Stumbling and Mumbling

Author: chris dillow   |   Latest post: Thu, 10 Jun 2021, 2:45 PM


On economic intuitions

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Recently on Twitter Will Bott asked: "a piece of string is wrapped tightly around the Earth. In order for the string to be lifted an extra metre in each direction, roughly how much longer would it need to be?"

Less than half of respondents got this right*, and 37% were wrong by a factor of 10,000. Which tells us that our intuitions can be not just wrong, but wrong by orders of magnitude.

This is not the only evidence here. Shane Frederick has devised a cognitive reflection test - three questions in which there is an intuitive but wrong answer and a non-intuitive but right answer. He has found that even at the US's top universities, less than half of students get all three questions right.

Which poses the question: if our intuitions can be so wrong, might people's intuitions about economics also be wrong with adverse impacts on policy-making?

Yes. The most obvious example is the idea that the government's finances are like a household's and so governments must "balance the books." You don't need me to tell you this is nonsense.

Another, albeit less egregious example, is immigration. Intuition tells us that an increased supply of workers bid down wages and so immigration must be bad for workers. The truth, however, isn't so simple because there are other mechanisms at work: migrant workers also add to demand; any incipient fall in wages raises demand for workers, or cuts prices or interest rates, and so on.

David Leiser and Zeev Kril show that laypeople interpret economics by using a "good-begets-good heuristic." Which might explain attitudes to Brexit; if you think Brexit is a good thing for whatever reason, you'll be inclined to think it good for the economy too.

Of course, all this is old hat. Back in 1850 Frederic Bastiat warned against relying upon our intuitions because the economic mechanisms which we see are only a few of those that actually operate. And more recently Bryan Caplan has argued that irrational voters systematically misunderstand economics:

Compared to the experts, laymen are much more skeptical of markets, especially international and labor markets, and much more pessimistic about the past, present, and future of the economy. When laymen see business conspiracies, economists see supply-and-demand. When laymen see ruinous competition from foreigners, economists see the wonder of comparative advantage.

But, but, but. The public's intuitions are not always wrong. Leiser and Kril say that one example of the good-begets-goo heuristic is that people think that a good thing such as falling unemployment is associated with another, such as lower inflation. That contradicts the Phillips curve. But it's not a catastrophic interpretation of the 2010s, when joblessness declined in the UK and US whilst inflation also stayed low.

Similarly, right-wing economists have for years objected to the public's intuitive support for minimum wages and rent controls on the Batiatian grounds that these have unseen adverse effects. We now know, though, that such effects are small. Arindrajit Dube summarized the evidence as pointing to "a muted effect of minimum wages on employment." And J.W. Mason says "there is no evidence that rent regulations reduce the overall supply of housing." (In both cases the reason is similar: the interventions offset monopoly or monopsony.)

Non-economists' intuitions aren't always terrible.

We've other evidence on this point. One is that yield curves are far better predictors of recessions than economists, who are essentially useless for this purpose. Rsasi

The other is my chart. It shows that the ratio of retail sales to the All-share index has been an excellent predictor of medium-term equity returns. When spending is high relative to the index equities subsequently do well, and when spending is low they do badly.

This is partly evidence that equities over-react: the ratio of prices to a simple time trend can also predict returns. But it's also because spending is partly forward-looking: we spend more if we expect good economic times - and these are times when equities do well.

Intuitions, when aggregated, can then be correct. Bond investors intuitions about future rates, and households' intuitions about their future incomes, tell us something about future economic conditions that economists cannot.

Hayek and Polanyi were, therefore, right - sometimes. Our knowledge of the economy doesn't consist only of conscious evidence-based propositions but also of hunches, gut feels and instincts - which are sometimes correct.

Which poses the question: when are intuitions right, and when wrong?

I'd suggest two criteria, which aren't necessarily 100% reliable.

One is: are people backing their belief with real money? Bond investments and household spending decisions involve hard money. Voters' opinion on fiscal austerity, by contrast, is not. And cheap opinions are more likely to be poor quality ones.

Another is: do the conditions for there to be wisdom of crowds actually hold? One of these is that opinions be uncorrelated. Except where there are strong peer effects, this is likely to be true of household spending decisions. But it is not true of attitudes to politically-charged questions such as austerity or Brexit, where the influence of the media (among other forces) generates correlated and incorrect opinion.

So, this is one area where we need triangulation. Sometimes, we should listen to laypeople's intuitions and ignore experts and sometimes we should do the opposite. Our problem is that existing institutions do a bad job in selecting for when listen and when not.

* The correct answer is around 6m. You don't need to know the circumference of the earth to work this out. You just need to know that the circumference is equal to 2πr.

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