Jason Furman vs Steven Landsburg 2

The Los Angeles Times has another "DUST-UP" between Jason Furman and Steven Landsburg. This time Landsburg and Furman discuss the stimulus package in the context of the government's deficit spending.

Tax burden

According to figures in the latest edition of the OECD’s annual Revenue Statistics publication the average tax burden in OECD countries is back up to the historic highs of 2000 after a brief reduction between 2001 and 2004. The tax burden is measured as the ratio of total tax revenue to gross domestic product (GDP). The average tax burden in the 30 OECD countries reached 36.2% of GDP in 2005, the latest year for which complete figures are available. The lowest burden appears to be Korea (South I would assume) with a ratio of 25.5%. The highest is Sweden at a whopping 50.7%!

In the case of New Zealand the ratio stands at 37.8 for 2005, so above the OECD average. For comparison, Australia's ratio is 30.9, Ireland's 30.6 and the US is 27.3. It is interesting to note that in 1975, the first year for which figures are given, New Zealand's ratio was 28.5 while Australia's was 25.8. So back in 1975 New Zealanders paid a bit less than 3% more of GDP in tax than Australians while by 2005 the gap had risen to about 7%. In 1975 the OECD average was 29.5%, so New Zealand was below the average back then. Over time the government in New Zealand is taking an ever increasing share of people's income.

Voting with your feet.

An article on the website CFR.org reports that

Some sixty thousand Zimbabweans were deported from Botswana in 2006, and over 23,000 were deported between April and November 2007. South Africa deported over 150,000 Zimbabweans in the first nine months of 2007, according to Refugees International.

The report goes on to point out that

... the primary reason Zimbabweans leave their country: the need for money.

These people are economic refugees who are simply fleeing Zimbabwe's economic collapse. The huge number of such people just goes to show how bad the situation in Zimbabwe has become.

There is little point in trying to bring about change by voting in an election in Zimbabwe, so people vote with their feet ... repeatedly,

"These repatriations are more or less a vicious cycle," says Moses M. Gaealafswe, Botswana's chief immigration officer told CFR.org. "You arrest them today, you repatriate them tomorrow, next week they are here."

Don't Cry for Free Trade

Or so says Jagdish N. Bhagwati, and who would know better? In an article on the website of the Council on Foreign Relations Bhagwati points out that if you

[t]urn to the leading American newspapers these days and you will read about the "loss of nerve", even "loss of faith", in free trade by economists.

Bhagwati tries to give some perspective on the current media stories about the economists' disappearing consensus on free trade by looking at three recent episodes where journalists have sounded similar false alarms on the topic. He writes,

... let me then turn to document different episodes in recent years when false notes of alarm were sounded over free trade, similar in hype to those of the motley crew that I have just cited as the latest journalists writing in a similar vein. I will assess and dismiss the "heretical" arguments that were advanced against free trade in each episode; in fact, I was cast by the media in the role of the defender of free trade in all these episodes.

The episodes Bhagwati deals with are

• Episode 1. The Rise of Japan: Krugman and Tyson
• Episode 2. The Rise of India and China: Paul Samuelson
• Episode 3. India and China and Fear of Outsourcing: Alan Blinder

Bhagwati's basic aim is to point out the obvious, that

[t]he truth of the matter is that free trade is alive and well among economists, their analytical arguments in favor of it, developed with great sophistication in the postwar theory of commercial policy, having hardly been dented by any original arguments by the few economists, including Alan Blinder in today's debate, arrayed against it.

It is an article well worth reading.

Jason Furman vs Steven Landsburg

The Los Angeles Times has a "DUST-UP" between Jason Furman and Steven Landsburg on the usefulness, or otherwise, of the recent stimulus package in the US.

(HT: Greg Mankiw)

Collier on EconTalk

Russ Robert's guest on EconTalk this week is Oxford University Economics Professor Paul Collier, author of the recent book The Bottom Billion. This book is analysis of why the poorest countries in the world fail to grow. Collier talks with Roberts about conflict, natural resources, being landlocked, and bad governance; four factors Collier identifies as causes of the desperate poverty and stagnation in the countries where 1/6 of the world's poorest peoples live.

A point worth noting is that William Easterly is scheduled to appear on EconTalk in two weeks. He'll provide a different perspective on some of the same issues, as is demonstrated by his review (pdf) of Collier's book.

Marginal Revolution book forum 2

The second instalment of the Marginal Revolution book forum on Tim Harford's book, The Logic of Life is available. The reviewer is Fabio Rojas and he's looking at chapter 2.

Coalition against fiscal stimulus (updated)

Greg Mankiw has a "coalition against fiscal stimulus" here.

Update: The Bayesian Heresy has links to a number of views on the merits of fiscal stimulus.

New Hayek blog

There is a new blog on the ideas and works of F. A. Hayek available at Taking Hayek Seriously.

One must have a prize. (updated)

Tim Harford has an interesting column at FT.com on the use of prizes rather than, say, patents to stimulate innovation. Harford points out that in the past governments used prizes as the standard way of rewarding innovators. The most famous example being John Harrison's answer to the problem of finding a way for a ship's navigator to determine a ship's longitude and therefore its position at sea. But as Harford notes such prizes fell out of fashion. Patents became the standard way to encourage and protect commercial innovators while basic research is funded more by grants than prizes.

Until now. A number of groups are beginning to use prises again to motivate innovators to find answers to the groups problems. Harford gives the examples of

The most famous innovation prize of this century, the $10m Ansari X Prize, was designed to promote private space flight. The pot went to Mojave Aerospace Ventures in 2004, after the successful flights of SpaceShipOne. And even the Ansari X Prize is dwarfed by a quasi-prize of up to $1.5bn that is about to be offered by five national governments and the Gates Foundation to the developers and suppliers of a more effective vaccine against pneumococcal diseases such as pneumonia, meningitis and bronchitis. The prize, called an "advanced market commitment" or "advanced purchase commitment", takes the form of an agreement to subsidise heavily the first big orders of a successful vaccine. Given that the top companies in the UK’s powerful pharmaceutical industry spent little more than £5bn in 2006 on research and development, a $1.5bn prize should be taken seriously on hard-nosed commercial grounds alone.

Prizes have some nice features, one of which is that they overcome the biggest problem with patents; namely the monopoly that patents provide. This downside is fundamental to the very design of a patent,

... in order to reward an innovator, the patent confers a monopoly. Economists view this as, at best, a necessary evil since monopolies distort prices. In the hope of raising profits from some customers, they will price others out of a market. The most obvious victims are consumers in poor countries.

But as Jean Tirole has explained, in a world of incomplete contracts (ie the real world) the patent system may make sense,

It has long been recognized that patents are an inefficient method for providing incentives for innovation since they confer monopoly power on their holders. Information being a public good, it would be ex post socially optimal to award a prize to the innovator and to disseminate the innovation at a low fee. Yet the patent system has proved to be an unexpectedly robust institution. That no one has come up with a superior alternative is presumably due to the fact that, first, it is difficult to describe in advance the parameters that determine the social value of an innovation and therefore the prize to be paid to the inventor, and, second, that we do not trust a system in which a judge or arbitrator would determine ex post the social value of the innovation (perhaps because we are worried that the judge might be incompetent or would have low incentives to become informed, or else would collude with the inventor to overstate the value of the innovation or with the government to understate it). A patent system has the definite advantage of not relying on such ex ante or ex post descriptions (although the definition of the breadth of a patent does).

But as Harford explains it isn't all or nothing, patent or prize, but rather the

[c]hampions of prizes see them as a component of a wider system to promote innovation, rather than as an outright replacement either for grants or patents. Instead, the hope is that prizes will help to compensate for the specific weaknesses of those alternatives.

Another way to reward innovation would be to grant a patent and then have the government buy it and place in the public domain. Each patent could be put up for auction and at the end of the auction ownership of the patent could be randomly determined. If the (private) winner of the auction is chosen then he pays his bid and gets the patent and if the government is chosen it pays the amount of private winner's bid and is assigned the patent.

Anyway the Harford article is worth reading.

Update: The Victory Project proposes billion-dollar prizes for

To the first person(s) that solves any of these Problems:

1. Develop a cure for breast cancer.
2. Develop a cure for diabetes.
3. Reduce greenhouse emissions from petroleum powered automobiles by 95% without increasing the cost of a normal car more than 5%.
4. Achieve 150 miles per gallon of gasoline in a 3,000 lb. car, using EPA standards; without increasing the cost of a normal car more than 10%.

(HT: Arnold Kling, EconLog)

Chocolate chips are distributed Poisson

According to Herbie Lee, an associate professor of applied mathematics and statistics at the University of California, Santa Cruz, Baskin School of Engineering, the numerical distribution of chocolate chips in commercially baked cookies is Poisson!!!

Now thats important news!

The Law of Unintended Consequences (updated x4)

Alex Tabarrok has an excellent post on the topic of The Law of Unintended Consequences at Marginal Revolution. Tabarrok writes,

The law of unintended consequences is what happens when a simple system tries to regulate a complex system. The political system is simple, it operates with limited information (rational ignorance), short time horizons, low feedback, and poor and misaligned incentives. Society in contrast is a complex, evolving, high-feedback, incentive-driven system. When a simple system tries to regulate a complex system you often get unintended consequences. Unintended consequences are not restricted to government regulation of society but can also happen when government tries to regulate other complex systems such as the ecosystem (e.g. fire prevention policy that reduces forest diversity and increases mass fires, dam building that destroys wet lands and makes floods more likely etc.) Unintended consequences can even happen in the attempted regulation of complex physical systems (here is a classic example involving turbulence).

The fact that unintended consequences of government regulation are usually (but not always or necessarily) negative is not an accident. A regulation requiring apartments to have air-conditioning, for example, pushes the rental contract against the landlord and in favor of the tenant but the landlord can easily push back by raising the rent and in so doing will create a situation where both the landlord and tenant are worse off.

Tabarrok then makes an important point,

More generally, when regulation pushes against incentives, incentives tend to push back creating unintended consequences. Not all regulation pushes against incentives, some regulations try to change incentives but incentives are complex and constraints change so even incentive-driven regulations can have unintended consequences.

Yet again we see incentives matter, and if we ignore them we are heading for trouble, unintended or otherwise. Tabarrok ends by asking the question,

Does the law of unintended consequences mean that the government should never try to regulate complex systems? No, of course not, but it does mean that regulators should be humble (no trying to remake man and society) and the hurdle for regulation should be high.

Update: Steve Phelan at Organizations and Markets comments here.

Update 2: Russ Roberts at Cafe Hayek comments here.

Update 3: Arnold Kling's comments are here.

Update 4: The Ambrosini Critique comments here: Nominee for MR post of the decade.

The foolishness of economic 'stimulus' (updated)

Donald J. Boudreaux has an article in the Christian Science Monitor under the title The foolishness of economic 'stimulus'. In it Boudreaux argues that

... stimulus, however, is futile. Government cannot create genuine spending power; the most it can do is to transfer it from Smith to Jones. If the Treasury sends a stimulus check to Jones, the money comes from taxes, from borrowing, or is newly created.

If it comes from taxes, the value of Jones's stimulus check is offset by the greater taxes paid by Smith, who will then have fewer dollars to spend or invest. If Uncle Sam borrows to pay for the stimulus checks, this borrowing takes money out of the private sector. Any dollars borrowed – whether from foreigners or fellow Americans – for purposes of stimulus would have been spent or invested in other ways were they not loaned to the government.

The only other means of paying for such stimulus is for the Federal Reserve to create new money. Unfortunately, this option leads inevitably to inflation.

Boudreaux's last paragraph makes an important point that we should not lose sight of,

Sound money, low taxes, and free trade might not "stimulate" the economy today, but this combination will surely increase its vigor over the long-run.

And it is economic growth over the longer term that raises our standard of living.

Update: Arnold Kling gives his view on Boudreaux's view in Boudreaux vs. Macro.

Incentves matter: Chinese peasant file

As I have noted before Venezuelan President Hugo Chavez has threatened to nationalise farms, in an effort to tackle food shortages. Perhaps he should take note of the effects of agricultural reforms in China before doing so. As John McMillan describes in his book, Games, Strategies, and Managers, the lives of some 800 million peasants in China were radically changed when Deng Xiaoping abolished the commune system and introduced the "household responsibility system". The incentives under the two schemes are very different.

Under the commune system, peasants were organised into production teams. The members of each team were assigned work points. These points were an attempt to measure both how many hours and how effectively that particular team member had worked. Each members income was dependent on the number of work points accumulated. Income was not perfectly related to effort, however, because it was impossible to observe how conscientiously each individual worked. Moreover, there was a tendency to spread the commune's earnings across the individual commune members: those with larger families were given more income, regardless of effort. Thus the link between individual effort and reward was weak.

On the other hand, under the responsibility system each peasant family is given a long-term lease of a plot of land. There is a requirement that the household deliver a certain quota of produce to the government each year but any production over and above this quota may kept by the household. The household is free to consume it themselves, sell it to the government, or sell it in the newly instituted rural markets. With the exception of the special case of rice, they may decide for themselves what crops to sow and what animals to raise. The peasants know that, after the quota is exceeded, they own the entire extra output resulting from any extra effort they choose to make.

The results of this change in terms of productivity are interesting, and the thing Hugo Chavez should take note of. By productivity we mean the amount of output for a given set of inputs; the efficiency with which the input are used. As McMillan describes it,

Through the Maoist period ... productivity fluctuated randomly, though the net effect was negative - by 1977, according to these estimates, productivity had declined to about 90% of its 1952 (precommune- system) level (despite technological advances such as improved rice strains during that period). In 1978 and 1979, under Deng, the government increased the prices paid for agricultural outputs, while leaving the structure of the commune system unchanged. [...] productivity increased, showing that the commune system was not completely devoid of efficiency: the communes could respond to the incentive of higher prices. Then, from 1980 to 1984, the commune system was gradually replaced by the responsibility system: the [data] shows the productivity growth as the peasants began to respond to the strengthened individual incentives. In marked contrast to the apparently random alternations between positive and negative growth in the pre-1978 picture, productivity increased in each year from 1978 on, with the most spectacular growth, 11%, occurring in 1984. Output increased by 67% between 1978 and 1985. In part this was caused by an increase in inputs. But mainly it was due to the strengthened incentives: productivity increased by nearly 50%. The effective quality of labor was much higher under the responsibility system than in the communes. Individual workers in the commune had an incentive to shirk, since they were paid only a fraction of the return from the effort they exerted. Chinese agriculture provides, therefore, a dramatic experiment in the effectiveness of incentives. [p.97-8]

The state of the public service. (updated x3)

I see that the National Business Review is reporting that Mark Prebble, the State Services Commissioner has announced that he will be leaving his job about a year earlier than planned. This is apparently for "health reasons". However as the NBR also points out

... the temptation to chalk him up as another casualty of a series of minor scandals about the alleged politicization of the public service in the last year may prove irresistible.

At the same time the NBR has an article by Dr. John Gibson, Professor of Economcis at the University of Waikato, reporting on research into why public servants in New Zealand get paid 20 per cent more than similar workers in the private sector. Gibson writes,

My research shows that this pay gap is not due to obvious differences in job conditions, such as stress, whether jobs require physical labour, how interesting the work is or the scope for improving ones skills.

But the source of this pay gap has become apparent in recent months. It's the "bite your lip and be the fall guy" premium. (My emphases.)

May be 20% isn't enough for Mark Prebble. Gibson goes on to say,

This economy with the truth is aided and abetted by some of the weakest public sector leadership that we have seen in many years. Why don’t public sector CEOs stand up and defend the integrity of advice that their staff have given? Why do they roll over and play dead while the politicians tell porkies?

But this comes at a price to New Zealand as a whole. The public service is the major supplier of economic policy advice in this country. It dominates the market for advice in a manner not true overseas and so its all the more important that their advice is truly independent. There are few outside checks on what the public service says. Gibson writes,

It is no wonder that almost all of the researchers in Treasury have either left or taken secondments so that they spend as little time as possible at No 1, The Terrace. What’s the point, when research is systematically ignored or distorted by politicians?

What's the point, when senior management check which way the wind is blowing before taking a position and will even disassociate themselves from research done in their own department.

Having a compliant rather than an independent, research-led Treasury is hugely costly to New Zealand. Unlike in larger countries, there are few other sources of evidence-based advice on which to set economic policy.

Good independent economic advice is a must if New Zealand is to move up the OECD rankings as we are told by the government we must do. But if the government really believes this then why is it not encouraging honest, open and independent advance from its own departments?

Update: Not PC comments on the issue here: The demise of the Head Bureaucrat.

Update 2: Kiwiblog comments on Mark Prebble here: Prebble quits.

Update 3: The New Zealand Herald story on Mark Prebble is here.

Marginal Revolution book forum

For those few who don't already know, Marginal Revolution is hosting a book forum on Tim Harford's new book, The Logic of Life (pin factory error and all). The first reviewer is Bryan Caplan of the Economics Department at George Mason University.

Strange simulus idea

There is a very strange article in the New York Times. Make the Tax Cuts Work is by Len Burman, director of the Urban-Brookings Tax Policy Center. In his article Burman says,

But if they were repealed in a year, the Bush tax cuts could spur a burst of economic activity in 2008. If people knew that their tax rates were going up next year, they’d work to make sure that more of their income is taxed at this year’s lower rates. Investors would likewise have a giant incentive to cash out their capital gains now to avoid paying higher taxes later.

But if this is right then why doesn't the government declare that as from next year the tax rate will be 100% and then people would work like crazy this year to avoid having their income taxed at 100% next year. The increase in work this year would be huge!

The problem here seems to be short term thinking. Maybe people would work harder today, but how much extra spending would result? It seems likely that people would spend their addition income over time, not all today. So any increase in consumption today would be small which means the stimulus resulting form this spending would be small. And what of the future? Would work effort in the future be reduced under Burman's plan? So future spending and stimulus would be reduced. So in the future some additional stimulus plan would be needed, which I'm sure Mr Burman would provide.

Ken Lay as a CEO

From Peter Klein at Organizations and Markets we learn that James A. Brickley of the Simon Graduate School of Business, University of Rochester, has a working paper out on "The Role of CEOs in Large Corporations: Evidence from Ken Lay at Enron", and the results are not what I would have thought.

Internal documents released through the Enron litigation allow for a more detailed examination of the activities of top executives than is typically possible. This clinical study of Enron's Ken Lay highlights the difference between popular opinion on the role and knowledge of CEOs with that suggested by economic theory and evidence. In contrast to popular opinion, the evidence is consistent with the following three hypotheses: 1) Lay performed a role at Enron that is consistent with existing economic theory and evidence, 2) he performed this role with reasonable diligence, and 3) while he was relatively well informed about Enron at a high level, it is unlikely that he would have had detailed information on many of Enron's transactions - including deals with Fastow's partnerships. News analysts assert that a positive feature of Lay's legacy is that CEOs are now spending more time monitoring the details of financial reports and internal controls. This study suggests that the opportunity costs of this change in CEO behavior are higher than these analysts suggest.

Inefficiency is good!

This from an address, Economic Freedom, Human Freedom, Political Freedom, given by Milton Friedman, at the Smith Center for Private Enterprise Studies in 1991.

The United States today is more than 50% socialist in terms of the fraction of our resources that are controlled by the government. Fortunately, socialism is so inefficient that it does not control 50% of our lives. Fortunately, most of that is wasted. People worry about government waste; I don't. I just shudder at what would happen to freedom in this country if the government were efficient in spending our money.

Rambo Inflation

From Marginal Revolution comes figures on Rambo Inflation: the number of people killed per minute in the Rambo series.

Rambo: First Blood (1982): 0.01

Rambo: First Blood Part II (1985): 0.72

Rambo III (1988): 1.30

Rambo IV (2008): 2.59

Roberts on stimulus, again. (updated)

Following on from his commentary on National Public Radio (NPR), Russ Roberts continues to discuss proposals to stimulate the economy. Here Roberts starts by considering a basic question: If you received a windfall, that is, an unexpected increase in your income, what would you do with it? He considers two cases

1. Your rich uncle dies who hated you. But he left you money anyway—$1600. What do you do with the money?

2. The government announces a $1600 rebate for all families, financed by borrowing. What do you do with the money?

The answer, of course is, it depends,

With the inheritance, you feel a little richer. You might splurge on a fancy weekend in New York. Or you might save all of it. Or something in between. But with the rebate, you are less likely to spend it. Why? Because your taxes (or someone's taxes) are going to go up in the future and that will discourage the feeling that you're wealthier.

The basic point here is what economists call Ricardian equivalence, for a given level of government spending, a tax cut today implies a tax increase tomorrow and so you save the tax cut to pay for the future tax increase. If this happens there wouldn't be much stimulus from a tax decrease. As Roberts explains it,

Well, if the government isn't going to cut spending (and they're not, because that would offset the stimulus of the tax cut, wouldn't it?), then it's going to have to borrow all the money to cover its spending for this year. The bonds the government sells are going to have to be repaid. We're going to have higher taxes next year and the year after. I think we better put [the tax cut] aside to pay for those taxes.

Thus no increase in spending.

Update: For a quick overview of the standard view on a stimulus package see this from Arnold Kling, Stimulus: The Mainstream View.

Don Boudreaux on Globalization and Trade Deficits

Don Boudreaux is Russ Roberts guest on EconTalk this week. Boudreaux is in the economics department at George Mason University. He and Roberts talk about the ideas in Boudreaux's new book, Globalization. The topics discussed include comparative advantage, the winners and losers from trade, trade deficits, and inequality.

Chavez following Mugabe?

This BBC report says that Venezuelan President Hugo Chavez has threatened to nationalise farms, in an effort to tackle food shortages. Exactly how this will help isn't clear. The report states that Venezuelan government controls keep food prices low in shops to help even the poorest Venezuelans feed themselves. But some farmers prefer to sell their produce in neighbouring countries where prices are higher and this leads to shortages of bread, milk, eggs and meat. Arbitrage anyone?

You do have to wonder why Chavez thinks that nationalisation will improve the incentives for framers to produce more and sell locally. Has nationalisation increased farm output in any country that has tried it?

The report also says that Chavez also announced a rise in milk prices, in an apparent attempt to tackle recent shortages. That will help. It will at least reduce the incentives for arbitrage.

Are wages in Africa too high?

Tyler Cowen points us to this interesting posting by Chris Blattman, a political science professor at Yale. Blattman writes,

One thing that has always struck me in the African countries I have worked is that the real wages (i.e. wages adjusted for the cost of living) of African formal sector workers seem to be incredibly high, at least compared to that of workers in China or India. Given that firms in China and India seem to be more productive than their African counterparts, it creates a double disadvantage for African workers, and raises the question of why the situation continues. Why don't manufacturing wages fall in Africa, stimulating more jobs for more people at wages still higher than those available in agriculture or informal business?

Why, when I run a survey in rural Uganda, do youth with the same education and experience expect a wage three to four times higher than the youth I worked with in India? I don't begrudge anyone anywhere a living wage. It's the relative differential that puzzles me, and that could be keeping Africa from doing business globally.

There are probably lots of plausible reasons. Perhaps we ought to consider (and get data on) the informal sector in Africa, which could be larger and have more moderate wages than the formal sector ones. It may be that all my notions and data about African wages are erroneous.

Another possibility, however, is that the largest employers of skilled workers in most African countries are international NGOs and the local government. They are competing, in many cases, for the same pool of skilled and semi-skilled workers as the manufacturers and service sector firms. Neither the government or NGOs, moreover, seem to set wages according to the local market or local conditions, and it requires little imagination to wonder whether they set their wages higher than the market would normally do.

Why not just stop expanding the money supply?

A story from the BBC says that Zimbabwe's central bank is to introduce new higher-denomination banknotes (the highest value note is worth 10m Zimbabwean dollars) in an effort to ease the critical shortage of cash in the country. But according to the report the $10m note will be worth less than US$3.90 or £2 or 2.60 euros on the black market.

There is any interesting question as to why you run out of currency when hyperinflation is driven by rapid growth of the money supply. And Zimbabwe is suffering from hyperinflation, it has an annual inflation widely thought to be in excess of 50,000%.

There are two possible reasons for a currency shortage. The first is that currency is just a subset of the broader money stock which also includes bank deposits in the form of cheque accounts. Currency (dollar bills for example) can become too small a proportion of the broad money stock if the currency printing presses can't keep up with growth in the broader money stock. Growth in the broader money stock is driven by central bank expansion of bank reserves. So your cheque account went up by $2 but the currency supply only went up by $1 and thus you can't convert the cheque account balance into cash. The second reason is that an excess demand for money can occur if prices begin to rise even faster than the money stock is growing. Here the problem is that people anticipate ever faster shrinkage in the value of the dollar and increase their prices to compensate. One wonders what the velocity of money is.

The game is up? (updated x4)

The pin factory problem (see More on Harford on Smith) is solved. David Warsh has put up his hand and said the error was mine. Warsh points out that Tim Harford depended on the assertion made in Warsh's book Knowledge and the Wealth of Nations that Smith didn't visit a pin factory. Warsh wrote on page 40:

The first three chapters and the plan of the book provided the whole kernel of what today we would call a theory of growth. Much stress has been laid over the years on the significance of the description of the pin factory. In fact Smith never visited one. Apparently he based his account on an article in an encyclopedia. Never mind that Smith was widely traveled and sharply observant everywhere he went. His failure to expend much shoe-leather in this case has occasionally been cited to discredit him. Such cavils entirely miss the point.

What was the basis of Warsh's error? Warsh writes,

I am pretty certain that, when I wrote that passage, I was thinking in a general way of my old and dear friend Charles P. Kindleberger, from whom I first learned much of what I know about various controversies of historical economics. Specifically, I was remembering an essay that he wrote for Thomas Wilson and Andrew Skinner to commemorate the bicentennial of the publication of the appearance of Smith’s great work in 1776.

Warsh then goes on to state,

As usual, Charlie set out his thesis concisely and joyfully in the first paragraph of "The Historical Background Adam Smith and the Industrial Revolution:"

An early version of this paper focused on the dispute, if one may call it that, between historians of economic thought who sometimes seek to demonstrate that Adam Smith was fully aware of the industrial revolution taking place around him as he wrote The Wealth of Nations, and economic historians who think he was not. It is true, as Samuel Johnson put it, that “in lapidary inscriptions, a man is not upon oath,” and piety demands that the guest of honour be given the benefit of the doubt. Nonetheless, I propose to dismiss this question quickly, with an open-and-shut verdict for the economic historians.

I am, however, pretty certain that it was the recollection of this zinger a few pages farther on that caused my fingers to slip. CPK was nothing if not memorable:

It may well be true, as Viner says, that “Smith was a keen observer of his surroundings and used skillfully what he saw to illustrate his general argument”…. But it is surely going too far to say with Max Lerner in his introduction to the Modern Library Edition: “Smith kept his eyes and ears open… Here was something that gave order and meaning to the newly-emerged world of commerce and the newly-emerging world of industry… Smith took ten more years. He could not be hurried in his task. He had to read and observe further. He poked his nose into old books and new factories.”
That last sentence is half right.

So there we have it. Does it matter? As Warsh says,

Whether my error is serious or trivial depends on the business you are in. It is, I suppose, a calumny on Smith to say that he never saw to a pin factory, even if in the same breath I gave him credit for getting out and around. Certainly I deeply regret the error. It is still the case that Kindleberger was correct in the essay that made such an impression on me: Smith failed to report a lot of stuff that was going on right under his nose. The great figures of the early Industrial Revolution – Wedgewood, Arkwright, Boulton and Watt – are mostly missing from The Wealth of Nations. But does that demonstrate that Smith was ignorant of the industrial revolution that was going on around him? I don’t think so.

Update: The Undercover Economist (Tim Harford) has this to say on the matter.

Update 2: Gavin Kennedy's response to Warsh is here.

Update 3: Tim Worstall makes an interesting point about this debate, namely how quickly it was over. Worstall writes,

Aside from all of this trivia, there's one other thing I think interesting. The speed with which all of this was worked out. The original contention, that Smith didn't, was published last Wednesday, as was the assertion that he did (we're still in panto season, aren't we?)

We're now only at Monday and we've got the whole thing sorted, down to the footnotes of which earlier writers he did reference, as well as who was at fault for the implication that he hadn't also visited such a manufactury himself.

See A Tiny Technology Story for Worstall's article.

Update 4: Tim Harford offers Adam Smith: an apology

French Bookseller's Union v. Amazon

Alex Tabarrok at Marginal Revolution has this to say about Amazon and the French Bookseller's Union. Tabarrok writes,

A French court has ruled in favor of the French Bookseller's Union that Amazon's free shipping policy violates a law forbidding booksellers from offering discounts of more than 5 percent off the list price. Amazon was told to start charging for shipping within ten days or pay a daily fine. It must also pay €100,000 to the French Booksellers' Union.

Amazon CEO Jeff Bezos, however, is refusing to charge for shipping and is taking the case to the French public. Way to go Jeff! My advice? Tell the state, laissez nous faire!

A law forbidding booksellers from offering discounts of more than 5 percent off the list price????? How does such a law help consumers? It hardly helps competition if the state is willing to enforce a cartel's rules on pricing of books.

More on Harford on Smith (updated x2)

In this post on Tim Harford's new book, The Logic of Life I noted that Gavin Kennedy asked of Harford,

My question to the Undercover Economist is simple. 'On what do you base your assertion that Adam Smith never visited a pin factory?'

Now Marshall Jevons at The Bayesian Heresy offer this explanation;

Harford refers to David Warsh's book, chapter 3 in the references. It is actually chapter 4.

"These first three chapters and the plan of the book provided the whole kernel of what we would call today a theory of growth. Much stress has been laid over the years on the significance of the description of the pin factory. In fact Smith never visited one. Apparently he based his account on an article in an encyclopedia. Never mind that Smith was widely traveled and sharply observant everywhere he went. His failure to expend much shoe-leather in this case has occasionally been cited to discredit him. Such cavils entirely miss the point."
-Knowledge and Wealth of Nations, p. 40 ( you can go to Amazon’s search inside the book feature)

No Tim Harford didn't lie, he was just quoting David Warsh.

So according to Jevons, it is David Warsh who may be at fault. On checking my copy of Knowledge and Wealth of Nations Warsh does make this claim. So I guess the question now is, What is Warsh's evidence for his claim?

Update: Gavin Kennedy has brought things up to date at his Adam Smith Lost Legacy blog, see the posting David Warsh is Named as the Source for the Allegation that Adam Smith Did Not Visit a Pin Factory.

Update 2: See The game is up? for a summary of David Warsh's response to Kennedy.

More on stimulus

Russell Roberts puts his 2 cents worth in on the idea of a stimulus package for the US. His very sensible essay Economist: Don't Jump the Gun on Stimulus Plans is on the National Public Radio (NPR) website.

Roberts makes the point

The standard stimulus package doesn't change incentives. It's a check from the government. The hope is that the receiver will spend it.

Steven Landsburg once wrote, "Most of economics can be summarized in four words: People respond to incentives. The rest is commentary". If you don't change incentives you will get little change in behaviour.

Roberts goes on to say,

But when you just send out checks from the government, whoever gets stimulated is likely to be offset by someone who gets unstimulated.

The money has to come from somewhere. If you raise taxes to fund the plan, the people who are taxed are poorer and they'll spend less. If you borrow money to fund the plan, the people who buy the government bonds have less money to spend and that offsets the stimulus. It's like taking a bucket of water from the deep end of a pool and dumping it into the shallow end. Funny thing—the water in the shallow end doesn't get any deeper.

A point politicians, and voters, should keep in mind.

Peter Boettke looks at the problems with public policy measures intended to provide short-term economic stimulus this way.

A less measured way to put this would be, why Keynesianism was wrong in 1936, 1956, 1976, and will be wrong in the year 2056. In other words, Keynesianism is just wrong analytically and practically as argued by both Hayek (analytically) and Friedman (practically). But it does have a powerful lure politically that has persisted despite its intellectual defeat by first Hayek, then Friedman, and finally by Lucas.

I think both Roberts and Boettke would agree that policies that try to provide short run economic stimulus have been less than successful and what we should be looking at is long run economic growth. We need policies designed to structure and align peoples incentives so that they are more productive and innovative, not policies designed to stimulate a politician's approval rating.

A Market in "Markets in Everything"

Markets in Everything.com is a new website which has a chronological index to Tyler Cowen & Alex Tabarrok's Markets in Everything posts at Marginal Revolution. I guess when sites like this start appearing you really know you've made it big!

What to Expect When You’re Free Trading: part 2 (updated x3)

Earlier I commented on a essay by Steven Landsbury "What to Expect When You’re Free Trading". Now the Undercover Economist shares his view on the essay. Harford writes

I broadly agree but I am not nearly so sure of myself.

I am aware that John Stuart Mill is in the opposing camp here. He argued that when slavery (which he opposed) was abolished, the slave-owners were entitled to compensation because they had built their businesses on a system of laws that suddenly changed. I do not know what to make of that argument, but it does point to a way in which the bullying analogy fails: bullies are not encouraged by society, even if one might argue that they should be discouraged even more.

A separate argument: people lose their jobs all the time for reasons that have nothing to do with foreign trade. I'd argue that they deserve some help. Why are jobs lost to foreign competition so privileged?

Would the answer not be that if the system of laws has suddenly changed then they are entitled to compensation? A change in the legal system is an (uninsurable) arbitrary change due to government action, not the result of market changes. After all why do we demand compensation under eminent domain?

Update 1: The Free Exchange blog gives its view here. Dani Rodrik's view is here.

Update 2: In comments on the Rodrik blog, noted above, Tim Worstall makes any interesting point:

"But once we accept that trade creates losers, at least we can begin to confront these questions explicitly."

Perhaps. But we should also acknowledge that not trading also creates losers.

Imagine (as has actually happened recently) that trade in bra and panty sets between the EU and China is open. Imports to the EU come flooding in, threatening jobs of those textile workers in the EU. But also to the benefit of consumers of the bra and panty sets.
Protecting those textile workers (as was done) by quotas was a transfer of resources from consumers to those textile workers. An inefficient one too.
Now here we have the usual logic of compensation for trade changes turned on its head.
*Normally* we are told that we should compensate those who lose out from increased trade. Again, normally, in the form of a lump sum transfer from those who benefit to those who suffer.
Fine, when I see people arguing that the newly protected textile workers of the EU are to make a lump sum transfer to the consumers of bra and panty sets then I'll start listening to arguments that such transfers should happen in the reverse case, when we lower trade barriers.

Update 3: Megan McArdle gets into the act as well.

The Logic of Life

Peter Boettke tells us that Tim Harford's new book, The Logic of Life: The Rational Economics of an Irratinal World is another book he wished he would have written. Bottke says

Harford's The Logic of Life is actually the sort of work that those schooled in Misesian and Hayekian economics can be, and should be writing. Use economics to make sense of the world around us --- write in clear and entertaining prose. Harford's model of rational choice is very Austrian (he doesn't call it that) -- but it is not the fiction of homo-economicus, or the lightening calculator of pleasure and pain, or the omniscient agent with perfect self-control. Instead, as William Jaffe once wrote about Menger's man is the same as Harford's, he is "caught between alluring hopes and haunting fears." He is, however, the pivotal chooser and as such the unit of analysis.

What Harford does in this book is walk through several of the main papers in economics written over the past few decades and provides the basic intuition that is behind the papers. In the case of some of these papers, I think Harford's reasonable interpretation excuses the excesses of formalism that in those papers cloud the basic economic intuition rather than illuminate it. In other instances, he captures not only the essence of the argument, but the reason the author approached the topic the way they did. In all instances, he makes more plain language sense of the econoimc argument than the professional economists on which he is drawing.

It is not however the book Gavin Kennedy would have written. Kennedy writes

I have my copy on order but I came across this excerpt and found this:

"Adam Smith, the father of modern economics, traveled Europe as tutor to the Duke of Buccleugh. But despite his travels, Adam Smith never actually visited a pin factory. While sitting at home in Kirkcaldy and penning the most famous passage in economics, he was inspired by an entry in an encyclopedia."

He then goes on to comment,

My question to the Undercover Economist is simple. 'On what do you base your assertion that Adam Smith never visited a pin factory?'

You must have some evidence. It is important that you because it will have to be reconciled with the following extract of Adam Smith from Wealth Of Nations:

"I have seen a small manufactory of this kind [the famous pin factory of 18 labourers from Diderot’s Enclyclopaedia on the same page] where ten only were employed, and where some of them consequently performed two or three distinct operations." (WN I.i.3: 15)

So, you see my problem, Tim Harford, either you have outstanding evidence that Adam Smith was lying or you are mistaken. You would also have to make a strong guess as to why he would lie about such a matter.

We know there were nail manufactories close by his mother's house in Kirkcaldy, Fife, any one of which could have had a small workshop attached that specialized in pins, and was distinguished from the '18 operations' in Diderot in France ('25' according to Murray Rothbard in 'England') by the precise number of "10" labourer’s in Fife, Scotland, some of them doing 'two or three operations'.

Take that Tim Harford!

Schwartz on the Fed

She may be 92 but Anna Schwartz is still going strong and taking a swing at the US Federal Reserve. The Telegraph in the UK has an article in which they state

According to Schwartz the original sin of the Bernanke-Greenspan Fed was to hold rates at 1 per cent from 2003 to June 2004, long after the dotcom bubble was over. "It is clear that monetary policy was too accommodative. Rates of 1 per cent were bound to encourage all kinds of risky behaviour," says Schwartz.

The article also explains that Schwartz

... says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.

In addition Schwatz is quoted as saying

"There never would have been a sub-prime mortgage crisis if the Fed had been alert. This is something Alan Greenspan must answer for,"

This is a point on which Stephen Kirchner at Institutional Economics disagrees (respectfully, in this case).

It is hard to pin the under-pricing of risk in credit markets on monetary policy, as opposed to the innovative nature of the products involved. One can make a case that the amplitude of the most recent Fed funds rate cycle has been a factor in triggering widespread mortgage defaults, but that in turn reflected the preponderance of fixed rate mortgages in the US, which delayed the pass through of changes in the Fed funds rate to actual lending rates. The Fed was simply not getting much of an effect from changes in the Fed funds rate back in 2002 and 2003, which was also a factor in the very gradual re-tightening from mid-2004. If anything, this suggests that the US economy is not all that responsive to changes in official interest rates. The Fed stopped tightening and held rates steady for more than a year before the problems in credit markets emerged. It is hard to believe that the Fed triggered a credit shock by doing nothing for more than 12 months.

The Telegraph makes the point that

As rebukes go in the close-knit world of central banking, few hurt as much as the scathing indictment of US Federal Reserve policy by Professor Anna Schwartz.

At Marginal Revolution Tyler Cowen is taking

... nominations for the following: given perfect hindsight, what should the Fed have done and when? Keep two things in mind: a) looser money sooner probably would not have helped the credit problems (and might have tied the Fed's hands later on), and b) your recommendations cannot refer to actions which predate the Bernanke regime.

Incentives matter: Adam Smith file 3

In Book V., Chapter 1, Part III, of An Inquiry into the Nature and Causes of the Wealth of Nations Adam Smith wrote on the different incentives faced by the directors of regulated companies and those the directors of joint stock companies,

... the directors of a regulated company have no particular interest in the prosperity of the general trade of the company for the sake of which such forts and garrisons are maintained. The decay of that general trade may even frequently contribute to the advantage of their own private trade; as by diminishing the number of their competitors it may enable them both to buy cheaper, and to sell dearer. The directors of a joint stock company, on the contrary, having only their share in the profits which are made upon the common stock committed to their management, have no private trade of their own of which the interest can be separated from that of the general trade of the company. Their private interest is connected with the prosperity of the general trade of the company, and with the maintenance of the forts and garrisons which are necessary for its defence. They are more likely, therefore, to have that continual and careful attention which that maintenance necessarily requires.

But then went on to warn about the incentives facing directors of joint stock companies,

The directors of such companies, however, being the managers rather of other people's money than of their own, it cannot well be expected that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own. Like the stewards of a rich man, they are apt to consider attention to small matters as not for their master's honour, and very easily give themselves a dispensation from having it. Negligence and profusion, therefore, must always prevail, more or less, in the management of the affairs of such a company.

But as Gavin Kennedy has pointed out,

[t]he polemic is strong but ought not to obscure the fact that his criticism of the organisational structure of joint-stock trading companies did not extend to all joint stock companies. He recommended them for such activities as banks, citing in particular the Bank of England, the Bank of Scotland and the Royal Bank of Scotland (all still profitably trading today without the whiff of corruption, nor the stench, of corruption and scandal). They were also highly efficient as well as being honest and did not have exclusive monopolies in their fields of business.

He also recommended joint-stock companies for activities like the insurance industry and canals; the need for vast capitals to run these companies successfully made the joint stock arrangements necessary.

Saving and the balance of payments

Bryce Wilkinson and Trinh Le have an excellent article in the National Business Review entitled Why blame the ordinary New Zealander? Wilkinson and Le point out that

Loose assertions have been made that high household spending and low household savings are the cause of the large current account deficit or inflationary pressures.

When it comes to the balance of payments it should be noted that the deficit is an outcome rather than a cause. Something else is going on to cause it. Wilkinson and Le explain that

... any balance of payments outcome is a response to fundamental drivers which include world prices for oil and dairy products, the availability of world savings, investment confidence and the exchange rate pressures that reflect the competition for resources between the sectors that are exposed to international competition and those (like government) that are sheltered from it.

Thus even if households in New Zealand increased their savings this would not necessarily reduce a balance of payments deficit. Wilkinson and Le note, with regard to research by the NZIER, that

... there is no reliable association between household savings and the balance of payments through time or across the 21 countries for which such statistics are readily available.

They then go on

[t]o illustrate the point by two opposite cases, Canada’s measured household saving ratio dropped from 13 percent of GDP in 1990 to 2 percent in 2007 while the same ratio in the USA fell from 7 percent to minus 1 percent.

Yet Canada’s current account balance ‘improved’ from a deficit of 4 percent of GDP to a surplus of 2 percent whereas the US current account deficit ‘deteriorated’ by 5 percent of GDP.

It should also be explained that the flip side of a current account deficit is a surplus on the capital account, since the current and capital accounts sum to zero. And as Wilkinson and Le put it,

This surplus represents the use of overseas savings to finance higher investment in New Zealand than might otherwise occur. New Zealanders benefit as long as that investment is profitable.

Perhaps the most important point is that if we really do care about improving economic growth so that we can improve living standards then the we should not look to the balance of payments for our troubles but to

excessive taxation to fund wasteful spending, excess bureaucracy and stifling regulations.

These issues are more important if we wish to increase productivity growth and thus economic growth in New Zealand.

What to Expect When You’re Free Trading

Steven E. Landsburg, one of my favourite economics writers, has a new article in the New York Times entitled What to Expect When You’re Free Trading. Landburg's basic question is

All economists know that when American jobs are outsourced, Americans as a group are net winners. What we lose through lower wages is more than offset by what we gain through lower prices. In other words, the winners can more than afford to compensate the losers. Does that mean they ought to?

His answer, no. But if compensation doesn't take place why would those who fear losing, at least in the short term, not fight a move towards free trade? If you want defuse the very vocal and dangerous anti-free trade movement isn't an attempt at compensation a sensible and justifiable policy? As Jagdish Bhagwati has pointed out trade liberalization can backfire politically

... as workers in import-competing industries are likely to mobilize against the adjustment being imposed on them. Politicians in democratic countries are also unlikely to be impervious to their complaints, especially as those who lose are more likely to vote to punish you than those who win are likely to reward you, an symmetry that seems to be fairly common.

The New Deal Jobs Myth

Amity Shlaes, author of The Forgotten Man: A New History of the Great Depression, has an article, The New Deal Jobs Myth, on the AEI website.

Shlaes contention is that New deal policies, at times, got in the way of recovery, rather enabling it,

The story of the mid-1930s is the story of a heroic economy struggling to recuperate but failing to do so because lawmakers' preoccupation with public works rather got in the way of allowing productive businesses to expand and pull the rest forward.

Part of the problem, according to Shlaes, was that

... the public jobs did their work inefficiently. That was because the jobs were scripted to serve political ends, not economic ones.

Another part of the problems was that the government took all available investment and undermined private enterprise,

But in the later part of the 1930s, the same model infrastructure projects did their part to prolong that privation. The private sector, desperate, was incredibly productive -- those who did have a job worked hard, just as our grandparents told us. But the government was taking all the air in the room. Utilities are a prime example. In the 1920s electricity was a miracle industry. There was every expectation that growth in utilities might pull the country through hard times in the future.

And the industry might have indeed done that, if the government had not supplanted it. Roosevelt believed in public utilities, not private companies. He created his own highly ambitious infrastructure project -- the Tennessee Valley Authority. The TVA commandeered the utility business in the South, notwithstanding the vehement protests of the private utilities that served that area.

Washington sucked up much of the available capital by selling bonds and collecting taxes to pay for the TVA or municipal power plants in towns. In order to justify their own claim that public utilities were necessary, New Dealers also undermined private utilities directly, through laws--not only the TVA law but also the infamous Public Utilities Holding Company Act, which legislated many companies out of existence. Other industries saw their work curtailed or pre-empted by government as well.

Overall an interesting essay.

Incentives matter: but is it true? file

From Steven N. S. Cheung's "The Contractual Nature of the Firm", Journal of Law and Economics, Vol. 26, No. 1. (Apr., 1983), pp. 1-21.

As examples of the gain from collaboration and the difficulty of delineating contributions, Alchian and Demsetz cite the examples of loading and of fishing. My own favorite example is riverboat pulling in China before the communist regime, when a large group of workers marched along the shore towing a good-sized wooden boat. The unique interest of this example is that the collaborators actually agreed to the hiring of a monitor to whip them. The point here is that even if every puller were perfectly "honest," it would still be too costly to measure the effort each has contributed to the movement of the boat, but to choose a different measurement agreeable to all would be so difficult that the arbitration of an agent is essential. (p.8)

Anyone know if this story is true?

Road safety

What do economists know about road safety? More than you might think. Charles Wheelan explains:

I'll start with the socially relevant questions:

1. Do car seats for children over age two actually make them safer, compared to just wearing a regular seatbelt?

2. Do graduated licenses for young drivers make the roads safer? (Graduated licenses place limitations on new drivers during a specified learning period. Depending on the state, for example, they may only be allowed to drive during the day or with an adult in the car.)

3. Do motorcycle helmets save lives?

4. How dangerous are senior drivers?

The answers are:

1. Probably not.

2. Yes, but not for the reason you think.

3. Yes, definitely.

4. Very dangerous, but mostly to themselves.

For the reasons see Wheelan's article.

Munger talks about the Firm

Previously I made comment on an essay by Michael Munger, Bosses Don't Wear Bunny Slippers: If Markets Are So Great, Why Are There Firms? Now you can listen to Munger discuss his essay. He is interviewed on EconTalk by Russ Roberts.

Munger talks about why firms exist. If prices and markets work so well (and they do) in steering economic resources, then why does so much economic activity take place within organizations that use command-and-control, top-down, centralized structures called firms? Within a firm, most of the goods and services that the workers use are given away rather than allocated by prices--computer services, legal services and almost everything else is not handed out by competition but by fiat, decided by a boss. A firm, the lynchpin of capitalism, is run like something akin to a centrally planned economy. Munger's answer, drawing on work of Ronald Coase, is a fascinating look at the often unseen costs of making various types of economic decisions. The result is a set of fascinating insights into why firms exist and why they do what they do.

Unintended consequences file

From Johan Norberg's blog

23:49 - GOOD INTENTIONS CREATE CHILD PROSTITUTION:

Some of us have warned that banning child labour might force children into worse circumstances. Via Hårek Hansen I find a report from Norwegian television, where a respected Danish NGO explains that this is what they have just seen in Bangladesh:

"Due to Western pressure, Bangladesh outlawed work in garment factories for children under 14.

- When the children lost their jobs, many of them ended up on the streets, as prostitutes. We know that much, says Rasmus Juhl Pedersen, adviser in Save the Children, Denmark.

Somewhere between 30.000 and 100.000 children lost their jobs when the garment factories introduced the age limit.

To work as a prostitute, maid or further down the line of production is much worse than working in the garment industry, according to Juhl Pedersen.

Western companies are so afraid of being associated with child labour that the children are thrown out of the factories even though no one has prepared any alternatives.

Well-meaning western consumers who boycott products that can be tied to child labour can do more harm than good, according to Save the Children, Denmark.”

(Translation by Norberg)

Incentives matter: politicians file

Usually the reasons for public ownership are placed into one of three categories: market failure, regulation problems or transaction cost reasons. An interesting case study of waterworks in the US is offered in the Troesken and Geddes paper Municipalizing American Waterworks, 1897-1915. This paper provides support a transaction cost interpretation of municipal acquisition of private waterworks. The incentive facing the local governments and the private companies are an important factor in the government take over.

The basic Troesken and Geddes story is that municipalities were unable to credibly precommit to not expropriating value from private water companies once (sunk) investments were made. This gave the private firms an incentive to reduce investment in water provision. This rational under investment was then used by local governments a pretext for municipalizing the private water companies.

Troesken and Geddes explain that their evidence supports the idea that because local governments held the assets of the private firms hostage, they could use their police powers to undermine the value of the private waterworks and thus acquire these firms at reduced rates. The water companies anticipated such opportunistic behaviour and rationally devised strategies to reduce its effects. For example, firms would demand contractual provisions limiting the power of local governments and reducing investments in idiosyncratic assets. Water companies would, for example, reduce the number of water mains they installed if they faced a high probability of future public takeover. Such underinvestment was then used by local authorities as justification for a takeover. Troesken and Geddes summarise the situation as

When Progressive Era reformers advocated municipalization of urban water systems, they often pointed to places like New Orleans and Duluth, where there was clear evidence that private water companies were providing inadequate service. While reformers were certainly justified in claiming that water companies in such places were failing to deliver adequate service, they did not appreciate the ultimate cause of that failure: the threat of municipalization itself, which was often accompanied by a host of opportunistic strategies. The fact that the threat of future municipalization discouraged private water companies from extending their distribution systems suggests failure stems not from private provision per se, but from a more fundamental contracting problem.

Austrian economcis syllabus

For those interested in Austrian Economics here is Peter Boettke's syllabus (pdf) for his PhD course in Austrian Economics.

The Armchair Economist

Aaron Schiff has been blogging on his reading of Steven Landsburg's book, The Armchair Economist: Economics and Everyday Life. He writes

I've been reading The Armchair Economist by Steven Landsburg. I think it’s the original "pop econ" book, published more than 10 years before the Freakonomists et al got in on the act. If you liked the other pop econ books and haven't read Landsburg’s yet, I recommend it. I like this book because it really made me think more deeply than, say, Freakonomics did.

First of all I have to agree with two points Schiff makes. The first, that Landburg's book is well worth reading. Despite all the new "pop econ" books that have some out since "The Armchair Economist", I think in many ways it is still the best. Secondly, his view on Freakonomics. I don't really like it, its just seems too glib, and smart for its own good. I think Ariel Rubinstein makes a good point, in his review of the book, when at one stage he asks "What have we learned about Levitt? He is a smart guy with connections in the municipality. What is the connection to economics? None." And the book is supposed to be about economics.

Anyway back to "The Armchair Economist". I agree with Schiff in that it made me think more about the basis ideas of economics. But I think he misses the best part of the book, the chapter on the Coase Theorem. The Coase Theorem is one of the most misunderstood ideas in all of economics. Deirdre McCloskey reckons that only,

Something like a dozen people in the world understand that the "Coase" theorem is not the Coase theorem. (I'll adopt the convention of putting quotation marks around the non-Coasean "Coase" theorem.) One of this select group is Ronald Coase himself, so I suspect we blessed few are right.

The group would be much larger if more people read chapter 9, "Of Medicine and Candy, Trains and Sparks: Economics in the Courtroom", of Landsbury's book. Let me see if I can explain.

Landsbury opens the chapter with a discussion of the famous Bridgman v. Sturges case.

Bridgman made candy in the kitchen of his London home. He got along well with his neighbors, including Dr. Sturges, who lived and practiced medicine in a house around the corner. In 1879, Dr. Sturges built a new consulting room at the end of his garden, adjacent to Bridgman's kitchen. [Bridgman produced candy.] Only after the construction was complete did the doctor discover that Bridgman's machinery made noise-so much noise that the consulting room was unusable. Sturges brought suit in an attempt to shut down Bridgman's business.

The ruling was in Sturges's favour. He got the right to demand that Bridgman shut down his machinery. The judges explicitly referred to the effects their decision would have on the production of goods and services when justifying their decision. The point however is that their decision had no effect on the production of candy or medical care.

What Coase pointed out was that as long as Bridgman and Sturges could negotiate, the decision of the court didn't matter as far the allocation of resources is concerned. If Sturges had the right to stop Bridgman's machinery but Bridgman valued running the machines more than Sturges valued stopping them, then Bridgman could buy the right to run the machines from Sturges. Thus no matter what the court decided, the resource would end up in the hands of whoever valued it most highly.

The court's decision matters to Bridgman and Sturges since it determine who pays who. But it doesn't matter for the allocation of resources, which is what matters to economists. This gave rise to what is normally called The Coase Theorem:

It applies whenever the parties to a dispute are able to negotiate, to strike bargains, and to be confident that their bargains are enforceable. Under these circumstances, the Coase Theorem says that the allocation of property rights, or the choice of liability rules, or more generally any distribution of entitlements (a formulation that includes both property rights and liability rules) has no effect on the ultimate allocation of resources. Judges' decisions don't matter.

Its easy to find examples of when the Coase Theorem doesn't apply because negotiation is either impossible or prohibitively expensive. This can happen when there are many people who need to be negotiated with. In a case like this, the court's decision does matter. Whenever the court's orders are unlikely to be undone by subsequent negotiations, then how the court rules does matter.

Let us suppose that the court's aim is to allocate resources in an economically efficient way. Then how should the court rule? Before Coase, the answer would have been make whoever "causes" the problem liable. Coase argued, however, that it makes no sense to say that one party causes the problem. For example, if a railroad runs tracks through farmland and the trains throw off sparks which occasionally ignite the surrounding crops, then farmers will suffer damage. But does the train cause the problem or the does the farmer cause it? Coase's view is that both parties are needed for the problem to arise. Without the trains, there are no sparks and thus no crops are damaged, but without the crops, they cannot be damaged, no matter how many trains are run. So we see that both the trains and the crop are needed for damage to occur.

Landsburg summaries things thus far as:

And so we come to the flip side of the Coase Theorem. When circumstances prevent negotiations, entitlements-liability rules, property rights, and so forth-do matter. Moreover, the traditional economist's prescription for efficiency-making each individual fully responsible for the costs he imposes on others-is meaningless. It is meaningless because the costs in question result from conflicts between two activities, not from either activity in isolation. The traditional prescription blinds us to the fact that either party to a conflict might be in possession of the efficient solution, and that the wrong liability rule can eliminate the incentive to implement that solution.

The big question is what should the courts do in this situation? Landsburg's advice to judges is

First, we can offer a note of reassurance: If you are trying a case in which the opposing parties are able to negotiate and enforce contracts, then your decision does not matter and you cannot be wrong. Subsequent negotiations will lead to an efficient allocation of resources that is entirely independent of what you decide.

Second, a note of caution: Do not attempt to decide a case by deciding who is at fault. Even if you think that you can make sense of this notion, there is no reason why it should lead to an efficient decision. The costs of damage should be borne by the party who can prevent the damage more cheaply, not necessarily by the one who would be labeled the "perpetrator" by misguided common sense.

Third, a note of condolence: It might be very difficult for you to tell who can prevent the damage more cheaply. Suppose you announce in court that the trains will be liable for spark damage unless farmers can prevent the damage at low cost, in which case the trains bear no liability. Do you then expect the farmers to reveal that they can prevent the damage at low cost? Of course they won't, and unless you are an expert in both farming and railroading, you are unlikely to know where to place the burden.

Fourth, a suggestion: Try to make it easier for the parties to negotiate. If they can, then we are back in the situation where you can't go wrong.

Even Deirdre would have to be happy with this. To end, let me quote what Coase has written about how he views the Coase Theorem:

... I tend to regard the Coase Theorem as a stepping stone on the way to an analysis of an economy with positive transaction costs. The significance to me of the Coase Theorem is that it undermines the Pigovian system. Since standard economic theory assumes transaction costs to be zero, the Coase Theorem demonstrates that the Pigovian solutions are unnecessary in these circumstances. Of course, it does not imply, when transaction costs are positive, that government actions (such as government operation, regulation or taxation, including subsidies) could not produce a better result than relying on negotiations between individuals in the market. Whether this would be so could be discovered not by studying imaginary governments but what real governments actually do. My conclusion: Let us study the world of positive transaction costs.

Seems like good advance.

What Ends Recessions?

I have noted previously that there have been calls in the US for fiscal stimulus given that the economy is slowing. Now Tom Firey at Cato@Liberty asks What Ends Recessions? Based on Christina and David Romer’s 1994 NBER Macroeconomics Annual paper, What Ends Recessions?, he explains that

Government response to recessions comes in three forms: monetary policy (the Federal Reserve’s Open Market Committee lowers interest rates to spur investment and borrowing), automatic fiscal policy (the automatic increase in government spending during recessions that results from increased unemployment insurance claims, welfare disbursements, etc.), and discretionary fiscal policy (the adoption of stimulus packages that contain increased government spending and/or tax cuts).

The track records for both FOMC action and the automatic stabilizers are strong, the Romers show. Both kick in quickly when recessions begin, and the economy turns around fairly soon afterward.

Stimulus packages have a much shoddier record, however: they take months to move through Congress, and additional months to implement — long after the recession has come and gone. Moreover, many of the specific actions initiated by stimulus packages are hardly stimulatory — extending unemployment benefits or launching major government construction programs requires several months to several years (and sometimes even decades) before the federal monies hit the economy.

What have economists learned in the last year?

Tyler Cowen has a new New York Times column, on four things that we have learned over the last year. He opens the article with:

Harry S. Truman once said he wanted to talk to a one-armed economist, "so that the guy could never make a statement and then say: 'on the other hand.' " Yet economic knowledge continues to progress in unexpected ways. Here are a few of the things we learned in the last 12 months...

The four things are to do with

Revising The Chinese Economy

It's Not Just The Lenders

In Music, Hardware Rules

Lethal Cold Fronts

Combining Transaction Cost Economics and the Property Rights Approach

Peter Klein at Organizations and Markets brings to our attention to an interesting paper which attempts to combine the transaction cost framework of the likes of Benjamin Klein and Oliver Williamson with property-rights approach of Grossman, Hart, and Moore.

Klein explains that the transaction cost economcis and the property-rights approach have a complicated relationship. See Bob Gibbons on this point. Klein also emphasises that the property-rights theory is not simply a formalization of the transaction cost framework, as is sometimes claimed. See Williamson, Whinston, and Whinston, for a second time, on this latter point. One key difference, as noted by Klein, and emphasized by Williamson and Gibbons, is that the property-rights approach focuses on the alignment of incentives ex ante, assuming efficient bargaining ex post, while the transaction cost economics emphasizes ex post hazards. Peter Klein goes on to explain,

A recent paper by Patrick Schmitz, "Information Gathering, Transaction Costs, and the Property Rights Approach" (AER, March 2006) tries to reconcile the two perspectives by creating a GHM-style incomplete-contracting model in which parties can obtain private information about their ex post benefit, resulting in inefficient rent-seeking over the realized gains from trade. Under certain circumstances, the PRT conclusions are reversed — i.e., the party with the most important relationship-specific investment should not necessarily own the other party’s investment, as the PRT implies. Worth a read.

Evidence on Sarbanes-Oxley Act

The US introduced the Sarbanes-Oxley Act (SOX) in 2002 in response to several well known corporate scandals. A recent working paper from the New Zealand Institute for the Study of Competition and Regulation reviews the last 5 years of empirical research on the effects of SOX. The paper, Sarbanes-Oxley and its Aftermath: A Review of the Evidence by Glenn Boyle and Eli Grace-Webb, opens by pointing out that no less than, a staggering, 528 studies of SOX can be found on the Social Science Research Network!

The SOX sought to change the manner by which a firm's directors, executives and auditors provide information to share-holders about firm's performance and financial well being and to give shareholders control over the all important incentive structures used for aligning the interests of management with those of the firm's owners. And there is evidence that owner and management incentives are not aligned. The book, Pay without Performance: The Unfulfilled Promise of Executive Compensation by Lucian Bebchuk and Jesse Fried offers evidence that the compensation process has been corrupted. The Bebchuk and Fried view is that the process has been captured by CEOs. They argue that executives use the power they have to pay themselves large amounts which are not related to performance. Some commentators, however, argue that SOX was a typical knee-jerk political reaction rather than a reasoned response to corporate problems.

SOX focused on four key areas, thought to be in need of reform: the accuracy and reliability of financial disclosures, corporate governance, fraud, and the accounting industry. Research on the effects of SOX can be placed in one of three categories.

First, the effect of SOX on firms - on their costs, their governance, their investment and risk-taking strategies, and so on. Second, its effect on the quality of information provided to investors by firms and auditors. Third, its effects on the efficiency of capital markets.

As far as a firm's costs are concerned, studies into the effects of SOX usually take one of two approaches: "either statistical studies of the reaction of securities prices to events affecting the implementation of SOX, or direct surveys of post-SOX changes in costs." The underlying idea for the market reaction studies is simply that a firm's stock price is the present value of future discounted earnings, so any SOX- attributable changes in this price represents an estimate of the net cost of SOX to the firm. Different studies reach different conclusions, some showing costs going up while others show them going down. Other results suggest that while SOX may have targeted the correct governance attributes, the mandatory imposition of these measures is called into question since the market was already rewarding firms who adopted these measures voluntarily. The results of some studies also suggest that the market perceived a benefit from the adoption of SOX for firms that had previously offered weak governance protection to their shareholders. Still other results tell us that small firms are particularly badly affected by higher SOX-imposed costs. Any benefits are offset by the additional costs imposed. Studies based on other capital markets conclude that debt markets reacted negatively to announcements that made the passage of the SOX more likely. But studies also show that SOX was successful in "creating a climate of investor confidence in financial information, and restoring normalcy in the financial markets particularly in the long term."

Another groups of studies attempted to identify actual cost increases. One study found that average audit fees climbed by US$2.32 million between 2003 and 2004. It can be argued that at least part of this increase can be attributed to SOX compliance costs. Other evidence indicates that smaller firms suffer more due to SOX-mandated increases in compliance costs.

SOX appears to have effected the governance of companies both via the composition of board and their behaviour. Boards have become larger and more independent with audit committee meetings becoming more frequent. Directors are less likely to be current executives and more likely to be lawyers, consultants, financial experts and retired executives.

One paper suggests that in the time after the introduction of SOX firms with shareholder protection greater than that mandated by SOX reduced their level of protection.

As one might expect executive compensation has been affected. The evidence tells us that the ratio of incentive to fixed salary compensation decreased post-SOX. There has also been a reduction in attempts by executives to influence the value of stock options (cf Bebchuk and Fried).

SOX has also had some unintended consequences.

Faced with more onerous regulations, economic agents inevitably react in ways that minimise the obligations thus imposed. SOX has been no exception to this general rule.

Incentives matter! Who would have guessed?

A number of studies suggest that there has been an increase in the frequency of firms reducing their shareholder numbers to below 300 in order to escape Securities and Exchange Commission overview. The market's reaction to "going dark" is strongly negative - the delisting move is seen as a indication of a weak financial situation. Also as public floats of less than US$75 million escape Securities and Exchange Commission scrutiny, in terms of Section 404 of SOX, there is an incentive to remain under this level. Evidence also points out that SOX has had a chilling effect on IPOs and US listings of foreign companies. SOX avoidance moves also include a move away from bond sales to the public towards bond sales to institutions on the private debt market - which do not have to be registered with the SEC. Other measures taken by some firms include a reduction in risk-taking and investments by management along with lower R&D and capital expenditures and an increase in cash holdings; relative to similar firms in the UK. There is also evidence that US firms have reduce their investment in risky projects and with this lower exposure to risk, firms seem to be more risk adverse.

With regard to the quality of information provided by firms to investors some of the available evidence tells us that investors are being provided with very reliable information post-SOX. Other studies suggest that managers now disclose less information even though the precision of supplied information has increased. As to information provided by the firm's auditors Boyle and Grace-Webb state,

Another objective of SOX was to increase investor confidence in the quality of audit reports. However, the evidence that is available to date suggests that the firms most in need of quality audits are now less likely to obtain the services of top-tier auditors.

The evidence also shows that after the passage of SOX, riskier firms have had a higher growth in audit fees and are more likely to see their auditors resign. Other papers show that there has been more detection of fraud by auditors. (Or are auditors just telling us about more of what they find?) But the evidence also notes that whistle-blower detected fraud fell post-SOX.

To the extent that more reliable information is being provided, capital markets would be expected to react more decisively to the release of new information and there is evidence to support this view. Also the market appears to find some, if not all, of the new information valuable. The evidence suggests that firms who are able to show effective internal controls have a lower costs of equity. On the other hand, there is less certainty as to the usefulness of CEO and CFO certification. Also it still appears that private information is a source of capital market profit. The evidence shows that post-SOX the exploitation of private information in the exercising of options has increased in profitability. Thus SOX has not prevented the continuation of this form management opportunistic behaviour.

In conclusion Boyle and Grace-Webb say

While apparently improving market liquidity and some aspects of corporate governance and information disclosure, SOX has also had a number of more deleterious effects: greater costs of auditing, governance and human capital, and compliance more generally; a mismatch between auditor quality and firm risk; more firms delisting or otherwise staying below the regulatory radar; less corporate investment and risk-taking; and ambiguous changes in the quality of investor information and capital market efficiency.

One thing that may be of importance for economies like New Zealand, should they wish to go down the SOX-type path, is the finding that the downsides of SOX are more extreme for small firms.

Boyle and Grace-Webb emphasise that the studies they have reviewed suffer from at least two problems in isolating the effects of SOX:

First, it is difficult to differentiate any impact of SOX from that of other post-scandal regulatory initiatives - Coates (2007) notes that SOX was enacted "amidst sharp financial, economic, and political changes". Second, it is also often difficult to distinguish the impact of SOX from that of the corporate scandals themselves.

Boyle and Grace-Webb end their paper by drawing the sobering conclusion that,

... the evidence to date is not particularly reassuring: commentators who argued that SOX would be a case of "legislate in haste, repent at leisure" look increasingly likely to be proved correct.