Oxonomics

A New Online Issue of Oxonomics

A new online issue of our journal Oxonomics is freely available here.  I will blog about some of the articles in the next few days.  Particular highlights include an articte on the Financial Crisis by Nicholas Dimsdale and an article about the British housing  market by Stephen Nickell, former MPC member and chair of the National Housing and Planning Advice Unit.  There is also an excllent article on different concepts of equality and inequality by Sophie Elliott, an economics student from New Zealand who tragically died last year.  

The '"Economics" behind the Happy Planet Index

The UK is less happy than Georgia and Costa Rica is the most happy country in the world. At least according to the ludicrous Happy Planet Index (see here for the Telegraph's coverage). Will Wilkinson has a nice deconstruction of it.  It is actually driven by how much of the world's resources a country uses so the idea that it is a measure of happiness is basically false advertising. 

Interesting Interview with Paul Collier on EconTalk

The interview with Russ Roberts on the subject of Wars, Guns and Votes is available here.  It is particularly interesting as Russ Roberts challenges Paul Collier to defend his empirical methodology.   They also discuss the policy implications of the book and touche on the some of the themes we discussed with Paul back in our interview with him.

The Economic Consequences of the French Revolution

Exogenously imposing the institutions of the French Revolution apparently had a beneficial impact on Western Germany. This is one of the conclusions of this very nice Vox article based on this paper by Acemoglu, Cantoni Johnson and Robinson,  (available as an NBER working paper here).  They argue that 

'French-induced reforms created an environment favourable to the Industrial Revolution, which reached Continental Europe precisely in those decades. French reforms involve no effort to be “appropriate” to local conditions and were imposed from the outside “Big Bang” style. Nevertheless, they appear to have spurred significantly faster economic growth in the second half of the nineteenth century, once the process of industrialisation throughout Europe was underway.'

The argument is consistent with AJR's earlier emphasis on how established elites can prevent the adoption of new technology or superior institutions.

Kevin Murphy on Drug Policy

What consequences does Becker and Murphy's celebrated rational addiction model have for drug policy? From this interview with Chicago economist Kevin Murphy:

`what do we know about demand for any commodity, whether it’s drugs or haircuts or strawberries? You make them more expensive, people consume less. So our view of the world is that, basically the way drug policy works in the United States at least, is it tries to make drugs more expensive, less attractive, and cause people to consume less. In economic terms, it pushes us back up the demand curve. And rough estimates say we’ve quadrupled the cost of drugs relative to what they would be in a world without this interdiction.

If you quadruple the price of something, people are going to buy less of it. But, unfortunately, the way we bring about that quadrupling of price is by increasing the cost of supplying drugs. The amount of money people are spending on drugs is actually higher than it would be if the price were lower, because the demand for drugs is not very elastic.

Region: You’ve shifted the supply curve, and moved up the demand curve.

Murphy: Exactly. So think about a simple world where the elasticity of demand is about a half. You quadruple the price of drugs, and the quantity of drugs is cut in half. So you’ve got four times the price, half the quantity. You’ve doubled expenditures. People are spending twice as much and consuming half as much.

Well, where did that added expenditure go? It goes to the drug dealers. It doesn’t go to the government; it doesn’t stay with the consumers. It goes to drug dealers. And that revenue actually finances the supply of drugs and finances the drug lords who supply drugs to the United States. So what we’ve really done in this case is financed the people who are on the other side of the War on Drugs. So, the War on Drugs, in our view, has been kind of doomed by its basic economics. That is, the harder you fight the war, the higher you push up the price. The higher the price, the higher the revenue of suppliers; the higher the price, the greater the incentive to supply drugs to the United States.

Now, what are the costs to the suppliers? Well, they have to avoid detection. They fight over turf for drug territories. They pay people off. They may go to prison. All those costs are pretty much bad things. They use violence to enforce their contracts and the like. Not a good outcome.

But when you put people in prison, you have to consider not only does it cost society in the form of people in prison who could otherwise be gainfully employed, but it also costs us money to put them there. So for every dollar of cost we impose on the drug suppliers, we spend at least a dollar of our own money on top of it to keep them there. If we normalize what we would have spent in a free market on drugs at $100, consumers are now spending $200 on half the quantity of drugs and then spending another $100 on top of that to put all those people in jail. So we’re paying three times as much for half as much output. From an economic point of view, that’s more than a little bit counterproductive.

Usually you think, if I’m going to produce less output at least it should cost me less.

Region: So, rational addiction but irrational ...

Murphy: Irrational policy, right. So, what’s the answer? If you want to reduce consumption, raise the price. What’s the natural way to raise the price of something? Tax it. what do we know about demand for any commodity, whether it’s drugs or haircuts or strawberries? You make them more expensive, people consume less. So our view of the world is that, basically the way drug policy works in the United States at least, is it tries to make drugs more expensive, less attractive, and cause people to consume less. In economic terms, it pushes us back up the demand curve. And rough estimates say we’ve quadrupled the cost of drugs relative to what they would be in a world without this interdiction.

If you quadruple the price of something, people are going to buy less of it. But, unfortunately, the way we bring about that quadrupling of price is by increasing the cost of supplying drugs. The amount of money people are spending on drugs is actually higher than it would be if the price were lower, because the demand for drugs is not very elastic.

Region: You’ve shifted the supply curve, and moved up the demand curve.

Murphy: Exactly. So think about a simple world where the elasticity of demand is about a half. You quadruple the price of drugs, and the quantity of drugs is cut in half. So you’ve got four times the price, half the quantity. You’ve doubled expenditures. People are spending twice as much and consuming half as much.

Well, where did that added expenditure go? It goes to the drug dealers. It doesn’t go to the government; it doesn’t stay with the consumers. It goes to drug dealers. And that revenue actually finances the supply of drugs and finances the drug lords who supply drugs to the United States. So what we’ve really done in this case is financed the people who are on the other side of the War on Drugs. So, the War on Drugs, in our view, has been kind of doomed by its basic economics. That is, the harder you fight the war, the higher you push up the price. The higher the price, the higher the revenue of suppliers; the higher the price, the greater the incentive to supply drugs to the United States.

Now, what are the costs to the suppliers? Well, they have to avoid detection. They fight over turf for drug territories. They pay people off. They may go to prison. All those costs are pretty much bad things. They use violence to enforce their contracts and the like. Not a good outcome.

But when you put people in prison, you have to consider not only does it cost society in the form of people in prison who could otherwise be gainfully employed, but it also costs us money to put them there. So for every dollar of cost we impose on the drug suppliers, we spend at least a dollar of our own money on top of it to keep them there. If we normalize what we would have spent in a free market on drugs at $100, consumers are now spending $200 on half the quantity of drugs and then spending another $100 on top of that to put all those people in jail. So we’re paying three times as much for half as much output. From an economic point of view, that’s more than a little bit counterproductive.

Usually you think, if I’m going to produce less output at least it should cost me less.

Region: So, rational addiction but irrational . . .

Murphy: Irrational policy, right. So, what’s the answer? If you want to reduce consumption, raise the price. What’s the natural way to raise the price of something? Tax it. '

Some interesting recent readings

Scot Sumner on Woodrow Wilson as a president and Keynes as an invester

Market size in pre-industrial France  (I saw this paper in Oxford about a year and a half ago)

Robert Margo on North, Weingast and Wallis 

A post on Bob Allen's recent book  

John Quiggin on Andrew Glyn

Austrialian economist John Quiggen has some interesting comments on Andrew Glyn's last book Capitalism Unleashed which are worth reading. 

Inflation and Price Fixing in the late Roman Empire

Here is a fasincating account of Diocletian's attempt to legislate prices in the Roman empire.

Is Cristiano Ronaldo worth £80?

No says Simon Kuper in this article:

'Buying a player at his peak is bad timing, like buying a stock after a run of good news. The market has seen his quality but he is exhausted and possibly sated with success.'

Real Madrid are of course buying more than the player and if the marginal product of a player is what really matters then the contributions of the best player in the world maybe worth more than twice the price of the fifth best player. Nevertheless this deal looks like good business for the selling club who have made a net profit of about £67.5 million on the player. As Stefan Szmanski points out in this Time piece, it is the Glazer family, owners of Man United who benefit from this deal.  Research by  Szamnski has shown that as Kuper reports, a

`clubs’ outlay on transfers explained only 16 per cent of their total variation in league position. By contrast, their spending on salaries explained 92 per cent of that variation. The more a club pays its players, the higher it finishes. But what it pays for players in transfer fees to other clubs does not seem to make much difference'

The Bounds of Reason

PUP have kindly sent us a review copy of Herbert Gintis's new book The Bounds of Reason. The book is a combination of an excellent textbook on game theory and an innovation treatise advocating the unification of the behavioural sciences and refounding of game theory on different epistemic foundations. In particular Gintis argues that we should replace methodological individualism - the view that social phenomenon can be explained solely in terms of the beliefs and preferences of the individual actors that comprise them with a social epistemology:

'Epistemic game theory suggests that the conditions ensuring that individuals play a Nash equilibrium are not limited to their personal characteristics but rather include their common characteristics, in the form of common priors and common knowledge. We saw that both individual characteristics and collective understandings, the latter being irreducible to individual characteristics, are need to explain common knowledge. it is for this reason that methodological individualism is incorrect when applied to the analysis of social life' [162]

This claim is a contentious one.  I've not yet read solidly beyond the first few chapters so I'm not able to comment on the plausibility of the argument Gintis builds.  It is clearly an important contribution to the current debate over the rational actor model that the rise of behaviourial economics has provoked.

.

'A drunkard's walk'

Here is a nice description of a random walk process as being like `a drunkard's walk':

'where the drunk's position at any point in time during his walk is equal to his position one period ago, plus a completely random change. '

From this extremely insightful obituary of Sir Clive Granger who died this week.  It also contains a nice and intuitive description of co-integration.

'A simple analogy can again be drawn using the drunkard's walk. Suppose our drunkard is accompanied by his two faithful dogs. If we looked at the behaviour of the dogs in isolation they, like the drunk, would appear to follow random walks, yet the difference between their positions and the drunk are both, on average, constant. Here the drunk is the common trend.

The discovery of co-integrated relationships allows several of these "wandering" integrated variables to be combined in a way that allows for the reliable application of standard econometric methods, and it was this contribution that led Granger and Engle to be awarded the Bank of Sweden Nobel Memorial Prize in Economic Sciences in 2003.'

The Telegraph also have an obituary here which contains the following wry quote:

'Granger once wrote: "A teacher told my mother that 'I would never become successful', which illustrates the difficulty of long-run forecasting on inadequate data." '

Reality TV show contestants can sue for unfair dismissal in France

This hilarious Guardian article outlines how a French court are basically legislating Reality TV shows [as we know them at least] out of existence by stipulating that they pay overtime and provide holidays as well as allowing contestants to sue for unfair dismissal:

'After all, three L'Ile de la Tentation contestants who spent 12 days wearing very little, massaging each other and dancing on an island off the Mexican coast can now call their participation work under French labour laws – which stipulate that no one can be made to work more than 35 hours a week with the right to overtime, holidays and even damages for wrongful dismissal upon elimination from the show.

'The three "contestants realité" – Anthony Brocheton, Marie Adamiak and Arno Laizé – also trousered around £11,000 each after their three-year legal battle, including €8,176 each in overtime on the grounds that they had worked for 24 hours a day. They also won €817 for being denied a holiday, €500 for unfair dismissal and €1,500 for the wrongful termination of their contracts.'

The courts are probably canny enough to be intentionally using France's stringent labour laws to undermine the success of reality tv shows which are probably viewed as crass Anglo-Saxon imports.

Throwing stones into one's own habour

Some of the consequences of the Buy American provisions that could have straight from one of the parables of Bastiat.

'A contractor at the Camp Pendleton Marine base in California ripped out a section of sewerage pipe because it was Canadian-made; and a Canadian salesman travelling to an equestrian-products trade show was turned back at the Washington state border on the ground that he was “stealing” American jobs.'

From this article in the Economist.

Joachim Voth on the Industrious Revolution

An insightful review by Joachim Voth of Jan De Vries's 2008 book The Industrious Revolution has been put up on EH.net.  The review is very positive. Voth closes with a very interesting caveat:

The Fight over Adam Smith

A couple of weeks ago EconJournal Watch published a very erudite and informative article by Gavin Kennedy arguing that twentieth century economists had invented the 'the theory of the invisible hand' since Smith only refers to the concept fleetingly in three places in his writings.  Dan Klein responds here.   Gavin Kennedy's conclusion is:

'But modern economists took an isolated metaphor, used rarely by Adam Smith,
and in his name invented a wholly misleading belief of how commercial markets
function and how people in them necessarily and unintentionally work for public
benefit, independent of the consequences of their actions. And they introduced a self contradictory concept into economics, described as an ‘invisible hand explanation’,
yet it does not explain anything close to the explanatory value offered by economics
as a science, even where Smith left it. If anything, it obfuscates everything to which
it is applied.'

Twentieth century economists have seized on the metaphor of an invisible hand  in an anachronistic fashion. His critique of Paul Samuelson his spot on.  Many twentieth century economists from Samuelson to Arrow and Hahn, to Hayek and many others have been guilty of reading in modern views into Smith's own work and neglecting the eighteenth century context in which Smith was writing. In fact I wrote about this my undergraduate thesis:

'For Mark Blaug the invisible hand is ‘nothing more than the automatic equilibrating mechanism of the competitive market’ But Smith had used the metaphor in earlier works without reference to economics . . . There is also a rhetorical element to the invisible hand neglected in economic theory. Rothschild claims that the invisible hand was partly an aesthetic device ‘a sort of trinket’ intended to persuade, partly ‘an ironic joke’ on us, on himself and ‘on his immense posterity as well. It beautifies Smith’s ‘system’, and it certainly evokes religious imagery and symbolism for a secular cause, but it also evokes the bloody and invisible hand of Macbeth and pagan superstition, hence Rothschild’s speculation that Smith is secretly undermining and mocking his own system.’

In the same thesis I also called into doubt the claims of mid-twentieth century economists that the Smith’s `theory’ had now been fully worked out in the form of general equilibrium theory.

`The dynamic character of Smith’s model, and his preoccupation with the market process rather than with its results, cast doubt upon the claims of general equilibrium theorists that the static result obtained in the Arrow-Debreu model formalises Smith’s insights. For neoclassical economists the invisible hand is a poetic explanation of the general equilibrium welfare theorems. Kenneth Arrow and Frank Hahn, two of the most distinguished proponents of general-equilibrium-analysis maintain ‘that Smith was a creator of general equilibrium theory’ with a proviso concerning only the fact that ‘the coherence and consistency of his work may be questioned

So to this extent I am in total agreement with Gavin Kennedy’s argument.  However by his book, I was [in my 2003 thesis at least] also guilty of being anachronistic.  Like Dan Klein I think the idea or concept of an invisible hand is an excellent description of the theoretical framework that Smith does layout, an framework that explains how orders emerge. 

‘Smith’s economic and sociological theory required a device similar to the one he employed in his moral philosophy to explain how order comprised itself out of the apparently chaotic minds of individual men. The invisible hand metaphor was intended to change the way in which we think about how orderly social structures are formed. Smith’s point was that though no hand actually existed, there was a process at work, which generated order out of the actions of self-interested individuals but which was independent of any of their intentions. The invisible hand was in this sense, a device for separating the idea of order from the idea of an ‘orderer’, thereby freeing the notion of an orderly society from its authoritarian connotations, and making possible the ordered anarchy of the system of natural liberty. ‘

By a strict historical reading of the sort advocated by Gavin Kennedy and Emma Rothschild this view of Smith and the invisible hand might be judged as an anachronistic as that advocated by Samuelson or Arrow and Hahn or George Stigler. But this seems to be wrong too.  The Hayekian view of Smith that I think both myself and Dan Klein wish to push for is surely closer to Smith's own framework than is the general equilibrium framework. 

This distinction been different modern readings of Smith can be defended and is surely worth defending since I get almost as annoyed with people as Gavin Kennedy does when they talk loosely about Smith's 'theory of the invisible hand'.

At several points in both the theory of Moral Sentiments and the Wealth of Nations, Smith suggests a theory of social order as a emergent and self-organizing phenomenon.   He also dwells on the role self-interest plays both in motivating the baker to supply us with bread and in driving merchants to pursue monopolistic rights and privileges.  The interactions of self-interested individuals are what is ultimately driving the formation of the types of societal orders Smith is interested in. Together these two points suggest that identifying what institutions lead the interaction of self-interested individuals into produces socially suboptimal ends and what institutions lead to socially desirable ends, is an important question.  From this perspective, the term `invisible hand' is a convinient short 'hand' for the types of processes that lead to 'good' outcomes. 

[1] M. Blaug, Economic Theory in Retrospect (London 1962), p 50

[2] E. Rothschild. Economic Sentiments (London 2001), p 136-138

[3] K. Arrow and F. Hahn, General Equilibrium Analysis ( Oxford 1971), p 2

More on the Industrial Revolution in a Global Perspective

The Economist has this interesting article on Bob Allen's interpretation of the industrial revolution.

'JUST why the industrial revolution took place in Britain is a puzzle that arouses fierce emotions among social scientists. François Crouzet, a French historian, calls the search for an explanation “somehow akin to the quest for the Holy Grail”. Was it because capitalism was further along in Britain than in, say, France, the Netherlands or indeed China? Because Britain’s constitutional monarchy after 1688 minimised the intervention of the state and entrenched property rights? Because the British were better at science, or culturally more attuned to technology? Or did dumb luck drop the first spinning jenny on Lancashire rather than Lyon?

This debate matters, for the industrial revolution is quite probably the most important economic development of the past 500 years. It produced not a once-only step-up in productivity but a century-and-a-half of industrial expansion and continuing innovation that transformed lives everywhere. What is more, it stemmed from the globalisation of the early-modern period (Tudors, and all that) and gave rise to more. With global crisis raging anew, readers could do worse than ponder that long-ago upheaval.'

Kling on NWW

Here is Arnold Kling on North, Wallis and Weingast's new book Violence and Social Order (mentioned here ). He summarizes their views in the following 6 take home points:

1. The libertarian view of the ideal of limited government is a fantasy. Instead, for NWW the best state is an open-access order. The law is administered impersonally. There is very broad access to the tools for creating and participating in both economic and political organizations. Political and economic organizations are expected to be able to outlive their individual leaders. In an open-access order, government is not small. However, the competitive environment does lead government to provide public goods, rather than serve as a mechanism for the dominant coalition to extract rents from the population at large. Some organizations can be economically important without wielding great political power, and conversely some organizations can be important in politics without have great economic power.

2. The alternative to an open-access order is a limited-access order--also called a natural state. In a limited-access order, there is a dominant ruling coalition. All of the groups with a potential for organized violence are part of the coalition. They partition economic and political power among themselves. They exclude others. For an organization to have economic power, it must have political power. The law is far from impartial, particularly with respect to conflicts between those within the dominant coalition and those outside the dominant coalition.

3. Everywhere before 1800, and in most countries today, one finds natural states. Open-access orders are very recent developments.

4. The transition from a natural state to an open-access order is not simple or automatic. For elites, the transition means going from having privileges to having rights, and these rights are then extended to those outside of the dominant ruling coalition.

5. For NWW, the transition to an open-access order in the United States was not marked by the adoption of the Constitution. Rather, it occurred gradually over the 19th century. A key was granting citizens the right to charter corporations for any purpose. This right was granted by individual states, as the result of a competitive process among state governments. Another key was the development of political parties.

6. Most people start with the assumption that the state has a monopoly on the legitimate use of force. NWW point out that this monopoly should not be taken for granted. In natural states, there are multiple organizations with a capacity for violence. Equilibrium is maintained by agreements over privileges and rents. Outside reformers complain about corruption. However, there is no way to end the corruption without destroying the equilibrium and risking civil war. Think of Iraq. Or Pakistan. Or Mexico.

Violence and Social Order

I've just finished reading the new book from Douglass North, John Wallis and Barry Weingast Violence and Social Order.  Again I've blogged about it previously (here). The book is about the transition from 'natural states' to 'open access orders'. These two different forms of social organization solve the 'problem of violence' in very different ways and hence individual institutions like elections work very differently in each type of society.  Each type of order has its own logic.

On the Industrial Revolution in a Global Context

I've previously blogged about Bob Allen's work on the industrial revolution (see here ). Here is a Voxeu article which provides a nice summary of the main arguments of his book. Bob advances a purely economic or factor price explanation of why particular innovations occurred in England and not elsewhere.  This obviously contrasts with the significance most economists currently place on the role of political institutions in development.  Other economic historians like Joel Mokyr and Deirdre McCloskey have recently placed a lot of emphasis on cultural explanations of the emergence of modern economic growth. Since both these authors also have books on the causes of the industrial revolution coming out quite soon, as does  Jan Luiten van Zanden, the resulting debate in the months to come should be extremely interesting.   

Weidenfeld debate on the Financial Crisis

Here is the flyer for a debate taking place in Oxford between Pascal Salin and Valpy Fitzgerald on the 26th May at 6 pm in the Manor Road Lecture Theatre. Here is the blurb:

The present crisis appears to show that market economies are fundamentally unstable and cannot operate without stringent government regulations. What is even worse, financial markets might seem to operate in ways that are morally unacceptable. This would only reinforce the case for more government intervention – both in the West and in the developing world.

Are these views correct? What caused the present crisis? Was it greed, market failure, lack of regulation, bad policies or a mixture of all these? Should we blame Wall Street bankers or the FED? And what can be the way out of the current mess? Are the measures currently undertaken by world governments the right way to go? And, most importantly, what does the present crisis mean for the future of capitalism?

Interesting pieces on the financial crisis

Exam revision is not leaving much time to blog or keep up with the financial crisis, but I came across something today that I would definitely recommend: a paper by Andy Haldane of the Bank of England entitled 'Rethinking the Financial Network'. I'd also highly recommend a previous speech by Andy Haldane, 'Why Banks Failed the Stress Test', which is not actually related to today's relase of the US stress tests (for excellent coverage of these, and the crisis as a whole, see Baseline Scenario). Haldane makes a number of points and raises some compelling ideas that could potentially be formalised.

Economic History Blog

This (relatively) new economic history blog provides nice summaries of many of my favourite papers in economic history. They also mention plenty of papers that I've not read but now want to.

Robert Barro on Fiscal Multipliers in WW2

Tyler Cowen points to an interesting interview with Robert Barro on the New Deal and on the size of the fiscal multiplier.  Barro's done some recent work on the size of the wartime multiplier in the US between 1941 and 1945.  He argues that the multiplier on fiscal spending is less than one even during periods of high unemployment.

This bulids on the point he made in more detail in this article in the Wall Street Journal.

'I have estimated that World War II raised U.S. defense expenditures by $540 billion (1996 dollars) per year at the peak in 1943-44, amounting to 44% of real GDP. I also estimated that the war raised real GDP by $430 billion per year in 1943-44. Thus, the multiplier was 0.8 (430/540). The other way to put this is that the war lowered components of GDP aside from military purchases. The main declines were in private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses -- there was a dampener, rather than a multiplier.'

Supposing that this is correct, I'm not sure Barro can draw the implications from this that he wants to. In the interview he says:

'So I don’t think you can reliably say what the effect is. But conceptually you’d expect the wartime spending to have a bigger effect for various reasons on the GDP than the equivalent amount of expenditure in a non-war situation. And the wartime effect you can estimate pretty precisely and the multiplier is clearly less than 1, even in World War II'.

But why would the wartime multiplier be bigger than the peacetime multiplier? It seems plausible to me that the proportion of spending that is wasteful would be much higher during wartime. Furthermore  much of the goods being built in wartime would have been sent overseas so the leakages would be much higher. More importantly as Robert Higgs has pointed out many times the idea that fiscal spending in WW2 caused the American economy to grow in any meaningful sense is a statistical artifact.  

That said I share Barro's scepticism of the size of the fiscal multiplier cited in Christina Romer's policy piece. I'm not convinced that trying to identify the 'true' multiplier is a useful exercise as it varies greatly in each historical episode examined.

Update: I've just come across this Economist's Voice piece by Barro on the subject. The commentator on the article is somewhat sceptical.

Douglass North on the Natural State

I'm currently waiting for my copy of Douglass North's new book Violence and Social Orders cowritten with John Wallis and Barry Weingast.  To keep me occupied in the mean time I've been watching this lecture from 2008 on the Natural State. Hatip Division of Labour.

A Return to Industrial Policy

The Independent's front page today was entitled Labour's Industrial Revolution. This was unfortunate. There is a reason why the original industrial revolution  is not entitled the Whig's Industrial Revolution or the Tories's Industrial Revolution, and that is because it was not the brainchild of George III or William Pitt the Younger but the name historians have subsequently given to the unintended outcome of the spontaneous actions of untold thousands of private individuals. 

What the Independent are of course talking about (without mentioning the word) is old fashioned industrial policy. Now industrial policy has its defenders notably Dani Rodrik and I recently saw Ethan Kaplan present an interesting looking paper co-written with Fabrizio Zilibotti on this entitled "Industrial policy: a theory of coordination in development". But there appears to be little academic nuance in the government's plans.

We are told that the new report 'says the credit crunch showed that markets cannot be relied upon to serve the public interest'. This is a politically convinient narrative; it is also nonsense. The failures of finance (and of financial regulation) however say next to nothing about the optimal level of regulation or state direction that we should have in the auto industry or in goods markets generally.  The rest of the article is full of disclaimers by the government that they are not attempting to 'pick winners' when of course this is what their proposals call for. 

Rawls and Immigration

The dominant Rawlsian paradigm in political philosophy has always struggled to deal with questions concerning foreigners and immigration (for instance the Difference Principle applied to the whole world has very different implications from the Difference Principle applied to a single society).  Jonathan Dingle over at TradeDiversion has a nice post on this from the perspective of economic geography.  Rawls argues that in his discussion of an ideal society immigration will be irrelevent since political oppression and political failure are main reason why people migrate and that these factors will be irrelevent in an realistic utopia. Jonathan writes:

Even if the long-run steady state of ideal societies might result in little concern for immigration policy, immigration between decent and indecent societies would likely be a significant determinant of the transition dynamics to the realistic utopia. Surely liberal societies ought to have concern for immigration policy in this context . . .  For the sake of argument, concede everything that Rawls says above and contemplate the “realistic utopia” condition. Rawls is still wrong . . .

. . .  In a world of increasing returns and agglomeration economies, it makes no sense to keep people trapped within historically-produced arbitrary boundaries. It massively decreases human welfare. We want people to be free to gather in densely populated areas and reap the gains of more complex and frequent human interaction.

The Banco di San Giorgio

This weekend's FT has a nice piece on the origins of central banking and the Banco di San Giorgio. It claims that

It is Felloni’s contention that what he has discovered in these archives will transform our understanding of the origins of modern finance and banking, and perhaps even of capitalism itself. Many of the concepts and practices that are commonplace today were, Felloni argues, pioneered or improved upon by the Banco di San Giorgio. They include the issuing and management of government debt, double-entry book-keeping, sinking funds – funds into which payments are made so that a particular debt can be repaid – the role in financial transactions of the clearing house, which wasn’t adapted in England until the 18th century, and the organisation and conduct of lotteries.

The article celebrates the work of the historian Giuseppe Felloni whose article on the bank is available here. This recent article in the European Review of Economic History by Michele Fratianni and Franco Spinelli on the role of the Italian city states in pioneering modern financial techniques is also highly recommended.

Some interesting bits of economic history

I've come across a couple of interesting pieces of recent economic history research on the web which I thought I'd share.

1. This is old but this post by YouNotSneaky on the Brenner Debate is excellent. For those not in the know the Brenner debate (for a interesting summary see here) refers to the puzzle that the Black Death resulted in the demise of serfdom in Western Europe but the imposition or reimposition of serfdom in Eastern Europe. Since it illustrates how a common shock can have different effects in different places because of how it is channelled by existing political/economic mechanisms, this debate is highly relevant to the modern debate on the importance of institutions.
2. Also relatively old but Economic Logic mentions this paper by Cem Karayalçin on the rise of the West.  It uses a formal model to revisit the classic argument that economic growth began in Europe because competition between European states limited taxation and expropriation while Asian empires were not so constrained because their citizens had no exit options. The main problem with the paper is that it doesn't explain how come growth took off in  England in the eighteenth century which had the highest taxes in Europe (and higher taxes than any Asian economy).
3. Joachim Voth and Nico Voigtlaender have two excellent papers on the Malthusian economy (see here and here) . I particularly like the second paper on the European marriage pattern (EMP) as the this was largely responsible for why England was such a high wage economy in the period before the industrial revolution (this is an topic I've been thinking a lot about recently and is obviously important for Bob Allen's account of the industrial revolution). 

Phelps on the true nature of capitalism

Edmund Phelps channels Hayek, Knight and Keynes in today's excellent FT comment. Like Acemoglu's relatively recent artlcle, he cautions us not to repudiate the economic system that has made us rich. He outlines the great benefits that capitalism has brought:

'new cities rising, unbroken productivity growth, steadily climbing wages and generally high employment. Lifetime prospects improved for all or nearly all participants. Less measurable but ultimately fundamental, growing numbers of people in capitalist economies had engaging careers and were energised by their challenges and explorations.'

Crucially Phelps hits on what I think is the true reason for this achievement and this is not be found in notions of market efficiency, or even in R&D and science but in Hayek's insight that

'Any modern economy, capitalist or state-run, is a great soup of private “know-how” dispersed among the specialised participants. No one, he said, not even a state agency, could amass all the knowledge that each participant “on the spot” inevitably acquires. The state would have no idea where to invest. Only capitalism solves this “knowledge problem”.'

The question this current crisis raises is what went wrong institutionally? [since this is not a crisis caused by greed or self-interest or even by a lack of regulation but rather by the wrong regulation or more pertinently the wrong set of institutions]. Phelps notes that

An explanation offered is that the bankers, whatever they knew about capitalism, knew that to keep their jobs and their bonuses they would have to borrow more and more to lend more and more, in order to meet profit targets and hold up share prices. The implication was that the crisis flowed from a failure of corporate governance to curb bonuses and of regulation to rein in leveraging of bank capital to levels that made the banks vulnerable to a break in housing prices.

But why did big shareholders not move to stop over-leveraging before it reached dangerous levels? Why did legislators not demand regulatory intervention? The answer, I believe, is that they had no sense of the existing Knightian uncertainty. So they had no sense of the possibility of a huge break in housing prices and no sense of the fundamental inapplicability of the risk management models used in the banks. “Risk” came to mean volatility over some recent past. The volatility of the price as it vibrates around some path was considered but not the uncertainty of the path itself: the risk that it would shift down. The banks’ chief executives, too, had little grasp of uncertainty. Some had the instinct to buy insurance but did not see the uncertainty of the insurer’s solvency.

Bob Allen's new book

I've just come back from the Economic History Society annual conference at Warwick with an copy of Bob Allen's new book The British Industrial Revolution in Global Perspective. Bob gave the Tawney lecture which should appear online at some point.  Bob focuses on the famous technological innovations. At the core of the book is an economic argument based on the idea of biased technological change to account for why these innovations occurred in England and not in France or India.  You can get a sense of the argument from the press release:

Development Drums

Following on from Mark's post, a podcast discussion with Paul Collier is available in episode 10 of the Development Drums podcast which can be found at http://developmentdrums.org/

I'd highly reccomend the whole series of podcasts for anyone interested in development issues. Owen Barder puts thought-provoking and topical issues to some of the highest profile names in the development arena.

Owen also blogs at http://www.owen.org/blog

War, Guns and Votes

I've just finished reading Paul Collier new book War, Guns, and Votes. It is getting good reviews (in  The Guardian and The Sunday Times for instance) though few people seem on board with the policy proposals yet. Marginal Revolution mention it here. 

One of the big themes of the book is incentive compatibility. It reads like a modern version of the Prince at times - and not only when the author is directly addressing dictators - because it focuses on what is feasible rather than on what is desirable. The message I took from it was that democratic institutions in general – and elections in particular - have been mythologized.  Institutions are about incentive structures. Transferring the semblance of an institution from one society to another is one thing but transferring the institution itself and all the informal beliefs, customs and social norms that the institution entails is another.

The state of the state of the art

There has been a lot of discussion lately on the state of economics in light of the profession’s collective failure to foresee or prevent the financial crisis and its inability to offer simple prescriptions to remedy it. This is a sharp turn of events from a few years ago when macroeconomists were involved in a lot of self-congratulatory behaviour and hubris was common. For example, Robert Lucas in 2003 said “macroeconomics in this original sense has succeeded: Its central problem of depression-prevention has been solved, for all practical purposes.” Just last year Olivier Blanchard wrote that “The state of macro is good.”

 

Of course this is not to say that most macroeconomists thought that their research agenda was anywhere near complete. If you were to ask leading policy related macroeconomists what the obvious blind spots were in the field my guess would be that the top answers would include the use of fiscal policy (Justin Wolfers illustrates this one nicely), how to conduct monetary policy at the zero bound and the role of financial frictions and banks in the real economy. So in some ways the crisis has hit macroeconomics where it is most wanting.

 

However, some are now suggesting a more systematic failure of the discipline. Not only did economists not pay enough attention or come up with good enough answers to what proved to be important features of the economy, but their whole perspective was lacking. Willem Buiter is typically damning. Here are a few characteristically brilliant excerpts:

“Both the New Classical and New Keynesian complete markets macroeconomic theories not only did not allow questions about insolvency and illiquidity to be answered.  They did not allow such questions to be asked.”

“If any market takes a finite amount of resources (however small) to function, complete markets would exhaust the resources of the universe.”

“Confusing the equilibrium of a decentralised market economy, competitive or otherwise, with the outcome of a mathematical programming exercise should no longer be acceptable. So, no Oikomenia, there is no pot of gold at the end of the rainbow, and no Auctioneer at the end of time.”

Mark Thoma adds some thoughtful comments here.

 

The ‘Dahlem report’ is also well worth a read looking deeper as to what led economics off track and into “a sub-optimal equilibrium in which much of its research efforts are not directed towards the most prevalent needs of society”. Here are some comments by Justin Wolfers.

Markets don't exist in a vacuum

Amartya Sen on reading Smith in today's FT.

And so to zero (or not)

I had been planning on writing a more detailed blog post on monetary policy at the zero bound and quantitative easing, but for now I wanted to highlight a point about UK interest rates.

Last thursday the Bank of England announced a reduction in the base rate by a further 50bps to 0.5%. I believe, and get the impression that the Bank also believes, that this is as low as rates will go. This contrasts with the Federal reserve who now have effectively hit the zero bound with a target range for the federal funds rate of 0-0.25%. In contrast the ECB remain very much behind the curve, at 2.5%. Willem Buiter arguesin favour of a larger rate cut, criticising the reduction as putting “the Bank further behind the curve.”

 

However, I would argue the exact opposite: that leaving rates at 0.5% is a deliberate and insightful move by the Bank of England, and puts them ahead of the curve. For once I would disagree with Buiter. The reason for this strategy is that further reductions in the base rate are likely to have a negative impact on the health of the banking sector. The Bank of England has repeatedly hinted at this, including in the minutes from the February meeting: “It was possible that the negative impact on profitability could be significant for some banks as Bank Rate fell further” and in their statement today: “But the Committee also noted that a very low level of Bank Rate could have counter-productive effects on the operation of some financial markets and on the lending capacity of the banking system.”

 

This is the case because banks cant set interest rates on deposit accounts at below zero, and hence the spreads that banks generate their profits from are squeezed. The banking sector makes a profit on all the deposits it holds by offering an interest rate on them below the Bank of England base rate. This spread covers the costs of running a financial intermediation service and generates a profit for the bank in question. Now most deposits are held in current accounts, which pay very little interest anyway. As the base rate falls towards zero, this spread too shrinks towards zero. Therefore at the moment the desired deposit rate for banks would be negative, but instead its spread is being squeezed and interest rate cuts not being passed on to depositors. Banks in the traditional sense of liquidity transformation use these deposits to make loans, on which the interest rates are higher than the base rate. As deposit rates fall to zero and are desired to be negative, maintaining the spread between the base rate and the lending rate reduces the spread between the lending rate and the deposit rate. Hence either banks see this spread squeezed, or choose not to pass on the rate cut to borrowers. In some instances banks may seek to preserve profitability by pricing up lending rates.

 

These effects are problematic at the moment because not only does the monetary transmission mechanism become impaired, but bank profitability reduces. And so the ability of the banking sector to rebuild its capital is damaged by reducing interest rates. The Bank Rate has to balance the twin objectives of boosting aggregate demand which is deficient because the economy is in a credit crunch and to maintain banks profitability in order to encourage lending. And so the authorities are risking taking away with one hand what they gave with the other.

 

Overall, this seems to be a good move. We have to remember that the zero bound we are approaching is not yet as is typical being accompanied by the spectre of a deflation trap (despite some of the rhetoric coming from the MPC). The crisis is in the banking sector, and so special consideration has to be paid to banks. And so not only is monetary policy pushing on a string with regards to stimulating the whole economy, it has become a blunt instrument with regards to the banking sector. It makes sense to begin quantitative easing now, and leave rates at 0.5%, rather than further harm the health of the banking sector and leave them to “grin and bear it” as Buiter suggests.