A peek behind the veil of ignorance

Last week's post about a paper that documented the remarkable level of economic ignorance amongst New Zealand's business managers seems to have hit the spot, going by page views and comments.

Comments have been somewhere on a spectrum between head-shaking bafflement and outright incredulity, with a soupçon of "how can people this ignorant stay in business?". And, mostly, I'm somewhere in that range myself.

But one commenter pointed me to something that shows managers' beliefs in a modestly less awful light. It's an earlier paper by largely the same people, 'How do firms form their expectations: new survey evidence', an NBER working paper from April of this year. The abstract is here, but the whole thing will cost you US$5 unless you 're in academia or the media or a developing economy: us common or garden bloggers have to pay up, and I did. Oh, and the NBER is funny about copyright, so here it is - © 2015 by Olivier Coibion, Yuriy Gorodnichenko, and Saten Kumar.

What this paper found is that managers may be terrible at estimating the current or likely rate of consumer inflation - no better than the populace at large, which seems rather strange for people at the business coalface - but they are rather better at knowing what producer prices are doing in their industry. Here's the graph that shows it.

The left-hand panel A shows the distribution of managers' estimates of various recent macroeconomic data - the inflation rate in their own industry, inflation overall, GDP growth, and the unemployment rate. Negative values mean that the managers' estimates are too high relative to the real number.

Managers aren't too bad at getting their own sector's inflation rate right: on average, in fact, they're bang on, though there's still quite a big dispersion around the right answer. They're reasonably good at the unemployment rate (they have it a little higher than it really is), but not so hot at GDP growth (they have it about 1.5% - 2.0% higher than reality, from eyeballing the graph). And as my previous post said, they're really bad at the CPI inflation rate, being well off the mark on average and with estimates all over the shop.

The authors show that you can explain the managers' ignorance of the true rate of inflation in terms of 'rational inattention' - life's too short to be on top of everything, and if it's not important to you, you don't bother. Equally they show that managers who think inflation is important for their business do a better job of tracking it, and as we've seen in the graph above, managers stay on top of their industry's inflation pretty well, given that they've got both the incentive and the opportunity. And the paper's authors also show that if you give managers some additional information on actual and forecast data, they improve their estimates. Managers, in sum, aren't the complete ignoramuses you might have imagined when (for example) you see their level of ignorance about the basics of what the Reserve Bank does.

But it all still leaves that basic question: why do so many managers think inflation isn't important to them, and hence or otherwise get it so wrong?

There'a clue in the right-hand Panel B. It takes the (badly overestimated) inflation estimates in the left-hand panel, and breaks them out by the sector of respondent. You can see that there's a decent proportion of people in manufacturing and trade who have an accurate idea of inflation (though even then there's a tail of people with shots that are too high). But there isn't even a semblance of getting within cooee of the right answer for the average managers in professional and financial services firms, or in construction and transport businesses.

So here's my interpretation, not the authors' (though there are also bits of the paper that point the same way, such as the bit that shows managers in businesses with more competition pay more attention to inflation). That sectoral breakdown in Panel B is pretty much along tradables/non-tradables lines. Managers in tradables sectors have to be reasonably okay at getting inflation right, as there are enough competitors (domestic and overseas) who will eat their lunch if they're systematically bad at it. And managers in non-tradables sectors don't have to be, because there aren't.

I've thought it before, and I'm thinking it again: there are a lot of businesses in non-tradables sectors who can coast on a cost-plus mentality, and I doubt if we're going to make much inroads on our national productivity issues until stronger competitive pressures are brought to bear on them.