The Armchair Economist

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Landsburg summaries things thus far as:

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

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

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

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

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

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

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

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

Seems like good advance.

What Ends Recessions?

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

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

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

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

What have economists learned in the last year?

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

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

The four things are to do with

Revising The Chinese Economy

It's Not Just The Lenders

In Music, Hardware Rules

Lethal Cold Fronts

Combining Transaction Cost Economics and the Property Rights Approach

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

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

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

Evidence on Sarbanes-Oxley Act

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

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

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

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

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

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

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

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

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

SOX has also had some unintended consequences.

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

Incentives matter! Who would have guessed?

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

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

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

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

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

In conclusion Boyle and Grace-Webb say

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

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

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

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

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

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

A Primer on Fiscal Stimulus

As the US economy slows people from Larry Summers to Martin Feldstein are calling for a fiscal stimulus while Alex Tabarrok is against. Now Greg Mankiw brings to our attention a Primer on Fiscal Stimulus by Doug Elmendorf and Jason Furman to help us make sense of it all.

Kerr on the economics media (updated)

Roger Kerr asks Can The Media Help Promote Economic Literacy? in a column in the Otago Daily Times on Friday 11 January 2008. Kerr points out that

Speaking to the Journalism Education Association in Wellington recently, prime minister Helen Clark said she wished the New Zealand media were better informed about, among other things, economics.

This seems unlikely, the last thing politicians wants to face is an economically literate group of voters. Politicians survive in large measure because voters don't understand the true effects of their economic policies. For example, how many politicians support protectionist policies despite the fact that nearly all economists, from Adam Smith on, have attacked such ideas. Do politicians really want votes realising the true effects of these policies and agreeing with the economists?

Kerr also writes

Probably the resources of media organisations don't allow them to employ specialists of the calibre of The Australian's Alan Wood or the UK Financial Times' Martin Wolf.

Certainly newspapers may be unwilling to pay what is need to attract top economists to move into journalism. The opportunity cost of any economist who moves into journalism in this country would be high. One would think the top economic journalists around the world don't come cheap.

Kerr continues on to say

However, many media organisations do their best to compensate by featuring economic commentary by qualified people through articles and interviews

I'm not sure how true this is. If you look at papers like the New York Times columnists include the likes of Paul Krugman, Tyler Cowen and Alan B. Krueger, the Financial Times includes the likes of Lawrence H. Summers and John Kay. Steven Landsburg is economics columnist at Slate. In the US we have seen regular columns from economists of the standing of Paul Samuelson, Milton Friedman and Gary Becker in the past. I see no attempt to use academic economics in this way here in New Zealand. Are there any regular columns written by an academic economists in New Zealand?

Of course New Zealand's newspapers may be acting perfectly rationally. It may well be that readers of New Zealand's newspapers simply don't want to read about economics, in which case the lack of any serious economic comment is what we would expect.

Update: I came across the following comment in an article by Richard Baldwin, Professor of International Economics at the Graduate Institute in Geneva, Economic policy and the New Century public discourse.

With all these excellent tools at hand, one might have expected the newspapers and Parliamentary debates to be filled with new insights, new results and new approaches. Alas, with few exceptions, the public debate has not moved much beyond the simplistic pro- vs anti-market exchanges that have dominated Europe since the post-war rise of welfare states. Case in point? The 2007 French Presidential election debate.

In the 1980s, brilliant young economists like Paul Krugman, Larry Summers, Jeff Sachs and Joe Stiglitz felt obliged to write Brookings or Economic Policy articles, to sit on government panels, to write policy reports, and to send Op-Ed pieces to the Financial Times. At the time, it was part of the definition of a being a leading scholar. It helped you get tenure at Harvard. It also bridged the gap between cutting-edge research and the public debate on trade policy, exchange rates, current account dynamics, etc.

Today's brilliant young economists are much less interested in participating in the public debate in these ways. I have no empirical evidence to back up this opinion, but I think it is shared by many economists involved in economic policy issues and I had first-hand experience of it during my five years as a Managing Editor of Economic Policy. Young people need publications in good anonymously-reviewed journals; everything else is a luxury.

So the lack of academic involvement in public debate isn't just a New Zealand problem, Europe suffers as well. If this is so, then we have to ask What can be done about it? Do we need direct incentives for academics to become involved in public debate in their areas of expertise? If so, of what form?

Minto on property rights (updated x2)

In an article in the New Zealand Herald, John Minto, spokesperson for Global Peace and Justice in Auckland, shows he completely misunderstands the nature and importance of property rights. But he also show little understanding for the economics of poverty. Minto claims

The US has the highest levels of poverty in the Western world (more than 30 million) despite one of the highest per capita incomes in the world.

I assume this number 30 million comes from the US Census Bureau. What we learn from this site is that in 2006 12.3% of people are poor or 36.5 million people, not statistically different from 2005. We also learn that the poverty rate in 2006 was lower than in 1959, the first year for which poverty estimates are available. From the most recent trough in 2000, the rate rose for four consecutive years, from 11.3 percent in 2000 to 12.7 percent in 2004, and then declined to 12.3 percent in 2006 – a rate not statistically different from those in 2002 and 2003 (12.1 percent and 12.5 percent, respectively). The Age newspaper in Australia tells us that around 10% people are in poverty there. So US doesn't seem completely out of step with Australia.

What are we to make of the statement "The US has the highest levels of poverty in the Western world". Does his statement mean that other countries have a lower level of poverty because they have less than 30 million people in poverty? But the US has a larger population than most other Western countries so it is no surprise that they have a greater number of people in poverty.

Also we are told

Last year in the US the increase in income of the top 1 per cent of income earners was greater than the entire income of the bottom 20 per cent of the population. What this staggering statistic means is that the bottom 20 per cent of US citizens, all of whom live in poverty, could have had their incomes doubled if the wealthiest 1 per cent had simply forgone an increase in income last year.

Now 20% of the US population is around 60 million, all of whom are in poverty we are told. So what are we to make of the 30 million figure are are quoted before?

Also American economist Stephen Rose tells us, in a Washington Post article, that compared with 1979

... fewer people today live in households with incomes between $30,000 and $100,000 (a reasonable definition of "middle class") than in 1979. But the number of people in households that bring in more than $100,000 also rose from 12 percent to 24 percent. There was no increase in the percentage of people in households making less than $30,000. (My emphasis)

So the percentage of people in households making less than $30,000, which I assume includes the poor, has not increased over the last, roughly, 30 years. But the percentage of people in households that bring in more than $100,000 also rose from 12 percent to 24 percent. So it looks like people are doing better in the US over time.

There is also the question of how Minto plans on carrying out the income transfer from the "rich" to the "poor" implied in his statement "the bottom 20 per cent of US citizens, all of whom live in poverty, could have had their incomes doubled if the wealthiest 1 per cent had simply forgone an increase in income last year." After all if the "rich" know their income is to be taken from them why would they created it in the first place. Not good incentives for wealth creation. In addition Minto's statement would imply that economic activity is a zero-sum game, had the "rich" forgone their income increase, somehow the "poor" would have received it. But how?

Minto also tells us that

[Mike] Moore himself brings to the commission New Zealand's local experience in poverty creation. We have seen huge increases in poverty following policies introduced by the Labour governments of the 1980s, of which Moore was a Cabinet minister and briefly Prime Minister.

The 2005, Ministry of Social Development, Social Report Indicators for Low Incomes and Inequality: Update from the 2004 Household Economic Survey tells us

Figure 2 shows the trends in income poverty using this measure with the three thresholds. Regardless of which threshold is used, the proportion of the population with low incomes increased sharply in the early 1990s, reached a peak in the mid-1990s, and generally declined over the latter half of the decade. The decline continued from 2001 to 2004, with the drop at the 60% threshold being from 22% to 19%.

So according to these figures poverty increased from 1988 to the early-to-mid 90s and has been decreasing since. So Minto has to pick his time period carefully for his statement to be true. Also one could argue that the basis of the economic growth of the mid-to-late 90s, which reduced poverty, were the reforms started by the 84 Labour government.

Turning to Minto's view of the role property rights in people's well being we begin by noting that journalist Tom Bethell argues, in his book The Noblest Triumph: Property and Prosperity Through the Ages that

There are four great blessings that cannot easily be realized in a society that lacks the secure, decentralized, private ownership of goods. These are: liberty, justice, peace and prosperity. The argument of this book is that private property is a necessary (but not a sufficient) condition for these desirable social outcomes.

Harvard historian Richard Pipes in his book Property and Freedom says,

The idea occurred to be some forty years ago that property, ..., provides the key to the emergence of political and legal institutions that guarantee liberty.

Pipes sees the growth of legal protection for the individual in England as being closely associated with the recognition of property rights. He also sees that "the critical factor in the failure of Russia to develop rights and liberties was the liquidation of landed property in the Grand Duchy of Moscow," which resulted in the Russians being unable to limit the power of their sovereigns. In Pipes's view property rights have been a critical factor throughout history in the development of liberty.

Economist Hernando de Soto's book The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else is basically about poverty and he argues that most Third World poverty is both misunderstood, as John Minto shows, and unnecessary.

de Soto shows that there is tremendous amount of wealth generated by poor people in Third World countries. In many of the Third World countries, the legal economy is much smaller than the underground economy and the wealth of all the poor in total "dramatically outweighs the total wealth of the rich." But, and this is crucial, this wealth cannot be used, as you would expect to see it used in the west, as investments which lead to creation of still more income and wealth, thereby raising the standard of living of the poor. This simply because real estate, businesses and other assets in the Third world underground economies can not be used as collateral to raise capital to finance commercial or industrial expansion. Illegality also creates other economic problems.

Many businesses in the west are started by someone who used his or her home as collateral on the loan used to finance the business. But if the home is outside the legal system then the "owner" has no legal title and thus nothing that a bank will accept as collateral for the loan. This is also true for businesses created and run without having gone through all the necessary legal processes.

Those in the Third World "have houses but not titles, crops but not deeds, businesses but not statutes of incorporation." An obvious question is, Why then do they not get legal titles? In short because it can be an seriously difficult ordeal, especially if the people involved have little education and are in countries where red tape is virtually boundless.

de Soto examined the processes in a number of Third World countries. In Peru, for example, the process to get a legal title to your home "consists of 5 stages" and the first stage alone "involves 207 steps."

Another example is Egypt. Here anyone "who wants to acquire and legally register a lot on state-owned desert land must wend his way through at least 77 bureaucratic procedures at thirty-one public and private agencies." This process "can take anywhere from five to fourteen years." But it can be worse, in Haiti it can take up to 19 years!

Given this situation, it is not surprising that most economic activity in the Third World (and the former Communist countries) takes place outside the legal economy. When a combination of mad bureaucracy and frustrating legal systems force economic activity outside the legal economy, the losers are not just those actually carrying out these activities. The whole country loses when legal property rights are not readily available because investment is stifled. And when this happens investment doesn't take place, economic activity stagnates, and poverty remains. Minto should read de Soto's book since he seems to think that property rights are just privileges for the rich. But it is the poor who need them most, especially if they want to stop being the poor.

William Easterly makes the same basic point in his book The White Man's Burden: Why the West's Efforts to Aid the Rest Have Done So Much Ill and So Little Good,

Property rights also determine whether markets work. Do I have title to the land, building, and equipment making up my taco stand? Hernando de Soto noted in his great book The Mystery of Capital that the majority of land occupied by the poor urban majorities in the developing world does not have legal title-nobody owns it. Only if I felt secure that I would keep my taco stand would I invest in more sanitary food-processing equipment. I can borrow from a bank to purchase such equipment only if I have title to the property to put down as collateral. Only then will the bank feel secure that I will not abscond with the loan. Even then, the loans will be available only if the laws allow the bank to take my taqueria if I default on the loan. Property rights are also critical if I opt for incorporation. Lenders and shareholders need to feel secure that they really do have a claim on corporate property.

Property rights are an incentive to accumulate assets over time and across generations, which is often necessary to have the productive capacity to meet consumer needs. When I sacrifice consumption to buy land, factories, or other assets, I don't want someone else seizing the assets. For example, a man in Isla Trinitaria, Ecuador, cut back even on food and clothing to save enough to build up a small shellfish business. But he lost it all when the mayor seized the land.

What determines property rights? Alas, property rights are more complicated than the state enforcing them from the top down (and the state itself may be a thief, as the next chapter discusses). Property arises from a decentralized searching for solutions, just like the other complexities of markets.

[...]

Even countries with strong property rights today had those rights emerge gradually from the bottom up. American property rights did not spring full-blown from the minds of the Founding Fathers, ...

Recently the Institute of Economic Affairs in London released a book Paths to Property: Approaches to Institutional Change in International Development that makes the same point about the bottom up evolution of property rights. In this book authors Karol Boudreaux and Paul Aligica argue that the result of traditional approaches to development has, to a large degree, been failure. Boudreaux and Aligica point out that successful development requires the creation of sound political and legal institutions – in particular, secure and functional property rights. In their view clearly defined and enforced private property rights are needed to encourage entrepreneurship and thus economic growth.

But among policy-makers in there is ignorance about how to design, create and secure functional property rights systems in the developing world. To be successful programmes of property rights reform must recognise the complexity and uniqueness of existing property environments. Each individual context calls for its own tailed response. Universal one-size-fits-all solutions are likely to fail. Because there is no unique solution to fit all cases, one needs to think of property rights policy as a strategic process, not a blueprint-based social engineering undertaking. A process view of property rights reform shifts the attention from the creation of a static configuration of rules and laws to the creation of a flexible and resilient system which can adapt to changes in costs, technologies and social circumstances.

Again we see the importance of property rights to development and thus to the poor, who have most to gain from economic growth. But all of this is an anathema to Minto, for him "property rights often mean little, if anything, to people in poverty." Nothing could be further from the truth.

Update: As a addition to my message above, the best summary of the argument as to why property rights are important to the "poor" in a society I've come across (and only just found) comes from Thomas Sowell's book Applied Economics: Thinking Beyond Stage One. This is recommended reading for John Minto and his like:

Those who do not think beyond stage one often think of property rights as simply benefits to those fortunate enough to own property. This ignores the role of property rights as a key link in a chain of events that enable people without property to generate wealth for themselves and the whole society.

One implication of this is that some Third World countries could gain the use of more capital by making property rights more accessible within their own borders than by a ten-fold increase in the amount of foreign aid they receive. Moreover, the increased capital would be in the hands of millions of ordinary people, while foreign aid goes into the hands of the political elite. In short, although property rights are often thought of as things that are important primarily to the affluent and the rich, these legal recognitions of existing assets may be especially needed by poor individuals in poor countries, if they do not wish to continue to be poor. Millions of Third World people have already demonstrated their ability to create, in the aggregate, vast amounts of wealth, even if their tangled legal systems have not yet demonstrated an ability to let that wealth readily become property that can be used for further expansion and development. As Peruvian economist Hernando de Soto concluded, after a worldwide study of this phenomenon:

The lack of legal property thus explains why citizens in developing and former communist nations cannot make profitable contracts with strangers, cannot get credit, insurance, or utilities services. They have no property to lose. Because they have no property to lose, they are taken seriously as contracting partners only by their immediate family and neighbors. People with nothing to lose are trapped in the grubby basement of the precapitalist world.

Put differently, what property rights provide, in countries wherethese rights are readily accessible, is the ability of people to convert phvsical assets into financial assets, which in turn enables them to create additional wealth, whether individually or in combination with others. Property rights enable strangers to cooperate in economic ventures, some of which are beyond the means of any particular individual and must be undertaken by corporations which can mobilize the wealth of thousands or even millions of people, who cannot possibly all know each other. Moreover, property rights provide incentives to monitor their own economic activities more closely than government officials can-and protects them from the over-reaching caprices or corruption of such officials. In short, property rights are an integral part of a price-coordinated economy, without which that economy cannot function as efficiently. This in turn means that its people in general-not just property owners-cannot prosper as much as if it did operate more efficiently. (p.199-201)

Update 2: Owen McShane's response to Minto is here, One man's need is another's wealth (HT: Bryce W)

Blog rankings

The latest econblog rankings are out. Freakonomics at 1, Marginal Revolution at 2 and Greg Mankiw's Blog at 3.

Anti-Dismal, at ................ 199 equal. Oh well.

Truck and Barter and ... maybe Bandits

Arnold Kling responds to my post 1500 year old markets with Truck and Barter or Bandits? Kling argues

And it could very well be that the difference between voluntary trade and stolen goods is more of a continuum than a sharp distinction. It could be that markets have always been a mix of goods produced for voluntary trade and stolen goods. But for what it's worth, my picture of pre-modern markets is that they consisted mostly of stolen goods. My picture of modern markets is that they consist mostly of goods produced voluntarily with the intent of selling.

Personally I'm nearer the "voluntary trade" end of continuum than Kling. One reason for this is my reading the work of Morris Silver, in particular his 1995 book Economic Structures of Antiquity. Part II of the book, "Markets in Antiquity: The Challenge of the Evidence", contains two chapters; the first on "The Existence of Markets" and the second on "The Credibility of Markets". These chapters challenge Karl Polanyi's position that the ancient world did not know market activity. Which I'm assuming is, at least roughly, Kling's position as well. Silver presents 14 factual assertions that outline Polanyi's view and confronts them with the available evidence. All of the chapters are worth reading but let me pick out one assertion, number 8 - p.153, which I think is relevant.

As a general rule, the cities (e.g., Babyon) of the ancient world possessed no marketplaces of any significance. We First meet an important market for the retailing of food in the seventh century B.C. at Salamis in Asia Minor.

Silver argues on pages 153-6 that is is in fact wrong. "Free" markets do seemed to have existed. Silver writes,

Polanyi's assertion is nevertheless surprising because marketplaces - the geographic concentration of transactions-are a predictable and easily implemented adaptation to high information and transportation costs. In a world without daily newspapers, the location of similar trades in a compact area would have reduced the cost to consumers of acquiring information about prices and product characteristics. The resulting increase in information acquired would reduce price dispersion and help traders to interpret market signals accurately. The gains from reducing travel time between shops would be greatest for relatively standardized goods and for "search goods," whose quality is easily ascertained by inspection (Nelson 1970: 323-25). The benefits to consumers were not forgone because, despite Polanyi, there is ample evidence for marketplaces in the ancient Near East. (p.153-4)

Silver continues

Nehemiah 13.16 (fifth century B.C.E.) tells of the "men of Tyre . . . who brought in fish, and all manner of ware, and sold on the sabbath unto the children of Judah, and in Jerusalem." (p.154)

and

Edward Lipinski (personal correspondence) calls my attention to the phrase bab abulli, an expression designating the gate as a place where business is transacted. There are references in commercial contexts to the babtu "quarter of a city, neighborhood," a word arguably derived from babu. Texts of the earlier second millennium record that the copper of several individuals lies at Assur in the babtu and show merchants using silver from the babtu. Babylonian and Assyrian texts of the frist millennium speak of the "gate of buying." Note also the evidence of grain sales at Samaria's gate in the ninth century. Another Akkadian word, machiru, often has the abstract meanings "price, market value" and "commercial activity." Rollig (1976) has shown, however, that beginning in the Old Assyrian and Old Babylonian periods, machiru also has the concrete meaning "marketplace." The machiru is a place for macharu "receiving" goods. Slaves, garments, and grain are purchased in the marketplace and loans are repaid there. At Mari grain is "(measured) in the container (used in) the marketplace"; a tablet is written in Nuzi's marketplace and a stela with "correct prices" is set up in the marketplace. Again, loans are given, sacks are bought, and captured Arab camels are sold at the bib machiri "marketplace gate". In the Old Babylonian period bit machiri "seems to refer to the stall of a merchant. . . , small in size . . . and adjacent to other stalls".(p.154-5)

This I would interpret as being trade nearer the "voluntary trade" end of continuum than the "stolen goods" end.

Silver also points out, (p.156-66), that money was used in ancient economies, "[i]n fact, the ancient Near East knew money very well in the generic sense of common media of exchange" (p.157). If there was no voluntary trade, why would money be used on a widespread basis? After all Menger's explanation of the historical origin of money relies on trade.

1500 year old markets

From the New York Times comes a report that the ancient Maya civilization may have had a market economy,

Scientists using improved methods of analyzing the chemistry of ancient soils have detected where a large marketplace stood 1,500 years ago in a Maya city on the Yucatán Peninsula of Mexico.

The findings, archaeologists say, are some of the first strong evidence that the ancient Maya civilization, at least in places and at certain times, had a market economy similar in some respects to societies today.

Arnold Kling isn't buying into this. He writes,"I just don't believe that over a thousand years ago human beings had the trustworthiness, discipline, numeracy, and institutional base to engage in what we would today recognize as free trade." I'm not sure why. In his book, The Origins of Human Society, Peter Bogucki writes

One of the major advances in Maya research has been the identification of early trading networks, since the procurement of status goods such as jadeite, marine shell, quetzal feathers, and obsidian was linked with the emergence of elites. The site of Cerros, on the Caribbean coast of Belize, is particularly significant (Robertson and Friedel 1986). It lies on Chetumal Bay near the mouths of the New River and Rio Hondo, which lead into the interior of Belize. Not only was it well-suited to engage in coastal trade between the salt-producing areas of Yucatan to the north and the source area of obsidian and jade in Guatemala and El Salvador to the south, but from this location goods could also move into the interior of Belize and northern Guatemala. (p.348)

Why are there firms?

This is the question Michael Munger asks in his essay Bosses Don't Wear Bunny Slippers: If Markets Are So Great, Why Are There Firms? This is also the question Ronald Coase asked 70 years before. Munger asks

If prices and competition do such a terrific job of directing resources (and they do!), then why are there firms? Why are there hierarchical organizations that are internally directed by command and control, rather than the price system? Why not outsource everything? Why don't bosses sit home wearing bunny slippers?

Coase, clearly not a man for bunny slippers, explains his view of the problem this way,

However, in 1931, I had a great stroke of luck. Arnold Plant was appointed professor of commerce in 1930. He was a wonderful teacher. I began to attend his seminar in 1931, some five months before I took the final examinations. It was a revelation. He quoted Sir Arthur Salter: "The normal economic system works itself." And he explained how a competitive economic system co-ordinated by prices would lead to the production of goods and services which consumers valued most highly. [...] Plant had described in his lectures the different ways in which various industries were organised but we seemed to lack any theory which would explain these differences. I set out to find it. There was also another puzzle which, in my mind, needed to be solved and which seemed to be related to my main project. The view of the pricing system as a co-ordinating mechanism was clearly right but there were aspects of the argument which troubled me. [...] Competition, according to Plant, acting through a system of prices, would do all the co-ordination necessary. And yet we had a factor of production, management, whose function was to co-ordinate. Why was it needed if the pricing system provided all the co-ordination necessary? (The Institutional Structure of Production. The 1991 Alfred Nobel Memorial Prize Lecture in Economic Science, delivered 9 December 1991.)

Coase goes on to explain that he had

... found the answer by the summer of 1932. It was to realise that there were costs of using the pricing mechanism. What the prices are have to be discovered. There are negotiations to be undertaken, contracts to be drawn up, inspections to be made, arrangements to be made to settle disputes, and so on. These costs have come to be known as transaction costs. Their existence implies that methods of coordination
alternative to the market, which are themselves costly and in various ways imperfect, may nonetheless be preferable to relying on the pricing mechanism, the only method of co-ordination normally analysed by economists. It was the avoidance of the costs of carrying out transactions through the market that could explain the existence of the firm, in which the allocation of factors came about as a result of administrative decisions (and I thought it did explain it). (The Institutional Structure of Production. The 1991 Alfred Nobel Memorial Prize Lecture in Economic Science, delivered 9 December 1991.)

It was for his discovery and clarification of the significance of transaction costs and property rights for the functioning of the economy that Coase was awarded the 1991 Nobel Prize in Economics.

Munger explains Coase's answer this way,

His remarkable 1937 paper in Economica contained two key insights. First, firms are contractual means of reducing transactions costs. Division of labor requires groups, sometimes large groups, of workers. But it would be too expensive and time-consuming to negotiate sales of labor, services, and products at every stage of production. So, an entity called "the firm" is created, which specializes in directing these activities. Firms compete with each other, but within the firm, activities are directed by command and control.

Second, Coase argues that the optimal size of firms responds directly, though in undirected ways, to market forces. This is true both for vertical integration (owning suppliers, and retail outlets) and market share (the number of units sold, total). So the market is at work after all, since the expansion or contraction of the firm is directed by prices and the actions of consumers and suppliers. Firms that guess wrong, and expand (or contract) too much will lose profits, and may even be "selected" for extinction by bankruptcy.

Best two sentences of the day

Samuel Brittan from his Financial Times article, It is time to jettison the forecasts:

"More than 30 years ago, Denis Healey, a UK Labour chancellor of the exchequer, said he wanted to be to economic forecasters what the Boston Strangler was to door-to-door salesmen. Unfortunately, he did not succeed."

Economcis indocrtination

Stefan Theil, Newsweek's European economics editor, has an article - Europe's Philosophy of Failure - in the January/February 2008 issue of Foreign Policy outlining what passes for economics in some French and German schools. Theil opens his article with,

In France and Germany, students are being forced to undergo a dangerous indoctrination. Taught that economic principles such as capitalism, free markets, and entrepreneurship are savage, unhealthy, and immoral, these children are raised on a diet of prejudice and bias.

As far as France is concerned Theil writes,

"Economic growth imposes a hectic form of life, producing overwork, stress, nervous depression, cardiovascular disease and, according to some, even the development of cancer," asserts the three-volume Histoire du XXe siècle, a set of texts memorized by countless French high school students as they prepare for entrance exams to Sciences Po and other prestigious French universities. The past 20 years have "doubled wealth, doubled unemployment, poverty, and exclusion, whose ill effects constitute the background for a profound social malaise," the text continues. Because the 21st century begins with "an awareness of the limits to growth and the risks posed to humanity [by economic growth]," any future prosperity "depends on the regulation of capitalism on a planetary scale." Capitalism itself is described at various points in the text as "brutal," "savage," "neoliberal," and "American."

I would guess that being "American" is capitalism greatest sin. But Germany is little better,

Germans teach their young people a similar economic narrative, with a slightly different emphasis. The focus is on instilling the corporatist and collectivist traditions of the German system. Although each of Germany’s 16 states sets its own education requirements, nearly all teach through the lens of workplace conflict between employer and employee, the central battle being over wages and work rules. If there’s one unifying characteristic of German textbooks, it’s the tremendous emphasis on group interests, the traditional social-democratic division of the universe into capital and labor, employer and employee, boss and worker. Textbooks teach the minutiae of employer-employee relations, workplace conflict, collective bargaining, unions, strikes, and worker protection. Even a cursory look at the country’s textbooks shows that many are written from the perspective of a future employee with a union contract. Bosses and company owners show up in caricatures and illustrations as idle, cigar-smoking plutocrats, sometimes linked to child labor, Internet fraud, cell-phone addiction, alcoholism, and, of course, undeserved layoffs.

Globalisation is another hot topic all round the world. In student workbooks on globalization in Germany, students get to read about a number of different topics,

One such workbook includes sections headed "The Revival of Manchester Capitalism," "The Brazilianization of Europe," and "The Return of the Dark Ages." India and China are successful, the book explains, because they have large, state-owned sectors and practice protectionism, while the societies with the freest markets lie in impoverished sub-Saharan Africa. Like many French and German books, this text suggests students learn more by contacting the antiglobalization group Attac, best known for organizing messy protests at the annual G-8 summits.

One wonders what effect this has on the upcoming generations of voters in France and Germany. Politicians in democracies are in the business of agreeing with the preferences of the majority of their constituents, that's what gets them into power. So if future voters maintain the biases they have been taught this will continue to affect both election and policy outcomes in these countries.

It is worth noting that the Nobel Prize winning economist Edmund Phelps argues that attitudes and mind-sets affect the economic outcomes of a country. In Phelp's view attitudes towards responsibility, markets, work, and risk-taking are significant factors in explaining the variation in countries' actual economic performance. More so, in fact, than the factors which economists' normally consider, things like social spending, tax rates, and labour-market regulation etc. Europe's economic problems may not be quickly reversed.

Does Economic Development Reduce Terrorism?

The Becker-Posner Blog ask this question. Becker's comments are here, while Posner responds with Terrorism and Economic Development.

Economists and the public good

At Organisations and Markets, Peter Klein notes

An interesting result from Aaron Schiff’s survey of econo-bloggers (I was a respondent):

There [was] a series of questions asking respondents to rate factors according to their importance as motivations for blogging on a scale of 1 to 5. "Fun or entertainment," "To raise my profile," "Contribute to policy/political debates," "To educate the public or disseminate research." and "As a way of recording thoughts or ideas" were rated highest, all with a median score of 4. "Contribute to academic debates" had a median of 3, "To get reader feedback from comments" and "To improve writing skills" both scored 2, while "Actual or potential direct income" and "Actual or potential indirect income" both had a median of 1.

So we have economists providing public goods!

Politicisation of public firms

One problem with state ownership commonly pointed out by economists today is the politicisation of public firms. For example, Sowell (2007) discusses the situation of banks in India after nationalisation in 1969. He writes,

Moreover, government ownership and control lend to political influence in deciding to whom bank loans were made:

I once chanced to meet the manager of one of the rural branches of a nationalized bank. ... He was a sincere young man, deeply concerned, and he wanted to unburden himself about his day-to-day problems. Neither he nor his staff, he told me, decided who qualified for a loan. The local politicians invariably made this decision. The loan takers were invariably cronies of the political bosses and did not intend to repay the money. He was told that such and such a person was to be treated as a "deserving poor." Without exception, they were rich.

(Basic Economics: A Common Sense Guide to the Economy, 3rd Ed. p.426-7)

A local example of such concerns is the discussion of state-owned enterprise reforms in New Zealand by Spicer, Emanuel and Powell (1996). When discussing the pressures faced by the SOE model Spicer et al note that some politicians, public interest groups and parts of the media and the public wish to back away from the SOE corporate form and return to more direct forms of government ownership. With regard to this Spicer et al write,

As a consequence, political involvement in the policies and operations of these organisations would again become commonplace. Commercial objectives would once more be confused and mixed up with non-commercial considerations. This in turn can be expected to have direct effects on the strategies, organisation design and cost structures of SOEs and the motivations of their boards and managers. In this type of environment, boards and managers would be likely to explicitly build political considerations into their decision making as conflicting and irreconcilable demands are placed on them.The end result is likely to be a significant loss of accountability and control over performance. (Transforming Government Enterprises: Managing Radical Organisational Change in Deregulated Environments, p.199-200)

But a concern with politicisation of public firms is not new. John Jewkes in 1965 argued, with reference to British nationalised firms, that state owned industries could not help but be politicised,

Thus it is claimed that a government may take responsibility for some new public service but take the whole operation 'out of politics' and thereby escape any increase in its own administrative burdens. [...] Experience in the past twenty years suggests that that view is naive. Nationalization has not taken industries out of the political area. It has pushed them more firmly into it. (Public and Private Enterprise: The Lindsay Memorial Lectures given at the University of Keele 1964, p.13-4)

But even Jewkes was not saying anything new. The problem of politicisation of public firms had been noted before. M. N. Baker in 1899, for example, pointed out, with respect to waterworks in cities around the United States, that,

The absence of political considerations, generally speaking, from the management of private works, is undoubtedly a great advantage [...] Private companies ... certainly will not be accursed of lowering rates unduly for political effect, as cities sometimes do. ('Water-Works'. In Edward W. Bemis (ed.), Municipal Monopolies, New York: Thomas Y. Crowell and Company, p.41-2).

As is clear form the examples above the incentives facing government owned firms are very different from those facing a private firm. Sowell makes the point that

The incentives facing government enterprises tend to result in very different ways of carrying out their functions, compared to the way things are done in a free market economy. (Basic Economics: A Common Sense Guide to the Economy, 3rd Ed. p.426)

An example he gives is that after the nationalisation of banks in India uncollectible debts increased to 20 percent of all loans outstanding. Sowell also notes that efficiency suffered,

An Indian entreprenuer reported that "it takes my wife an hour to make a deposit or withdraw money from our local branch." (Basic Economics: A Common Sense Guide to the Economy, 3rd Ed. p.426)

The basic problem is, as Sowell puts it,

The nationalization of banks in India was not simply a matter of transferring ownership of an enterprise to the government. This transfer changes all the incentives and constraints from those of the marketplace to those of politics and bureaucracy. The proclaimed goals, or even the sincere hopes, of those who created the transfer often meant much less than the changed incentives and constraints. (Basic Economics: A Common Sense Guide to the Economy, 3rd Ed. p.427)

This, like so much in economics, boils down to the fundamental premiss, "people respond to incentives".

Friedman on the gift giving puzzle

David Friedman writes,

Economists, especially those familiar with Gary Becker's analysis of altruism, find the practice of giving gifts puzzling for two different reasons.

If, as a Becker altruist, I take your utility as one of the things I value, the obvious way to increase it is by giving you money and letting you spend it. While there are exceptions, in most other contexts we assume that each individual knows what is in his interest better than others do. Gifts, however, are usually things, not cash.

Becker altruism implies, roughly speaking, that from the altruist's point of view there is an optimum division of the combined income of altruist and beneficiary between the two, a division that maximizes the altruist's utility. If the beneficiary already has more than his share, the result is a corner solution--no transfer. If he has less, the altruist transfers money to him until that division is reached--that being the point at which an additional dollar of transfer costs the altruist as much in lost utility from his own reduced consumption as it gains him in increased utility from the beneficiary's consumption.

One implication of this is that, when transfers occur, they should be large. How likely, after all, is it that my beneficiary's share of our combined income, adding up to many tens of thousands of dollars, will be precisely five dollars less than the optimum? Yet gifts are usually small.

He then puts forward a possible solution to these puzzles.

On Export-Led Growth

Don Boudreaux has another excellent message on mercantilist trade policy at Cafe Hayek. Boudreaux writes

The January 5th edition of The Economist reports that China's recent economic growth is less dependent upon exports than is commonly believed. Reflecting on the widespread mercantilist myth that countries can prosper by exporting as much as possible and importing as little as possible led me to send the following letter to The Economist:

It's no surprise that "Contrary to popular wisdom, China's rapid growth is not hugely dependent on exports" ("An old Chinese myth," January 5). Just as no individual prospers by giving the fruits of his labor to others in exchange only for pieces of paper that he never spends, no group of people - including the Chinese - prospers by such a foolish strategy.

Exports are costs. They promote economic growth only if, in return, the exporters receive goods, services, and assets that improve their living standards and their capacity to produce. Any country that insists on exporting its produce and importing in return as little as possible is on a certain path to poverty.

Sincerely,
Donald J. Boudreaux

Yes, yes. Accumulating money might be a prosperity- enhancing strategy -- but only if that money is eventually spent. If it is never spent, all the exports shipped abroad in order to gather all this money turn out to be gifts given to foreigners. Any people foolish enough to permit their government to enforce such a strategy will enrich others and impoverish themselves.

One must ask why the mercantilist myth is still alive today. After all Adam Smith attacked the mercantilist system more than 200 years ago. As Gavin Kennedy has written,

Wealth of Nations contains a long polemic in the whole of Book IV against what Smith called the mercantile system, a deformed variation of the commercial system characterised by state interveintion in political economy, ostensibly to enrich the people, but really to enrich the State (i.e., the sovereign). (Adam Smith's Lost Legacy, p.162)

Kennedy continues,

Mercantile doctrine begins from the observation that sovereign states fight foreign wars and need the wherewithal to do so. Allegedly, they do this best by accumulating gold and silver in peacetime and spending bullion on their armies in wartime. This led to the spurious policy (futile too, for it only promoted lucrative smuggling trades) of prohibiting the export of gold or silver. To this policy, a balance of trade embellishment was added: export more than you import, because by curbing imports using taxes (tariffs) and prohibitions, and by allowing gold and silver bullion from foreigners to flow into the country to pay for their trade deficits, rather than out of the country to pay for ours, the State grew strong enough militarily to thwart attempts by envious neighbours to encroach on our territory. The mercantile system, in these terms, was a neat but fallacious policy for credulous governments inclined to warfare as an instrument of State policy. (Adam Smith's Lost Legacy, p.162)

And yet we see that such a "spurious and fallacious policy" is in fact all too alive and well in this age, despite the efforts of Adam Smith (and most economists since his time).

Blinder on Inequality and Trade

Greg Mankiw points us towards this New York Times article by Alan Blinder on trade and inequality. Blinder writes,

Many Americans are justifiably distressed about rising income inequality, but foreign competition gets far too much of the blame. In fact, the best and most comprehensive studies of the inequality question assign international trade only a bit part in the drama. The main protagonists are all domestic, including changes in technology, the decline of unions, failures of public policy and changing social attitudes toward inequality.

A point that should be understood by all of us, not just Americans.

Are Libertarians "Anarchists"?

This is the question address by Murray Rothbard in an article which was written in the mid-1950s under the byline "Aubrey Herbert," a pseudonym Rothbard used in the periodical Faith and Freedom. It was never published, until now. The Ludwig von Mises Institute have made the article available online at Are Libertarians "Anarchists"?. Rothbard concludes his article with,

We must conclude that the question "are libertarians anarchists?" simply cannot be answered on etymological grounds. The vagueness of the term itself is such that the libertarian system would be considered anarchist by some people and archist by others. We must therefore turn to history for enlightenment; here we find that none of the proclaimed anarchist groups correspond to the libertarian position, that even the best of them have unrealistic and socialistic elements in their doctrines. Furthermore, we find that all of the current anarchists are irrational collectivists, and therefore at opposite poles from our position. We must therefore conclude that we are not anarchists, and that those who call us anarchists are not on firm etymological ground, and are being completely unhistorical. On the other hand, it is clear that we are not archists either: we do not believe in establishing a tyrannical central authority that will coerce the noninvasive as well as the invasive. Perhaps, then, we could call ourselves by a new name: nonarchist. Then, when, in the jousting of debate, the inevitable challenge "are you an anarchist?" is heard, we can, for perhaps the first and last time, find ourselves in the luxury of the "middle of the road" and say, "Sir, I am neither an anarchist nor an archist, but am squarely down the nonarchic middle of the road."

Krugman v. Krugman

In a recent New York Times article Paul Krugman again suggests that trade with low-wage countries poses real problems for high-wage America. Don Boudreaux, the Chairman of the Department of Economics at George Mason University, has sent the following excellent letter in response,

Paul Krugman again insists that trade with low-wage countries - especially China - threatens to depress wages in America ("Dealing With the Dragon, January 4). So I again refer Mr. Krugman (the shrill pundit) to Dr. Krugman (the skilled scholar of trade).

In his excellent 1996 essay "Ricardo's Difficult Idea," Dr. Krugman pointed out that wages are determined by worker productivity. Therefore, low wages reflect low productivity. This fact, once grasped, reveals that low-wage countries have no general competitive advantage over high-wage countries. Dr. Krugman continued: "Someone like [James] Goldsmith [a protectionist] looks at Vietnam and asks, 'what would happen if people who work for such low wages manage to achieve Western productivity?' The economist's answer is, 'if they achieve Western productivity, they will be paid Western wages' - as has in fact happened in Japan."

Substitute "Mr. Krugman" for "Goldsmith," and "China" for "Vietnam," and Dr. Krugman's learning should calm Mr. Krugman's fears.

An Inconvenient Year

From Dave Barry we get a retrospective of 2007. An Inconvenient Year: Relive the zany antics of Al Gore, Leonardo DiCaprio, Madonna and a cast of thousands in 12 months we need to remember to forget is published in the Washington Post.

5 Myths About How Americans Vote

Bryan Caplan has a article in the Washington Post on 5 Myths About How Americans Vote.

1. People vote their self-interest

2. Unselfish voting will solve our problems.

3. Voters' errors balance out.

4. Political disagreement is all about values.

5. Voters want serious change.

Something tells me these are not only myths about the way Americans vote, but myths about how we all vote.

Are Journal Impact Factors Reliable?

The answer given by Peter Klein at Organisation and Markets is "not really". Klein writes,

Thompson (formerly ISI) uses an imprecise and inconsistent method to compute journal impact factors and, even worse, refuses to release the raw data so that scores can be independently verified. Journals typically require authors to make data public as a condition of publication; why use rankings based on hidden data? Writes RePEc: “[A]ll of us should treat impact factors and citation data with considerable caution. Basing journal rankings, tenure, promotion, and raises on uncritical acceptance of [these] data is a poor idea.”

It would be nice to have more information about the magnitude and direction of the potential bias. Do these problems affect the rank ordering of journals, or simply the precision of the point estimates? Is there any research on this problem?

Paths to Property

A new book has been published by the Institute of Economic Affairs in London. The book, Paths to Property, is by Karol Boudreaux and Paul Dragos Aligica of the Mercatus Center, George Mason University, USA. In it Boudreaux and Aligica argue that contrary to the conventional wisdom provety in Africa will not be solved by the wealthy countries sending even more foreign aid. But the use of legislative-top-down "market solutions" will also not work. While markets and property rights are essential for prosperity these must emerge from the bottom up.

Without proper enforcement of property rights and contracts, businesses cannot raise capital and cannot conduct business except with people they know and trust intimately. In the extreme, as in Zimbabwe, all economic life can grind to a halt.

The role of government, the book argues, should be to formalise the informal systems of property rights that develop within communities. Governments in developing countries and overseas aid agencies should avoid the use of privatisation "blueprints" that ignore traditional norms and customs. The "easy option", used by agencies in developing countries, of working to a blueprint to try and recreate institutions in Africa that work the West often fails. The failures of such approaches can give the whole privatisation and property rights process, vital for sustainable economic growth, a bad name.

Boettke on misinformation about "free market ideology"

This article in the New York Times on the "free market ideology" induced the following response from Peter Boettke at The Austrian Economists blog:

The problem is that various statements in the piece are so misinformed theoretically, empirically, and policy application wise that it is hard to know where to start to set the matter straight. But the article is extremely useful as a means to remind us as economic educators that our work is cut out for us and that it does take varied reiterations to force alien concepts upon reluctant minds.

Kahneman on happiness and wealth

Some interesting comments by the psychologist, and 2002 winner of the Nobel Prize in Economic Sciences, Daniel Kahneman on happiness and wealth, appear in "The sad tale of the aspiration treadmill". Kahneman tells us

The most dramatic result is that when the entire range of human living standards is considered, the effects of income on a measure of life satisfaction (the "ladder of life") are not small at all. We had thought income effects are small because we were looking within countries. The GDP differences between countries are enormous, and highly predictive of differences in life satisfaction. In a sample of over 130,000 people from 126 countries, the correlation between the life satisfaction of individuals and the GDP of the country in which they live was over .40 – an exceptionally high value in social science. Humans everywhere, from Norway to Sierra Leone, apparently evaluate their life by a common standard of material prosperity, which changes as GDP increases. The implied conclusion, that citizens of different countries do not adapt to their level of prosperity, flies against everything we thought we knew ten years ago. We have been wrong and now we know it. I suppose this means that there is a science of well-being, even if we are not doing it very well.

Adam Smith Was Not a 'Proto-Marxist'

Gavin Kennedy is this time defending Adam Smith against the charge of being a proto-marxist. Kennedy explains that

Because it is fashionable to make the connection between Adam Smith and Karl Marx (or Ricardo), it does not follow that this assertion is true. It is another distortion of Adam Smith's legacy.

The issue is Smith's use of the labour theory of value. Kennedy shows that Smith's view was that in 'rude' society (hunting) the sole basis of exchange value was labour but as society developed labour was no longer the sole basis of exchange value.

In-outsourcing

At CARPE DIEM Mark J. Perry asks if outsourcing saves 15-20% on average and American women earn, on average, 77 cents for each dollar made by men, why isn't work being outsourced to American women? That is, the gap between American men and women is higher than the cost savings from overseas outsourcing, so why not have American women doing the work?

Unnecessary opulence

At the Free Exchange blog they are discussing a New York Times article by Jared Diamond in which he lays out the crux of the environmental challenge we'll likely face over the next century. The Free Exchange explains,

Many of those sceptical about humanity's ability to reduce the threat and impact of climate change view this situation in a relatively straightforward manner--fixing the problem either means reducing our standard of living or stunting the improvement of living standards in developing nations. Since neither is likely to take place, our best hope is investing in magic technologies which may allow us to continue to consume at current levels.

The Free Exchange blogger then goes on to argue

My perspective is a bit different. Both developed and developing economies can continue to grow, so long as everyone--and particularly the most wasteful among us--becomes a bit more efficient. The best way to encourage such efficiency, it seems, is to price overused resources or overproduced pollutants to account for environmental externalities. Where greenhouse gases are concerned, this should mean an increase in the cost of carbon, via tax or cap-and-trade regime. The advantages of such a system are significant: the lowest-hanging fruit are picked first, no hard limits are placed on economic growth, return on efficient technologies increases, and developing nations may profit from preservation of valuable natural resources.

The question is then asked "Can we be confident, however, that strict environmental regulation is compatible with economic growth?" In answer to this it is noted that research carried out by Arik Levinson of Georgetown University has looked at American manufacturing since 1972 and points out that in the last three decades, manufacturing output has increased 70 percent while manufacturers' emissions of primary pollutants have dropped by 58 percent.

Mr Levinson tests whether that drop in pollution is attributable to outsourced production from America to places with lax environmental rules. In fact, he finds that such shifts are not at all the primary source of emission reductions in manufacturing. Rather, 60 percent of the gap between output growth and emission decline has resulted from technological innovation.

This result can be explained by standard trade theory. Counties like America have a comparative advantage in the production of pollution creating goods and thus such production is carried out at home, and not sent overseas.

Review Papers on Personnel Economics

Peter Klein at Organizations and Markets draws our attention to two review papers on Personnel Economics. One is a new NBER working paper by Edward P. Lazear and Paul Oyer entitled Personnel Economics, the other is also an NBER working paper with the title Personnel Economics: The Economist's View of Human Resources. It is by Lazear and Kathryn Shaw and destined for a future issue of the Journal of Economic Perspectives. Klein comments

These reviews emphasize the generality of the economic approach and argue that it explains observed HR practices, such as the rising variance in pay across individuals, increased use of pay-for-performance schemes, greater reliance on teamwork, and the like better than rival theories.

Evonomics

The January 2008 issue of Scientific American includes an interesting article by Michael Shermer, Evonomics: Evolution and economics are both examples of a larger mysterious phenomenon. In it Shermer writes,

As with living organisms and ecosystems, the economy looks designed — so just as humans naturally deduce the existence of a top-down intelligent designer, humans also (understandably) infer that a top-down government designer is needed in nearly every aspect of the economy. But just as living organisms are shaped from the bottom up by natural selection, the economy is molded from the bottom up by the invisible hand.

The correspondence between evolution and economics is not perfect, because some top-down institutional rules and laws are needed to provide a structure within which free and fair trade can occur. But too much top-down interference into the marketplace makes trade neither free nor fair. When such attempts have been made in the past, they have failed—because markets are far too complex, interactive and autocatalytic to be designed from the top down. In his 1922 book, Socialism, Ludwig von Mises spelled out the reasons why, most notably the problem of "economic calculation" in a planned socialist economy. In capitalism, prices are in constant and rapid flux and are determined from below by individuals freely exchanging in the marketplace. Money is a means of exchange, and prices are the information people use to guide their choices. Von Mises demonstrated that socialist economies depend on capitalist economies to determine what prices should be assigned to goods and services. And they do so cumbersomely and inefficiently. Relatively free markets are, ultimately, the only way to find out what buyers are willing to pay and what sellers are willing to accept.

Evonomics helps to explain how Yanomamö-like hunter-gatherers evolved into Manhattan-like consumer-traders. Nineteenth-century French economist Frédéric Bastiat well captured the principle: "Where goods do not cross frontiers, armies will." In addition to being fierce warriors, the Yanomamö are also sophisticated traders, and the more they trade the less they fight. The reason is that trade is a powerful social adhesive that creates political alliances. One village cannot go to another village and announce that they are worried about being conquered by a third, more powerful village—that would reveal weakness. Instead they mask the real motives for alliance through trade and reciprocal feasting. And, as a result, not only gain military protection but also initiate a system of trade that—in the long run—leads to an increase in both wealth and SKUs.

SKUs are Stock Keeping Units, a measure of the number of types of retail products available.

The Liberal Skew in Higher Education

The latest posting on the Becker-Posner blog is by Posner on The Liberal Skew in Higher Education. Comments by Becker are under the title, Events, Field, and the Liberal Skew in Higher Education. Posner begins by noting,

A recent paper by two sociology professors contains a useful history of scholarship on the issue and, more important, reports the results of the most careful survey yet conducted of the ideology of American academics. See Neal Gross and Solon Simmons, "The Social and Political Views of American Professors," Sept. 24, 2007, available at http://www.wjh.harvard.edu/~ngross/lounsbery_9-25.pdf (visited Dec. 29. 2007)

Posner then states the findings of the survey as

In the sample as a whole, 44 percent of professors are liberal, 46 percent moderate or centrist, and only 9 percent conservative. (These are self-descriptions.) The corresponding figures for the American population as a whole, according to public opinion polls, are 18 percent, 49 percent, and 33 percent, suggesting that professors are on average more than twice as liberal, and only half as conservative, as the average American.

Interestingly "[t]he Gross-Simmons study notes that the liberal skew is not limited to the United States, but is found in Canada, Britain, and much of Continental Europe, as well." I should point out that liberal in all of this is in the American sense of the word.

Posner then goes on to deal with the question, What is the explanation for the results?

Becker's comments start "by concentrating on the effects on academic political attitudes of events in the world, and of their fields of specialization." He then considers "whether college teachers have long-lasting influences on the views of their students".

These articles are an interesting read and they do raise the question, How different is New Zealand in this regard? My guess would be, not very.

The economic isolationists are winning

So says Greg Mankiw. He notes that a new poll from NBC News/Wall Street Journal (conducted Dec. 14-17, 2007) asked:

"Do you think the fact that the American economy has become increasingly global is good because it has opened up new markets for American products and resulted in more jobs, or bad because it has subjected American companies and employees to unfair competition and cheap labor?"

The result:

28 % of the American public said globalization is good, while 58 % said it is bad.

Mankiw also notes the mercantilist approach to the question,"In actuality, trade is not primarily about more or fewer jobs but about allocating labor among industries toward those in which we have a comparative advantage." A good point.

I wonder if the result would be any different here in New Zealand? It could be because trade is such a obvious and important part of our economy.

Wine and restaurants

In his book Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don't, John Lott makes the interesting argument that some drinks -tea, coffee and wine for example- cost more in restaurants than in stores because people linger longer over over meals that include them. The addition cost is a table rental charge. The longer people spend over a meal the more money the restaurant loses by not being able to sell extra meals to other people at that table. So the high cost of wine in a restaurant amounts to an opportunity cost. This cost is in addition to the inventory cost of having to hold stocks of many different types of liquor.

But this does raise a question, What about BYOs? People linger just as long over a bottle of wine they bring as opposed to one they buy from the restaurant, so how do BYOs recover the rental costs of a table? The inventory costs will be less for BYOs but they still have the opportunity cost of a table. Do meals cost more in BYOs than in licensed restaurants, all else constant? Do BYOs have faster turnover of customers, to reduce table opportunity costs?

Markets and movies

Frederic Sautet at The Austrian Economsits blog points out that "... some movie stars get paid way more than they should considering the income they generate with their movies." But he also points out that the market adjusts to "stars" whose movies don't make money, "[h]owever, as the profitability of an actor goes down, so does the interest of producers" and he notes that, for example, Jim Carey is not being paid up front for his latest movie, Yes Man.

Competition law and Adam Smith

Gavin Kennedy ends the old year with an interesting comment on state of competition law in the time of Adam Smith. The title of the blog posting, at Adam Smith's Lost Legacy, says it all "In Adam Smith's Day Cartels Were Legal". Kennedy writes,

Well, in pure fact that was the case, but Adam Smith’s point was far more serious than the absence of laws against cartels.

Wealth Of Nations contains his critique of mercantile political economy. A singular feature of the time was the legalization, and statutory protection of cartels! Adam Smith’s complaint about ‘trades’ was precisely about their legal status.

The whole article is well worth a read.