respect to China. For example:

IMF officials “underscored the urgency of reforms to rebalance the economy toward more consumption-led growth,” the lender said. 

Or this:

Why hasn’t China done more to rebalance? The scale of the adjustment necessary to switch from an investment-led to consumption-led growth machine is so monstrous that the country would likely experience a lower rate of growth while it is taking place

Or this:

The transition from export- and investment-led growth to domestic consumption-led growth based on technology innovation, and from lifting tens of millions out of abject poverty to satisfying a more demanding middle class will be even harder for the party to execute.

What the heck is "consumption-led growth"? What does it even mean for a sector to "lead growth"?

Recall that GDP = consumption + investment + government spending + net exports.

Does "consumption-led growth" just mean that the consumption share of GDP should be higher than it is? If so, fine. Then why not just say "consumption-led GDP"?

Or does it mean that consumption should rise faster than the other components of GDP? Fine, but consumption's share of GDP can't increase forever. Eventually, consumption's share will hit a ceiling, and the "consumption-led growth" - if this is what it means - will be gone.

Or does it somehow mean that the shocks to GDP become shocks to consumption preferences, instead of shocks to productivity? That GDP grows because people want more stuff, not because people figure out how to produce more stuff? If so, it's a bit confusing as to how it would work. You can want more stuff til you're blue in the face, but only if you figure out how to make more stuff will you actually get what you want. Sure, you can work harder to get more stuff, but that kind of "growth" will pretty quickly hit a wall.

So what does "consumption-led growth" mean? I am a bit at a loss. Can someone explains what it means?

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More Reasons Why Traditional Publishing is in Trouble

No longer publishable.

The other day, I got into an interesting conversation (via e-mail) with fellow pilot and bestselling author Richard Bach, of Jonathan Livingston Seagull fame.

Let me fast-forward to the crux of our conversation. Which was that conventional publishing is (how can I put this delicately?) messed up beyond belief, now that all major book publishers have been bought up by mega-corporations and are interested only in blockbusters, and only those authors who are represented by top-flight literary agents. And only those with a very recent track record of mega-stardom.

You may think (as I did) that this means, simply, that new authors and fresh voices in fiction are effectively locked out due to the "old boy network" that has always dominated publishing. But in reality, it's much worse than that.

Richard Bach has sold many millions of books. He has authored 20 books, in fact, one of which (Seagull) was made into a major motion picture. And yet, he is having trouble finding a publisher for his upcoming (21st) book. He finds himself locked out.

Bach told me he has finally decided to go with a tiny, up-and-coming publisher, simply because he couldn't get in the door of major publishers.

What he told me, specifically, is: "My queries about my own new book to Random House, HarperCollins and Scribner, all of whom have published my books, were either rejected or ignored." (Emphasis added.)

Folks, that's messed up, bigtime.

Most major publishers will not even look at un-agented submissions. Their attitude is one of "when you're the only girl in town, you don't need deodorant." But it's worse than that. Even if you're a bestselling author with 20 books to your credit, you're now locked out, unless (apparently) you can prove you're Jesus in a business suit.

Of course, Writers Digest (and others) would have you believe you actually have a chance of getting published, if only you persist (and act like a professional rather than a lame-ass jerk).

Fact is, you have less of a chance than you think. What Writers Digest doesn't like to tell you is that your chances of getting a literary agent to request your entire book manuscript after a cold query are roughly one in 200. That's just to get them to read it, not sign you as a client.

And this is a tragedy, not only for authors (new or otherwise), but for the publishing industry as a whole. Because it means rationality is going out the window. The old-school publishing industry is now officially insane.

Many New York literary agents now won't even accept new clients unless they're recommended by existing clients. (Talk about an old-boy network.) But what if you're recommended by Richard Bach, who has sold millions of books but can't even bust the door of a New York publisher himself?

Let me break it down for you. It means that even if you are a talented writer, you're playing a cruel new type of Lotto.

So let's call a club a club, a heart a heart, a diamond a diamond, and a spade a spade. The old-school publishing industry is dead. Or rather, they're the walking undead, a bunch of characters from a George Romero movie, still ambulatory but totally unaware that they are just animated corpses without a reason to exist.

Random House, Macmillan, Scribner, Pearson-megalith, etc. Just lay down already. Your time is over.

Long live e-books. Long live self-publshing. Long live Lulu.com.

The hell with New York.

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Financial repression, Japanese style

For anyone who is interested in the Japanese economy, the recent paper by Takeo Hoshi and Takatoshi Ito is a must-read. Basically, it says that the days of Japan's seemingly infinite capacity to increase its national debt are numbered.

Everyone knows that Japan sustains its unprecedented national debt by borrowing money from its own people. The willingness of Japan's private sector to lend near-infinite amounts of money to the government at a pittance of an interest rate is legendary.

What Hoshi and Ito do is this: They assume that Japan's current government deficits, current GDP growth rates, and current savings rates will basically be maintained. Then they simply calculate the time when ALL of Japan's private wealth will be held in Japanese government bonds. Beyond that point, Japan will only be able to finance its deficits by borrowing money from foreigners, which of course will instantly push interest rates up to the point where Japan is forced to default. Under all of the scenarios, doomsday comes before 2023. Of course, that is making some very extreme assumptions, i.e. that government borrowing crowds out all other borrowing and that Japan's private sector demand for government bonds does not falter.

The upshot: Unless it balances its budget, Japan will start borrowing from foreigners in the next decade.

So there are three questions that follow, in my mind. The first is: Who is buying Japanese government bonds, and why? The second is: Why can't Japan balance its budget? The third is: "What will happen if Japan has to borrow from foreigners?" To answer these questions, I asked some Japanese econ professors what they thought. What follows is a distillation of facts that they gave me about the Japanese economy, some but not all of which can be verified by looking at official statistics.

On the question of "Who is buying Japanese government bonds, and why?", the answer appears to be: Pension funds, insurance companies, and regional banks. This answer is slightly different, though not hugely different, from the answer I gave when I blogged about the topic last year.

Japan's private individuals, who previously bought a lot of bonds with their non-pension savings, hold a lot of JGBs but are not buying any new ones. Partly, this is because Japan's household savings rate has dropped to near zero (which itself is partly due to rapid aging). Partly, it is because - all talk of "culture" to the side - people are just not that interested in holding such a low-yielding asset.

Japan's big banks and non-financial companies are similarly refusing to buy more JGBs. The Ministry of Finance, whose job it is to sell JGBs, had been leaning hard on big banks and companies to buy more of the bonds. However, the bureaucracy is not all-powerful (again, contrary to the stereotypes), and companies have basically said "No more!".

Pension funds and insurance companies, however, are a different story. The Ministry of Finance apparently has much more leverage over these guys, and basically forces pension funds to put households' savings in JGBs. But you may ask: Why don't workers demand that their funds invest in something higher-yielding? And here is what a professor told me:

In Japan, you can't do that!! In America, workers have a say in what asset classes their pensions go into. In Japan, this is apparently not the case. A 22-year-old entry-level worker, who really should have all of his money in global stocks, has absolutely no ability to stop his pension from putting all his money into low-yielding Japanese government bonds. Nor can he simply withdraw his pension early; apparently that is also not allowed in Japan. I am not 100% sure I believe that Japanese pensions work like this, but this is what people insist is true. If they are telling me something wrong, please let me know.

If true, this is "financial repression" at its worst. Japan's decrepit government is only keeping itself afloat by confiscating the savings of its hard-working populace. Some of these workers are staying in the office until late at night, only seeing their families one day a week, not even getting paid for the overtime...and their pensions are being confiscated by government pressure on fund managers.

So that answers that question. Next up is the question of why Japan can't balance its budget. I mainly outsource this answer to Yuriko Koike. Japan used to waste untold billions on pointless construction projects (concreting over every riverbed in the country, for example), but after a decade of cuts, that sort of thing now accounts for only about 5% of the budget.

The real problem is this: Japan has European-style health care with American levels of taxes. If you're going to pay for universal health care, you need high taxes, and Japan does not have them. With an aging population raising health care costs, Japan is going to have to either eliminate universal health care (ha!), or raise taxes a lot to balance the budget. Taxes have been raised, with the national sales tax recently going from 5% to 10%. But that change doesn't kick in til 2015, and won't put a particularly big dent in the deficit. Meanwhile, the tax hike was only popular because of the brave actions of a prime minister who will likely be fired as a result. Japan's populace, tired of working themselves to the bone and seeing their savings be stolen by pension funds, appear to be engaging in a full-fledged tax revolt.

So it seems unlikely that Japan will balance its budget. And Hoshi and Ito show that Japanese private investors, captive as they are, will soon have their backs broken by the sheer unbearable weight of government debt. So when Japan's government goes hat in hand to foreigners in the next decade, what will happen?

If Japan has to sell JGBs to rich countries, it's game over. No one will accept such low yields with such high default risk. The only investor who might buy the requisite amounts of JGBs is China. China, facing pressure from the U.S. to stop supporting exports by buying Treasuries, might turn to JGBs as an alternative mercantilist strategy. The idea would be to hold down the yuan against the yen, inducing Japan to buy a bunch of Chinese exports. This would be insanely expensive for China, but would give China de facto political power over one of its biggest geopolitical rivals.

So I see the following possible scenarios for Japan:

1. An early default, as pension funds escape government pressure and/or regional banks get spooked.

2. A default in 10 years, after Japan's private investors become totally tapped out.

3. A delayed default, but Japan becomes a client state of China in perpetuity, as China loans Japan's government the money it needs to stay afloat.

4. No default, as Japan carries out economic reforms, lets unproductive companies die, and experiences rapid productivity growth.

5. No default, as Japan's government ignores political pressure and raises taxes to European levels.

6. No default, as Japan's government ignores political pressure and eliminates universal health care.

7. Hyperinflation, as Japan's government pays off its debt by seigniorage.

(Actually, there is another scenario: Nightmare Socialism. Savings rates continue to rise, instead of falling as old people retire; more and more savings are hurled into JGBs, as the populace impoverishes itself to postpone default indefinitely. I didn't give this scenario a number because it's a little silly, and would represent an enormous and sustained reversal of many existing trends.)

I think Scenarios 1 and 2 are the most likely, though 5 is also possible. What do you think?

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Hedge funds and Econ 101

Felix Salmon has a very interesting post, detailing the fight between Simon Lack, author of The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, and the Alternative Investment Management Association, which I presume represents the sales departments of a bunch of hedge funds. Basically Lack's thesis is that hedge fund managers do beat the market, but keep all of the excess returns for themselves.

It seems to me that this result is what is predicted by basic Econ 101. In Econ 101 you have "consumer surplus" and "producer surplus", which are defined by the supply and demand curves:

The size of the two surpluses is determined by the slopes of the curves, which are called the elasticities of supply and demand. If demand is highly elastic - if the demand curve is close to flat - then the consumer surplus will be very small, and most of the benefits of the market will flow to the producers.

Think of hedge funds as producers and investors (who can give their money to hedge funds) as consumers. What do hedge funds produce? They produce "money tomorrow", and the price is "money today" (this ignores risk, but let's go ahead and ignore risk for the moment). So "money tomorrow produced by hedge funds" is the commodity being supplied in this Econ 101 diagram, and "money today" is the units of the price.

Econ 101 teaches us that demand curves are more elastic when there are substitutes available. For example, if New Balance shoes cost $60, and are just as good as Nike shoes, then as soon as Nike raises its price to $65, consumers will buy a lot fewer Nike shoes (because they will flock to New Balance). When the commodity is "money tomorrow supplied by hedge funds", there are many close substitutes available - money tomorrow provided by index funds, money tomorrow provided by Treasury bonds, etc.

So we expect demand for hedge funds' products to be highly elastic. That means that the consumer surplus will be small.

The producer surplus, on the other hand, might be pretty big, because different hedge funds probably have very different costs of production of "money tomorrow". A great fund manager might be able to produce a dollar of "money tomorrow" for only 70 cents today, while a mediocre manager might have a cost of production of 95 cents. Since production techniques can't easily be copied (investing techniques are secret), this producer cost heterogeneity should persist. Hence, there will be a big producer surplus - great managers will rake in the cash while mediocre managers will scrape by. This will show up as large excess returns to fund managers, which are extracted from investors via large fees.

So Econ 101 tells us that our baseline expectation should be that while hedge fund managers might beat the market, investing in hedge funds is unlikely to let you, the customer, beat the market. Which is Simon Lack's main result.

Of course, so far we've ignored risk. Many hedge fund sales departments, including the AIMA, are eager to remind investors that hedge funds can help you diversify your portfolio even if their after-fee rate of return is no better than any other asset class. This is true. It is true because hedge funds have access to investment opportunities that retail investors and mutual fund managers lack. So you might want to give some of your money to hedge funds (even at below the safe rate of return!), just to have indirect access to these other assets and thus diversify your portfolio.

Also, according to efficient-markets theory, hedge funds in general will have to offer above the safe rate of return (i.e. Treasuries) if most hedge funds take on a bunch of non-diversifiable risk. In this case, giving your money to hedge funds would be pretty much like buying a bunch of risky stocks. You get more returns, but only because you are able to demand those returns in exchange for committing your capital to risky projects.

And finally, if you have some special way of picking which hedge funds will perform the best, then of course you should give your money to those funds. Which basically means that you, yourself, are a market-beating manager of a fund-of-funds.

So there are certainly possible reasons to give your money to hedge funds. But these are side points. The main point is that, if we believe in supply and demand, then we should not expect hedge fund managers to give you their winnings when they could keep the winnings for themselves via fees. Which they usually can do, since the elasticity of demand for "money tomorrow" is high. Simon Lack's results should not especially surprise anyone who believes in Econ 101.

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The perils of Phlogistonomics

In a recent post, Matt Yglesias complains about a kind of economic analysis that has always kind of bothered me. I've called it "label-the-residual economics"; on Twitter, Matt suggested "phlogistonomics" and Richard Thaler suggested "aether". I like "phlogistonomics" a bit better, despite its unwieldliness, for reasons I'll explain later. In the meantime, let me go into a bit more depth than Matt did about the dangers of the approach.

What is this type of analysis that I'm warning about? In economics, when explaining a phenomenon, you generally encounter a "residual". The residual is the part you can't explain in terms of things you can measure directly. For example, suppose you are trying to explain a country's GDP. You can (somewhat inaccurately) measure how much labor the country has. You can (somewhat more innacurately) measure the amount of capital it has. So you assume that GDP is a function of capital, labor, and something else:

GDP = TFP * K^a * L^1-a

Here, K is capital ("das kapital"), L is labor, and TFP is the "something else". TFP is the residual.

This residual represents how productive capital and labor are, which is why we call it "total factr productivity" (TFP). What determines TFP? It could be "human capital". It could be technology. It could be institutions like property rights, corporate governance, etc. It could be government inputs like roads, bridges, and schools. It could be taxes and regulations. It could be land and natural resources. It could be some complicated function of a country's position in global supply chains. It could be a country's terms of trade. It could be transport costs and urban agglomeration. It could be culture. It could be inborn racial superpowers. It could be God, Buddha, Cthulhu, or the Flying Spaghetti Monster. It could be an ironic joke by the vast artificial intelligences that govern the computer simulation that generates our "reality", putting their metaphorical thumb on the scales because they are bored underpaid research assistants with nothing better to do.

Many, many economists refer to TFP as "technology". They are usually careful to stress that what they mean is not "technology" as we usually think of it, but a "generalized technology" that represents all the ways that society has found to utilize capital and labor to pump out GDP. But despite this careful qualifier, using the label "technology" has implications for how people think about and evaluate models like this. "Technology" sounds like something exogenous, something that we can't predict and can't control. Hence, using the label "technology", which has outside meanings, instead of the more neutral term "TFP", puts us in danger of allowing semantic biases to cloud our judgment.

This is "labeling the residual". Another example is in development economics, where the things we don't understand are often labeled "culture". This can lead to semantic biases. For example, when explaining Japan's wealth, many people turn to old cultural stereotypes such as "Japan is conformist" or "Japanese people imitate foreign things but don't invent new things". These stereotypes are blunt and inaccurate. Many of them were manufactured by either Japan's fascist government in the 1930s (as a way to promote the idea of racial differences) or else by writers in the British Empire. Many may no longer be very accurate. Others may never have been very accurate. Others may be somewhat accurate but miss crucial details. Nearly all of them greatly annoy Noah Smith.

What is the danger of semantic bias? Semantic bias may discourage us from trying to delve deeper into the workings of the economy. For example, suppose we find that TFP looks kind of like an AR(1) random process:

TFP_t = p*TFP_t-1 + e_t

In other words, TFP looks like it has "random" shocks (e_t) that decay after a while. Most of the action is in the shock, e_t. If e_t is truly random - if it's like a quantum fluctuation or a sunspot - then we're done, we can't do any better. But if e_t depends on things that we can observe, then we can do better than this model. We can explain more than we have already explained. So the question of whether e_t is truly random is crucial to the question of how well we can explain the economy.

I argue that calling TFP "technology" biases us toward thinking that e_t is truly random. After all, things like the invention of the internet can't be predicted in advance with any kind of certainty. For all intents and purposes, they are truly random events, like sunspots or earthquakes. So even though TFP might include a lot of things other than what we normally think of as technology, using the label "technology" for TFP discourages us from trying to actually go and predict TFP. In reality, we might be able to predict other determinants of TFP, like terms of trade or government investment. I know some economists try to predict these things. Good!! But maybe if we didn't call TFP "technology", more people might try, and they might get more funding to develop new sources of data that would help explain TFP.

I also argue that calling TFP "technology" allows some models to get a free pass on the Lucas Critique. TFP (or the persistence parameter p) might be a function of all kinds of government policies, in which case the model presented above would not be policy-invariant. Remember that applying the Lucas Critique involves a judgment call - the only thing deciding whether a parameter like TFP is "structural" is the consensus judgment of macroeconomists. And I suspect that the label "technology" makes it easier for economists to just assume that TFP is structural...because hey, policy can't affect whether some genius invents something in his garage, right?

I think this semantic bias is even more evident when "culture" is the residual being labeled. Culture is assumed (wrongly, I believe) to be something ancient and immutable. Japanese "culture" (i.e. cultural stereotype) is usually explained in terms of ancient traditions and conditions - Japanese people are risk-averse because they live on an island with lots of earthquakes, Japanese people are imitators because of the dominance of China in East Asian culture hundreds of years ago, Japanese labor markets are a reflection of samurai-era feudalism, etc. This in turn implies that "culture" cannot easily change. (The assumption is clearly false. For example, Japan had very little lifetime employment or seniority-based pay before World War 2; so much for samurai feudalism!)

Labels like "technology" and "culture" may bias economists toward being lazy and sloppy. If we allow our beliefs to be guided by our labels, we risk reducing ourselves to speculating about the future trends of technology or invoking the same tired cultural stereotypes that fill internet forums, instead of searching out new sources of data to explain the heretofore inexplicable. I should caution the reader that I don't know how much of this sort of thing really happens; I am NOT alleging that the econ profession as a whole commits these mistakes. It just seems like a danger. If pressed for examples of when the "technology" label was over-influential, I'd point to the wide acceptance of the RBC paradigm in the 1980s. Regarding "culture"...well, let's just say the whole country of Japan is a serial offender on this count.

Another danger of residual-labeling is that it may bias us against parsimony. When we see a new phenomenon that is difficult to explain - for example, the slowness of Japanese cafes to offer free wi-fi - we may be tempted to postulate a new cultural trait ("Japanese businesses are suspicious about giving anything away for free") instead of looking for some incentive (Perhaps Japanese cell phone service is so good that few people own laptops?) to explain the phenomenon. We just point at stuff we can't explain and say, in the parlance of blogs, that it's "the culture that is Japan". But if you add a new parameter to explain a new data point, you haven't really explained anything.

So what should we call the practice of labeling residuals with semantically laden words? I like Matt Yglesias' proposed label of "phlogistonomics" a little better than Richard Thaler's suggestion of "aether". In the late 1800s and early 1900s, "aether" was something we could and did investigate; it was supposed to be the medium in which light waves moved. We proved it didn't exist. On the other hand, "phlogiston" was more like a residual - it was just "whatever makes stuff burn" (the error was in thinking it had mass). We know there is something that makes stuff burn. And we know there is something that makes some economies function differently from others. The danger in labeling this residual is that in doing so we may trick ourselves into thinking we understand the residual as well as we ever will. That would be a mistake. Eventually, we figured out what makes stuff burn. Someday we may figure out what makes economies different.

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The Japanese tragedy, causes and consequences

Ryan Avent has some new points in our debate over Japan's post-1990 economic performance (see my original post and Ryan's earlier post). I have some problems with the points he makes, but instead of getting into those things, I'd like to step back and take a look at the broader argument.

The original question was: "Why has Japan performed poorly relative to 1990-vintage forecasts?" My answer was: "Because 1990-vintage forecasts were overestimating Japan's ability to exceed the West in productivity." Ryan's answer is, basically: "Because Japan's monetary policy has been too tight."

In macroeconomics, it is very hard to generate a good "counterfactual" - in other words, it's very hard to know what would have happened if some policy had been different. History only happens once, after all. So what we usually do is come up with "stories", and then look to see how the evidence, informed by our theories, fits with each story. It's not exactly science, but it's what we have to work with.

So let me see if I can characterize the stories Ryan and I are telling about the Japanese economy.

Ryan's story: "Japan is (or was) a country with better institutions and/or technology than the West. In the absence of a demand shortage, Japan would be considerably richer than the larger nations of Western Europe, as it was in 1990."

My story: "Japan is (and was) a country with about the same quality of institutions and productivity as the West. In the absence of a demand shortage, Japan would be doing better than it currently is, but not significantly better than the larger nations of Western Europe."

It's essentially impossible to quantitatively measure the quality of a country's institutions. Hence, to evaluate these two stories, let's look at the notion that an aggregate demand shortage has caused Japan's economy to underperform for 20 years.

Here is a picture of Japan's employment-to-population ratio:

As you can see, about 4% of Japan's population stopped working over the period of 1995-2003. This resulted in an unemployment rise of about 3 percentage points, with the remaining 1 percentage point presumably being some mix of "discouraged workers", grad students, housewives, and kids deciding to play instead of work. In any case, suppose that proper monetary policy had prevented any of this decline from occurring. Japan's labor force would then be about 7% bigger than it currently is. Assuming productivity would be the same then as now, that would raise Japan's per capita GDP (PPP) by 7% from its current level. This would account for about half the gap between Japan and Germany that Ryan shows opening up since 1995, and a quarter of the gap between Japan and the United States.

What would account for the rest? Two things: 1) total factor productivity, and 2) hours worked by the employed. Let's assume for the moment that TFP is determined entirely by institutions, and so let's look at how Japanese work hours per employed person have changed over time:

The steady drop in working hours since 1988 (most of which, interestingly, happened before 1995) corresponds to a reduction in the Japanese workweek from about 47 hours per week to just under 42. In comparison, the U.S. workweek is just under 39 hours, and the European workweek is just under 38.

Whose story does this support? It depends on what you think Japanese people's work habits would be if monetary policy had been looser. If the Bank of Japan had circumvented the zero lower bound by doing a bunch more quantitative easing, would Japanese people still be working 47 hours a week? Maybe, maybe not. A somewhat related question is whether that would be a good thing.

But note that the graph of hours worked provides a very natural explanation for the question of how Japan was managing to outperform the West before 1990. The answer: they worked more. A lot more. The only way they could have continued to outperform the West was by continuing to work more.

(Side note: OK, so what if TFP isn't exogenous? It's hard to think of why this would be the case. Labor hysteresis isn't an explanation, because for skill loss to matter, unemployed people have to come back to work, which hasn't happened in Japan (except slightly in 2003-2007). And endogenous growth isn't the answer, since Japanese total R&D spending has strongly outpaced the West since 1995. So I don't find it plausible that persistently tight monetary policy caused Japan's TFP to stagnate.)

So was what happened to Japan a preventable tragedy? I think part of it was a minor preventable tragedy. More aggressive easing probably could have saved up to 3% of Japan's working-age population (over 2 million people!) from unemployment. And in fact, Japan's bright spot in the mid-2000s came after the BOJ did a bunch of quantitative easing. So I think Ryan's story is right.

But I don't think it is the whole story. Japan stopped outperforming the West in large part because they started working less (though still more than people in the West). That change mostly happened well before the zero lower bound was hit, and began even before the Japanese asset bubble reached its peak. So I suspect not all of it could have been reversed by quantitative easing. But even if some could have been reversed, I do not see the end of the 47-hour workweek as a tragedy. Knowing what I know of Japanese society, I see it as a minor triumph.

Update: It has been brought to my attention that the "employment-population ratio" for Japan is not defined the same as in the U.S., where the denominator is as the population aged 16-64; in Japan there is no upper age limit for the denominator. So some of the decrease in Japan's employment-population ratio was from aging. However, the trough-to-peak unemployment change during the "lost decade(s)" was 3%, so there was definitely still some unemployment that might have been prevented by looser monetary policy.

Update 2: Matt Yglesias weighs in with a much better overview of the vagaries of PPP than I provided in my last post. But my argument applies perfectly well using PPP, which is why I didn't want to go there in this new post. Still, give Matt's post a read.

Update 3: Karl Smith weighs in as well. He points out that Japanese unemployment has mostly been youth unemployment, as Japanese companies are unwilling to fire older workers. He also shows that Japan's GDP per hour lags behind Italy's, something I did not know. That does not, however, mean that Japan's institutions and/or technology are worse than Italy's, however, since working more hours makes productivity/hour go way way down, as any grad student has experienced when finishing his or her dissertation. We should not expect GDP/hour to converge between countries whose work weeks are very different in length, even under the Solow model.

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What happened to Japan?

Sorry, dude, no one looks good in skinny jeans. Dig the curly mullet though.

Since I'm in Japan, I had better do some Japan-related blogging. Brad DeLong poses a question, originally asked by one of his commenters:

Japan is now 40 to 50 percent below what the world in 1991 would have estimated their GDP to be in 2012. 

Do we attribute this to: 

The forecasting community was just wrong--Japan was having adverse technology shocks that few foresaw, and so no matter what macro policies they followed and no matter what antibubble policies they followed their GDP today would be about what it is, for the prevailing potential estimates back in 1991 were just wrong? 

If Japan had avoided its bubble and the resulting financial crisis, it would today have far higher GDP--but once the crisis happened, it ruined into an adverse supply shock and most of what has happened since was then predestined. 

If only Japan had followed the Posen plan rapidly after their bubble burst, their world would be very different today and GDP in Japan would indeed be 30-40% higher than it is. 

What is the best way to think about this?

Well, I can't answer this properly, because I don't really know what the forecasting community was smoking saying back in 1990. But I have a few thoughts.

Basically, by 1990, Japan had caught up to the richest large nations in terms of per capita GDP. The only way for Japan to have continued at its previous high rate of growth post-1990 would be for either A) an unprecedented technological boom to power a rapid expansion among all the world's rich countries, or B) for Japan's productivity to significantly exceed that of the other rich countries. In other words, anyone who forecasted continued rapid Japanese growth in 1990 was predicting that Japan was capable of doing far better than the other countries of the world, and indeed that this was the most likely outcome.

Now, let's look at Japan right now. Wikipedia tells us that Japan's per capita GDP, in market-exchange-rate (sometimes called "nominal") terms, is $45,900. That compares with $44,500 for Germany, $43,100 for France, and $39,600 for the UK. I picked Germany, France, and the UK because these are other rich developed nations with populations between 50 and 150 million and growth rates similar to Japan's. In other words, in nominal terms, Japan is richer, per person, than any comparable country. I suspect that what difference exists is due to labor inputs, since Japan does not force its citizens to take lots of time off of work the way Germany and France do.

At purchasing power parity, the numbers are a little less favorable for Japan - $34,300, compared with $38,400 for Germany, $35,900 for the UK, and $35,000 for France. However, I am suspicious of these numbers, since PPP does not take into account quality differences between similar products across countries. Japanese consumers have a famous preference for quality. Japanese plastic kitchen wrap, for example, is so strong and easy to use that it doesn't even deserve to be mentioned in the same sentence as Saran Wrap. Japanese pens last longer. The cheapest, lowest-quality Japanese milk is what we Americans call "organic milk" and pay a price premium for. Etc. (To be fair, Japanese houses are built of shoddy materials, have terrible floor plans, and don't have central AC.)

So the "real" level of Japanese GDP, if such a thing can be said to exist, is probably somewhere right around that of Germany, France, and the UK. "Lost decade" or no, Japan in 2012 is right where the Solow Model says it should be. 

What could forecasters in 1990 have been smoking that made them see this as anything other than the inevitable outcome? I suggest two things: 1) dumb trend projection, and 2) attribution error.

Dumb trend projection is people's tendency to view trends as structural. Examples of this include: "Housing prices have never fallen; hence they will never fall." "This stock returned 17.2% over the past three decades; hence it will continue to do so." "The center of gravity of the global economy is inevitably shifting to Asia." And so forth. But in reality, past performance is no guarantee of future results. Or, to put it more pithily, "The trend is your friend til the bend at the end."

Attribution error is our tendency to attribute phenomena to the wrong causes in certain reliable ways. One of these is that we tend to attribute outcomes to fixed person-specific characteristics rather than to circumstance and situation. In Japan's case, this means that people thought that Japan was growing fast in the 70s and 80s because of Japanese culture, superior Japanese government, or - and I suspect that this was more significant than people will admit - the inborn superpowers of the Japanese race.

Whatever superpowers Japanese people may have (I have found that they tend to be extremely good at "Where's Waldo?"), it did not turn out to give them a decisive productivity advantage over the Germans, French, and British. I guess in 1990, Japan was the only East Asian country ever to have gotten rich, and so there was perhaps more cause to believe that maybe East Asian countries could do things European countries couldn't. There are few who now believe that South Korea will blast through the productivity frontier. 

So maybe we learned something from the Japan episode. We learned that East Asians do not have superpowers. They have not figured out a better economic model any more than they have found a way to look good in skinny jeans. No one looks good in skinny jeans. And no one beats the Solow Model.


Update: Ryan Avent says I'm completely wrong. Market-exchange-rate GDP numbers, he says, are distorted by currency fluctuations; the yen is strong right now, so Japan looks rich. And this is true, although the Big Mac Index, produced by Mr. Avent's employer The Economist, says that the yen is not currently overvalued. My point is that neither market-exchange-rate nor PPP numbers tell the whole story. Mr. Avent does not address the limitations of PPP calculations, which go far beyond what I wrote about in this post. I still maintain that when trying to make cross-country comparisons, you should look at both numbers.

Mr. Avent is trying to defend his thesis of a "Japanese tragedy" caused by tight monetary policy. I agree that tight monetary policy has hurt Japan to some degree, and I'd draw attention to the fact that Japan's best post-bubble performance (in 2004-2007) came on the heels of a program of Quantitative Easing. But  that does not change the fact that Japan's standard of living is comparable to that of the major Western European economies (Australia is not an appropriate comparison, being a sparsely populated economy powered by abundant natural resources). And in addition, during the worst years of the "Lost Decade", Japanese unemployment was only 3% higher than at the peak of the bubble. So yes, there have been policy mistakes here, but the end of catch-up growth was no "tragedy", it was inevitable.

Update 2: On Twitter, my advisor Miles Kimball suggests that I look at the change in the yen's real exchange rate in order to better evaluate Ryan Avent's claim about market-exchange-rate GDP measures. Here, via Wikipedia, is a long-term (but up-to-date) chart of the yen/dollar real exchange rate:

Ryan's claim is that changes in this exchange rate distort Japan's market-exchange-rate GDP (making PPP the only good measure). But from this chart, we can pretty clearly see that he's wrong. The yen is currently at or weaker than its long-term average value (when the blue line is higher the yen is weaker). There has been no trend of yen strengthening since the mid-80s (when Japanese growth was robust). Hence, neither the trend nor the level of the yen exchange rate indicate that market-exchange-rate GDP is a worse measure than PPP GDP when discussing Japan's wealth relative to the United States.

But what about the European countries? If the pound, deutschemark, and euro have gotten steadily weaker since 1990, then their market-exchange-rate GDP numbers are "too low". But this is also not the case. In other words, Ryan is not right...exchange rates are not distorting the comparison between Japan and other rich countries. Japan is right up there with the richest large countries in the world.

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