Monday, January 21, 2013

How to Do a Controlled Macro Economic Experiment

I had a professor of anthropology in college who believed that there are certain deep-seated evolutionary memories programmed into our DNA.  As examples, he gave people's innate fondness for grass and trees and tests that showed people's pupil's dilated more at the sight of a leopard than any other predator.  He also believed that given the choice, people are more likely to escape danger by going up (as a primate climbing a tree) than dropping down.  However, he said that last would be difficult to be sure of because there is no ethical way to perform an experiment of having a leopard chase people and see whether they prefer to climb a tree or drop into a hole.  It occurred to me at the time that there would be one way to simulate it -- by video games.  Of course, video games were a lot more primitive back then and would consist of a stick figure leopard chasing a stick figure human.  It could be done more convincingly now.

All of which leads to one notorious difficulty in macro-economics -- the difficulty in performing controlled experiments.  It simply is not ethical to blow two economies up and then see which set of policies leads to a better recovery.  Besides, economies are such complex systems that any number of variables could account for the difference in performance.  But assuming there are actual economic laws nearly as immutable as scientific laws, we can run controlled economic experiments by complex role-playing games.  An article by Andrew Sullivan (alas, I cannot find the link) linked to an account of a complex economic role playing game that yielded some interesting results.  When the game failed to reign in banks, the role-playing banks did exactly what real world banks have done when inadequately regulated -- they went on a huge speculative binge and ended up losing huge amounts of money, most of it other people's.  This upset the people whose money was lost, and the game managers were forced to impose strict banking regulations in order to induce anyone to put money in the banks ever again.

Certainly the harmful effects of too-tight money can be simulated on smaller-scale models.  Paul Krugman likes citing the example of the babysitting coop.  About 150 couples in Washington, D.C., mostly congressional aides, agreed to babysit for each other.  In order to coordinate among so many people, they issued babysitting coupons, each exchangeable for one hour of babysitting.  But everyone wanted a sufficient reserve of coupons so that they could go out several nights in a row.  When the coop failed to issue enough coupons, everyone wanted to accumulate more and was unwilling to go out until they had enough.  The amount of babysitting activity declined.  The coop was having a recession!  A babysitting coop recession is not characterized by the features we normally associate with a recession and dread -- unsold inventory, rising unemployment, layoffs, plant closings, business failures, and so forth.  But it was having a real recession, and all participants saw it as a bad thing.  The solution, it turned out was easy -- just issue more coupons and babysitting picked right up.

Krugman says elsewhere that an economy of 150 people is about the smallest economy that can experience a recession, but that the recession was no less real for that.  I can attest that 150 people is not, in fact, the smallest economy that can experience a recession.  I do not know what that number is, but the smallest economy I have ever observed to experience a recession had five members.  Those members were myself and my four siblings, then aged 4 through 14.  We were playing The Shell Game, something closely resembling Monopoly, except with shells for currency and using pieces of furniture around the house instead of squares on a board.  (My sister recalls other economic activity as well, like making things for sale).  We had a bank that was available to deposit money and also made loans.  There were no speculative binges or bank failure; our bank was very conservatively managed.  Although we knew that banks both take deposits and make loans, we did not understand fractional reserve banking -- that a bank can both make loans and agree to repay the entire amount people deposit in it  So we had the bank simply seize a quarter of everyone's deposits and use that amount to make loans.  In other words, it kept 100% reserves, but charges a 25% tax/service fee.  Our mother asked in that case why anyone would put money in the bank in the first place.  The best answer I could give was that it was a necessary sacrifice to keep the economy going.  Because we definitely noticed that when people stopped putting money in the bank and the bank stopped having money to lend out, the level of economic activity slowed way down.  In short, when credit got too tight in our little five-person economy, it fell into recession.  Once again, there was no unsold inventory, no layoffs, no unemployment, no plant closures, but all of us regarded these slow-downs as bad.  We did not realize our economy was going through recessions. (I was only just becoming familiar with the concept of recession and certainly didn't understand how they worked.  I don't know if any of the others had heard of recessions at all).  But we were all distressed when our little economy slowed down.

But both these examples are cases of the simplest of macro-economics -- a credit crunch putting a squeeze on an economy.  Krugman briefly mentions that the babysitting coop later issued to many coupons and causing other problems.  We can guess what those problems were -- everyone wanting to go out and not seeing the need to babysit, maddening difficulty finding a sitter, and the few sitters available charging extortionate prices.  He did not say how the coop resolved the problem.  This is an important question because there is a sticky price problem.  If there are insufficient coupons, members are unlikely to object to being issued more.  But if there are too many coupons, members will strongly resist having their coupons taken away.  And neither the babysitting coop nor our extended monopoly game had the capacity for bubbles -- a binge of excess lending leading to excess, inadequately secured debt.

Nonetheless, as the more complex economic role playing games made clear, a sufficiently complex economic model is quite capable of generating bubbles if the banks are not adequately regulated.  So, set up a whole series of complex economic role playing games (without telling the players you are running en experiment, of course).  Let the banks run riot and blow up the economy.  Then let the game managers (in the role of a government) adopt a different policy in each game and see which is most successful.  Of course, there are limits to the approach.  Sooner or later, people will figure out the dangers of letting banks run riot and refuse to play unless the banks are well-regulated.  But judging from the real world, but boom can be sufficiently alluring to bring a lot of people in until it is too late.

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