Now this could start a fight

There is a paper forthcoming in the American Economic Journal titled "Partisan Grading" by two economists Talia Bar and Asaf Zussman. The abstract reads:

We study grading outcomes associated with professors in an elite university in the United States who were identified - using voter registration records from the county where the university is located - as either Republicans or Democrats. The evidence suggests that student grades are linked to the political orientation of professors: relative to their Democratic colleagues, Republican professors are associated with a less egalitarian distribution of grades and with lower grades awarded to Black students relative to Whites.

One thing I noted taking a very quick look at the papers was:

We were able to match 511 out of 1,169 professors, i.e. about 44 percent of the total. Of these professors, 27 (5.3 percent) are Republicans and 370 (76.3 percent) are Democrats. The rest either registered to vote for smaller parties or were unaffiliated with any party.

Only 5.3% of the professors stated they were Republicans with three quarters of the sample being Democrats. And what do we make of results based on 27 people?

As to the second result noted in the abstract, that Republicans give lower grades to Black students, Bar and Zussman write,

An obvious question that arises regarding the second finding is whether and to what extent Democratic professors “discriminate” in favor of Black students or Republican professors “discriminate” against them. At this stage we only note that in the absence of an appropriate benchmark for comparison, this question cannot be credibly answered;

One thing I would like to know is what effects on this result does the ethnicity of professor have? That is, Do Black Republican/Democratic professors grade in the same way as White Republican/Democratic professors? Another point Bar and Zussman make is that

Our analysis finds practically no association between professor political orientation and the relative grading outcomes of Hispanic and female students.

So, Why only “discrimination” for/against Black students?

Bar and Zussman’s results on the grading question show

The variance of grades is higher in courses taught by Republicans than in courses taught by Democrats. Moreover, in additional analysis we find that relative to their Democratic colleagues, Republican professors tend to assign more very low and very high grades: the share of the lowest grades (F, D-, D, D+, and C-) out of the total is 6.2 percent in courses taught by Republican professors and only 4.0 percent in courses taught by Democratic professors; the share of the highest grade (A+) out the total is 8.0 percent in courses taught by Republican professors and only 3.5 percent in courses taught by Democratic professors. Both differences are highly statistically significant. These suggestive results are consistent with our grading egalitarianism hypothesis.

A different illustration of the relationship between political identification and grading egalitarianism is contained in the chart above. The figure displays mean grades by student SAT score ranges in courses taught by Republican and Democratic professors. The observed pattern is consistent with the hypothesis that Republican professors are associated with a steeper slope of the grade-ability profile, i.e. with higher returns to student ability. (Emphasis added.)

One wonders about selection issues here. As Mark J. Perry says,

One conclusion here might be that highly motivated, high-achieving students should prefer classes from Republican professors because it's more likely they'll be rewarded with a really high grade (A or A+), and less motivated, lower-achieving students should prefer classes from Democratic professors, because it's less likely that they'll receive a really low grade.

The conclusion of the paper states,

We studied grading outcomes associated with professors in an elite university in the United States who were identified - using voter registration records from the county where the university is located - as either Republicans or Democrats. Assuming that Republicans are conservative and Democrats are liberal [liberal in the American meaning, not the correct meaning], the paper tested two main hypotheses which are based on key differences between conservative and liberal political philosophies. The first concerns egalitarianism and the second concerns the treatment of traditionally disadvantaged racial and ethnic minorities. We found that relative to their Democratic colleagues, Republican professors are associated with a less egalitarian distribution of grades and with lower grades awarded to Black students relative to Whites.

Professors control the allocation of grades which serve as the primary currency of academia. Our results suggest that the allocation of grades is associated with the worldview or ideology of professors. This finding may inform the public debate on potential reforms to university grading practices. To the extent that the application of objective standards is an important university goal, policy makers should consider limiting the discretion professors enjoy when it comes to grading and making it more difficult for them to use student characteristics as factors in the grading process.

Such results and conclusions will, no doubt, be controversial and we will see much heat, if little light, generated in the discussion that is sure to follow publication of the paper.

Oh no!

Sadly there is a posting at the Aid Watch blog saying that the blog is no more. William Easterly and Laura Freschi write

The simple reason for ending the blog is that we want to free up our own time for writing longer and more substantive pieces, both academic and non-academic, on development.

The blog is a hungry mouth that always wants to be fed, and the longer projects we’d like to take on don’t fit in with those constraints.

Economists are professionally trained to be wary of diminishing returns to any one activity, and to be entrepreneurial about starting new activities. Although we’ll still write about aid, we plan to move away from aid criticism as our main focus, and put more emphasis on the high-stakes development debates going on now. We still believe that more aid will reach the poor the more people are watching aid, but, as we’ve always known, there’s a lot more to development than aid.

While I can fully understand the time issue, blogs do take a lot of your time, it's sad to see Aid Watch go. It was always a good and useful read.

Good news on free trade agreements

Free trade agreements can be controversial. While they promote trade between the member countries, they may also divert trade away from non-member countries, potentially reducing welfare. A new column by James Anderson and Yoto V. Yotov at VoxEU.org provides evidence that, even when trade diversion is taken into account, the overall effects are still strongly positive.

Back in 1950 Jacob Viner put for ward the idea of trade diversion and since then it has been an issue of concern in the academic literature on free trade agreements (FTAs). Simply there has been a concern about the potential harm to outsiders from trade diversion away them towards the insiders of the trade agreement. But economists are still not clear on the magnitude of trade diversion.

• How large is the harm from trade diversion?
• Does the gain to current FTA partners from trade diversion create a stumbling block to further expansion because that gain would have to be given up?

Recent research sheds new light on these questions.

Anderson and Yotov look at the basic economic logic:

Free trade agreements divert trade from outsiders to insiders because the relative cost of insider business falls. Tariffs between partners disappear while remaining in place for non-partners. More important in the modern setting of already low tariffs are the non-tariff barriers that fall between partners as regulatory barriers are reduced and the greater security of trade relations stimulates potential traders to invest in deals with insider counter-parties.

To understand the effects of trade diversion through non-tariff barrier reductions, an empirical analysis of trade flows before and after implementation of FTAs is required. Enter Anderson and Yotov. Their recent work tackles these questions (Anderson and Yotov 2011) and their findings are reassuring:

• FTAs provide gains to partners, large for the smaller partners, while inflicting very small losses on outsiders.
• Regional trade agreements appear to be building blocks rather than stumbling blocks.
• Direct gains to new partners are big, while indirect effects on outsiders are small.

An upshot of this is that an expansion of FTAs appears in the future is unlikely to be hampered by insiders having to give up important previous gains at the expense of outsiders. The Anderson and Yotov findings of very small terms-of-trade losses to outsiders, less than 0.2%, suggest that such potential stumbling blocks would be too small to notice while the size of the direct benefits to partners that join suggest much larger building blocks.

Anderson and Yotov provide further evidence of this overall effect in a counterfactual analysis by removing Mexico from NAFTA, reverting to the previous Canada-US FTA. In that scenario, all parties lose, while Mexico’s loss is larger by far, wiping out over 80% of its 7.6% terms-of-trade gain from its 1990s FTA implementations.

• Anderson, James E and Yoto V. Yotov (2011), "Terms of Trade and Global Efficiency Effects of Free Trade Agreements, 1990-2002", NBER Working Paper 17003.

Missing posts

The posts missing from last Friday have now turned up, two were posted yesterday while the remain two have been posted today. Who knows what was going on at Blogger last week?! But at least it looks to have been sorted out now.

What scientific concept would improve everybody’s cognitive toolkit?

This is the Edge Question 2011. There are 159 responses in all.

The last two paragraphs from Matt Ridley read:

Human achievement is based on collective intelligence — the nodes in the human neural network are people themselves. By each doing one thing and getting good at it, then sharing and combining the results through exchange, people become capable of doing things they do not even understand. As the economist Leonard Read observed in his essay "I, Pencil' (which I'd like everybody to read), no single person knows how to make even a pencil — the knowledge is distributed in society among many thousands of graphite miners, lumberjacks, designers and factory workers.

That's why, as Friedrich Hayek observed, central planning never worked: the cleverest person is no match for the collective brain at working out how to distribute consumer goods. The idea of bottom-up collective intelligence, which Adam Smith understood and Charles Darwin echoed, and which Hayek expounded in his remarkable essay "The use of knowledge in society", is one idea I wish everybody had in their cognitive toolkit.

The opening two paragraphs from Daniel Kahneman read:

Education is an important determinant of income — one of the most important — but it is less important than most people think. If everyone had the same education, the inequality of income would be reduced by less than 10%. When you focus on education you neglect the myriad other factors that determine income. The differences of income among people who have the same education are huge.

Income is an important determinant of people's satisfaction with their lives, but it is far less important than most people think. If everyone had the same income, the differences among people in life satisfaction would be reduced by less than 5%.

And there are lots of other interesting ideas, go read!

James Otteson interview

James Otteson is Professor of Philosophy and Economics at Yeshiva University and Senior Fellow at the Fund for American Studies in Washington, DC. He is the author of the books Adam Smith, Adam Smith’s Marketplace of Life, and Actual Ethics and the editor of several other works including Adam Smith: Selected Philosophical Writings. Otteson is interviewed by Jack Russell Weinstein discussing "On Liberty and Libertarianism".

See here for an audio of the interview.

Political freedom lies at the core of any democracy. Yet some people claim that even countries like America and England aren’t free enough. What does a free society look like and how much liberty is necessary for the moral life? What is the role of government, how big should it be, and what happens when individual interests clash? Join WHY?’s guest James Otteson as he examines these questions, talks about Adam Smith, the father of free-market theory, and discusses his own account of political morality with its roots in the “classical liberal tradition” (the political tradition that has led to everything from the American Tea Party to libertarians who argue for gun rights and drug legalization).

Are financial markets ‘short-termist’?

A common attack made by critics of financial markets is that suffer from 'short-termism'. They failure to take into account the long-term effects of what they are doing. This claim was made for the U.K. by Andrew Haldane, one of the most-well-regarded managers at the Bank of England in a recent paper. But at the blog of the Institute of Economic Affairs Philip Booth notes a basic error in Haldane's argument.

Haldane came to that conclusion that financial markets and companies were short-termist by assuming that the time preferences of savers were such that the interest rates that savers require on their investments were the same over all time periods. In other words, Haldane assumed that, if a saver wanted a return of 4% per annum over a one-year period, he would want a return of 4% per annum if his saving was for a 20-year period. If this were the case, we would expect the cash flows from investment projects to be discounted at the same rate of interest however far in the future they stretched.

This is a fundamental error. There may be many reasons why savers demand higher rates of return over longer time periods: if they do so, financial markets – and managers acting on behalf of company shareholders – should reflect this by demanding higher returns from longer-term projects. The market is then working well if it reflects the time preferences of savers.

Assuming a constant rate of time preference does seem a bit odd, if nothing else a longer term investment is riskier than a short term one and thus demanding a higher rate of return makes sense.

Good news for Christchurch?

John Small writes,

This is the best news I’ve heard from ChCh in some time. Roger Sutton has accepted appointment as head of CERA.

Good news? The news would be better if we were being told that they have done away with CERA. I have never really seen any justification for it. Rebuilding the city should be a bottom up process not top down. Let the property owners rebuild their property their way, not the government's way. Let the people with the best information and incentives make the decisions, that is, the property owners.

But given we live in a second (or third) best world may be this is good news. They could have appointed someone a lot worse.

Technology and people

Erik Brynjolfsson writes at the Economic of Information blog about self-driving cars. He says,

I suspect the biggest barrier to the adoption of self-driving cars is not technological [ ... ]. Instead, the impediments will be regulatory and cultural. There are about 40,000 deaths on the America's roads each year with our human drivers. But suppose the robotic cars were 100 times safer. That would still be 400 deaths per year. Can you imagine the public outcry, no to mention the legal judgments, that would follow the first time a human was killed due to an error by a robotic car? Will they have to be 100% perfect before the are adopted?

Its easy to see that fear of litigation or over regulation could delay the introduction of this new technology. The government not letting self-driving cars on the road until they are "100% safe" would clearly delay their introduction and cost lives, in much the same way as delays in getting new drugs approved by the FDA does, while fear of legal judgements could stop the firm from introducing the technology.

Geography and offshoring to China

An often asked question with reagrd to production these days is Why do firms offshore manufacturing to China? Alyson C. Ma and Ari Van Assche use data from China's processing trade regime to argue that a hidden driver is the country's geographic proximity to its East Asian neighbours.

Anecdotal evidence is rife with tales of multinational firms that have offshored their production to China, stoking fears that it is leading to a hollowing-out of manufacturing around the world. Many private sector analysts and policymakers attribute this offshoring wave to Chinese home-grown factors such as its low labour costs, stable political system, aggressive export promotion policies, and undervalued exchange rate.

But the usual explanations may not tell the whole story. China depends heavily on imported intermediate inputs [ ... ]. In recent research we consider the possibility that some of China’s attractiveness stems from its proximity to East Asian suppliers of industrial inputs [ ... ]. In short, another factor behind China’s success may simply be the bliss of its proximity to its East Asian neighbours.

So China's attractiveness as an offshoring location is due, in part, to the smiple fact that it is close to other countries in East Asia. Its geographic proximity to its East Asian neighbours provides it with access to the region's upstream suppliers and downstream markets. These results should be no surprise if we look at other famous offshoring locations around the world. They virtually all are located next to large and wealthier economies. Mexico neighbours the US. Turkey and Poland are located next to the EU-15. China, Thailand and Vietnam are in the vicinity of Japan, Korea, and Taiwan.

Geography does matter.

EconTalk this week

William Byers of Canada's Concordia University and author of The Blind Spot talks with EconTalk host Russ Roberts about the nature of knowledge, science and mathematics. Byers argues that there is an inherent uncertainty about science and our knowledge that is frequently ignored. Byers contrasts a science of wonder with a science of certainty. He suggests that our knowledge of the physical world will always be incomplete because of the imperfection of models and human modes of thought relative to the complexity of the physical world. The conversation also looks at the implications of these ideas for teaching science and social science.

Opportunity to see the MONIAC in action

Come and see a public demonstration of the MONIAC – 'Monetary National Income Analogue Computer' – the first Wednesday of every month.

This early econometric computer ingeniously uses water to model flows of money in an economy. Kiwi Bill Phillips built it in 1949, drawing on his electrical and engineering experience, to make a computer that could do complex calculations beyond the ability of other computers at the time. Phillips went on to become a professor at the London School of Economics, and is best known for his work on the Phillips Curve.

The acronym MONIAC was apparently invented to echo the ENIAC digital computer then being developed in the United States.

By contrast with those machines the MONIAC operated wholly on analogue principles, using water to simulate flows of money. Around 14 were built.

The MONIAC was capable of making complex calculations that could not be performed by any other computer at the time. The linkages were based on Keynesian and classical economic principles, with various tanks representing households, business, government, exporting and importing sectors of the economy.

Water pumped around the system could be measured as income, spending and GDP. The system was programmable, and experiments with fiscal policy, monetary policy and exchange rates could be carried out.

This is a FREE public demonstration.

When: from12.15 to 12.45 pm on the first Wednesday of every month.

Where: Reserve Bank Museum, No. 2 The Terrace, Wellington

Website: http://www.rbnzmuseum.govt.nz/activities/moniac/introduction.aspx for more information on the MONIAC

Economist’s favourite economists

From the survey mentioned in the previous posting comes three questions on economist’s favourite economists.

The first question:

Are there any economic thinkers who wrote prior to the twentieth century whom you regard with great respect, admiration, or reverence? If so, please list, up to three:

The top three economists: (1) Adam Smith, (2) David Ricardo and (3) Alfred Marshall. Not great surprises there.

What may be more surprising is just how much Smith dominates everybody else. To get a numerical ranking the authors awarded Smith six points, Ricardo five points, and Marshall four points. On this ranking Smith got more than 1200 points (1265) with Ricardo getting least than half that (520) and Marshall just 329points.

The second question:

Are there any economic thinkers of the twentieth century and now deceased whom you regard with great respect, admiration, or reverence? If so, please list, up to three:

The top three economists: (1) John Maynard Keynes, (2) Milton Friedman and (3) Paul Samuelson. Here, Keynes would get six points, Friedman five points, and Samuelson four points.

The points for the top three are: Keynes 726, Friedman 654 and Samuelson 460. So Keynes and Friedman are well ahead of Samuelson. Hayek came in fourth, but well back on only 219 points.

I’m not sure I would rank Samuelson that high. I would go for Hayek above him and I really don’t see how J. K. Galbraith got to 6th on the list!!

The third and last question:

Are there any economic thinkers alive today over the age of 60/under the age of 60 whom you regard with great respect, admiration, or reverence? If so, please list, up to three:

The top three in each group: Economist over the age of 60: (1) Gary Becker, (2) Kenneth Arrow and (3) Robert Solow. Economist under the age of 60: (1) Paul Krugman, (2) Greg Mankiw and (3) Daron Acemoglu.

The Becker/Arrow/Solow grouping makes some sense, although for me I would put Coase at number 1 for this group. He came in 4th. Tullock got to 19th. John Nash is 13th on the list and he's not even an economist. What about Bengt Holmström, Oliver Williamson or Oliver Hart? None of then even make it to the list.

As to the Krugman/Mankiw/Acemoglu group. This I really don’t get. Ok may be Acemoglu makes sense but Krugman and Mankiw at (1) and (2)? Not for me. What about Jean Tirole, Andrei Shleifer or Kevin M. Murphy?

Right-wing economists?

The results of a a new survey of U.S. economists have been released in a new paper in the journal "Econ Journal Watch". The paper is 'Economics Professors’ Favorite Economic Thinkers, Journals, and Blogs (along with Party and Policy Views)' by William L. Davis, Bob Figgins, David Hedengren, and Daniel B. Klein, "Econ Journal Watch", Volume 8, Number 2 May 2011, 126-146.

The authors generated a random list of 2000 individual professors (tenure-track, assistant to full professors, excluding emeriti) belonging to 300 U.S. economics departments, in proportion to the size of the department. The response rate was 15.2 percent with 299 surveys being returned. The mean age of our 299 respondents is about 59, and the median 58, so the group is older than one might expect. Of the 299 respondents, 239 were men, 57 women, and 3 did not report gender.

One question asked in the survey related to political views:

To which political party have the candidates you’ve voted for in the past ten years mostly belonged? The answers:

The possible responses being: Democratic, Green, Libertarian, Republican and other.

Democratic 56.4%
Green 1.7%
Libertarian 5.4%
Republican 20.7%
“Other” checked but nothing written 3.8%
Cannot vote 3.7%
Choose not to vote 1.0%
No answer 7.4%

So the sum of Democratic and Green voters is nearly 60% of the survey. The sum of Republican and Libertarian voters is half that.

The authors also calculate a party-voting index: (#Democratic + #Green)/(#Republican + #Libertarian + 0.1). The “+ 0.1” appearing in the denominator is there to solve the problem that arises when it is otherwise zero. Crudely speaking, the index is the ratio of Left to Right. The Left to Right ratio within the entire sample is 2.23.

Which means economists, in the U.S. at least, are far from being a bunch of "right-wingers".

Governments are here to help(?)

Some governments set out to help entrepreneurs ...

Russian tax law is so complex that Novikov Restaurant Group employs five accountants at each restaurant.

this just isn’t one of them. But it does give new meaning to "cooking the books".

(HT: Marginal Revolution)

Interesting blog bits

1. Joan Costa-i-Font, Stefan Felder and Andrew Felton ask Does ageing really affect health expenditures? If so, why?

   Over the last half century, life expectancy in the industrialised world has risen dramatically – and so has the healthcare bill. Is population ageing the main reason? This column argues that while ageing does affect health spending, it is far less important than many think. It adds that obsession with an ageing population is a dangerous red herring that prevents dealing with the real culprits of rising costs.

2. Richard Posner asks Does the Earth Have Room for 10 Billion People?

   On May 3, the United Nations issued its 2010 Revision of World Population Projections, which, according to the media, predicts that the world’s population, expected to reach 7 billion by the end of this year, will be 10.1 billion by the end of the century. But the media reports have tended to be imprecise. The UN report offers three predictions—a high, medium, and low—depending on different assumptions. The high is almost 16 billion and the low 6.2 billion (which is actually lower than the current world population), and a cautious appraisal of the report is that it provides a plausible basis for thinking that the world population will probably be between 6 and 16 billion 89 years from now.

3. Laura Freschi asks Are Lax US Gun Laws Spilling Violence into Mexico?

   The answer may be yes. But you do have to ask, What are the effects on deaths of "the war on drugs"?

4. Liberty Scott gives a UK and NZ roundup

   Recent political events in both countries.

5. Peter Klein on Frank Knight and the Austrians

   In what ways was or wasn't Knight an Austrian?

6. Matthew Philips asks Does Destroying Highways Solve Urban Traffic Congestion?

   And yes it could.

7. Don Brash's Dear John Letter

   Makes a number of good points.

8. Greg Mankiw on Evaluating ARRA

   Tim Conley and Bill Dupor have a new paper on the American Recovery and Reinvestment Act (that is, the Obama stimulus bill).

Guaranteed to Fail: Fannie Mae, Freddie Mac and the debacle of mortgage finance

In this audio from VoxEU.org Viral Acharya and Matthew Richardson talk to Viv Davies about their recent book ‘Guaranteed to Fail: Fannie Mae, Freddie Mac and the Debacle of Mortgage Finance’. Originally set up as government sponsored enterprises, the financial collapse of Fannie Mae and Freddie Mac led to a massive government intervention that has already cost US taxpayers around $150 billion. The authors discuss their analysis of how these institutions collapsed, why housing finance in the US is broken and what now needs to be done to reform the system.

The top ten lines for hitting on an economist

Sarah Skwire at the Modified Rapture blog points out the obvious,

Economics is the sexiest and most romantic of professions.

Like somebody actually needed to be told this!! She goes on to offer "The Top Ten Lines for Hitting on an Economist":

1. You’ve got the curves to supply my demand!

2. Let’s go to bed and try to disprove the law of diminishing marginal utility.

3. You’re my very favorite kind of moral hazard.

4. I have a feeling you really understand the “nature of the firm.”

5. Baby, I love you so much I’m willing to forgo my exit option.

6. Wanna talk about our private goods?

7. You’re an economist. I’m an economist. How about a little horizontal integration?

8. Now those are some tangible assets!

9. I’ll reveal my preferences if you will.

And the very best pick up line to catch your own economist, as well as the filthiest thing ever said in public by an economist (and I include various jokes I’ve heard at cocktail parties) is brought to us by the dynamic duo of Roberts and Papola, and comes straight from their new Hayek/Keynes rap video.

10. Bottom up or top down?

In the comments to the post Steve Horwitz offers up,

Hey baby, let’s make our utility functions interdependent!

Missing posts

I see I'm still missing four posts from yesterday. Blogger keep telling us that they are coming back but I've yet to see the evidence. Don't know if any comments are missing.

Understanding the US housing boom

At the centre of the global financial crisis was a housing boom and bust in the U.S. A New York University team has looked at the flaws in the design of U.S. housing finance that opened the door for the mayhem that followed. A column at VoxEU.org describes the race to the bottom that occurred among Fannie Mae, Freddie Mac, and the too-big-to-fail private financial institutions.

In their article, A race to the bottom: Understanding the US housing boom, Viral Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence J. White argue that

There was, during 2003-7, a race to the bottom between the huge government-sponsored enterprises (GSEs) – Fannie Mae and Freddie Mac – and the private financial sector, consisting of too-big-to-fail large complex financial institutions. Both the GSEs and the too-big-to-fail institutions were making highly leveraged bets on the mortgage market at below-market funding rates in credit markets that were implicitly backed by the government.

The U.S. mortgage market changed dramatically starting 2003:

The mortgage market in the US increased dramatically in size, especially starting late 2003 with the sharp growth of the riskier subprime and Alt-A mortgage lending [ ... ]. Since the too-big-to-fail institutions couldn’t compete directly with Fannie and Freddie because of the GSEs’ access to government guaranteed capital and their roughly 40 basis points lower cost of borrowing, they instead moved along the credit curve, dealing in increasingly shaky mortgage loans that the GSEs had difficulty competing with given the walls, even if somewhat porous, around their underwriting standards. Also, the too-big-to-fail institutions greatly increased their leverage, through use of asset-backed commercial paper and sale-and-repurchase (“rep”) financing, allowing them to expand by issuing cheap debt.

The too-big-to-fail firms were not only creating more toxic mortgage-backed securities but also investing in those same securities. Over 50% of AAA-rated non-GSE mortgage-backed securities were held within the financial sector!

The Acharya, Richardson, Van Nieuwerburgh and White column continues,

This growth in private label mortgage-backed securities was the culmination of the dream of the 1982 “Commission on Housing”. It did, however, have an important and unintended consequence that what would have caused great consternation to that Commission: it encouraged the GSEs to take on riskier portfolios too in order to prevent their market share from being eroded by the private sector too-big-to-fail institutions.

It is instructive to note that the Fannie and Freddie share of the mortgage market rose shapely beginning 2005. This was in contrast to the sharp fall in the preceding years when they lost market share to private label mortgage-backed securities.

Before 2003, as a fraction of their total mortgage-backed securities portfolio, each year the GSEs purchased approximately 10% in lower-quality loans. For the period from 2004 to 2007 this fraction saw a shape increase, averaging 50%.

While there is little doubt that, starting in the mid 1990s, government-mandated affordable housing goals played an important role in shifting Fannie and Freddie’s profile to riskier mortgage loans, it is an interesting question as to how much of the GSEs’ steeper dive into lower-quality mortgages was driven by those mandates and how much by their desire to maintain and expand their market shares.

Acharya, Richardson, Van Nieuwerburgh and White's conclusion:

The bottom line is that it is not possible to fix the US housing finance without dismantling the GSEs in a phased manner and removing their impact on housing markets, lest another race to the bottom emerge in due course once benign conditions return and capital and credit more readily available. However, it is pie in the sky to believe that systemic risk will not exist in the mortgage finance market once the GSEs leave this world. Too-big-to-fail institutions will gradually build up this risk on their balance sheets. It is unavoidable. As a result, it is crucial that the external costs of systemic risk are internalised by each of these firms, or we will end up with an alternative group of private GSE-financial firms in the mortgage finance area. The Dodd-Frank Act in the US, even if imperfect, serves as a useful step in the direction of focusing regulatory attention on systemic risk contributions of the private financial firms.

and

[ ... ] when governments run their own banks badly in good times, they crowd out private banks and thereby encourage them to take greater risks. A secular credit boom and bust must follow. The seeds of such a new cycle are currently being sown.

Things you learn at 2am

It is widely assumed that Ronald Coase introduced the concept of "transaction costs" to economics in 1937, he just didn't use the term, and that the term was first used by Jacob Marschak in 1950. But, it seems, life and economics isn't that simple. For the record Coase wrote about "the cost of using the price mechanism".

So what I discovered at 2am was that Sir John Hicks wrote back in 1935 that,

The most obvious sort of friction, and undoubtedly one of the most important, is the cost of transferring assets from one form to another" (Hicks 1935: 6).

His friction looks a lot like our transaction cost. So Hicks was 5 years ahead of Coase.

As to the label, "transaction costs", Marschak did write,

"[...] the individual has exchanged one commodity against another (say 1 against 2), he had to sacrifice, in addition, positive amounts of at least one of the N commodities: 'the so called transaction cost' (in money paid to advertising agents or brokers, or in ones own leisure, etc.)" (Marschak, 1950: 162).

in 1950 but Tibor Scitovsky wrote in 1940,

One reason (for holding cash rather than profitable assets - annotation by the author) must be liquidity preference, another, perhaps equally important one, seems to be high transaction costs (brokerage charges, stamp duties, commissions, etc.) on long-term securities" (Scitovsky, 1940, 307).

So Scitovsky was 10 years ahead of Marschak.

• Hicks J. R. 1935. A Suggestion for Simplifying the Theory of Money. Economica 2: 1-19.
• Marschak, J. 1950. The Rationale for the Demand for Money and of "Money Illusion". Metroeconomica, 2: 71-100.
• Scitovsky, T. 1940. A Study of Interest and Capital. Economica 7 (27): 293-317.

If you want a hundred trillion dollars

this is what it could look like.

Unfortunately its a one hundred trillion dollar note from Zimbabwe and is worth around US$5

But that's what hyperinflation does for you.

The Wall Street Journal has a story on this note.

The notes are a hot commodity among currency collectors and novelty buyers, fetching 15 times what they were officially worth in circulation. In the past decade, President Robert Mugabe and his allies attempted to prop up the economy—and their government—by printing money. Instead, the country's central bankers sparked hyperinflation by issuing bills with more zeros.

The 100-trillion-dollar note, circulated for just a few months before the Zimbabwe dollar was officially abandoned as the country's legal currency in 2009, marked the daily limit people were allowed to withdraw from their bank accounts. Prices rose, wreaking havoc.

The runaway inflation forced Zimbabweans to wait in line to buy bread, toothpaste and other essentials. They often carried bigger bags for their money than the few items they could afford with a devalued currency.

These days all transactions in Zimbabwe are carried out in foreign currencies, mainly the U.S. dollar and the South African rand.

Free trade and democracy

The economic effects of free trade agreements (FTAs) are widely studied, but what about the political impact of FTAs? Using data from over 125 countries over the past 60 years, this column from VoxEu.org argues that by removing protectionism, free trade can lower the government's power and hence the incentives of autocrats to hold office. All this can help strengthen democracy.

In recent research, Ornelas and Liu (2011), Xuepeng Liu and Emanuel Ornelas present evidence that participation in free trade agreements can destroy protectionist rents. They can also serve as commitment devices to destroy future protectionist rents. Of course rent seekers are never much in favour of FTAs and now we have on more reason why.

Since such [protectionist] rents are attractive for autocratic groups, FTAs can lower their incentives to seek power. While this has little value in established democracies, where the rule of law is strong and the risk of authoritarian disruption is negligible, it can be important for unstable democracies. These threatened states should therefore have an extra incentive to seek involvement in FTAs, over and above the incentive stemming from the agreements’ potential trade gains.

Ornelas and Liu

[...] provide the theoretical basis for [their] claims by extending the trade integration model of Ornelas (2005) to allow for endogenous changes in the political regime. At any trade regime domestic firms exchange contributions for protection with the government, which cares about national welfare and the contributions it receives. Key to understand the impact of an FTA is the recognition that the equilibrium external tariffs change with the constraint imposed by the agreement on the internal tariffs. Taking this into account, it can be shown that even though an FTA still permits lobbying for protection against excluded countries, the volume of protectionist rents falls after the formation of the agreement.

In a dynamic setting this implies that, all else equal, groups motivated mainly by office rents will have lower incentives to seek power if the country is deeply engaged in FTAs. Authoritarian groups tend to fit this description best. After all, due to their aptitude to resort to violence to keep power, authoritarian groups have less incentive to pursue policies that favour the population at large than democratic ones. If the gain of authoritarian groups from keeping power falls when the country is engaged in FTAs, but the costs and risks from attempting a coup d’état are unaltered by the agreements, the likelihood of democratic failure will therefore be lower if the country participates more intensively in FTAs.

From this we learn that if the incumbent government in an unstable democracy realises this effect of "democratic consolidation", it will seek participation in FTAs more actively than it would otherwise. There are two reasons for this:

1. An FTA will weaken the authoritarian threat, increasing the likelihood of democracy survival.
2. Even if the dictatorial group takes control despite the FTA, the agreement will constrain its rent-extraction activities. Hence, unstable democracies tend to enter in FTAs more frequently than other countries, all else being equal.

What does this data stuff have to say about these results?

As a start Ornelas and Liu carry out a non-parametric survival comparison between democracies with and without FTA partners. They utilise a dataset that involving 126 countries over the period 1948-2007. Their statistical analysis confirms that, democracies without FTAs are unequivocally more likely to fail than those with FTAs.

Ornelas and Liu comment,

While striking, this result may be due to other differences between democracies with and without FTA partners. Thus, we also carry out a detailed econometric analysis. We rely on the strategy pursued by Persson and Tabellini (2009), who estimate the likelihood of democratic breakdown employing the concept of “democratic capital”. The domestic component of democratic capital takes into account the history of democracy in the country, while its foreign component considers current levels of democracy abroad. Along with other covariates, these two components of democratic capital allow us to estimate the likelihood of democratic failure in a country. Employing duration analysis techniques, we find that greater participation in FTAs significantly reduces the probability of democratic breakdown; i.e., FTAs contribute to the “consolidation” of democracies. This helps to explain why democratic experiences have been particularly successful since the late 1980s.

Having estimated the likelihood of democracy failure, we use its fitted values to estimate changes in FTA participation. In doing so, we consider only the portion of the likelihood that is not predicted by FTA participation. We find that a higher level of regime uncertainty indeed induces democratic governments to seek greater participation in FTAs. This helps to rationalise the outbreak of regionalism since the early 1990s, when many countries with limited democratic experience became involved in FTAs.

Our empirical results are robust to different econometric specifications and to different measures of democracy. The results are also economically meaningful. For example, Mongolia’s hazard rate in 2005 would drop from 3% to 1% if it had the same level of FTA participation as Chile, or to just 0.3%, had Mongolia the same FTA import share as Mexico.

Now what of free trade and political freedom?

Ornelas and Liu explain that

Our analysis also indicates that the rent destruction forces of FTAs are important drivers of the results. For example, our predictions hold consistently for agreements where most of the trade among the involved parties is liberalised. By contrast, the estimates are generally indistinguishable from zero for partial-scope agreements signed under the Enabling Clause of the GATT, which allow for many exceptions, and therefore impose few restrictions on the availability of rents from protection. It is also possible that FTAs help to maintain democracies not because of their rent destruction effects, but because of pressure from more democratic FTA partners. While this is a very plausible alternative mechanism, our empirical tests suggest that FTAs with more democratic partners are as valuable for the sustainability of a country’s democracy as FTAs with less democratic partners.

To end a word of caution is needed,

While all this is “good news” for democratic countries involved in FTAs, we must stress that participation in FTAs is, unsurprisingly, no panacea. They can help to consolidate democracies, but their reach is limited, as our estimates make clear. Similarly, there are as well many reasons other than democratic instability that also foster participation in FTAs.

That said the results still give us one more reason to support FTAs. Now we see that FTAs are good for both economic and political reasons.

• Ornelas, Emanuel (2005), “Rent Destruction and the Political Viability of Free Trade Agreements”, Quarterly Journal of Economics, 120(4):1475-1506.
• Ornelas, Emanuel and Xuepeng Lio (2011), "Free trade agreements and the consolidation of democracy". (pdf)

The role of economics in an imperfect world

In the New York Times Edward L. Glaeser discusses what economics has to contribute to the war of ideas. Given that no one seems to take any notice of what economists say I'm not that sure it really matters. Glaeser notes that

John Neville Keynes, the father of John Maynard Keynes, promulgated the distinction between positive and normative economics. Milton Friedman later made that division canonical.

Positive economics attempts to understand the world as it is; normative economics describes how the world should be. Most economists spend most of their time doing positive economics, but most economics columns advocate particular policies, which is implicitly normative economics.

Glaeser continues,

Positive economics, as usually practiced today, combines formal, mathematical models and lots of quantitative, statistical work. That’s not what economists did before World War II; Keynes’s General Theory is short on both formal models and statistics. But formal theory and statistics have triumphed, and that’s a good thing.

It's interesting that Keynes, the younger, didn't bother much with quantitative approaches given he was trained as a statistician.

In the wake of the recent crash and recession, it has become fashionable to deride the quants, whether on Wall Street or in the academy. After all, few of them saw it coming. The critics may be right to criticize excessive overconfidence, but they are wrong to suggest that the fault lies in either formal models or statistical work.

Hubris has been part of the human condition, with or without math, long before the Black-Scholes asset-pricing formula. Mathematical models create discipline. They ensure that we specify our assumption and that our conclusions then follow from our assumptions. Statistics then provide us with indispensable tests of our theories.

Glaeser adds a note of caution:

But we need to always remember that data and statistical tests never prove a theory. Typically, many different theories can explain almost any observed phenomenon. Data allows us only to reject a theory. The theories that survive are those that haven’t been rejected yet, and that’s a good reason for humility.

But what of normative economics? What place does it have in economic discussion and public policy development?

At its best, normative economics draws heavily on positive economics: scores of studies have shown the ways in which rent control can screw up a housing market, with too little supply and misallocation of housing units, and that helps formulate policy prescriptions.

Yet the economic approach to public policy is distinguished by attributes beyond an attention to evidence.

There is a strong predisposition within economics to emphasize individual freedom. Our theories start with the assumption that giving individuals more choices is a good thing — and that assumption leads to the view that people benefit from having more money or lower prices for the goods that they buy.

The basis ideas is that people know what is best for themselves and have the right to live by their assessment of what they want. In short, personal freedom. This does mean that all regulation is bad, in fact markets only work because they are regulated, in most cases by the people within the market and by competition.

That assumption doesn’t mean that all regulation is bad or even that, in some cases, people are better off facing fewer soups on a supermarket shelf. Even though people value more choices, they also value information, and an overload of choices can make it hard to figure out which soup is really best. But our assumptions do put freedom first, and that’s an important perspective.

Economics marries a predilection for personal freedom with a longstanding tendency to view the interests of the government as being distinct from the welfare of the people. Adam Smith’s “Wealth of Nations,” modern economics’ founding document, emphasized that point.

In the 18th century, it seemed clear that what was good for King George III was not necessarily good for Britain and certainly was not necessarily good for his American subjects.

Its worthwhile to keep in mind that both markets and governments are imperfect, and it's important to weigh their failures against each other - we need a comparative institutional approach. Always keep in mind that governments are not a faultless servant of the people's will, even assuming "the people" have a will. There is a healthy scepticism about the benevolence and competence of the state continued within economics.

The organisational economics of Al Qaeda

Craig Pirrong at the Streetwise Professor blog writes of the organisational structure of Al Qaeda and Osama Bin Laden:

There is a concerted effort underway to portray Bin Laden as exerting operational control over Al Qaeda, based on material collected during the raid on his compound. Color me skeptical.

First, it’s hard to imagine how he could exercise any control at anything but the broadest strategic and conceptual level while he was relying on couriers to communicate with subordinates. Second, this hierarchical model is contrary to virtually all that has been written about Al Qaeda going back to its early days: the organization has been consistently portrayed as networked and distributed rather than hierarchical. Indeed, the conventional characterization of Al Qaeda represents it as more of a franchise operation in which the franchisees have considerable autonomy.

But let’s assume for a moment that the organization was hierarchical, and that operational elements required direction and approval from Bin Laden to implement any attack. If that’s true, we may have actually done ourselves a disservice by killing Osama. For it would be almost trivially simple to get inside AQ’s OODA (“observe, orient, decide, and act”) loop and disrupt and destroy its operations. Even if we didn’t know what AQ was up to, we could disrupt their plans just by mixing (randomizing) our strategies, by unexpectedly changing up the way we do things. If response to such changes required the locals carrying out missions to report back to OBL via a painfully slow communications system, await a decision, and wait for the decision to be couriered back, they would be unable to do anything serious. In this case, killing OBL would free the locals to be more flexible and responsive–and hence more dangerous. It would permit AQ to become more of a network, less predictable, and more able to adapt to our moves.

Given these difficulties, I find it hard to believe–exceedingly hard–that AQ actually operated this way. Even if OBL wanted to play terrorist mastermind, how could he enforce decisions? Put different, if he was the principal, how could he overcome the agency problems that would bedevil his ability to impose his will on his subordinates?

It is hard to see Al Qaeda as a hierarchical organisation. The people on the ground have the best information about what is going on in their area and thus are the best people to make operational decisions. There is no advantage to in running a top-down organisation where information has to be sent to (and from) Bin Laden, via couriers, to get a decision on what actions to take. When local information is of such importance decentralising decision making just makes sense. Also having decentralised independent operators makes the job of countering Al Qaeda that much harder since taking out one group doesn't effect any other operation. There is not central control mechanism for the U.S. to destroy in an attempt to disrupt Al Qaeda operations.

International car theft rings

The Washington Post reports on International theft rings steal hundreds of vehicles in D.C. area every year. The article says,

Officials estimate that each year in the Washington area alone, hundreds of cars are stolen and shipped overseas. New York authorities announced last June that they had charged 17 people with stealing and shipping hundreds of luxury cars. Other D.C. area police officials and a spokesman for the FBI’s Baltimore Field Office said their detectives have worked similar cases.

and

The ring’s bosses are usually based in African countries or other developing nations, where it is more difficult to find reasonably priced, mid- to high-end vehicles, authorities said. They order specific cars from middlemen in the United States, and then low-level thieves set out to get their cut.

The article also points out that incentive matter even for crime, different cars are worth different amounts to steal:

In the Prince George’s ring, the thieves are paid according to the vehicles they carjack or steal — $1,500 for a Toyota Camry, $2,500 for a RAV4, $5,000 for a Porsche Cayenne, Aponte said.

After a car is stolen,

The middlemen handle the rest. They stash the stolen cars in parking lots or neighborhoods, waiting to see whether police are on their trail. Then they load the vehicles onto shipping containers bound for Africa, police said. The rings are especially prevalent in the D.C. area, police said, because of its proximity to ports.

The question this raises is, What kinds of controls do these developing nations have on the importation of cars that makes this sort of international operation worthwhile?

NZAE meetings

Over at Offsetting Behaviour Seamus Hogan notes the upcoming New Zealand Association of Economists annual conference. He writes,

The conference is in Wellington, Wed June 29 - Fri July 1. Details are here. Eric and I are both on the programme, Eric exalting the value of alcohol and I exalting electricity markets. The visible hand's Rauparaha is also on the programme, having first gone to a phone booth to change back into his undercover identity as James Zuccollo.

But far more interesting than we humble bloggers is our keynote speaker, Tim Harford, "today's best active popular economics writer". He is scheduled to speak on the Wednesday.

Early-bird registration closes this coming Thursday.

Economically illiterate journalists

I have in the past said some harsh things about the level of economic understanding of journalists in this country. Thanks to Don Boudreaux at Cafe Hayek I now discover New Zealand in not alone in having economically illiterate journalists. Professor Boudreaux has been writing to the editor of the Washington Post about the same problem in the U.S.:

You’re right that high-school graduates should know more economics (“Va. high school grads should be economically literate,” May 9). But so, too, should newspaper columnists such as E.J. Dionne who today writes “Far too little attention has been paid to the success of the government’s rescue of the Detroit-based auto companies, and almost no attention has been paid to how completely and utterly wrong bailout opponents were when they insisted it was doomed to failure” (“Rescuing Detroit: No news about government’s good news“).

Mr. Dionne misses two fundamental economic insights: first, nothing is free, and, second, that which is unseen is as real as that which even the most myopic pundits manage to spy.

Economically literate opponents of the Detroit bailout never denied that pumping hundreds of millions of taxpayer dollars into Detroit automakers would restore those companies to health. Instead, they argued, first, that bailing out Detroit takes resources from other valuable uses. Because he doesn’t even recognize that other valuable uses were sacrificed by this bailout, Mr. Dionne offers no reason to think that the value of saving Detroit automakers exceeds the value of what was sacrificed to do so. No legitimate declaration that the bailout is successful is possible, however, without evidence that the value of what was saved exceeds the value of what was sacrificed.

Economically literate bailout opponents argued also that it sets a bad precedent. By signaling to big corporations that government stands ready to pay the tab for the consequences of their poor decisions, big corporations will more likely make poor decisions in the future. It’s far too early for Mr. Dionne to conclude that this prediction is mistaken.

Ideas like opportunity cost and moral hazard are basic to economics and I would hope that most people, and journalists, would have some understanding of them, especially if they want to write about issues where they are obviously important.

EconTalk this week

Bryan Caplan of George Mason University and EconLog talks with EconTalk host Russ Roberts about the ideas in Caplan's new book, Selfish Reasons to Have More Kids. Caplan argues that parents spend too much time trying to influence how their kids will turn out as adults. Using research on twins and adopted children, Caplan argues that nature dominates nurture and that parents have little lasting influence on many aspects of their children's lives. He concludes that parents should spend less time and energy trying to influence their children. If parenting takes less time, then have more kids, says Caplan. The conversation concludes with a discussion of whether a larger population is bad for the planet.

Entry restrictions are bad for business ......

if you are a consumer, but not if you are an incumbent firm.

As an example we can look at the situation in Europe. Retail trade is regulated in all European economies. A recent column at VoxEU.org studies a 1998 Italian reform that delegated retail regulation to local authorities and therefore generated regional variation in barriers to entry. It shows that entry restrictions favour incumbent shops and reduce productivity and employment in the sector. Consumers pay for all this through higher prices.

Due to things like urban planning considerations and the desire to protect "small, traditional stores", retail trade has being subject to substantial regulation in all countries in Europe. An often seen form of regulation is entry restrictions for large outlets. You see the same thing in the U.S. with restrictions on the location of stores like Walmart and in New Zealand when RMA considerations stopped an IKEA store from opening up in Wellington. It is important to understand the economic consequences of such regulation.

In their column, The costs of entry restrictions in retail trade, Fabiano Schivardi and Eliana Viviano write,

[...] a small but growing literature has analysed the effects of various forms of regulation on sectoral performance in some EU countries. Bertrand and Kramarz (2002) for France, Viviano (2008) for Italy, and Sadun (2008) for the UK have studied the effects of barriers to entry to large outlets on sectoral employement at the local level. They all find that entry barriers depress employment. The evidence is more scant on other measures of sectoral performance. Griffith and Harmgart (2008), again for the UK, find that entry restrictions reduce the number of large supermarkets and that restrictive planning regimes are associated with higher food prices. Schaumans and Verboven (2008) study the highly regulated pharmacies in Belgium, where regulation is usually justified on the necessity to ensure availability of pharmacies over the whole national territory. They conclude:

Our overall conclusions are that an appropriate reduction in the regulated markups, combined with a removal or relaxation of the geographic entry restrictions, can lead to a large shift in rents to consumers (taxpayers) without the risk of reducing the availability of supply. This strongly indicates that the current regime of high regulated markups and restricted entry protects the private interests of pharmacies rather than the public interest.

In their study Schivardi and Viviano carry out a general assessment of the effects of entry barriers for large outlets on retail performance in Italy. They explain,

The Italian retail sector, which has a prevalence of traditional small stores, underwent a major regulatory change in 1998. A central feature of this reform is that it delegates the regulation of entry of medium–large stores to local authorities. As it turns out, local authorities chose very different approaches to entry regulation. In particular, most regions established stringent ceilings to the expansion of medium-large stores. This constitutes an interesting policy setting, as we can compare the sectoral performance across provinces with different degree of entry restrictions. We used as a measure of entry barrier the ratio between the local population and the entry ceilings for medium and large stores. The higher this value, the more stringent the entry regulation.

We compared retail trade firms’ performance at the local level before and after 2000, the year in which local regulations came into effect. We found that entry barriers play a substantial role. According to our estimates, large stores in the area at the 75th percentile of the barrier distribution recorded higher margins by about 8% with respect to those in the area at the 25th percentile. The same exercise for productivity implies a difference of about 3%. We also find that a stringent regulation depresses investments in technology, curtails employment, and increases labour costs in large stores. Finally, consistently with lower margins and higher productivity, prices of goods in the “food and beverages” retail sub-sector – the segment with the greatest presence of large stores – are higher the more stringent the entry regulation.

To exclude the possibility that regulation itself is determined by the local structure of the retail sector, we used political variables to model barriers variability across local markets. Specifically, we exploit the positive relationship between the barrier indicator and the local share of votes of the right-wing parties (traditionally supportive of the interest of small retailers) in the general elections. We find that the effects become even stronger under this specification.

Schivardi and Viviano's overall conclusion,

[...] the conclusions of the literature on the effects of entry regulations in retail trade are very consistent. Although the country, method of analysis and measures of performance differ between studies, they all arrive at the same conclusions. Entry barriers and restrictive regulation produce one category of winners and many losers. The winners are incumbents, who enjoy substantially higher profits. On the other side, economic efficiency and employment is reduced and consumers are harmed through a less efficient distribution system and higher prices. These results fit with the idea that anti-competitive regulation is the main cause of the large US–Europe difference in productivity growth in the service sector in the recent years. Moreover, differences in productivity growth between the US and Europe have been greatest in retail trade, which alone explains a large fraction of the total gap.

So the higher the entry restrictions, the higher are incumbent profits and prices, the lower are economic efficiency and employment and the less is productivity. All of this means welfare of consumers is lower than it otherwise would be.

David Hume and Friedrich Hayek: classical liberal giants

Is the title of a posting by Mario Rizzo at the ThinkMarkets blog. It turns out that May 7th was David Hume’s birthday and May 8th is Friedrich Hayek’s birthday. Hume would be 300 while Hayek is just a youngster at 112.

Rizzo writes,

The Hume-Hayek tradition in political philosophy stresses the importance of general and (relatively) inflexible rules, especially with respect to property and contract rights (“justice”).

Hume’s reasons for rules might be characterized today as “incentive” arguments. Property must be secure to encourage the production of wealth. But property is a “convention” (or an artificial virtue) in the sense that the individual respects the property of others because others respect his property. When that mutuality goes, the system goes. The continual making of exceptions weakens the general rule. It also opens the door to “avidity” and “partiality.” Special interest groups pursue their partial interests and neglect the good of each and all.

Hume’s “justice” is a public good – valuable to all, but subject to the free-riding of exception-making. Each exception in itself does little harm but may have large benefits to some special group. Step by step, a world of deteriorated general justice is created beyond anyone’s intention.
In an important sense then, Hume is a father of rule-consequentialism. The goodness or badness of an action is determined by the consequences of the rule that subsumes the action. Thus, the rule, not the action, is the focus of morality.

Hayek took Hume’s argument and went a step farther. He argued for rules for “epistemic” reasons. We follow rules because we do not know what is best to do in the individual case. Tracing individual consequences is actually more difficult than determining the general effects of general rules.
We do not know in an acceptably objective way what makes particular individuals happy; we do not know what tradeoffs should be made between benefits to certain individuals and those to other individuals. A particular act of justice may be, in fact, contrary to the public or private interest (people may suffer) but the rationale of that decision can only be understood at the level of rules. Furthermore, relatively simple and inflexible rules have an epistemic advantage as rules of the road for people operating in an open-ended and complex world.

So let us celebrate the birthdays of two great men whose thinking is still entirely relevant to us today, in so many ways.

Interesting blog bits

1. Eric Crampton on Youth unemployment and evidence-based policy

   I'm probably the only one on my block who runs around the house shouting "The new Household Labour Force Survey is here! The new Household Labour Force Survey is here!". The neighbours likely already think I'm a jerk anyway.

2. Elizabeth Lesly Stevens on The Small-Time Landlord vs. Big-Time Tenants’ Rights

   San Francisco's strong renter protections are a big reason why the city has the region's highest vacancy rate

3. Peter Drysdale on Why Doha Round matters to Asia and the Pacific

   Discussions on breaking the impasse between the US and China are continuing following last month’s landmark meeting of WTO members. This column – written by the intellectual father of APEC – argues that allowing Doha to languish for years is deeply dangerous. Part of an eBook posted in April, the column asserts that failure to conclude Doha this year would put a dagger at the heart of the multilateral system. With the rise of China, the decline of US trade leadership, turmoil in the Middle East, and a damaged and imbalanced global economy, the world needs multilateralism more than ever.

4. Raihan Zamil notes The illusion of bank capital

   How much capital should banks hold to cover their risk? This column argues that the preoccupation with capital rules misses a more fundamental concern. No amount of feasible regulatory capital can be an appropriate substitute for robust asset selection and valuation standards of banks.

5. Tim Worstall on Inequality is rising: so?

   It's most certainly true that inequality is rising within the economically advanced countries. The question is, does this matter?

6. John Taylor on How to Avoid the New Bailout Authority

   Title II of the Dodd-Frank bill, which creates a new orderly liquidation authority for financial institutions, has recently come under fierce attacks from a variety of perspectives. Missing from the recent debate is the role of a possible amendment to the bankruptcy code to deal with large financial firms.

7. Gary Becker asks Can Poor Countries Afford Democracy?

   “Poor countries cannot afford democracy” is a common refrain suggesting that poor countries need strong and authoritarian leaders to overcome the various forces that kept them poor for centuries. In apparent support for this claim is the fact that the great majority of rich countries are mainly democratic. Yet, while the effects of democracy on economic performance are controversial, democracies can have some economic advantages for poor as well as rich countries.

8. Mark Perry Amazing U.S. Manufacturing Productivity Gains

   Perry charts the story of rising worker productivity in America’s manufacturing sector.

Risk v. uncertainty

Brayden King quotes Charles Perrow,

In what should be considered a classic case of the failure to take a possibilistic approach, consider this statement by Tsuneo Futami, a nuclear engineer who was the director of Fukushima Daiichi in the late 1990s: “We can only work on precedent, and there was no precedent. When I headed the plant, the thought of a tsunami never crossed my mind.”

Futami was not alone in his thinking. Experts throughout the nuclear industry and government regulatory agencies not only failed to predict the likelihood of a giant earthquake and tsunami, but also failed to examine the vulnerabilities of Fukushima Daiichi’s design to a natural disaster of this scale. Instead, they relied on a history of successful operation as an assurance of future safety. As a result, they ignored or underestimated a number of major risks that have since doomed the plant.

Here we see that the engineers were working in a world of uncertainty not risk. There were outcomes to which they could not and did not assign probabilities. Sometimes the set of possibilities is just too big to fully consider or some outcomes are simply not known. But this doesn't mean they can't happen.

Milgrom looks at market design

Paul Milgrom has an article in Economic Inquiry (Vol. 49, No. 2, April 2011) on "Critical Issues in the Practice of Market Design". The abstract reads:

The years since 1994 have witnessed the emergence of market design as a new discipline within economics, in which research and practice exert powerful mutual influences in matching and auction markets. The problem of designing well-functioning auction markets has led economic designers to revisit such fundamental issues as the definitions of commodities, the ways participants communicate with markets, the trade-offs between the incentives provided for truthful reporting and other attributes of mechanism performance, and the determinants of the scope of markets, especially whether and how trade in different goods is linked.

I has always wondered about the relationship between market design and mechanism design. On this Milgrom writes,

In the decade or so before 1994, the field of mechanism design was already established
as a leading field of research in economic theory and game theory, but the focus on applications in the years that followed widened the range of questions being asked. As Roth (2002) has emphasized, market design is a kind of economic engineering and demands a comprehensive attention to implementation questions, including ones beyond the traditional scope of research in mechanism design theory.

Checkout page 318, the export market for powdered milk from New Zealand gets a mention.

The modern day candlemakers’ story

This is from Tyler Cowen at Marginal Revolution,

Candles are one industry in which U.S. producers dominate their home market. The National Candle Association estimates the U.S. market is about $2 billion, with imports accounting for 20% or less of that. Imports have been low since 2004, when “the anti-dumping duties came into play,” said the association’s president, Frederic Contino. That’s when duties for Chinese-made candles entering the U.S. more than doubled to the current 108.3%.

Someone has been taking Bastiat far too seriously!

Games young people play: experimental evidence of children’s attitudes to risk, time and trust

In this audio from VoxEU.org Martin Kocher of the University of Munich talks to Romesh Vaitilingam about his experimental research with children and adolescents aged 8 to 18 – and the implications for policy debates around smoking, drinking, drugs, obesity and other health and education issues.

Firms in economics 2

In their 2007 JEL survey of the empirical literature on vertical integration and firm boundaries Lafontaine and Slade write,

Understanding what determines firm boundaries and the choice between interacting in a firm or a market is not only the fundamental concern of the theory of the firm, but it is also one of the most important issues in economics. Data on value added, for example, reveal that, in the United States, transactions that occur in firms are roughly equal in value to those that occur in markets.

In a footnote they also explain that

For manufacturing the ratio is about one third, whereas for services it is twice that.

Which may just tell us that transaction costs are lower in manufacturing than services.

What is interesting in what Lafontaine and Slade write is that despite noting the importance of knowing what determines firm boundaries they still go on to argue that firms are the poor relation in economics,

The economics profession, however, has devoted much more attention to the workings of markets than to the study of firms, and even less attention to the interface between the two.

If fact it has only been since the mid-1970s that the mainstream "theory of the firm" has moved away from asking questions about how the firm acts in the market, how it prices its outputs or how it combines its inputs, to questions about the firm's existence, boundaries and internal organisation. That is, it is only relatively recently that there has been a movement away from the theory of the firm being seen as developing a component of price theory, namely issues to do with firm behaviour, to the theory being concerned with the firm as a subject in its own right.

MBAs and economics

Peter Klein raises an interesting issue with regard to the teaching in MBA degrees,

Mike Ryall on the MBA curriculum (via Josh Gans):

What is the logic for having world-class academic researchers (who, for the most part, have never managed a business themselves) teach business classes to MBA students? The topics covered in many first-year microeconomics MBA courses, for instance, are a subset of those contained in Section III of Economics for Dummies. There may be good reasons for someone to pay $3,000 for a class taught by a researcher that covers the same topics in this $12 book — greater clarity and/or depth, for instance — but still, at a 250:1 cost ratio, students had better be getting something more for their money. It’s not clear that they are.

This is a good question, and not just about microeconomics. It's a question for all subjects in the MBA. Having "world-class academic researchers" teach MBAs has another cost, the opportunity cost of the researcher. If this person spends their time working on MBA teaching they are not doing what they are "world-class" at: research. Is this really a good use of their time?

Another question I would ask is, What is economics doing in the MBA program in the first place? I don't see the justification for having it.

Power corrupts ......

Russ Roberts writes at the Cafe Hayek blog

Go back to the campaign of 2008, McCain (remember him?) and Obama. Suppose in the middle of the campaign, someone returned from the future and told you that by 2011, the President of the United States will have kept Guantanamo Bay open, launched a war against Libya, and crossed covertly into an ally’s territory to assassinate Bin Laden. Who would you think that would be? McCain or Obama?

To me Obama has ended up looking a lot like Bush on these matters. Roberts asks

What happened?

and comes up with three possible answers,

Three possibilities come to mind. The first is that politicians on the campaign trail lie and dissemble. They need to motivate their base, craft an image, and so on.

The second possibility comes from a CIA economist who told me in the middle of the 2008 campaign that when Obama becomes President, he’ll know what Bush knows (meaning horrific and frightening classified information) and he’ll do the same thing as Bush.

The third possibility is that when you get into power, you change. It’s fun to play video games with real lives. You can’t help yourself. It’s easy to convince yourself (given that classified information) that you have no choice.

Roberts goes for a combination of 2 and 3 as the answer and I would have to agree, with an emphasis on 3. What I don't get is why people seemed to think Obama would be different as president. Power corrupts ..........

Incentives matter: Bin Laden file

From the New York Times

When children playing in the fields let a ball fly into the compound by mistake, the owners never let them retrieve it but gave them 50 rupees to buy a new one, said one of the neighbors, a woman with a small boy on her hip who gave her name only as Bibi. When the children began to throw balls into the compound on purpose to get more money, the owners kept paying, she said, laughing.

Prepay, use less

Michael Giberson at the Knowledge Problem blog writes,

The most detailed study of a prepaid power program in the United States is EPRI’s “Paying Upfront: A Review of Salt River Project’s M-Power Prepaid Program.” The report provides a good overview and assessment of the program. See the abstract, copied below, for more of a description of the content.

Giberson continues,

One issue of interest with prepaid is whether it promotes energy conservation. The Salt River Project has studied this question a few times and, with varying methods, has found that M-Power customers tend to consume about 12 percent less power than customers on traditional post-paid power accounts.

Which raises the obvious question of Why? Giberson notes,

Not all of the conservation effect may be due to the prepaid program itself, however. In M-Power, consumers get an interval meter installed that can provide relatively instant feedback on consumption rates and remaining balance. Non M-Power consumers get a monthly paper bill that arrives a week or so after the end of the billing period. Some of the conservation effect may be driven by the instant feedback and greater sense of awareness and control that such a device provides.

So if you give people better information about their consumption, they control that consumption better. Is that really so surprising?

The abstract:

Arizona’s Salt River Project (SRP) has operated M-Power, the largest electricity prepayment program in the United States, since 1993. The customer population has grown to about 100,000 (approximately 12% of all residences served by SRP), and it has expanded from the initial target population—consumers with arrears facing service terminations and low-income customers—to include consumers with different expectations from M-Power service. The in-home portion of the SRP prepay configuration consists of a user display terminal (UDT) that communicates with the customer’s meter. The purchasing component of the M-Power program is the self-service kiosk, known as a PayCenter, accessed via a Smart Card, which is also the conduit through which electricity consumption information is transferred back to SRP.

The constant aspects of the M-Power experience have been a high level of customer satisfaction and an overall conservation effect reported by SRP of approximately 12%. SRP attributes the conservation effect to a variety of factors, noting that M-Power requires consumers to pay attention to when and how they use electricity, allowing them to make immediate adjustments in usage to lower their bills.

This report provides an overview of how the M-Power program works along with an examination of the technology, systems, and costs associated with the program. The overview is followed by an analysis of customer perceptions of the program as well as a discussion of the program’s potential conservation effect. The report concludes with a discussion of impact studies needed to answer several outstanding research questions, including the effect of various types of payment options on conservation as well as whether SRP’s experience is transferrable to other markets, climates, customer circumstances, and supply conditions.

Human capital and the industrial revolution

Or the knowledge economy has been important for a long time. A question often asked about the industrial revolution is, Why Britain? Well part of the answer may be human capital, the knowledge and skills of the British workforce. A new NBER working paper,"The Rate and Direction of Invention in the British Industrial Revolution: Incentives and Institutions", by Ralf Meisenzahl and Joel Mokyr argues:

During the Industrial Revolution technological progress and innovation became the main drivers of economic growth. But why was Britain the technological leader? We argue that one hitherto little recognized British advantage was the supply of highly skilled, mechanically able craftsmen who were able to adapt, implement, improve, and tweak new technologies and who provided the micro inventions necessary to make macro inventions highly productive and remunerative. Using a sample of 759 of these mechanics and engineers, we study the incentives and institutions that facilitated the high rate of inventive activity during the Industrial Revolution. First, apprenticeship was the dominant form of skill formation. Formal education played only a minor role. Second, many skilled workmen relied on secrecy and first-mover advantages to reap the benefits of their innovations. Over 40 percent of the sample here never took out a patent. Third, skilled workmen in Britain often published their work and engaged in debates over contemporary technological and social questions. In short, they were affected by the Enlightenment culture. Finally, patterns differ for the textile sector; therefore, any inferences from textiles about the whole economy are likely to be misleading.

If human capital was a big player in the industrial revolution then the claims made by some politicians and bureaucrats that in recent times we have developed a "knowledge economy" based around ICTs and the growing importance of human capital look a bit odd. They seems to have missed the basic point that knowledge and human capital have always been important to the economy.

Government ditches 2025 taskforce

But what is surprising here. As I have written on the taskforce before

I think most economists would basically agree that the government is involved in areas where it shouldn't be and reducing the government's business footprint and size in general would help simulate growth. The other points noted above also don't look all that radical. But the government will nevertheless ignore the report.

And if you are going to ignore the commission's reports, why have the commission?

As this report from YahooExtra news notes

The 2025 Taskforce made several recommendations the Government ruled out adopting, such as slashing spending by $9 billion, cutting taxes, reducing beneficiary numbers, raising the pension age, selling state-owned assets and vigorously encouraging foreign investment.

and there was never anyway that this government was going to run with such recommendations. This is a conservative government, in all meanings of the word.

Incentives matter: cycling file

This from Eamonn Butler at the blog for the Adam Smith Institute,

UK transport minister Norman Baker this week refused to apologise for saying that cyclists may be safer not wearing helmets. Baker, whose role includes responsibilities for cycling, cited research that drivers tend to go closer to cyclists who are wearing helmets, but give a wider berth to those who are not. Indeed, the national cyclists' organisation itself argues that those who wear helmets are 14% more likely to have a collision than those who don't. Perhaps drivers take more risks because they believe that helmet-wearing cyclists are well protected; or perhaps they think that cyclists without helmets are more amateur and likely to cycle more erratically, making it best to keep well out of their way.

The basic point is simple, and widely applicable: if people believe they are safer, they will take more risks. The strangest thing here is that a politician is saying something so sensible.

Christchurch door open for asset sales

We can only hope. An obvious question here is when should the government -local or national- own a firm? As a general guide, Hart, Shleifer and Vishny ("The Proper Scope of Government: Theory and an Application to Prisons", Quarterly Journal of Economics, 112(4): 1127-61, November 1997) argue that the case for government provision of goods or services is generally stronger when non-contractible cost reductions have large deleterious effects on quality, when quality innovations are unimportant and when corruption in government procurement is a severe problem. It has been argued that the case for government production is strong in such services as the conduct of foreign policy, police and armed forces. The case can also be made reasonably persuasively for the case of prisons. The case for private sector provision is stronger when quality reducing cost reduction can be controlled through contract or competition, when quality innovations are important and when patronage and powerful unions are a severe problem inside the government.

According to this piece at stuff.co.nz the City Council owns the following assets,

Christchurch City Holdings Ltd (CCHL) is the commercial and investment arm of the Christchurch City Council. CCHL manages the ratepayers' investment in these seven fully or partly-owned council-controlled trading organisations: Orion New Zealand Ltd – 89.3 per cent shareholding. Christchurch International Airport Ltd – 75 per cent. Lyttelton Port Company Ltd – 78.9 per cent. Christchurch City Networks Ltd (trading as Enable Networks) – 100 per cent. Red Bus Ltd – 100 per cent. City Care Ltd – 100 per cent. Selwyn Plantation Board Ltd – 39.3 per cent.

It's hard to see how any of these assets are in anyway like foreign policy, the police or the armed forces. It is difficult see how non-contractible cost reductions would have negative effects on quality and it seems likely that quality innovations are important in these areas, so (local) government ownership is not justified.

Matching markets: theory and practice

This the title of a new paper by Atila Abdulkadiroglu and Tayfun Sonmez which was presented at the 2010 Econometric Society World Congress in Shanghai.

This survey cover both one-sided matching and two-sided matching. In Section 2 they introduce and briefly go over some of the key results in two-sided matching model by Gale and Shapley (1962). In Section 3 they introduce the "housing market" model by Shapley and Scarf (1974) as well as a number of more recent one-sided matching models, some of which are closely related to two-sided matching models. In Section 4 they present the recent developments in School Choice and in Section 5 they present the recent developments in Kidney Exchange.

EconTalk this week

John Papola of Emergent Order talks with EconTalk host Russ Roberts about their collaboration creating rap videos based on the ideas of John Maynard Keynes and F. A. Hayek. Their first was "Fear the Boom and Bust" which was released January 25, 2010. This past week they released "Fight of the Century." The latest video discusses the overarching differences between the philosophies of Keynes and Hayek and their views on whether government spending promotes recovery from an economic downturn and whether it leads to prosperity. In this conversation, Papola and Roberts discuss some of the underlying ideas in the video--whether the military spending of World War II ended the Great Depression, the debate between Malthus and Say and their influence on Keynes and Hayek, and the fundamental differences between Keynes and Hayek in how economic prosperity is created.

Entrepreneurship and the economic theory of the firm

This is the title of a talk given by Peter Klein at the University of São Paulo. Click here to see the whole lecture.

The Church and the firm

From the JEL article mentioned in a previous posting comes the following comment:

Firms are an essential part of the economy. However, as Daniel Spulber points out [...] the modern firm is a relatively recent phenomenon. From the earliest times to the eighteenth century, business was carried out by farmer, artisans, and merchants (Spulber, p. 103). According to Alfred D. Chandler, merchants still ruled the (American) economy in 1790. The family remained the basic business unit. The general merchant bought and sold all types of products and carried out all the basic commercial functions. By the 1840s, such tasks were being carried out by different types of specialized enterprises. However, it was still true that these enterprises were personally managed by their owners or by managers who worked closely with the owners. It was only in the second half of the nineteenth century that the world saw the emergence of the modern corporation, a multiunit enterprise operated by teams of salaried managers who had little or no equity in the firm (Chandler 1977, p. 17; Chandler 1990, pp. 1, 14).

But I can't help thinking that the multiunit enterprise is older than this would comment would suggest. In fact what is, I'm guessing, the oldest multinational company still operating in world today would tell us that the large corporation is older than many would think.

The Roman Catholic Church has been in operation for hundreds of years, in multiple countries. From the start it has been a large, sophisticated, multinational company with the Pope acting as the CEO, the College of Cardinals as the board of directors and the bishoprics and monasteries as its franchises. It is an early antecedent to the General Motors, BPs and Microsofts of today. The Church is basically what Oliver Williamson calls a M-form corporation. The Church assigned operating decisions to self-contained operating divisions consisting of monastic orders, dioceses and other sub-entities. The general office maintains the papal bureaucracy (the Curia) that acts as an advisor to the Pope in his role of CEO. It also monitors the behaviour of the clergy (rather poorly in come obvious cases) who are in the operating divisions, in much the same was as franchises are controlled. Strategic policy for the Church is made by the general office, the Vatican in this case. The Vatican also allocates resources among the competing divisions-the monasteries, national churches etc.

The Roman Catholic Church has been, among many other things, a large economic player in many regions of the world for a lot longer than most people realise and thus the "modern" firm isn't as modern as you may think.