Don't forget: Condliffe Lecture 2013

What if... Our cities vanished?
Wednesday, 10 July 2013 from 6:30 PM to 8:00 PM
Undercroft 101 Seminar Room, James Hight Building, University of Canterbury
Presenter: Professor Edward Glaeser, Harvard University

• What if humanity stopped urbanising?
• What is the role of cities in promoting economic growth?
• What are the lessons for the Christchurch rebuild from cities around the world?

Cities are often seen as the source of social problems such as poverty and crime, while we retain romantic notions of idyllic rural life. The truth is very different. In this lecture, Professor Edward Glaeser, the world’s leading expert in the economics of cities, will discuss why cities are crucial to economic development, why proximity has become ever more valuable as the cost of connecting across long distances has fallen and why, contrary to popular myths, dense urban areas are the true friends of the environment, not suburbia.

You can register for the lecture here: http://www.eventbrite.co.nz/event/7114849707/es2/?rank=1

EconTalk this week

Betsey Stevenson and Justin Wolfers, of the University of Michigan talk with EconTalk host Russ Roberts about their work on the relationship between income and happiness. They argue that there is a positive relationship over time and across countries between income and self-reported measures of happiness. The second part of the conversation looks at the recent controversy surrounding work by Reinhart and Rogoff on the relationship between debt and growth. Stevenson and Wolfers give their take on the controversy and the lessons for economists and policy-makers.

The rise and fall of the gold standard

There is a new Cato Policy Analysis piece out on The Rise and Fall of the Gold Standard in the United States (pdf) by George Selgin. The executive summary reads,

There is, in informal discussions and even in some academic writings, a tendency to treat U.S. monetary history as divided between a gold standard past and a fiat dollar present. In truth, the legal meaning of a “standard” U.S. dollar has been contested, often hotly, throughout U.S. history, and a functioning (if not formally acknowledged) gold standard was in effect for less than a quarter of the full span of U.S. history.

U.S. monetary policy was initially founded upon a bimetallic dollar, convertible into either gold or silver. Although officially committed to bimetallism, from 1792 to 1834 the United States was functionally on a silver standard. From the Civil War until 1879, a fiat “greenback” standard predominated with the exception of a few states, such as California and Oregon, where a gold standard continued to operate.

Between 1870 and 1879 numerous countries embraced gold monometallism. France ended the free coinage of silver in 1873, while the rest the Latin Monetary Union followed in 1876. But it was above all Germany’s switch to gold that prompted the United States to demonetize silver and embrace gold. Thus began the era of the Classical Gold Standard in the United States.

The Classical Gold Standard Era lasted until about War World I, when as common in times of war countries abandoned their commitment to convertibility. What followed World War I was the Gold Exchange Standard, whose failure resulted from its dependence upon central bank cooperation. Post World War II, the Gold Exchange Standard was replaced by the Bretton Woods System and its reliance on a fiat dollar. Bretton Woods finally came to an end when President Nixon closed the “gold window” on August 15, 1971.

This paper reviews the history of the gold standard in the United States, explaining both how that standard came into being despite having been neither formally provided for nor informally established at the nation’s inception, and how it eventually came to an end. It concludes that the conditions that led to the gold standard’s original establishment and its successful performance are unlikely to be replicated in the future.

EconTalk this week

Dan Pallotta, Chief Humanity Officer of Advertising for Humanity and author of Uncharitable talks with EconTalk host Russ Roberts about the ideas in his book. Pallotta argues that charities are deeply handicapped by their culture and how we view them. The use of overhead as a measure of effectiveness makes it difficult for charities to attract the best talent, advertise, and invest for the future. Pallotta advocates a new culture for non-profits that takes the best aspects of the for-profit sector to enhance the mission and effectiveness of charities.

A philosopher's objections to NSA surveillance

Philosopher, and Adam Smith scholar, James Otteson appeared on the Wall Street Journal's "OpinionLive" on the 13th of June to discuss his objections to the recently revealed activities of the NSA with regard to their surveillance of American Citizens.

Alcohol policy in practice

Economist Phil Miller from the Market Power blog took this picture at a Nashville Sounds game on 13/6 "sometime during the 3rd - 4th innings +/-0.5 of an inning". He goes on to say,

Other than this section which is in section HH, the ballpark was about half full on a beautiful night for a ballgame.

Miller adds,

Imagine the difference in attendance in this section if the words "alcohol" and "free" were switched around.

Why does the public oppose privatisation?

This question is asked by Sinclair Davidson over at The New Zealand Institute. Davidson writes,

Privatisation provides an interesting case study for free-marketeers. Almost everyone is opposed to the notion, yet those same people often buy the stock. So what is it about privatisation that everyone hates?

There are at least three arguments why voters may dislike privatisation. First, there is Bryan Caplan’s voter bias argument. Caplan has argued that voters suffer from four sources of bias – an anti-market bias, an anti-foreign bias, a make work bias, and a pessimism bias. Privatisation as a policy hits all them. Government using markets to sell assets to foreigners who will lay off workers? That couldn’t possibly work.

Then there is Thomas Sowell’s conflict of visions. Privatisation as a policy goes to the very core of the political debate. What is the appropriate role and function of the state in civil society and in the economy?

For those of us who suspect the answer to that question is ‘minimal, at best’, privatisation is an uncontroversial policy. For others not so much.

The thing to remember is that elite opinion holds that the state can and should do more, not less. This remains the case 30 years on from the Thatcher, Reagan, Douglas, and Hawke-Keating eras.

State ownership has many plausible theoretical arguments to support it. The theoretical arguments for privatisation seems weak. It is the empirical evidence that supports the principle of privatisation for many people. But without a clear theoretical basis for the policy, we run into the third problem that privatisation policy faces.

Ok up to this point. What I don't get is why he says that the theoretical base for privatisation is weak when there is a, albeit, relatively recent - post-1990 - literature that provides a solid theoretical base for privatisation. See below. Now I admit its not the kind of material that your average bloke in street is going to read sitting up in bed of a Sunday morning, but the job of the economist then is to make this bloke sit up and take notice.

As to what the theory of privatisation is let us start by noting that there is a surprising overlap between the theory of the firm and the theory of privatisation. The theory of the firm gives us a framework for the theory of privatisation. Hart (2003: C69) makes this clear when he writes,

"Let me begin by discussing the very close parallel between the theory of the firm and the theory of privatisation. In the vertical integration literature one considers two firms, A and B. A might be a car manufacturer and B might supply car-body parts. Suppose that there is some reason for A and B to have a long-term relationship (e.g., A or B must make a relationship-specific investment). Then there are two principal ways in which this relationship can be conducted. A and B can have an arms-length contract, but remain as independent firms; or A and B can merge and carry out the transaction within a single firm. The analogous question in the privatisation literature is the following. Suppose A represents the government and B represents a firm supplying the government or society with some service. B could be an electricity company (supplying consumers) or a prison (incarcerating criminals). Then again, there are two principal ways in which this relationship can be conducted. A and B can have a contract, with B remaining as a private firm, or the government can buy (nationalise) B".

and

"[ ... ] the issues of vertical integration and privatisation have much more in common than not. Both are concerned with whether it is better to regulate a relationship via an arms-length contract or via a transfer of ownership". Hart (2003: C70)

The incomplete contracting framework gives an approach which can be utilised to study the difference between public and private ownership. In fact incomplete contracts are a necessary condition to explain the differences between the two forms of ownership. In a world of complete or comprehensive contracts there is no difference between private and state owned firms. In both cases the government can write a contract with the firm that will anticipate all future contingencies - it will detail the managers' compensation, the pricing policy of the firm, how changes in technology will the change the firm's products etc - and thus the outcome under both forms of ownership will be the same.

This intuition has been formalised into a series of what are called Neutrality Theorems. These theorems formally establish the conditions under which private or public ownership of productive assets is irrelevant for the final allocation of resources. In short they show the conditions under which ownership of the firm does not matter.

Of all the assumptions on which the neutrality results hinge the most important requirement is, as noted above, that complete contingent long-term contracts can be written and enforced. But writing complete contracts is only possible in a world of zero transaction costs. In a positive transaction costs world only incomplete contracts can be written but contractual incompleteness creates a role for ownership - making decisions under conditions not covered in the contract. It is only within such an environment that we can explain why privatisation matters, that is, why the behaviour of state owned and private companies differ.

These neutrality results also show why the previous, roughly pre-1990, theoretical privatisation literature was largely unsuccessful. That literature took a `complete' or `comprehensive' contracting perspective, in which any imperfections present in contracts arose solely because of moral hazard or asymmetric information. But as Hart (2003: C70) notes

"[ ... ] if the only imperfections in are those arising from moral hazard or asymmetric information, organisational form - including ownership and firm boundaries - does not matter: an owner has no special power or rights since everything is specified in an initial contract (at least among the things that can ever be specified). In contrast, ownership does matter when contracts are incomplete: the owner of an asset or firm can then make all decisions concerning the asset or firm that are not included in an initial contract (the owner has 'residual control rights').

Applying this insight to the privatisation context yields the conclusion that in a complete contracting world the government does not need to own a firm to control its behaviour: any goals - economic or otherwise - can be achieved via a detailed initial contract. However, if contracts are incomplete, as they are in practice, there is a case for the government to own an electricity company or prison since ownership gives the government special powers in the form of residual control rights".

Thus privatisation matters only in an incomplete contracts world. In such an environment the allocation of residual control rights will differ and so the behaviour of publicly owned firms will differ from that of privately owned firms and thus ownership and therefore privatisation will become meaningful. This is the basic approach taken in the post-1990 literature.

Schmidt (1996a) considers a monopolistic firm that producers a public good in a world of incomplete contracts. (Schmidt (1996a) is variant of Schmidt (1996b). 1996b considers the case of privatisation to an employee manager while 1996a applies to the case of privatisation to an owner-manager. While this second case is less realistic it is simpler and does not require the assumption that the manager is an empire builder that is utilised in 1996b.) His model is multiple period with the privatisation decision being made in the initial period. That is, the government must decide whether to sell the SOE to a private owner-manager or keep it in state hands and hire a professional manager to run it. Importantly knowledge concerning the firm's cost is private information known only by the firm's owner. Given this, privatisation amounts to a transfer of private information from the government to the private owner. In the next period the manager selects his effort level and the state of the world is then revealed. The importance of the manager's effort level is that it affects the probability of the state of the world. A high level of effort from the manager results in productive efficiency being enhanced and costs being lowered for any level of output. In the last period, the government selects the transfer scheme and payoffs are revealed.

When the firm is an SOE the government observes the firm's realised cost function and thus can implement the first-best allocation by choosing the ex post efficient level of production. But the manager's wage will be fixed, since contingent contracts can not be written, and thus independent of level of output. Given this the manager has no incentive to exert effort and the government knowing this will therefore offer him only his reservation wage.

On the other hand when the firm is in private hands the government does no know the exact cost structure of the firm. In an effort to get the private owner to produce the efficient level of output the government must provide an incentive via the payment of an informational rent.But if transfer are costly it will be impossible to implement the optimal allocation and therefore the cost to private ownership is an inefficiently low level of production. However given the rent payment provides an incentive to increase effort, productive efficiency is greater.

Schmidt's main conclusion is therefore that when the monopolistic firm produces a good or service which provides a social benefit, there is a trade-off between allocative and productive efficiency that needs to be considered when deciding if a firm is to be privatised. The equilibrium production level is socially suboptimal but the incentive for better management results in cost savings. Considered overall the welfare effect of privatisation should be positive for cases where the social benefits are small, but social welfare will be greater under public ownership for those cases where production exhibits large social benefits.

An important implication of this is that a case can be made for privatisation even when the government is a fully benevolent dictator who wishes to maximise social welfare. Even if all the deficiencies of the political system could be remedied it is still possible for privatisation to be superior to state ownership.

In the Laffont and Tirole (1991) model a firm is assumed to be producing a public good with a technology that requires investment by the firm's manager. In the case of a public firm this investment can be diverted by the government to serve social ends. For example, the return on investment in a network could be reduced by the government if it were to allow ex post access to the general population. Such an action may be socially optimal but would expropriate part of the firm's investment. A rational expectation of such an expropriation would reduce the incentives of a public firm's manager to make the required investment. For a private firm, the manager's incentives to invest are better given that both the firm's owners and the manager are interested in profit maximisation. The cost of private ownership is that the firm must deal with two masters who have conflicting objectives: shareholders wish to maximise profits while the government purses economic efficiency. Both groups have incomplete knowledge about the firm's cost structure and have to offer incentive schemes to induce the manager to act in accordance with their interests. Obviously the game here is a multi-principal game which dilutes the incentives and yields low-powered managerial incentive schemes and low managerial rents. Each principal fails internalise the effects of contracting on the other principal and provides socially too few incentives to the firm's management. The added incentive for the managers of a private firm to invest is countered by the low powered managerial incentive schemes that the private firm's managers face. The net effect of these two insights is ambiguous with regard to the relative cost efficiency of the public and private firms. Laffont and Tirole can not identify conditions under which privatisation is better than state ownership.

Shapiro and Willig (1990) consider a world in which there is a public-spirited social planner or framer who decides on the nationalisation/privatisation outcome and sets up the governance structure for the enterprise chosen. The framer's decision is driven by the informational differences between private and public ownership. The important pieces of information are: (i) information about external social benefits generated by the firm; (ii) information concerning the difference between the ``public interest" and the private agenda of the regulator; (iii) information about the firm's profit level (cost and demand information). In this paper there is also a regulator who sets the regulations that control the private firm and who pursues a different agenda from the framer.

Assume that either information about profitability is known before investment is decided upon or that there are costs to raising public funds. In these cases the neutrality results mentioned above don't hold. The equilibrium behaviour of the minister who is in charge of the firm is virtually unconstrained and he will set the activity levels of the firm as to maximise his utility. The regulator of the private firm has a more complex problem to deal with. This involves the designing of regulatory scheme which ensures non-negative profits for the firm. Given this is a case of optimal regulation under asymmetric information we would expect to see the firm enjoying informational rent, which are proportional to the activity chosen. As public funds are costly to raise these transfers are costly to the state.

The trade-off in this model is driven by how easily the public official can interfere with the operations of the firm. If the public official's objectives are the same of the (welfare maximising) framer, i.e. the public official has not private agenda, then public ownership is optimal. In this case private ownership reduces performance since the firm extracts a positive information rent. But when there is a private agenda then a reduction in discretion may increase welfare. Politicians find it easier to distort the operations of a firm in their favour when that firm is an SOE and under the direct control of the minister. The regulated private firms does earn a positive rent but is less subject to the control of the regulator. This means that regulated private firms are likely to out perform SOEs in poorly functioning political systems,which are open to abuse by the minister, and where the private information about the profitability of the firm is less significant. This makes it easier for the regulator to get the firm to maximise social welfare.

In Boycko, Shleifer and Vishny (1996) information problems do not explain the difference between public and private firms. Here it is differences in the costs to a politician of interfering in the activities of the different types of firms that explains the effects of privatisation. The starting point of the paper is the observation that public firms are inefficient because they address objectives of politicians rather than maximise efficiency. One common objective for a politician is employment. Maintaining employment helps the politician maintain his power base. In their model Boycko, Shleifer and Vishny assume a spending politician, who controls a public firm, forces it to spend too much on employment. The politician does not fully internalise the cost of the profits foregone by the Treasury and by the private shareholders that the firm might have.

Boycko, Shleifer and Vishny argue privatisation can be a strategy to reduce this inefficiency in state-owned enterprises. By privatisation they mean the reallocation of control rights over employment from politicians to a firm's managers and the reallocation of income rights to the firm's managers and private owners. The spending politician will still want to maintain employment and can use government subsidies to `buy' excess employment at the private firm. In this model the advantage of privatisation is that it increases the political costs to maintaining excess employment. It is less costly for the politician to spend the profits of the state-owned firm on labour without remitting them to the Treasury than it is to generate new subsidies for a privatised firm. Given that voters will be unaware of the potential profits that a state firm is wasting on hiring excess labour they are less likely to object than they are to the use of taxes, which they know they are paying, to subsidise a private firm not to restructure. This difference between the political costs of foregone profits of state firms and of subsidies to private firms is the channel through which privatisation works in this paper.

Shleifer and Vishny (1994) is a continuation of research stated in Boycko, Shleifer and Vishny (1996). As with the 1996 paper Shleifer and Vishny assume that there is a relationship between politicians and firm mangers that is governed by incomplete contracts and thus ownership becomes critical in determining resource allocation. As noted above the Shleifer and Vishny model is a game between the public, the politicians and the firm managers. The model derives the implications of bargaining between politicians and managers over what the firms will do. A particular focus is on the role of transfers between the private and state sectors including subsidies to firms and bribes to politicians.

To consider the determinants of privatisation and nationalisation Shleifer and Vishny utilise what they term a "decency constraint" which says that the government cannot openly subsidise a profitable firm. To do so would be seen as politicians enriching their friends. The first, obvious, point made is that politicians are always better off when they have control rights. Control brings political benefits, via excess employment, and bribes, to allow a reduction in the excess employment. Both the Treasury and the politicians prefer nationalisation. (Remember that as a SOE the Treasury has income rights and the politician has control rights.) to subsidising a money-losing private firm. Control brings bribes and even without bribes politicians get a higher level of employment and lower subsidies when they have control. The Treasury likes the smaller subsidies that come with nationalisation. When it comes to profitable firms politicians like control or Treasury ownership because these firms have a strong incentive to restructure since the profits go to the private owners and they lose little in terms of subsides due to the decency constraint. To ensure the firms achieve political objectives politicians need control. Given the decency constraint politicians don't want managers who have control rights to also have large income rights since the decency constraint means smaller subsidies are lost if employment is cut and income rights mean the managers gain from restructuring and maximising profits. Politicians who have control prefer higher private and lower Treasury ownership since higher private ownership implies higher bribes. Without bribes the private surplus is extracted via higher levels of employment.

Given that politicians like control, Why would they ever privatise a firm? To explain privatisation the interests of taxpayers must become more prominent. Given this the decision to privatise then becomes the outcome of competition between politicians who benefit from government spending (and bribes) and politicians who benefit from low taxes and support from taxpayers. We would expect privatisation to take place when political benefits of public control are low, and the desire of the Treasury to limit subsidies is high. This is most likely to occur when the political costs of raising taxes to pay subsides is high and when the political benefits from excess employment are low.

The final paper to be considered is Hart, Shleifer and Vishny (1997). Again in this paper information problems are not the driving force of the analysis of contracting out. The provider of a service, either public or private, can invest his time in improving the quality of the service or reducing the cost of the service. The important assumption is that investments in cost reduction have negative effects on quality. Investments are non-contractible ex ante. For the case where the provider is a government employee he must obtain approval from the government to implement any innovation he has created. Given that the government has residual rights the employee will gain only a fraction of return on his investment. This gives him weak incentives to innovate. If the service provider in an independent contractor, i.e. the service has been contracted out, then he will have stronger incentives to both cut costs and improve quality. This is because he keeps the returns to his investment. The downside to private provision is that the incentives to cut costs are strong and the provider does not fully internalise the negative effects on quality of the reductions in cost. With public provision the incentive for excessive cost cutting are reduced as are the incentive for innovation and quality improvements. Costs are always lower under private ownership but quality may be higher or lower under a private owner. Hart, Shleifer and Vishny argue that the case for public provision is generally stronger when (i) non-contractible cost reductions have large deleterious effects on quality; (ii) quality innovations are unimportant; (iii) corruption in government procurement is a severe problem. On the other hand their argument suggests that the case for privatisation is stronger when (i) quality-reducing cost reductions can be controlled through contract or competition; (ii) quality innovations are important; (iii) patronage and powerful unions are a severe problem inside the government.

So arguing that the theoretical basis for privatisation is weak is, I would argue, wrong and the job of any economist arguing for privatisation is to explain this theory to the public, no matter how difficult that may seem.The theory is there and if you want to argue for privatisation you need to find a way of making it  intelligible to the general public.

Davidson continues,

The promoter’s problem suggests that you can’t always trust the person trying to sell you something. Given that voters have such poor opinions of politicians, this might be especially true for a privatisation policy. It is easy to believe that past privatisations may have been successful, but that is no guarantee that future privatisations will be.

To be sure, not all privatisations are successful and some can be described as having failed after the fact. But the rate of failure is lower for all firms.

For an example of a not so successful privatisations one only has to look at the first large scale privatisation programme in Chile in the mid-1970s. Luder (1991) writes in his abstract,

Between 1974 and 1989, the Chilean government privatized 550 state-owned enterprises (SOEs). Before 1974, all but a handful of major corporations were SOEs. About 50 of the largest enterprises privatized during the 1970s fell into government hands again, only to be re-privatized later. This was due partly to the economic and financial crisis affecting most Latin American countries during the early 1980s but also was a consequence of the privatization modes used. This paper analyzes that unique privatization experience so as to extract policy lessons. The analysis focuses on economic conditions, objectives of government policy, privatization modes, and the divestiture effects on employment, fiscal revenues, public sector wealth, spread of own- ership, and capital market development. (Emphasis added)

In the text Luders writes,

Between 1974 and 1990, the Chilean government privatized about 550 enterprises under public sector control. These included all but a handful of the country's largest corporations. Moreover, the reversal during the early 1980s of the most important divestitures carried out during the first round of privatizations (1974-1978) allowed the government to apply different modes of divestiture during the second round (1985-1989).

and

Consequently, the government intervened in 16 financial institutions. It liquidated a few of them and put in a sound position and re-privatized the remainder. That is, the government, which did not legally own the financial institutions, assumed complete control of a high proportion of the assets it had privatized during the 1970s. These financial institutions included the main commercial banks, whose owners controlled the major pension fund administrators (AFP) and large commercial and industrial enterprises. Because intervention blurred the ownership relationship of these enterprises—i.e., they neither belonged to the public sector nor were owned by the private sector—this group of enterprises was called the "odd sector." Re-privatizing these enterprises as well as other traditional SOEs constituted the second large privatization effort that the military regime carried out.

In short, when privatisation goes wrong, it really can go wrong! Much of the 1970s privatisations had to be redone in the 1980s because they didn't get it right the first time.

Davidson ends by saying,

To my mind, privatisation is always a good thing. But there is a sting in the tail. Very often the proceeds of privatisation are used to buy down debt – in other words, validate past irresponsible government spending. The capacity for debt and deficit is unlimited while the stock of government assets that can be sold off is limited.

The challenge is to embed privatisation schemes into a broader reform agenda.

He is right here, a consistent well thought out reform package is needed. In particular sound market regulation must be in place so that the markets that the SOEs are privatised into are as competitive as possible. Markets have to be opened to competitors before the SOEs are privatised so that the (former)SOE has no incentive to lobby for slow and cautious market liberalisation or better still no liberalisation at all.

This does raise the issue of whether the current government's idea of a partial privatisation of some SOEs is a well thought out reform package. I would say no.

If you look at the economics literature you will also find that fully private companies outperform mixed ownership firms. Some insight on this is offered by a recent paper in the Scottish Journal of Political Economy (Volume 59, Issue 1, pages 1–27, February 2012). The paper "What Drives the Operating Performance of Privatised Firms?" by Laura Cabeza García and Silvia Gómez Ansón argues that the greater the amount of privatisation the better the performance of the firm. Not an entirely surprising result as the full force of market discipline can only be applied if the firm is fully in private hands but it is something for the government to keep in mind. It would suggest that any performance improvements due to the government's partial privatisation plans will be modest. The abstract reads,

Using a panel data analysis of Spanish privatised firms, we study how different factors influence the operating performance of divested companies. The results show that it is not privatisation per se but other factors that matter. After controlling for possible sample selection bias related to government timing of divestments, we find that the greater the relinquishment of State control and the smaller the percentage of ownership held by managers and/or employees, the better the firms’ post-privatisation performance. Moreover, privatisations that are accompanied by liberalisation programmes and occur during buoyant economic cycles turn out to be more successful. (Emphasis added)

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.

Why might the government's idea not work? Simply put there are 6 reasons I can think of:

• First, selling only 49% of the shares in the companies is unlikely to make a huge difference to the way the SOEs are run. In particular the sell off will not make the firms any more efficient since the government will still be the controlling shareholder.
• Second, if the government really does want to maximise the income it gets from the sales selling 49% is not a good idea. 51% is worth a lot more than 49%, that is people will pay a premium for control.
• Third, selling to "Mums and Dads" will do nothing for the amount of money raised, since Mums and Dads will need a discount to make them buy shares.
• Fourth, selling to "Mums and Dads" will do nothing for the efficiency effect of having private owners, since there will be too many "Mums and Dads" for them to be able to coordinate their effects to effect the firm's behaviour.
• Fifth, given that each "Mum or Dad" will own only a very small share of any of the firms, they have little incentive to become informed on the firm's activities since they will only capture a very small amount of any improvement in performance they could bring about. This is another reason why performance is unlikely to change.
• Sixth, the discipline of bankruptcy or takeover is not greater since the government is still the controlling shareholder and is unlikely to let either of these options happen.

Note to self, write shorter posts from now on!

Refs:

• Boycko, Maxim, Andrei Shleifer and Robert W. Vishny (1996). `A Theory of Privatisation', The Economic Journal, 106 no. 435 March: 309-19.
• Hart, Oliver D. (2003). `Incomplete Contracts and Public Ownership: Remarks, and an Application to Public-Private Partnerships', The Economic Journal, 113 No. 486 Conference Papers March: C69-C76.
• Hart, Oliver D., Andrei Shleifer and Robert W. Vishny (1997). `The Proper Scope of Government: Theory and an Application to Prisons', Quarterly Journal of Economics, 112(4) November: 1127-61.
• Laffont, Jean-Jacques and Jean Tirole (1991). `Privatization and Incentives', Journal of Law, Economics, & Organization, 7 (Special Issue) [Papers from the Conference on the New Science of Organization, January 1991]: 84-105.
• Luders, Rolf J. (1991). `Massive Divestiture and Privatization: Lessons from Chile'. Contemporary Economic Policy, 9(4) October: 1-19.
• Schmidt, Klaus (1996a). `Incomplete Contracts and Privatization', European Economic Review, 40(3-5): 569-79.
• Schmidt, Klaus (1996b). `The Costs and Benefits of Privatization: An Incomplete Contracts Approach', The Journal of Law, Economics & Organization, 12(1): 1-24.
• Shapiro, Carl and Robert D. Willig (1990). `Economic Rationales for Privatization in Industrial and Developing Countries'. In Ezra N. Suleiman and John Waterbury, (eds.), The Political Economy of Public-Sector Reform and Privatization, Boulder: Westview Press.
• Shleifer, Andrei and Robert W. Vishny (1994). `Politicians and Firms', Quarterly Journal of Economics, 109(4) November: 995-1025.

Interview with Thomas Schelling

In an interview with Thomas Schelling, the CTBTO Faces interview series presents one of the most influential thinkers of nuclear weapons strategy, nuclear deterrence and game theory during the Cold War. Schelling, aged 92, is a U.S. economist and professor of foreign affairs, national security, nuclear strategy and arms control at the University of Maryland, United States. From 1948 to 1953, Schelling served with the Marshall Plan in Europe, then the White House, and the Executive Office of the President. Later Schelling joined the Department of Economics at Yale University before being appointed Professor of Economics at Harvard and then at Maryland. In 1993, Schelling received the Award for Behavior Research Relevant to the Prevention of Nuclear War from the U.S. National Academy of Sciences. Schelling also received the Nobel Memorial Prize in Economic Sciences in 2005 for his research on game theory.

Schelling was interviewed by CTBTO Spokesperson Annika Thunborg in Vienna in November 2012. An advocate of nuclear deterrence, Schelling explains how nuclear weapons policies developed in the first decades of the Cold War. He shares his impressions of the impact of nuclear bombings at the end of World War II and how memories of Hiroshima and Nagasaki played a role during the Korean War. He also stresses the importance of game theory when promoting cooperation in disarmament.

http://youtu.be/BFE7gw7bEdQ

The gravity of knowledge

Thanks to an email from Eric Crampton I have been alerted to a paper, with the title given above, by Wolfgang Keller and Stephen Ross Yeaple on the transfer of knowledge between countries. More precisely the transfer of knowledge between countries but within multinational companies. The paper appears in the American Economic Review, 2013, 103(4): 1414–1444, and the abstract reads,

We analyze the international operations of multinational firms to measure the spatial barriers to transferring knowledge. We model firms that can transfer bits of knowledge to their foreign affiliates in either embodied (traded intermediates) or disembodied form (direct communication). The model shows how knowledge transfer costs can be inferred from multinationals’ operations. We use firm-level data on the trade and sales of US multinationals to confirm the model’s predictions. Disembodied knowledge transfer costs not only make the standard multinational firm model consistent with the fact that affiliate sales fall in distance but quantitatively accounts for much of the gravity in multinational activity.

If I'm getting this right the paper assumes that knowledge can move over geographic space in one of two forms: embodied or disembodied. When knowledge moves in an embodied form the costs of moving it can be measured as the cost of goods trade. For disembodied knowledge it is harder to see movements of it and harder to calculate the costs of moving this type of knowledge. The paper claims to shed new light on this issue by casting the question in terms of the operations of multinational firms.

Multinationals have an incentive to endow offshore affiliates with their knowledge as efficiently as possible—after all, knowledge transfer costs raise overall costs and therefore reduce competitiveness. The paper model focuses on the difficulty of communicating knowledge from one person to another versus the costs of moving knowledge in goods. Knowledge can often not fully be codified, and communicating knowledge is prone to errors; just ask any teacher! The authors explain,

In the model, multinational firms produce final goods from individual intermediate inputs that vary in the extent that their production requires non-codified knowledge. Inputs highly dependent on noncodified knowledge are called knowledge intensive. Because not all knowledge can be codified, offshore production calls for communication between home country CEOs and affiliate managers. We assume that communication is more costly the more knowledge-intensive inputs are, but these costs are invariant to physical distance. Alternatively, the multinational can transfer knowledge by shipping ready-to-go inputs embodying the knowledge. This entails no communication costs since the input is produced near the expert at home, however shipping incurs trade costs that rise in geographic distance. The reason why multinational sales in knowledge-intensive industries suffer most strongly from gravity is that here disembodied knowledge transfer costs are highest, and to avoid them means embodied knowledge transfer whose costs rise in distance.

Two predictions follow from the model,

First, the knowledge intensity of production affects the level of affiliate sales around the world. The competitiveness of affiliates, measured in terms of their sales, falls as trade costs rise, and the effect of trade costs is strongest for knowledge-intensive goods, precisely because it is here that the scope for offshoring is most limited by costly disembodied knowledge transfer. Second, the knowledge intensity of production affects the composition of knowledge transfers that the multinational will employ. The affiliate’s cost share of imports gives the relative importance of embodied knowledge transfer. It falls more slowly with distance in knowledge-intensive industries than in less knowledge-intensive industries. As trade costs increase, multinational affiliates substitute away from importing inputs, but their ability to do so is constrained by how high disembodied knowledge transfer costs are. Therefore, trade costs have the weakest influence on affiliate imports in relatively knowledge-intensive industries.

The authors have a data set, from United States’ Bureau of Economic Analysis, involving information information on the sales and intermediate goods trade of individual multinationals. Testing the model the authors find

[ ... ] strong support for both predictions using variation in multinational activity across industries and countries. Consistent with the model, there is evidence that both the level of the affiliate’s sales and its imports are affected by the ease to which knowledge can be transferred across space. A quantitative analysis based on these micro estimates shows that both market size and geography are central determinants of aggregate
foreign direct investment (FDI). This is in contrast to the benchmark model which largely ignores the geography dimension.

Moreover, the model predicts that as trade costs change relative to communication costs, the nature of trade in terms of its knowledge intensity changes systematically. Specifically, an increase in trade costs makes disembodied knowledge transfer more attractive so that the average knowledge intensity of inputs that continue to be traded increases. Despite the large body of work on the factor service content of trade, this is one of the few results on the knowledge content of trade of which we are aware. We find strong supportive evidence for this prediction from the international trade of US multinational firms.

One interesting implication of this work is to do with vertical integration. An observation in industrial organisation is that firms that are part of a domestic production chain do not transfer as many goods within the chain as theories of vertical integration would suggest they should. This outcome could be because knowledge inputs are the key inputs determining the firm's organisational structure. Given this, it follows that the spatial organisation of a firm will depend on the spatial barriers to disembodied knowledge transfer. As such barriers fall the vertical links between firms will become increasingly invisible as there is less embodied knowledge transfer and more disembodied transfer.

Well said, that man!

Peter Klein writing at the Organisations and Markets blog explains,

Speaking of pet peeves, here’s another of mine: the regular misuse of the word “methodology” in academic papers. Methodology is the study of scientific methods, a branch of epistemology. Econometric techniques, strategies for gathering data, means of testing hypotheses, etc. are methods, not methodologies. Yet how many empirical papers include a section titled “Methodology” or “Data and Methodology”? It makes me cringe. “We use an instrumental-variables methodology,” or “our methodology employs case studies and structured interviews.” No, those are your methods. Unless you’re citing Popper or Kuhn or Lakatos or Feyerabend or Blaug or Mäki you probably don’t have a methodology section.

If only econometricians could speak English as well as Greek.

Interesting blog bits

1. Tyler Cowen asks How sticky are wages anyway?

   On the front of this new Elsby, Shin, and Solon paper (pdf) it reads “Preliminary and incomplete,” but if anything that is a better description of the pieces which have come before theirs. They have what I consider to be the holy grail of macroeconomics, namely a worker-by-worker micro database of nominal wage stickiness under adverse economic conditions, including the great recession and with over 40,000 workers, drawn from the Current Population Survey.

2. Simon J Evenett on Protectionism’s quiet return: The GTA’s pre-G8 summit report
   

   Commentators increasingly talk about the steady rise of protectionism. This column presents evidence from the newest Global Trade Alert report to suggest that they’re right: the past twelve months have seen a quiet, artful, wide-ranging assault on free trade. Little of this has showed up in traditional monitoring. Protectionism in Q4 2012 and Q1 2013 far exceeds anything seen since the onset of the global financial crisis.

3. Francesco Sobbrio, Ruben Durante and Filipe R Campante on Politics 2.0: Short-run and long-run effects of broadband internet on political participation

   What has been the impact of high-speed internet on political participation? This column reports new evidence from Italy and the formation of Beppe Grillo’s Five Star Movement. Largely through social media, broadband internet has enabled a fledgling political movement to reach a large number of people, overcoming the costly barriers to entry usually associated with new political parties. And it is this reach that has encouraged some disillusioned voters back to the ballot box.

4. Felix Bungay on John Rawls: For School Choice, Against the Minimum Wage

   When looking at contemporary liberal political thought, philosophers like Samuel Freeman and John Tomasi like to play up the difference between classical liberals, like Hayek and Friedman, and high liberals, like Rawls and Nagel. I happen to think there’s more common ground between the two groups than is commonly perceived.

5. Brennan McDonald on Watch Out! NZ Inc Is Everywhere (Especially In NBR Comments)

   Over at an article highlighting the Twitter spat between Rod Drury and Russel Norman, NZ Inc is used in the comments. I almost spat out my midday coffee.

6. John Taylor on Former Fed Chairs Speak Out

   Paul Krugman’s reply to my post on Allan Meltzer’s and Paul Volcker’s critiques of monetary policy failed to mention what Paul Volcker has been saying. Yet Volcker’s views are important, especially since, as Krugman points out, he “deserves immense respect for past achievements.”

7. Christopher Snowdon on Alcohol Concern sticks to the ideology

   It is brave for a lobby group that has a long track record of using dodgy surveys, junk science and misleading press releases to release a report entitled Stick To The Facts, but that is what state-funded 'sock puppet' charity Alcohol Concern have just done.

8. Sam Bowman on Politics is so nasty because we're all speaking different languages
   

   If you’re frustrated by how vicious and pointless politics is, a brief Kindle single by Arnold Kling may offer some insight. “The Three Languages of Politics” (£1.34, US link) dissects one of the main problems with politics: that progressives, conservatives and libertarians are all speaking different languages that rarely overlap and cause us to misunderstand and vilify our opponents.

9. Daron Acemoglu and James Robinson on Whither Turkish Presidentialism

   Daron’s piece in the New York Times argued that the ongoing protests in Istanbul’s Taksim Square and several other cities may be a coming-of-age moment for a more participatory democracy in Turkey, but also that things are likely to get worse before they get better.

You know your economy is in trouble when .......

you need a smartphone app to find toilet paper. Tim Worstall writes at the Forbes.com website that

There are often little signs that all is not well in an economy. Large numbers of young men hanging around moodily on street corners might indicate that the unemployment rate is rather high just as one example. Another might be that the simple basics of a modern life are not available in the shops. So it is in Venezuela at present, so much so that someone’s written a smartphone app to provide crowd sourced information of where those basics are:

Toilet roll has been in short supply in the South American country in recent months, with economists blaming price controls imposed by the government.

The new programme, launched last week, uses crowdsourcing technology to enable users to let each other know which supermarkets still have stocks of the tissue.

Called Abasteceme – “Supply Me” in English – the free Android app has already been downloaded more than 12,000 times.

Matt Roper at The Telegraph writes,

Creator Jose Augusto Montiel said most downloads have been made by residents from the capital Caracas.

He said: "Lots of things are in short supply, but what people are most worried about is finding toilet paper. People never knew how much they needed it until it started running out."

Nicolas Maduro, who became Venezuelan president earlier this year, claims anti-government forces are deliberately buying up basics like toilet paper to destabilise the country.

Government destabilisation via toilet paper, now there's an idea for the CIA to consider!

Robert Fogel: Nobel Laureate for economics, dies at 86

Bloomberg.com is reporting the death of the economic historian Robert Fogel. Laurence Arnold writes,

Robert Fogel, the University of Chicago economic historian awarded a Nobel Prize for his data-driven reconsiderations of how railways and slavery influenced U.S. economic history, has died. He was 86.

and

The Royal Swedish Academy of Sciences awarded Fogel and Douglass North of Washington University in St. Louis the 1993 Nobel in economics “for having renewed research in economic history by applying economic theory and quantitative methods in order to explain economic and institutional change.” Both men were pioneers in applying modern mathematics to the study of history, a field known as cliometrics, after Clio, the muse of history in Greek mythology.

As founding director of the University of Chicago’s Center for Population Economics, Fogel oversaw creation of large sets of data on American life that help economists, medical researchers and other experts forecast health-care costs, the size of the labor force and the demands on pension programs.

The most controversial part of Fogel's work was that on American slavery.

He made a similar splash in 1974 with “Time on the Cross: The Economics of American Negro Slavery,” co-written with Stanley Engerman, a professor of economics at the University of Rochester.

Approaching the subject as economists, without making moral judgments, Fogel and Engerman wrote that Southern slavery was an economically rational and efficient system that, by and large, kept slaves well-fed, taught them to farm and collapsed for political rather than economic reasons.

“Our emphasis was not to deny that slavery was an oppressive system,” Fogel said, “but that it was within the system for the development of black culture.”

Reviewing the book for the New York Times, Columbia University economist Peter Passell wrote: “Fogel and Engerman have with one stroke turned around a whole field of interpretation and exposed the frailty of history done without science. They force us to confront contemporary social failings instead of pushing them into the past.”

In a 1989 book, “Without Consent or Contract: The Rise and Fall of American Slavery,” Fogel presented the moral case against slavery that many other critics saw as conspicuously missing from his work of 15 years earlier.

The New York Times writes,

Professor Fogel, a rumpled former New Yorker by turns amiable and combative, was widely known for work that aroused objections if not open hostility in academic circles, chiefly through his pioneering use of cliometrics, which applies economic theory and statistical methods to the study of history. (Clio was history’s muse in Greek mythology.)

and

But it was the publication 10 years later of “Time on the Cross,” a two-volume study of slavery, written with Stanley L. Engerman, that propelled Professor Fogel into the critical spotlight and instant celebrity.

They contended that slavery had not been, as widely portrayed, an inefficient system destined for collapse, with slaves living in virtual concentration camps and worked to death.

Rather, after studying medical records, cotton yields and other data, the authors argued that slavery had been highly efficient in utilizing economies of scale and that plantation owners had regarded workers as economic assets whom they were inclined to treat at least as well as livestock. This tended to limit exploitation, Professor Fogel and his colleague found, declaring, in fact, that slave life in the South was generally better than that of industrial workers in the North.

An intellectual firestorm resulted. Some critics accused Professor Fogel, who was married to an African-American woman, of being an apologist for slavery, though he and Professor Engerman had been explicit in acknowledging that slaves had been exploited in ways not captured by statistical data.

Despite the attacks, the authors did not budge from their findings and their main point — that slavery would not have ended without the Civil War.

George Selgin's talk "Could deflation be salvation"

From the Adam Smith Institute comes this video of a talk given by Professor George Selgin on the possibility that some deflation—that coming from improvements in the supply side, productivity improvements—is not harmful to the economy, but good. He makes the case that the so-called Long Depression of 1873-1896 was actually the site of a vast improvements in living standards and social welfare. And he points out that the problems attendant with deflation, that economists are fond of pointing out, only obtain when that deflation comes from a demand shock, not a change in supply.

A country is not a corporation (updated)

In a way this statement is obvious and yet as Brennan McDonald points out many people still seem to think that a country is in fact like a corporation. McDonald asks MFAT Please Kill The Phrase NZ Inc. He writes

The phrase NZ Inc is so nauseating. Please stop using it. New Zealand is a collection of individuals, firms, government agencies, councils, charities, families, iwi and a whole lot of other fluid groups that change their composition and goals frequently.

A country is not a corporate. New Zealand is not some sort of business enterprise that can be called “NZ Inc”.

And he is right, a country is not a corporation. Hayek made the distinction between the "economies" of the small-scale entities such as firms, farms or family units and the "economy" of a nation state, that is the "economy" of a corporation and the "economy" of country. In the case of a firm's (or household's) economy, Hayek argued, the ends around which decisions are made are generally known in advance and decisions about resource allocation are therefore relatively uncomplicated. In this sense then the economy of a household or firm or farm, is the economy of an organisation, or "taxis". But, Hayek goes on to say, the same does not hold for the economy of a large-scale complex society. Society is not an organisation. Owing to its size and the indirect nature of the social relationships within it, Hayek contends that the Knowledge Problem that the economy of such a society consequently faces means that it is not immediately apparent to what use resources should be put. For this reason, Hayek employs the term "catallaxy" to describe the economic aspect of the complex spontaneous order, or cosmos, of a large-scale society.

Another way to see why countries are not corporations is to turn to Paul Krugman's essay entitled, funnily enough, A Country Is Not a Company. A distinction made in the essay is about competition between firms and countries. Firms complete while countries do not, an important distinction. Consider, for example, Coke and Pepsi, they do compete. One of them gains at the others expense, management in each company spends a lot of time and energy trying to out do the other. But what about New Zealand and Australia, do they compete? Of course they don't, Australia's loss is not New Zealand's gain and vice versa. 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 gains a lot, in terms of sales and profits, from not having Pepsi to complete 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 sales 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.

Countries do a lot of trading, but they don't compete. Corporations do little trading but a lot of competing.

Update: Matt Nolan notes that NZ Inc: Good marketing, bad for society

EconTalk this week

Bruce Schneier, author and security guru, talks with EconTalk host Russ Roberts about power and the internet. Schneier argues that the internet enhances the power of the powerless but it also enhances the power of the powerful. He argues that we should be worried about both corporate and government uses of the internet to enhance their power. Recorded before news of the PRISM system and the use of Verizon's customer information by the NSA (National Security Agency), Schneier presciently worries about government surveillance that we are not aware of and explains how governments--democratic and totalitarian--can use the internet to oppress their citizens. The conversation closes with a discussion of terrorism and the costs of the current system for reducing the probability of a terrorist attack.

Don Boudreaux makes the case that economic freedom and freedom generally are inseparable

Here’s a video of the six-minute talk that was given by Don Boudreaux last month at the Oslo Freedom Forum - a talk that preceded a longer panel discussion – on the inseparability of economic and non-economic freedoms.

The falling income share of labour

At his blog Conversable Economist Timothy Taylor quotes from a International Labour Organization report that shows that labour’s share of income has declined between 1990 and 2009 in 26 out of the 30 countries that were considered for the report. Taylor then makes an important but often missed point that when looking for an answer as to why labour's share has fallen, looking within country isn't likely to be fruitful. If the trend affects many countries the cause is likely to be something had has affected all countries and not something particular to one country.

When a trend cuts across so many countries, it seems likely that the cause is something cutting across all countries, too. Looking for a "cause" based on some policy of Republicans or Democrats in the U.S. almost certainly misses the point. The same is true of looking for a "cause" based in policies more common in Europe, or in China.

So just blaming the previous government or the current government isn't going to cut it as an explanation for the fall. And who reads ILO reports anyway?

Vertical integration in perfect competition?

Over at the SSRN website there is a new working paper out on the question Do Prices Determine Vertical Integration? Evidence from Trade Policy by Laura Alfaro, Paola Conconi, Harald Fadinger and Andrew F. Newman. The abstract of the paper reads:

What is the relationship between product prices and vertical integration? While the literature has focused on how integration affects prices, this paper shows that prices can affect integration. Many theories in organizational economics and industrial organization posit that integration, while costly, increases productivity. If true, it follows from firms' maximizing behavior that higher prices cause firms to choose more integration. The reason is that at low prices, increases in revenue resulting from enhanced productivity are too small to justify the cost, whereas at higher prices, the revenue benefit exceeds the cost. Trade policy provides a source of exogenous price variation to assess the validity of this prediction: higher tariffs should lead to higher prices and therefore to more integration. We construct firm-level indices of vertical integration for a large set of countries and industries and exploit cross-section and time-series variation in import tariffs to examine their impact on firm boundaries. Our empirical results provide strong support for the view that output prices are a key determinant of vertical integration.

How if I'm getting this right the argument is that under perfect competition, if integration increases productivity, then a price-taking firm will integrate more when the price of its product is higher. At a low price, the increment in revenue resulting from integration is too small to justify any fixed cost integration may incur but at a high price, the incremental revenue is large enough to make integration worthwhile.

My issue with this is that we can't give meaning to integration within perfect competition.

As Nicolai Foss has noted

With perfect and costless contracting, it is hard to see room for anything resembling firms (even one-person firms), since consumers could contract directly with owners of factor services and wouldn't need the services of the intermediaries known as firms.

So if consumers can do it all and there is no need for firms then you have to ask, How can nonexistent firms integrate with one another?

In the neoclassical theory, the firm is a 'black box' there to explain how changes in inputs lead to changes in outputs. It is a black box in the sense that inputs go in and outputs come out, without any explanation of how one gets turned into the other. The firm is taken as given; no attention is paid to how it came into existence, the nature of its internal organisation, where the boundary between one firm and another is or between a firm and the market; or whether anything would change if two firms merged and called themselves a single firm, i.e. integration. The neoclassical production function is a way of representing the black box conversion of inputs into outputs but tells us little about the inner workings of the black box. The production function is independent of the institutional framework of output creation. Thus it represents the 'firm' without explaining the 'firm'.

That the theory cannot explain the boundaries of the firm - that is, explain integration - has been noted by several authors including the Nobel winner Oliver Williamson. He asks,

What determines which activities a firm chooses to do for itself and which it procures from others?

A simple answer to that question is that the natural boundaries of the firm are defined technology-economies of scale, technological nonseparabilities, and the like. The firm-as-production function is in this tradition. [ ... ] In mundane terms, the issue is that of make-or-buy. What is it that determines which transactions are executed how?

That posed a deep puzzle for which the firm-as-production function approach had little to contribute.

So I'm a little confused as to how the authors of the paper can discuss integration within perfect competition.

All great economists are tall .......

“All great economists are tall. There are two exceptions: John Kenneth Galbraith and Milton Friedman.” –George J. Stigler

The picture is of Stigler, Friedman and Galbraith.

(HT: Mark Skousen)

Work harder, live healthier

A new study, Work Harder, Live Healthier: The relationship between economic activity, health and government policy, has been published by the Institute of Economic Affairs and the Age Endeavour Fellowship in the U.K.

A summary of the findings of the research are:

In the past 50 years, labour market participation among older people has declined significantly, though the trend has reversed a little in recent years. In the EU, about 70 per cent of people aged between 60 and 64 are inactive.

In the case of the UK there has been a significant drop in the employment rate among older men. The employment rate among men aged 55-59 decreased from over 90 per cent to less than 70 per cent between 1968 and the end of the 1990s. Employment for men aged 60-64 slumped from around 80 per cent to 50 per cent and, for those aged 65-69, it halved from 30 per cent to about 15 per cent.

As with the rest of the OECD, this trend has reversed in recent years. The employment rate in 2008 was about 80 per cent for the 55-59 group, 60 per cent for the 60-64 group, and 20 per cent for the 65-69 age group.

Whilst people have been retiring earlier on average, they have also been living longer. A 61-year-old man in 1960 had the same probability of dying within a year as a 70-year-old man in 2005.

Healthy life expectancy at age 65 has also increased in the UK, although at a somewhat slower pace than regular life expectancy. This would suggest that people have the capability to work longer, though perhaps not to increase their working life on a one-for-one basis as life expectancy increases. Life expectancy at age 65 increased by 4.2 years for men between 1981 and 2006. During the same period, healthy life expectancy at age 65 increased by 2.9 years for men.

Increases in the number of healthy years of life that we can enjoy have not been reflected in longer working lives – indeed, the reverse is the case: people were working longer half a century ago.

If rising pension ages and labour force participation at older ages caused greater ill health then it would be a matter for concern. Most research on the relationship between health and working in old age has produced ambiguous results. Research in this area is inherently difficult because of the fact that, just as retirement can influence health, health can influence retirement decisions.

To date, research has not generally examined the relationship between the number of years spent in retirement and health. This issue is important. It is possible that health will initially improve when somebody retires and then, after a while, start to deteriorate due to reduced physical activity and social interaction.

New research presented in this paper indicates that being retired decreases physical, mental and self-assessed health. The adverse effects increase as the number of years spent in retirement increases.

The results vary somewhat depending on the model and research strategy employed. By way of example, the following results were obtained:

• Retirement decreases the likelihood of being in ‘very good’ or ‘excellent’ self-assessed health by about 40 per cent
• Retirement increases the probability of suffering from clinical depression by about 40 per cent
• Retirement increases the probability of having at least one diagnosed physical condition by about 60 per cent
• Retirement increases the probability of taking a drug for such a condition by about 60 per cent.

Higher state pension ages are not only possible (given longer life expectancy) and desirable (given the fiscal costs of state pensions) but later retirement should, in fact, lead to better average health in retirement. As such the government should remove impediments to later retirement that are to be found in state pension systems, disability benefit provision and employment protection legislation.

If results such as these continue to be found then you have to ask, in the New Zealand context, Why is the government so against increasing the age of eligibility for superannuation? A longer working life brings benefits to those still working and reduces the fiscal burden of superannuation. A win-win?

Boudreaux on fair trade

Don Boudreaux has written a letter, as only Don Boudreaux can, to the Washington Post:

Harold Meyerson dislikes foreign trade, in part because it destroys some American jobs (“Go slower on free trade,” June 4). And so Mr. Meyerson favorably quotes one of Congress’s staunchest protectionists, Sen. Sherrod Brown (D-OH): “A trade deal, says Brown, ‘should both protect workers and small businesses and better prepare them for globalization.’”

Let’s make a deal. Government will agree to protect only those American workers and small-business owners who in return agree to stop buying foreign-made products.

For example, American steel workers will get protection from steel imports only if they, in exchange, agree to stop buying the likes of Toyota cars, Samsung televisions, Ryobi hand tools, Ikea furniture, Shell gasoline, Amstel beer, vacations to Cancun, and musical recordings by foreign artists such as the Beatles, Elton John, and k.d. Lang. They must also promise to stop buying the likes of bananas, cinnamon, and vanilla and, indeed, even American-made food items if these are shipped to their favorite restaurants and supermarkets in foreign-made trucks – or in trucks equipped with tires made by Michelin, Bridgestone, or some other job-destroying foreign company. These workers would be permitted to drink only Hawaiian coffee; they must quit drinking the Colombian, Guatemalan, and Ethiopian coffees that they’ve become accustomed to drink. Oh, and absolutely no diamond jewelry, as those gems come from Africa. (Sorry, ladies.)

Small-business owners likewise will get such protection, but only in return for their agreement not only to stop consuming foreign-made products, but also to never sell their outputs to non-Americans. These businesses must, in addition, promise to use in their operations only American-made inputs – such as aluminum, wood, chemicals, and insurance services – even when foreign-made substitutes are available at lower prices or in higher qualities.

Deal?

One wonders just what this "deal" would do to the living standards of Americans and if those backing protectionism even realise the effect it would have. Its the seen and unseen. Protectionists see that some group or industry would benefit from protection but don't see the costs of that protection throughout the rest of the economy. Just how would the cost of living rise and the quality of goods and services fall. Doing things that you don't have a comparative advantage in only reduces the average income of the country. America could produce all the goods it wants to consume, it just would mean producing things that those overseas are better at doing and not doing things the US is good at. And foregoing the gains from trade.

Interesting blog bits

More good mid-week reads:

1. Aaron Chatterji, Edward Glaeser and William Kerr on The origins of entrepreneurship and innovation clusters

   Contrary to received wisdom, entrepreneurial clusters in the US – like Silicon Valley – are seen as success stories. But what is the rationale behind these clusters? Do they actually work? This column reviews the evidence and discusses localised policies currently being pursued in the US. In general, our understanding of what works remains limited and economists should more thoroughly pursue researching the effects of entrepreneurial clusters

   .
2. John Taylor on Unforgettable Economics Lessons in Tombstone

   Last night Yang Jisheng was awarded the 2012 Hayek Prize for his book Tombstone about the Chinese famine of 1958-1962. It’s an amazing book. It starts with Yang Jisheng returning home as a teenager to find a ghost town, trees stripped of bark, roots pulled up, ponds drained, and his father dying of starvation. He thought at the time that his father’s death was an isolated incident, only later learning that tens of millions died of starvation and that government policy was the cause.

3. Sajjad Faraji Dizaji and Peter A.G. van Bergeijk ask Could Iranian sanctions work? ‘yes’ and ‘no’, but not ‘perhaps’

   Will harsh sanctions against Iran change its politics? This column models the effects of sanctions to include both economic and political factors. The impact of an oil boycott is considerable, and economic costs act as powerful incentives to move toward democracy. However, initial positive effects turn negative after around seven years because efforts to adjust to sanctions undermine their economic and political impact. Sanctions only work in the short to medium term.

4. David S. D'Amato asks How independent are central banks?

   In the wake of the financial crisis, there are growing movements in the USA and the UK to abolish the countries’ central banks, the Federal Reserve System and the Bank of England. And while such movements are often regarded as the radical domain of cranks and fanatics, their arguments deserve much more in the way of a careful consideration than they typically receive. Although the mainstream narrative has blamed the current financial crisis on ‘free markets’ and ‘cutthroat competition’, we have had nothing even remotely akin to either for a very long time. If we had, we would find ourselves in a very different position today.

5. Phil Miller asks Why Opera Subsidies and not Stadium Subsidies?

   In this TSE post a commenter asks why there is so much negativity towards sports subsidies and not towards opera subsidies, presumably at TSE.

6. Marc J. Melitz and Stephen Redding ask How do firm-level responses to trade affect industry productivity and the gains from trade?

   Trade theory is ten years into the ‘new new trade theory’ revolution. This column reviews the new thinking and how it shifted thinking from why nations trade to why firms trade. This opened the door to documenting the impact of firm-level changes on industry productivity and national welfare.

7. Daron Acelmoglu and James Robinson on Natural Resources and Political Institutions: Democracy

   Might oil or more generally natural resource wealth lead to institutional deterioration in the political sphere?

8. Tyler Cowen asks Who is the worst philosopher?

   Tyler asks and answers this question.

9. Tim Worstall on Astonishing Numbers: America's Poor Still Live Better Than Most Of The Rest Of Humanity

   There’s a lot of debate (from certain quarters it’s less debate than whining actually) about the increasing inequality in the United States. Sure, maybe it’s true that the country continues to grow but what about the poor and their incomes?

EconTalk this week

Arnold Kling, author of The Three Languages of Politics, talks with EconTalk host Russ Roberts about the ideas in the book. Kling argues that Progressives, Conservatives, and Libertarians each have their own language and way of looking at the world that often doesn't overlap. This makes it easier for each group to demonize the others. The result is ideological intolerance and incivility. By understanding the language and mindset of others, Kling suggests we can do a better job discussing our policy disagreements and understand why each group seems to feel both misunderstand and morally superior to the other two.

The theory of the firm and tax

Courts in many countries have articulated any number of legal tests that they use to supposedly distinguish between corporate transactions that have a legitimate business or economic purpose and those carried out largely, if not solely, to avoid paying tax. In a couple of recent US cases the modern theory of the firm has been applied to try and make this distinction and the basic reasoning seems sound. But I can't help thinking that the most sensible way to handle such problems is to simplify the tax code so that firms don't have the incentive to avoid tax in the first place.

But given that the tax code is unlikely to be simplified any time soon, How are we to make a sensible distinction between legitimate and illegitimate corporate transactions? A new NBER working paper looks at this question and applies the property rights approach to the firm to answering it. The paper explains,

Policy makers have long faced challenges in designing and implementing tax legislation that provides the intended benefits while at the same time avoiding abuse. This tension is well illustrated in a long and diverse series of United States tax shelter cases in which parties disagree over nature of tax-advantaged transactions: corporations, or taxpayers, argue that the terms of the transaction comply with the tax code while the government argues that e transaction violates the spirit of that law. In order to address challenges associated with interpreting complex provisions of the tax code, the Courts have established an economic substance test that is based on evaluating whether a taxpayer would have undertaken the actions at hand absent their tax consequences.

Traditionally some sort of discounted cash flow analysis is used to evaluate the economic substance of tax-motivated transactions. Such an analysis compares the incremental, risk-adjusted benefits of the activities with the incremental risk-adjusted costs, ignoring taxes. The purpose is to determine whether the taxpayer could reasonably expect to realize a profit absent the disputed tax benefits. Discounted cash flow analyses are based on principles of corporate finance that are widely accepted in both business and academic settings. However, a serious shortcoming of such analyses is that they can be very sensitive to long-term financial projections and estimates of discount rates that are developed in the context of litigation, sometimes many years after the fact.

The argument put forward here – consistent with those made in recent court cases – is that additional principles of economics and corporate finance, based on the modern theory of the firm, can be helpful in evaluating the economic substance of corporate reorganizations. In particular, according to the property rights theory of the firm, a key difference between an arm’s length transaction and a transaction inside an organization concerns who has residual control rights, that is, who has the right to determine what happens in events not covered by explicit contractual terms. The possession of residual control rights can have important efficiency consequences in a world where contracts are incomplete. Among other things, to motivate individuals it may not be enough to offer them high-powered incentives; it may be necessary also to allocate them ownership or residual control rights.

In many transactions leading to the creation or reorganization of corporate entities no meaningful transfer of residual control rights actually occurs. These transactions are structured in such a way that both before and after the transaction the company initiating the transaction has complete control. This suggests that the same benefits could have been achieved in-house: that is, such reorganizations or creations of a new entity lack economic substance and should not be respected for tax purposes.

Basically if the same people face the same incentives to make the same (uncontracted for) decisions both before and after the reorganisation then the reorganisation will not change any decision and thus serves no economic purpose.

Making trade easier and less bureaucratic actually helps trade

Who would have guessed?

In a new column at VoxEU.org Bernard Hoekman and Ben Shepherd asks Who profits from trade-facilitation initiatives?. Trade-facilitation is just WTO jargon for making international trade easier and less bureaucratic. As it turns out trade-facilitation is one of the few areas where WTO talks are still making progress. The Hoekman and Shepard column discusses recent research that looks at the distribution of gains from trade facilitation among exporters of different sizes. Firm-level data from many developing countries show that firms of all sizes export more in response to improved trade facilitation.

The basic conclusions and policy implications of the research discussed are:

In a global sense, trade facilitation is a ‘good deal’ for countries, in that it has the potential to bring economic benefits at least on a par with, and perhaps well in excess of, those that would come from a major round of tariff cuts in manufacturing. However, from a negotiating standpoint, as well from the point of view of development policy, it is not just the global economic gains that matter, but also their distribution. Two questions are important.

• First, is it primarily developed countries that stand to reap significant gains from improved trade facilitation, or will developing countries also gain?
• Second, and tied to the first, in the context of computable general-equilibrium models, is it only large firms (mostly headquartered in developed countries) that benefit from trade facilitation, to the exclusion of small suppliers (mostly located in developing countries)?

On the first question, the available research suggests that both developed and developing nations stand to gain from improved trade facilitation, and that exports are expected to increase for both country groups.

The second question is also empirical in nature, but has not been subject to any rigorous testing. In Hoekman and Shepherd (2013), using a large dataset from a variety of developing countries, we find that firms of all sizes benefit from improved trade facilitation by exporting more in response to improvements like reductions in the time taken to export goods. Thus, except under special circumstances that do not appear to hold widely in practice, small firms stand to benefit from trade facilitation through the same mechanism that large ones do. As a result, countries where small, supplier firms are prevalent and lead firms are few or non-existent – which is the case for many developing countries – also stand to gain from improved trade facilitation.

In terms of policy, our results and review of the literature suggest two main conclusions:

• First, those interested in supporting small producers and exporters in developing countries – policymakers, researchers, and the development community – should actively support improved trade facilitation in developing countries.

It flows from this that the same parties should welcome a WTO Agreement on Trade Facilitation.

• Second, one of the main arguments put forward by some in the policy community as a reason for developing countries to be wary of the trade-facilitation debate does not stand up to empirical scrutiny.

The fact that small firms can benefit in the same way as large firms from improved trade facilitation means that economies where supplier firms are prevalent but lead firms are not still stand to gain from trade-facilitation reforms. This is not to deny that gains from trade facilitation could be distributed unequally or that governments should monitor the impacts of trade-facilitation initiatives. Distributional issues are, of course, important to the political economy of trade negotiations, and to their development implications. In this area – as more generally – it is important that reforms and projects are designed in a way that allows assessments of impacts over time. But the available firm-level data suggests that distributional concerns do not undermine the wealth of evidence showing that trade facilitation can boost trade and real incomes across the globe.

So I say unto you, go forth and be less bureaucratic and multiply thy trading.

Reference:

• Hoekman, B, and B Shepherd (2013), “Who Profits from Trade Facilitation Initiatives?”, CEPR Discussion Paper 9490, May.

New challenges for bank competition policy

In a column at VoxEU.org Lev Ratnovski discusses New challenges for bank competition policy. In particular he asks How can bank competition policy support financial stability? His answer,

My analysis suggests three priorities:

First, help address ‘too-big-to-fail’.

The too-big-to-fail problem is a major prudential concern [...]. The Basel III capital surcharges for systemically important banks (up to 2.5% of risk-weighted assets) might be too small to give banks incentives to shrink. Bank competition policy can help address too-big-to-fail.

A blunt approach would be to use competition-policy tools to directly restrict bank size (by limiting mergers, forcing spin-offs, etc.). However it may be hard to restrict size on competitive grounds when banking is contestable and efficient. And since we do not know much about optimal bank size, blunt restrictions may have unintended effects.

A more nuanced approach would be price-based. Competition in banking is distorted because large banks have access to cheaper funding than small banks (thanks to the too-big-to-fail guarantee, as much as 80 basis points cheaper; [...]). Levelling the playing field is a natural area for competition policy. The funding advantage of too-big-to-fail banks can be offset through equivalent taxes or fines (think of a tax on wholesale funding of banks, with a rate that is increasing in bank size). This competition policy measure, as a by-product, would reduce excess incentives for banks to grow, reducing the too-big-to-fail problem.

There seems another obvious way to deal with too-big-to-fail, let the big fail.

Recent structural policy initiatives aim to restrict bank or non-bank activities that contribute to systemic risk [...]. These limits would have important interactions with competition policy.

The Volcker Rule and the Vickers and Liikanen proposals suggest restricting market-based and, to an extent, international activities of banks. The rationale is that such activities may contribute disproportionately to systemic risk [...]. From a competition perspective, these restrictions might also be desirable. They would allow authorities to use different approaches to less contestable (core) and more contestable (market-based and international) sectors of banking, resulting in a more precise competition policy.

Another structural problem highlighted by the Crisis is excess competition for retail deposits. Retail deposits are the most stable source of bank funding [...]. When deposits are scarce, banks have to rely on unstable wholesale funding. A common reason for the scarcity of deposits is excess competition for household savings – from insurance companies or asset managers (as in Australia or the Nordics) or from local savings banks with implicit public guarantees (as in Germany). Competition policy may help by pressuring governments to level the playing field – deal with implicit guarantees and lax regulation of non-banks.

If there is a problem with "implicit public guarantees" then do away with the guarantees. In short let banks fail.

The Crisis put into sharp relief possible conflicts between bank competition policy and crisis management [...]. Normally, competition policy advocates limited government involvement in banks in order to maintain a level playing field. Yet, crisis management may require governments to take ownership in banks or offer banks guarantees in order to maintain financial stability and the capacity to lend. Also, governments may need to exercise control over banks to direct their restructuring.

In such exceptional circumstances, competition policy should acknowledge the trade-off between preserving the level playing field versus effective bank resolution, and aim for a balance. Also, competition policy might need to temporarily allow higher banking-system concentration, when that is necessary to allow banks to rebuild charter values or to facilitate the shrinking of a previously over-expanded banking-system.

But does crisis management mean that governments have to take ownership of banks or offer banks guarantees? What is wrong with normal bankruptcy procedures? As Hart and Zingales have written,

As an example of an effective bankruptcy mechanism, one need look no further than the FDIC procedure for banks. When a bank gets into trouble the FDIC puts it into receivership and tries to find a buyer. Every time this procedure has been invoked the depositors were paid in full and had access to their money at all times. The system works well.

From this perspective, one must ask what would have been so bad about letting Bear Stearns, AIG and Citigroup (and in the future, General Motors) go into receivership or Chapter 11 bankruptcy? One argument often made is that these institutions had huge numbers of complicated claims, and that the bankruptcy of any one of them would have led to contagion and systemic failure, causing scores of further bankruptcies. AIG had to be saved, the argument goes, because it had trillions of dollars of credit default swaps with J.P. Morgan. These credit default swaps acted as hedges for trillions of dollars of credit default swaps that J.P. Morgan had with other parties. If AIG had gone bankrupt, J.P. Morgan would have found itself unhedged, putting its stability and that of others at risk.

This argument has some validity, but it suggests that the best way to proceed is to help third parties rather than the distressed company itself. In other words, instead of bailing out AIG and its creditors, it would have been better for the government to guarantee AIG's obligations to J.P. Morgan and those who bought insurance from AIG. Such an action would have nipped the contagion in the bud, probably at much smaller cost to taxpayers than the cost of bailing out the whole of AIG. It would also have saved the government from having to take a position on AIG's viability as a business, which could have been left to a bankruptcy court. Finally, it would have minimized concerns about moral hazard. AIG may be responsible for its financial problems, but the culpability of those who do business with AIG is less clear, and so helping them out does not reward bad behavior.