The Knowledge Problem in Firms

Micromanagement and many of the coordination and alignment problems within firms are actually manifestations of what Hayek characterized as the knowledge problem and was his major and most damning criticism of socialism. It's a limitation of planning and bureaucracy in general and applies to both profit and non-profit organizations. You could characterize Hayek's concept of firms as being 'little islands of socialism in a sea of markets.' The only saving grace for firms is that because bureaucracy and management don't scale so well in the long run the limits of irrationally are eventually tested by the external pressures of the price system which in a capitalist economy results in profit and loss, reorganizations, mergers, or bankruptcies. Creative destruction. Non-profits and government institutions have to rely on other kinds of institutional arrangements to work through these frictions. Better leadership and institutional arrangements can make things better but will ever only go so far solving the knowledge problem. 

Going to Bat for the Constitution

 In the Feb 4, 2013 EconTalk podcast Russ Roberts discusses the constitution with Louis Michael Seidman. Both agree on a really important observation about how we approach the constitution and originalism in practice in the United States:

"if you look at how the Supreme Court settles disputes about political morality in our country today, there's very little that ties that, or nothing that ties that to the Constitution. So, really, the important decisions, like the decision outlawing segregated schools or creating an abortion right or limiting affirmative action or protecting the rights of gay men and lesbians, those decisions have basically no grounding in the Constitution. They are some combination of the Justices' views of political morality, their views of our traditions, their interpretation of their own prior precedents; and if we are going to have a body act like that, I think we need to be honest with the American people and come clean and make clear that that's what it's doing."

That is a good point. Originalism in general is based on the idea that the constitution sets a floor or boundary around the powers of the government. Laws should be interpreted and applied under this view based on the the meaning of the text, as understood by the authors when discernible. Seidman argues in so many ways that this is moot, we aren't doing this now and never strictly did so from the very beginning, so why should we begin to do so today? Why should we pretend to hold ourselves to limits set by our founders some 250 years ago who would have known little about the world we live in today?

At risk of oversimplifying both an originalist view and Siedman's position I'll propose a fable. Suppose in a simple world a government writes a constitution and they only a few clauses. One clause relates to a single law. It states that they will have a speed limit set at 25 miles per hour. The second clause states that this law can be changed with a 4/5 majority of the legislative body or something like that. Now suppose over time it was largely ignored and was never really enforced, no fines no penalties etc.  People just drove at their own whim as fast or slow as they wanted. This seems to parallel loosely the world both Russ Roberts and Seidman agree exists today. 

Now suppose the day comes when a new regime starts a new initiative clocking speeders. A law enforcement officer tickets someone at 70 mph and they end up in court. The textual originalists might argue that according to our written law, this was a clear violation and the speeder should pay the fine. 

However, the legal advocates for the speeder argue that when that law was written few people owned automobiles and most cars were not capable of such excessive speeds on a normal basis especially given the state of the roads at the time. Their argument is that the case should be dismissed based on the view that laws should be interpreted with a more expansive, dynamic, evolving perspective and interpreted in light of changing social and political circumstances. The originalists push back in their opinion, recognizing that society has changed, and maybe 25 mph is no longer a reasonable standard, but it is the role of policy makers, not the court to update this law through the appropriate governing channels (the 2nd clause in our fictional constitution). 

Suppose the defendant wins and in its ruling the court states that speeds up to 70 mph are okay. The government could then post new signs with new speed limits. Citizens and law enforcement can be confident about the laws new meaning and the penalties involved.

Suppose the prosecution wins, and maintains the 25 mph speed limit. After much debate and pressure from voters policy makers go through the channels necessary to vote to change the law so that the new speed limit is 70 mph. 

One might argue, what's the difference if we get the same result? Critics of originalism might argue that its much more pragmatic and expedient to change outdated laws through the court system, because going through the necessary channels may be too time consuming and intensive. Going through the proper channels creates a sluggish and nonreactive government artificially constrained by ideals that may be outdated and irrelevant to current circumstances. 

But this oversimplified fable illustrates perfectly that focusing on the policy outcome completely misses  a much more important question. The most important question is not about policy, or about how time consuming or difficult it is to make policy. Or how much society has or has not changed. And while it is absolutely important to think about the incentives created by decisions and the consequences, there is still a more important question. The most important question is about who makes these decisions. Who is in the better position to recognize that society has changed and we need new laws? Is it the role of unelected judges to make these decisions? Do we send our judges to the bench to go to bat for the policies we like and pitch against the policies we find appalling? Do we really want to leave such important decisions up to an elite bench of unelected jurors that will always have a much more limited pool of knowledge and preferences than the population at large? Or do we send judges to the bench to go to bat for the constitution? 

In Judicial Activism Reconsidered, Economist Thomas Sowell describes our Constitution this way:

“The federal Constitution is "the supreme law of the land," not because it is more moral than state constitutions or state or federal legislative enactments, but because it represents a larger and more enduring majority.Minorities receive their constitutional rights from that enduring majority to which transient majorities bow, not from whatever abstract moral rights are imagined to exist as a brooding omnipresence in the sky.”

Letting judges decide policy represents a transfer of power away from the people. It is undeniably undemocratic. It may certainly seem more expedient to bring about change through the courts but this does not come without serous tradeoffs. Once we start making heroic interpretations of the meanings of words in the constitution it is weakened, and minorities are forced to give up their liberties to whatever transient majority takes power (either in the legislature or as appointed to the court). The short term gain from being able to bypass the amendment process (and shunning consent of the governed) in order to pass some much needed legislation to help some worthy cause comes at a long term cost to our liberty and national well being. This increases the incentives and opens the door for large corporations and special interests to influence our lawmakers, and provides the means for ever more concentration of power and the entrenchment of social classes. While the incentives created by an individual decision are important, we must think more globally about the incentives created when the courts are governed by a philosophy that favors policy making. Elections and politics become more divisive as more and more social norms are being set  by policy at the federal level by both 'conservatives' and 'progressives.' As Pierre Lemieux states in his article The Public Choice Revolution:

“The entire federal budget,” writes Mueller, “can be viewed as a gigantic rent up for grabs for those who can exert the most political muscle.”

Letting judges 'decide' also makes supreme court nominations the circus they have become. Hearings become opportunities to score political points as each party sends their nominees to bat for the policies most aligned with their base. Letting judges decide based on the whims of an ever changing political climate can further lead to bad precedent challenging the doctrine of stare decisis when questions of constitutionality would require overturning previous decisions.

Reforming the Way We View the Courts

We may hear a lot about judicial reform but just as important is reforming the way the public actually views the courts. One of the greatest mistakes by the left and the right is attempting to set social norms at the national level instead of local levels of government where consent is more easily ascertained. The constitution represents the social compact that we as a society agree to live by until it is changed. Until we are able to give it proper deference with regard to policy and our view of the role of the courts, we will not be able to achieve any meaningful reform and the courts as well as the judicial nomination process itself will remain in chaos subject to the changing whims of political climate.

Viewing the constitution as a 'living' document makes supreme court nominations and elections much more contentious and contributes to the increasingly divisive climate we have seen in society over the years. When circumstances arise, we can always escalate policy decisions to the federal level via the amendment process. This allows ultimate flexibility and breathes new life into the constitution. In this sense, it can be viewed as a living document. 

Perhaps there is an argument to be made about having justices on the benches with a diversity of philosophies. Doug Linder makes the point that a court without dissenters is a Court that will not adequately inform us of the costs of and consequences of different rulings. This would certainly be an argument against extreme measures like court packing. If there is an argument for expanding the number of seats on the court, then we should do it in a way that in a worst case achieves some sort of balance of judicial philosophies and possibly a larger pool of justices that rotate on and off the bench in a way to maintain balance.

Finally, we should stop referring to justices as either 'conservative' or 'liberal.' While used in their proper context these terms are meant to refer to an originalist or non-originalist judicial philosophy. But more commonly they give the impression that a justice will decide cases based on the political philosophy closely related to that of the president that may have nominated her. Continuing to refer to justices as 'conservative' or 'liberal' perpetuates the misunderstanding that judges are in a position to make policy decisions and not interpret statute or apply the constitution.

References:

Regulation, vol. 27, no. 3, The Public Choice Revolution. Pierre Lemieux.

Judicial Activism Reconsidered. Thomas Sowell. 1989

Economics, Evidence, and High Causal Density

How do we form our beliefs about the solutions to societies most complex problems? Do we trust data? Theory? Both? What does it mean to base policy on science and evidence?

According to Manski:

"Social scientists and policymakers alike seem driven to draw sharp conclusions, even when these can be generated only by imposing much stronger assumptions than can be defended. We need to develop a greater tolerance for ambiguity. We must face up to the fact that we cannot answer all of the questions that we ask."

I think Russ Roberts puts it well in his EconTalk Episode with Noah Smith:

"Can you think of a study that was so decisively performed in terms of the crossing of t's and dotting of i's that the identification and all the econometric challenges were met with such impressiveness that people on the other side of the debate had to throw up their hands and say, 'Well, I guess I was wrong. I've got to change my view.' Because I can't think of one. I can't think of one. And if that's true, then I would suggest that economics has some serious problems in claiming it's a science."

When it comes to evidence there are lots of challenges. For the most part, in economics and the social sciences it's often impossible to implement randomized controlled trials to identify treatment effects related to policy changes. For the most part we have to leverage observational data using quasi-experimental designs. The challenge for both approaches as Jim Manzi discusses in his book ''Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society'  is the issue of 'high causal density.'

In an environment of high causal density "the number of causes of variation in outcomes is enormous, and each has significant potential effects compared with those of the potential cause of interest. We don't know enough to list each of them and hold them constant, but if we randomly assign patients to the test and control groups, then these hidden conditionals won't confound our estimate of treatment causality."

Unfortunately in the social sciences, causal pathways are extremely complex. There are always hidden conditionals we may not be able to measure or don't have sufficient knowledge to even consider. Given that hidden conditionals are always present, a well entrenched proponent of a given policy can always find a reason to explain why it has failed to prove itself out in the face of evidence.

But Jim does more than offer criticisms of theory and methods. He introduces the concept of 'Liberty as Means.'  Embracing the concepts of evolutionary economics, he promotes a flexible system of government that sounds a lot like federalism. As he discusses, the mistake we often see from both the right and the left is enforcement of social norms at the national level vs. fostering numerous experiments at the local level.

While economic theory and applied econometrics are useful and powerful tools for policy analysis,  these tools will not necessarily help provide clear cut  always defensible evidence to improve public policy. These methods will never discover a 'Polio vaccine' for policy. It is in fact their shortcomings that provide the strongest argument for our constitutional republic and federalism that our founders envisioned.

Reference: Uncontrolled: The Surprising Payoff of Trial-and-Error for Business, Politics, and Society, by Jim Manzi https://www.amazon.com/Uncontrolled-Surprising-Trial---Error-Business/dp/046502324X/ 

See also: EconTalk: Manzi on Knowledge, Policy, and Uncontrolled

*this is cross posted at: https://ageconomist.blogspot.com/2019/01/economics-evidence-and-high-causal.html?m=0 

Trade, Jobs, and Political and Economic Disruption

 Two podcasts I listen to often include EconTalk with Russ Roberts, and Masters in Business, with Barry Ritholtz. No one could have called the election based on these episodes, and none of the guests  made any projections about it specifically, but each of the these guests below discuss issues that could have been informative about what's been going on in the minds of the electorate. And why non-conventional candidates like Bernie Sanders and Donald Trump had so much appeal. They also question conventional wisdom about the distributional effects of comparative advantage and free trade.

In a past podcast, just over a year ago, Gary Shilling offers some interesting thoughts on trade:(paraphrasing not quoting).

Basically globalization has led to income polarization, with 8 years of zero to no real income growth for a segment of the population and this frustration has been expressed politically through Bernie Sanders and Donald Trump. With regard to Trump, when you strip away the blustering, he may actually be more like an old school centrist politician. When you take the impacts of globalization, the recession, and the slow recovery, conventional politicians don't know how to react. 

I think this is the kind of environment in which it was possible for the 'blue wall' on the electoral map to crumble.

More recently, Aswath Damodaran touches on this: (again paraphrasing)

Brexit should be a warning sign that we've lost perspective. In the aggregate, trade and globalization can be good for the country, but the 55 year old steel worker in Pennsylvania gets little consolation out of the fact that free trade is going to create more world wealth when he says where the heck am I going to get my paycheck next month. 

"We are paying a price for almost deliberate blindness in the financial capitals of the world to the kind of costs that are being created sometimes."

Again this echoes Shilling above. In his paper, "The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade", David Autor takes a very detailed look at these issues and investigates them empirically. David was guest this past year on EconTalk with Russ Roberts. Some highlights:

• one of the standard arguments for free trade and globalization is that it makes the pie bigger, and sometimes the story sounds like some people get larger slices than others, but everyone gets a bigger slice, so on the net everyone is better off. 
• Another way of thinking about this is that trade increases aggregate wealth, and this increase more than offsets the losses for those that are displaced in the labor force.
• Autor points out that yes, gains can offset losses, but the gains are going to different people
• Example: sure consumers gain by saving 5 cents on the broom they buy at Wal-Mart, and if you add up all of those nickels its more than the total losses for people whose lives are ruined.
• But this is little consolation to those whose lives are ruined, it takes years to find alternative opportunities and often at a fraction of the salary they earned before
• In the past, maybe these distributional effects were of less concern because trade largely reflected differences in comparative advantage across different types of manufacturing- for example maybe we would lose jobs manufacturing electronics but make up for it with other jobs building tractors-And balanced trade resulted
• In the past, skillsets were much more congruent across different industries with changing comparative advantages- i.e. it was not extremely difficult to move from manufacturing one good to another if your former job was displaced by trade
• More recently, with globalization, things changed. Instead of reallocating across sectors of manufacturing, countries like China just supplanted manufacturing on a much larger scale. And instead of paying for imports with different exports for which we had a comparative advantage we ran trade deficits (of course with surpluses in capital accounts)
• However, the kinds of investments being made with the new wealth created by global trade are in areas and sectors where skills are not congruent for many workers supplanted by the trade outcomes
• Ultimately we have experienced a sharp decline in demand for labor that has been contractionary

Hence this is the 'stagnation' in real wage growth that so many have been talking about. Could it also be why conventional stimulus and monetary policy has not really moved the needle in terms of economic growth? Is this because our comparative advantage is in services, technology, marketing, research, and engineering and these sectors are not soaking up the excess labor freed up when manufacturers shut down or relocate overseas?

The conventional wisdom has always been with trade, labor and resources that were once tied up in lower valued uses are reallocated to higher valued uses creating more wealth making everyone better off. But Autor is arguing that this just isn't happening or is taking too long. Maybe its the next generation or two that reaps the rewards. But not necessarily. If you've got a good gig and lose it, you may end up living in an area with bad schools, or may not have the resources to provide your children or the next generation with the education and training required to take advantage of the new economy jobs where the gains more than offset the losses from globalization. 

This also makes me wonder...supply side policies designed to promote economic growth and  aggregate wealth (under the terrible misnomer 'trickle down economics' ) might not work quite as well as they used to either given the structural environment depicted by Autor in his paper. But that probably goes the same for fiscal stimulus related to infrastructure. It might boost those sectors related to construction, but the traditional multiplier working its way through manufacturing and labor demand just likely won't work the way the Keynesians believed it would 30 years ago. 

So what is the answer? Surely a world with trade is in aggregate better than one without. Does this mean renegotiating NAFTA? Should we put the brakes on future globalization and phase in tariffs and trade restrictions and slowly fade them out so that sectors can readjust over a few generations? (things Donald Trump may seem in favor of) Or more aggressive and progressive policies called for  to provide a soft landing for those future displaced?  Some combination?  This gets to more spending on a number of programs, healthcare, and education. (things Hillary Clinton would have supported)

I'm not sure what the answer is after considering the incentive effects and the impacts for long term economic growth and development. Not to mention government spending. However, it was the lack of policy response to these questions that made this past election what it was. 

References:

"The China Shock: Learning from Labor Market Adjustment to Large Changes in Trade," by David H. Autor, David Dorn, and Gordon H. Hanson. National Bureau of Economic Research Working Paper, January 2016.

Effects of the Minimum Wage on Employment Dynamics

Jonathan Meer, Jeremy West

NBER Working Paper No. 19262

Issued in August 2013

NBER Program(s):   LS   PE 

The voluminous literature on minimum wages offers little consensus on the extent to which a wage floor impacts employment. For both theoretical and econometric reasons, we argue that the effect of the minimum wage should be more apparent in new employment growth than in employment levels. In addition, we conduct a simulation showing that the common practice of including state-specific time trends will attenuate the measured effects of the minimum wage on employment if the true effect is in fact on the rate of job growth. Using a long state-year panel on the population of private-sector employers in the United States, we find that the minimum wage reduces net job growth, primarily through its effect on job creation by expanding establishments.

http://www.nber.org/papers/w19262

Sent from my iPad

An Estimate of the Impact of Regime Uncertainty on Current Unemployment

From:

http://economicsone.com/2013/07/31/policy-uncertainty-makes-firms-reluctant-to-hire-new-evidence/

  "In their paperUncertainty and the Slow Labor Market Recovery, they present "evidence that heightened uncertainty about economic policy during the recovery made businesses more reluctant to hire workers."

The Causes and Consequences of Antitrust: The Public-Choice Perspective:Amazon:Books

http://www.amazon.com/gp/aw/d/0226556352/ref=redir_mdp_mobile/175-7554683-8132925?keywords=mcchesney%20shughart&qid=1373541581&ref_=sr_1_1&s=books&sr=1-1

"The public-choice approach denies the assumption that government employees act in single-minded pursuit of the public interest, defined as allocative [Pareto] optimality. That belief lacks any theoretical or empirical basis. Oddly enough, many who support a shift in regulation from market to government processes because the market fails to provide the "right" incentives simultaneously disregard the possibility that government institutions also fail to provide the "right" incentives."