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James Mirrlees:Relevance Study in Economics

 

 (James Mirrlees: Born in 1936 in Minnigaff, Scotland, Sir James Mirrlees is a fundamental contributor to the “theory of incentives”. He is Honorary Professor at University of Cambridge, academician of British Academy as well as academician of the American Academy of Arts and Sciences. He taught at Oxford University for a long time, and was the president of Econometric Society and the president of the Royal Economic Society. Sir James Mirrlees was knighted by the Queen of the United Kingdom. In 1996, he was awarded the Nobel Prize in Economic Sciences due to his significant contributions to the economic theory of incentives under asymmetric information. In addition, Sir James Mirrlees received the Royal Medal of the Royal Society of Edinburgh in 2009. As a 79-year-old leading scholar in the global economic circle, Sir James Mirrlees has been firmly committed to the economics research with an attitude of “never say ‘what you should do’”. In recent years, Sir James Mirrlees has been paying attention to China’s economic development and contributing to the promotion of China’s economics.)

 

 (China’s economy is in the transformation period; therefore, there are a lot of confusions to solve, responsibilities to shoulder, and opportunities to seize. Taking the opportunity of the grand opening of the first “Great Minds China Forum” (“9·12”) held in Beijing, the National Economics Foundation invited Professor James Mirrlees, the 1996 Nobel Prize Winner in Economic Sciences, to deliver an insightful speech on the development of economics and China’s economic research on “Great Minds China Forum”. The following is the speech transcript of Professor James Mirrlees.)

 

I hope this will be illuminating for some of you at least. But I thought it was appropriate to me, not knowing all that much about the economics as it has done currently in China, to talk about the issues in contemporary economics. So I thought, what can I talk about in 15 minutes? So I thought I should talk about everything. But I will do it by some examples.

 

It is a rather striking feature of economics: how increasingly important, the factual side has become empirical economics for theorists. It may sound to outsiders perfectly straightforward remark. But a great deal of economic theory is based on acquaintance of factors and how it works. So anyone can easily make observations about the existence of prices, and money, and think about how people must really interact. But over recently years, it has become increasingly important.

 

A valuable economics relies on something that physicist don’t have to worry about: judgement of relevance. What I mean is that something different between actually measuring something and deciding the model you’ve used. I’ll give the obvious example of tax theory, of how you can make recommendations about particular tax rates. We got to use some model, we say a simplified model, but a model of reality that we do not claim to be a precise description of reality. So we have to make a judgement that our model is sufficiently relevant that the results of our analysis are valuable.

Now it’s hard or maybe impossible, actually to prove relevance. There is something very strange about economics and social sciences. But some relatively hard sciences have the same kinds of issues. Some science for example, has to decide they are dealing with models that are sufficiently precise, that they give an adequate presentation of reality. For many questions, nowadays, it has become increasingly important for theory to find better specifications of the models. I want to illustrate what I mean about that. The content, the relevance of the models has become increasingly important with the questions that we had to get into. There are three examples I’m going to speak of.

 

Investment. I’ll say production decisions, macroeconomics, and behavior of economics. There isn’t exactly a recognized theory here called theory of production decisions. But perhaps should be. The topic is generally discussed under the moral hazard. Seems to me it’s really rather a big set of issues. What am I talking about? Production outcomes, are of course uncertain. That’s a very important general fact about the world and about the economics. The outcome distribution, I mean the probability distribution of the outcomes, is definitely determined by decisions that are not observable. The process of decision taking is not observable. This is what we refer to as the phenomenon of moral hazard. What I have in mind is that when the chief executive of the company decides who to appoint for some important positions of management within the company, we cannot tell quite how carefully he has considered the issue. When somebody in the end decides which of various possible investment decisions will be taken, we cannot tell quite how carefully the necessary background researchers has been done and whether the appropriate attention has been given to advice from different sources.

 

So what I’m saying is the situation is very like the situation that people talk about when they talk about moral hazard and medical care, where decisions have to be made, which will not be trackable. So incentives began to be very important. There is a general proposition. It said, unlike standard wealth economics, it is not, as it stands, a tremendously useful result. And the question is what to do about that. The theory is that whatever principles you have, you could implement an optimal system by contracts between risk neutral insurance companies and the people, the entities, the businesses that are actually taking the decisions. For example, a loan contract, which takes the form of saying that the sample proportion of profits will be paid to the entity that has made the loan. For the theory to be correct, these contracts must be non-tradeable contracts. As to say you can have one contract with one particular lender but you cannot do it within the others. It has to be like a fire insurance contract, where you can only take out the insurance contract with one company.

 

This is the point which becomes totally impossible to implement it. It should in principle cover all aspects of the producers’ trade. So the contract is supposed in theory to take over the whole behavior of the company, of the individual. A standard example of that is that people have driving insurance, which simply relates the amount it has paid in later premiums, to the accident record of the driver. But you should also have the controls over the amount of driving that driver does. Not something this easy for an insurance company to observe. It happens here, an interesting and important argument for taxation of petrol, gasoline. But that’s only one aspect.

 

The same applies in the theory I’m talking about now. There are implications of this that I think we can rest on already. We can say that, for example, securitization of loans, as it has done with CDOs and a number of other derivatives, is completely undesirable, and not to be prevented. And that doesn’t require any more precise modeling. But thinking about this very important major situation with the world, most of what we would want to do means we should be saying not just there should be a contract, but what kind of information somebody creating the contract might use, and how he would actually work out the form of the contract. Questions like what proportion of profits should be paid for such and such loan? What is the typical structure of contracts of these kind? And you cannot do that without having a much more, a much better determining model than any others having at the moment for things of those kind. So we have to deal with that by having better underlying models. It is sort of empirical and theoretical task together, requiring acts of considerably imagination. And we also have to find ways of handling in a second best or third best kind of way, this completeness requirement which is too severe.

 

 Another example that strikes me very much like this is the whole issue of macroeconomics and policy. This is against the background of me being very Keynesian. People don’t think of me as Macroeconomist. Quite right, I’m not. But it doesn’t stop me thinking about it. And in broad terms I find Keynes very persuasive, although one has to make enormous modifications of one’s understanding of it in the real world, where trade is very important, if there’s unemployment of labor. And unemployment of labor means the economy is not in equilibrium. And that means it is not going to just stick there like that, something is going to change. And things do change. We need models that to set equilibrium dynamics, which actually explain, why it is that nevertheless the general idea of Keynesian in that equilibrium make sense. Not an equilibrium in a proper sense. This is not the occasion that I can go into the details what I have in mind. But I think the situation here is that I’m asking people to create models where they don’t have the normal guidance that you get from economic ideas, saying what would be the rational thing for people to do under these circumstances, what sort of information should they get, what should they do. Because many of the situations people are in, it doesn’t somehow seem quite sense to say you should change the price by this much, because it is the rational thing to do. Anyway, nobody is coming up with anything like that. And this seems to be another example, where one needs to do much better modeling when we have.

 

And my last example, imperfect rationality, which is something I have given a fair amount of thought to it. Of course, nobody doubts that there’s plenty of behavior that’s not rational. What do I mean by “not rational”? What I mean is not what you would do if you are wanting to achieve some particular ends, either for yourself or for other people. And there are a lot of examples sounds the way it might be impossible to prove this. There are some models, empirically based, particularly the sort of models that then affect others that have used for transport mode choice. But they are not some have great generality. There are also some very interesting models for labor markets. Reciprocity, is the one that we use in this area. That’s a little more controversial.

But models really ought to somehow relate behavior to interests of people, to help their well-being, and perhaps other people’s well-being as well. Because otherwise you cannot use the models for discussing what I think some of the most important issues here, which are policy issues. Because actually, if you think about it, a lot of policy issues on how realistic your ideas or model of less than perfectly rational behavior are. Behaviors are in mind of pensions of course, which is somewhere a lot of discussion, on a whole too implicitly. It is relying on some people not have been made the right choices, given the circumstance of what we should do about it. Financial regulation, which would take us back, perhaps my first example as well. And tax complexity, whether there is much of an idea that it would be a good idea to greatly simplify tax schedules, where this theory tends to say that it’s a very good idea to extremely complex and comprehensible tax schedules. This is an area where you put down a particular model, and people would say but that’s not what it’s like. There are lots of other problems as well, but we only have 15 minutes.

 

Thank you very much.

 

 

 

◆please indicate the source if authorized: National Economics Foundation

◆photo:National Economics Foundation