FROM THE PREFACE:
One day in 1991, I walked into a medium sized bookstore and counted over 80 titles on quantum physics and the history of the Universe. A few shelves over I found Richard Dawkins’s bestseller The Selfish Gene along with dozens of others explaining Darwinan evolution and the genetic code.
In the best of these books, I discovered natural wonders, confronted mysteries, learned new ways of thinking, and felt I had shared in a great intellectual adventure, founded on ideas that are dazzling in their scope and their simplicity.
Economics, too, is a great intellectual adventure, but I could find, in 1991, not a single book that proposed to share that adventure with the general public. There was nothing that revealed the economist’s unique way of thinking, using a few simple ideas to illuminate the whole range of human behavior, shake up our preconceptions, and jolt us into new ways of seeing the world.
I resolved to write that book. The Armchair Economist was published in 1993, and attracted much critical praise along with a large and devoted following. But what I take most pride in is that The Armchair Economist is still widely recognized among economists as the book to give your mother when she wants to understand what you do all day.
A lot has changed in that 20 years. Today, no bookstore patron could complain about a paucity of titles in the popular economics section. Some of the new titles are quite good. Several, I daresay, were inspired by Armchair. The most well-known of the recent titles is Levitt and Dubner’s Freakonomics, which I think is a rollicking good read (and I said so when I reviewed it for the Wall Street Journal). But for all its merits, Freakonomics is more a collection of wonderful and enlightening anecdotes than a guide to understanding economic principles. Freakonomics is out to dazzle you with facts; The Armchair Economist is out to dazzle you with logic.
Logic matters. It leads us from simple ideas to surprising conclusions. A simple idea is that people respond to incentives. A surprising conclusion is that when drivers are protected by air bags, they drive more recklessly and have more accidents. A simple idea is that when the price of something goes down, suppliers provide less of it. A surprising conclusion is that recycling programs, which reduce the price of timber, ensure that fewer trees are planted and forests shrink. A simple idea is that monopolists charge whatever price the market will bear for their output. A surprising conclusion is that when oil supplies are interrupted, steep price hikes are evidence of competition, not monopoly. A monopoly oil company wouldn’t wait for a supply interruption to raise the price.
Evidence matters too, but logic can be powerful all on its own. Take, for example, the argument about recycling and the size of forests. If I wrote that the reason we have large cattle herds in this country is that people eat a lot of meat, few readers would demand detailed numerical evidence to support that conclusion. The idea itself is too powerful and too compelling. It’s instructive, then, to realize that the same powerful and compelling idea tells us that one reason we have large cultivated forests is that people use a lot of paper. Of course, ideas can always be misleading — but then so can numbers. We advance by learning new ways to think, even if those ways are not infallible. (In this particular case, if you still insist on evidence, you might start here or here.)
Much else has changed since 1991. When I wrote The Armchair Economist, I envisioned (in Chapter 5) a “computer game of life,” where nobody ever tells you whether you won or lost. You live and you die, and if you play well you collect rewards. If you decide it’s not worth the trouble to play well, that’s fine too. Today that game exists, and over 20 million people have played it. It’s called Second Life. In 1991, when I wanted an example of a crazy entrepreneurial wild goose chase, I invented a CEO who wanted to build a computer you could carry in your pocket. Perhaps you’re now reading these words on that computer.
There’s also much that hasn’t changed. The basic principles of economics continue to surprise, delight and edify, and they’re much the same as they were in 1991, though there are always new applications.
In updating The Armchair Economist for the 21st century, I’ve culled the Internet, the media, and my own experience of life for good contemporary applications of the eternal ideas of economic theory. As a result, some chapters — those where the examples were starting to seem a little musty — have been almost entirely rewritten. Others have been updated to put more emphasis on today’s concerns. I’ve excised all references to cassette tapes, Polaroid film and Walter Mondale.
This edition has also benefited enormously from the critical eye of my amazing wife Lisa Talpey, who read multiple drafts of every chapter and wouldn’t let me stop revising until I’d met her extremely high standards for clarity. Until Lisa got her hands on this manuscript, I’d had no idea how much room there was for improvement.
One other thing has changed since 1991: The world has become a more ideological place. Nowadays, it’s almost impossible to explain a non-controversial bit of economic reasoning without being suspected of some ulterior ideological agenda. So let me be upfront about this: I do have opinions. Speaking very broadly, I tend to be optimistic about the power of markets to do good, and skeptical of the power of governments to do better. And I am sure there’s an occasional passage in Armchair where I’ve failed to restrain myself from betraying those prejudices. But The Armchair Economist is not a work of ideology. It is, with rare exceptions, about the basic principles that guide the work of almost all economists, regardless of where they lie on the political spectrum. There is some disagreement among economists about which of these ideas are most important, but very little disagreement that they are basically correct. Economists from the far left to the far right have praised The Amchair Economist for its accurate portrayal of the ideas we all have in common, and in this new edition I’ve aimed to continue deserving that praise.
No kindle/nook edition? Sigh.
(If I send you $15, will you email me a copy of the .dvi source? :)
Doctor Memory: The Nook edition should be available for pre-order from Barnes and Noble now. The Kindle edition will be available from Amazon shortly; I’m not sure what accounts for the (hopefully slight) delay.
Great. Just in time for Mother’s Day.
Well, much as I enjoyed the first edition, I must candidly admit I wasn’t about to buy the revised version.
And then you mentioned the new edition had excised all references to Walter Mondale.
I’ve already pre-ordered!
This is good news. Every time I pick up that book and re-read some sections, I’m re-impressed by how good it is!
How does pre-ordering differ from ordering?
Harold: Pre-ordering is the same as ordering, except that it takes place at a time when the book is not yet available. I’m not sure when this word got invented, or why we need it, but we seem to be stuck with it.
What I found most interesting about Dawkins book was how natural selection can be used to explain cyclical credit crises.
Essentially, you have to types of environment – the “normal” credit environment of growth and (normal) recession and the crisis environment of the credit crunch.
In these two types of environment, very different organisms flourish.
To survive a “credit crunch” environment, a financial institution has to be way more conservative than is optimal for growth in the “normal” environment. The result is that while times are good, the greedy and careless simply outcompete and outgrow (or take over) their cautious brethren until the financial markets are dominated by companies like Citigroup, Countrywide, Lehman. The systemic risk piles up until something triggers a run on the financial system, causing a credit crunch.
The aggressive players then go bankrupt (in a perfect world) and the cycle starts over.
The recent crisis offers a perfect example for this kind of Darwinian selection – the companies that went bust were PRECISELY the companies that grew the fastest during the preceding cycle, the companies best ADAPTED to the prevailing environment.
To put it in a Darwinian way – during normal times there is tremendous selection pressure on the bank gene pool to evolve a “95%” business model (a model that grows fast for 19 years and combusts in year 20).
Note also that while everyone is conservative, it is actually RATIONAL to be aggressive. If everyone in the market is acting conservatively, the chance of a sudden credit crisis is very low AND the rewards for being more aggressive tend to be high.
But even if that were not the case, the problem remains that for 19 years Darwinian selection favors greed and myopia and punishes it only in year 20.
Will your book be available on Audible? My job is to write and read all day so I have switched to audio books.
Advo – if you add in the “too big to fail” aspect, greed is favoured 20 years out of 20.
Steven – wonderful news! Can’t wait to re-read it and updated it. I accidentally stumbled on “The Armchair Economist” while bored at my Sydney based university library in 1995. I still remember how astounded I was with every chapter and inhaled the whole thing in one sitting (instead of studying for Econ 101). There are maybe 10 books that I have read in my life that I remember so vividly the experience of reading them. “The Armchair Economist” and “Fair Play” (which I delightfully happened across in a Barnes and Noble the first time I was travelling through San Francisco) are 2 of these books.
Speaking of “Fair Play” – hope that gets re-issued too. Not as many people have read it but I found it your most profound and fascinating work.
Advo: I am generally very skeptical of these attempts to adapt the Darwinian model to economics.
The problem is this: In Darwinian evolution, you can’t get from point A to point Z unless all of the intermediate steps B, C, D … are favored by natural selection. Whereas in finance/economics, a rational player can look ahead, see that Z is better than A, and jump to it.
That is true, Steve, but why do you think that is a problem in the case at hand? How, precisely would it trip up the selection mechanism driving the proliferation of greed and stupidity?
I grant you that in a situation of perfect information people would simply stop doing business with the greedy idiots, at least once it was observable that overall systemic risk and company-specific risks got too high (from a game theory standpoint you could argue that they wouldn’t even start doing business with them).
But the situation is very opaque. You don’t know who’s taking how much risk and how big the chances for a meltdown are. All you see is that your rational conservatism got you 2% growth while Citigroup grew by 5% and THEIR CEO gets celebrated like a rock star.
The players may be mostly rational, but they’re also groping in the dark.
And so, given the (very) limited information about the extent of existing systemic risk and about the risk inherent in specific other players (and even your own company) at any point in time, the drivers of the development AREN’T the rational players, the drivers are the greedy idiots willing to pursue short-term profits at the expense of a possible long-term blow up (they will, of course, convince themselves that they aren’t actually doing that).
All it needs is one idiot willing to push the envelope. His financial institution will grow faster than that of the rational players and eventually he will dominate the market.
Just look at what happens in practice – this is the story of Citigroup.
You can also look at the situation as a Darwinian competition not of institutions but of business plans. Business plans which yield faster growth will dominate the market because their companies outgrow others and because they are adopted by other companies.
By the way – I think that the concept of efficient financial markets being dominated by rational players is poisonous and its acceptance by economists is perhaps the most important reason for the recent disaster.
I grant you that markets may be considered efficient ON AVERAGE and in the long term.
But that is about as productive a statement as saying that the Rocky Mountains are flat, on average (slope goes up, slope goes down – on average, it’s flat all the way). Both statements are true, but both disregard important characteristics of human nature, the financial markets and topography.
Steve this is awesome. Do you keep good records of all your physical correspondence? I sent you a critique of your original book back in the first half of 1998, I believe. (I had graduated early and was working in Chicago, waiting for my first year at NYU to start in the fall.) I would like to think I set you straight, but you might not have fixed all the mistakes…
You answered me, btw. And like I said, I’m pretty sure we did it snail-mail.
On the book re-launch: Yea! Hearty congratulations – and an eye-catching cover, too!
On Darwinian models of the business cycle: Whether or not “Darwinian” is the appropriate term, various schools of econ thought have concluded that the business cycle reflects the fact that there is something systemically unstable about business.
[Heartwarming Anecdote] I recall playing a version of Feast or Famine. During each round of the game, each player is asked to display one of two cards: “Feast” or “Famine.” If all players display the “Feast” card, each player wins a point. If all players display the “Famine” card, each player loses 10 points. If there is a mix of cards, the ones that displayed “Feast” lose two points, while the ones that displayed “Famine” win two points. Or something like that.
The game is intended to illustrate the challenges of cooperation. Players exhort each other to display the Feast card in the next round, only to find their efforts thwarted by one or more defectors. The game typically ends with each player having a large negative score.
I was able to organize a strategy that worked better: I coordinated all players to display Famine cards EXCEPT two players – and then we took turns in successive rounds being one of the players to display the Feast cards. This strategy had two advantages over the prior one: It enabled most players to earn two points rather than one in any given round. And it proved to be vastly more stable; the defection of any one party would not lead to large penalties for all parties. With this strategy we achieved unprecedented scores in this game.
Until I led a conspiracy to undermine the strategy. By the end of the game I had the highest score – although we all, once again, had negative scores. [/Heartwarming Anecdote]
What social strategies are appropriate to deal with such a business cycle? One strategy is to clamp down on the most extreme versions of risk-taking as a means to reduce the completive pressures that compel firms to engage in such strategies. One could argue that the New Deal regulations fit this model.
But another strategy may be to let the risk-taking go wild – but to also build a mechanism to help people weather the crashes that will inevitably occur. Thus Reagan relaxed regulations of savings and loans, leading to a predictable boom in that industry and a predictable crash, costing taxpayers a $500 million or so. But perhaps it was worth it? Similarly, one could argue that deregulation under the Bush years contributed to our most recent crash. Was it worth it?
Perhaps so. Yeah, we obsess about what we’ve lost in the crash – but we may fail to account for what we gained in the boom. It’s a faulty comparison. What would our current circumstances have been in the absence of a boom and crash? Taking a stab at it, Carmen Reinhart told Ezra Klein last August:
I appreciate this effort to answer the question — but this answer is just crazy. I’m skeptical that in the absence of the boom and crash our stable growth rate would have been 4-4.5%, or that our unemployment rate would have been 3.3%.
So my question stands: How bad off are we – not relative to the peak of the boom, but relative to where we would have been in the absence of a boom?
Bob Murphy is probably best to explain the business cycle most succinctly….
Thus Reagan relaxed regulations of savings and loans, leading to a predictable boom in that industry and a predictable crash, costing taxpayers a $500 million or so.
You do realize that you said regulations were relaxed, then said taxpayers were on the hook, right? If the regulations are written such that rewards are private, while risks are socialized, then you’re really not talking about “relaxed regulations”. You’re talking about bad regulations because they put in place bad incentives. Specically, if the government’s going to bail you out for making bad decisions, what exactly will prevent you from making bad decisions?
Not to take anything away from “The Armchair Economist”, which I greatly enjoyed, “The Selfish Gene” is probably the best book I’ve ever read.
Al V.: exactly my case too. The Selfish Gene explains so much of the world, maybe the best “aha” book of all times. Also Richard Dawkins is probably the world champion in explaining complex concepts in a simple and comprehensible way.
I have liked the first edition of the Armchair Economist too.
Bravo. I hope your wife encouraged you to be precise with your words. Sometimes you elide things that you know but that make all the difference to a reader. So when you say “recycling programs, which reduce the price of timber, ensure that fewer trees are planted and forests shrink” I find myself raising my eyebrows.
A few sentences later you write “one reason we have large cultivated forests is that people use a lot of paper.” The difference between “forest” and “cultivated forest” may be just one word but conceptually they are quite distinct and (may, I haven’t checked the data) matter a great deal.
I look forward to reading the book and getting you to scribble on it for me (e-books be damned).
Along the lines of representing economists as a whole:
http://www.theatlantic.com/business/archive/2012/04/4-politically-controversial-issues-where-all-economists-agree/255600/
The IGM Economics Experts were surveyed about controversial issues and they had to indicate whether they agreed, disagreed, or were uncertain about whether or not certain issues were economically favorable such as free trade. Then, they rated their level of certainty and were allowed to give comments.
I would be interested to see how often their survey agrees with your findings in TAE. Can’t wait to read it!
Steve, this is the book that made me want to study economics (though I’m having trouble in real analysis right now…) Glad to see a new, updated version coming out.
Another topic request: explain the Crawford-Sobel signalling game results.
Steve,
I think the problem with many people today – and why we are so quick to condemn certain ideas to an ideological bend – is because these types of books don’t establish positive rhetoric. In other words, they don’t set up a structural, internally-consistent model that, with a little explanation, another person can easily reproduce and understand. People tend to be suspicious of other so-called experts who have a tendency to just say things – usually people like Matt Ridley or Paul Krugman. Or they tend to be suspicious of models that are NOT structural – and they should be suspicious of those models. Or the real wackos who are suspicious of ANY model – which is the problem you address quite frequently. Of course the type of book that uses internally-consistent, structural models as its logical structure would be boring to most people. So don’t take this as advice if you want to get sales.
Since Ken is making topic requests, how about explaining level-k theory a bit. You seem to explain quantum mechanics fairly well, so I don’t see why not level-k theory.
I know at least David Levine seems to think that it has a good opportunity to further contribute to what is considered: “modern economics”
Im sitting here enjoying a fine cigar in our nice Arizona weather reading your Armchair Economist. I just finished the chapter where you talk about letting the victims of crime mete out the punishment against their offenders. Wouldn’t that be the same principal as the avenger of blood in the Old Testament?
Steve: <blockquote
Advo: I am generally very skeptical of these attempts to adapt the Darwinian model to economics.
The problem is this: In Darwinian evolution, you can’t get from point A to point Z unless all of the intermediate steps B, C, D … are favored by natural selection. Whereas in finance/economics, a rational player can look ahead, see that Z is better than A, and jump to it.
Hmmm.
Each point B, C, etc also corresponds to a state reachable from the preceding one by a single mutation (let’s leave aside the rare exceptions).
An adjacent genotype.
(At the level of the phenotype that can actually be a large change.)
What constrains adjacency is the nature of DNA and cellular chemistry.
In economic terms, isn’t point Z simply adjacent to point A because rational thought is a mutagenic agent?
I’m not sure I’m disagreeing with Steve. I just think a better objection is, until you can define the replicators and the adjacency lattice your Darwinian arguments cannot be precise.
My standard concern about memes in fact.
“So let me be upfront about this: I do have opinions. Speaking very broadly, I tend to be optimistic about the power of markets to do good, and skeptical of the power of governments to do better. And I am sure there’s an occasional passage in Armchair where I’ve failed to restrain myself from betraying those prejudices.”
Steve – do you believe that you have appropriately updated your own views by taking into account the views of other (less libertarian) experts (as Aumann would have you do)? If so, why refer to your views as “prejudices”? If not, why not?
Stumbling across TAE I felt taught me more about what it really means to (try to) think like an economist, and how much fun that can be, than the four years I had just spent at an expensive university. Stumbling across TBQ blog has reinforced my appreciation for people (including many of the posters here) who have the intellectual courage to put their ideas out there and defend them to their logical conclusions.
My gratitude to you on both counts SL. I still struggle with the idea of pushing people in front of trolleys, or valuing the utility of murderers, but your interesting mind often makes my day more enjoyable.
iceman:” I still struggle with the idea of pushing people in front of trolleys”
Practice, practice.
Jonathan Campbell – Always plenty of room for different views, and good to consider as many as you can. But I would think one should only ‘update’ one’s own views either based on evidence, or where a differing view points to a logical gap in one’s own. I would interpret “prejudice” to mean having one’s beliefs color one’s expectations on a particular issue in advance of sufficient evidence to either confirm or refute.
Ken B – your mind is not unattractive either, in a sort of girl-next-door kind of way.
@iceman: Um. Thank you. I think. [bats eyelashes] A somewhat kinky girl next door.
iceman – the idea is that if another rational actor has a particular view which differs from your own, then even if you don’t see the evidence he saw, you should update your belief based on the fact that his view must be based on evidence (or else he wouldn’t be rational).
JC – ah yes, that’s the Red Sox-Yankees thing right out of TBQ right? Should’ve known you were playing some inside game. I guess the remaining question is whether it’s safe to assume a non-libertarian is rational.
iceman – yes that’s right TBQ discussed this issue in the context of a Red Sox – Yankees game. If Steve takes non-libertarians to be irrational, then he is doing himself an injustice by using the word “prejudice” in reference to his disagreement with them.
On evolution of businesses. As Ken B says, to apply evolutionary theory directly you must identify the level on which it operates. In biological evolution it is the gene (more or less). For businesses etc. it is the meme, or idea. It does not operate at the level of the business. There are parallels, but they are not identitical.
Evolution requires two things – production of variety through mutation and natural selection . One can argue that business has both of these things. In a free market, business can proliferate in good times, and try out new ideas (memes). When times get tough, some will close, and others will persist. Those memes that are adapted to the new environments will survive, and others will die.
Evolution is blind – and often leads up blind alleys. A peacock is adapted to its environment – the huge tail gives it a selective advantage in finding a mate. Currently, the cost of producing and carrying that immense tail is outweighed by the reproductive advantages. But if times get tough, then that tail will become a liability, and peacocks will probably become extinct. But maybe some gene that goes towards producing huge feathers will have some other advantage, and will persist in a new descendent of the peacock. Perhaps it will have a deadly spear-feather like a porcupine.
Ideas are similar. Investing heavily in derivatives was a good strategy, and those that did so were succesful. Those that did not were less succesful, and could not survive. Thus the idea becomes widespread.
In todays market, it is perhaps less desirable to use these instruments in the same way. The meme for that way of business has become extinct, but some elements persist in the new businesses.
Where the parallel breaks down is that the gene is bound to its “vehicle” and can only persist by reproducing a new vehicle. An idea can live or die within the same vehicle. Therefore there is no requirement for the companies using the meme to go out out of business for the evolution of the meme to continue. It is as if the peacock could chose to not have a big tail next year.
What this means is that the competitive environment driving evolution of memes is not what many people think it is. We think that succesful businesses thrive, and propagate their good practices, whilst others fail, taking their bad ideas with them. This does happen, but is not the only mechanism for meme evolution.
If natural selection via the market had been allowed to take its course, then those banks that had been too profligate would have gone out of business, and perhaps some meme of the new financial instruments would have persisted in descendents of those banks.
What happened was that the market selection was not allowed to take its course. The environment was not the competitive business environment that we thought it was. Instead, the failed institutions were propped up. This is a bit like someone feeding the peacocks when the environment becomes unsuited to huge tails.
This does not stop evolution, just sends it down a different path. Huge tails no longer carry the cost they should during tough times. This means they can get even bigger. Once we remove “normal” selection pressure, then these useless display features become the only basis for selection.
I believe this has happened to the banks today. We now see competition not on the basis of effective business, but on who can pay the biggest bonus. This is a display feature like the peacocks tail. This is the meme that is best adapted to the current environment. It does not indicate that this is in any way the optimum meme for the rest of us.
Any idea why the kindle version of the book isn’t available in Australia?
I bought the original hardback edition in 1995, along with Krugman’s essays “Pop Internationalism”. About five years ago I bought the paperback version to give to my daughter in order to counter her school’s attempts at brainwashing. The study of economics is the red pill of our time, and this book is an enjoyable method of self-administration. The sections on executive pay and environmentalism are particular favourites of mine. I pre-ordered the new edition and am looking forward to it. It will sit on my bookshelf next to David Friedman’s “Law’s Order” and William Coleman’s “Economics and its Enemies”.
I just met a bunch of urban planners and landscape architects who told me that the discipline of ecological economics proves that we are destroying the planet and that “we should stop using scarce resources”. What scares me is not the likely fate of the planet so much as the attitude of folks (with masters’ degrees and in many cases university teaching posts) who don’t want to read any literature that might challenge their sincerely-held beliefs!
Harold is my nomination for blog comment of the year.
Doc Merlin:
Harold is my nomination for blog comment of the year.
Hear, hear.
Doc Merlin:
“Harold is my nomination for blog comment of the year.
On evolution of businesses. As Ken B says,”
It surely does start well!!
I bought the kindle version on 2 May Hong Kong time, why it is still the old edition?
What should I do? I have got the old edition in hardcover already? Anyway I could return it to Amazon?
Gary: There was a major screw-up in communication between my publisher and Amazon, which caused many purchasers to receive the old edition even after May 1. We are working
on getting this fixed. It should be fixed in the next couple of days, quite possibly even tomorrow.
Meanwhile, yes, you should return what you bought, wait a few days, and buy it again. I will post a major announcement to the blog when this problem is solved, so you’ll know it’s safe to buy.
Many apologies for this. You’re not the only one affected. There are some very particular heads I would very much like to see roll.