Friday, December 21, 2012

It's the money, stupid!

kw: book reviews, nonfiction, economics, economists, textbooks

It weighs about a kilogram and contains 104 chapters in 331 pages (plus apparatus): The Economics Book: Big Ideas Simply Explained, edited by Niall Kishtainy and written with six other contributors. It is a great reference book, if used with a few caveats in mind.

Firstly, it is best to read through once. Then keep it handy to browse as needed. The ideas presented are in historical order, beginning with Aristotle's promotion of private property and ending with Charles Goodheart's analysis of the boom and bust cycle as it is mirrored, and typically forecast, by the housing market. A key element of the apparatus is the Directory of persons, 2-3 column inches about 37 of the most important figures in historical and contemporary Economics. The "Key Thinker" behind each chapter is usually also limned in a mini-biography of 200-300 words.

Secondly, the ideas are presented with very little value judgment, though with some indication of their level of controversy. It took me a while to determine that many of them contradict one another. For example, many influential economic ideas have been based on the consumer or investor as a rational being, while more recent work in the psychology of economic decision-making makes it clear that nearly any pronouncement with the word "Efficient" in it is incorrect, and possibly disastrously wrong.

An example of this is the excessively random nature of stock market valuations. I say "excessive" because most economists define "random" to mean that the expected variations follow a "Normal" or "Gaussian" distribution. In The Black Swan, Nassim Taleb claims that these variations follow a Cauchy distribution, in which the probability of extreme events is much, much greater than you would expect from a Normal distribution. Thus, the 1929 crash, in which the entire market lost half its value in a single day. Based on the variation seen over the prior several decades, you would expect a 50% variation to have a probability of once per several million years, and a 25% variation—remember 1987?—to occur once in many thousands of years. But 1987-1929 is only 58 years.

My own analysis does not support a Cauchy distribution, but it does indicate a "fat tailed" distribution somewhat closer to Cauchy than Gauss. Based on realistic analysis, the 35% drop over a few weeks in 2009 (22 years after 1987) should have been no surprise. But it caught everybody who wasn't simply lucky. Investors expect Normal randomness, but can't deal with excessive randomness.

I like how the book is laid out. Most chapters, and many "in between" essays, are introduced with cool clip art. This item illustrates "The Last Worker Adds Less to Output Than the First," first analyzed by Anne-Robert-Jacques Turgot in 1767. This maxim applies to many assembly-line operations, but not, for example, to the work of teams. In extreme cases, if any team member is missing, the work cannot proceed at all.

Every chapter is introduced by a gray section outlining the progress of ideas surrounding the key idea by the key thinker. The layouts often include capsule flowcharts that illustrate how a concept was derived (You'll need to click on this image to be able to read any of it). And this example also shows a capsule biography of Léon Walras (1834-1910), who studied the stability of free markets.

The book is worth having around to review and compare and contrast the various ideas. Modern economic trends are quite different from those that held sway even in the recent past, but they owe a lot to who and what has gone before. Those who still believe Karl Marx was right about abolishing private property (even my toothbrush?) may number in the single digits (most of them named either Castro or Kim), but the sharpness of ideas that contradict Marx has been honed by reaction to his writings.

Economics is presented as a science. I would say, "Not yet." Certain scientific skills are used and various equations are created to explain economic activity at all levels. But that also goes for some really crackpot notions, such as that today we were supposed to get wiped out by an asteroid or volcano or something. Fortunately, economics is not crackpot (though some economists clearly were). At its root, it is the study of incentives and how humans react to them. This is most clearly brought out by Levitt and Dubner's Freakonomics books. The clearest message of those books and of this one is that we are individuals, and different people react differently to the same incentive. However, as long as we react independently (a huge assumption), certain average behaviors emerge. Modern economics is just beginning to get a handle on some of the ways we actually react, dependently and co-dependently and so forth.

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