Government created "adverse section" in the war on drugs

Art Carden writes,

“But these drugs are so dangerous!” people might contend. Indeed, they are. But this overlooks the fact that drugs have increased in potency as a response to government crackdowns. Which would be easier to smuggle: $1,000,000 worth of marijuana, or $1,000,000 worth of cocaine? $1,000,000 worth of cocaine can be packed into a much smaller space than $1,000,000 of marijuana. If we decide to fight drugs, what is likely to disappear from the market and what is likely to end up all over the market? Low-potency drugs are likely to disappear. High-potency drugs—like higher-potency marijuana—are likely to stay. According to Milton Friedman, “crack would never have existed. ... if you had not had drug prohibition.”

So in a effort to drive all drugs out of the market the government has has only succeeded in creating a situation in which more dangerous drugs are driving less dangerous drugs from the market. Certainly a very "adverse selection".

Does homebrewing destroy jobs?

Clearly one of the most important economic issues of the age! Because they brew at home, those evil economy wrecking homebrewers don't buy as much beer from breweries and retail liquor stores. This means a reduction in brewery and liquor store jobs. Thus homebrewing results in a loss of jobs in the economy ... and thus should be banned!

Or is it a case of the seen and unseen? At the Market Power blog Phil Miller makes the case that it is.

But we brewers have to obtain ingredients with which to brew. We need our brewing grains, our adjuncts, our hops, our yeast, etc. We also have to have a few pieces of equipment that most people do not have sitting around the house. We need carboys and 5 gallon food-grade plastic buckets. We need bottle cappers, kegging equipment, CO2 canisters for force-carbonating our beer, and many other pieces of equipment. Homebrewers' demand for these products creates jobs in the industries where this stuff is made and sold. That's the unseen effect.

You can say similar things about other do-it-yourselfers. Home cooks, woodworkers, and do-it-yourself handymen simultaneously destroy jobs in one industry and create them in another industry. Calling Dr. Schumpeter!

So it is silly to say that homebrewing decreases the number of net jobs.

So relax when having that glass of home brew tonight safe in the knowledge you are not damaging the economy. Your kidneys may be, but not the economy.

The problem is central banking not fractional reserve banking

or so argues Steve Horwitz at the Free Banking blog. Some economists, especially Austrian economists, see fractional reserve banking as one of the great evils of the world. Murray Rothbard being an obvious example. But not all economists, even Austrian economists, see it that way. Horwitz looks at arguments against fractional reserve banking and finds them wanting.

He opens by noting,

In some free-market circles fractional reserve banking (FRB) is blamed for everything from business cycles to bad breath. Defenders are seen as apologists for inflation and fraud. Thankfully these views remain a minority because they are gravely mistaken. As I, and other Austrian monetary theorists, such as George Selgin and Larry White, have argued, there’s nothing wrong with FRB that getting rid of a central bank can’t cure. Fractional reserve banking works just fine in a free market.

And here, in a few words, is the point. The problem isn't with FRB as such, it is more to do with having a central bank. Get rid of the central bank and move to free banking and FRB would work just fine.

The whole Horwitz piece is worth reading.

EconTalk this week

James Otteson of Yeshiva University talks with EconTalk host Russ Roberts about Adam Smith. The conversation begins with a brief sketch of David Hume and his influence on Smith and then turns to the so-called Adam Smith problem--the author of The Wealth of Nations appears to have a different take on human nature than the author of The Theory of Moral Sentiments. Smith worked on both books throughout his life, yet their perspectives seem so different. Otteson argues that the books focus on social behavior and the institutions that sustain that behavior--market transactions in The Wealth of Nations and moral behavior in The Theory of Moral Sentiments. Both books use the idea of emergent order to explain the evolution of both kinds of social behavior and social institutions. The conversation concludes with a discussion of what Smith got right and wrong.

Politicising your role

As Eric Crampton notes over at Offsetting Behaviour Steve Maharey, Vice-Chancellor of Massey University, has decidied he is a labour economist and that the standard views on minimum wages are all wrong. Eric deals with his claims and I agree with what he says so I will raise another issue: Should Vice-Chancellors go round politicising their positions?

Ex-Labour MP and cabinet minister Maharey has taken a position on minimum wages, against much of the economic literature - see "Minimum Wages" by David Neumark and William L. Wascher (The MIT Press: 2008) for a recent overview of this area - but supportive of the Labour Party and trade union views. Is taking such an obvious political stance the role of VCs? How do you feel if you are in the economics department at Massey given your non-economict VC has decide he is a labour economist? Should VC be careful to keep public comments limited to their roles as head of the university or at least restricted to areas in which they are academically qualified and actively engaged? Maharey was once a senior lecture in sociology and claims "academic interests" in social policy (particularly social development), education, media and cultural studies, social change and politics. None of this suggests a great knowledge of the economics relevant to minimum wages. When was his last academic publication and on what?

Surely the role of a VC is to advance the interests of university and public statements by a VC should be to advocate for policy changes that assist the welfare of the staff and students of the university. Public statements should not be used to make party political broadcasts.

State capacity and development

From VoxEU.org comes this audio in which Tim Besley of the London School of Economics talks to Romesh Vaitilingam about the importance of a country’s fiscal capacity and legal capacity for its development prospects – and the link to policy debates about ‘fragile states’.

Interesting blog bits

1. Russ Roberts on Obama vs. ATMs: Why Technology Doesn't Destroy Jobs
   

   Doing more with less is what economic growth is all about. Not that many politicians see that. The president calls this a structural issue—we usually call it progress.

2. Steven Horwitz points out that Yes, It Is a Police State: A line has been crossed.

   Since 9/11 the biggest threat to the American people is not radical Muslim terrorists, nor deranged domestic terrorists, but the terrorists with the blue uniforms, badges, and body armor. Their weapons of mass destruction are not bombs, but state-approved guns, latex-gloved hands, and a profound disregard for our rights. Until we stand up and say, “Enough!”these terrorists will keep winning and our rights will continue to be lost.

3. David Henderson on Life in the USSA

   In his Thanksgiving 1981 interview with Barbara Walters, President Ronald Reagan, speaking during one of the warmer parts of the Cold War, told Ms. Walters that the biggest threat to our freedom was not the Soviets but our own governments. How right he was. The same applies to our own governments vis-a-vis terrorists today.

4. David Henderson on Life in the USSA (2010 version)

   An excellent illustration of two of the main themes in the life work of the late economist Friedrich Hayek, who shared the Nobel Prize in economics in 1974. One theme, which he emphasized in his 1944 book, The Road to Serfdom, is that when government grows and takes on more power over our lives, it threatens our freedom. The second theme is that central planning of an economy doesn’t work. Although Hayek never applied his insights about central economic planning to central anti-terrorism planning, the reasoning, as we shall see, is the same. So is the bottom line: It doesn’t work.

5. Lynne Kiesling on Horwitz, Henderson, Hayek on the police state

   On a subject too important to overlook … today Steve Horwitz wrote a short, clear argument providing evidence that we are indeed living in a police state.

6. Deirdre McCloskey on A Kirznerian Economic History of the Modern World

   I think the history of How I Discovered Israel illuminates the trouble that Austrian economics has had against Samuelsonian economics (which we commonly but self-defeatingly call the "mainstream"). And it shows how in the end the Austrians can save economics from itself.

7. Matt Ridley on The vested interests in doom

   POLLYANNA is a fool; Cassandra was wise. As a self-proclaimed "rational optimist" who argues that the world has been getting better for most people and that the future is likely to be better still, I am up against a deep prejudice towards pessimism that dominates the intelligentsia. As John Stuart Mill put it, "not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage".

8. Roger Kerr on The Truth About Privatisation: #14: Dividends

   New Zealand Herald political commentator John Armstrong was dispensing advice to the Labour Party on privatisation issues in his column last Saturday (June 11).
   
   First, he wrote:
   
   Labour needs to make merry hell with the foreign ownership bogie – perhaps to a point bordering on xenophobia.
   
   What sort of responsible economic journalism is that?

9. Bryan Caplan on The Ideological Turing Test

   If we did an apples-to-apples comparison, would liberals really excel on ideological Turing tests?

10. David Friedman on Caplan Contra Krugman: A Very Clever Post

    Paul Krugman has recently been claiming that people on the left understand the views of those on the right much better than people on the right understand the views of those on the left.

11. Roger Kerr is Playing the Well-Being Game

    We all know that GDP/head isn’t everything. But it’s amusing to see governments in countries that are economic losers wanting to focus on other elements of well-being. Sarkozy in France with his happiness trope, aided and abetted by Joseph Stiglitz, is a case in point. Unfortunately for people like Sarkozy, the happiness literature suggests that happiness seems to correlate quite closely with income and wealth!

12. Homepaddock on No need for another investigation into milk price

    The Ministries of Agriculture and Economic Development and Treasury havelaunched a second probe into Fonterra’s pricing of milk. They could save themselves a lot of time and effort by reading the National Bank’s Agrifocus.

13. Gavin Kennedy notes that A Serious Scholar Disagrees

    Over at the excellent Anti-Dismal Blog, Paul Walker raises important criticisms of my Monday post this week on Lost Legacy. What can I say?!

Relevance of the Austrian School for the 21st century

Peter Boettke, professor of economics at George Mason University, is interviewed at the New Media project at UFM.

(HT: Coordination Problem)

Thinking like an economist

At Cafe Hayek Don Boudreaux shows how thinking like an economist can help when dealing with people who don't think this way.

Opining in today’s New York Times, history professor Nelson Lichtenstein asserts that Wal-Mart uses an “authoritarian style, by which executives pressure store-level management to squeeze more and more from millions of clerks, stockers and lower-tier managers.” Then he scolds Wal-Mart for being so bigoted that it erects “obstacles to women’s advancement.”

This tale is highly improbable.

A company that squeezes maximum possible profits from its workers does not refuse to promote women simply because of their sex. Such refusals would leave money on the table by keeping many employees in lower-rank positions even though those employees would add more to the company’s bottom line by being promoted to higher-rank positions. Conversely, a company that indulges its taste for bigotry is not a company intent on squeezing as much profit as possible from its employees.

If Ms. Jones can add thousands of dollars to Wal-Mart’s annual profits by working as a manager, rather than hundreds of dollars by working as a cashier, squeezing “more and more” from her requires that Wal-Mart promote her to manager.

It’s simply unbelievable that a company with Wal-Mart’s record of consistently wringing profits from razor-thin retail margins intentionally – or even negligently – wastes the talents of large numbers of its employees by using them in ways that do not add maximum value to Wal-Mart’s bottom line.

So Nelson Lichtenstein can have either Wal-Mart maximises profits or it is anti-women, but he can't have both.

The minimum wage, once more

In an article published in Economic Affairs Karthik Reddy argues that Britain Too Sanguine on Minimum Wage. The introduction for the article reads,

Eleven years after the implementation of the National Minimum Wage, the British political establishment has come to accept the policy as a success. Even David Cameron, who initially opposed the policy, has publicly stated that it ‘turned out much better than many people expected’. This cautious acceptance of the minimum wage among policy-makers is reflected throughout the developed world, where few countries remain without a statutory wage floor. Unfortunately, this shift in opinion does not reflect the economic reality of the minimum wage.

When looking at the U.S. evidence Reddy writes,

Various studies have been undertaken to measure the effects of minimum wage laws in the 50 states. In 1977, the US Congress authorised the Minimum Wage Study Commission to investigate the economic effects of the minimum wage. In 1981, the Commission released its report, which found from analysis conducted over the previous decades, during which the real minimum wage was relatively high, that a 10% increase in the minimum wage generally increased teenage unemployment by 1–3%. This strong disemployment effect was well accepted by the academic and policy-making communities (Neumark and Wascher, 2007).

Controversy over the minimum wage begin in the early 1990s when certain studies purported to show that the minimum wage may not have disemployment effects and, in some cases, may even increase employment.

The controversy began in 1992, when Card (1992a) published a paper suggesting that the April 1990 increase in the federal minimum wage from $3.35 to $3.80 had no adverse effects on teenage unemployment. This study was followed by others, namely Katz and Krueger (1992), Card (1992b) and Card and Krueger (1994), which purported to show positive employment elasticities as a result of minimum wage increases of up to 2.65, 0.35, and 0.73, respectively. Card and Krueger proceeded to publish a book, Myth and Measurement, which concluded: ‘evidence suggests that the minimum wage does not have the effect on the labor market that would be predicted from the competitive neoclassical model’ (Card and Krueger, 1995). These data from the early 1990s were widely cited as evidence that the conventional understanding of the effects of the minimum wage was poorly conceived and that minimum wages in the USA did not have adverse effects.

Unfortunately subsequent analysis of the results from the early 1990s, as well as further studies, demonstrate that the minimum wage does, indeed, displace workers and have adverse long-term effects.

First, and perhaps most importantly, David Neumark and William Wascher (2007) point out that many of the studies that have sought to measure the effect of minimum wages on employment have operated under the assumption that it would be felt rapidly, due to high turnover in the minimum-wage labour market. Concordantly, many such studies have neglected to look beyond a short-term analysis. Yet this may well be a serious error as it ignores the possibility that firms’ demand for labour may decrease in the long run as they slowly adjust non-labour inputs. Much of the difference between those studies that purport to show no disemployment effect and those that do may be reconciled by the inclusion of time lags, a particularly salient observation raised by numerous critics. In particular, Neumark and Wascher (2000) replicated Card’s methodology in the 1992 study of the federal minimum wage increase, but included the possibility of such a lag. They found that this addition produced a negative and statistically significant disemployment effect of the minimum wage. A 1999 study by Baker et al. on employment and minimum wage changes in Canada found that, while evidence is less clear over the short run, including lags generally produces statistically significant disemployment effects, and that Canadian data indicate an employment elasticity of -0.25 over the long term. The inclusion of lagged employment effects produced similar results in further US research.

Another issue is the question of the control group used in many of the studies.

Furthermore, some of the studies that found the minimum wage did not affect employment use other geographical areas as controls to measure the impact of the minimum wage. Yet such comparisons may not be appropriate, given differences in labour markets, regulatory standards and macroeconomic conditions between the studied and comparison groups.

Addition problem that have been raised include,

Specific to the studies conducted by Katz and Krueger (1992) and Card and Krueger (1994), there exist questions about the reliability of the telephone surveys used to collect data, which in the words of Neumark and Wascher (2007), ‘were not subject to the same rigorous standards as those used to develop the surveys used in government statistical programs’. Adie and Gallaway (1995) raised further concerns about Card and Krueger’s Myth and Measurement. In addition to doubts surrounding the statistical significance and methodological integrity of the studies cited in the book, the two Ohio University economists suggest that Card and Krueger’s exclusion of certain minimum wage studies from their discussion skewed the data.

More recent studies have returned to the question of teh employment effects of minimum wages in the U.S. and have, importantly, returned data indicative of disemployment effects that are particularly considerable for unskilled workers.

Neumark and Wascher (2007), in a lengthy and comprehensive review of recent minimum wage literature published between 1992 and 2007, conclude: ‘the preponderance of evidence points to disemployment effects’. Of the 33 studies examined in depth, 28 indicated disemployment effects. Neumark and Wascher examine the methodological processes and results of the studies at considerable length, and some of these studies are particularly telling. In 1992, for example, Neumark and Wascher published their own study of teenage unemployment and minimum wage statistics throughout the 50 states over the 1970s and 1980s, and found unemployment elasticities of between -0.1 and -0.2 for teenagers (Neumark and Wascher, 1992). In various other studies that focused on the effects of the minimum wage on both teenage employment and school enrolment, the two economists concluded that ‘these results are consistent with a higher minimum wage causing employers to substitute away from lower-skilled teenagers (who are less likely to be in school) toward higher-skilled teenagers (who are more likely to be in school), with the resulting increase in the relative wages of higher-skilled teenagers inducing some of them to leave school for employment’ (Neumark and Wascher, 2007). Considering enrolment, they estimated the employment elasticity to be -0.22. Keil et al. (2001) found an employment elasticity of -0.11 for total employment and -0.37 for youth unemployment in the short term, while the long-run elasticities were even starker at -0.19 and -0.69, respectively. The significance of these long-run elasticities prompted the authors to conclude: ‘the cost of the minimum wage legislation, far from being negligible as claimed by its apologists, may be higher still than even the minimum wage hawks have argued’ (Keil et al., 2001). Burkhauser et al. (2000) estimated elasticities of -0.27 for the 1996 increase in the federal minimum wage, and -0.17 for the subsequent rise in 1997. Orazem and Mattila (2002) studied data from minimum wage increases in Iowa in the 1990s and found employment elasticities of between -0.31 and -0.85. A comprehensive study of the states of Oregon and Washington between 1994 and 2001 by Singell and Terborg (2007) found negative employment effects of the three minimum wage increases in each state throughout that period. The results of these studies are complemented by a number of others reviewed by Neumark and Wascher (2007). More recently, in 2010, Danziger found that employment in small firms is particularly affected in a negative manner by minimum wage increases.

Reddy then turns to the U.K. data and finds that the data from the U.K. generally supports the US evidence. Next Reddy looks at measurement issues to do with the study of the minimum wage.

There do exist significant problems that complicate the measurement of the effects of the minimum wage. Minimum wage increases that have been studied in the USA remain quite small as a proportion of the wage in total, rendering it difficult to find clear and discernible effects of the minimum wage, and the proportion of workers earning the minimum wage is very small. As Keil et al. (2001) note: ‘An intrinsic problem with event studies in this context is that the sought effect is acknowledged to be small compared to ambient fluctuations in employment rates.’ Moreover, there may be substantial endogeneity bias present that skews the data in a way that masks the negative effects of the minimum wage. Minimum wage increases do not happen randomly, and are instead controlled by political and economic conditions. As such, wage hikes may only take place in jurisdictions in which economic and employment conditions are good or improving, and may be resisted by governments in jurisdictions where such conditions are poor or worsening. This bias would indicate that studies of minimum wage increases may not fully recognise the full disemployment effect of the increase. Indeed, the effects may not be felt until many years later when the economy moves into recession and individuals find it more difficult to find employment after they have lost their jobs: the minimum wage could then be particularly problematic as workers are then seeking possible ‘second-best’ employment opportunities whilst their skills deteriorate. Thirdly, there is the significant difficulty of finding an adequate comparison group to serve as a control by which to measure the effects of minimum wage increases. These difficulties have undoubtedly contributed to the perception of uncertainty surrounding the effects of minimum wages.

When looking at studies on the minimum wage its worth keeping in mind that the effects of the minimum wage is likely to be masked in periods when the minimum wage is low compared to the average wage and/or when labour demand is strong.

Overall it seems most likely that increases in the minimum wage will not have positive effects for the working poor, increasing the minimum wage is likely to have a negative effect on employment, mainly for the low skilled groups in the economy.

Not all innovation is successful

From the New Zealand Herald,

Pam Corkery's bid to open the world's first brothel for women has failed.

The flame-haired former MP announced plans for Pammy's - a "6-star boutique haven" for discerning women - amid a blaze of publicity last year.

But Corkery and business partner Rebekah Hay have backed out of plans to set up shop in the Masonic Temple in Eden Terrace in inner-city Auckland.

[...]

Papers filed with the Auckland Council said the brothel would have a 24-hour bar, VIP lounge and "holistic centre" with day spa.

"Women will go to Pammy's to get a pedicure, a meal, a drink, and if they so choose sex with one of the male sex workers," it said.

As Tim Harford implies with the sub-title of his latest book, “Why Success Always Starts with Failure”, we must be willing to fail, to succeed.

The neoclassical model

When discussing The Emergence of Capitalist Economics II at the Adam Smith's Lost Legacy blog, Gavin Kennedy writes

[...] we are treated to an account of the usual Ricardian corn model, regarded by some economists as illustrative of the inner workings of a capitalist economy, upon which the seeds of the profession’s love affair with models were planted in 1817.

YHT also link Adam Smith to the problems with which the corn model is lined up to discuss and which the late 19th-century mathematical school went on to separate economics even further from the real world, leading to the fantasies of General Equilibrium and much of microeconomics as we know it today.

I find myself asking, if GE and much of microeconomics is just a bunch of fantasies, how did we come to these fantasies? If we assume, as economists normally do, that those like Ricardo, J S Mill, Marshall, Jevons, Menger, Walras, Knight and many others, who developed the neoclassical model were not stupid, then why does neoclassical economics look the way it does, there has to be a reason. Ether I'm wrong and all these economists were just morons as many critics seems to suggest or they were rationally attempting to answer some question. So, if neoclassical economics is the answer, what was the question? This is something those who just want to complain about microeconomics don’t ever seem to ask. And even less answer.

I would argue there are two possible answers to my question: one theoretical, the other empirical.

From the theoretical side as has been pointed out by Demsetz (1982, 1988a and 1995) the fundamental preoccupation of neoclassical economists is with the market and the price system and hence little, or no, attention gets paid to either the firm or the consumer as separate, significant, economic entities. Firms and consumers existed as handmaidens to the price system. In Demsetz's view the interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. Butler (2007: 25-6) briefly sums up mercantilism in the following way:

[...] it measured national wealth in terms of a country's stock of gold and silver. Importing goods from abroad was seen as damaging because it meant that this supposed wealth must be given up to pay for them; exporting goods was seen as good because these precious metals came back. Trade benefited only the seller, not the buyer; and one nation could get richer only if others got poorer. On the basis of this view, a vast edifice of controls was erected in order to prevent the nation's wealth draining away - taxes on imports, subsidies to exporters and protection for domestic industries. [...] Indeed, all commerce was looked upon with suspicion and the culture of protectionism pervaded the domestic economy too. Cities prevented artisans from other towns moving in to ply their trade; manufacturers and merchants petitioned the king for protective monopolies; labour saving devices such as the new stocking-frame were banned as a threat to existing producers.

The free trade versus mercantilism debate was, to a large degree, about the proper scope of government in the economy and the model it gave rise to reflects this. The question implicitly at the centre of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? The mercantilists would (surely) answer "yes" but Adam Smith famously answered "no". Smith

[ ... ] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' - would produce order and concord. They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly. Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature. (Butler 2007: 27-8.)

[Note that according to Smith the government has three duties: "[t]he first duty of the sovereign, that of protecting the society from the violence and invasion of other independent societies [...]". Smith (1776: Book V, Chapter 1, Part First, page 689). "The second duty of the sovereign, that of protecting, as far as possible, every member of the society from injustice or oppression of every other member of it, or the duty of establishing an exact administration of justice, [...]". Smith (1776: Book V, Chapter 1, Part II, page 709). "The third and last duty of the sovereign or commonwealth is that of erecting and maintaining those publick institutions and those publick works, which, though they may be in the highest degree advantageous to a great society, are, however, of such a nature that the profit could never repay the expense to any individual or small number of individuals, and which it therefore cannot be expected that any individual or small number of individuals should erect or maintain" Smith (1776: Book V, Chapter 1, Part III, page 723).]

For Smith, markets are the most prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. For economists, the 200 years following Smith involved a search for conditions under which the price system would not descend into chaos.

The formal (neoclassical) model that arose from this search is one which abstracts completely from any form of centralised control in the economy. [For Adam Smith this would be an abstraction too far. Smith knew of the importance of institutions to the proper functioning of the market economy.] It is a model delineated by "perfect decentralisation". Decentralised insomuch as authority plays no role in coordinating resources, the price system does the work. Note that the neoclassical model is often described as one of "perfect competition" and one reason that the emphasis on the firm and the household diminished as the model developed was that the neoclassicals placed a growing emphases on the concept of market competition and thus less emphases was given to firms and households. As McNulty (1984: 240) explains "[t]he 'perfection' of the concept of competition, beginning with the work of A. A. Cournot and ending with that of Frank Knight, which was at the heart of the development of economics as a science during the nineteenth and early twentieth centuries, led on the one hand to an increasingly rigorous analytical treatment of market processes and on the other hand to an increasingly passive role for the firm." For Knight "[p]erfect competition is conditioned by the existence of a set of assumptions, the most important of which are the following: (1) "a perfect market for productive services [ ... ], that is, uniform prices over the whole field" (1921[a], 316); (2) complete rationality and perfect knowledge by free and independent individuals; (3) "perfect mobility in all economic adjustments, no cost involved in movements or changes" (1921[b], 77); (4) "virtually instantaneous and costless" exchange of commodities (1921[b],78); (5) "perfect, continuous, costless intercommunication between all individual members of the society" (1921[b], 78); (6) perfect divisibility of commodities; and (7) "an indefinitely large number of competing organizations, each of the most efficient size" (1921[a], 316)." (Marchionatti 2003: 58).

Again, authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets - prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. Thus the neoclassical model gives a set of sufficient conditions under which the price system alone can achieve equilibrium.

Foss and Klein (2005: 6-7) argue that there is the possibility of an empirical reason for the way the neoclassical model considers the production side of the economy, at least. In short, the relative unimportance of the firm. Until relatively recently firms were simply not a large part of the economy. So treating firms as if they were all small may have been a reasonable approximation to a large section of the economy of the time. But they also point out that such an explanation is not wholly convincing. Large firms have existed since at least the time of Adam Smith and the classical economists knew this. Mokyr (2002: 122-3) summarises manufacturing in the U.K. before the Industrial Revolution by noting that,

[...] large plants were not entirely unknown before the Industrial Revolution. For instance, Pollard (1968) in his classic work on the rise of the factory, mentions three large British plants, each employing more than 500 employees before 1750. Perhaps the most ``modern" of all industries was silk throwing. The silk mills in Derby built by Thomas Lombe in 1718 employed 300 workers and were located in a five-story building. After Lombe's patent expired, large mills patterned after his were built in other places as well. Equally famous was the Crowley ironworks, established in 1682 in Stourbridge in the Midlands (not far from Birmingham), which at its peak employed 800 employees. [...] In textiles, supervised workshops production could be found before 1770 in the Devon woollen industry and in calico printing (Chapman 1974).

Also chartered companies were well known as witnessed by Adam Smith's negative assessment of chartered companies in general and the East India Company in particular, contained in the Wealth of Nations.

A more precise, and more defendable, version of the argument would be that the large, vertically integrated and diversified firm was not empirically important until recently. Thus analysing anonymous "firms" may not have been a bad approximation to the empirical realities of the time. As an approximation to "anonymous firm" production - that is, fully price-decentralised production - consider the case of rife manufacture in Birmingham, England in the 1860s,

[o]f the 5800 people engaged in this manufacture within the borough's boundaries in 1861 the majority worked within a small district round St Mary's Church. [...] The reason for the high degree of localization is not difficult to discover. The manufacture of guns, as of jewellery, was carried on by a large number of makers who specialized on particular processes, and this method of organization involved the frequent transport of parts from one workshop to another.

The master gun-maker-the entrepreneur-seldom possessed a factory or workshop. [...] Usually he owned merely a warehouse in the gun quarter, and his function was to acquire semi-finished parts and to give these out to specialized craftsmen, who undertook the assembly and finishing of the gun. He purchased materials from the barrel-makers, lock-makers, sight-stampers, trigger-makers, ramrod-forgers, gun-furniture makers, and, if he were engaged in the military branch, from bayonet-forgers. All of these were independent manufacturers executing the orders of several master gun- makers. [...] Once the parts had been purchased from the "material-makers," as they were called, the next task was to hand them out to a long succession of "setters-up," each of whom performed a specific operation in connection with the assembly and finishing of the gun. To name only a few, there were those who pre-pared the front sight and lump end of the barrels; the jiggers, who attended to the breech end; the stockers, who let in the barrel and lock and shaped the stock; the barrel-strippers, who prepared the gun for rifling and proof; the hardeners, polishers, borers and riflers, engravers, browners, and finally the lock-freers, who adjusted the working parts. (Allen (1929: 56-7 and 116-7), quoted in Stigler (1951: 192-3).)

Such a method of production would be a guide to the way production would take place under a functioning version the neoclassical model of the "firm".

Thus whether we see the neoclassical model as a set of conditions under which the price system alone can prevent decent into chaos, more formally conditions under which equilibrium can be achieved, or as an approximation to a large section of the economy of the time, the neoclassical model makes more sense than many of its detractors would permit.

Boudreaux writes to Krugman

A few days ago I noted that John Cochrane had asked How did Paul Krugman get it so wrong? Now Don Boudreaux writes an Open Letter to Paul Krugman. Boudreaux writes,

Interviewed recently in “The Browser,” you said that

if you ask a liberal or a saltwater economist, “What would somebody on the other side of this divide say here? What would their version of it be?” A liberal can do that. A liberal can talk coherently about what the conservative view is because people like me actually do listen. We don’t think it’s right, but we pay enough attention to see what the other person is trying to get at. The reverse is not true. You try to get someone who is fiercely anti-Keynesian to even explain what a Keynesian economic argument is, they can’t do it. They can’t get it remotely right. Or if you ask a conservative,”What do liberals want?” You get this bizarre stuff – for example, that liberals want everybody to ride trains, because it makes people more susceptible to collectivism. You just have to look at the realities of the way each side talks and what they know. One side of the picture is open-minded and sceptical. We have views that are different, but they’re arrived at through paying attention. The other side has dogmatic views.

Let’s overlook your failure to distinguish conservatives from libertarians – a failure that, for the point I’m about to make, is unimportant.

You’re able to conclude that “liberals” are open-minded thinkers while “conservatives” are dumb-as-dung dogmatists only because you compare the works of “liberal” scholars to the pronouncements of conservative popular pundits. However valid or invalid is the artistic license used by conservative celebrities such as Glenn Beck and Rush Limbaugh (and, for that matter, by “liberal” celebrities such as Rachel Maddow and Keith Olbermann) to entertain large popular audiences, you’re wrong to equate the pronouncements of conservative media stars with the knowledge and works of conservative (and libertarian) scholars.

Because, as you claim, you study carefully the works of non-”liberal” scholars, you surely know that the late Frank Knight, Ludwig von Mises, F.A. Hayek, and Milton Friedman – influential economists whom you would classify as “conservative” – were all steeped in and treated seriously the writings of Keynes, Marx, Veblen, Galbraith, and other “liberal” thinkers.

The same is true for still-living influential non-”liberal” scholars.

I’d be obliged to conclude that you in fact, contrary your claim, do not carefully engage the works of non-”liberal” scholars if you insist that “liberal” scholarship is ignored by conservative and libertarian thinkers such as James Buchanan, Gordon Tullock, Ronald Coase, Armen Alchian, Harold Demsetz, Anna Schwartz, Gary Becker, Vernon Smith, Leland Yeager, Henry Manne, Deirdre McCloskey, Allan Meltzer, Richard Epstein, Tyler Cowen, Arnold Kling, George Selgin, Lawrence H. White, and James Q. Wilson, to name only a few.

You do a disservice to scholars such as these, as well as to scholarship generally, to assert that serious thinking is done only by you and your ideological cohorts.

When I first read the Krugman interview something I thought odd was his use of the term "saltwater economist". I thought it showed just how out of touch Krugman is. I mean given the mixing of the waters that has taken place over the years I don't see the "freshwater/saltwater" divide having any real meaning today. Certainly not the meaning it has back in the days of Samuelson and Friedman.

EconTalk this week

Mike Munger of Duke University talks with EconTalk host Russ Roberts about the psychology, sociology, and economics of buying and selling. Why are different transactions that seemingly make both parties better off frowned on and often made illegal? In theory, all voluntary transactions should make both parties better off. But Munger argues that some transactions are more voluntary than others. Munger lists the attributes of a truly voluntary transaction, what he calls a euvoluntary transaction and argues that when transactions are not euvoluntary, they may be outlawed or seen as immoral. Related issues that are discussed include price gouging after a natural disaster, blackmail, sales of human organs, and the employment of low-wage workers.

More "economic journalism"

From the TVNZ news website:

The balance of payments probably swung to a surplus in the first quarter, driven by reinsurance flows for the Christchurch earthquakes, while the underlying current account deficit may have worsened.

How can something, in this case the BoP, which is zero by construction have "swung to a surplus"? I guess what they actually mean is that the capital account will have gone into surplus because of the reinsurance inflows and thus the current account must have gone into deficient, since (roughly) the current account is equal to the negative of the capital account. Thus leaving the BoP at zero.

Is this really so hard for journalists to understand?

What to do for prosperity

In an article in the Otago Daily Times on Friday 17 June 2011 Roger Kerr asks If We Know What To Do, Why Don't We Do It? In answer to this question Kerr writes,

It’s certainly the case that we know what makes for prosperity. For over two hundred years the essential nature of the ‘wealth of nations’ has been understood.

Adam Smith didn’t get everything right, and economics has been refined since his time, but his basic insights into the virtues of free markets and limited government have stood the test of time.

Modern economics confirms that the key to prosperity is the institutions (broadly the rules that govern economic and social interactions) and policies that nations adopt.

And Kerr is right, free markets ans, limited government and proper institutions are of major importance. But there must be more to it than just this. If not then why are we not at the top of the OECD? To a large degree we have gotten the institutions right and markets are freer today than they have been for much of the post war period. So what’s wrong? What is wrong with the policy mix we have adopted?

Part of what’s wrong is that we have done the easy, obvious things to increase productivity, growth and prosperity, This is what got us into the OECD in the first place. But to move up the ladder we have to start doing hard, less obvious things. The low hanging fruit have been picked.

To increase out productivity and growth we have to ask and answer harder questions. We have to look at how we deal with things like creative destruction, innovation, human capital, investment and competition, along with interactions between them.

By creative destruction I mean the exit of firms from industries, and the associated job losses, along with the development of new firms and markets. Entrepreneurs identify and realise new market opportunities, create investment opportunities and drive innovation. Maintaining free entry and exit to and from markets is an important issue if we wish to increase productivity. Accepting the exit of underperforming firms and, especially, the associated temporary loss in employment, is important to improvements in productivity. Trying to prevent such exit and loses will only prolong weak productivity growth. When considering the reasons for poor European productivity growth, the economic historian Nicholas Crafts has gone so far as to write,

“Politicians find it attractive to wax lyrical in support of the “knowledge economy” and rush to adopt targets for R&D spending and participation in tertiary education. This “happy-clappy” approach to addressing Europe's productivity growth shortfall keeps them in the comfort zone. More progress would be made if the dark side of productivity improvement implied by creative destruction – exit of established producers and re-deployment of labour – were accepted and facilitated. If only ministers could bring themselves to think (better still occasionally to say) “these job losses are good news”.”

How many ministers in New Zealand want to think such things, let alone say them?!

Questions that need answers include, Is it straightforward to start and run a business? How common are the types problems Ikea had in its attempts to find a site for a store in the North Island? How competitive is the business environment and how open is it to international competition? Are there barriers to entry in New Zealand’s industries? How competitive is the market for corporate control and how restricted is the flow of foreign investment? How large is firm turnover? Also we need to promote a climate that creates positive attitudes to risk taking, as Tim Harford implies with the sub-title of his latest book, “Why Success Always Starts with Failure”, we must be willing to fail, to succeed.

In terms of innovation note that innovators generate, adopt and adapt new ideas and create investment and entrepreneurial opportunities. Innovation increases productivity by increasing firms’ technological efficiency, it moves a firm’s production possibility frontier out. It can also introduce new products and services and thus help create new markets. But business R&D in New Zealand is low by international standards. The number of patents per million inhabitants is also low; suggesting that commercialisation of the research base is a challenge. Such issues need investigation.

Today human capital and skills are big players in productivity and growth. Higher skills increase individuals’ productivity and the productivity of others they work with. Skills have a dynamic effect on productivity growth by increasing the capacity to innovate and apply new ideas. Skills can enhance the returns to capital investment, and increase firms’ ability to adapt to new markets and competitive challenges. Productivity gains over the long term will come from improving the quality of early years education, and from targeting support to those children who are disadvantaged or at-risk. But this needs to be followed up by ongoing engagement in quality education and training both in school and after people enter the workforce.

In terms of human capital and skills issues arise at all levels of education. For example, at the tertiary level, the relevance and usefulness of graduates with regard to innovation requires attention. More importantly, in pre-tertiary education there is a large group of poor performers. We have a large variance in student achievement which needs to be addressed. Ongoing education for those already in the workforce is another area in need of attention. The relative importance of mechanisms by which education may affect productivity is the subject of debate. Are skills for imitation rather than new innovation more important in some cases?

Investment, rather obviously, improves and enlarges the capital stock; is an input in the entrepreneurial process; and increases the returns to skill acquisition. But care must be taken with policy changes since investment can be affected by policies in seemingly unrelated areas. Consider investment in ICTs in U.S. and Europe. Recent research argues that one reason for the lower productivity growth in Europe compared to the U.S., since the mid-1990s, is the lower investment in ICTs in Europe. One reason for this is the level of employment protection available there. Such protection raises the cost of exiting an industry if things go wrong and these exit barriers act as entry barriers. Badly designed bankruptcy law can have a similar effect in so much as it can raise exist costs and thus act as an barrier to entry.

Questions with regard to investment include. Are there problem with regime uncertainty? Are there are problems with the depth and breadth of New Zealand’s capital markets and with financial intermediation, along our reliance on foreign capital.

Competition is another player in productivity and growth. Consider as an example, Nicholas Crafts who argues that competition helped cure the “British disease”, which to a degree is now the “New Zealand disease”. There are several channels through which competition can affect productivity: (1) Stimulating innovation to sustain rents close to the technology frontier; (2) Acting as an antidote to corporate governance problems arising from weak shareholders and the separation of ownership and control; (3) Acting as a discipline which leads to better management practices; and (4) Removing the basis for low-productivity effort bargains between firms and their workers. Of course competition can come from two sources, local – governed largely by competition policy; and international – governed by how free people are to trade with other countries. It is commonly accepted that trade liberalisation can increase productivity. An interesting question is, How? Which of points 1-4 apply. The early literature emphasises the role of firms “learning” to be more productive, whereas recent studies suggest that more productive firms are “stealing” market share from less productive ones, thus raising overall productivity. One very recent study based on India’s trade liberalisation since 1991 finds support for both, but argues that learning outweighs stealing.

Things to think about with regard to competition would involve issues such as: Are there barriers to competition either locally or to competition from foreign firms? Are there negative, unintended, consequences from decisions of the Commerce Commission or other regulatory bodies? Is the Commerce Act itself adequate? Policy should aim to keep barriers to competition at low levels, does it?

But a word of caution with all of this: two considerations to keep in mind when thinking about policy approaches to New Zealand’s particular circumstances are geographical location and size. With four and a bit million people, the population of New Zealand is smaller than many cities overseas and with 10,000 kilometres to the U.S.A. or China and even a couple of thousand kilometres to Australia, New Zealand is a considerable distance from its main trading partners. While it’s clear that the cost of transporting goods, services and ideas has been declining and this has allowed for greater levels of trade and financial flows, evidence suggests that distance and size still play an important part in determining New Zealand’s prosperity. Research suggests that countries that are smaller and further away from international markets are likely to be poorer than countries that have larger domestic markets and are closer to international markets. New Zealand’s relatively small domestic market limits the extent to which firms can exploit internal economies of scale, benefit from product market competition and gain from specialisation. Aspects of this will be less of a problem in a comparison with Australia as it too is along way from its markets, but it still has a larger economy than New Zealand.

So Roger Kerr is right that there are easy, obvious, sensible things that can be done to increase the prosperity of a country. But New Zealand has done most of these and what we have to do from now on isn't so obvious and could come at a high political cost, so isn’t easy.

Smoot-Hawley 81 years later

The Smoot-Hawley Tariff Act was a grave error for U.S. trade policy. As the United States slid into depression, the act represented a desperation move by Congress and President Hoover. Since then, presidents have regarded free trade as the rule rather than the exception. In this Cato Daily Podcast economist Douglas A. irwin discusses the Smoot-Hawley Act and its legacy.

Price gouging laws hurt storm victims

This simple fact is pointed out by Art Carden at The Economic Imagination blog. Carden writes,

How many people see natural disasters like the tornadoes in Tuscaloosa, Alabama, and Joplin, Missouri and say “we should be working to impede the recovery and make life harder for storm victims?” Probably no one. How many people see prices rise after natural disasters like the tornadoes in Tuscaloosa, Alabama and Joplin Missouri and say “we should prosecute ‘price gougers!’”? Probably a lot. And yet prosecuting price gougers makes life harder for storm victims.

and adds

[...] someone has wisely pointed out that in post-disaster situations rising prices perform vital economic triage by showing which uses of resources are now high-value and which uses of resources are now low-value.

A disaster means a big shock both to what people want and to the resources available to fulfill those wants. Freely-moving prices make sure resources are allocated to their highest-valued uses, and rising prices send people a very important signal: resources have gotten scarcer and need to be conserved. If houses are destroyed by a tornado, rising lumber prices tell someone in an unaffected area to think twice about building a new deck because the lumber is probably more valuable rebuilding houses. Rising gas prices tell people to think twice about burning scarce gas for a Sunday drive in the country. And so on.

I’ve come to think that there is an iron law of intervention: if you want to make a problem worse, pass a law to fix it. Price controls create shortages: when the price isn’t allowed to rise to coordinate the wants of buyers with the wants of sellers, shortages result. The cruel irony is that any “benefit” for those we are trying to help is frittered away because people who aren’t allowed to pay for something with their money will pay for it with their time. Passing a law doesn’t change what someone is willing to pay, but it changes how they pay.

Suppose the price of a gallon of milk is normally $3 but would shoot up to $10 after a tornado. Suppose the government passes a “price gouging” law saying that people aren’t allowed to raise prices by more than 25% once a “disaster” has been declared. A grocery store raises the price of milk to $3.75. If Bob values his time at $6.25 per hour, he will be willing to pay for the milk by waiting in line for an hour to pay $3.75. Notice that while he’s waiting in line, he’s not fixing his house or working. His valuable time simply disappears.

Carden ends by saying,

Some argue that there is more to life than economic efficiency, and I certainly agree. However, price-gouging laws compound the already-onerous burden on people who are affected by natural disasters by creating shortages, which Giberson calls “a result that suggests neither shared sacrifice nor promotion of a common good.”

Naturally, the disasters and price-gouging witch-hunts have been accompanied by outrage from activists and politicians as well as platitudes about how we should “work together.” Outrage is always cheap, disaster or no disaster, but a storm victim can’t rebuild a house with your anger. That requires labor, and it requires resources–labor and resources that don’t materialize when the price isn’t allowed to rise.

The value of a firm

Tim Worstall writes,

With standard terrestrial radio there is a natural limit to the number of stations there can be in any one market. On the internet, anyone with the nous to set up a server to stream music and who can sign the contracts with the record companies can launch one or many such stations.

There’s just no limit to the number of people who can enter this space. So what actually, in a world of potentially unlimited compeition, is the value of any of the competitors?

The answer to his question is that the value of all the firms in the market will be the same, since economic profits of each of them will be (approximately) zero. Thus each firm will earn the market rate of return, that is, an amount that is just enough to keep the resources in their current use. Or, the opportunity cost of those resources. If you want to make your fortune don't enter highly competitive industries.

How did Paul Krugman get it so wrong?

This question is asked by John H. Cochrane in an article in the latest issue of Economic Affairs (Vol. 31 (2), June 2011). The abstract of the article reads:

This article is a response to Paul Krugman’s New York Times Magazine article,‘How Did Economists Get It So Wrong?’ Krugman’s attack on modern economics – and many adhominem attacks on modern economists – display a deep and highly politicised ignorance of what economics and finance is really all about, and a striking emptiness of useful ideas.

The introductory section reads:

Many friends and colleagues have asked me what I think of Paul Krugman’s New York Times Magazine article, ‘How Did Economists Get It So Wrong?’

Most of all, it is sad. Imagine this were not an economics article. Imagine this were a respected scientist turned popular writer, who says, most basically, that everything everyone has done in his field since the mid-1960s is a complete waste of time. Everything that fills its academic journals, is taught in its PhD programmes, presented at its conferences, summarised in its graduate textbooks, and rewarded with the accolades a profession can bestow (including multiple Nobel Prizes) is totally wrong. Instead, he calls for a return to the eternal verities of a rather convoluted book written in the 1930s, as taught to our author in his undergraduate introductory courses. If a scientist, he might be an AIDS-HIV disbeliever, a creationist or a stalwart that maybe continents do not move after all.

It gets worse. Krugman hints at dark conspiracies, claiming ‘dissenters are marginalised’. The list of enemies is ever growing and now includes ‘new Keynesians’ such as Olivier Blanchard and Greg Mankiw. Rather than source professional writing, he uses out-of-context second-hand quotes from media interviews. He even implies that economists have adopted ideas for pay, selling out for ‘sabbaticals at the Hoover institution’ and fat ‘Wall Street paychecks’.

This approach to economic discourse is a disservice to New York Times readers. They depend on Krugman to read real academic literature and digest it, and they get this attack instead. Any astute reader knows that personal attacks and innuendo mean the author has run out of ideas.

Indeed, this is the biggest and saddest news of this piece: Paul Krugman has no interesting ideas whatsoever about what caused the financial and economic problems that culminated in the crash of 2008, what policies might have prevented it, or what might help us in the future.

But maybe he is right. Occasionally sciences, especially social sciences, do take a wrong turn for a decade or two. I think Keynesian economics was such a wrong turn. So let us take a quick look at the ideas.

Krugman’s attack has two goals. First, he thinks financial markets are inefficient’, fundamentally due to ‘irrational’ investors, and thus prey to excessive volatility which needs government control. Second, he likes the huge ‘fiscal stimulus’ provided by multi-trillion dollar deficits.

When he turns to the idea of market efficiency Cochrane makes a point that I'm sure most economists have had to make a some point recently:

It is fun to say that we did not see the crisis coming, but the central empirical prediction of the efficient markets hypothesis is precisely that nobody can tell where markets are going – neither benevolent government bureaucrats, nor crafty hedge-fund managers, nor ivory-tower academics. This is probably the best-tested proposition in all the social sciences. Krugman knows this, so all he can do is rehash his dislike for a theory whose central prediction is that nobody can be a reliable soothsayer. It makes no sense whatsoever to try to discredit efficient market theory in finance because its followers didn't see the crash coming.

Cochrane adds:

Krugman writes as if the volatility of stock prices alone disproves market efficiency, and believers in efficient marketers have just ignored it all these years. This is a canard that Krugman should know better than to pass on, no matter how rhetorically convenient. There is nothing about ‘efficiency’ that promises ‘stability’. ‘Stable’ price growth would in fact be a major violation of efficiency as it would imply easy profits.

Cochrane then goes on to make another point that economists have to frequently make, and re-make: The case for free markets is not justified by the belief that markets are ‘perfect’

But this argument takes us away from the main point. The case for free markets never was that markets are perfect. The case for free markets is that government control of markets, especially asset markets, has always been much worse.

So its not that markets are perfect, its that the alternative is (normally) worse.

On the question of the stimulus, Cochrane writes:

Krugman is a strong supporter of fiscal stimulus. In this quest, he accuses us and the rest of the economics profession of ‘mistaking beauty for truth’. He is not clear on what the ‘beauty’ is that we all fell in love with, and why one should shun it, for good reason. The first siren of beauty is simple logical consistency. Krugman’s Keynesian economics requires that people make logically inconsistent plans to consume more, invest more and pay more taxes with the same income. The second siren is plausible assumptions about how people behave. Keynesian economics requires that the government is able to systematically fool people again and again. It presumes that people don’t think about the future in making decisions today. Logical consistency and plausible foundations are indeed ‘beautiful’ but to me they are also basic preconditions for ‘truth’.

Cochrane then says:

In economics, stimulus spending ran aground on Robert Barro’s Ricardian equivalence theorem. This theorem says that debt-financed spending cannot have any more effect than spending financed by raising taxes. People, seeing the higher future taxes that must pay off the debt, will simply save more. They will buy the new government debt and leave all spending decisions unaltered.

The question becomes, Does the theorem apply?

Economists have spent a generation tossing and turning the Ricardian equivalence theorem, assessing the likely effects of fiscal stimulus in its light, generalising the ‘ifs’ and figuring out the likely ‘therefores’. This is exactly the right way to do things. The impact of Ricardian equivalence is not that this simple abstract benchmark is literally true. The impact is that in its wake, if you want to understand the effects of government spending, you have to specify why and how it is false.

Doing so does not lead you anywhere near old-fashioned Keynesian economics. It leads you to consider distorting taxes, how much people care about their children, how many people would like to borrow more to finance today’s consumption and so on.

For example, most Keynesians think the Ricardian equivalence theorem fails because people don’t rationally anticipate the future taxes that must pay off today’s debt. OK, but what’s good for the goose is good for the gander: if sometimes people pay too little attention to future taxes, at others they pay too much, so stimulus has a negative effect. The latter seems at least plausible now! It is the logically consistent conclusion from Krugman’s views. He thinks deficit concerns are just Tea Party hysteria. OK, but if so, the voters are overestimating future taxes, not ignoring them. Furthermore, if ‘stimulus’ is rooted in people ignoring future taxes, then it makes no sense whatsoever to advocate ‘stimulus’ today but loudly announce the future taxes in ‘deficit reduction’!

When addressing "the crash" Cochrane writes:

Krugman’s New York Times article is supposedly about how the crash and recession changed our thinking, and what economics has to say about it. The most amazing news in the whole article is that Paul Krugman has absolutely no idea about what caused the crash, what policies might have prevented it and what policies we should adopt going forward. He seems completely unaware of the large body of work by economists who actually do know something about the banking and financial system, and have been thinking about it productively for a generation.

So, to return to the big question: How did Krugman get it so wrong?

So what is Krugman up to? The only explanation that makes sense to me is that Krugman isn’t trying to be an economist: he is trying to be a partisan, political opinion writer. [...]

To Krugman, economics is no longer a quest for understanding, delightful in its capacity to overturn one’s preconceptions. Economics is just a set of debating points to argue for policies that one has adopted for partisan political purposes. ‘Stimulus’ is just marketing to sell Congressmen and voters a package of government spending priorities that are wants for political reasons. It is not a proposition to be explained, understood, taken seriously to its logical limits, or reflective of market failures that should be addressed directly.

There is more to the Cochrane article than I have noted here. Get a copy and read, and think about, the whole thing.

Measuring systemic risk and the dismal failure of Basel risk weights

From VoxEU.org comes this audio in which Viral Acharya talks to Viv Davies about capital requirements and measuring systemic risk. Acharya describes the development of the NYU Stern systemic risk rankings of US financial institutions and what he considers to be the dismal failure of the Basel risk-weight approach to addressing systemic risk. He cautions against the blanket call for more capital and instead recommends for more capital against systemic risk contributions of financial firms. He also discusses the shadow banking sector and how banking risk and sovereign risk are becoming dangerously intertwined.

NZ/Australia comparisons: useful?

One of the often stated economic aims for New Zealand is to “catch up with Australia.” That is, we want to increase New Zealand’s economic growth, income and welfare to a level equal to that of Australia. One of the most important ways of achieving this aim is to increase our productivity growth to the point where it is higher than that of Australia. But what if comparisons between New Zealand and Australia are not meaningful? Are we trying to achieve a meaningless goal?

A paper from the International Review of Applied Economics (Vol. 21, No. 1, 55–73, January 2007), “Convergence in Productivity Across Industries: Some Results for New Zealand and Australia” by Troy D. Matheson and Les Oxley, looks at the issue of Australia/New Zealand comparisons and suggests that they may not be meaningful. The paper’s abstract reads:

New Zealand shares a wealth of common interests and experiences with Australia. This has tempted some to assume that these economies form an ‘Economic Club’, in which one would expect to identify common aggregate trends and growth experiences. In this paper we present results that test, and generally reject, convergence in labour productivity across Australia and New Zealand, using both aggregate and disaggregate, industry-level data. We find that only two industries satisfy our definition of Conditional Convergence (Agriculture, Forestry and Fishing and Cultural and Recreational Services), and that the Mining and Wholesale Trade industries have particularly important roles to play in explaining the measured divergence. Cointegration-based tests reveal more stochastic trends governing Australian productivity than in New Zealand. The evidence suggests, therefore, that the underlying growth processes of the two economies are fundamentally different, thereby questioning the relevance of aggregate comparisons between them. New evidence using industry-level data does not, therefore, resolve the aggregate-level ‘nonconvergence puzzle’ identified here, and elsewhere. (Emphasis added)

And the conclusion of the paper reads:

New Zealand’s aggregate real GDP per capita growth performance seems to have improved following the reforms of the late 1980s and early 1990s, but not when compared to other OECD countries, particularly Australia (see, e.g. Dalziel, 1999; Greasely & Oxley, 1999). In this paper we attempt to explain this recent performance by considering market sector and industry level measures of labour productivity in New Zealand and Australia over the 1990s, and consider whether there exists any form of ‘Trans-Tasman convergence in productivity club’. We presented cross-country (New Zealand and Australia) comparisons both at the aggregate, market sector level and the disaggregate, 11-industry level. In particular, in Section 4 we gauged the persistence of the discrepancy between Australian and New Zealand market sector productivity using time-series tests of the convergence hypothesis where convergence in terms of long-term forecasts was rejected. The Australian market sector was found to have more stochastic trends than that of New Zealand, questioning the comparability of the two economies at the market sector level; we found evidence of eight stochastic trends in Australia and three stochastic trends in New Zealand.

At the disaggregate level we found that only two of the 11 industries in the market sector were classified as being (conditionally) converged (Agriculture, Forestry and Fishing and Cultural and Recreational Services). With the exception of the Wholesale Trade industry, whose productivity is independent across the two countries, relative productivity levels of the remainder of the industries display evidence of transition to new steady states and of structural change. The diversity of productivity level and growth differences across the industries calls into question whether the fundamentals of growth in the respective economies are comparable. This was perhaps most apparent in the Mining industry, where we found that Australian Mining productivity was more than 80% higher than New Zealand’s at the end of the
sample period.

The empirical conclusion to be drawn here is that disaggregating to the level of the industry does not resolve the puzzle, identified at the aggregate market level, that New Zealand and Australian labour productivity do not exhibit a tendency to converge over time. In fact, the results based upon industry rather than market level data indicate a much more complicated picture and little if any support for a traditional neoclassical growth model paradigm. (Emphasis added)

All of this does not make good reading if you want to play catchup.

Interesting blog bits

1. Roger Kerr point out that Protectionism Never Completely Dies

   Remember the days of Fortress New Zealand when tight import licensing and high tariffs allowed domestic producers to sell goods at far above the price of competing foreign goods?

2. Gary Becker on “Capture” of Regulators by Fannie Mae and Freddie Mac-Becker

   Political economists describe the process whereby government officials end up being the servants rather than the masters of the firms they are regulating as the “capture” by the industry of their regulators. When regulators are captured, much of what they do is motivated, consciously or not, by a desire to help the companies they are regulating, even when the social goals that the regulators should pursue are very different.

3. Jean-Pierre Chauffour on Development as freedom: New empirical evidence (1975-2007)

   The Arab Spring is again raising fundamental questions about the place of freedom and entitlement in economic development. Reviewing the performance of more than 100 countries over the past 30 years, this column finds evidence that economic freedom and civil and political liberties are the root causes of why certain countries achieve and sustain better economic outcomes than others.

4. Alessandra Bonfiglioli and Gino Gancia ask Why are reforms so politically difficult?

   Most economists agree that the global crisis has exposed the need for economies to reform, particularly those along Europe’s periphery. The problem is making these reforms politically viable. This column notes that many governments fear electoral defeat if they enforce unpopular policies. But it also argues the risk of punishment in the polls is the lowest in times of crisis.

5. Eric Crampton on Alcohol minimum pricing

   The Australians are considering imposing alcohol minimum price regulation to reduce alcohol's social costs. Oh dear.

6. Lynne Kiesling notes that They can’t even pull off the ethanol subsidy repeal

   Although the federal government is actually in a budget crisis and our elected so-called representatives claim to be dealing with it, they are acting rather like they are in denial, or still embroiled in such petty partisan bickering that they refuse to make difficult choices with short-run costs and long-run benefits.

7. Lynne Kiesling on the Distortionary effects of three-tier liquor regulation, Wisconsin edition

   As Jonathan Adler notes at the Volokh Conspiracy, the Wisconsin legislature is considering a piece of legislation that would change the regulations governing the production, wholesale distribution, and retail sale of beer in Wisconsin. The controversial provision in this legislation is one that prevents brewers from owning wholesale distributors, and the controversy arises primarily because of the possible effects on small craft brewers of a piece of legislation that is intended to blunt the market power of Anheuser-Busch.

8. George Selgin on Capital and Cash Reserves

   I promise to make this my last post for a while concerning the matter of 100-percent versus fractional-reserve banking. However, in addressing some comments on my recent posts it occurred to me that some very serious misunderstanding is at play concerning the difference between a bank's capital and its cash reserves. The distinction between these is important, because in an important sense, and particularly with respect to comparisons of fractional and 100-percent reserve institutions, the two are substitutes.

9. Mark Perry points out that Our Trade With Rest of World is Always Balanced

   Or in other words, our balance of payments is zero.

The Smoot-Hawley Tariff Act

On the 17th June 1930, U.S. President Herbert Hoover signed the infamous Smoot-Hawley Tariff Act into law. Not a great day for the U.S., or the rest of the worlds, economic well being.

Interestingly on May 4, 1930, 1,028 economists signed a petition urging Congress and President Herbert Hoover to reject the Smoot-Hawley Tariff Act, arguing that "increased restrictive duties would . . . operate, in general, to increase the prices which domestic consumers would have to pay." Neither Congress nor the president listened. And the rest is, as they say, history.

As Douglas Irwin has written in the Wall Street Journal:

The Smoot-Hawley tariff, conceived as a Republican ploy to gain the farm vote in the 1928 election, was a bad idea from the start. A tariff could not help farmers cope with low prices because most of them depended on exports. The nation sold one-half of its cotton, one-third of its tobacco, and one-fifth of its wheat and flour abroad. Their prices were set on the world market. The farmers who did compete against imports -- sugar and wool -- were already protected with high duties.

And once politicians opened the door to duties on farm goods, the result was a log-rolling, pork-barrel free for all in which the interests of consumers and exporters were ignored. When Colorado demanded a higher tariff on animal hides, Massachusetts, home of the shoe industry, insisted on a higher tariff on leather shoes.

Every congressman had some producer interests he wanted to protect. For Utah's Sen. Reed Smoot it was sugar beets. [...]

More than a thousand American economists signed a petition against the tariff bill. Prominent journalist Walter Lippmann criticized it as "a wretched and mischievous product of stupidity and greed." No matter. Proponents such as New York Republican Congressman Frank Crowther pooh-poohed fears of reprisals and claimed the tariff would "raise the standard of American labor and American wages."

While most economists do not hold the Smoot-Hawley tariff responsible for the Great Depression itself, it contributed to a sharp decline in world trade. The tariff slashed U.S. dutiable imports by about 15%, for example. Even worse, it spawned protectionism abroad.

America's trading partners, notably Canada, did not turn the other cheek. Outraged at being kicked out of the U.S. market, the pro-American Canadian government retaliated against U.S. exports. Anti-American sentiment allowed the pro-British Conservatives to win a general election there just weeks after the tariff took effect. They retaliated again.

To illustrate the blowback: U.S. imports of eggs from Canada dropped to 8,000 dozen from 13,000 dozen after Smoot-Hawley. But U.S. egg exports to Canada dropped to 14,000 dozen from 920,000 dozen as a result of Canada's retaliation.

Canada also led the charge to create a trade bloc within the British Empire that discriminated against U.S. goods. As a result, U.S. exports fell faster than U.S. imports during the Depression, even though the slump was more severe in the U.S. than elsewhere. There were other adverse political effects. The tariff helped ruin Cuba's sugar economy, which led to the overthrow of Cuba's pro-American government.

Yes people, tariffs really are dumb!

Donald J. Boudreaux writes to the President

Productivity is the key driver of increasing economic growth, increasing wages and increasing income and welfare more generally. So I only hope that President Obama takes careful note of Don Boudreaux's open letter to him and drops his the anti-innovation and anti-productivity stand.

In your recent interview with NBC News you explained that your policies would promote more private-sector job creation were it not for (as you put it) “some structural issues with our economy where a lot of businesses have learned to become much more efficient with a lot fewer workers. You see it when you go to a bank and you use an ATM, you don’t go to a bank teller, or you go to the airport and you’re using a kiosk instead of checking in at the gate.”

With respect, sir, you’re complaining about the source of our prosperity: innovation and the increases it causes in worker productivity.

With no less justification – but with no more validity – any of your predecessors might have issued complaints similar to yours. Pres. Grant, for example, might have grumbled in 1873 about “some structural issues with our economy where a lot of businesses have learned to become much more efficient with a lot fewer workers. You see it when you go to a bank that uses a modern safe and so employs fewer armed guards than before, or when you travel on trains which, compared to stage coaches, transport many more passengers using fewer workers.”

Or Pres. Nixon might have groused in 1973 about such labor-saving innovation: “You see it when you step into an automatic elevator that doesn’t require an elevator operator, or when you observe that polio vaccination keeps people alive and active without the aid of nurses and all those workers who were once usefully employed making iron-lung machines, crutches, and wheelchairs.”

Do you, Pres. Obama, really wish to suggest that the innovations you blame for thwarting your fiscal policies are “structural issues” that ought to be corrected?

The last thing any country needs is for its politicians to be anti-productivity, but for New Zealand such a stance would certainly mean we will never "catchup with Australia".

Imports good; exports bad; redux

I have argued before that Imports good; exports bad. Now it appears Daniel Griswold, director of the Herbert A. Stiefel Center for Trade Policy Studies at the Cato Institute in Washington, is following a similar line of thinking. He has released a Trade Policy Analysis paper on the topic: The Trade-Balance Creed Debunking the Belief that Imports and Trade Deficits Are a “Drag on Growth”.

The executive summary reads:

A nearly universal consensus prevails that the goal of U.S. trade policy should be to promote exports over imports, and that rising imports and trade deficits are bad for economic growth and employment.

The consensus creed is based on a misunderstanding of how U.S. gross domestic product is calculated. Imports are not a "subtraction" from GDP. They are merely removed from the final calculation of GDP because they are not a part of domestic production.

Contrary to the prevailing view, imports are not a "leakage" of demand abroad. In the annual U.S. balance of payments, all transactions balance. The net outflow of dollars to purchase imports over exports are offset each year by a net inflow of foreign capital to purchase U.S. assets. This capital surplus stimulates the U.S. economy while boosting our productive capacity.

An examination of the past 30 years of U.S. economic performance offers no evidence that a rising level of imports or growing trade deficits have negatively affected the U.S. economy. In fact, since 1980, the U.S. economy has grown more than three times faster during periods when the trade deficit was expanding as a share of GDP compared to periods when it was contracting. Stock market appreciation, manufacturing output, and job growth were all significantly more robust during periods of expanding imports and trade deficits.

The goal of U.S. trade policy should not be to promote exports at the expense of imports, but to maximize the freedom of Americans to trade goods, services, and assets in the global marketplace.

The view that the goal of trade policy should be to promote exports over imports, and that rising imports and trade deficits are bad for economic growth and employment is not just a U.S. thing. You, unfortunately, see exactly the same attitude in New Zealand or any other country you care to name. So we should think carefully about the result that "An examination of the past 30 years of U.S. economic performance offers no evidence that a rising level of imports or growing trade deficits have negatively affected the U.S. economy. In fact, since 1980, the U.S. economy has grown more than three times faster during periods when the trade deficit was expanding as a share of GDP compared to periods when it was contracting. Stock market appreciation, manufacturing output, and job growth were all significantly more robust during periods of expanding imports and trade deficits." A similar outcome will hold for New Zealand.

The long-run impacts of early childhood education

One of the most important factors determining productivity is human capital. One of the most important inputs to human capital is education and one of the most important areas of education is early childhood education. So this new NBER working paper on The Long-Run Impacts of Early Childhood Education: Evidence From a Failed Policy Experiment is worth noting.

The abstract for the paper, which is authored by Philip DeCicca and Justin D. Smith, reads

We investigate short and long-term effects of early childhood education using variation created by a unique policy experiment in British Columbia, Canada. Our findings imply starting Kindergarten one year late substantially reduces the probability of repeating the third grade, and meaningfully increases in tenth grade math and reading scores. Effects are highest for low income students and males. Estimates suggest that entering kindergarten early may have a detrimental effect on future outcomes.

Now that is a result I would not have guessed and I would love to know the psychology behind it. If correct the result does raise interesting policy issues to do with when we start children in education.

Douglas Irwin on Peddling Protectionsim

Another Cato Institute video in which Douglas Irwin talks about his new book Peddling Protectionism: Smoot-Hawley and the Great Depression.

Pennington on Robust Political Economy

From the Cato Institute comes this video in which Mark Pennington talks about his book Robust Political Economy: Classical Liberalism and the Future of Public Policy.

Adam Smith's birthday, again

Round 3 on Adam Smith's birthday. Eamonn Butler enters the ring at the Adam Smith Institute blog by posting on June 14 that

It's Adam Smith's birthday today. Well, probably. We know that he was baptised on 5th June 1723 – which, because of the calendar change in 1752 translates to 16th June today. And generally, children in Fife would be baptised a couple of days after they were born, so it's a fair bet that today is his birthday.

Perhaps we should arrange a cage match between Eamonn and Don Boudreaux to settle the question Smith's birthday once and for all.

EconTalk this week

Yes I know its a day late, but I was in Wellington yesterday so am just catching up on things.

Todd Buchholz, author of Rush: Why You Need and Love the Rat Race, talks with EconTalk host Russ Roberts about the ideas in the book. Buchholz argues that competition and striving for excellence is part of our evolutionary inheritance. He criticizes attempts to remake human beings into gentle creatures who long to return to an Eden-like serenity. He argues that it is action, creativity, and planning for the future that makes us happy. The discussion includes the implications of our interest in the future for theater and story-telling.

The value of research

What is the value of the research we do? Can we workout the contribution we make to social welfare? The Economic Logician writes,

Robert Hofmeister tries to give research some value. The approach is to consider the scientific process through cohorts, where each wave provides fundamental research as well as end-applications based on previous fundamental research. A particular research results thus can have a return over many generations. It is an interesting way to properly attribute the intellectual source of a new product or process, but the exercise is of little value if it is not possible to quantify the social value of the end-application. Indeed, Hofmeister goes back to using citations in Economics for a data application, which is equivalent to evaluate research only within the scientific community. In terms of the stated goal of the paper, we are back to square one. In terms of getting a better measure of citation impact, this is an interesting application of an old idea. And the resulting rankings of journals and articles look very much like those that are already available.

My guess would be that most research adds nothing to social welfare. I see no real social value in anything I've written or in most of what I read.

The abstract of the Hofmeister paper reads,

This paper proposes a generational accounting approach to valuating research. Based on the flow of scientific results, a value-added (VA) index is developed that can, in principle, be used to assign a monetary value to any research result and, by aggregation, on entire academic disciplines or sub-disciplines. The VA-index distributes the value of all applications that embody research to the works of research which the applications directly rely on, and further to the works of research of previous generations which the authors of the immediate reference sources have directly or indirectly made use of. The major contribution of the VA index is to provide a measure of the value of research that is comparable across academic disciplines. To illustrate how the generational accounting approach works, I present a VAbased journal rating and a rating of the most influential recent journal articles in the field of economics.