Wednesday, 27 May 2015

So what *is* the most misleading term in Economics?

On Monday, I wrote disagreeing with John Quiggan’s piece on “Pareto optimality” being the most misleading term in economics. My disagreement was more with his argument than his conclusion, but nevertheless, it got me thinking about what is the most misleading term in Economics. I have four favourites, which I will list in reverses order. These are all misleading in some way, but to different audiences.

4. Efficiency.

As I said, I don’t entirely disagree with John’s conclusion. I believe that when economists use the term efficiency without an adjective, it (nearly) always refers to Pareto efficiency, which properly understood is a fairly innocuous concept. It simply refers to a situation where no-one can be made better off in terms of the things he or she values (more stuff, cleaner environment, better civic amenities, living in a civil society, whatever) without making anyone else worse off in terms of the the things they value.  But I always advise my students to never use the word efficiency when talking with non-economists. Exhibit A to explain why is the following quote from the 1962 verison of mutiny on the bounty. Captain Bligh (Trevor Howard) is explaining to Fletcher Christian (Marlon Brando) why he just had a sailor flogged for something he didn’t do, saying that it won’t be possible to run the ship in bad weather if sailors don’t fear their captain more than they fear the weather. He goes on to say: 
Now don’t mistake me. I’m not advising cruelty or brutality with no purpose. My point is that cruelty with purpose is not cruelty—it’s efficiency
This scene, which happens early in the movie, is important for setting up Bligh as a horrible person in the minds of the movie watchers (much like Joffrey’s encounter with the diawolf and the butcher’s boy in the second episode of Game of Thrones). The screenwriters knew that having Bligh use the word efficiency to describe the treatment of people would be chilling to viewers. It invokes notions of Dickensian eight-year-olds up chimney, of sacrificing human values to the end of maximising material production, the total opposite of the totally human-values-centric approach to welfare that Pareto efficiency invokes.

3. Aggregate Demand

Efficiency is a problematic term as it can mislead those outside the subject. Aggregate Demand is worse as it misleads our own students. I complained about this one here. A standard demand curve is a statement of intentions. It shows how much buyers would buy if they could buy as much as they wanted at a given price. At the equilibrium price, the desired demand will equal actual purchases. It is also possible, however, to be on the demand curve at points where desired demand and actual purchases are different (say as the result of a legislated maximum price). The so-called aggregate demand curve is not analogous. It shows different equilibrium combinations of price and quantity such that demand for output equals actual output. It is possible to be out of this equilibrium, through undesired changed in inventories or other quantity buffers, but that implies being completely off the curve. The aggregate demand curve is a useful graphical device for teaching some basic macro concepts, but its name pretty much guarantees that the majority of first-year students will misunderstand its properties.

2. Investment

Here we have a term that, I think, misleads even seasoned economists. Investment in economics, refers to the accumulation of capital goods. The term in general usage is often used to mean particular mechanisms that consumers use to save. So, for instance, buying a rental property is investment in this everyday use, but, if it is an existing house, it is not “investment” in the economics sense. I am convinced that slippage in the meaning of the word investment mid-sentence is the reason for some half-baked justifications for a capital gains tax, as in statements like “we need a capital gains tax so that people will switch from investing in houses to more productive investments”. As I noted here, buying an existing house is not “unproductive investment”; it isn’t investment at all. Once that is noted, the link between a capital gains tax and productive use of savings becomes extremely tenuous.

But these three misleading terms are trivial compared to the granddaddy of them all:


That is, the "non-accelerating-inflation rate of unemployment". This is just embarrassing. As a profession, we like to get smug and despondent about innumeracy in the press with respect to the number of derivatives, sighing every time we read statements “inflation rose by 3% in the year to March”, when what is meant is either that “prices rose by 3%” or “inflation was 3%”. But then we do the same thing ourselves with one of our technical terms. 

For goodness sake, it should be the non-accelerating-prices rate of unemployment (NAPRU) or the non-increasing-inflation rate of unemployment (NIIPRU). There is an alternative term—the natural rate of unemployment. If it weren’t for the existence of NAIRU, I would have the natural rate in my list of misleading terms. It conveys a notion of unemployment being something that is just given to us, not something that can be affected by policy, and certainly not something that has very real human consequences. Again, it is a term that misleadingly conveys economics as a cold, heartless subject. But I would rather our profession was incorrectly perceived as cold and heartless than correctly perceived as innumerate. So as long as NAIRU is the only alternative, I will champion the natural rate!


  1. A couple of fairly trivial observations:

    1. Most financial economists would not associate the term "efficiency" with pareto efficiency.
    2. In financial economics, buying an existing house does indeed form part of the sub-field known as Investments.

  2. I was thinking of Finance as being its own field and language, albeit one with a lot of commonality with Economics. If thinking of Finance as a branch of economics, I would argue that "efficient" in "efficient markets hypothesis" is more of an abuse of terminology than if taken in the Pareto sense.

    But now that you mention it, perhaps it was EMH that motivated John to say that Pareto efficiency is separate from how economists use the term "efficiency" in general. EMH was one of concepts he termed "zombie ideas".

  3. If it is moan about economic terms time I would like to add the whole concept of unemployment rate. It is the employment rate that counts. UK has ~73% employment. US has <60%. France around 63%. The unemployment rates for US & UK are relatively similar. If society aims for "full" employment surely the official unemployment rate is irrelevant as it ignores those who have given up on joining the workforce and who are not willing or able to jump through the hoops to pretend they are actually looking for work to get official benefits.
    I would contend that the UK economy is doing vastly better for those at the lower end of the spectrum by providing vastly more people with an income yet everyone focuses on the unemployment rate. /

  4. Why an "abuse of terminology"? It's just short-hand for "informationally efficient".

    Given his views on other things, Quiggan's opinion of the EMH is hardly surprising. Unfortunately for him, everybody else I've come across making similar claims has turned out to totally misunderstand what the EMH actually says (I guess this is where the use of the word "efficiency" is indeed confusing!)

  5. The unemployment rate doesn't count those who have given up on joining the workforce, a group whose existence might be an unfortunate result of policy. Differences in the employment rate between countries or periods within a county, may reflect differneces in that group, but may also simply reflect age demographics (number of retirees), cultural differences (employment rates went up sharply following the feminist revolution in the 70s), and so on. No one figure tells a full story.

  6. I think of "efficienct" as meaning you can't get more of some ouptut (e.g. useful work from a machine) without having less of some other output or more of some input (e.g. energy). Inefficient means that you get less output than you could from an input, or that it takes more input than ideal to get a certain output. That is, it involves some notion of being on a frontier in 2 or more dimensions. I don't think of information efficiency in that way. Efficient markets, in the sense of the EMH, might be thought of as getting the most useful summary of information as an output (price) from a given input (information), but I'm not sure that if markets were inefficient in the EMH sense, that we would say that it takes more information than an efficient market would need to get the same information into prices. That is, I don't see it in the sense of being on a frontier in multi-dimensional space.

  7. I see what you're getting at Seamus, but I'm not sure these really are fundamentally different definitions of efficiency. If markets were inefficient in the EMH sense, then this tells us that some relevant information isn't being incorporated properly in prices, i.e., there's a shortage of 'analysis'. In the Grossman-Stiglitz form of the EMH--prices reflect information up to the point where the marginal benefit of that information equals the marginal cost of acquiring it--it would then be possible for a given set of prices to be efficient (by your definition) in the sense that they couldn't be made more informationally efficient except by having more of the analysis 'input'.