Wednesday, February 15, 2006

Facts and Theories

At its most basic, good economics is about two things: good theory and good data. Some will say it's more about the data and some will emphasize the theory but a good economist combines both into a coherent explanation about the world around us. If your theory can't be supported by the data, you better rethink your theory. Yet if your data says one thing but you can't construct an explanation that's consistent with accepted truths, there's something probably wrong with your data.

That reality came to head Friday night when an AU student and I got into a discussion about income data. He pointed to the old claims that the rich are getting richer and the poor are getting poorer. Remembering an IHS seminiar Steve Horwitz spoke at a few years ago, I pointed to data that said the poor were getting richer, too.

He responded that the data--which tracks a family's income over time--is flawed because poor people move more than other people, so you don't count them and there's a sampling bias. He, who has been studying income data for ten years, noted stasticians have come up with a weight to adjust for this and when applied, the poor are getting poorer. (Note that according to the data 95% of the lowest quintile move up from it at least one quintile, suggesting that must have been one hell of a weight to make such a drastic change. Perhaps poor people are literal nomads...)

I've never heard of this weight, so I let it go and gave him the benefit of the doubt. "So what's your explanation, then?" I asked. His theory was quite....elaborate.

He noted that the rich are more likely to save than the poor. Seems reasonable. So, he said, the rich put their money in a bank and live off the interest and the wealth stays at the top. I insisted we follow the money beyond that. So we agreed that the bank could then take all of that money and lend it to a corporation which then could give it all to their highest paid inwhich the whole cycle could start over again.

Now to fully grasp this AU student's theory, replace every "could" with "always" because that's the only way the money could stay at the top. He insisted that all you need is that higher liklihood for savings but, as I tried to explain, that doesn't work. Money leaks out and spreads around; it moves between classes, industries and countries. It's a medium of exchange--that's why we have it.

I also wanted to point out that even if this "100% always" theory held, it still wouldn't mean the data's telling a good story. Companies don't give millions to CEOs just because they feel like--they do it as a reward for making the company more efficient which means society just got richer. I avoided that point, however, as I suspected the conversation would quickly devolve into conspiratorial claims that the rich focus on keeping the downtrodden poor.

Still, the bias claim was new to me so I e-mail Steve Horwitz about it. He responded quite quickly and suggested the burden of proof rests on the AU student. The PSID data is highly respected and widely used; what special ability allows for him to know how much to reweight the data? I'm not sure how I feel about this; it seems pretty straightforward to run surveys and ask people how many times they've moved in the past five or ten years, even if you include complications such as students moving from college to home.

But Steve offered an even better bit of evidence that the poor have gotten richer over the past thirty years: They have more stuff. Even if there's more debt, are they really "poorer" if that debt means having AC, cable and a washer and dryer? They clearly don't think so.

If your theory is sloppy, then your data probably is too, especially when your data contradicts accepted truths.


ryan said...

Not to get all conspiracy theory and behavioralist on you, but is that why executives get paid so much? Probably, but we do need to acknowledge things like the Lake Wobegone effect, the principal-agent problem, and, well, that boards of directors are often appointed by the CEO. Yeah, yeah, tell me about the efficient market, and I tell you about securities scandals ... and laws against hostile takeovers.

Mike said...


Here's the fundamental problem: how do you define poor? We can set an absolute: having the basic necessities, etc. Or, we can set a relative: some general fraction of the wealthiest members of society. Income disparity is widening, despite the fact that real income might be rising. You and I measure any rise of real income to be good, and the disparity to be relatively uninteresting.

But most people, when they talk about the poor, talk about the relative difference between them and the rich. They might have more stuff, but that stuff is something a rich man had ages ago. At some level they want to assign cable tv as a necessity. And perhaps there might be a point; we certainly would not want to define running water as a luxury.

I'm not disagreeing with any of your points here, just suggesting on some level you can't ever win this battle, because you are discussing such different things.

David said...

Ryan: In one of the books I'm reading for class (the Armchair Economist, I think) the author actually turns that question around. Why do executives get paid so little? It turns out for every $1,000 the company makes, a top brass makes about $1.75. Sure it adds up but good execs are hard to find and they are cheifly responsible for the direction the company takes.

By the way, no one says the market is perfect. There are scandals and mistakes and whatnot. The part we need to consider is if the firms get punished for their mistakes and they usually do (though sometimes the law protects them).

Mike: I don't see it as "winning" or "losing," I'm just concerned about getting my point accross. And despite the barriers you pointed out, I think it's possible to do so; we just need to agree on definitions. However, given how this AU student "corrected" the data and his general attitude toward free markets, it seems clear he was talking about "the poor" in an absolute and not relative sense.

ryan said...

Oh, you're mainly right. I'm a big fan of Landsburg, too. But didn't he write that just before a big stock market bubble and during a massive increase in the executive pay/employee pay ratio? Executive performance obviously hasn't increased, so the best we can say is that they've managed to leverage themselves a bigger chunk of the producer surplus. So isn't that "why do executives get paid so little?" sort of like me wondering in 1999 why oil prices were so low?