On economic intuitions

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.

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.

Comments

[dilbert dogbert]

This old and obsolete engineer says the question “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?”
IS UNDEFINED!!! how is the string wrapped? North South Pole to Pole? Wrapped at the equator or wrapped at some latitude?
Define "each direction". East, West, North South or vertically from the center of the earth. The x, y, z coordinates? What unobtainium material is the string made of??? If infinitely stiff, the string could not be moved.
Silly question and my questions are even sillier.

[nick j]

that immigration reduces wages has been amply illustrated by the current crop of employers wailing about the "labour shortage" occasioned by brexit and covid. in the absence of desperate immigrants employers will have to improve terms and conditions if they want to attract local labour.

[Jan Wiklund]

One example where people beat economists was the Euro referendum in Sweden in 2003. Most economists told us it would be a disaster not to be in the euro union, but a majority voted against. And now we know rather well what is wrong with the euro - and Sweden does on the whole better than the euro countries.

I think the economist majority simply were prisons in a neo-classic bubble, where everything that made trade easier was right, with no other questions asked. Not only laymen are simplicists, sometimes.

[Paulc156]

@nick. But like the man said..."migrant workers also add to demand; any incipient fall in wages raises demand for workers, or cuts prices or interest rates..."

[V.M. Smith]

Fewer.

. . . fewer than half of students . . .

https://www.youtube.com/watch?v=G0zNWswcqMg

[Jim]

I had seen the string/earth thing before - the answer is counter intuitive and illustrates the benefit of wide reading and long experience - sometimes. Then we get into assumptions - the earth is a perfectly smooth sphere, no seas or mountains and a perfectly light inextensible string etc etc.

I suppose we all conjure up theories as to why this or that - look at Aristotle on biology - sort of logical but mostly wrong. Only when someone goes and has a close look do better theories come along. Even that depends on how close a look, at what samples and with what background - think phlogiston. We will do anything to make a crap theory look like a good one. Possibly why it takes so long to get a workable theory going.

I like the correlated example. If you want to get a rubbish idea through get the media on your side, get a bit of correlation going. Known as witness tampering in other circles.

[Dave Timoney]

@dilbert/Jim,

The trick of the question is to get you to imagine a 3-dimesional, not quite perfect sphere. The trick of the answer is to reduce it to a 2-dimensional circle whose radius is irrelevant. So, using the well-known formula for calculating a circumference ...

(2π(r+1)) - (2πr)

This reduces to: 2π1, or 2 x 3.1415 = 6.283 metres.

It's always best with such puzzles to start by asking: what is misleading or irrelevant in the question? That's the same principle that can be applied to issues such as immigration and fiscal management.

[P S BAKER]

@Paulc156 yes "migrant workers also add to demand" - especially for housing, which is rather inelastic, so property prices and rents go up. Hence even if wages do not decline, workers will have less disposable money in their pockets.

Since 1997 property prices have increased by over 173% in England whereas real incomes for 25-35 year-olds have increased by just 19%.

https://www.richardnelsonllp.co.uk/record-number-young-adults-living-with-parents/

[Paulc156]

Well property prices might be inelastic but that doesnt say so much about migrant workers as it does about developers and their land banking on steroids business model and the point blank refusal of government to do what it did for several decades after the war;build homes for social rents.

[rsm]

"The trick of the question [...] The trick of the answer [...]"

Isn't the questioner just trying to confirm their own intuitions about the "wrong by orders of magnitude" intuitions of others?

[Jim]

Nothing beats a good experiment that proves your favourite theory wrong. Back to the quadrille paper and pencil. That seems the trouble with economics, not so easy to go in the lab, knock up an experiment and chuck it in the bin when it fails. Worse still statistics, just cuts the signal to noise ratio a bit whilst adding a whole load of problems. Even the logicians are apt to go wrong very easily. Without a confirmatory experiment you are out on a limb.

Some games plus a few students may be suggestive but you don't usually get to mess with a real economy. Indeed what is an economy - is it maths or sociology or guesswork. Not like the physical sciences - the thing you are looking at changes all the time and indeed really does do its best to confound the experimenter. A great many unknown unknowns and feedback paths and people doing their best to confound the effects.

Interesting to watch the experts trying to understand and practice economics - looks pretty difficult though.

[rsm]

I'm reminded of Fischer Black's unjustly ignored 1986 essay Noise https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1986.tb04513.x

"Noise in the form of expectations that need not follow rational rules causes inflation to be what it is, at least in the absence of a gold standard or fixed exchange rates. Noise in the form of uncertainty about what relative prices would be with other exchange rates makes us think incorrectly that changes in exchange rates or inflation rates cause changes in trade or investment flows or economic activity. Most generally, noise makes it very difficult to test either practical or academic theories about the way that financial or economic markets work. We are forced to act largely in the dark."

[joe]

Jan Wiklund perfectly illustrates the thrust of the article by confusing correlation with cause "One example where people beat economists". Economists did not predict disaster and people may have wanted far more to retain a currency they were perfectly happy with, rather than take a risk on an unproven one. Sweden is ranked a modest 12th among 45 countries in the European region. It has not gained by not being in the Euro. It has made currency exchanges very rich.
"And now we know rather well what is wrong with the euro" - do we? In spite of the criticism it remains one of the World's most stable currencies. UK not being in the Euro has enable Brexit to take place, losing the UK tens of £Bs, and its place in the World, and the £ has sunk against the Euro by around 20% for the last 5 years - that is a huge loss of UK asset valuation and off-putting to any inward investment. France now has UK's former top spot there.