Public choice

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So a long side discussion I had with Scott after class wound up being interesting enough to merit posting. Only tangentially related to econ so you can stop reading if that your only concern.

The question posed was how I could possibly believe that governments could be efficient economic actors. The assumptions went like this. There are outcomes in the world that are inefficient from a perspective of maximizing utility. There is also theoretical government action that could make those markets more efficient. From there we have two problems with government actually implementing a more efficient policy, (I’m also assuming that government action is legitimate, ie it can tax and spend for public welfare w/o causing moral harms) first, that government agents have a knowledge problems and secondly that they have an incentive problem.

The issue of knowledge problems is divided into two parts. First is the concept that government agents aren’t able to frame legislation because they lack the capacity to conceptualize the complex workings of the economy and that the only agents that have a vested interest in displaying potential legislation are special interests, ex only a tobacco company has (enough) interest in helping craft tobacco legislation. I find this reasoning inconclusive. On a wide variety of issues, not the least of which would be monetary policy, you find numerous interest groups pushing a variety of policy prescriptions more or less for (their own perception of) the public good. Assuming that any of these agents are right, it does not seem too farfetched for me to assume that government is capable of picking between policy alternatives.  The second and thornier knowledge problem is that government and indeed any actor can only guess at the utility curves of other individuals and thus any action by government is not maximally efficient compared to people seeking their own remedies. My first response to this is dogma. I think that most goals government pursues, ex. increased education, health care, support for the elderly, infirm, or disabled are inherently good goals and that most people believe these are good goals. My second response is that, given that dogma, government reduces transaction/coordination costs among actors. Keep in mind that for things that I think government should be involved in there’s an inherent difference between alot and a little. For instance giving 50% of my income to know that there are no children starving in America is me buying a totally different good then if I were to spend the half of my income supporting some number of starving children. In short the first knowledge problem is in practice surmounted and the second is an article of faith that certain goals are inherently worthwhile.

The second issue is that of incentives. The argument goes that politicians first and foremost goal is to win reelection, secondary to ideology because if they allow themselves to act as an ideologue in scenarios where it is toxic to their political career they find themselves unable to implement their ideology. Related to their goal of winning elections they have the goals of fund raising and mobilizing the base. Thus come the pernicious scenario that advocates of smaller government fear. There is a bill on the table. The bill started as an attempt to provide free lunch to all school age children. Lunch for all kids is commonly believe by society at large to be socially efficient. But there’s a problem. Me and you and other individual constituents gain a little bit if the bill passes. But if the bill were to include language that says, for example, that each lunch must have 2 servings of dairy, then a certain group might benefit disproportionally from writing the bill in such a way. And in order to insure it was so written they might be willing to make a large donation to a certain politicians campaign coffers. Now the extra dairy probably won’t be very helpful to the children but it probably won’t do anything to harm them. So the politician writing/voting on the bill goes ahead with it and gets the campaign contribution.

The above scenario is bad. Its not what I want. But I don’t think of it as a crippling indictment of government. Say there are  types of legislation:Perfect, Imperfect and None. Perfect legislation is that maximally efficient solution that we assumed exists, that government enacts and everyone is happy. I don’t think this actually occurs but its nice to think about. Imperfect legislation is the legislation that we actually get. Its warped by the differing incentives politicians face as individuals versus the preference their constituents feel as a whole as well as knowledge issues in properly accounting how people want things to be. Finally we have no legislation which is the status quo. Most people believe that perfect legislation is better then the status quo, the question is whether the imperfect legislation we actually get is better then none.

One fact that I think is important to remember about imperfect legislation is that the options available to the politician are filtered through what the people want. The politician (or rather the lobbyist) can only exploit the delta between how much people care about an issue and how much the lobby cares about the issue, filling the gap in public perception with money.  If I’m providing meals to children, which the public wants, I can write in a boon to the milk industry because the public doesn’t care about it and the fraction that does the politician can replace with those they sway with increased campaign advertising due to the donation. On the other hand the tobacco lobby can’t convince me to write a rider including a cigarette with every meal because they can’t  pay me enough to bribe the public to better my goal of being reelected. I would also like to add that I don’t think, by and large, that political agents are solely moved by Machiavellian self interest. They, to a greater or lesser degree, internalize the values and wants of their constituents and society at large.

So given these 2 problems in crafting public policy, in order to believe that public policy can in fact be good, I have to believe a number of things. To solve the knowledge problem I have to believe that there are sufficient relevant institutions, organizations or individuals that are willing to propose policy solutions, in additions to the governments own bureaucrats. Once I assume the knowledge or solution exists I have to justify for why a politician would pick the “ideal” or societal beneficial solution, solving the principal agent problem. To do this I have to believe that the public cares about benefiting society, for its own sake, and the politician does likewise. This is obviously not perfectly true but the closer it is to absolute truth, the closer the proposed policy will come towards being ideal.

I don’t have any problem believing those claims. It might be that I’m wrong and as I became older and bitter about the human condition I’ll drift towards libertarianism because it minimizes harms. But I think its important to note that the question of government interaction in markets and the degree to which its efficient is an entirely empirical one.  If we’re operating from a utilitarian standpoint then I can see reasonable people disagreeing about the level government intervention, mishaps the level of corruption and indifference to politics is higher then I want to think it is. But if that’s the sphere from which we’re starting then it seems ludicrous to hold it as an inherent tenant that government intervention is always and everywhere evil. At some level of public involvement, at some level of people trying to better the world, there has to be a point at which the benefits from government intervention outweigh the costs. Libertarians might think that point is never reached in real world situations. If they happen to be right, I still refuse to believe them.

Rational expections

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To the best of my understanding rational expectations assumes that people use the best information available to them to make their decisions. A key features of this is that people in this mode will also “rationally” realize the limits of their expertise and when the cost of acquiring more knowledge exceeds the benefits they will instead rely on experts in the field or vague heuristics for decision making. The model assumes that people are generally really good at making this decision making (both when they make professional prognostications based on expertise and when they rely on the expertise of others) with all errors being random.

I have two problems with accepting this. First their seems to be an assumption that the random nature and distribution of errors (presumably following a normal distribution) means that all errors will cancel out. I don’t think most markets work this way. Say the price of lunch at the local store varies day by day in response to local conditions. I’m worried about buying cookies if I have extra money so I want to minimize the amount of money I bring. If I guess right, all is well. But if I guess wrong and bring too little or too much money, my whole afternoon is ruined. Random errors don’t cancel each other out, rather the degree of deviation from the correct answer diminishes my overall utility.

This critique is of course begging the question of whether we can really predict very well at all, even given some kind of error term. In simple scenarios I can see we could be fairly decent at this. I buy myself lunch, I know that lunch was worth it, you buy me a present and reason using your expert knowledge of me that I’ll like it. But if we look at more complicated financial devices we soon are faced with a lot more hidden information. I buy a stock. The value of the stock is, in general, based off what someone else is willing to pay for it.  Now the stock might be for a plumbing company. As I am a master of all things related to plumbing I can look at the company and figure, based on the secret plumbing techniques that I know, about how much the plumbing company should be able to earn and thus how much I can expect it to be worth in the future. But most people are not me. They don’t have the secret knowledge of all thing related to plumbing graven deeply into their hearts. So when they try and discern the worth of the plumbing stock the only thing they can look to is the past prices and people past willingness to pay. But there’s a problem. My informed decision has a measure of error in it. I might be over valuing it or undervaluing it but surely I have not perfectly priced it. So when the uninitiated looks for the value of a plumbing company and makes his judgment as to its worth he’s going to be wrong, because the information he was basing his decision on was wrong, and then he’s going to be wrong again, because everyone has some small amount of error in their judgments.

Now this won’t always lead to tragedy.  The concept I dismissed in my first example, where random variations and errors cancel each other out, could indeed fix problems a fair percentage of the times. But as long as a large percentage of the market is making their own decisions on market actions, solely on the perceptions of others, you have a system that is in fact not rational because errors within the system will systematically become larger, like waves. I buy many shares of the plumbing company do to my plumber-iness. Sometimes this will reflect a true new discovery of real value. But often I will merely be mistaken. Nevertheless outsiders won’t know I’m mistaken. They’ll see an uptick in the price of stocks and, as their only way of knowing the worth of something is assuming that “the market” will set the prices at the appropriate level,  buy more stock. This causes a further uptick in the stock, and so on and so forth. As long as other peoples perceptions, invariably flawed, are included with the model, error terms will occasionally multiply, making the market, made up of rational individuals, occasionally act in an irrational manner.

I’m curious how close the explanation of booms and bust fits, both with established econ explanations and with the data we have on booms and bust. Suffice to say that it defies rational expectations, that a theory called rational expectations, would seem to posit that we behave in ways that don’t coordinate towards maximum efficiency. As always interested in logical flaws in my argument.

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