Monday, 28 September 2015

Could software modelling techniques help complexity economics?

Models used in complexity economics require a high degree of intellectual investment which presents a barrier to dissemination. Their features and implications could be captured and communicated in a way which is quicker and easier to grasp. 

Economic agent-based models could borrow 
techniques from software modelling to easily 
communicate key features. This diagram shows
a simple high-level example based on entity-
relationship modelling.

Those of us who regularly work within the framework of mainstream economics can often be frustrated by its deficiencies: a far-fetched view of rationality and perfect information; assumptions made to serve mathematical tractability rather than observation; and the omission of dynamic effects, agent interactions and behaviour that may be routinely far from equilibrium.

Complexity economics has made significant progress in building models that describe the latter. However, this progress often struggles to make an impact in wider economic and policy communities, or in the public consciousness, despite the very strong arguments for moving economics forward from the 19th/20th century algebraic paradigm.

So perhaps it is time for complexity economics to apply its own concept of "fitness" to itself and ask how it can be made fitter to compete with mainstream economics.

To make an idea spread, lower the cost of learning and applying it

One thing that mainstream economics really has going for it is a transferable analytical framework, presented by micro-economic theory, of marginal analysis (generally), partial equilibrium analysis, competition models, and so on. After an initial intellectual outlay to understand this framework, it can be applied to a wide range of research questions by commissioners and researchers alike. 

Complexity economics lacks a similar universal “analytical workhorse”The closest analogue is the agent-based model (ABM). Agent-based models have been a standard tool of complexity economics research for some time. They are computer models representing populations of economic actors, such as individuals or firms, following repeated simplified rules over a number of iterations. So far they have been mostly used for simulating a particular aspect of the economy to gain qualitative insights into the mechanisms behind it. Examples include models of financial markets, and this large-scale model of the European economy.

However agent-based models form a disordered and impenetrable ‘zoo’, opaque to anyone who is not a specialist in the field. By their very nature, the essential design components of ABMs – rules governing how agents interact, how interconnected agents are, whether agents change or learn, exogenous factors – are usually specific to the question under scrutiny and not easily transferable from context to context. Furthermore, they are buried in the verbal detail of papers. From an outsider's perspective, for any given research question, it is difficult to grasp what is 'out there' – which existing ABMs could add insights, or be used as a basis for a new model.

This imposes a large investment in time and knowledge for non-experts and a high cost on policy research using agent-based models. Mainstream economics is at a great advantage. It will be favoured not just because of its dominance at undergraduate level teachingbut because of its transferable framework and the lower intellectual and actual cost of commissioning it in new contexts and disseminating its insights. 

Part of the solution could be to make communication of ABM research more efficient. If non-expert and expert researchers alike could grasp the key features of models more rapidly, this would enable easier comparison and promote the exchange of ideas. So, alongside pluralism in undergraduate courses, the heterodox community should be aiming to develop techniques for communicating and sharing its insights.

Borrowing ideas from software modelling

One idea is to improve how the essential design components and economic implications of agent-based models are summarised and described. Software modelling already has a range of techniques and diagrammatic tools which could be adapted for this purpose, such as entity-relationship modelling, Unified Modelling Language (UML) and Jackson Structure Diagrams.

This suggestion has been made before. A 2006 paper by Matteo Richiardi and colleagues proposed the use of Class and Sequence diagrams from UML as a basis for describing ABMs. The Open ABM Project also recommended a protocol for communicating ABMs and suggested that "ultimately, something similar to UML should be developed for ... agent-based models".

However, the latter project was designed principally for ecologists, and (I'm happy to be corrected on this), the idea as a whole seems to have lost momentum. Now that the impetus for new economic thinking has grown since the 2008 Financial Crisis, perhaps it's time to revisit the idea with a particular focus on economic models.

UML-type diagrams would of course need to be supplemented by a verbal summary; perhaps an outline in pseudo-code (or even natural language programming?), as well as clear highlighting (in text or a table) of the things an economist most needs to know from a model. 

A very basic guess at what these are would be:

  • What are the phenomena being simulated and key insights?
  • What agents and variables are involved?
  • How are they related mathematically (e.g. Cobb-Douglas Production Function)?
  • What assumptions are made about agent behaviour, decision-making and the information available to them?
  • What are the rules for agent connectivity? Is this static or evolving?
  • How many distinct calculation steps are there, and what is the sequence?
  • Do agents change or learn?
  • How is time treated?
  • Are there any exogenous drivers of change?
  • Is there any scope for empirical testing?

What's the ultimate goal?

As economists, we know all to well that high cost prevents the spread of ideas and technologies. ABMs are one of the great hopes for new economic thinking, and they need
a boost beyond the initiated. A systematic way to summarise their design and key implications, potentially based on the existing diagrams and techniques of software engineers could help. This could even provide a common language for harnessing the creativity of computer scientists.

Ultimately, we need to aim for a situation where economics undergraduates study ABMs, and are able to easily interpret and promote research based on them in their later careers in finance ministries, central banks and everywhere else – just as they do with standard economic models today. 

Monday, 14 September 2015

Pigouvian taxes: the century-old idea in need of an overhaul

A highly simplified model of environmental taxation still holds sway despite some profound questions over its applicability to the carbon problem.

The idea of using a tax to correct an environmental problem, or 'externality', was first described by the economist Arthur Pigou in 1920. This is the basic model that students of environmental economics are still taught today. It suggests that, for any environmental pollutant, there is a socially optimal level of emissions, a balance between the benefit associated with reducing it, and the cost of doing so. This can be reached by applying a tax to the pollutant to disincentivise its release.

All very sensible. So what's the problem? The most urgent environmental problem today, and the one most likely to require the application of environmental taxes, is climate change. The original Pigouvian model was just not designed to tackle an externality so fundamentally and inextricably linked to almost every kind of economic activity.

To illustrate, I will refer to a recent IMF working paper, How Large are Global Energy Subsidies? This paper uses a Pigouvian approach to estimate the scale of global fossil fuel subsidies, and the potential welfare gains of scaling them back. It estimates them at $5.3 trillion, a truly alarming sum.

There are three main reasons I would take issue with this analysis. One is to do with communication to non-economists, one relates to the actual economics, and the other concerns the political 'sellability' of environmental taxation.

Communication: subsidies and missing taxes are not really the same thing
Firstly, if you said "fossil fuel subsidy" to most non-economists, they would probably envisage some kind of fiscal transfer between government and fossil fuel producers, like the subsidy which the German government gives to coal mining. Or they might imagine breaks on existing taxes, R&D grants, or controls on the prices paid by consumers, as with India's kerosene subsidies.

However, 87% of the fossil fuel subsidies outlined in the IMF paper are "underpriced externalities" – they represent the social cost of not imposing environmental taxes on fossil fuel emissions, in terms of health and environmental impacts, at the Pigouvian socially optimal level. 

Whatever the arguments for and against environmental taxes, it is certainly not the norm to price externalities with any kind of exhaustive consistency even in the developed world; so it's a bit of a stretch to say that Honduras or Botswana are subsidising fossil fuels by not taxing them fully. Economists describe subsidies and missing taxes as conceptually identical, but for a policy-maker or member of the public, they have very different political, fiscal and social implications, and the conflation is misleading. The $5.3 trn figure gives the impression that there is a ready money stream in national budgets to divert away from fossil fuels towards clean technologies. Not so.

Economics: when it comes to fossil fuels, we can't ignore the rest of the economy
Next, the economic reasons. There are two of these. The traditional Pigouvian framework:
  1. uses partial equilibrium analysis, in other words, looks at the effect that increasing the price of fossil fuels has on their demand, but not on the knock-on effects on prices and demand for other goods and services. 
  2. is unable to tell us anything about macroeconomic impacts, even if very large.
The upshot is that the Pigouvian approach need not linger on what would happen to a national economy if it applied across the board fossil fuel taxes to fully reflect their social cost. This starkly highlights its limits in the context of climate change. In the current era, fossil fuels are all-pervasive in economic activity. As past oil price shocks and slumps have shown, we cannot assume away the economy-wide impacts of changes to their prices. A partial equilibrium framework which ignores these does not provide policy-makers with the overall picture which they need to guide decisions.

The IMF paper is not remiss in this respect – the profession as a whole lacks better tools, at least, ones which you don't need a relevant PhD to apply. The macroeconomic impacts of environmental taxes specifically seem to have received little attention. A quick web search reveals a splurge of papers in the 1990s. Since then, the macroeconomics of climate change has been dominated by models which tend to focus on the economic impacts of climate change itself rather than on policy instruments, and which have been largely driven by academic rather than policy questions (see this review by Vivid Economics for more info).

The question of whether economists can come up with better, more policy-relevant workhorse models and frameworks, which are both more comprehensive but not prohibitively complex, is one we should consider.

Politics: what would you think if you were a finance minister?
Economists need to articulate how emissions can be cut to acceptable levels at lowest cost and with least social disruption.

While I can't speak for developing world politicians, I can imagine that on hearing a proposal to tax fossil fuels, their reaction might be to think of the child who can't get to school, the farmer who can't get produce to market, and the rural mother who can't earn extra cash from sewing without lighting; at least in the short term until clean alternatives are cheap and widespread. I would be looking for some sensitivity to these concerns in any policy proposal.

The IMF paper states that "energy subsidy reform [i.e., for the main part, raising taxes] is clearly beneficial from the view of the entire society" and that, because many of the external costs relate to local air pollution "unilateral price reform is in countries' own interests". If this is the case, perhaps we should ask ourselves why it hasn't already happened. Proposals which would lead to reductions in transport fuel use of 20-50% in some regions are drastic. A Pigouvian framework can't say anything about the availability, affordability and take-up of substitutes, or the appropriate timeframe, or the overall impact on the economy of such far-reaching reductions.

If I were a finance minister reading a proposal containing these statements I would be fairly disinclined to give it serious consideration. People who are not already in the climate community will be sceptical towards, and will misread, the case for carbon taxes if political difficulties are brushed aside.

What needs to happen?
We need a new approach to assessing the potential overall economic impact and advisability of environmental taxes specifically

The UK Chancellor of the Exchequer (finance minister) recently announced a review of UK energy taxes and subsidies. It would be fantastic if this review were to put some thought into how we can build an improved framework for the economic analysis of environmental taxes. How can we better communicate with policy-makers? What do politicians need to know, and how should economists respond?

We need to be clearer and more precise in our language. The $0.5 trn or so real fossil fuel subsidies are significant enough – let's make what that means clearer to non-specialists without getting into a conceptual muddle.

Above all, economists need to be more open about the shortcomings of the Pigouvian model whenever it is brought out of the textbooks into the real world.