The second best

When looking at many of the discussions of claims of some form of market failure and how governments can fix things, I wonder if this is one area where partial equilibrium modelling can leads us astray. While the use of taxes or subsidies may, in theory, correct a failure in a single market the question has to be asked, What effect does this have in general? It is here that the theory of second best can ruin the day of our would be market failure fixes.

It is well known that the attainment of a Paretian optimum requires the simultaneous fulfillment of all the optimum conditions. The general theorem for the second best optimum states that if there is introduced into a general equilibrium system a constraint which prevents the attainment of one of the Paretian conditions, the other Paretian conditions, although still attainable, are, in general, no longer desirable. In other words, given that one of the Paretian optimum conditions cannot be fulfilled, then an optimum situation can be achieved only by departing from all the other Paretian conditions. The optimum situation finally attained may be termed a second best optimum because it is achieved subject to a constraint which, by definition, prevents the attainment of a Paretian optimum.

From this theorem there follows the important negative corollary that there is no a priori way to judge as between various situations in which some of the Paretian optimum conditions are fulfilled while others are not. Specifically, it is not true that a situation in which more, but not all, of the optimum conditions are fulfilled is necessarily, or is even likely to be, superior to a situation in which fewer are fulfilled. It follows, therefore, that in a situation in which there exist many constraints which prevent the fulfillment of the Parteian optimum conditions, the removal of any one constraint may affect welfare or efficiency either by raising it, by lowering it, or by leaving it unchanged. (R. G. Lipsey and Kelvin Lancaster, The General Theory of Second Best, The Review of Economic Studies, Vol. 24, No. 1 (1956 - 1957): 11-2)

So even if the use of a tax or subsidy may appear to have removed some market failure in a single market it may cause more trouble that it is worth in a general equilibrium setting.

Interesting blog bits

Mark Blaug

1. Frederic Sautet on Mark Blaug (1927-2011), fellow traveller of Austrian economics
2. Tyler Cowen on Very sad news, Mark Blaug passes away, 1927-2011
3. Eric Schliesser on Weekly Philo economics: Mark Blaug (1927-2011)
4. Gavin Kennedy on Mark Blaug and the Invisible Hand
5. Eric Crampton on Blaug
6. Steve Kates on Mark Blaug

Andrew Skinner

1. Eric Schliesser on Weekly Philo economics: Mark Blaug (1927-2011) & Andrew Skinner (1935-2011)
2. Gavin Kennedy on Andrew Skinner; doyen among Smithian Scholars, 1935-2011

Blaug on Smith

Given the recent deaths of both Mark Blaug and Andrew Skinner I was reminded of this comment by Blaug on Adam Smith and the "invisible hand",

"[ ... ] Smith's faith in the benefits of 'the invisible hand' has absolutely nothing whatever to do with allocative efficiency in circumstances where competition is perfect a la Walras and Pareto; the effort in modern textbooks to enlist Adam Smith in support of what is now known as the 'fundamental theorems of welfare economics' is a historical travesty of major proportions. For one thing, Smith's conception of competition was, as we have seen, a process conception, not an end-state conception. For another society, a decentralised competitive price system was held to be desirable because of its dynamic effects in widening the scope of the market and extending the advantages of the division of labour - in short, because it was a powerful engine for promoting the accumulation of capital and the growth of income."

Blaug, Mark 1996. Economic Theory in Retrospect. 5th edn. 60-1. Cambridge: Cambridge University Press.

In today's terms, in some ways, I would see Smith as more "Austrian" than "neoclassical".

Andrew Skinner, 1935-2011

Eric Crampton has noted the passing of Mark Blaug. It now turns out that we must also note the passing of another great historian of economics, the Adam Smith scholar, Andrew Skinner. From the Adam Smith’s Lost Legacy blog comes this tribute to Skinner:

Eric Schliesser, a fine scholar who is much appreciated for his knowledge of 18th-century leading figures of the Scottish Enlightenment, has written a tribute to Andrew Skinner, whose death was reported today:

“This has been a terrible week for the history of economics: two of its giants, Andrew Skinner and Mark Blaug, died a few days apart. Skinner was the Daniel Jack Professor of Political Economy from 1985 to 1994 and Adam Smith Professor of Political Economy from 1994 until 2000 at University of Glasgow. Skinner is best known for his superb editing of the 2-volumes of the The Wealth of Nations in The Glasgow Edition of the Works and Correspondence of Adam Smith (1976).

He was also the author of a very fine collection of essays on Adam Smith, A System of Social Science: Papers Relating to Adam Smith. (He also edited several volumes of scholarly papers on Adam Smith.) He should have been better known for his very helpful (1966) edition of Sir James Steuart (1767) An Inquiry into the Principles of Political Economy. (The edition does contain some cuts, so let the buyer be aware.) Steuart was a subtle reader of Hume's political economy, and was deliberately ignored by Adam Smith; it mattered a lot to Skinner to ensure that Steuart was not forgotten.

I did not have much interaction with Skinner. But one is worth recounting. At the start of 2000, I sent him a draft of my main methodological/interpretive chapter on Smith's Wealth of Nations of my dissertation-then-in-progress. (We had never met.) Skinner was a natural choice because he was the leading scholar of the connections between Adam Smith's economics and Smith's Kuhnian theory of science. A few months went by, and just before his official retirement from the university he sent me his (kind) reflections on my chapter. Then I did not realize how rare such generosity is. He concluded his letter with a remark that I quote: "I met [Thomas] Kuhn in 1975 in Princeton when he told me, as I recall, that he was unaware of [Adam Smith's "The History of] ASTRONOMY" - if true, intriguing in that both Kuhn and Smith cite Copernicus' introduction as a classic example of the crisis state?"

Mega-events “crowding out effect”

One reason economist frequently cite when arguing that the economic impact of mega-events like the rugby world cup or the Olympics is lower than advertised is the “crowding out effect.” According to the UK’s Guardian newspaper,

The Really Useful Group, Andrew Lloyd Webber’s production company, is reportedly considering closing West End shows including The Phantom of the Opera and The Wizard of Oz, with tourist bookings predicted to slide in July and August.

The European Tour Operations Association (ETOA) has announced that its members are facing a 95% decrease on London bookings for the period, while the managing director of Encore Tickets, John Wales, said the company was bracing itself for “sales from tourists to be at least 40 per cent down on last year”.

While it will be true that London will have more that its fair share of Olympics tourists next summer, it has to be remembered that London is normally overrun with all sorts of other tourists in the summer including those who go to musicals. Sports fans, rugby or Olympic, don't always add to the tourist base, rather they simply displace other visitors leading to lower than expected increases in net tourism.

The case against a financial transactions tax

There is a new web publication from the IEA on The case against a financial transactions tax by Tim Worstall. The main points made in the article are:

• There is strong economic evidence that the proposed Financial Transactions Tax (FTT) would not increase the amount of tax revenue collected by governments. In fact it would reduce total tax revenue by shrinking the economy.
• Workers and consumers in general - not the banks - would carry the main economic burden of the FTT. Wages would be lower because the tax would increase the cost of capital, thereby reducing growth in productivity.
• Returns on pension funds and other savings would also be lower, in part because the FTT would increase the costs of buying and selling shares as well as reducing their values.
• The FTT would not have prevented the financial crisis, nor would it have avoided current sovereign debt problems. The tax would shrink those parts of the financial markets which did not contribute to the recent crisis but would not make much difference to the factors that caused the crash.
• The FTT would not reduce volatility; it would increase it. Market movements will come in larger steps if speculation is discouraged. It is preferable to have deep and liquid markets so that changes are incremental and smooth.

The Green Party supports such a tax if all countries were to implement one, while the Maori Party and Hone Harawira are also in favour. May be they should read the essay.

EconTalk this week

Gary Taubes, author of Good Calories, Bad Calories, talks to EconTalk host Russ Roberts about what we know about the relationship between diet and disease. Taubes argues that for decades, doctors, the medical establishment, and government agencies encouraged Americans to reduce fat in their diet and increase carbohydrates in order to reduce heart disease. Taubes argues that the evidence for the connection between fat in the diet and heart disease was weak yet the consensus in favor of low-fat diets remained strong. Casual evidence (such as low heart disease rates among populations with little fat in their diet) ignores the possibilities that other factors such as low sugar consumption may explain the relationship. Underlying the conversation is a theme that causation can be difficult to establish in complex systems such as the human body and the economy.

Oh dear ... the Standard on privatisation

Ben Clark writing at the Standard says

There are so many arguments against asset sales:

The fact that even Bill English thinks that they may raise less than $5 billion – when last year’s deficit was $18 billion – shows how quickly the money raised will disappear, leaving us without the income stream or the cash.

As I have noted before, I don't know how many times, the amount of money raised by privatisation isn't the issue. Let the debate about privatisation be in terms of efficiency, not price. Also note that an income stream along way in the future is worth a close approximation zero in present value terms so even if you do "lose it" you don't lose much. But assuming a competitive method of sale, the price received by the government for a asset will equal the present value of the revenue stream. In addition you don't lose all the stream anyway since tax is paid on the profits made by the new owners of the asset and we gain by making more efficient use of resources given that on average over time private firms out perform public ones. Also a competitive sale process it will capture some of these likely efficiency gains.

The fact that the only “Mums and Dads” able to afford to buy shares of assets we already own will be the top 1 or 2% – ensuring another National transfer of wealth from all of us to the richest in the country.

As to the idea that "we already own" these assets, we don't. The taxpayers or the "public" do not own government assets in any meaningful sense of the word "ownership". All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the government or the bureaucracy in control of the asset in question.

The important point here is that without control you don't have ownership. As Oliver Wendell Holmes Jr. put it,

But what are the rights of ownership? They are substantially the same as those incident to possession. Within the limits prescribed by policy, the owner is allowed to exercise his natural powers over the subject-matter uninterfered with, and is more or less protected in excluding other people from such interference. The owner is allowed to exclude all, and is accountable to no one. (The Common Law, p193, (1963 edn.))

Clearly the "public" does not have the rights Holmes refers to. The government (or its bureaucracy) has these rights. Following Grossman and Hart ("The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration", 'Journal of Political Economy', 94:691-719) economist's tend to define the owner of an asset as the one who has residual rights of control over the asset; that is, whoever can determine what is done with the asset: how it is used, by whom it is used, when they can use it etc - note that ownership is not defined in terms of income rights. Under "public" ownership it isn't the "public" who has the control rights, its the government. The "public" can not determine what use is made of a "public" asset, rather its use is determined by the politicians and managers in command of it. As Madsen Pirie has noted

The term 'public ownership' is a misnomer. The state sector may have the name of the public filled in on the dotted line, but the public do not own it in any meaningful sense of the word. All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the bureaucracy in command of it. Far from being owned by the public, it is owned in effect by the people who administer it. The public actually has more influence, via its choices and purchasing decisions, on private sector businesses than it can ever have over state industries and services. In those cases its influence is diffuse and diluted through the political process.

Just think of any of the SOEs in New Zealand, what control does the "public" have over them? Control rests with either the government or the bureaucracy or the firm's managers. The taxpayers have the least say of anyone in their running.

If you are worried about the amount of money raised, as Clark is in the first point above, selling to all "Mum and Dads" is a bad idea as this will result in a lower price being received. A sale of shares in general will result in underpricing.

The fact that those uber-wealthy “Mums and Dads” will inevitably sell off their shares for a quick buck to foreign owners, as they did with Contact Energy, meaning a much worse balance of payments as those profits head offshore – growing other countries’ economies, not ours.

A good bit of xenophobia. Also note the selling of the shares will have no effect on the balance of payments given that the BoP is always zero by construction. Also note that if profits are heading overseas this means that good and services must have already been produced here in New Zealand to give rise to the profits in the first place. This production of goods and services means our economy has grown.

The fact that those foreign owners will have no motive to protect and improve our vitally important electricity supply, only to rake as much wealth out of us as they can.

As I have noted before an SOE, New Zealand owned firm and a foreign owned firm will all act in the some way, i.e. maximise profits, so the performance of firm does not depend on the nationality of the owner. Is this just more capital xenophobia from the Standard?

A justification for partial asset sales

A justification in the view of Seamus Hogan over at Offsetting Behaviour at least. Hogan writes,

At the same time, however, vertical integration makes the retail market less contestable. If competition between retailers is not as intense as we would like, it is difficult for a new entrant to come into the market, as it would be highly exposed being a buyer and not a seller on the wholesale market, particularly in periods when low rainfall or transmission constraints gave a seller some temporary monopoly power.

One would have to say that any such market power arguments have to be trade-off against efficiency and relationship-specific investment arguments as pointed out by Oliver Williamson et al many years ago. And why can't you deal with such problems via a long-term contract?

Now imagine, however, that a new entrant in the retail market could simultaneously buy shares in the company that was the dominant generator in the region the entrant wanted to sell in. This would be a risk management strategy that would enable it to price to the retail market based on normal wholesale prices, knowing that losses in the event of a high wholesale price would be offset by the return on its shareholdings.

I can't help but think this is a better argument for the sale of 100% of the shares in an SOE.

More on asset sales

Over at Kiwiblog it is argued that

“Mixed ownership” will improve the SOEs performance:

This one can be debated for ever. My view is simple. If you look globally, on average private sector companies significantly out-perform state owned companies. Now let’s us be very clear about this. This does not mean every single private sector company does better than every single state owned company. Of course not. It doesn’t mean that no private sector company never fails and it doesn’t mean that all state owned companies fail. It also doesn’t mean that private sector companies out-perform public sector companies every minute of every day.

The first thing to note here is that the literature that shows that on average private firms out-perform SOEs is dominated by private firms which are controlled by their private shareholders and thus are not mixed ownership firms as the government means to set them up. That is, the private owners have at least 51% of the firm's shares. As to the evidence on the subject the following comes from the summary of chapter 4, ‘Empirical Evidence on Privatization’s Effectiveness in Nontransition Economies’, from William L. Megginson’s book The Financial Economics of Privatization, New York: Oxford University Press, 2005,

The 87 studies from nontransition economies discussed in this chapter offer at least limited support for the proposition that privatization is associated with improvements in the operating and financial performance of divested firms. Most of these studies offer strong support for this proposition, and only a handful document outright performance declines after privatization. Almost all studies that examine post-privatization changes in output, efficiency, profitability, capital investment spending, and leverage document significant increases in the first four measures and significant declines in leverage.

Secondly when you look at the performance of mixed ownership firms they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude 'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].' So fully private firms out-perform mixed ownership firms.

The basic problem is that partial government ownership politicises the firm. Full privatisation is the better option.

Why big firms die

There is an arresting moment in Walter Isaacson's biography of Steve Jobs in which Jobs speaks at length about his philosophy of business. He's at the end of his life and is summing things up. His mission, he says, was plain: to "build an enduring company where people were motivated to make great products." Then he turned to the rise and fall of various businesses. He has a theory about "why decline happens" at great companies: "The company does a great job, innovates and becomes a monopoly or close to it in some field, and then the quality of the product becomes less important. The company starts valuing the great salesman, because they're the ones who can move the needle on revenues." So salesmen are put in charge, and product engineers and designers feel demoted: Their efforts are no longer at the white-hot center of the company's daily life. They "turn off." IBM and Xerox, Jobs said, faltered in precisely this way. The salesmen who led the companies were smart and eloquent, but "they didn't know anything about the product." In the end this can doom a great company, because what consumers want is good products.

That is from Peggy Noonan in the Wall Street Journal.

Is there a political version of this? Can political parties govern only for so long when led by a "salesman" who can sell an image but can't deliver a quality product - jobs, growth, small deficit etc? Will this ultimately be a problem for National?

More Goffonomics

From Kiwiblog today we learn:

On The Nation today:

Duncan So looking at the asset sales, if you were to get into government and not sell those assets, how would you control power prices? Because that has been a major issue over the last ten years, and National one of their big attacks in office has been that under your leadership, when I say leadership I talk about the Labour government, power prices went up 70-80% over ten years. What will you do? What reassurance can you give to voters that you’ll control power prices.

Phil [Goff] Oh the power prices are gonna fluctuate depending on how much extra you build in terms of generation. No but what you can assure them is this. That you don’t have an outside foreign investor coming in, wanting a really big return on their investment, because you know, and you know from Contact Energy that this happened, that your power prices will go up if you privatise. Contact Energy was charging 500 bucks a year more for an average family of four, than any of the SOEs.

Now I take it from what Phil Goff says about foreign investors that when they take over a company they want a really big returns on their investment. But even if they do want such a return how can they get it? Does Phil think that just because they want a big return they can somehow force people to pay a high enough price to give them this return? And if they can create any revenues they need to get the return they want why not go for an infinite return?! I mean if you can get any return you want then infinity sounds good. Phil seems to miss the point that customers can change suppliers if they think prices from one particular suppler are too high and even if they couldn't investors can't get any return they want since the maximum willingness to pay is bounded by the height of the demand curve.

Also if foreign investors can want, and get ,these high returns why can't New Zealand investors want and get the same returns? The price of power does not depend on the nationality of the owner of the power company. I assume that New Zealand firms can maximise profit just as well as foreign companies.

In addition the SOE Act requires that the SOE is as successful as a non-state owned firm:

Principal objective to be successful business
(1) The principal objective of every State enterprise shall be to operate as a successful business and, to this end, to be—
(a) as profitable and efficient as comparable businesses that are not owned by the Crown;

So if foreign owners can get these really big returns then the SOE has to act in such a way as to get them as well.

So the SOE, an New Zealand owned private firm and a foreign owned private firm will all charge the same prices for power as they are all trying to maximise profits. Thus prices will not rise if SOEs are privatised.

Now if these evil, bad "foreign investors" really can increase the profits and return paid by the power companies then this will be because they are more efficient in using the resources of the companies. But in this case we want them to be the owners as we want our resources utilised in the most efficient manner possible.

So ignoring capital xenophobia, foreign ownership looks good.

Viner on Smith on government

The standards of honesty and competence of the governments of his day with which Smith was acquainted were unbelievably low, moreover, not only in comparison with what they are today in England, Germany, and the Scandinavian countries, but apparently even in comparison with earlier periods in English political history. Smith had encountered few instances in which government was rendering intelligent and efficient service to the public welfare outside of the fields of protection and justice. The English government of his day was in the hands of an aristocratic clique, the place-jobbing, corrupt, cynical, and classbiased flower of the British gentry, who clung to the traditional mercantilism not so much because of a strong faith that it met the problems of a growing trade struggling to burst its fetters, but because they did not know anything else to do. Even when Smith was prepared to admit that the system of natural liberty would not serve the public welfare with optimum effectiveness, he did not feel driven necessarily to the conclusion that government intervention was preferable to laissez faire. The evils of unrestrained selfishness might be better than the evils of incompetent and corrupt government. (Jacob Viner, "Adam Smith and Laissez Faire", Journal of Political Economy, Vol. 35, No. 2 (Apr., 1927), pp. 198-232.)

How much have things really changed since Smith's time?

Interesting blog bits

1. Joanne Nova on Naomi Klein’s crippling problem with numbers

   Naomi Klein was the wrong person to send to a heavy-weight science conference — in “Capitalism vs Climate” she notices hundreds of details, but they’re all the wrong ones. Naomi can tell you the colour of the speakers hair, what row they sat in, and the expression on their face — it adds such an authentic flavor to the words, but she’s blind to the details that count. She can explain the atmosphere of the room, but not the atmosphere of the Earth. One of these things matters, and Klein has picked the wrong one. Her long attack on the Heartland ICCC conference this year is all color and style, and nothing of consequence — the lights are on and no brain is home. Unpack the loquacious pencraft and we wallow in innumerate arguments that confuse cause and effect, peppered with petulant name-calling. She can throw stones, but she can’t count past “one”.

2. Hans-Werner Sinn on The threat to use the printing press

   The first major crisis in the era of independent central banks is severely testing that independence – nowhere more so than the Eurozone. This column argues that the ECB is monetising the sovereign debt – a view widely held in Germany. It argues that the ECB is the Eurozone’s economic government with the power to enforce comprehensive rescue measures, up to and including a fiscal transfer union.

3. Joel Waldfogel asks Is the Sky Falling? The quality of new recorded music since Napster

   Napster – the first peer-to-peer file sharing service – changed the music industry forever. Many people now download music without paying, often illegally. This column looks at the effect on the music industry, in particular what it means for the quality of new recorded music.

4. Bruno S Frey and Lasse Steiner on Selecting World Heritage sites: A new proposal

   There are nearly 1,000 UNESCO World Heritage sites. These sites benefit hugely from tourism, so suspicions of fixing the judges’ verdicts are rife. This column suggests a novel way to get rid of the politicisation: random selection.

5. Gary Becker asks Has Structural Unemployment Become Important in the United States?

   The persistently high unemployment rate in the United States during the Great Recession has led to claims that much of American unemployment is “structural”. According to this view, the demand for workers by companies is insufficient to employ all unemployed workers because there is a mismatch between the skills possessed by many American workers and the skills required by companies. The structural advocates believe the skills demanded by companies tend to exceed or otherwise be different from the skills possessed by many unemployed workers. As a result, so goes the argument, these unemployed workers cannot find jobs and remain unemployed for a long time.

6. John Mackey says To Increase Jobs, Increase Economic Freedom

   Business is not a zero-sum game struggling over a fixed pie. Instead it grows and makes the total pie larger, creating value for all of its major stakeholders, including employees and communities.

7. Eric Crampton on Post-Kyoto

   Extending the date for various industries' entry into the New Zealand Emissions Trading System costs the public purse only to the extent that the government is required to buy carbon credits on the international market to make up for any failure to reach aggregate pollution reduction targets.

8. Peter Klein on Shakespeare and Epistemology

   We university types love The Bard — we’ve got bookstores hither and yon, pizza joints, you name it. Not surprisingly, Shakespearean scholars are up in arms at Roland Emmerich’s film Anonymous, which they view as silly entertainment at best, disreputable Oliver Stone style revisionism at worst.

9. Art Carden on Absolut Insanity? Underage Drinkers Don't Need Vodka-Soaked Tampons

   This much is certain: people like to get high. Indeed, people have probably been experimenting with mood-altering substances since the beginning of time. Attempts to control these impulses with prohibitions and regulations have either backfired completely or created “cures” that are probably worse than the disease.

The foundations of economic models

How important are foundations to what economists do? Take, for example, the way economists think about competition. Milton Friedman has written,

Of course, competition is an ideal type, like a Euclidean line or point. No one has ever seen a Euclidean line – which has zero width and depth – yet we all find it useful to regard many a Euclidean volume – such as a surveyor’s string – as a Euclidean line. Similarly, there is no such thing as “pure” competition. Every producer has some effect, however tiny, on the price of the product he produces. The important issue for understanding and for policy is whether this effect is significant or can properly be neglected, as a surveyor can neglect the thickness of what he calls a “line”. The answer must, of course, depend on the problem.

In other words there is a trade-off between the usefulness of our models and the foundations of those models. Jean Tirole has made this point with regard to incomplete contracts models.

A methodological divide may have developed in our profession in recent years between those who advocate pragmatism and build simple models to capture aspects of rea;ity, and others who wonder about the foundations and robustness of these models [...]

Personally I’m more in the build simple models that help us understand the issues we are dealing with camp rather than worry about getting all the foundation exactly right before using models. To take Tirole’s example of incomplete contracts models. We know that there are issues with the standard, property rights, story told about why contracts are incomplete. The reliance of the property rights approach to the firm on a theory of incomplete contracts that assumes unforeseen or indescribable states of the world as a way of generating incompleteness has lead to a number of criticisms, the most significant of which is the Maskin and Tirole (1999) critique. Maskin and Tirole argue that information which is observable to the contracting parties can be made verifiable (to a third party) by the use of ingenious revelation mechanisms. The contracting parties write into their contract a game which when played gives the appropriate incentives for them to truthfully reveal their private information in equilibrium. This undermines the non-verifiability approach to incomplete contracts.

But such issues have not prevented the property rights approach from becoming a workhorse in the theory of the firm literature or from being applied in many other areas such as the analysis of firms’ internal organisation; firms’ financial decisions; the costs and benefits of privatisation; and the organization of international trade between inter- and intra-firm trade.

So the question remains, Does this lack of proper foundations for some economic modela really matter? Or is getting answers to important questions, regardless of foundations of the model, enough?

Incentives matter: education file

Incentives matter even for university professors. From a new paper in Economic Letters on Piece rates for professors

Using panel data, we demonstrate a 50% increase in research productivity following a dramatic increase in the piece rate paid for articles by a major Chinese University. The increased productivity comes exclusively from those who were already research active.

Of course one wonders how much of this extra output is actually worth having. Are they producing a whole lot of extra articles at the AER standard or a whole lot at the NZEP standard?

No advantage

A successful business needs a competitive advantage. A successful country is no different.

Or at least this is what "Pure Advantage" want us to believe. As I said earlier, A country is not a company and should not be run like one. I wrote,

As Paul Krugman (yes even he is right about some things!) said A Country Is Not a Company. To see why consider, for example, the basic point that companies compete with each other but New Zealand doesn't compete with other countries. Thinking that countries compete is a just one false analogy that comes from thinking that countries are like companies when they're not. The point is that Coke and Pepsi, for example, do compete, one gains at the others expense, but New Zealand and Australia, for example, don't, their loss is not our gain. International trade is not a zero-sum game. To see this, note that while Coke may wish to put Pepsi out of business, so that Coke can increase their sales and prices and therefore profits, New Zealand would not gain if we put Australia "out of business".

Why? Well in the Coke/Pepsi case, Coke gain a lot, in terms of sales and profits, from not having Pepsi to compete with and lose little since Pepsi doesn't buy much, if anything, from Coke. Or Coke from Pepsi. This is not true of the New Zealand/Australia example. We may gain some sells if Australia stopped producing, but we would lose much more. Australia is our biggest export market and if they "went out of business", they would stop importing, and that would hurt us a lot. Also they are suppliers of much of our useful imports and that would stop too, which would hurt us even more.

So New Zealand does not need a "competitive advantage", it needs, and has, a comparative advantage. We do not compete with other countries like Coke and Pepsi compete with each other, other countries are your friends, they buy our stuff and sell us their stuff. What we need to do is look for the most efficient way of trading with these countries, that is, workout our comparative advantage.

Bill Kaye-Blake writes with regard to a Pure Advantage press release,

The language of this media release is atrocious. The sloppy thinking, the non-sequiturs, the begging the question. The leaders of the group are supposed to be scientists, and this is what they produce? I don’t have time or energy for a Fisking, so I’ll leave it at that.

While rauparaha at TVHE sees

[...] the dangers of management thinking in economics.

So economist-bloggers seem to see no advantage in Pure Advantage. But then again I'm guessing economists are not their target audience. The government and taxpayers money looks a more likely target.As Bill Kaye-Blake points it,

What’s the solution? More money for science! And not just any science — the science that particularly interests the scientists behind the organisation.

Or rent seeking as some would call it.

Weitzman talk

Remember Professor Martin Weitzman is presenting here at Canterbury tomorrow afternoon, on the economics of climate change.

RSVP now if you haven't already!

Talk: 4:30 - 5:30pm, Law 108, Law Building

EconTalk this week

Roy Baumeister of Florida State University and the author of Is There Anything Good About Men talks with EconTalk host Russ Roberts about the differences between men and women in cultural and economic areas. Baumeister argues that men aren't superior to women nor are women superior to men. Rather there are some things men are better at while women excel at a different set of tasks and that these tradeoffs are a product of evolution and cultural pressure. He argues that evolutionary pressure has created different distributions of talent for men and women in a wide variety of areas. He argues that other differences in outcomes are not due to innate ability differences but rather come from different tastes or preferences.

Religious competition

A new NBER working paper looks at Substitution and Stigma: Evidence on Religious Competition from the Catholic Sex-Abuse Scandal.

This paper considers substituting one charitable activity for another in the context of religious practice. I examine the impact of the Catholic Church sex-abuse scandal on both Catholic and non-Catholic religiosity. I find that the scandal led to a 2-million-member fall in the Catholic population that was compensated by an increase in non-Catholic participation and by an increase in non-affiliation. Back-of-the-envelope calculations suggest the scandal generated over 3 billion dollars in donations to non-Catholic faiths. Those substituting out of Catholicism frequently chose highly dissimilar alternatives; for example, Baptist churches gained significantly from the scandal while the Episcopal Church did not. These results challenge several theories of religious participation and suggest that regulatory policies or other shocks specific to one religious group could have important spillover effects on other religious groups.

So different religious denominations are substitutes for one another. That is an interesting result and not one I would have expected. I would have thought there would be "lock-in" when it comes to religion. But when the "price" of being Catholic, in terms of dealing with scandals, goes up the demand for other religious denominations goes up. How people substitute is also interesting, they seem to go for denominations which are very unlike the Catholic Church. I would have expected, if there was to be substitution, that it would be to similar denominations.

You have to be careful about how you word things

Yes but its the amount of debt that they would leave that many people are worried about.

(HT: Homepaddock)

Brian Edwards and economics

Not two things that go together well. I'm guessing Brain doesn't know much about economics given this,

I’m against selling our state assets. I’m impressed by Labour’s argument that you can only sell an asset once, and that, as soon as you’ve sold it, you’ve lost the revenue stream forever. Forever is probably the key word. You have to calculate the dividend loss for an indefinite period that ends – never.

There are a number of things you could say about this but let me cover a few. 1) you don't lose a revenue stream forever since the firm is unlikely to be around forever. 2) even if it was around forever the present value of an income stream along way in the future is to a close approximation zero. Thus Brian will be adding up a lot of nothing. 3) assuming a competitive method of sale the price received by the government for a asset will equal the present value of the (finite) revenue stream. 3) you don't lose all the stream anyway since tax is paid on the profits made by the new owners of the asset. 4) we gain by making more efficient use of resources given that on average over time private firms out perform public ones. 5) a competitive sale process it will capture some of these likely efficiency gains.

Let me return to a question I have asked before: Why do we care about the price? Let there be a debate about privatisation but let it be a debate about efficiency not price.

Government and business: a bad idea

From the New York Times:

WASHINGTON — Halfway between Los Angeles and San Francisco, on a former cattle ranch and gypsum mine, NRG Energy is building an engineering marvel: a compound of nearly a million solar panels that will produce enough electricity to power about 100,000 homes.

The project is also a marvel in another, less obvious way: Taxpayers and ratepayers are providing subsidies worth almost as much as the entire $1.6 billion cost of the project. Similar subsidy packages have been given to 15 other solar- and wind-power electric plants since 2009.

The government support — which includes loan guarantees, cash grants and contracts that require electric customers to pay higher rates — largely eliminated the risk to the private investors and almost guaranteed them large profits for years to come. The beneficiaries include financial firms like Goldman Sachs and Morgan Stanley, conglomerates like General Electric, utilities like Exelon and NRG — even Google.

and

“It is like building a hotel, where you know in advance you are going to have 100 percent room occupancy for 25 years,” said Kevin Smith, chief executive of SolarReserve. His Nevada solar project has secured a 25-year power-purchase agreement with the state’s largest utility and a $737 million Energy Department loan guarantee and is on track to receive a $200 million Treasury grant.

And yes, there is no doubt that the deals are lucrative for the companies involved.

G.E., for example, lobbied Congress in 2009 to help expand the subsidy programs, and it now profits from every aspect of the boom in renewable-power plant construction.

It is also an investor in one solar and one wind project that have secured about $2 billion in federal loan guarantees and expects to collect nearly $1 billion in Treasury grants. The company has also won hundreds of millions of dollars in contracts to sell its turbines to wind plants built with public subsidies.

Mr. Katell said G.E. and other companies were simply “playing ball” under the rules set by Congress and the Obama administration to promote the industry. “It is good for the country, and good for our company,” he said.

And I have no doubt that that last statement is 50% right. It is good for his company. But as for the country keep in mind,

A great deal of attention has been focused on Solyndra, a start-up that received $528 million in federal loans to develop cutting-edge solar technology before it went bankrupt

Iceland and the IMF: why the capital controls are entirely wrong

The IMF has emerged from the global crisis bigger and more powerful. But this column from VoxEU.org argues that the capital controls it required Iceland to adopt in 2008 are not of the soft and cuddly modern type that slow hot money flows. Instead they are akin to the draconian controls common in the 1950s. They violate the civil rights of Icelanders and significantly hamper economic growth.

Iceland was faced with a serious problem of hot money overhang following its crisis in 2008 and it was feared that speculators would head for the exits, causing an uncontrolled collapse in the exchange rate. In our view, this fear was unfounded. Any speculator exiting under those circumstances would have faced significant losses compared with the option of waiting for economic stabilisation and the consequent currency appreciation. After all, the currency approximately reached its long-term equilibrium rate immediately after the collapse.

Thus, in our view, the imposition of capital controls was both unnecessary and unjustified. Without them, the exchange rate might have temporarily fallen even further in a worst case scenario, in which case a surgical intervention in the form of a temporary tax on short capital outflows would have been a sufficient policy response.

Instead, the IMF forced the Icelandic government to impose draconian capital controls of a type last seen in developed economies in the 1950s, causing significant short-term and long-term economic damage. The capital controls were initially touted as a temporary measure, but now three years after the event it looks like they are there to stay, and as the domestic economy adapts to their presence, they will be increasingly costly to abolish. After all, the last time Iceland imposed capital controls in the 1930s, they lasted until 1993.

The capital controls have resulted in an intrusive licensing regime, with government permission required for foreign travel and those emigrating prevented from taking their assets with them. Both are direct violations of the civil rights of Icelandic citizens and Iceland’s international commitments as a democratic European country.

Our hope is that other countries facing a similar situation will have the good fortune of receiving better advice from the IMF.

The IMF got it wrong. Who would have guessed?

Not-for-profits have owners

One of the most common features associated with not-for-profit firms is that they don't have owners. Or do they? In a 2001 article Jennifer Kuan writes,

So, for example. when a nonprofit hospital is sold to a for-profit firm, proceeds from the sale go into a public trust. In fact, Hansmann (1996) goes so far as to state that nonprofits do not have owners.

Hansmann's claim always seemed odd to me since if we follow Grossman-Hart-Moore and see ownership in terms of control rights rather than income rights then clearly someone has the control rights over the nonprofit, for if they did not how could they sell it?

Kuan paper, "The Phantom Profits of the Opera: Nonprofit Ownership in the Arts as a Make‐Buy Decision", backs up my intuition in that she models the nonprofit firm and shows that they do indeed have owners.

Her model looks at a performing arts firm which has two consumers, a high-type consumer and a low-type consumer. These two consumers comprise the market for an indivisible good and each would like to consume exactly one unit of the good. In the classical performing arts industry we know that both types of consumers want to consume the good, tickets are indivisible, and consumers are unlikely to consume the same concert more than once. Next Kuan introduces a profit-maximizing entrepreneur. The entrepreneur is assumed to be able to produce the good profitably, so that a good can be produced at a cost that is lower than a consumer's willingness to pay for that good. Not the high-type has a higher willingness to pay than the low-type. Kuan shows that nonprofits can arise even when a good can be marketed profitably.

In her model Kuan assumes that has a make-or-buy decision. That is, he an either buy the good from the entrepreneur or make the good himself. Making will amount to a nonprofit firm.

It is obvious that the high-type consumer would choose to make the good himself, rather than buy it from an entrepreneur, because the consumer surplus is highest in the make case. Notice that when the consumer chooses to make, he achieves first best and the quality level and total surplus are higher than in either the pooling or separating case.

So the high-type makes the good, but why is this a nonprofit firm?

Now the high-type can charge the low-type an amount, say t, to consume the good. Le t be the ticket price. The high-type also pays t so revenues for the firm are 2t. Let c(x) be the costs of producing the good by the high-type. If c(x)>2t then a "donation" (of c(x)-2t) from the high-type will be needed to keep the firm afloat. The high-type is willing to pay this since he is consuming a good worth this maximum willingness to pay to him which is greater and he only paid c(x)-t and he is getting a surplus greater than that he would have gotten by buying the good from the entrepreneur.

So even though the firm generates a surplus, that surplus is consumed and unobservable. Meanwhile, the firm itself appears lo be always just "breaking even" or on the brink of disaster, and why these firms seem to be dependent on charity.

So the high-type produces the good himself, making him the owner of the nonprofit firm.

Note also that as modelled by Kuan, nonprofits are economically efficient. And just as nonprolits have owners. they also have well-defined  utility maximizing objectives rather than some exotic, unpredictable optimization. Having a framework which identifies a well-behaved objective function for nonprofits enables economists to better deal with issues like the behaviour of nonprofits relative to for-profits, and to understand why nonprofits pursue profit-motivated activities.

Richard Epstein, George Soros and Bruce Caldwell discuss Hayek's Constitution of Liberty

An interesting set of presentations on Hayek's "Constitution of Liberty" by Richard Epstein, George Soros and Bruce Caldwell at a seminar at the Cato Institute. I think Richard Epstein's discussion is the best of them. The discussion that takes place after the formal presentations is also worth watching.

Interesting blog bits

1. Francisco de Castro, Javier J. Pérez and Marta Rodríguez on Fiscal data revisions in Europe and the credibility of fiscal policies

   The recent huge revisions witnessed in Greek data have raised concerns also about the credibility of the EU’s fiscal data reporting system. This column argues that initially published fiscal-deficit figures tend to be to revised towards an increased deficit at subsequent publication dates, and that the proximity of elections and the business cycle explain data revisions. It says that the EU should strengthen the role of Eurostat, the EU’s statistical agency, in auditing individual countries’ fiscal accounts and encourage EU countries to adopt more stringent fiscal rules.

2. Dani Rodrik argues Manufacturing is special

   Poor countries have access to world markets and rich countries’ technologies. In principle, they should catch up. Yet the record belies this expectation. But this column argues labour productivity in manufacturing displays a clear tendency towards convergence, unconditional on the countries’ institutions or policies. The policies that matter for growth are thus those that bear on the reallocation of labour from nonconvergence to convergence activities.

3. George Selgin on Paper bugs, or, Stupid Arguments Against Gold

   Some arguments against a gold stanard are just stupid.

4. Stephen Franks on “Can we just vote now to end this embarassment”

   Elections are full of crap.

5. Tim Harford argues Capitalism can’t just be about money.
6. Jesús Fernández-Villaverde and Juan F Rubio-Ramirez on Supply-side policies and the zero lower bound

   With nominal interest rates in many western countries at or approaching the zero lower bound, economists are calling for more quantitative easing or greater fiscal expansions to generate inflation, reduce real interest rates, and rejuvenate the economy. But what if these policies fail? Or are no longer possible? This column outlines a third way: supply-side policies.

7. Richard Posner on How the United States Is Like, and Unlike, Greece

   The economic situations of the United States and Greece are more alike than one might think. In both countries, the government is insolvent, in the sense that its taxing power, constrained by politics, is insufficient to finance the government’s liabilities, which include not only bonds but also entitlements (such as social security and medicare) and essential public services (such as defense)

8. Winton Bates asks Do commercial interests have excessive influence on people in modern societies?

   Jeffrey Sachs makes it difficult for any libertarians who happen to look at his book, ‘The Price of Civilization’, to consider seriously his claim that powerful corporate interests have excessive influence in America. He claims that libertarians ‘hold that the only ethical value that matters is liberty, meaning the right of each individual to be left alone by others and by the government’.

9. Alex Tarrant on Labour's attacked on StatsNZ.

   I have to agree with Tarrant's article, it does make Labour look desperate. An attack on the political neutrality of StatsNZ 8 days after their media release itsn't a good look.

10. Bill Kaye-Blake on the "economic stories" the political parties are telling

    National
    Labour
    Minor parties
    and then from Narratives to policies

Green growth? evidence from energy taxes in Europe

Seán Lyons and Richard S J Tol discuss green growth in a new column at VoxEU.org. A quick summary:

Politicians around the world like to argue that ‘green growth’ will create jobs and stimulate innovation. This column examines the impact of energy taxes on business, with a dataset of 11 million European firms between 1996 and 2007. The results are mixed – it seems that dirty, smoke-filled growth may well be better for the firm’s workers and their customers.

Lyons and Tol discuss the impact of energy taxes on corporate behaviour.

We test four hypotheses:

• Do energy taxes create employment?
• Do energy taxes stimulate innovation?
• Do energy taxes increase profits?
• Do energy taxes raise investment?

What is the impact of energy taxes on employment by sector?

There are substantial sectoral differences. Most effects are statistically significant. Some sectors show a positive effect; notably wearing apparel, textiles, and primary-resource sectors. Labour, typically less skilled in these sectors, may be used as a substitute for energy. Air transport shows a strongly negative association, which may be spurious – the sample period coincides with the rise of the discount airlines. Other sectors exhibit weaker negative effects, notably machinery and construction. For these sectors, higher energy costs imply an overall contraction. For employment, the average effect is negative and significant. Overall, increased energy taxes reduce employment.

What is the impact on TFP growth rate by sector?

Sectoral variation is large. Primary resources, manufacturing, power generation, pulp and paper and the media sector all show a positive effect. Most of these sectors are energy-intensive. This suggests that higher energy costs forced these firms to innovate. However, energy taxes reduce input price variability and raise barriers to market entry; both could increase TFP as measured here. TFP in chemicals, textiles, wearing apparel, leather and quarrying shows a negative association with energy taxes. These sectors are in decline in Europe, and higher energy taxes seem to spur this trend. The average effect of a tax change on TFP growth is positive. Overall, higher energy taxes accelerate TFP growth in Europe.

What is the impact on the return on capital employed by sector?

This is positive in most cases, particularly for tobacco and air transport. Air transport is exempt from energy taxes. Higher energy taxes, however, imply a lower demand for energy and hence a lower price of kerosene. Higher energy taxes also reduce the price of air travel relative to road and rail. However, the effect may be partly spurious because of the restructuring of the airline industry. Water transport, wood products, quarrying, and refining have significant negative coefficients. Faced with higher energy costs, firms in these sectors take a hit on the bottom line. However, other firms see positive effects as they are able to pass on the higher costs to their customers and take advantage of improved productivity. The average effect is positive. Overall, higher energy taxes increase profitability in Europe.

What is the impact on corporate investment?

The tobacco sector again stands out, but this sector was in decline too for reasons other than energy taxes. It may be that energy taxes were raised faster in countries that reduced smoking most substantially. Textiles and plastics show a negative impact – these sectors substitute energy and capital for labour. In contrast, metal mining, gas extraction, basic metals, refining, and water transport have large positive coefficients. High energy taxes spur investment, we presume in primarily in energy-saving equipment. The average effect is positive. Overall, higher energy taxes spur investment in Europe.

The Lyons and Tol conclusion?

In sum, the following results emerge.

• First, results vary dramatically between sectors, both in size and in sign.
• Second, energy taxes reduce employment.
• Third, TFP accelerates with higher energy taxes.
• Fourth, energy taxes increase the returns to capital.
• Fifth, energy taxes increase investment.

Overall, these results provide only mixed support for the political ‘green growth’ agenda. Energy taxes appear to favour capital over labour. Innovation accelerates, but it may not be the type of innovation that spurs economic growth.

Horizontal integration and competition policy

Today I came across an interesting comment on integration and antitrust policy by Joseph J. Spengler

RECENT decisions suggest that the United States Supreme Court is beginning to look upon integration as illegal per se, under the antitrust laws. It may be presumed, in so far as this inference is valid, that the Court believes that integration necessarily reduces competition "unreasonably." No sharp distinction is made by the Court between vertical and horizontal integration. (Joseph J. Spengler, "Vertical Integration and Antitrust Policy", Journal of Political Economy, Vol. 58, No. 4 (Aug., 1950), pp. 347-352.)

This was written in 1950 and things have changed since, at least with respect to vertical integration,

Because there are often efficiencies to vertical integration, the Antitrust Division typically requires a showing of market power before it considers whether a vertical arrangement poses serious competitive concerns.

At least part of the reason for the change in view is due to the work of Oliver Williamson,

Williamson was skeptical of the conventional wisdom of the time [1960s], which presumed that the purpose and effect of many vertical practices was the enhancement of market power and the erection of entry barriers. Contrary to this view, which was widely adopted by antitrust lawyers and courts in the 1960s, Williamson could see rationales for various vertical practices that were based instead on economic efficiency.

The view of horizontal integration has changed less, but the work of Hart and Holmstrom may be a step in the direction of greater change even here. In their model, two firms are in a lateral relationship and yet they can show that there are conditions under which integration is optimal. So they can show that even horizontal integration can be efficiency enhancing.

This result follows on from a similar conclusion found by Williamson, arrived at via a different framework of analysis, who argued that there is a trade-off between reduced market competition and increased efficiencies due to a horizontal merger. Hart and Holmstrom gives us another reason to consider the efficiency side of the argument.

Greece – where next?

Down the gurgler, would seem the obvious response.

But for another view checkout this audio from VoxEU.org in which Dimitri Vayanos of the London School of Economics talks to Viv Davies about Greece and the eurozone crisis, and argues that leaving the euro would be a disaster for both Greece and Europe. They discuss the bailout package, the appointment of Lucas Papademos as Prime Minister and the benefits of a coalition government of technocrats. Vayanos maintains that the emphasis for Greece should be on deeper institutional and structural reforms.

And why do we care about the price?

At the TVHE blog recently there has been activity base around the question of asset sales, see for example here and here and the comment sections of these posts. The big issue seems to be the price that we get for the sale of any state assets.

But why, I ask, do we care about the price? The logic behind the sate of state assets is about efficiency not the price. As Anbarci and Karaaslan point out in their paper "An Efficient Privatization Mechanism":

In this paper, we consider the privatization of State-Owned Enterprises (SOEs) that are legal monopolies but not natural monopolies; their markets can be opened to competition once privatization takes place and other competitors can emerge and compete successfully against them in a few years. But until that happens, these privatized SOEs can have a significant level of market power. The currently used “Revenue Maximization (RM)” privatization scheme maximizes the government revenue from privatization but does not provide sufficient incentives for the privatized SOE eiher to charge a price lower than the monopoly price or to improve production efficiency until competition arises. We propose a new scheme to privatize such SOEs. We term this new scheme the “Welfare Maximization (WM)” scheme. The WM scheme practically yields no revenue to the government from the privatization of any such SOE; however, it induces the privatized SOE to charge a competitive price in the absence of any regulation. It also turns out that the WM scheme provides greater incentives for post-privatization process invention (i.e., for post-privatization cost reduction) than RM scheme. (emphasis added)

This is a very specific situation but it helps make the point that just worrying about the price received for an asset is not a good idea. In the above example welfare is maximised (and isn't welfare what we should be concerned with?) while revenue is basically zero.

The point I wish to argue here is that there is problem with thinking about privatisation in terms of the money raised. The reasons for privatisation can hold even if you get nothing from the privatisation programme. Talking about maximising the return from privatisation misses the whole point of privatisation which is to improve the efficient and productivity of the economy. If we just worry about how much we will get for the sale of assets then we should sell all of the state assets with the firms being monopolists. But that's unlikely to do much for efficiency and welfare.

The point to note is that the advantage of privatisation is that it will depoliticise the firm. The aim is to have the greatest possible "distance" between the government and the firm. Government interference in the running of a firm is impossible to eliminate completely but a good privatisation plan will result in a situation where any government interference is as obvious and politically costly as possible.

For successful privatisation it is more important to get the regulatory environment right so that competition can breakout in the industry than it is to maximise the price for which the asset is sold. Basically I'm arguing we should have lexicographic preferences, with price low on the list. Worrying about whether or not the ‘family silver’ was sold too cheaply misses the point, the price received can only be see as too high or low relative to the market structure the firm finds itself it. Just arguing that a higher price could be obtained with a different market structure is only useful if the new market structure improves welfare.

So let there be a debate about privatisation in terms of efficiency not price.

Why do firms get merged or acquired?

This question is asked at the Economic Logic blog. There are a number of possible reasons, one of which could be to get the firm's workforce.

Paige Ouimet and Rebecca Zarutskie show that mergers and acquisitions can also be the result of a drive to get access to the other firm's pool of workers. This is particularly true when the labor market is tight and the workers carry high human capital.

I can't help but think there has to be more to it than just a workforce. After all if you just want the workers why not employ them directly? Why buy a whole lot of non-human capital if you don't have to?

The likely answer seems to me to be that you do want the non-human capital. The likely reason you want the human capital is that it highly complimentary to the non-human capital. And buying the firm gets you both.

Complicating GST

Homepaddock points out that

Labour leader Phil Goff reckons removing GST is simple.

He says it will be taken off a lettuce, it will also be taken off a salad at the supermarket and the mayonnaise that is packed with it but it won’t be taken off either if they’re in a hamburger.

One of the things the overseas advisers told the government at the time when GST was introduced was to keep it simple. One important way of doing this was to (basically) put it on everything, at a constant rate. Any change to such a policy is just asking for trouble. Once different rates are charged sellers have an incentive to get their goods and services into the lowest GST grouping and trying to workout who is cheating the system increases compliance costs hugely.

Simple is best.

Investment banking

Professor Charles A.E. Goodhart has an column at VoxEU.org in which he discusses Investment banking. Goodhart argues that the protestors who occupy Wall Street and financial centres around the world and claim that investment banks are “socially useless” are wrong. His column argues that investment banking is critical to any effective economy and the idea that policymakers can safeguard retail banking alone is not only tragically mistaken but also horribly dangerous.

Markets get made by participants taking positions. No one objects to agents taking positions if they bear the loss themselves. Problems arise when there are major externalities to society from such losses. It is the thesis of this note that the role of investment banks is so central to the efficient operation of our complex financial system that losses to such banks have major social externalities. The idea that, once you have carved out the ‘socially valuable’ parts of retail banking, ie the payments system and retail lending and deposit-taking, you can liquidate the rest without massive adverse effects is not only tragically mistaken but also horribly dangerous.

Goodhart is right that investment banking is critical to the economy but I can't help thinking that the best policy would be that governments don't "safeguard" any form of banking.

What is the value of the financial sector?

At VoxEU.org Wouter den Haan of the London School of Economics talks to Viv Davies about his lead commentary in the current Vox Debate on the value of the financial sector. He argues that standard measures of the sector's economic contribution overestimate its true value to a modern economy. They also discuss the views of other notable economists, as well as how regulation could curb excesses in the sector and prevent socially negative spillovers.

EconTalk this week

Steven Kaplan of the University of Chicago talks with EconTalk host Russ Roberts about the richest Americans and income inequality. Drawing on work with Joshua Rauh, Kaplan talks about the composition of the richest 1% and 1/10 of 1%--what proportions come from the financial sector, CEOs from non-financial corporations, athletes, lawyers and so on. Then he discusses how the incomes of these different groups have changed over time. Kaplan argues that these groups have increased their incomes by similar proportions, suggesting that a failure of corporate governance is not the explanation of rising CEO pay. The discussion closes with a discussion of the financial crisis and the compensation in the financial sector.

Quote of the day

“The state has no business getting involved in a matter between two individuals,”

And before you get too excited, the quote is by Cuba's president Raúl Castro and he is explaining why Cuba will now allow people to sell their own cars. Last month the government published rules allowing Cubans to buy and sell used vehicles freely for the first time in half a century. I hope buyers have read their Akerlof.

However while buying and selling used cars is now ok, those allowed to buy new cars is limited to people who earn some foreign currency, including doctors, artists, musicians, members of airline flight crews and the handful of Cubans who work at the American naval base at Guantánamo Bay.

Student protest at Harvard

Students have walked out of Gregory Mankiw's first year economics lectures at Harvard to protest about what the event organizers call a class that promotes a “strongly conservative neoliberal ideology.” Now I can't help but think that "conservative neoliberal" is an oxymoron. Consider that F A Hayek, one of the leading neoliberal economists of his day, wrote an essay on "Why I'm Not a Conservative" and Milton Friedman also called this ideas liberal, not conservative (see the introduction to "Capitalism and Freedom").

Anyway here is Greg Mankiw being interviewed on NPR about the protest.



When I did first year political science we were lectured by an out and out Marxist, should I have walked out in protest because of the "Marxist ideology" being promoted in the class?

I didn't because the classes really were fun.

Critiques of economics

In the comments section of a recent post at TVHE blog the question of Keen's critique of economics given in "Debunking Economics" is raised. Responses to Keen's argument have been made in a number of different places. As to local blogs, in the past, Matt Nolan has commended here and here and I have posted here, here and here. Canadian economist Chris Auld has a more detailed discussion in Auld, M.C., 2002. Debunking Debunking Economics. Working Paper, University of Calgary. Available at http://jerry.ss.ucalgary.ca/debunk.pdf.

An executive summary of a standard reply to Keen's arguments about models of firm behaviour would be that given by Schiffman (2004: 1909-1)

According to Auld, Keen is mistaken concerning the distinction between perfect competition and monopoly (or lack thereof—topic 3), and his perception that mainstream modeling ignores dynamics (topic 6). These errors, in Auld’s estimation, are caused by "either a lack of familiarity with the literature, conceptual errors, or both". As Auld shows, perfect competition can be rigorously derived as the limit of a model of imperfect competition (as the number of firms becomes large). Assume that each firm takes competitors’ outputs as given, but recognizes that it has some degree of market power (its own output influences the market price). The ratio of output under this form of imperfect competition to output under perfect competition is n/(n+1) (where n is the number of firms). When standard theory assumes that firms take prices as given, it is making an innocuous assumption; for example, an imperfectly competitive industry with 100 firms will produce slightly over 99% of the perfectly competitive output.

Another possible approach to rigorously deriving perfect competition is to assume there exists a continuum of firms. In such a situation , it is literally true that any firm can change its output without changing price, even when the market demand is smooth and downward-sloping. Aumann, R. (1964) ("Markets with a continuum of traders," Econornetrica 32:39-50) is a standard reference.

Overall Schiffman notes,

To summarize, Keen is correct that many issues that should be taught to students are not being taught. There is need for a book that introduces students to controversies in theory and methodology, on a level that is accessible to advanced undergraduates. Debunking Economics is, however, too biased to fulfill this need. If one wishes to advocate a reform of economics (and Keen may very well be correct that it is a necessity), one must provide a more nuanced, more accurate, and more up to date picture of its current state.

What to do about Italy?

Right now the Italian economy is doing worse than the Italian rugby team. And that’s not a good thing. As there is an over-400 basis point spread between Italian bonds and German bunds, a 1,900 billion euro public debt, a public debt to GDP ratio of 120% and zero growth prospects for 2012, Italy could be the next Greece.

So, what should the government do now, in the context of the current crisis?

At the IEA blog Dr Alberto Mingardi, the Director General of Istituto Bruno Leoni (www.brunoleoni.it),  outlines some policy options the Italian government could take.

The quickest answer lies in one word: privatisation. The Italian state owns assets worth €1,800bn. Not all of them can be privatised quickly. Nonetheless, Istituto Bruno Leoni, among others, has estimated that the Treasury still holds €100bn in listed or private companies that could be released to the market.

This includes shares in the energy giants ENIand ENEL, 100% of the post and railways monopolies (Poste Italiane and Ferrovie dell Stato), a fully state-owned insurer against accidents at work (INAIL), an insurance company that guarantees to domestic entrepreneurs against political and commercial risks linked with the export of goods and services (SACE) and many others.

On the top of that, the Italian national and local governments own €400bn in real estate. The Berlusconi government is planning to sell some - for a value of €5bn euros a year for three years, which means €15bn all together, i.e. less than 5% of those assets and less than 1% of the total public debt.

It is amazing that, for purely ideological reasons, the Italian government is not undertaking privatisations that would both contribute to the objective of reducing public debt and release still monopolised business sectors to entrepreneurial creativity.

It has often been lamented that Italy's problem is one of credibility. This is true. Italyis not a country without strengths: impressive private savings and strong entrepreneurs are the two most relevant ones. Still, incentives matter. In a world where capital is far more mobile than in the past, Italy's intricate and unpredictable regulations, plus its heavy taxation, make it an unlikely candidate for more investment.

Italians have long waited for a simplification of their legal codes and deep tax cuts. Yet the ingrained resistance of interest groups to a strong restructuring of public finances and, thus, of the scope of government, has made such policies impossible.

Mr Berlusconi and the Italian government should now be what they have never been: bold. This is the right moment to start long awaited liberalisation, aiming at boosting growth. But since the effects of liberalisation take time to materialise, the markets must be reassured of the Italian government's seriousness in getting public debt under control. Privatisation is the right instrument to achieve this.

The problem with academic journals

Noam Nisan at the Algorithmic Game-Theory/Economics blog writes that

Journals are simply not fulfilling their main three functions: dissemination, verification, and allocation of attention.

1. Dissemination: While originally the main point of a print journal was so that Prof. A. can see the results of Prof. B. relatively quickly, it is clear that, in the age of the Internet, journals only slow dissemination compared to, say, putting stuff on the arXiv.
2. Verification: Despite pretenses, refereeing is not really trust-worthy. Results of some importance become believed not when refereed but rather only after the community has studied them for a while.
3. Allocation of attention: an important goal of leading journals is to filter the “important” papers out of all the submitted ones, so that readers need not read everything but rather only the important stuff. I am afraid that today so much is published so that most of what one reads in most journals should have been filtered out. Partially this is a problem of the publish-or-perish culture and partially due to the coarseness of the refereeing model as a filtering tool.

All three of these main goals can be improved upon considerably using the right tools (that need to be figured out) on the Internet. At the same time that the journal system has lost its usefulness, it has created a lot of harmful side effects: the writing of countless worthless papers, lack of recognition for surveys, books, or other non-”paper” contributions, blind and silly use of metrics like impact factors for hiring, grants and promotion which lead to wasteful optimization of these rather than of real research. All these harmful side-effects could be tolerated had the system served its main purpose — but now we are just paying the price but not getting the goods.

I think there are a number of problems with academic journals but the negative externalities that Nisan points out in his last paragraph are not, I would argue, the fault of the journals. Problems with lack of recognition for some types of work or the use of silly metrics for hiring etc are caused by the incentives put in place by administrators for things like promotion, getting grants etc. Here is New Zealand efforts like the PBRF drive the types of side-effects Nisan notes rather than the journals. A lot of useless publishing, for example, takes place just to keep your PBRF ranking up. A lot of lower ranking journal have been created so that people have places to publish the aforementioned useless articles.

On a related matter, the question of the excessive journal pricing by commercial publishers, see Ted Bergstrom's homepage.

Interesting blog bits

1. Kyle Almond asks Just how big is 7 billion?
2. Ed Dolan asks Can Spaceship Earth Carry Seven Billion Passengers, and More to Come?
3. Mario Rizzo notes there are Seven Billion People and Counting
4. Tim Harford on Malthus’s ghost and baby number 7bn
5. Matt Ridley writes on Coping with only six billion

Economics at a young age

From the food blog at NPR.com

But not all candy is created equal, as all children will tell you. And increasingly American kids are getting an early lesson in economics — and business — by finding ways to trade their Halloween candy with friends and siblings.

I decided to peek in on a candy trading party in one of the top 10 Trick-or-Treat scenes in the country — Washington, D.C. I spent the evening with 25 kids, most about 11 years old, who aggressively traded candy after working the streets of the Chevy Chase neighborhood Monday night.

Within seconds of returning home, the first group at the trading party spilled their pillow cases onto the floor and started making piles.

"I've got Whoppers and Nerds. Who wants 'em?" Sierra Lewter, 11, shouted across the room once the floor opened.

Sierra quickly became the queen of Reese's by jumping into the market early. While most kids were still organizing their piles by brand, she was already making moves and trading her way to a hefty collection of Reese's Pieces and Peanut Butter Cups.

Lauryn Donahue displayed a solid grasp of the concept of excess supply. She was working hard to move the less-desirable candy given out at her house earlier that night.

[...]

The decibel level in the candy-trading room rivaled that of Wall Street. The trading peaked about 20 minutes in as cross-room deals had Milk Duds flying overhead while a Jolly Rancher came the other way. Whoppers went for Smarties. Kit Kats went for a Twix. Charleston Chews, the pennies of the lot, didn't seem to move at all.

[...]

As the trading died down, the candy consumption began. Everyone seemed satisfied with the deals they had made.

The first fundamental theorem of welfare economics in action.

Goff on markets

Eric Crampton has been marking Phil Goff on his understanding of how markets work. Eric writes,

Now, here's Phil Goff in last night's Leaders' Debate.

At times you have to intervene. The market is a good system. But there's a thing called market failure. And when you've got 10,000 people chasing sections all at the same time, that's not the normal functioning of the market. And if there isn't the supply to meet that, then your property prices are going to be inflated.

Sorry, Phil, that gets you a C- at best. Yes, if there's a shock to demand for standing houses and supply is relatively inelastic, property prices go up.

I have to say a C- seems a bit too generous for me. Yes prices will rise given that  the relative demand for housing has risen, but to say this is a market failure really is bollocks. The rise in prices shows that markets are working exactly how we would expect them to work. To miss this really does show that Goff doesn't understand a really basic point about how markets work, they allocate scare resources via the price mechanism. They bring about equilibrium by cutting off demand and giving incentives to increase supply.

The real problem here isn't the rise in prices, its the lack of response on the supply side of the market which largely due to restrictions on supply due to local government regulation. So the problem is is government failure rather than market failure.

A slow-growth America can't lead the world

This somewhat obvious point is made by John Taylor in the Wall Street Journal. Taylor argues that after World War II, the U.S. promoted international economic growth through reliance on the market and the incentives it provides. Times have changed. Taylor writes,

At the most recent meeting a year ago in Seoul, the G-20 rejected the president's [Obama] pleas for a deficit-increasing Keynesian stimulus and instead urged credible budget-deficit reduction and a return to sound fiscal policy. And on that trip he had to defend the activist monetary policy of the Federal Reserve against widespread criticism that its easy money was damaging to emerging-market countries, causing volatile capital flows and inflationary pressures.

With a weak recovery—retarded by new health-care legislation and financial regulations, an exploding debt, and threats of higher taxes—the U.S. is in no position to lead as it has in the past.

By contrast, in the years after World War II, the U.S. led the world in promoting economic growth through reliance on the market and the incentives it provides, the rule of law, limited government, and more predictable fiscal and monetary policy. It created a rules-based, open trading system by helping to found the General Agreement on Tariffs and Trade, which slashed tariffs multilaterally. The miraculous postwar European and Japanese recoveries came from greater adherence to these principles of economic freedom and direct support from the U.S.

After getting off track with interventionist policies in the 1970s, the U.S. put its economic house in order in the 1980s, adopting pro-growth policies and creating a long boom that lasted through the 1990s. Again its economic ideas were contagious, not just in Britain under Margaret Thatcher but in the developing world. Seeing the advantages of American-style economic liberty over state intervention and control, Deng Xiaoping expanded his initial and tentative market-based reforms in China and created an economic renaissance. The U.S. helped the countries in Central and Eastern Europe implement market-based reforms, and it encouraged other countries and the international financial institutions to do the same in Africa and Latin America.

As the U.S. has moved away from the principles of economic freedom—instead promoting short-term fiscal and monetary interventionism with more federal government regulations—its leadership has declined. Some, even in the U.S., may cheer the decline, but it is not good for the world or for the U.S.

It could rightly be argued that American economic policy post WW2 was not perfect given its over use of regulation and high marginal tax rates, but comparatively speaking the American model was better than that being used in large areas of the world which were not free either economically or politically. Just compare it with post WW2 Britain with its even greater controls over the economy. John Jewkes summed up the situation in the title of this book "The new ordeal by planning: the experience of the Forties and the Sixties". And it was often better than much of the policy we see today.

Taylor is right when he says,

If [...] the U.S. starts to return to the principles of economic freedom—the best route to improving its own economy—then perhaps it will be able to reassert its economic leadership, benefit the world economy, and in turn create an even more prosperous American economy in a grand virtuous circle.