Monday, 21 November 2016

Economists vs. The Public

As was demonstrated in the Trump-mania, there is a mismatch between "experts/establishment" and the "general public" in many places of world: Brexit and Trump are simply the most recent and evident examples. I am very much enjoying the show, the only sane way of dealing with politics, but does this mean I buy the entire anti-establishment, stagnant-wages, manufacturing-workers-in-Pennsylvania story?

Of course not.

My understanding is that there is very little truth to the Trump economic narrative; the onset of China (or NAFTA...) on the world market hasn't meaningfully changed the fate of American manufacturing. But politics isn't economics, and its sporadic relationship with truth means that false story tales and emotional appeal are more likely to win the political game than truth is.

An age-old way to see this is the mismatch between beliefs held by the vast majority of economists and the general public. Bryan Caplan illustrates this very well in his 2006 book The Myth of the Rational Voter:
Noneconomists and economists appear to systematically disagree on an array of topics. The SAEE ["Survey of Americans and Economists on the Economy"] shows that they do. Economists appear to base their beliefs on logic and evidence. The SAEE rules out the competing theories that economists primarily rationalize their self-interest or political ideology. Economists appear to know more about economics than the public. (p. 83)
Harvard Professor Greg Mankiw lists a couple of positions where the beliefs of economists and laymen diverge significantly. The list includes the usual culprits: rent control, tariffs, (agricultural) subsidies and minimum wages. The case I, Mankiw, Caplan and pretty much any economists would make is one of appeal to authority: if people who spent their lives studying something overwelmingly agree on the consequences of a certain policy within their area (tariffs, minimum wage, subsidies etc) and in stark opposition to people who at best read a few newspapers now and again, you may wanna go with the learned folk. Just sayin'. Caplan even humorously compared the 'appeal to authority' of other professions to economists.
In principle, experts could be mistaken instead of the public. But if mathematicians, logicians, or statisticians say the public is wrong, who would dream of “blaming the experts”? Economists get a lot less respect. (p. 53)
I wasn't gonna add more examples to these extensive lists, but rather illustrate a few areas where the basic terminology differs between economists and the public. This is by no means enough to explain the vast differences between economists and the average Joe, but it would help you next time you're talking to an economist.

1) Money and Wealth and Income

The average public confusingly uses all of these terms interchangeably. A rich person has 'money', and being rich is either a reference to income or to wealth, or sometimes both sometimes even in the same sentence. Economists, being specialists, should naturally have a more precise meaning attached to these words. For us Income refers to a flow of purchasing power over a certain period, whereas wealth is a stock of assets or "fixed" purchasing power; my monthly salary is income whereas the ownership of my house is wealth (the confusion here may be attributable to the fact that prices of wealth  shares, house prices etc  can and often do change over short periods of time, and that people who specialize in trading assets can create income for themselves). 

'Money', which to the average public means either wealth or income, is to the economist simply the metric we use, the medium of exchange, the physical object we pass forth and back in order to clear transactions. That little green or blue or pink-ish piece of paper we instantly think of as 'money'. To illustrate the difference; I have currently very little income (read none...?) and negative wealth, but still possess money with which I pay my rent and groceries. In the same way, Bill Gates with massive amounts of wealth (but perhaps not much income?) can lack 'money', simply meaning that he would need to stop by the ATM. 

2) Rationality

I recently discussed rationality where I pointed out that even most critics of mainstream economics gets this one wrong. To the general public, rationality simply means prudence, being smart or decisions made by reason as opposed to impulse or emotion. To economists, however, it means two things and two things only: a) that you have a rational preference ordering; and b) that when faced with a choice, you always choose the most preferred item; (a) obviously begs the question of what a rational preference ordering is, so we let Angner explain it again
A rational preference ordering is simple. Completeneness ensures that each person will have exactly one list, because completeness entails that each element can be compared to all other elements. Transitivity ensured that the list will be linear, because transitivity entails that the strict preference relation will never have cycles (p. 24; 26)
An easier way of explaining this is with the Axiom of Revealed Preference; by doing one thing, you are necessarily not doing another thing and we as observers can conclude that you preferred this first thing over the second at that given moment. This axiom has caused a lot of confusion inside and outside the economics discipline, ranging from serious disputes to laughable strawmen. One vital point here, that by no means is necessarily part of 'rationality', but nevertheless often assumed is what Rothbard (1956) pointed out in his attack on Samuelson:
The prime error here is the assumption that the preference scale remains constant over time. There is no reason whatever for making any such assumption. All we can say is that an action, at a specific point of time, reveals part of a man's preference scale at that time. There is no warrant for assuming that it remains constant from one point of time to another. (p. 6)
In the Misesian (=Austrian) tradition, rationality is much less strict, and simply means that an actor has an aim with his action, rather than mindlessly wanders around and randomly does things:
Human action is necessarily always rational. The term 'rational action' is therefore pleonastic and must be rejected as such. When applied to the ultimate ends of action, the terms rational and irrational are inappropriate and meaningless. The ultimate end of action is always the satisfaction of some desires of the acting man." (Mises, Human Action, p. 18/19, depending on edition).
The example of rationality shows how economists are engaged in much more specific disputes, and are much more accepting toward misuse of certain terms, than is the general public. For most aspects of life, however, a Misesian (though more logically accurate) definition of rationality is meaningless, and I'm almost tempted to side with the layman on this one.

3) Investment

This one, like 'money', is a lot more annoying to economists. The use of 'rationality' causes less anger in our hearts simply because of its disputed status, whereas misuse of money/wealth/income and Investment drives us nuts. Seriously. As recently as a few hours ago I was told that my yoga mat was an investment; I've had major disagreements with flatmates and friends over the investment or consumption status of cars, houses, clothes and probably a million other examples. Much like 'money', 'investment' to the general public seem to mean anything that gives you some form of benefit. Or it may more narrowly mean buying financial assets (stocks, shares, derivatives...). 

For economists, it means something much more specific. Investopedia brilliantly explains it:
An investment is an asset or item that is purchased with the hope that it will generate income or will appreciate in the future. In an economic sense, an investment is the purchase of goods that are not consumed today but are used in the future to create wealth.
The definition has two components; first, it generates an income (or is hoped to appreciate in value); secondly, it is not consumed today but used to create wealth. This definition clearly shows why my yoga mat isn't an investment; it is clearly a consumption goods that, although giving me lots of joy and benefits, generates zero income, won't appreciate and is gradually worn out. Almost as clearly, houses (bought to live in) aren't investments: they generate no income for the occupants (but lots of costs!) and deteriorates over time as they are consumed. The only confusing element here is the appreciation in value, which is an abnormal feature of the last say 30 years: the general trend in history has been that housing prices move with inflation, i.e. don't lose value other than through deterioration. In fact, this is what Adam Smith said about housing as an investment:
A dwelling-house, as such, contributed nothing to the revenue of its inhabitant; and though it is no doubt extremely useful to him, it is as his cloaths and household furniture are useful to him, which however make a part of his expence, and not his revenue. (AS, Wealth of Nations, II.1.12)
Cars are even worse, depreciating significantly the minute you leave the parking lot of the dealership. Where the Investopedia definition above comes up short is for business investments; when my local bakery purchases a new oven, it passes the first criteria (generates incomes, in terms of bread I can sell), but not the second, since it is generally consumed today.

Another tricky example is the standard political claim that we need to invest in our future, either meaning non-fossil fuel energy production or some form of publicly-funded education. It is much less clear that these are investments, since they seldom generate an income or return above its initial costs. Or maybe they do count as investments, but very bad ones.

In summary, economists think of investments as something yielding monetary returns in one way or another. Either directly like interest paid on bonds or deposits (or dividends on stocks) or like companies transforming inputs into revenue-generating output. It is, however, clear that most things the public refer to as investments (cars, yoga mat, clothes, beer, houses) are very far from economists' understanding.

Economists and the general public often don't see eye to eye. But improving the communication between the two should hopefully allow them to.

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