Where I'll be on Friday and Saturday .......

I'll be at the 4th Australian Workshop on Experimental Economics which is taking place at Canterbury on Friday and Saturday. Alan Wood, in The Press here in Christchurch, had this to say about the Workshop this morning,

The control of asset bubbles such as the ones that impacted the dotcom world, property markets and commodities is just one topic for an "experimental economics" workshop in Christchurch.

The University of Canterbury will on Friday and Saturday host the conference to be attended by "leading economists" from around the world.

The workshop is organised by Dr Maros Servatka and Dr Steven Tucker, experimental economists from the university's department of economics and finance.

In conjunction with the workshop the university is establishing a "New Zealand Experimental Economics Laboratory (NZEEL)", a purpose- built experimental economics laboratory with private rooms and observation areas.

Tucker said the fact the fourth Australasian workshop on experimental economics had moved outside its previous hosting place - the University of Melbourne - for the first time was a coup for Canterbury.

Topics to be presented during the two-day workshop include the world's "financial meltdown" and creation of asset bubbles, market institutions and the effect they might have on the behaviour of firms and consumers, and altruistic behaviour by individuals.

Experimental economics tried to use a methodology to test theories within "controlled laboratory experiments" to create economic parameters that were not observable in the real world, Tucker said.

"We actually bring in human subjects into this laboratory to make decisions within this environment which we create."

One of his co-authors Volodymyr Lugovskyy, was presenting from their paper "An experimental study of bubble formation in asset markets using the tatonnement pricing mechanism", Tucker said. The paper was also co-written by Daniela Puzzello.

They were reporting the results of an experiment designed to study the role of institutional trading systems or structures in the formation of bubbles and crashes in laboratory asset markets.

In the study they had employed the tatonnement trading institution - not previously explored in laboratory asset markets - with the results showing bubbles were eliminated. This was a much different trading system than the standard "double auction" used, for example, at the New York Stock Exchange.

The tatonnement system was an auction in which participants were together bidding and selling assets at many different price intervals. Prices are raised or lowered depending on demand.

Tucker said the area of experimental economics - using controlled experiments within a laboratory setting to study economic behaviour - was relatively young. A prime mover behind the studies had been Vernon Smith, who in 2002 was awarded (jointly with Daniel Kahneman) a Nobel memorial prize in economic sciences.

The establishment of a New Zealand Experimental Economics Laboratory as the main experimental economic research centre in New Zealand.

The thinktank would be of potential help to Kiwi companies in areas such as bargaining, and beneficial outcomes in business.

"We have just been granted the right for our research centre in experimental economics. We approached the vice-chancellor Rod Carr . . . and he awarded [money to] our proposal for the development of the lab," Tucker said.

Keynote speakers for the Workshop are: Tim Cason - Purdue University, Martin Dufwenburg - University of Arizona, Charles Noussair - Tilburg University and James C. Cox - Georgia State University.

Speakers will include: Morris Altman - Victoria University Wellington, Ananish Chaudhuri - Auckland University, Stephen Cheung - University of Sydney, Lana Friesen - University of Queensland, Ben Greiner - University of New South Wales, Anna Gunnthorsdottir - University of Sydney, Volodymyr Lugovskyy - Georgia Institute of Technology, Vai-Lam Mui - Monash University, Nikos Nikiforakis - University of Melbourne, Joerg Oechssler - University of Heidelberg, Maro Servtka - University of Canterbury, Robert Slonim - University of Sydney, Steven Tucker - University of Canterbury, Richard Watt - University of Canterbury and Tom Wilkening - University of Melbourne.

The program for the event is available here.

Personally I'm looking forward to hearing Maros's paper on Sense of Unity and the Hold-up Problem: A Behavioral Study of Firm Boundaries. The issue of how hold-up determines a firm's boundaries, via a reduction in hold-up problems because of vertical integration, is still not fully understood, so hopefully Maros's paper will be throw some light an important issue in the theory of the firm.

Hayek and the common law

At Cato Unbound the topic of the moment is Hayek and the Common Law.

Among non-economists, Nobel laureate Friedrich A. Hayek is perhaps best known for two things: his seminal book The Road to Serfdom, and his defense of the theory of spontaneous order. Briefly stated, the theory of spontaneous order holds that many of the most useful social institutions are the product of human action, but not of human design.

Examples abound. No one individual or committee sets market prices; those who have tried have always failed. No designer created the English language, and artificial languages have never met with any great success. Scientific discovery through repeated experiment causes truth to emerge, but scientific truth is not forged through rationalistic design. Instead, it is a product of many uncoordinated searches, serendipity, and replication across the scientific community.

Arguably the greatest example of spontaneous order outside the market, however, is the development of the common law, a legal tradition that proceeds incrementally, case by case, privileging precedent and continuity. No one individual or committee created the common law. Indeed, it is said that the common law is discovered by judges rather than created by legislatures. The common law is robust for the same profound reason that markets and language are robust, and each therefore deserves great deference.

Yet, argues lead essayist Timothy Sandefur, there are problems with the concept of spontaneous order, especially as it regards the law. As virtually everyone acknowledges, the mere fact that a law has been in force for a very long time doesn’t necessarily prove its rightness. Hayek, too, allowed that the common law may change over time, and he attempted to integrate this notion into the theory of spontaneous order. Yet there are clearly some changes that are not properly a part of spontaneous order. How do we separate the good changes from the bad? We must seemingly reach outside the spontaneous order for our normative supports.

Commenting on Sandefur’s essay will be legal and business scholar John Hasnas of Georgetown University, economist Daniel Klein of George Mason University, and economic historian and Hayek biographer Bruce Caldwell of Duke University.

Sandefur's essay is here, John Hasnas's comment is here, Daniel Klein's comment is here and Bruce Caldwell's comment is here.

What have we learnt about the theory of the firm?

My question of the day. In a recent paper I used a 1989 quote from Oliver Hart about the state of our understanding of the theory of the firm,

“An outsider to the field of economics would probably take it for granted that economists have a highly developed theory of the firm. After all, firms are the engines of growth of modern capitalistic economies, and so economists must surely have fairly sophisticated views of how they behave. In fact, little could be further from the truth. Most formal models of the firm are extremely rudimentary, capable only of portraying hypothetical firms that bear little relation to the complex organizations we see in the world. Furthermore, theories that attempt to incorporate real world features of corporations, partnerships and the like often lack precision and rigor, and have therefore failed, by and large, to be accepted by the theoretical mainstream.” (Hart 1989: 1757).

In recent correspondence (from November 2008), Professor Hart said of the 1989 quote

“The language of 1989 is strong, and I’d probably tone it down a bit now. There’s been a lot of work in the last twenty years, and some progress. However, we are still not at the point where we have good models of the internal organization of large firms.”

So I’m left wondering, What have we really learnt over the last 20 years? Have we really made any process in understanding the organizations that we refer to as firms? I have trouble in trying to think of what we have learnt.

Take, as an example, the point that there doesn’t even seem to be agreement on a definition of a firm. Alchian and Demsetz (1972) started a literature which argues that there is no real difference between markets and firms and so it is not generally useful to talk about firms as distinctive entities. The Grossman/Hart/Moore approach on the other hand thinks of firms as a collection of non-human assets under common ownership. Others see the firm in terms of the employment relationship. This seems a very basic point for there to be no agreed upon answer.

So, are we really any further advanced than we were 20 years ago?

• Alchian, Armen, and Harold Demsetz (1972). ‘Production, Information Costs, and Economic Organization’, American Economic Review, 62(5) December: 777-95.
• Hart, Oliver D. (1989). ‘An Economist’s Perspective on the Theory of the Firm’, Columbia Law Review, 89(7) November: 1757-74.

Incentives matter: tax file

The incentive effects of taxes are well appreciated by most people, if not by governments. The following comes from a piece, Hundreds of bosses flee UK over 50% tax by Robert Watts and Maurice Chittenden, in The Sunday Times, December 13, 2009:

Britain’s financiers and entrepreneurs are quitting the UK at a rate of 10 a week to avoid Labour’s new 50% taxes.

The burgeoning exodus threatens to deepen a £178 billion black hole in the public finances and leave middle-class voters with higher taxes for years to come, figures obtained from Companies House reveal.

The number of directors of British businesses registered as living in the low-tax centres of Jersey, Guernsey or the Isle of Man has risen by almost 500 to 6,729 in the past 12 months.

The British Virgin Islands is also a popular destination, with 615 directors of UK companies now based in the Caribbean tax haven — an 18% rise on a year ago.

Those known to be fleeing the UK include hedge fund managers, property tycoons, bankers and people who made their money setting up companies organising private healthcare, call centres and luxury holidays.

May be not all governments ignore the incentive effects of taxes, some try to take advantage of them. The article notes that a new marketing brochure published by the island of Jersey’s authorities promises “in Jersey, keep more of what you earn”.

Boettke on Samuelson

Over at the Austrian Economists blog Peter Boettke has a posting on Paul Samuelson. With regard to Samuelson two most famous books, Economics and Foundations of Economic Analysis, Boettke writes,

His Economics became the leading textbook for college freshman, and his Foundations became the leading text for first-year graduate students in economics.

When you scratch the surface of Economics you find Keynesianism at each turn of the page, when you scratch the surface of Foundations you find economics as social physics at each turn of the page. That Keynesian policies are best served by social physics was Samuelson's true legacy for the economic imagination of multiple generations of economics, policy commentators, and policy makers. The discipline of economics was transformed from a tool for understanding and social criticism and an instrument for intellectual enlightenment, to a tool for social engineering and an instrument for progressive politics.

More importantly Boettke argues that Samuelson helped push economics down the wrong road,

John Hicks once wrote that the story of economics in the 1930s was the battle between Hayek and Keynes. I think Hicks is right, and that this battle continues to this day as witnessed in our current policy debates. But I think there is a deeper debate that goes at the very project of economics as a scientific discipline. And that battle is the one between Samuelson and Mises, and the fateful choice was the late 1940s. Rather than following Mises's Human Action, the economics profession went the path of Samuelson's Foundations. Formalism was intereprted as synonymous with logical rigor, and in the subsequent decade positivistic testing was interpreting as synonymous with empirical analysis. By the 1960s, formalism and positivism transformed the science of economics so that the Misesian understanding of "theory" and "history" was actually completely dismissed as a relic of a pre-scientific age.

Since then a large part of the great efforts by economists have been directed at recapturing insights that Mises-Hayek possessed already by mid-century --- whether we are talking about cognitive limits of man, the role of property rights (and legal and political institutions in general and behavior related to them), and the microfoundations of all macroeconomic phenomena. New institutional Economics, New Classical Economics, New Economic History, Experimental and Behavioral Economics, etc. all deviate in significant ways from the scientific and policy project that Samuelson initiated in the late 1940s and which dominated economic thinking from that time until the 1980s. The Samuelsonian project had to be pecked away at for progress in economic understanding to take place. Yet the 'scientific' allure of the project still remains --- unfortunately even among many of those who pecked away at the Samuelsonian project. The pretense of knowledge (see Hayek's Nobel) and the claim to the mantle of science (see Rothbard's paper of that title) have a much stronger grip on the minds of economists and intellectuals than what might be reasonably expected in the wake of repeated failures.

I'm not sure how much the positivistic testing route was really due to Samuelson, Friedman may have more to answer for there. But Samuelson did have a great effect, or good or bad, on the approach that economists take to doing theory.

EconTalk this week

Arnold Kling of EconLog and the author (with Nick Schulz) of From Poverty to Prosperity: Intangible Assets, Hidden Liabilities and the Lasting Triumph over Scarcity talks about the book with EconTalk host Russ Roberts. Kling discusses how modern economists think about growth in both developed and undeveloped countries and contrasts those ideas with earlier views in economics. The focus of the modern understanding is on ideas and the ability of ideas to improve technology, leading to prosperity. Unlike physical capital, ideas can be enjoyed by many people at once, explaining why past models that ignored ideas and focused on physical capital failed to account for the observed magnitude of economic development. Kling also discusses the success of China and India.

FairTrade, mostly a marketing gimmick?

At Marginal Revolution Tyler Cowen offers up some Facts about FairTrade. Cowen writes,

We might think of sub-Saharan subsistence economies when we think of Fairtrade, but the biggest recipient of Fairtrade subsidy is actually Mexico. Mexico is the biggest producer of Fairtrade coffee with about 23% market share. Indeed, as of 2002, 181 of the 300 Fairtrade coffee producers were located in South America and the Caribbean. As Marc Sidwell points out, while Mexico has 51 Fairtrade producers, Burundi has none, Ethiopia four and Rwanda just 10 – meaning that "Fairtrade pays to support relatively wealthy Mexican coffee farmers at the expense of poorer nations".

The article offers many other points of interest. For instance:

By guaranteeing a minimum price, Fairtrade also encourages market oversupply, which depresses global commodity prices. This locks Fairtrade farmers into greater Fairtrade dependency and further impoverishes farmers outside the Fairtrade umbrella. Economist Tyler Cowen describes this as the "parallel exploitation coffee sector".

Coffee farms must not be more than 12 acres in size and they are not allowed to employ any full-time workers. This means that during harvest season migrant workers must be employed on short-term contracts. These rural poor are therefore expressly excluded from the stability of long-term employment by Fairtrade rules.

The Guardian article Cowen refers to also says,

However, economist Paul Collier argues that Fairtrade effectively ensures that people "get charity as long as they stay producing the crops that have locked them into poverty". Fairtrade reduces the incentive to diversify crop production and encourages the utilisation of resources on marginal land that could be better employed for other produce. The organisation also appears wedded to an image of a notional anti-modernist rural idyll. Farm units must remain small and family run, while modern farming techniques (mechanisation, economies of scale, pesticides, genetic modification etc) are sidelined or even actively discouraged.

One wonders what New Zealand's farming sector would look like if run by FairTrade.

Another point made in the Guardian article is

Another criticism is over institutional inefficiencies. The vast majority of the money from Fairtrade sales remains in the west – with only about 5% of the Fairtrade sale price actually making it back to the farmers. As Philip Oppenheim says, "any intelligent person will ask why I should pay 80p more for my bananas when only 5p will end up with the producer".

Scientific peer review, ca. 1945

I reckon things haven't changed all that much in 60 years.

Unintended consequences of environmentalism: LED traffic light edition

Steven Horwitz at the Austrian Economists blog explains that

Apparently a number of communities in the Green Bay, WI area recently installed some energy-conserving LED traffic lights as an environmentalist gesture. The unintended consequence? The lights don't give off enough heat to melt ice and snow, which means during snowstorms the lights are obscured by the snow, which has led to a number of automobile accidents. The further result is that city crews have had to manually scrape the lights.

Horwitz goes on to note

So in attempting to save a fractional amount of energy, we have not only risked human life and limb (and perhaps damaged some), we have caused a number of unnecessary accidents, each of which will require various forms of energy-usage to fix (everything from tow-trucks to body shops use energy you know), and we have diverted human labor from more highly valued uses (such as clearing other roads to prevent further accidents) to scraping traffic lights that should not have needed scraping in the first place.

The unrelenting pressure of protectionism

At VoxEU.org Simon J Evenett has a column on The Unrelenting Pressure of Protectionism: The Global Trade Alert's Third Report. The full report is available here.

The third report of the Global Trade Alert is published today. It contains:

1. The latest assessment of protectionist dynamics at work in the world economy, with a focus on the second half of 2009 to see whether the welcome news of economic recoveries in many countries has feed through into less protectionist pressure.
2. A focus on the Asia-Pacific region: a separate assessment of who is imposing what forms of protectionism in that region and which nations are getting hurt by crisis-era protectionism.
3. An analysis showing the differential impact of crisis-era beggar-thy-neighbour policies on the exports of the leading sectors of the Japanese economy.
4. A comparison between the products and trading partners targeted by antidumping investigations before and during the crisis.
5. Accounts of the impact of the crisis on the trade policy priorities of China, India, and Russia.

Evenett notes that,

Many economies may have turned the corner in the second half of the year, but protectionist pressures have not relented. If anything, recent evidence suggests that the protectionist dynamics were worst in the first three quarters of 2009 than the Global Trade Alert reported in September 2009. For sure, protectionism hasn't yet reached the scale of the 1930s--but water doesn't have to boil to scald.

and

Concerning governments' resort to protectionism, the main findings are:

1. Since the first G20 crisis-related summit in November 2008, the governments of world have together implemented 297 beggar-thy-neighbour policy measures; that is, more than one for every working day of the year. Add another 56 implemented measures that are likely to have harmed some foreign commercial interests, the total reaches 353.
2. Since the GTA's last report was published in September 2009, the number of beggar-thy-neighbour measures discovered (105) was more than eight times the number of benign or liberalising measures (12). Looking back on all of the measures implemented since November 2008, the ratio of blatantly discriminatory measures to liberalising measures stands at nearly six to one.
3. When examining quarter-by-quarter changes in protectionism, experience has taught us that many beggar-thy-neighbour acts only come to light with delay. This fact alone has had an important impact on the number of discriminatory measures reported in the GTA database in the last quarter of 2008 and first two quarters of 2009. In the GTA's second report it was estimated that in the first half of this year approximately 70 measures that likely harmed foreign commercial interests were imposed by governments. This estimate is now revised upwards by 20-25 percent; conservatively estimated, governments imposed 85 protectionist measures per quarter during the first half of 2009.
4. In the light of this finding, the reported number (78) of discriminatory measures implemented in the third quarter of 2009 is not far short of this quarterly average, especially when one bears in mind that this figure will almost certainly be revised upwards as more information about protectionist acts comes to light.
5. 5. Particular caution is needed in interpreting the reported figure of 38 harmful measures imposed in the fourth quarter of 2009. First of all, this figure only refers to measures announced or implemented in October and November 2009, two out of the three months of the quarter. Moreover, prior experience suggests that information about many recent protectionist measures taken by governments is not yet in the public domain. For these reasons, the very recent fall off in the number of discriminatory measures is more apparent than real.

Other key findings about contemporary protectionist dynamics found in this Report are:

1. During the past three months the number of state measures announced which--if implemented would likely harm foreign commercial interests--has expanded from 134 to 188. The protectionism in the pipeline keeps growing--there is no respite here. This protectionist overhang could limit the contribution of exports to economic recovery.
2. Since the last G20 Report was published in September 2009, every one of the top 10 most targeted countries has been hit a minimum of 20 more beggar-thy-neighbour state measures. China has been hit by 47 more measures (the most), followed by the USA (32 more measures) and Germany (21 extra hits.) Many nations retain a strong interest in monitoring and discouraging foreign protectionism, even as economic recovery takes told.
3. On the GTA's four indicators of harm done by a nation's commercial policy, the Russian Federation is always in the top 5 worst offending nations. Meanwhile, China and Indonesia are always in the top 10 worst offenders. If the measures taken by each EU member state were aggregated, then the European Union would always appear in the list of top 10 worst offenders.
4. Since the last GTA report was published, bailouts and trade defence measures account for the overwhelming majority of new discriminatory state measures. Recently, the action is in these two policy instruments, with tariff increases running a distant third.
5. Tariff increases account for only one in seven of the total number of discriminatory state measures imposed in the current global economic downturn. This calls into question how representative of contemporary protectionism, the much-studied, easy-to-measure, and typically-transparent tariff increase is.
6. Looking ahead, the basic metals and basic chemical sectors could be affected by over 30 pending measures. Should these announced--but not yet implemented measures--actually come into force over the next year or so, both sectors will eclipse the financial sector as the principal sector most affected by crisis-era protectionism.

All of which is bad news.

Paul Samuelson has died

This from the New York Times.

Paul A. Samuelson, the first American Nobel laureate in economics and the foremost academic economist of the 20th century, died Sunday at his home in Belmont, Mass. He was 94.

"the foremost academic economist of the 20th century" may be going a bit far, given the likes of Keynes or Friedman, depending on our point of view.

Samuelson was properly best known to most people for his textbook,

Mr. Samuelson wrote one of the most widely used college textbooks in the history of American education. The book, “Economics,” first published in 1948, was the nation’s best-selling textbook for nearly 30 years. Translated into 20 languages, it was selling 50,000 copies a year a half century after it first appeared.

In the 13th edition of Economics Samuealson offered up this assertion:

"[T]he Soviet economy is proof that, contrary to what many skeptics had earlier believed, a socialist command economy can function and thrive."

13 does seem to have been unlucky.

Doing economics at Goldman Sachs

In this audio from VoxEU.org, Jim O’Neill, head of global economic research at Goldman Sachs, talks to Romesh Vaitilingam about the crisis and its impact on the emerging giants of the world economy, the BRICs (Brazil, Russia, India and China). They also discuss the value of economic research in both the commercial and academic spheres, and how the economics profession has come out of the crisis.

How the resource curse works its anti-magic

Roughly the resource curse says that countries and regions with an abundance of natural resources, specifically point-source non-renewable resources like minerals and fuels, tend to have less economic growth and worse development outcomes than countries with fewer natural resources. A question often asked is, Why?

Now a new paper looks at how the resource curse can actually work. The paper is Do Oil Windfalls Improve Living Standards? Evidence from Brazil by Francesco Caselli and Guy Michaels, NBER Working Paper No. 15550, issued in December 2009. The abstract reads,

We use variation in oil output among Brazilian municipalities to investigate the effects of resource windfalls. We find muted effects of oil through market channels: offshore oil has no effect on municipal non-oil GDP or its composition, while onshore oil has only modest effects on non-oil GDP composition. However, oil abundance causes municipal revenues and reported spending on a range of budgetary items to increase, mainly as a result of royalties paid by Petrobras. Nevertheless, survey-based measures of social transfers, public good provision, infrastructure, and household income increase less (if at all) than one might expect given the increase in reported spending. To explain why oil windfalls contribute little to local living standards, we use data from the Brazilian media and federal police to document that very large oil output increases alleged instances of illegal activities associated with mayors.

Michael Giberson at the Knowledge Problem blog writes about the paper,

Most of the body of the paper is taken up with a discussion of data sources and the analysis by which they conclude that royalties paid by PetroBras to municipalities do increase municipal budgets, but seem to generate very little in the way of a broader increase in income or welfare.

From this comes the obvious question, What is happening to the oil revenues?

To partly address this question we put together a few pieces of tentative evidence. First, oil revenues increase the size of municipal workers’ houses (but not the size of other residents’ houses). Second, Brazil’s news agency is more likely to carry news items mentioning corruption and the mayor in municipalities with very high levels of oil output (on an absolute, though not per capita, basis). Third, federal police operations are more likely to occur in municipalities with very high levels of oil output (again in absolute terms). And finally, we document anecdotal evidence of scandals allegedly involving mayors in several of the largest oil producing municipalities, some involving large sums of money. To partly explain why senior municipal workers may have thought that they could “get away” with large-scale alleged theft in a country where local elections are held regularly, we note that a survey in the largest oil producing municipality found considerable ignorance among residents regarding the scale of the municipal oil windfall.

Do we really need a central bank?

This question is asked by Steve Horwitz. On December 2, 2009, Horwitz gave the following speech at The Future of Freedom Foundation’s “Economic Liberty Lecture Series.”

Economic Liberty Lecture Series: Steve Horwitz from The Future of Freedom Foundation on Vimeo.

Prices responding to supply and demand

Strange but true. Thanks to Homepaddock we learn that

News release – South Island wool price movements reflect levels of supply

NZ Wool Services International Ltd reports prices at today’s South Island wool auction saw wool supply factors driving price movements, with prices of different types rising or falling depending on the quantity of wool available.

Who would have thought, prices depend on the supply available. Is this really news?

Nobel prize lecture by Elinor Ostrom

This 28 minute video is of the Nobel prize lecture on "Beyond Markets and States: Polycentric Governance of Complex Economic Systems" given by Elinor Ostrom who is the co-winner of the 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Ostrom delivered her Prize Lecture on 8 December 2009 at Aula Magna, Stockholm University. This video was downloaded from the Nobelprize.org. The video here is based on the "low quality" (20mb) version. There is also a "high quality" (100mb) version available.

Nobel prize lecture by Oliver Williamson

This 38 minute video is of the Nobel prize lecture on "Transaction Cost Economics: The Natural Progression" given by Oliver Williamson who is the co-winner of the 2009 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel. Williamson delivered his Prize Lecture on 8 December 2009 at Aula Magna, Stockholm University. This video was downloaded from the Nobelprize.org. The video here is based on the "low quality" (27mb) version. There is also a "high quality" (137mb) version available.

The lecture slides from Williamson's talk are available (pdf 126 kb) from Nobelprize.org.

Chinese vs. Russian reforms

An article in Policy Review by Paul R. Gregory and Kate Zhou on How China Won and Russia Lost. The article looks at two dissimilar paths towards economic reform. What worked and why?

Take agricultural reform in China and Russia as an example,

The results in each country could not have been more different. Chronically depressed Chinese agriculture began to blossom, not only for grain but for all crops. As farmers brought their crops to the city by bicycle or bus, long food lines began to dwindle and then disappear. The state grocery monopoly ended in less than one year. Soviet Russian agriculture continued to stagnate despite massive state subsidies. Citizens of a superpower again had to bear the indignity of sugar rations.

These two examples point to the proper narrative of reform in Gorbachev’s Russia and Deng Xiaoping’s China. Our narrative contradicts much received doctrine. The standard account is that China succeeded because a wise party leadership deliberately chose gradualism, retained the monopoly of the Communist Party after rebuffing democracy at Tiananmen Square, and carefully guided the process over the years. The narrative says that Russia failed because the tempestuous Gorbachev ignored the Chinese reform model, moved too quickly, and allowed the party monopoly to fall apart. This standard account is incorrect.

How did liberating electricity markets in Texas work out?

There is a new book out that asks this question. Electricity Restructuring: The Texas Story, edited By L. Lynne Kiesling and Andrew N. Kleit.

In the early 1990s, the U.S. electricity industry was plagued by cost overruns and stagnant productivity. Many states turned to deregulation to promote innovation and cut costs, a strategy that had worked for the telecommunications, trucking, natural gas, and airline industries. Yet, after the California energy market's infamous meltdown in 2000-2001 triggered the recall election of Governor Gray Davis, deregulation lost popular and political support. Plans to introduce competition and retail choice in electricity markets were stalled or abandoned nationwide--in every state but Texas.

This volume explores how Texas's groundbreaking program of electricity restructuring has become a model for truly competitive energy markets in the United States. The authors contend that restructuring in Texas has been successful because the industry is free from federal oversight within the state; because new investments in electricity supply have been encouraged to insure that increased demand for power is met; because restructuring has spurred the growth of more efficient electricity technologies and business models; because the markets integrate wholesale and retail competition; and because the operation of the transmission grid has been changed to maximize its efficiency.

The success of electricity restructuring in Texas proves that deregulation is both feasible and potentially effective. State policymakers' commitment to competition, decentralized coordination, and ongoing market analysis have made Texas's electricity industry the most competitive in the country. Electricity Restructuring: The Texas Story offers a unique set of guidelines for deregulation done right.

A lesson here for New Zealand ... and our Commerce Commission?

(HT: Edward J. Lopez at Division of Labour)

The folly of economic forecasts

In this podcast at Plant Money Russ Robert, George Mason University economist and host of EconTalk, says he has come to believe it's impossible to predict future economic conditions because good data is so hard to come by and even harder to compare. So what about all his fellow economists who seem to have an opinion on almost any topic? Roberts says they should come out and tell the truth -- that their policy recommendations are based on philosophy and ideology, not on empirical data.

The Coase theorem at work?

In the US, Illinois instituted a smoking ban in bars and restaurants in January 2008. What happened? This comes from Lynne Kiesling at the Knowledge Problem blog.

The Crowbar, on the southeast side of Chicago near the Indiana border, provides an experiment on precisely this point. The bar’s owner takes donations to pay for the fines that he is charged for allowing smoking:

Owner Pat Carroll said his customers — smokers and nonsmokers alike — contribute to a “smoking fund” canister that often sits on the bar, to subsidize the fines he’s incurred for flouting the law.

Carroll said he’s been ticketed twice and paid at least $680. He fears that if he forbids smoking, his cigar-and-cigarette crowd would switch to bars that permit smoking just a few blocks away in Indiana. …

But some smokers say they’ll support any tavern that gives them sanctuary. Laura Pugh said she contributes $5 a month to Crowbar’s smoking fund, considering it akin to membership fees at a private club. If she couldn’t smoke there, Pugh said she’d probably go to a bar in Indiana.

First, notice what the legislation has done in terms of redefining property rights. In essence smokers are purchasing the right to smoke, because the legislation makes the default property right the non-smoker’s right to clean air.

If the legislators in Illinois had read Coase's 1960 paper "The Problem of Social Cost" they may have been able to workout that their law wouldn't effect the outcome. If the law leads to an inefficient allocation of property rights then smokers will just buy the right to smoke from the non-smokers, as in this case they are effectively doing.

Interesting blog bits

1. MacDoctor on Laid to Rest. It is time to lay the myth that cellphone use causes cancer to rest.
2. Brad Taylor says Well Done, Danish Sex Workers.
3. Mark J. Perry says We Live Longer Than Ever, Food's Never Been Cheaper, Economy's Never Been More Efficient. At least in the US.
4. Greg Mankiw on The Pigou Club talks to the Senate. A good thing?
5. Al Roth on The market for blood plasma. Is money tainting the plasma supply?
6. Eric Crampton points out Reasons to distrust petitions. People sign a petition to raise the inflation rate. No I'm not having you on.
7. Daniel Gros explains Why a cap-and-trade system can be bad for your health. The purpose of a cap-and-trade system is to help in the fight against global climate change. This column warns that a unilateral approach could increase global emissions by shifting production to more carbon-intensive methods abroad. Acting alone, the EU’s Emission Trading Scheme may be doing more harm than good.
8. Matt Nolan on A little bit of filler on monetary policy: An addition to the Dom article

Intergenerational accounting

(HT: Peter Boettke at The Austrian Economists)

A couple of interesting seminars

Over the next two weeks the Econ Department is running two interesting looking seminars:

December 11 (Friday in Room 534 (Commerce Building) beginning at 3:10pm)

An Equilibrium Model of the New Zealand Electricity Market

Lew Evans, Victoria University of Wellington

Abstract

The seminar presents results of a thesis that is complete but has not been submitted. It sets out a general equilibrium model of the New Zealand electricity market. The model includes thermal and hydro generators, stochastic inflows to storage, transmission frictions, and generator decisions that are based upon the proper value of (stored) water. The model is simulated and the results compared to the experience of the New Zealand market and to the approach of the "Wolak Report".

and

December 16 (Wednesday in Room 534 (Commerce Building) beginning at 3:10pm)

Martin Dufwenberg, University of Arizona

Hold-Up: With a Vengeance

Abstract

When contracts are incomplete or unenforceable, inefficient levels of investment may occur due to hold-up. If individuals care for negative reciprocity these problems may be reduced, as revenge becomes a credible threat. However, negative reciprocity has this effect only when the investor holds the rights of control of the investment proceeds. We explore this issue analytically, deriving predictions for hold-up games which differ as regards assignment of rights of control. We also test and support these predictions in an experiment.

The perfect way to spend your afternoon.

Alfred Marshall and hold-up

In their paper "Reflections on the Theory of the Firm", Journal of Institutional and Theoretical Economics, 143 (1987), 110- 136, Armen Alchian and Susan Woodward use the following example of hold-up,

We first acknowledge the forgotten precedence of Alfred Marshall, who in his principles [1890] identified "composite quasi-rent". First, a quasi-rent is the excess above the return necessary to maintain a resource's current service flow. It is a recovery of sunk costs. Composite quasi-rent is that portion of the quasi-rent which depends on continued association with some other specific resources, and consequently is vulnerable to expropriation. Marshall's compelling example of such vulnerability was a steel mill that locates near a public utility and makes investments which depend on being able to buy power at some given price. Once the steel mill's investment is complete and the sunk costs are sunk, the utility can raise the price of power and the steel mill will continue to operate because marginal cost, even with the higher cost of power, still exceeds marginal revenue, even though the sunk costs are not being recovered.

Now there is an obvious problem with the "marginal costs ... exceeds marginal revenue" bit at the end of the quote but my question is aimed at example of the steel mill and a public utility. Marshall's Principles first came out in 1890 and the eighth edition appeared in 1920. Given this timing what are the chances that Marshall would use the example of a steel mill and power producer? Was the technology even available at this time to make the example credible?

EconTalk this week

Megan McArdle, who writes the blog Asymmetrical Information at The Atlantic, talks with EconTalk host Russ Roberts about debt and the challenge of self-restraint. She discusses her recent Atlantic article on her experience at a Dave Ramsey personal finance seminar, how it affected her life, and the psychology of self-restraint. The conversation concludes with a discussion of debt and savings during the Great Depression and the current national debt of the United States.

Making migration work after the crisis

In this audio from VoxEU.org Demetrios Papademetriou, president and co-founder of the Migration Policy Institute in Washington DC, talks to Romesh Vaitilingam about the key elements of wise migration policy both at a time of economic crisis and for the longer term.

Brash to Garth George (updated)

In the New Zealand Herald Garth George attacked the report of the 2025 Taskforce. Don Brash has now replied to the George attack

Garth George was way off beam in his attack on the first report of the 2025 Taskforce.

Leaving aside the personal invective, he claims that the "biggest absurdity" in the report is the proposition that New Zealand can and should catch up with Australia.

He says that "there is just no comparison between the two countries", with Australia having five times our population, 32 times our land area, and huge resources of minerals. Well, those are factual statements about Australia, but they ignore some important facts which he would be aware of had he read the report.

First, there is no correlation between living standards and population - if there were, India would be super-rich and Singapore would be poor.

Second, there is no correlation between living standards and land area - if there were, Russia would be super-rich and Finland would be poor.

Third, there is no correlation between living standards and mineral wealth - if there were, the Congo would be super-rich and Japan would be poor.

In any event, a recent World Bank study showed that, in per capita terms, New Zealand has more natural resources than almost any other country in the world.

For most of New Zealand's history, our standard of living has been very similar to that in Australia - sometimes a bit ahead, sometimes a bit behind.

And the Taskforce didn't off its own bat decide that catching Australia again by 2025 would be some good idea: the goal was set by the Government itself, and the Taskforce was set up both to advise on how best to achieve the (very challenging) goal and to monitor annually progress towards achieving it.

Too often in the past, governments have announced grandiose commitments to lift living standards - such as the last Government's commitment to lift us into the top half of developed countries within 10 years - but then totally ignored those commitments, hoping that nobody would notice it. It is to the Government's credit that they made a commitment and then established a mechanism to hold them to account.

Garth George accuses the Taskforce of recommending a whole range of things which we do not recommend.

For example, he accuses us of recommending a flat personal income tax, and notes that if such a tax were established a whole range of low income people would have to pay more tax.

But whatever the merits of a flat tax, the Taskforce did not recommend such a tax. What we did say was that, if core government spending were cut to the same fraction of GDP that it was in both 2004 and 2005 (29 per cent), the top personal rate, the company tax rate, and the trust tax rate could comfortably be aligned at 20 per cent. Under such a tax structure, all those earning above $14,000 a year would pay less income tax, while nobody would pay more income tax.

Nobody seriously argues that government was vastly too small in New Zealand in 2004 and 2005 (the end of the Labour Government's second term in office), so why the ridiculous reaction when the Taskforce suggests reducing government spending to that level?

Mr George also suggests that we recommended abolishing subsidised doctor visits, and implies that we are advocating an American approach to healthcare. This is again utter nonsense. We suggested targeting subsidies for doctor's visits at those who need them, either because they have low incomes or have chronic health problems.

He suggests that we favoured removing subsidies for early childhood education. Again, not true. What we said was that those subsidies - which have trebled in cost from $400 million a year to $1.2 billion a year over the last five years - should be focused on those who need them.

The recommendations of the 2025 Taskforce are actually totally in line with orthodox thinking in most developed countries, and are almost entirely consistent with the recommendations of the recent OECD report on New Zealand.

I agree with Brash in that the recommendations of the Taskforce are in line with orthodox economic thinking. As I have noted before there is

[n]othing particularly new or radical in any of this. There are a number of good ideas in contained within the recommendations. Things like a flatter tax system and restraints on government spending. The water rights trading scheme is an ideas whose time has come. More privatisation is an idea whose time has come again. Welfare, education and labour market reform is clearly needed, etc. But the devil is in the detail, so how successful any actual reform would be would depends on the details of that reform. Not that the government will have the balls to take action on any reform.

If George really wants to get upset about something to do with the 2025 report then I would suggest the lack of government action in implementing the recommendations of the taskforce should be his target.

Update: Not PC has been writing about 2025 and all that, Kiwiblog notes that Brash responds to George, Homepaddock points out that Brash responds to George and that there is No conspiracy in the fact that the Herald did not print the rebuttal earlier.

Pigou on state action

This is from an article by Arthur Cecil Pigou in a 1954 issue of the journal Diogenes. (It was also reprinted in the third edition of the fantastic collection, Great Political Thinkers: Plato to the Present edited by William Ebenstein.)

It must be confessed, however, that we seldom know enough to decide what fields and to what extent the State, on account of them, could usefully interfere with individual freedom of choice. Moreover, even though economists were able to provide a perfect blueprint for beneficial State action, politicians are not philosopher kings and a blueprint might quickly yield place on their desks to the propaganda of competing pressure groups. ‘Fancy’ finance, like a fancy franchise, whatever its theoretical attractions, has, at all events in a democracy, dim practical prospects.

So according to Pigou you can't implement Pigouvian taxes.

(HT: Mario Rizzo at ThinkMarkets)

Sumner on Selgin

George Selgin's monograph Less than Zero: The Case for a Falling Price Level in a Growing Economy, is one of the most well known defences of the productivity norm and its implied price deflation in the face of increased productivity. Under a productivity norm, monetary policy would allow permanent improvements in productivity to lower prices permanently. Thus the idea that there are good and bad types of deflation. The basic point is that bad deflation is driven by demand shrinking while good deflation is caused by supply expanding. The good kind of deflation is the result of increases in productivity.

In this blog posting Scott Sumner raises a number of interesting issues about Selgin's argument. Sumner's preliminary response to the Selgin argument,

1. The productivity norm as a monetary policy regime? It’s OK with me if it is OK with you (meaning my fellow Americans.)

2. Mild deflation at the rate of productivity increase? Yes, but only if several stringent preconditions are met. And we haven’t yet met them.

Note that Selgin responds to a couple of Sumner's points in the comments. Well worth a read.

Just for fun: theory of the firm 10 (updated)

In an provocative and interesting paper written for the Markets, Firms and Property Rights: A Celebration of the Research of Ronald Coase conference, Harold Demsetz articulates a somewhat non-standard view of the firm as it appears in the neo-classical model of the competitive economic system. A common attack, one which I would make, on the neo-classical model is that it has no theory of the firm in it. It is a theory with firms but without a theory of firms. The model has no theory of the structure and methods of firms and no theory of why a firm should even exist in an economy in which prices are treated as the sole guides to the opportunities available for putting resources to work. As Foss, Lando and Thomsen (2000: 632) summarise it:

"The pure analysis of the market institution leaves almost no room for the firm (Debreu 1959). Under the assumption of a perfect set of contingent markets, as well as certain other restrictive assumptions, the model describes how markets may produce efficient outcomes. The question how organizations should be structured does not arise, because market-contracting perfectly solves all incentive and coordination issues. By assumption, firm behaviour (profit maximization) is invariant to institutional form (e.g. ownership structure). The whole economy can operate efficiently as one great system of markets, in which autonomous agents enter into very elaborate contracts with each other. However, by treating the firm itself as a black box, where internal structure, contracts, etc. disappear from the picture, there are many other issues that the theory cannot address. For example, the theory does not tell us why firms exist".

Demsetz takes issue with all of this. He argues that the neo-classical model offers both a definition of the firm and a rationalisation for the existence of firms, but, he notes, these are mostly implicit. For Demsetz the concern of the neo-classical model is with the function of the firm. The function is what defines the neo-classical firm: this function being the production of goods and services for purchase by persons who, in the main, are not involved in the production of what they buy. The firm is an institution specialised in production for use by others. The rationale for the existence of firms in this theory is implicit in this function. They exist because specialisation is productive.

But what form does this institution being called the firm take? Demsetz explains that the internal organisation of the firm is largely irrelevant to the neoclassical theory of a private, decentralized economic system. If the firm has no internal organisation, then how does production take place? The view of the firm Demsetz is arguing for is one in which the theoretical task served by the firm is that of creating a grand coordination problem whose resolution is sought in the price system. He argues this view of the firm is very different from that of Ronald Coase. For Coase the firm stands in contrast to the market, it becomes less vertically integrated and less important in the economic system the smaller are the costs of using the price system, ie lower are the costs of using the market. For Demsetz the firm stands in contrast to self-sufficient production within households. The firm becomes more important the lower is the cost of using the market. This is simply because low transaction costs facilitates the substitution of specialised production destined for others for self-sufficient production for oneself. The lower is the cost of using the price system the more effectively firms can bring their products to consumers and the more effective are households in supplying inputs to specialised producers.

I think this still leaves the question of the institutional structure that production takes place in unanswered. If production does not take place via Coase-type firms, how does it take place? Is it, as the Foss, Lando and Thomsen quote above would suggest, taking place via groups of autonomous agents who enter into very elaborate (complete) contracts with each other. That is, production takes place over the market. If this is so it would, in turn, make the firm look, perhaps unsurprisingly, like a "nexus of contracts".

The nexus of contracts view was developed in papers by Alchian and Demsetz (1972), Jensen and Meckling (1976), Barzel (1997), Fama (1980) and Cheung (1983). The important innovation here was to see that it is difficult to draw a line between firms and markets, firms are seen as a special type of market contracting. What distinguishes firms from other forms of market contract is the continuity of the relationship between input owners.

Most famously in the Alchian and Demsetz version of this approach, they argue that the authority relationship between the employer and employee is in no way the defining characteristic of a firm. The employer has no more authority over an employee than a customer has over his grocer. "Firing", of either the employee or grocer, is the ultimate punishment that either the employer or customer can use in cases of "disobedience". Alchian and Demsetz argue that, in economic terms, the customer "firing" his grocer is no different from the employer firing his employee. In both cases one party stops dealing with the other, terminating the "contract" between them. In this approach the firm is seen as little more than a nexus of contracts, special only in its legal standing and characterised by long term nature of the relationship between the input owners. In this approach it is not generally useful to talk about firms as distinctive entities, a nexus of contracts could be called more firm-like if, for example, the residual claimants belong to a concentrated group but the term "firm" has little meaning beyond this.

Would such a burring of the lines between markets and firms make sense within the neo-classical model? Given the implicit use of complete contracts in the neo-classical approach I would argue that it does. Under complete contracts any institutional form is able to mimic any other institutional form. A well known example of this is the neutrality theorems of the theory of privatisation literature, under whichstate-ownership and private ownership of firms results in the same outcome. In the case of the neo-classical model, production via the market would achieve anything that production via (Coase-type) firms could achieve and thus there is no need for (Coase-type firms in the model.

But I'm not sure we are left with a role for a firm of any type in the neo-classical model. If the firm is defined by its function, production for outsiders, in a zero transaction cost world it is not clear to me that we have any form of firm at all. What we have is production via the market, which doesn't result in a real meaning being given to the term "firm".

In the neo-classical model, then, I think we are left with having to take production for outsiders as the definition of the firm, without knowing how that production takes place, or we have to say that the model doesn't really have firms in it at all. The grand coordination problem is resolved by the price system, by the market, but without recourse to firms. Demsetz's definition of the "firm" and his rationalisation for their existence is, if I understand it correctly, a definition and rationalisation for production, but production via the market, without firms.

If we accept this position, then we also have to ask, What meaning can we give to the "household" in the neo-classical model?

Of course it could all just be semantics.

Update: Thinking about this a bit more, I wonder if perhaps another way to see the point I’m trying to make is to follow the Alchian and Demsetz argument a bit further. As noted above Alchian and Demsetz argue that it is meaningless to try to draw a hard line between markets and firms. They go on to say that the reason that firms are special has to do with the technology of team production., that is, production where the individual production functions are inseparable from one another. This gives raise to the problem of free riding since team production can act as a cover for shirking. Alchian and Demsetz’s answer to this principal-agent problem is to appoint a monitor to oversee the workers. So in this framework team production is the underlying reason that the "nexus of contracts" can be considered a firm. But there are no team production or principal-agent problems within the neo-classical framework. So while the neo-classical firm may be a "nexus of contracts", it is a "nexus of contracts" without team production and thus there is no rationale for firm based production as opposed to market based production.

References:

• Alchian, Armen and Demsetz, Harold (1972 ). 'Production , Information Costs, and Economic Organization', American Economic Review, December, v. 62, iss. 5, pp. 777-95.
• Barzel, Yoram (1997). Economic analysis of property rights Second edition. Political Economy of Institutions and Decisions series. Cambridge; New York and Melbourne: Cambridge University Press.
• Cheung, Steven N.S. (1983). 'The Contractual Nature of the Firm', Journal of Law and Economics, 26(1) April: 1-21.
• Fama, Eugene F. (1980). 'Agency Problems and the Theory of the Firm', Journal of Political Economy, April, v. 88, iss. 2, pp. 288-307.
• Foss, Nicolai J., Henrik Lando and Steen Thomsen (2000). 'The Theory of the Firm'. In Boudewijn Bouckaert and Gerrit De Geest (eds.), Encyclopedia of Law and Economics, Volume III, Cheltenham U.K.: Edward Elgar Publishing Ltd.
• Jensen, Michael C. and Meckling, William H. (1976). 'Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure', Journal of Financial Economics, October, v. 3, iss. 4, pp. 305-60.

Blame Canada

Eric Crampton says we should Blame Canada. I'm all for this,

South Park - Blame Canada - Click here for more blooper videos

But in Eric's case its not the affect of Canada on kids that's the problem, its the effect of Canada on climate change. Eric quotes George Monbiot on the evils of Canada re climate change:

Until now I believed that the nation which has done most to sabotage a new climate change agreement was the United States. I was wrong. The real villain is Canada. Unless we can stop it, the harm done by Canada in December 2009 will outweigh a century of good works.

In 2006 the new Canadian government announced that it was abandoning its targets to cut greenhouse gases under the Kyoto Protocol. No other country that had ratified the treaty has done this. Canada was meant to have cut emissions by 6% between 1990 and 2012. Instead they have already risen by 26%(1).

It’s now clear that Canada will refuse to be sanctioned for abandoning its legal obligations. The Kyoto Protocol can be enforced only through goodwill: countries must agree to accept punitive future obligations if they miss their current targets. But the future cut Canada has volunteered is smaller than that of any other rich nation(2). Never mind special measures; it won’t accept even an equal share. The Canadian government is testing the international process to destruction and finding that it breaks all too easily. By demonstrating that climate sanctions aren’t worth the paper they’re written on, it threatens to render any treaty struck at Copenhagen void.

So feel free to blame Canada!

What happened to the term monetarism?

This is the question asked by Matt Nolan over at the TVHE blog. Matt writes

For example, the term monetarist. In a discussion with my sister and on this post from the DimPost the term “monetarist” was used to describe a relatively right wing outlook about political issues and policy in general. However, this confuses me. My impression was that monetarists at their most narrow are people that believe money supply growth = inflation completely. While more generally a monetarist is someone that believes money supply growth is in some way related to higher long run inflation

Let me say what Milton Friedman thought monetarism was, and he should have known. This comes from "The Counter-Revolution in Monetary Theory", (First Wincott Memorial Lecture delivered at the Senate House, University of London, 16 September, 1970), by Milton Friedman, London: The Institute of Economic Affairs, 1970, pp. 22-26:

IV KEY PROPOSITIONS OF MONETARISM

LET ME finally describe the state to which the counter-revolution has come by listing systematically the central propositions of monetarism.

1. There is a consistent though not precise relation between the rate of growth of the quantity of money and the rate of growth of nominal income. (By nominal income, I mean income measured in pounds sterling or in dollars or in francs, not real income, income measured in real goods.) That is, whether the amount of money in existence is growing by 3 per cent a year, 5 per cent a year or 10 per cent a year will have a significant effect on how fast nominal income grows. If the quantity of money grows rapidly, so will nominal income; and conversely.

2. This relation is not obvious to the naked eye largely because it takes time for changes in monetary growth to affect income and how long it takes is itself variable. The rate of monetary growth today is not very closely related to the rate of income growth today. Today's income growth depends on what has been happening to money in the past. What happens to money today affects what is going to happen to income in the future.

3. On the average, a change in the rate of monetary growth produces a change in the rate of growth of nominal income about six to nine months later. This is an average that does not hold in every individual case. Sometimes the delay is longer, sometimes shorter. But I have been astounded at how regularly an average delay of six to nine months is found under widely different conditions. I have studied the data for Japan, for India, for Israel, for the United States. Some of our students have studied it for Canada and for a number of South American countries. Whichever country you take, you generally get a delay of around six to nine months. How clear-cut the evidence for the delay is depends on how much variation there is in the quantity of money. The Japanese data have been particularly valuable because the Bank of Japan was very obliging for some 15 years from 1948 to 1963 and produced very wide movements in the rate of change in the quantity of money. As a result, there is no ambiguity in dating when it reached the top and when it reached the bottom. Unfortunately for science, in 1963 they discovered monetarism and they started to increase the quantity of money at a fairly stable rate and now we are not able to get much more information from the Japanese experience.

4. The changed rate of growth of nominal income typically shows up first in output and hardly at all in prices. If the rate of monetary growth is reduced then about six to nine months later, the rate of growth of nominal income and also of physical output will decline. However, the rate of price rise will be affected very little. There will be downward pressure on prices only as a gap emerges between actual and potential output.

5. On the average, the effect on prices comes about six to nine months after the effect on income and output, so the total delay between a change in monetary growth and a change in the rate of inflation averages something like 12-18 months. That is why it is a long road to hoe to stop an inflation that has been allowed to start. It cannot be stopped overnight.

6. Even after allowance for the delay in the effect of monetary growth, the relation is far from perfect. There's many a slip 'twixt the monetary change and the income change.

7. In the short run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices. What happens to output depends on real factors: the enterprise, ingenuity and industry of the people; the extent of thrift; the structure of industry and government; the relations among nations, and so on.

8. It follows from the propositions I have so far stated that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. However, there are many different possible reasons for monetary growth, including gold discoveries, financing of government spending, and financing of private spending.

9. Government spending may or may not be inflationary. It clearly will be inflationary if it is financed by creating money, that is, by printing currency or creating bank deposits. If it is financed by taxes or by borrowing from the public, the main effect is that the government spends the funds instead of the taxpayer or instead of the lender or instead of the person who would otherwise have borrowed the funds. Fiscal policy is extremely important in determining what fraction of total national income is spent by government and who bears the burden of that expenditure. By itself, it is not important for inflation. (This is the proposition about fiscal and monetary policy that I discussed earlier.)

10. One of the most difficult things to explain in simple fashion is the way in which a change in the quantity of money affects income. Generally, the initial effect is not on income at all, but on the prices of existing assets, bonds, equities, houses, and other physical capital. This effect, the liquidity effect stressed by Keynes, is an effect on the balance-sheet, not on the income account. An increased rate of monetary growth, whether produced through open-market operations or in other ways, raises the amount of cash that people and businesses have relative to other assets. The holders of the now excess cash will try to adjust their portfolios by buying other assets. But one man's spending is another man's receipts. All the people together cannot change the amount of cash all hold - only the monetary authorities can do that. However, as people attempt to change their cash balances, the effect spreads from one asset to another. This tends to raise the prices of assets and to reduce interest rates, which encourages spending to produce new assets and also encourages spending on current services rather than on purchasing existing assets. That is how the initial effect on balance-sheets gets translated into an effect on income and spending. The difference in this area between the monetarists and the Keynesians is not on the nature of the process, but on the range of assets considered. The Keynesians tend to concentrate on a narrow range of marketable assets and recorded interest rates. The monetarists insist that a far wider range of assets and of interest rates must be taken into account. They give importance to such assets as durable and even semi-durable consumer goods, structures and other real property. As a result, they regard the market interest rates stressed by the Keynesians as only a small part of the total spectrum of rates that are relevant.

11. One important feature of this mechanism is that a change in monetary growth affects interest rates in one direction at first but in the opposite direction later on. More rapid monetary growth at first tends to lower interest rates. But later on, as it raises spending and stimulates price inflation, it also produces a rise in the demand for loans which will tend to raise interest rates. In addition, rising prices introduce a discrepancy between real and nominal interest rates. That is why world-wide interest rates are highest in the countries that have had the most rapid rise in the quantity of money and also in prices - countries like Brazil, Chile or Korea. In the opposite direction, a slower rate of monetary growth at first raises interest rates but later on, as it reduces spending and price inflation, lowers interest rates. That is why world-wide interest rates are lowest in countries that have had the slowest rate of growth in the quantity of money - countries like Switzerland and Germany.

This two-edged relation between money and interest rates explains why monetarists insist that interest rates are a highly misleading guide to monetary policy. This is one respect in which the monetarist doctrines have already had a significant effect on US policy. The Federal Reserve in January 1970 shifted from primary reliance on 'money market conditions' (i.e., interest rates) as a criterion of policy to primary reliance on 'monetary aggregates' (i.e., the quantity of money).

The relations between money and yields on assets (interest rates and stock market earnings-price ratios) are even lower than between money and nominal income. Apparently, factors other than monetary growth play an extremely important part. Needless to say, we do not know in detail what they are, but that they are important we know from the many movements in interest rates and stock market prices which cannot readily be connected with movements in the quantity of money.

Celebrating the work of Ronald Coase.

This weekend in Chicago, they are celebrating the work of my favourite economist, Ronald Coase.

Markets, Firms and Property Rights
A Celebration of the Research of Ronald Coase

Friday, December 4 to Saturday, December 5, 2009
University of Chicago Law School Auditorium

This Conference brings together a group of scholars to honor the life and research of Ronald Coase. 2009 marks the 50th anniversary of the publication of Coase’s seminal paper on the Federal Communications Commission. 2010 marks the 50th anniversary of the publication of his paper on “The Problem of Social Cost,” and his 100th birthday.

The presentations on this occasion cover specific topics on which Coase’s work has exerted profound influence, including such areas as telecommunications policy, airline regulation and development, environmental economics, economic development, organization of the firm, and general discussions of the questions of transactions costs and social rationality to which he has contributed so much.

In the Conference Schedule I found this paper:

Coase and the New Zealand Spectrum Reforms
Charles Jackson, George Washington University

A draft version of the paper is available here. The paper makes mention of the Fountain Report:

• The Economics of Spectrum Literature: A Survey of the Literature, John Fountain, 1988, Department of Trade and Industry, Wellington, NZ.

John taught the second year microeconomics paper when I, and Rodney Hide, did it.

Klein on Cassidy

I have pointed out before that John Cassidy is arguing for the relevance of the ideas of Arthur Cecil Pigou to the recent financial crisis. Peter Klein at the Organizations and Markets blog takes issue with what Cassidy has written:

Another mistake in John Cassidy’s ditty on externalities is the claim that Pigou “was reacting against laissez faire — the hands-off approach to policy that free market economists, from Adam Smith onwards, had recommended. Such thinkers had tended to view the market economy as a perfectly balanced, self-regulating machine.” Forget that the British Classicals, Adam Smith in particular, were far from “hands-off” types. Note instead that Cassidy provides no textual evidence of unnamed “free-market economists” viewing the market system as a “perfectly balanced, self-regulating machine.” How could he, when no sensible economist ever wrote or thought such a thing? The free-market economists — actually, virtually all sound economists — have maintained that the market economy works remarkably well, given the limits of human knowledge, our devious character, the brutality of nature, and so on. Paris gets fed, as Bastiat noted, and that is a miracle. Government intervention into markets inevitably makes things worse, the economists argued, not because the market system is “perfect,” whatever that means, but because men are fallible, and giving coercive power to fallible men is — to borrow P. J. O’Rourke’s metaphor — like giving whiskey and car keys to teenage boys. Cassidy’s caricature shows how little he understands what free-market economics is actually all about.

Smith would not have seen the market economy as a perfectly balanced, self-regulating machine. He knew of the imperfections of markets but also knew that within the right institutional framework, markets were a natural, organic-like process which lead not to chaos but to social harmony. Smith also knew of the dangers that government over interference in the market process could bring. As Eamonn Butler has briefly summarised it:

He [Smith] realised that social harmony would emerge naturally as human beings struggled to find ways to live and work with each other. Freedom and self-interest need not lead to chaos, but - as if guided by an 'invisible hand' - would produce order and concord.

They would also bring about the most efficient possible use of resources. As free people struck bargains with others - solely in order to better their own condition - the nation's land, capital, skills, knowledge, time, enterprise and inventiveness would be drawn automatically and inevitably to the ends and purposes that people valued most highly.

Thus the maintenance of a prospering social order did not require the continued supervision of kings and ministers. It would grow organically as a product of human nature. To grow best and to work most efficiently, however, it required an open, competitive marketplace, with free exchange and without coercion. It needed rules to maintain this openness, just as a fire-basket is needed to contain a fire. But those rules, the rules of justice and morality, are general and impersonal, quite unlike the specific and personal interventions of the mercantilist authorities.

Tabarrok on Irving Fisher

Earlier I noted that John Cassidy was arguing for the relevance of the ideas of Arthur Cecil Pigou to the recent financial crisis. Now Alex Tabarrok, over at Marginal Revolution, is arguing for another "underappreciated economist", Irving Fisher, and his relevance to the current crisis. Tabarrok writes,

Tyler points to Malthus as a much underappreciated economist. John Cassidy points to Pigou. For my money, Irving Fisher dominates. Other people (e.g. London Banker and Yves Smith) have also extolled Irving Fisher, but I would still rank Fisher as highly underappreciated relative to insight and clarity of thought.

Here from his classic, The Debt-Deflation Theory of Great Depressions, are some choice insights.

Then we may deduce the following chain of consequences in nine links: (1) Debt liquidation leads to distress selling and to (2) Contraction of deposit currency, as bank loans are paid off, and to a slowing down of velocity of circulation. This contraction of deposits and of their velocity, precipitated by distress selling, causes (3) A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above stated, that this fall of prices is not interfered with by reflation or otherwise, there must be (4) A still greater fall in the net worths of business, precipitating bankruptcies and (5) A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the concerns which are running at a loss to make (6) A reduction in output, in trade and in employment of labor. These losses, bankruptcies and unemployment, lead to (7) Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause (9) Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or money, rates and a rise in the real, or commodity, rates of interest.

Evidently debt and deflation go far toward explaining a great mass of phenomena in a very simple logical way.

With perhaps the qualification that even real rates of interest may fall is this not a brilliant summary of current events?

Trust, law and social norms: fundamentals of economic progress

In this audio from VoxEU.org Sir Partha Dasgupta of the University of Cambridge talks to Romesh Vaitilingam about why some countries are rich and others are poor. He argues that trust is the fundamental building block of societies – without it, there can be no basis for cooperation, which in turn leads to progress and economic development.

Interesting blog bits

1. Wenli Li and Michelle J. White on Bankruptcy, mortgage default, and foreclosure. Did US bankruptcy laws exacerbate the housing crisis? This column says that a 2005 reform that made declaring personal bankruptcy more difficult increased mortgage defaults and home foreclosures. It recommends reversing that legislation to reduce the number of foreclosures, which have high social costs.
2. Matt Nolan writes a Dear Rod Orman letter. Matt disagrees with Orman about monetary policy.
3. Matt Nolan also writes on Agreement or no? David Cunliffe has stated that new prudential regulation by the Reserve Bank shows that they agree with Labour on the need to dump the monetary policy consensus. Matt says no.
4. Eric Crampton writes about the Advantage: Arts over Commerce. As an arts man myself I have to say an arts degree has a huge advantage over a commerce degree.
5. Fatih Guvenen, Burhanettin Kuruscu and Serdar Ozkan on Taxation of Human Capital and Wage Inequality: A Cross-Country Analysis. High top marginal tax rates erode incentives to acquire human capital. Anyone surprised?
6. Jaime de Melo, Jean-Marie Grether and Nicole A. Mathys on Trade, pollution, and the environment: New international evidence. The "pollution haven" view asserts that globalisation draws industries to countries with lax environmental regulation. This column present evidence that that the major polluting industries are not very footloose and that changes in emissions through the relocation of activities are relatively small. The growth of trade itself, however, is likely to contribute to growing emissions associated with transport.

North on Williamson and Ostrom

In this short video Douglass North discusses the work of the 2009 Nobel Prize winners in economics, Elinor Ostrom and Oliver Williamson.

EconTalk this week

Peter Boettke of George Mason University and author of Challenging Institutional Analysis and Development: The Bloomington School (co-authored with Paul Dragos Aligica), talks with EconTalk host Russ Roberts about the Bloomington School--the political economy of Elinor Ostrom (2009 Nobel Laureate in Economics), Vincent Ostrom, and their students and colleagues at Indiana University. The discussion begins with the empirical approach of Elinor Ostrom and others who have studied the myriad of ways that actual communities have avoided the tragedy of commons. Boettke emphasizes the distinction between privatization vs. informal norms and cultural rules that prevent overuse. The conversation also looks at urban development and the benefits and costs of multiple municipalities vs. a single, large city. Throughout, Boettke embeds the conversation in the Ostroms' interest in how the citizenry can be self-governing and the challenges of implementing local knowledge.

The ideas of Arthur Cecil Pigou

John Cassidy offers, in the Wall Street Journal, this article in which he reviews the ideas of Arthur Cecil Pigou and their application to the recent financial crisis. At one point Cassidy writes about Pigou's most famous idea that the social and private benefits/costs of economic activities can differ and thus (Pigouvian) subsidies/taxes may to needed to correct this "market failure":

Mr. Pigou drew an important distinction between the private and social value of economic activities, such as the opening of a new railway line. The savings in time and effort that users of the railway enjoy are private benefits, which will be reflected in the prices they are willing to pay for tickets. Similarly, the railroad's expenditures on tracks, rolling stock, employee wages are private costs, which will help to determine the prices it charges. But the opening of the railway may also create costs for "people not directly concerned, through, say, uncompensated damage done to surrounding woods by sparks from railway engines," Mr. Pigou pointed out.

Such social costs—modern economists call them "externalities"—don't enter the calculations of the railroads or its customers, but in tallying up the ultimate worth of any economic activity, "[a]ll such effects must be included," Mr. Pigou insisted. In focusing exclusively on private costs and private benefits, the traditional defense of the free market misses out on a vital element of reality.

To correct the problems that spillovers created, Mr. Pigou advocated government intervention. Where the social value of an activity was lower than its private value, as in the case of a railroad setting ablaze the surrounding woodland, the authorities should introduce "extraordinary restraints" in the form of user taxes, he said. Conversely, some activities have a social value that exceeds their private value. The providers of recreational parks, street lamps, and other "public goods" have difficulty charging people to use them, which means the free market may fail to ensure their adequate supply. To rectify this shortcoming, Mr. Pigou advocated "extraordinary encouragements" in the form of government subsidies.

It was this idea that gave rise to what George Stigler famously called the "Coase Theorem". What Coase was trying to point out was that Pigou's taxes and subsidies were not need within the framework - perfect competition, which assumes zero transaction costs - that Pigou himself assumed. As Stigler put it

The Coase Theorem thus assets that under perfect competition private and social costs will be equal.

Given this equality, there is no need for any taxes or subsidies. This is not to say that such taxes/subsidies are not useful within a positive transaction cost framework, this, as Coase noted, would have to be decided on a case-by-case basis.

Incentives matter: the blood file

Economist Steven E. Landsburg has written

Most of economics can be summarized in four words: People respond to incentives. The rest is commentary.

But it has been argued that this is not entirely true for some areas of social activity where "intrinsic" motivation is important, such as blood donation. A number of contributions in both the psychology and economics literatures have argued that when people are "intrinsically" motivated to perform a task, as in activities such as blood donation, adding an extrinsic incentive could reduce supply of the activity because the extrinsic incentive might undermine the intrinsic motivation and also attract the "wrong" types of agents to perform the activity. Surveys and laboratory experiments lend support to this non-standard response to economic incentives for the provision of pro-social behaviour. But new research shows that blood donors responding to incentives in the "standard" way; offering donors economic incentives significantly increases turnout and blood units collected, and more so the greater the incentive’s monetary value.

The abstract of the paper, Will There Be Blood? Incentives and Substitution Effects in Pro-social Behavior by Nicola Lacetera, Mario Macis and Robert Slonim, Discussion Paper No. 4567, November 2009, Institute for the Study of Labor, reads,

We examine how economic incentives affect pro-social behavior through the analysis of a unique dataset with information on more than 14,000 American Red Cross blood drives. Our findings are consistent with blood donors responding to incentives in a “standard” way; offering donors economic incentives significantly increases turnout and blood units collected, and more so the greater the incentive’s monetary value. In addition, there is no disproportionate increase in donors who come to a drive but are ineligible to donate when incentives are offered. Further evidence from a small-scale field experiment corroborates these findings and confirms that donors are motivated by the economic value of the items offered. We also find that a substantial fraction of the increase in donations due to incentives may be explained by donors substituting away from neighboring drives toward drives where rewards are offered, and the likelihood of this substitution is higher the higher the monetary value of the incentive offered and if neighboring drives do not offer incentives. Thus, extrinsic incentives motivate pro-social behavior, but unless substitution effects are also considered, the effect of incentives may be overestimated.