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A Socio-Economic Letter 2 Issued November 11, 2005 I send out a trial letter a few weeks ago to determine whether I could re-ignite a dialogue with my colleagues about the need for a distinct paradigm for socio economics, distinct from neoclassical economics. I focused on the need for a new theory of saving. That letter may be found HERE. In Section I are the responses I received, my comments on them in the spirit of extending the dialogues, and observations about new subjects for the same basic give and take, about the need for a distinct paradigm.
Section I: Give and take Ned Phelps of Columbia University writes: Much of the problem, I guess, is that we can't easily test new models - or even the old ones. The marketplace tests new products by launching them - the experimental method - since the results are pretty informative most of the time (rarely is something a flop first, then discovered to a potential success later on).
James K. Gailbraith of the University of Texas writes: The view of saving as an active economic decision was already essentially defunct in 1919, when Keynes published The Economic Consequences of the Peace, whose first chapter described the vanished Victorian world in which "the duty of saving became nine-tenths of virtue and the growth of the cake the object of true religion." The war had by then already "disclosed the possibility of consumption to all and the vanity of abstinence to many." Keynes constructed the decisions to invest and to consume as the active elements in economic life, leaving savings, realized after the fact, as the residual consequence of the resulting level of incomes. If businesses invest, in other words, the growth of incomes will assure that realized savings will equal realized investment. This obviated the need for a theory of saving as such, or for the study of the "motivation to save." And here The Economist gets it wrong. Franco Modigliani's life-cycle hypothesis isn't a theory of saving. It's a theory of consumption, a modification of Keynes's consumption function to incorporate the influence of wealth on the consumption decision. When Modigliani's theory is fitted into the Keynesian income-determination framework, gross saving remains a residual governed by investment and income, not by the life-cycle hypothesis. The life-cycle hypothesis cannot be casually flipped into a theory of gross saving, without imposing the assumption that total income is fixed at the full employment level--an assumption Keynes would never accept and I don't think Modigliani was much interested in it either. Perhaps the key point here is that we need to focus on the active agents in charge of the most volatile decisions affecting aggregate expenditure. Since the consumption behavior of households is comparatively stable, the active elements of greatest interest are business investment decisions and government's discretionary policy actions, including public capital formation but also such matters as the decision to go to war. Your alternative theory needs to explain these phenomena, not the motivation to save. If investment and government capital formation are strong, the theory predicts that incomes will rise more rapidly than consumption, and the existence of bequests ceases to be any kind of a puzzle at all. You will have them, whether they are thought desirable or not, simply because financial assets will accumulate more rapidly than they can be disposed of. (It is the rapid growth of income -- and not cultural factors often invoked by people who know very little of Asian cultures -- that explains high realized saving rates of China, Korea, and historically of Japan in the postwar period.) Of course, our problem is that private business investment is not strong -- it is still suffering the hangover of the technology bust, and government capital formation is grossly under-funded, in part because of the dysfunction of our federal system. Here is where the problems are and where solutions must be sought. As for interest rates, the short-term rate is set by Alan Greenspan as the world knows, and the long-term rate by a combination of convention and liquidity preference. There is no reason to expect that the short-term rate will push the long-term rate up, unless markets become convinced that short term rates will remain high for a very long time. And the markets do not believe this, since they realize that the policy of raising short-term rates will be reversed once economic growth slows down -- something they fully expect will occur as the housing boom comes to an end. In general, Keynes's theories of these matters suit the facts far better than the neoclassical versions, and do not need to be revised constantly to keep up with the facts, as is the case for the neoclassical notions, as you point out. A great part of our problem is that Keynes's theories have been quite deliberately forgotten, so we now need to rediscover them in order to account for "puzzles" thrown up by failures of neoclassicism. But the supposed puzzles are rarely new; they or their close relatives led to the Keynesian revolution in the first place. AE: I grant that Keynesianism is one alterative theory to several key elements of neoclassical economics. I am less confident that it obviates the need for a theory of saving and a study of the motivations to do so. For at least this sociologist, there is no difference between deciding not to consume, and deciding to save. Investing is but one outlet for saved funds. Most people who save do not put the money under their mattresses. They invest their savings or the banks in which they deposit their saving invest for them. Right?
On the issues that you raise, several important perspectives are downplayed: 1) Expectations - "rational expectations” obliterates this concern but, as Keynes and his supporter Shackle argued, expectations affect consumer behavior. Stock market fluctuations are about expectations, as are consumer decision to buy at certain times of the year (e.g. after Christmas). What people feel about inflation and economic stability affect bond yields. 2) Aims - as you wrote, savings, hopes, dreams, and aspirations affect people's behavior. Economic calculations affect them but aims affect economic calculations as well. 3) Differentiation - American society is increasingly varied. People have different experiences, levels of living, aspirations and expectations. Summarizing them by using the median or other averaging measure (e.g., "total expenditures") obscures the great variations (e.g. in household composition) within the society. I am unsure how these three influences produce the stability of long-term bond rates. One influence: there are many different kinds of investors. Why doesn’t the U.S. exchange rate decline? My guess is that China and other exporting nations do not want more competitive U.S. exports. It is not only China that invests in U.S. bonds to reduce the amount of dollars floating on world monetary exchanges. The "savings glut" explanation seeks to avoid admitting that decisions are made, that market situations do not automatically and independently produce outcomes. What is the (theoretical?) ground that lies between automatic market explanations and political-deliberate action explanations? An interesting interview with Philip Mirowski, "A Revisionist's View of the History of American Thought," appears in Challenge Magazine, Sept/Oct 05. AE: Here is a good step in the socio-economic direction. Neoclassical economists do use expectations—as a random variable which they cannot explain in their terms. Thus if people purchase more—when prices rise (counter to econ 1), economists say people “must” expect that prices will rise some more. When people buy less, economists simply remove this claim. This does not help one bit. It is time to study what affects expectations other than prices (e.g. trust in government?) and formulate tests before the fact and not use expectations as a post hoc rationalization.
Professor Michael Lewis of Stony Brook University School of Social Welfare writes: Given the examples above, one might ask why I don’t just agree with Etzioni that we need a paradigm different from neoclassical economics. The reason is that I can also think of examples where neoclassical predictions are consistent with the available evidence. Two should suffice to make my point. Lundborg (2002), in a study on drug use among young people, found that children whose parents were willing to provide them with alcohol had a higher level of alcohol consumption than those whose parents did not do so. A sociologist looking at this finding might see this as a socialization effect that is, parents are simply socializing their children into the consumption of alcoholic beverages. Yet, being an economist, Lundborg views this finding as a possible price effect; that is, children whose parents provide them with alcohol, all else being equal, face a lower price of alcohol consumption than those whose parents don’t do so. Now the finding is obviously consistent with the sociological and economic view, and it isn’t clear how to go about deciding which view, if either, is the better one. Luckily my point doesn’t require me to decide this question because all I’m suggesting is that the consistency between the finding and the price effect view provides an illustration of a finding that supports neoclassical economics. This is because neoclassical economics predicts an inverse relationship between price and quantity demanded, which is precisely what was found. Early and Olsen (1998), in a study on rent control, found that rent control laws decreased the rental vacancy rate and increased the rental price of housing in the uncontrolled sector. This finding is consistent with the prediction of the effect of rent control on housing price and supply found in almost any contemporary neoclassical economics textbook. So, as suggested above, I don’t feel I’m ready to decide if we should get rid of neoclassical economics just yet. Let’s assume for the moment that I think we should get rid of what I’ll call the content of neoclassical economics, that is, its specific assumptions about human behavior, used to create mathematical models, and the specific derivations from these models. References AE: My concern is not to get rid of neoclassical economics, but to find a paradigm that can predict economic behavior, explain it, and nurture pro social values rather than undermine them. If and when this happens, the rest will take of itself. Moreover, I grant that sociology did not help much in the past. As one wit put it, for economists everything has a price, for sociologists—nothing. That is why we need a new sub-discipline, which will pay mind to prices, saving, productivity, trade, etc., but one that also includes social, cultural and political factors in its core theory to deal with these economic facts.
Professor Fred Foldvary of Santa Clara University writes:
My analysis is that there is no "savings glut." Savings do not just sit there. They either get loaned out or else is directly invested. The reason that folks save is very simple. They prefer to consume some of their wealth in the future rather than in the present, or prefer that those they give gifts to do so. Most people actually have the opposite desire. Most folks prefer to spend their income at the present day rather than in the future. They pay a premium to do this, which is interest. That is why there is a positive rate of interest. At a zero rate of interest, there is not enough savings relative to what folks want to borrow. Since current interest rates are positive world-wide, this implies that there is no savings glut. If there were a glut, the rate of interest would be zero.
Professor Sujit Sur of Concordia University in Montreal writes:
We could view it in terms of prospect theory (gain frame, loss frame), i.e people save when insecurity about the future is high, and spend more when insecurity levels are lower. It can fit on national, cultural, community, generational and situational levels... You also wrote: “In this same essay, The Economist reports that two other MAJOR neoclassical economic theorems recently bit the dust. One is the notion that as short-term interests and deficits rise, so will long-term interest rates. Recently U.S. short term rates have been increased eleven times with no effects on long term ones. Second is the idea that if a nation (like the U.S.) runs a huge and growing international trade deficit (imports much more than it exports), its currency will fall. Indeed, “a Federal Reserve study has found no historical evidence that a crash in the dollar causes a surge in bond yields, rebutting the views of many prominent economists who argue the nation risks a financial calamity by borrowing so heavily from foreigners.” (“Dollar-Crash Tie to Surge in Yields Rebutted by Fed” Joseph Rebello, The Wall Street Journal 8/11/05, p. C4) Actually, the dollar grew stronger. The fact that the US dollar IS the only viable international currency, and that most nations hold US bonds as their reserves might be the reason why the US dollar does not 'crash'. The foreign nations do not want the value of their reserves to be depleted, so they might buy more US bonds and thus the long term interest rates do not decline. Again, this possibility can be linked with 'loss frame' terms of prospect theory for the foreign nations. A way to assess this view would be to check if any other currency in the world “behaves” in the same contrary way as the US currency. AE: I am delighted to see this effort to develop elements for socio-economic theory. Insecurity is a psychological state which in turn is affected by the government (which sometimes promotes fear of terrorism), the culture (e.g. where one might test whether people who have strong communal ties feel more secure than others) and so on.
Mark Pingle, Professor of Economics, University Of Nevada, Reno writes:
Richard Marens of Sacramento State University writes: One point rarely mentioned in the “why Americans don’t save” discussion, is the effect of weak or non-existent growth of wages over the last generation. American life is structured so that people tend to have reasons to spend more, at least until they hit middle-age. However, “normal” (i.e. historical) growth in earnings has largely disappeared for most Americans, so the difference is made up from potential savings.
W. Allen Martin of the University of Texas at Tyler writes:
AE writes: Many thanks
Professor Roger A. McCain of Drexel University writes: There is no conflict between the life cycle hypothesis and "bequest motivations." Remember that the life-cycle model is deduced from a utilitarian model of decisions with results that emerge over time -- and utilitarian models may be wrong or right, but they are more flexible than you seem to give them credit for. Thus, the life-cycle model can incorporate bequest motives by simply adding an argument in the utility function, to represent a balancing of both the smoothing and bequest motives, and there is a large literature that does just this. The results are changed in magnitude not in direction, and the magnitudes are foggy enough anyway that adjustments are quite On the other side, one thing that is missing from the standard model-- not inconsistent with much of it either, but missing and ignored-- is liquidity constraint. That is: according to the Modigliani life-cycle theory, people in some stages of life would be expected to borrow deeply in order to smooth consumption, but they don’t have enough assets to pledge as collateral to do it and consequently face rising interest rates, credit rationing and lower levels of consumption than a pure life cycle model would indicate. This probably changes saving theory less than it changes e.g. the theory of the firm. Still, it is a wide problem in economic theory, and though it has been discovered a number of times -- Kalecki, Baumol, Sirkin and Stiglitz can be mentioned -- it always seems to be brushed aside and forgotten. I see this as a major obstacle to real-world applications of neoclassical theory, but one that is best remedied within the utilitarian framework of the economic theory itself. Barbara Bergman of the University of Maryland writes: Glad you are taking up the sword in the fight on conventional economics. I recently published a paper in the Annals of the American Academy of Political and Social Science. The anecdote with which I end shows the strength of the resistance to changing to a more empirical methodology: The study of the economy has not developed as have other sciences, in which direct observation and data collection by the scientists themselves play a large part. Most members of the economics profession study and create economic theory that is neither inspired nor validated by observation. There is little direct engagement by economists with people, businesses, banks, markets, little inquiry as to who does what and why, little observing at first hand of any actual economic functioning. There are exceptions: a relatively small segment of the profession is doing hands-on research on the way economic actors behave. However, they are only in the earliest stages of developing a body of knowledge that could inform economic policy-making. One indication of the poor state of development of economics is the well-known and much ridiculed lack of agreement among professional economists on policy with regard to such vital issues as unemployment, budget deficits, taxes, inflation, international trade, the promotion of growth, the government regulation of business. What is even more disturbing than the lack of agreement is the fact that political ideology quite obviously determines which side of any controversy about economic theory or economic policy any particular economist is likely to take. A small fraction of professional economists and psychologists have left off making up stories about how economic actors function, and started instead making direct observations of humans engaged in economic behavior. The experimentalists and behaviorists do little if any direct interacting with the people who manage businesses as they actually conduct their affairs. It is assumed that the students they pay to come to their laboratories are stand-ins for them, and that the students' behavior patterns will predict that of the managers, as well as that of buyers and sellers generally. Yet observations on managers' behavior as they play their roles in their actual businesses will surely be necessary to the construction of a realistic science describing the functioning of the economy. One might argue that economists would do best if they adopted the strategy of anthropologists, who go to live with the tribe they are studying and become participant-observers. The most intensive interaction with business people so far seems to have been carried out as a solo venture by Truman Bewley, who himself interviewed about 300 business managers, asking why they don't lower wages in a depression. The failure to do so, which may (or may not) be an important reason for the failure of unemployment to dissipate rapidly, has long been a subject of speculation among economists. Bewley's book lists no less than 25 published theories that economists had invented to explain the phenomenon, 24 of which were wrong. Bewley was the first who dared to go out and ask those making the decisions what they did and why. AE: It is great to hear from a former president of SASE and one who knows neoclassical economics inside and out. Thanks, Barbara.
Dr A.H.G.M. Spithoven of Utrecht University writes: The idea that people save for "precautionary reasons" does not suggest that in places where government welfare is generous and popularly used, people would save less than in places where it was less a part of the national culture. Firstly, several welfare states are characterized, among others things, by several institutions that make saving mandatory (for example about 10 percent of wages is put into pension funds in the Netherlands) or give an attractive fiscal incentive to save (for example, private pension premium tax deductions, mortgage tax deductions, tax free savings, relative low tax tariffs on income out of saving in comparison to wage income). Secondly, people born before World War II know what poverty is. The older generations are still burdened with the psychological legacy of the shortages endured during the many years before high productivity, adequate storage facilities practically banished scarcity of food and other material necessities. This experience might have affected their tendency to save, and the elderly might have educated their children that accumulation of wealth is a cushion for future. Thirdly, social security safety nets are not endless and moreover subject to changes. People raised in welfare states may distrust their government and take their own security measures by saving. Finally, saving might be partly explained because saving enlarges the individual's freedom of choice. With enough accumulated wealth people can theoretically allow themselves to abstain from their entitlement to social security benefits if they dislike the benefit conditions. AE: This is a fine hypothesis which socio-economists should test.
Maritsa V. Poros of the Illinois Institute of Technology writes: I read your letter with interest, especially regarding the third theory, which addresses the question of what motivates savings and other financial behaviors of immigrants or "ethnic communities." Two phenomena, which have been well researched in studies of migration and racial/ethnic groups come to mind: immigrant remittances to their home countries and rotating credit associations. Both, I suppose, are considered non-rational behavior by most economists. However, they serve as modes of financial exchange within kinship or community networks based on trust, and are especially useful when these groups perceive themselves to be, or, in fact, are constrained in their access to formal market institutions, such as banks. Far from simply altruistic, their development and functioning are rooted in networks of exchange that rely on trust, placing valued goods, resources, or activities into the hands of others. Studies of wealth inequality in the US and of immigrant economic behavior both show that people save in order to give to their kin or others, and often do so at varying points in the lifecycle, not just when they die. Immigrant remittances might be seen as an extreme form of this sort of exchange, where regular (often monthly) remittances sustain entire households, neighborhoods, or villages in the countries of origin of these migrants. Not to mention, the great extent to which remittances contribute to the GDP of nations, e.g. Mexico, Philippines. Immigrant economic behavior may see much more embedded in their kin and community relations or interpersonal social networks because they depend on them to lower the risks of migration, secure housing, jobs, future care when they are old, and elevate their status - especially in host societies where their citizenship or membership is precarious or contested. However, some wealthier immigrant and ethnic communities who have good access to formal institutions and membership in other societies engage in very risky economic behavior that keeps them far away from formal economic institutions, and which affects how and why they save, pass on inheritances, etc. Rather large literatures exist on these kinds of non-rational economic phenomena in migration studies.
Hugh Schwartz of the University of the Republic in Montevideo, Uruguay writes: Reinoud Bosch of European University Institute in Florence, Italy writes: I fully agree with Professor Etzioni’s argument that we need a different paradigm than that provided by neo-classical economics. But I do think it is important to avoid the replacement of one dogma by another. While it is clear that the neo-classical paradigm neglects the normative elements that are so rightly emphasized by Professor Etzioni, a paradigm solely stressing social norms neglects not only the (potential) importance of self-interested (though not often rational) behavior but also the entire spectrum of human motivations, emotions, and cognitive heuristics as studied by preeminent economic psychologists such as Daniel Kahneman and Vernon Smith. And the importance of other social factors - such as institutional structures or shared cultural elements - risks to become undervalued. Take the first example provided by Professor Etzioni. I think it one-sided to argue that ‘To help one another and one’s parents or children is not a matter of altruism, but of abiding by prevailing social norms’. In fact, I find it plausible that parents have many reasons to save beyond self-enhancement or prevailing social norms, including altruistic motivations, emotions such as love, caring, or liking, and cognitive heuristics such as reciprocity and limits to thinking abilities. In addition, the way the saving process is organized in different regions and cultures seems highly relevant to me. This is not to deny the possibility that differences in saving rates between ethnic communities in one particular region may largely be determined by social norms, but the example chosen by Professor Etzioni deals with absolute saving rates, not relative ones. This, then, brings up the question of how to deal with multi-causality. Here, I feel that academic economists have much to learn from their practising cousins. Few managers and marketeers believe or use the neo-classical paradigm, and several major US investment firms no longer even hire (mainstream) economists. The most applicable method to determine relevant psychological factors seems to me that of the ‘focus group’ as used in marketing. Thus, an answer to the question ‘why do people save?’ would require, first, a determination of the particular focus group under consideration (Hispanic-Americans, Japanese, Belgians?), followed by a multi-method technique (including, e.g., surveys, behavioral data, financial figures, etc., with a decent interpretation). This would ideally be combined with different structural and cultural analyses to provide an overall picture, from which a theory of saving could be deduced. This kind of multi-method technique is quite feasible; in fact, it is often used by major investment firms and banks in their practical assessments of investments. While the other examples provided by Professor Etzioni appear at this point in time more difficult to approach in this manner (largely due to the relative absence of good relevant psychological, sociological, and cultural studies regarding the specific issues), this does not mean they could not be studied using a similar multi-method technique. This would require some groundwork in the form of a systematic categorization of relevant psychological and social factors. AE: I could not agree more that a socio-economic paradigm needs to take into account both self-interest and other regarded behavior (and, commitments to the common good). In effect, this is a key thesis of my book The Moral Dimension: Towards a New Economics. Second, my experience also validates the observation that managers of corporations know better than to listen to neoclassical economists. The trouble is that when they search for other, more reliable economists, they cannot find any.
SASE member Jose Ripoll writes:
Section II: Upcoming Socio-Economic Events
“Constituting Globalization: Actors, Arenas and Outcomes” Click here to submit a paper—deadline is January 15, 2006 The Communitarian Network plans to run a workshop on socio-economics on the morning of June 30, before the start of the SASE meeting, at the same site. Section III: More topics for dialogue
Pay more for your health care—rationalize the system?
There is much evidence to show that this theory is, in fact, inaccurate. Princeton professor Uwe Reinhardt notes that the demand for health care is not unlimited. Very wealthy people who are well-insured do not check themselves into hospitals simply because it is free. The Rand Corporation performed a study in the late 1970s in which they randomly assigned families to health plans that had co-payments of zero, 25 percent, 50 percent, or 95 percent on medical fees up to $6,000. In general, the more people were asked to spend on their health care, the less care they actually used. However, because people often are unable to tell when treatment is needed, they cut back both on trivial and serious care. Especially poorer people who were in the high deductible category were not able to adequately control medical problems such as high blood pressure or diabetes, resulting in a higher likelihood of death. A patient who has a mole checked by a doctor could find it to be benign, making their appointment appear to be frivolous. Or, he or she could learn that the mole is cancerous and, by catching it early on, save the health-care system a lot of money on further treatment. Buying health care is unlike buying most products, which people can judge whether they taste fine to them, have too many calories, etc. The question for socio economists is not what is wrong with higher deductibles – but what policy would keep costs from growing as rapidly as they do, without grossly harming the patients? (For a recent popular treatment of this subject, which led to this note, see “The Moral-Hazard Myth: The bad idea behind our failed health-care system” by Malcolm Gladwell. The article was published in the August 29, 2005 issue of The New Yorker)
At first, it would seem that this is a prime example of neoclassical theory at its best. Higher prices cut demand, period. I cannot reiterate enough, no one should claim that prices have no effect. However, there is much work left for socio-economists. Why not keep raising these prices until only a handful of teenagers abuse alcohol and tobacco? Where is the line where it becomes socially acceptable to cheat, using other people to buy these products or fake ID cards? To smuggle items from lower-taxed states or overseas? Economists’ arguments that this depends on the level of “rent” do not work; social acceptance has tipping points. It is not as continuous a variable as rent would make one to believe. What political factors lead to higher taxes and penalties in some states versus others? Is using teenage patrols to verify cigarettes and booze are not sold to teenagers an acceptable public policy? To the extent the education can replace the need for punishment, it is not to be preferred? Does education lead to less cheating?
Makes sense, right? But why do brides want to make a fashion statement and grooms don’t? Socio-economists who can explain what forms preference are crucial in answering this question. (see Robert Frank “Students Discover Economics in Its Natural State,” The New York Times, Thursday, September 29, 2005
Love to hear from you! Sincerely,
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