Kauffman forum video: Blogging and your economics career

I was unfortunately unable to attend the Kauffman Economics Bloggers' Forum this year. In lieu of a personal appearance, Brad DeLong asked me to do a quick video on the topic of how blogging might affect one's career in economics. So here is that video. It's a topic I've covered before, so not a ton of new stuff here if you're a regular reader. But with the video version, you get to see my office bookshelf! Awesome!

(Note: I now realize that this video makes it sound as if Justin Wolfers started blogging after me, when actually, he was blogging before I was.)

Update: As some people have pointed out, this video contains a mistake. I say that I spend "1 to 1.5 hours a week" blogging. I totally misspoke. I spend 1 to 1.5 hours per post. At 2-3 posts a week, that's 2 to 5 hours per week. Thanks to the people who caught that...

Anyway, for much much more on the Kauffman forum, visit Brad DeLong's blog.

Nuthin' but a 'g' thang

I had a professor at Michigan who always thought in pictures. He would much rather draw a graph than write down a system of equations. As he drew the curves on the board, he would say "OK, here is the thing, and it touches this thing, and they go like this." And that would be it! And I would be sitting there scratching my head and thinking "OK, now are you going to tell us what you just did?" Because I've always been the exact opposite kind of guy; I would rather write down equations and define words for everything. Rarely do I think in pictures. On IQ tests, I do much worse on the "visual" sections.

Over the course of my academic existence, I've often observed this dichotomy. You have the Einstein-type people who seem to visualize everything, and then you have the Heisenberg-type people would would rather use the symbols. So I've always had the intuitive hypothesis that there are different types of intelligence; that different people tend to process information in different ways, whether due to habit or nature.

But then there are all those people who say that intelligence can be boiled down to a single factor, the mysterious "g" (which I assume stands for either "general intelligence" or "gangsta"). Since this went against years of casual observation, I was somewhat pleased to see the eminent Cosma Shalizi write an essay debunking the notion of "g". But then I saw this blog post defending the notion of "g", and claiming that Shalizi makes a bunch of errors. Basically, the disagreement revolves around the question of why most or all psychometric tests and tasks seem positively correlated with each other. Shalizi points out that this correlation structure will naturally lead to the emergence of a "g"-like factor, even if one doesn't really exist; his opponent points out that if no "g" exists, it should be possible to design uncorrelated psychometric tests, which so far has proven extremely difficult to do.

The latter post, by a pseudonymous blogger calling himself "Dalliard", contains a bunch of references to psychometric research that I don't know about and have neither the time nor the will to evaluate, so I'm a bit stumped. Normally I'd leave the matter at that, shrug, and go read something else, but I realized that my intuitive hypothesis about intelligence didn't really seem to be explicitly stated in either of the posts. So I thought I'd explain my conjecture about how intelligence works.

In a nutshell, it's this: What if there are multiple "g's"?

Suppose that simple mental tasks (of the kind apparently used in all psychometric tests) can be performed by a number of different but highly substitutable mental systems. In other words, suppose that any simple information-processing task can be solved using spatial modeling, or solved using symbolic modeling, or solved using some combination of the two. That would result in a positive correlation between all simple information-processing tasks, without any dependence between the two mental abilities.

Let's illustrate this with a simple mathematical example. Suppose the performances of subject i on tests m and n are given by:

P_mi = a + b_m * X_i + c_m * Y_i + e_mi
P_ni = a + b_n * X_i + c_n * Y_i + e_ni

Here, X and Y are two different cognitive abilities. b and c are positive constants. Assume X and Y are uncorrelated, and assume e, the error term, is uncorrelated across tests and across individuals.

In this case, assessing the covariance of performances across two tests m and n across a pooled sample of subjects, we will have:

Cov(P_m, P_n) = b_m * b_n * Var(X) + c_m * c_n * Var(Y) > 0

So even though the two cognitive abilities are uncorrelated (i.e. there is no true, unique “g”), all tests are positively correlated, and thus a “g”-type factor can be extracted for any set of tests.

Now suppose that by luck, we did manage to find "pure" tests for the X and Y. In other words:

P_xi = a + b_x * X_i + e_xi
P_yi = a + c_y * Y_i + e_yi

These tests would have no correlation with each other. But they would have positive correlations with every other test in our (large) battery of tests! So the "positive manifold" (psychometricians' name for the all-positive correlation structure between tests) would still hold, with the one zero-correlation pair attributed to statistical error. Only if we found a whole bunch of tests that each depended only one X or only on Y could we separate the "single g" model from the "two g" model. But doing that would be really hard, especially because in general test-makers try to make the various tests in a battery different from each other, not similar.

Notice that all I need for my "two-g" model to fit the data is that most of the b and c coefficients are nonzero and positive. It makes sense they'd all be positive; more of some mental ability should never hurt when trying to do some task. And the "nonzero" part comes from the conjecture that simple mental tasks can be performed by a number of different, substitutable systems. (Note: the functional form I chose has the two abilities be perfect substitutes, but that is not necessary for the result to hold, as you can easily check.)

Update: A commenter reminds me of the time Richard Feynman discovered that while he counted numbers by internally reciting the numbers to himself, his friend counted by visualizing pictures of the numbers scrolling by. This is the kind of thing I'm thinking of.

So anyway, there's my proposed model of basic intelligence. For those of you who didn't follow it, just imagine several dozen hyperplanes, and project them all onto one hyperplane... ;-)

An addendum: Why do people care whether there is one "g" or several? According to "Dalliard", the notion of multiple types of intelligence is attractive because it suggests that "that everybody could be intelligent in some way." Well, if that's what you want, then realize this: It's true! Remember that psychometric tests are simple mental tasks, but most of the mental tasks we do are complex, like computer programming or chess or writing. And for those tasks, learning and practice matter as much as innate skill, or more (for example, see this study about the neurology of chess players). Therefore, everyone can be "smart" in some way, if "smart" means "good at some complex mental task". Which, in adult American society, it typically does. So don't worry, America: We're all stupid in most of the ways that matter.

...Wait, that didn't come out right...


(Final note: Looking through "Dalliard's" blog, I see that most of it is an attempt to prove that black people are dumber than white people. Sigh. Depressing but hardly surprising. Needless to say, the fact that I addressed a "Dalliard" blog post is not intended as an endorsement of his views or his general interests...)

Update: A commenter points out that Dalliard's post does consider a theory similar to the one I outline here, which he calls the "sampling" theory. Dalliard cites some fairly weak arguments against the theory by someone from long ago, but recognizes that these arguments are weak. Dalliard also makes a good point, which is that for many applications - say, separating kids into classes based on test-taking skill - it doesn't matter whether there is one "g" or many.

Update 2: Here's some recent evidence supporting my conjecture.

Two versions of Goodhart's Law

Goodhart's Law is often called a generalization of the Lucas Critique, but it's really not. The "law" actually comes in several forms, one of which seems clearly wrong, one of which seems clearly right. Here's the wrong one:

Any observed statistical regularity will tend to collapse once pressure is placed upon it for control purposes.

That's obviously false. An easy counterexample is the negative correlation between hand-washing and communicable disease. Before the government made laws to encourage hand-washing by food preparation workers (and to teach hand-washing in schools), there was a clear negative correlation between frequency of hand-washing in a population and the incidence of communicable disease in that population. Now the government has placed pressure on that regularity for control purposes, and the correlation still holds.

Incidentally, this also means that the oft-repeated statement that "Social science can never discover any laws of nature, because human beings react to the discovery of the 'law'" is false. For example, suppose you see that when gas prices rise, people drive less. You place pressure on that regularity for control purposes by instituting a gas tax, which raises the consumer price of gas. Lo and behold, people drive less! Sometimes people actually do what you try to get them to do.

Anyway, here's the version of Goodhart's Law that seems obviously true:

As soon as the government attempts to regulate any particular set of financial assets, these become unreliable as indicators of economic trends.

This seems obviously true if you define "economic trends" to mean "economic factors other than the government's actions. In fact, you don't even need any kind of forward-looking expectations for this to be true; all you need is for the policy to be effective. In other words, this law could as easily describe "Milton Friedman's thermostat" as the Lucas Critique.

An application of this correct form of Goodhart's Law is the suggested use of financial market outcomes as guides for Fed policymaking. At a speech at a conference at Michigan last year (and elsewhere), Narayana Kocherlakota suggested that instead of using its own internal inflation forecasts, the Fed should set policy according to market forecasts of inflation. Specifically, he suggested using the prices of TIPS and other inflation-dependent financial assets to calculate risk-neutral probabilities of future inflation, and to set Fed policy accordingly. His reasoning was that unlike the Fed's own forecasts, risk-neutral probabilities take into account the degree to which people value price stability in different states of the world.

I raised an issue with this approach. The risk-neutral probabilities obtained from financial markets are unconditional probabilities - in other words, markets may have already taken into account what they expect the Fed to do, but they have not yet taken into account what the Fed actually decides to do. The Fed's ultimate policy decision is something the Fed knows and the markets do not. Thus, the Fed is able to make internal conditional forecasts for each possible policy choice, and use only one of those conditional forecasts when making its decision. If it relies on markets, it must necessarily use unconditional forecasts, which may be less informative about conditional outcomes (which is what the Fed really cares about).

This seems to me to be an application of the second version of Goodhart's Law. If you set interest rates mechanically (i.e. according to some rule) based on current market expectations of inflation, you will change those expectations, and markets will move, requiring you to set interest rates differently according to your policy rule. It's possible that markets and policy might converge to some stable equilibrium, but also possible that market volatility might increase once it was known that policy was being set based on market prices themselves.

To link this to Goodhart's Law, if the Fed targeted the prices of inflation-linked assets, those prices would mostly contain information about expectations of Fed policy decisions (which the Fed already knows better than the asset market), rather than about non-Fed economic forces that might affect inflation or people's utility of stable prices (i.e. the things the Fed wants to use the asset prices to ascertain).

So Goodhart's Law, in its obviously true form, seems very important for policymaking.

A world without macroeconomists?

Miles Kimball, myself, and some other folks were having a discussion on Twitter the other day about the question of "What would happen if there were no economists?" So we decided to do some blog posts on the topic.

Of course, the definition of "economist" is fuzzy; if you make a chart of past GDP growth rates on your home computer just for fun, does that make you an "economist"? So I'll assume that "economist" means "academic economists, or economists working at government research institutes." In other words, paid econ researchers.

Anyway, the question is much too hard! There are a LOT of kinds of economists, and they do lots of different things. Tax economists study tax policy. Labor economists study individuals as they make their way through the economy. Decision theorists study how individuals make decisions. Applied game theorists study how people bid on auctions, and lots of other stuff like that. Financial economists study financial markets. Econometricians do statistics. Development economists study how countries get rich. Trade economists study patterns of trade. Industrial organization economists study...um...Well, anyway, there are a lot of different types of economist. The question of what would happen if they all vanished is fun far-out speculation, but I'll leave that task to somebody else.

Instead I thought I'd just stick to the type of economist everyone hears about: Macroeconomists. What if universities, and the Fed, stopped hiring people to do macroeconomics?

Well, for one thing, universities probably wouldn't save any money. The demand for econ profs is based mainly on the demand for undergrad econ classes, which probably wouldn't much change if one subfield of econ research were abandoned. Econ classes would just focus more on micro and on subfields of micro, and would be taught by micro researchers. As for the U.S. government, it would save a tiny bit of money, but not much, since macroeconomists have tiny research budgets.

Would we lose the ability to forecast the macroeconomy accurately? It's tempting to conclude "No," since macro models of the type overwhelmingly used, created, and studied by modern macro researchers (DSGE models) haven't really proven better at forecasting than the non-structural spreadsheet-type models used by most private firms, or than consensus individual forecasts (actually one DSGE model has performed slightly better in recent years, but this might just be data mining and publication bias). It's telling that private firms don't hire people to make DSGE models, but do hire people to make forecasts with much simpler tools.

However, here's an interesting thing about research, and about science: Past discovery is no guide to future discovery. Chemists were basically a joke for centuries before they stumbled on a few key principles, and rapidly turned into the most reliable discovery-factories in all of science. Biologists had an even longer history of uselessness before they became incredibly useful thanks to new technologies. So someday, macroeconomists might learn how to forecast the economy extremely well. We really just don't know. A breakthrough in forecasting power would yield huge payoffs to society.

OK, what about policy? Macroeconomists will gladly tell you that modern models are not a lot of use in forecasting - that their main use is in giving policy recommendations, conditional on your assumptions (i.e. "If for whatever reason you believe that the economy works this way, here's what you should think you can do with policy.") But as I've often griped, I don't think they really do this particularly well...it's too hard to choose which one to use, even if you know your own general priors about how the economy works. And people have silly priors anyway. Not to mention that even if you choose a model, its output may be incredibly hard to interpret and use. And when the world seems to hit on a consensus policy that seems to work well - the Fed using interest rates to lean against fluctuations in inflation and GDP, for example - the models seem to follow the policy rather than the other way around.

So does this mean that macro research is useless for policymaking? No! Not at all!! Because here's an interesting thing about policymaking: No matter who advises the policymakers, policy is going to get made. That includes economic policy. So if there were no academic and Fed macroeconomists around to advise policymakers, who would policymakers listen to on economic matters?

My guess: Some very dangerous people. 

For all the talk of academic macro being politicized, it's much less politicized than the macroeconomic discussion outside of the research community. My own experience is that most macroeconomists are pretty apolitical, and research supports that...but even if my sample is biased, macro's interventionist and laissez-faire schools are pretty close to each other ideologically, compared to, say A) armchair-theorizing politicians, B) TV commentators, C) the denizens of internet forums. It really is a jungle out there. You have David Stockman. You have Ron Paul and his followers. You have David Graeber and his followers. And worse. You have "Austrians" who think all of economics can be deduced from some vague derp. You have Marxists who think - well, I'm not sure, because they tend to denounce and vilify you if you even ask them what they mean, but it sounds nuts. In short you have a cavalcade of vast unending wackitude, often with a proven track record of wrecking economies and societies.

So it's possible to see macroeconomists as doing plenty of good, simply by sitting there not being absolute wackaloons. A million DSGE models from which it is impossible to select sounds a lot better to me than three or four totally nutcase worldviews, the selection of any one of which is likely to cause human tragedy on a vast scale. (Note: This idea, of macroeconomists as a vaccine against macro-lunacy, was first suggested to me by Justin Wolfers.)

(Update: In the comments, Robert Waldmann writes:

A world without macroeconomists wouldn't be a world without economists who talk to journalists about the macroeconomy. The risk is that the voice of the economics profession will be trade theorists, economic historians, behavioral economists and finance economists such as Krugman, DeLong, C Romer, Goolsbee, Fama and Cochrane. 

I think Waldmann is right, and the danger from having zero dedicated macroeconomic researchers is not as great as I'm making it out to be; other economists could still hold back the crazies, they'd just have a harder time doing it with no empirical research or macro theory to back them up. So the crazies might not immediately take over, but they might gain more clout and respect.)

And actually, there's a huge area of macroeconomic research that I haven't even mentioned yet: macro empirics. Empirical macro is fundamentally constrained by the limitations of time-series data ("history only happens once", i.e. ergodicity and stationarity are near-impossible to verify) and cross-country comparisons. But within those limits, macro empiricists can tell us a lot, just by quantifying things and noting seeming regularities. That's enormously helpful both for policy and for forecasting. You need controlled experiments to create a reliable predictive theory of the world, but there's a huge amount you can know without controlled experiments, just by watching the world go by and keeping careful track of what you see. And macro empiricists can certainly do the latter. It's thanks to them we know things like Okun's Law, which tells us that fast growth is consistently associated with low unemployment. It's also thanks to them that we know that investment is much more sensitive to the business cycle than consumption. Or that slightly less than half of people seem to be "hand-to-mouth" consumers who don't obey the Permanent Income Hypothesis. Etc. Without macroeconomists, we just wouldn't know these things, and reasonable people would argue about them.

Also, I didn't even mention spinoff products. Macro empiricists, struggling to wring some insight out of terrible data, often come up with truly remarkable innovations that may be useful in many disciplines. I'd put Chris Sims' work with structural vector autoregressions in this category.

So, in short, from macroeconomists we get at least the following benefits:

1. Quantification of macroeconomic phenomena.

2. Observation of correlations between macroeconomic variables (and between macroeconomic and microeconomic variables).

3. The creation of "spinoffs" like sVARs.

4. The unknown potential for big breakthroughs in forecasting methods.

5. An "anchor" that keeps policy away from the dangerous extremes urged on us by various politically-motivated fringe groups.

So without macroeconomists, it seems to me that we would lose quite a bit, actually. And since macroeconomists are very cheap, all in all, it seems we should keep them around.

That doesn't mean we bloggers have to stop complaining about them, of course. ;-)

Abe surprised me!

I was wrong.

For months I voiced heavy skepticism that Shinzo Abe's new administration would follow through on its plans for huge economic policy changes - in particular, a serious push for reflation. Yesterday, Abe's new central bank chief, Haruhiko Kuroda, proved me wrong by announcing a dramatic new program of quantitative easing:

The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years. In order to do so, it will enter a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases... 

With a view to pursuing quantitative monetary easing, the main operating target for money market operations is changed from the uncollateralized overnight call rate to the monetary base...The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 60-70 trillion yen... 

With a view to encouraging a further decline in interest rates across the yield curve, the Bank will purchase JGBs so that their amount outstanding will increase at an annual pace of about 50 trillion yen... 

With a view to lowering risk premia of asset prices, the Bank will purchase ETFs and Japan real estate investment trusts (J-REITs) so that their amounts outstanding will increase at an annual pace of 1 trillion yen and 30 billion yen respectively... 

The Bank will continue with the quantitative and qualitative monetary easing, aiming to achieve the price stability target of 2 percent, as long as it is necessary for maintaining that target in a stable manner...

Note that "price stability target" means inflation target.

Now, 60-70 trillion yen is about $600-700 billion, which is about the size of America's recent "QE1" and "QE2". Japan will basically do an new "QEx" every year. In addition to buying long-term government bonds (which the Fed did in QE2), Japan's central bank is going to buy stock and real estate. This is exactly the sort of reflationary policy that Miles Kimball recommended as a cure for depressions, back when I took his macro class. In any case, the move is very very big. George Soros says that the BOJ's plan is "three times as big" as the Fed's attempts at QE. People from big banks and research companies are saying much the same thing.

Anyway, so Abe defied my expectations and really implemented a serious policy change. Now, we get to see how well monetary policy really works, in an economy with a deflationary trap and well-anchored deflationary expectations. A dramatic (though uncontrolled) natural macroeconomic experiment is being carried out in Japan - probably the biggest thing since Volcker whipped U.S. inflation in the early 80s.

IF monetary policy works - i.e. if it can raise inflation in a controlled manner while boosting output - it's not only a huge win for Japan - which needs moderate inflation to erode its mountainous debt, and could probably use an employment boost too - but also for New Keynesian and monetarist type macroeconomics, which generally holds that a central bank has the tools to control the rate of inflation (or to beat any depression). A failure would mean either an uncontrolled "inflation snap-up", or a failure to budge Japanese expectations and prices. A majority or plurality of top macroeconomists probably believes in some sort of monetarism, so hopes are high. I'm a little bit more agnostic, and I'm excited to see what happens.

So, Mr. Abe (or "Shinzo" as I somewhat cheekily called him in a recent interview on a Japanese website)...you convinced me. Excellent job. Now let's see if you can convince me again with structural reform and the TPP!

Superior Mayan engineering

I met a Mayan engineer on the plane last December. He was headed to Detroit to learn something about some mechanical engineering thing that I didn't understand. He handed me his business card, very politely, and made fun of me and all other Americans for predicting an apocalypse later that week. He told me that the Mexican economy was doing great, especially in the south of the country, and that I should come to visit him in Mexico City.

Now, if I were Tom Friedman, that conversation would be enough to make me believe in the power of the Mexican economic miracle. But I'm not Tom Friedman, so instead I decided to check the numbers. Here is Mexico's GDP per capita (PPP):

As you can see, the income of the average Mexican, after stagnating in the early 2000s, took off in 2003 and has grown by over 64% since that time (more, since that data is from 2011). That is a 6.4% annual rate of growth! (Update: Oops, I noticed that this wasn't inflation-adjusted. The actual numbers are more modest; here's the inflation-adjusted series from 1995 through 2010, and here's Mexico's real growth rate since 1999. The actual growth is more modest than the non-inflation-adjusted number, but still solid.)

OK, so the "average" Mexican is quite a bit richer than two decades ago. But is that the median, or the mean? Aren't all those gains being pocketed by the rich? Well, as it turns out, no. In 1998, Mexico's Gini coefficient was 53.1; in 2008, it was 51.7. Now that's a small change, but the fact that it's negative means that Mexico's poor and middle class have shared equally in that rapid growth. Of course, the number is still too high, and that tiny change is not a trend. But Mexico's rising tide is lifting all boats.

It's not hard to see what's driving the growth: Mexico's exports have exploded since NAFTA and more than doubled since 2003. Most of those exports go to the U.S., but Mexico is diversifying its markets to places like India. Nor are those exports things like fruit and oil and minerals; Mexico is a booming manufacturer of cars, electronics, aircraft, and appliances. In fact, Mexico exports more manufactured products than the rest of Latin America combined. Mexico - not China - is now the world's leading exporter of flat-screen TVs and fridge-freezers. Those are high-tech products, and those factory jobs are good jobs. Mexican engineering is powering the world...or this corner of it, anyway.

So what's the point of this post? "Yay Mexico"? Well sure, but actually it's a lot deeper than that. It's about two competing narratives of how countries become rich and happy.

For a long time, Mexico and other Latin American countries - and countries elsewhere in the Global South, like India - couldn't pull off the trick of getting rich. They tried import-substituting industrial policy...didn't work. They tried free trade and deregulation...didn't work. Some experimented with forms of quasi-socialism...didn't work. The lands of Europe and America and Japan, the former imperial powers, were rich and powerful and industrialized; the lands of the South were agrarian, resource-based, poor, and hideously unequal, and nothing seemed likely to change that.

I'm not sure, but I have to imagine that this repeated failure made a certain narrative of national development very seductive in Latin America. That narrative goes like this: Rich countries get rich by stealing their wealth. Imperial powers got rich because they seized the wealth of the lands they colonized. And they stay rich by continuing to exploit the resource wealth of the poor countries in the global South. Even within rich countries, the rich people get and maintain their wealth by forcibly extracting labor and land from the poor people. In other words, there is a lump of wealth in the world, and it goes to the people who have the power.

We've all heard that narrative at some point.

Now, I don't want to get too down on people who believe that narrative, because that really was the way the world worked for many thousands of years. Almost all economy was farming, logging, mining, fishing, etc. The only capital was land, and land was fixed. Grab the land, and you grab the wealth. A zero-sum game where kings ruled and slaves starved.

And in plenty of countries today, something similar is still true. In countries suffering from the "resource curse", most of the income comes from oil drilling, or mining, or farming, or logging - in other words, from land. The people who own the land get fabulously rich, and the poor people languish in poverty, with little to do but open little shops and stalls in the slums, or work the mega-farms of the land barons. The rich people buy the government, and use it to stifle any attempt at a change in the status quo. Meanwhile, the government doesn't invest in things like education and health, because its tax revenues come from land instead of human capital.

So the zero-sum narrative is not obviously wrong and dumb. But it's not the only narrative. And it is not the narrative of industrialization. And we know this because of...South Korea.

South Korea has never had its own empire. It was desperately poor, a tributary of China and Russia, then a colony of Japan. It has no natural resources to speak of. And yet, beginning in the late 20th century, South Korea began to get rich very rapidly. And it continued getting rich. And now it is rich. With those riches came not a rise but a fall in inequality, and of course huge improvements in health. The rising tide lifted all Korean boats. Nor has that country been blighted by pollution. In fact, South Korea is just an awesome place to live.

How did South Korea pull off that trick?

Well, no one knows exactly what worked and what didn't; all we see is the overall result. But in general, South Korea followed a blueprint outlined by America, Germany, and Japan. That blueprint is called, for lack of a better term, "manufacturing-export capitalism". We don't really know what countries can do to get rich, but the really successful ones all seem to do something that looks like "manufacturing-export capitalism". And it's basically what Mexico is doing right now.

What is "manufacturing-export capitalism"? Basically, it involves policies designed to get a country to export as much manufacturing output as possible. That means, first and foremost, capitalism, since private companies are good at exporting manufactured goods and state-owned companies are not. But it usually involves a huge raft of government policies to get the country into a position to do lots of manufacturing exporting. Those include education (because you need a literate workforce), public health (because you need a healthy workforce), infrastructure investment, urbanization (because you need the workers close to each other and to consumers), property rights (especially for farmers to sell their land and move to the cities), and rule of law. It also means giving the working class the feeling that they have a stake in the economy and society, that society cares about them and not just the rich people. That's really important, since strikes and labor strife can make a country a very unattractive hub for manufacturing.

"Manufacturing-export capitalism" also involves trade. Lots of trade. Not necessarily "free" trade, though. It's not clear why, but things like a cheap currency and various types of "financial repression" seem to really help. Export incentives, FDI incentives, and other types of industrial policy also seem useful, though probably less crucial than the cheap currency. "Free trade" agreements with rich countries (e.g. NAFTA) are essential for securing markets for a developing country's manufacturing exports.

Why does "manufacturing-export capitalism" work so well? No one really knows, but it looks like the model that works. Actually, economists do have a sort of theory of why it works - namely, Paul Krugman's "New Economic Geography". But it's a pretty simplified version of the real thing.

But in that theory, there's a catch - not all countries can industrialize at once. There's only a certain amount of manufacturing exports that the rich countries can absorb. So countries have to wait and develop one by one, which is unfortunate, and which is frustrating. Actually you can almost see this happening in East Asia - first Japan got rich, then Korea and Taiwan, now China, tomorrow maybe Vietnam. Yes, it's crappy to languish in the queue while the fast movers finish their economic miracles...but the good news is, the more rich countries there are, the more can industrialize at the same time.

So who gets to hop on the development train first? Education, health, urbanization, functioning government, and "inclusive institutions" definitely seem to all play a role, but proximity to a rich country seems to really help. Which is almost certainly why Mexico is the first of the Latin American countries to take off into full industrialization mode - if that is what is truly happening there.

Of course, "manufacturing-export capitalism" has eventual costs. When growth slows and the economy shifts toward services, the institutions that encouraged manufacturing exports are no longer relevant and often become parasitic and stifling (this is evident in Japan, for example). But by then, a country is rich.

So Mexico can win at the game of national development. It can do what South Korea did. And it may already be doing it.

Of course that leaves the question: Should Mexico get rich? The answer is "Of course yes!" Even if you don't think big houses and shiny cars are the true measure of human welfare, you should remember that rich countries have much better health than poor countries. They have much better natural environments than poor countries (though about half of that improvement comes from exporting polluting activities to poorer countries lower down the development chain). They have much less starvation and insecurity than poor countries. And they are happier.

(This doesn't mean I think that the Right has it right in Latin American countries. I know little about the situation, but anecdotes suggest that conservative forces are typically much more interested in preserving the corrupt, land-based economy in which they live like kings, than in kicking off real broad-based industrial development. Anecdotes also suggest that center-Left leaders, like those currently in power in Brazil, often seem to be the most open to modernization and development.)

(This also doesn't mean I think everything is great in Mexico. Far from it! Mexico has a bloody gang war, high inequality, an education system that needs lots of work, and still a lot of poverty. But I do think Mexico is on the right track in terms of economics.)

In any case, back to the master narrative: Real national wealth does not come from theft. It comes from reorganizing society into a more productive form. As South Korea did. As Japan did before that. As Mexico is hopefully doing right now. The nations of the Global South were late to the industrialization party, but I think they are finally here.

Don't believe false narratives. If you think the apocalypse is coming, chances are you're just going to get laughed at by a Mayan engineer on a plane.

(See? I gave it a schmaltzy Tom Friedman ending after all!)

What is an economic equilibrium?

I get asked about this one a lot. And it's also a source of controversy...on one hand you have some econ critics who say "Econ models wrongly assume that the economy is always in equilibrium," and on the other hand you have economists responding that "No, economics models are defined to always be in equilibrium." So I thought I'd try to clear things up...hopefully I don't just end up muddling them further. But anyway:

"Equilibrium" can mean many different things.

There are many different types of equilibria in economics. This may sound intellectually dishonest, but it's not;  the same is true in biology, physics, or any other science. "Equilibrium" just means "balance", and there are lots of different kind of things that can balance. In fact, any equation you write down that isn't true by definition can be interpreted as an "equilibrium" relationship, or "equilibrium condition" - the equation is simply a statement that whatever's on the left-hand side of the equation is balanced with whatever's on the right-hand side.

Different economic models have different kinds of equilibria, so it's not like there's one kind of "equilibrium" that is all-important to modern economics. But, as my macro teacher Rudi Bachmann drilled into me, it's good to always be specific about what kind of equilibrium your model actually models.

Example 1: Walrasian Equilibrium

Walrasian equilibrium, also called "competitive equilibrium" or sometimes "general equilibrium", is basically when prices adjust so that all markets clear. In other words, supply and demand are in equilibrium for all goods in the economy. Walrasian equilibrium also contains the subtler idea that people's plans are in equilibrium; my plan takes your plan into account, and your plan takes my plan into account, etc.

Example 2: Nash Equilibrium

A Nash equilibrium is when people's strategies are best responses to each other - in other words, when no one would choose to change their plans if everyone else's plans stayed fixed. Note that Walrasian equilibrium is a type of Nash equilibrium (since in a Walrasian equilibrium, neither suppliers and demanders would choose to change their plans), but there are many types of Nash equilibria that are non-Walrasian (for example, in an adverse selection model, where markets don't clear).

Example 3: Rational Expectations Equilibrium

A Rational Expectations Equilibrium (REE) is a kind of Walrasian equilibrium with uncertainty about the future. In addition to the condition that prices adjust to clear markets, a REE includes the condition that people's subjective beliefs about the probability of future events are equal to the actual probabilities of those future events. In other words, in REE, beliefs and probabilities are also in balance; this is in contrast to, say, models in which people learn about the probabilities as they go. A REE is a kind of Radner Equilibrium.

Example 4: Constrained General Equilibrium

What if prices can't adjust to clear markets? This could happen if, for example, there were menu costs or other kinds of costs to changing prices. (It could also happen if there were a magical fairy who decided when you could and couldn't change your prices. And it could also happen with search frictions.) In that case, markets might not clear, so you wouldn't have a Walrasian equilibrium. BUT, you'd still have people's plans being consistent with each other. In this case, you'd have the kind of equilibrium in a sticky-price New Keynesian macro model, in which labor markets don't always clear.

Note: I don't think "constrained general equilibrium" is the right name for this sort of equilibrium, but I don't actually know a general name for it.

Example 5: Steady States

In most dynamic models (for example, DSGE models), the economy tends toward some "steady state", in which either nothing in the economy is changing, or in which things are only changing at constant long-term trend rates. The economy may or may not ever get to the steady state. But regardless, a steady state is technically a kind of equilibrium as well.

So how can the economy be "in equilibrium" before it reaches the steady state, if the steady state is also a kind of equilibrium? Well, that brings me to this point:

There are different equilibria for different "terms" or "runs".

In a Ramsey growth model, the economy is always in Walrasian equilibrium, but not always in the steady state. Eventually, the economy reaches the steady state, at which point it is in (at least) two kinds of equilibrium. This demonstrates the principle that dynamic econ models - models that change in time - often have short-run and long-run equilibria. The difference is how fast the economy tends toward the equilibrium. And those speeds are basically assumptions of the model. For example, in the Ramsay model, prices and plans adjust very fast, but capital adjusts slowly. Thus, Walrasian equilibrium is assumed to hold at any given time, while the steady state equilibrium only holds sometime in the future.

In New Keynesian DSGE type models, there are even more levels. There is a "short run" equilibrium, in which prices can't adjust, but plans are in equilibrium. Then there's the "long run" equilibrium in which prices have had time to adjust and supply and demand are in equilibrium, but capital has not necessarily reached its steady state. And then there's the steady state, which is an even longer-run equilibrium.

And if you modeled the adjustment of plans, you'd have another level - a "very short run". So it's clear that the economy can be in short-run equilibrium at the same time it's in long-run disequilibrium. It all hinges on those assumptions about which things happen faster and which things happen slower.

Every equilibrium has a disequilibrium.

In economics at least, everything takes some amount of time. So for every equilibrium, there's some sufficiently short time horizon at which the economy may not be close to the equilibrium yet (depending on initial conditions). This is obvious once you realize the difference between short- and long-run equilibria. It's possible (in a New Keynesian model) for plans to be in equilibrium even while supply and demand are in disequilibrium.

This means that one model's equilibrium is always another model's disequilibrium dynamics. The question of "Should we model the disequilibrium dynamics?" is therefore not well-posed.

Stability matters, but at some level you just have to assume it.

As anyone remembers from first-year differential equations class (or before), some equilibria are stable and some are unstable. As my another of my teachers, the great Yusufcan Masatlioglu, famously said, stability means "I kick you, you come back."

Any model deals with a certain "term" or "run" of equilibria, and leaves the shorter-term stuff un-modeled. This is unavoidable (unless you think you can model economics based on the interactions of its constituent particles, in which case you are both wrong and a doofus). You have to just make an assumption about the stability of the stuff that happens quicker than the stuff in your model - you have to either assume it's stable or  assume it's unstable (in which case you are still assuming that the stochastic process that governs it is, on some level, stable).

As for the stuff that is in your model, you do need to check the stability of that stuff.

For example, suppose you're making a growth model. You decide to assume that demand and supply are in equilibrium; you justify this assumption because you think that growth happens on a much longer time-scale than price adjustment. If you do this, it will make your life a lot easier to assume that supply and demand don't suddenly, unpredictably go haywire, thus throwing off your model - in other words, it's convenient to assume that the supply-demand equilibrium is stable. (Alternatively, you could assume instability of the shorter-run equilibrium; in this case you would model excess demand as a stochastic process.) Then, you have to check whether your model yields a stable long-run equilibrium (in this case, a "balanced growth path").

But if you're making a model of how supply and demand work, you can't just assume stability; you have to show it. This will generally depend on the price adjustment mechanism; getting stable supply-demand relationships is possible, but not trivial.

(Side question: Do real economies have stable prices? Some do, for sure - for example, a continuous double auction. That's an empirical fact, not a theoretical one! But there are lots of very general, plausible theoretical cases in which supply-demand equilibria are unstable.)

Also, I haven't talked about uniqueness, but that's important for similar reasons. Also, in discussing "stability" I've ignored the different kinds of stability, such as cyclic stability, in which you cycle around and around an equilibrium without ever hitting it. But anyone who has worked with those kind of things can understand pretty intuitively how those would be important.

So what about the criticism that economists "assume the economy is always in equilibrium?"

This criticism sometimes has merit, but is usually not well-phrased. It's not well-phrased because economists inevitably have to assume that some type of shorter-run equilibrium always holds in their models. That's unavoidable. But the criticism sometimes has merit, because in some cases this assumption doesn't make a lot of sense.

For example, suppose we do a lot of work analyzing the way people form their beliefs and plans, and we find that it's possible for their beliefs to change very rapidly - in other words, it seems that equilibria of plans are not usually stable (maybe due to some quirk of how people learn). But suppose all our models of slower, longer-term things - price adjustment and supply-demand balance, capital adjustment and business cycles, etc. - assume that beliefs and plans form stable very-short-term equilibria. Well, our longer-term models are going to make some mistakes! Because they're going to ignore the effects of those sudden shifts in beliefs and plans. In this case, a better thing for the long-term modeler to do would be to assume that beliefs and plans can change randomly, and assume that they change according to some sort of stochastic process.

In conclusion: "Equilibrium" is not a single, unified, principle of economics.

It's just a term for "equations describing economic relationships that are not true by definition." Some equilibrium assumptions are right; some are wrong.

That doesn't mean that arguments about specific equilibrium assumptions are pointless - far from it! For example, in his famous 1976 "Lucas Critique" paper, Robert Lucas argues that we can just assume that price adjustment happens quickly and that supply-demand equilibria are stable:

On the theoretical level, one hears talk of a "disequilibrium dynamics" which will somehow make money illusion respectable while going beyond the sterility of dp/dt = k(p-p_e)...[but this] will fail...

But then along came Greg Mankiw, Mike Woodford, Guillermo Calvo, and others, and came up with sticky-price theory, which led to New Keynesian models, which are entirely based on the idea that prices don't adjust as smoothly as Lucas assumes. And those New Keynesian models ended up basically winning the battle of hearts and minds among a majority (though not an overwhelming majority) of macroeconomists, pushing out the RBC models that made the kind of equilibrium assumption that Lucas prefers.

In other words, sometimes modeling the disequilibrium dynamics of one kind of "equilibrium" is really important. But to make that model, you assume an "equilibrium" of another kind.