Selgin v. Summer

Over at the Free Banking blog the ever interesting George Selgin has a post discussing why Austrian cycle theory and monetarist explanations of booms and busts are not mutually exclusive. Selgin writes,

Having learned my monetary economics from both the great monetarist economists and their Austrian counterparts, I've always chafed at the tendency of people, including members of both schools, to treat their alternative explanations of recessions and depressions as being mutually exclusive or incompatible. According to this tendency, a downturn must be caused either by a deficient money supply, and consequent collapse of spending, or by previous, excessive monetary expansion, and consequent, unsustainable changes to an economy's structure of production.

During the 1930s and ever since, this dichotomy has split economists into two battling camps: those who have blamed the Fed only for having allowed spending to shrink after 1929, while insisting that it was doing a bang-up job until then, and those who have blamed the Fed for fueling an unsustainable boom during the latter 1920s, while treating the collapse of the thirties as a needed purging of prior "malinvestment." As everyone except Paul Krugman knows, the Austrian view, or something like it, had many adherents when the depression began. But since then, and partly owing (paradoxically enough) to the influence of Keynes's General Theory, with its treatment of deficient aggregate demand as the problem of modern capitalist economies, the monetarist position has become much more popular, at least among economists.

It is, of course, true that monetary policy cannot be both excessively easy and excessively tight at any one time. But one needn't imagine otherwise to see merit in both the Austrian and the monetarist stories. One might, first of all, believe that some historical cycles fit the Austrian view, while others fit the monetarist one. But one can also believe that both theories help to account for any one cycle, with excessively easy money causing an unsustainable boom, and excessively tight money adding to the severity of the consequent downturn. I put the matter to my undergraduates, who seem to have little trouble "getting" it, like this: A fellow has an unfortunate habit of occasionally going out on a late-night drinking binge, from which he staggers home, stupefied and nauseated. One night his wife, sick and tired of his boozing, beans him with a heavy frying pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by the ruckus, pokes his head into the doorway, sees our drunkard lying unconscious, in a pool of puke, with a huge lump on his skull. "What the heck happened to him?," he asks. Must the correct answer be either "He's had too much to drink" or "I bashed his head"? Can't it be "He drank too much and then I bashed his head"? If it can, then why can't the correct answer to the question, "What laid the U.S. economy so low in the early 1930s?" be that it no sooner started to pay the inevitable price for having gone on an easy money binge when it got walloped by a great monetary contraction?

This not just a good piece of marriage advise, it is also a good piece of economic advise, one which is missed by many economists who see the Austrian and monetarist views as mutually exclusive.

Selgin goes on to argue that modern economists, including Scott Sumner, have been sucked into a false dichotomy:

Sumner basis his position, not merely on the claim that prices are more flexible upwards than downwards, but on a dichotomy erected in the literature on asset price movements, according to which upward movements are either sustainable consequences of improvements in economic "fundamentals," or are "bubbles" in the strict sense of the term, inflated by what Alan Greenspan called speculators' "irrational exuberance," and therefore capable of bursting at any time. Since monetary policy isn't the source of either improvements in economic fundamentals or outbreaks of irrational exuberance, the fundamentals-vs-bubbles dichotomy implies that monetary policy is never to blame for changes in real asset prices, whether those changes are sustainable or not. If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary policymakers shouldn't be concerned about booms" crowd are right, and the Austrians, Schwartz, Taylor, and others, including Obama and his advisors, who would hold the Fed responsible for avoiding booms, are full of baloney.

Scott Summer not surprisingly sees it differently,

I’m happy to reassure George that I do not believe the things he claims I believe. I believe the Fed often creates booms, and that these booms often lead to recessions. So in that sense my views are quite Austrian. I am particularly surprised by his claim that I don’t believe that monetary policy affects real asset prices, as he recently commented on a post that was devoted to exactly that proposition:

Now here’s where I part company with Keynesians who might have been with me so far. Although short term interest rates are one of those “asset prices” that cause the money market to achieve near instantaneous equilibrium, even as the goods and labor markets are in disequilibrium, they actually have very little role in moving NGDP and prices to the level necessary to restore long run macro equilibrium (and to move interest rates back to their original level.) In my view 60% of the heavy lifting is done by what Keynes called “confidence” and I call “expectations of NGDP growth” and Ford Motors economic forecasters call “expected nominal incomes in 2014 available to buy Ford cars.” Another 35% of the transmission is done by asset markets like stocks, forex, commodities, real estate prices, junk bond yield spreads, etc. And maybe 5% by risk-free short term rates. At most.

So I just claimed that 35% of the transmission effect of monetary policy works through changes in real asset values, and have been saying similar things all along. George is a smart guy, so clearly something I said was misleading, or created a false impression. Perhaps it’s my denial of “bubbles.” I believe in the EMH (i.e. no bubbles), but only for asset markets. Because goods and labor markets have sticky wages and prices, they are not efficient, and monetary stimulus creates booms and busts in terms of output. In some cases, such as the 1970 recession, the blame is almost 100% the preceding boom. Indeed the preceding boom also played a big role in the next few recessions. Where I differ from some Austrians is that I believe the preceding booms in 1929 and 2007 were not major factors in the subsequent slump. In those two cases I think tight money is mostly to blame, perhaps 90% or more. It’s hard to be more precise as the trend line is a judgment call (in the absence of NGDPLT.)

Summer goes on to say that he sees booms and bubbles as unrelated phenomenon. If by boom we mean "excessive nominal spending" then he doesn't see a strong correlation between booms and bubbles.

"When goods don't cross borders, armies will."

Over at the EconLog blog David Henderson is discussing the above quote normally attributed to Frederic Bastiat. But as Henderson points out there is little evidence that Bastiat actually said it. I posted on this topic back in 2009, see here and here.

The closest thing to the above quote I was able to find back in 2009 was one that says,

If soldiers are not to cross international borders, goods must do so.

According Jeffry Frieden, on page 255 of his 2006 book "Global Capitalism", the above quote is due to one Otto Maller and he gives a reference to page 37 of Alfred E. Eckes's 1975 book, "A Search for Solvency: Bretton Woods and the International Monetary System, 1941-1971". Maller, we are told, was a supporter of FDR's Secretary of State Cordell Hull.

It looks like the name Maller is a bit wrong as it should be Mallery. If you can find a copy of the Alfred E. Eckes's book you will indeed find the above quote is on page 37. Eckes writes,

Like nineteenth-century liberals, Otto Mallery believed that free trade was the panacea for economic nationalism and great power rivalries. "If soldiers are not to cross international boundaries," he said, "goods must do so."

The reference that Eckes gives to for the Mallery quote is "Otto T. Mallery, "Economic Union and Enduring Peace," Annals 216 (July 1941): 125-134; quotations on p. 125."

Let me give the full, albeit only two sentence, paragraph from "Economic Union and Enduring Peace" which runs over the bottom of page 125 and the top of page 126:

If soldiers are not to cross international boundaries, goods must do so. Unless shackles can be dropped from trade, bombs will be dropped from the sky. (Emphasis in the original.)

The details given at the end of the paper on Mallery are

Otto Tod Mallery, A.B., Philadelphia, was one of the drafters and sponsors of the National Employment Stabilization Act and is a consultant on the National Resources Planning Board which administers this act. He has originated legislation which brought into being new governmental agencies in Philadelphia and Pennsylvania and has held administrative positions in city, state, and Federal Governments. He was chief economist of the United States Department of Commerce. In 1937 he was economic adviser to the United States Government Delegation to the Conference of the International Labor Organization at Geneva, and in 1939 to the United States Employers' Delegation to the Conference of the American States, members of the Inter- national Labor Organization, at Habana. He is president of the Playground and Recreation Association of Philadelphia, and member of the Board of Directors of The American Academy of Political and Social Science. He is part author of "Business Cycles and Unemployment" (1923).

All of which means we are still left with the question of whether or not the Bastiat quote is genuine. But it seems unlikely.

Robert Pindyck on climate models

Robert Pindyck has a recent NBER working paper that looks at one of the critical tools used in climate policy:
Climate Change Policy: What Do the Models Tell Us?
Robert S. Pindyck
NBER Working Paper No. 19244, July 2013 The abstract answers the question in the paper's title:

Very little. A plethora of integrated assessment models (IAMs) have been constructed and used to estimate the social cost of carbon (SCC) and evaluate alternative abatement policies. These models have crucial flaws that make them close to useless as tools for policy analysis: certain inputs (e.g. the discount rate) are arbitrary, but have huge effects on the SCC estimates the models produce; the models’ descriptions of the impact of climate change are completely ad hoc, with no theoretical or empirical foundation; and the models can tell us nothing about the most important driver of the SCC, the possibility of a catastrophic climate outcome. IAM-based analyses of climate policy create a perception of knowledge and precision, but that perception is illusory and misleading.

Freedom in ideas matters

In their recent book, "How China Became Capitalist," Ronald Coase and Ning Wang argue that the market in ideas matters for the future well-being of China. Coase and Wang deplore China's lack of a free market for ideas and the damage that this has wrought on universities and on the Chinese economy's capacity to innovate.

But just how bad are the controls on academics in China's universities? A part answer to this question may be reflected in this recent posting on Greg Mankiw's blog:

A professor in China brings this story to my attention:

A renowned professor has confirmed online rumours that his peers will decide whether he will be expelled from China's most eminent university after he made a series of remarks in favour of free speech and constitutional governance.

Economics professor Xia Yeliang of Peking University was told by his department that his fate would be decided by a faculty vote, he told the South China Morning Post on Monday.

"They told me it's because of all the things I have said and written," Xia said. "They have threatened me before, but this is the first time they will vote on my expulsion."

My correspondent says that the vote will likely take place in September. He also reports that this is not an isolated incidence. He writes, "Though you may not be aware, there is a quiet crack down currently under way in China with other professors being removed for similar offenses....I can tell you from my personal experience here, most Chinese faculty at PKU and other elite Chinese institutions having been educated at top schools in the US are appalled but are quite fearful to speak out."

There are some very obvious issues here about the role of academics in Chinese society - "critic and conscience of society" in New Zealand terms - and for the freedom of speech but if Coase and Ning are right then the effects of such repression could go further than just the social and political spheres, it could negatively effect the future growth of the Chinese economy. Growth that in recent times has resulted in millions of people being raised out of poverty. Anything which retards the enormous potential for future growth that the Chinese economy has must be of concern to anyone who is worried about the well-being of the many millions of people who are still poor in China today.

Why is it that the expression "third way" always worries me? 3

Let me make a few quick comments in reply to Jason Krupp. First let me apologise for any misrepresentation I may have made, this was unintended.

My point about the meaning of ownership is that even taking into account "democracy and the nature of general elections versus specific referenda" taxpayers do not have the rights defining ownership. The residual controls rights for SOEs are not in the hands of taxpayers, these rights are held by the government or its bureaucracy. I fail to see how your dinner companion can in anyway think they are an owner of any SOE in that they do not have residual control rights over any SOE. Or at least this would be my reply to them.

My point about the government being the single shareholder isn't that having a single shareholder is bad, its about the government being a majority shareholder. I would argue that there is likely to be little difference in the operations of an SOE as long as the government is the majority shareholder. Thus an SOE under 100% government ownership will look much like an SOE with 51% government ownership. Hence my comment on the García and Ansón paper.

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

As to having millions of people acting in the role of shareholder this may or may not be a good thing. It is not clear that we need to "foster a savings culture in New Zealand", there is no saving problem here - see, for example, Le, Scobie and Gibson (2009) and Le, Gibson and Stillman (2012) for more on this.

Even if we want, and don't have currently, a "thriving equity market" its not clear that this should be an aim of a privatisation program. The aim should be efficiency and productivity. Roger Douglas made this point in an article from the New Zealand Herald.

"Privatisation is not really about how much money you get for the asset, that's important, but the more important issues are to get the regulatory environment right so that competition can take place in the industry.

"What you measure your success by is the productivity that flows following the corporatisation / privatisation process."

The New Zealand sharemarket may not be thriving, but is it the government's job to fix this, any more than it is the government's job to fix or support any other sector of the economy? I can't help thinking it is not the job of any government to bolster the sharemarket, that is the job of the those who run the sharemarket.

Refs:

• Le, Trinh, Grant Scobie and John Gibson (2009). Are Kiwis saving enough for retirement? Evidence from SOFIE, New Zealand Economic Papers 43(1): 3-19.
• Le, Trinh, John Gibson and Steven Stillman (2012). Wealth and saving in New Zealand: evidence from the longitudinal survey of family, income and employment, New Zealand Economic Papers 46(2): 93-118.

Why is it that the expression "third way" always worries me? 2

The following comes from the comments section to my previous posting Why is it that the expression "third way" always worries me? and is from Jason Krupp author of the New Zealand Institute piece I was commenting on. Let me thank Jason for taking the time to write this comment.

Dear Anti-Dismal:

I enjoyed the article, and you raise many valid points, though some of the positions you attribute to me are a little off.

Firstly, it's the critics of the mixed ownership who've claimed New Zealanders already own the state owned assets. In fact I remember a particular dinner conversation in which one guest said of the partial float “why should I pay for what’s already mine?”.

As for the complicated morass of property rights, democracy and the nature of general elections versus specific referenda, well, I’m sure you’ll agree that it’s too broad to tackle in the 500 words I had to work with.

Also, in a piece of this nature you have to take a few short cuts, such implying Government ownership when referring to a single shareholder. Should I have spelled it out?
Perhaps, but I’m giving the reader the deductive benefit of the doubt – one I’m confident they’ve made.

This need for short cut extends to the share ownership issue you’ve taken umbrage with. Of course we won't have 4.4m shareholders for long as some will sell and some will hold because there is a free market to sell them - something that wasn't available in the Soviet example you used.

But those who sell can use those funds for other things – investing in a business, paying down debt, splashing out at the shops – which have upside benefits for the economy and the government’s coffers.

And adding millions of people to the shareholder roll is a good on many levels. It’s a fantastic way of building up knowledge in the equity market, which we need if we are going to foster a savings culture in New Zealand.

I’m sure you’d also agree that a thriving equity market (which we don’t have at the moment, but it’s getting better) is essential if we’re going to lower the cost of capital for New Zealand businesses, which is notably higher than across the Tasman.

Lastly, “selling 100 per cent of the SOEs by any means would mean that this is at best a one-off trick” is exactly the point, albeit a Hayekian one. If, as a politician, you know you can’t sell the family silverware to get you out of debt, you’re likely to think a bit more carefully about what you’re getting into debt for (actually that might be a little naive).

In conclusion, you’re right, the third way is not that clear at all, but equally neither are the benefits/costs of other options.

Jason Krupp
The New Zealand Initiative

Abusing science in the cause of paternalism

The Institute of Economic Affairs in London has released a new policy paper on Quack Policy – Abusing Science in the Cause of Paternalism by Jamie Whyte.

A quick summary of the paper's findings is given by:

• Politicians and lobbyists who promote new regulations and taxes typically claim to have science on their side. Scientific evidence shows that the actions they wish to discourage are harmful and that government intervention would reduce this harm. Yet much ‘evidence-based policy’ is grounded on poor scientific reasoning and even worse economics.
• Recent examples from the U.K. of flawed evidence-based policy include the proposal to introduce a minimum alcohol price, the ban on smoking in enclosed public spaces, measures to reduce greenhouse gas emissions and attempts to increase gross national happiness.
• A frequent error is to ignore the costs resulting from the policy. For example, minimum alcohol price plans do
not consider the welfare losses associated with reduced consumption among recreational drinkers. The benefits of alcohol consumption, and hence the cost of reducing it, are simply ignored in the analysis.
• Evidence-based policy typically also fails to account for substitution effects, such as the way a minimum alcohol price would encourage consumers to purchase drinks in the shadow economy or adopt intoxicating alternatives to alcohol.
• The external costs of harmful activities are central to the arguments for state intervention but often cannot be calculated with any certainty. To estimate the external cost
of carbon emissions, for example, we would need to know
the subjective preferences of people around the world, and somehow weigh them against each other. We would also need to make assumptions about the preferences of people living many decades in the future.
• The predictions of theories that have not been tested, and are not entailed by well-known facts, do not warrant high levels of certainty. Those who insist on this are not ‘anti-science’, as they are often claimed to be. On the contrary, it is those who are willing to be convinced in the absence of predictive success who display an unscientific cast of mind.
• High levels of scientific doubt are often concealed as a result of ‘noble-cause corruption’. Scientists may exaggerate levels of confidence in their findings if it promotes actions they happen to support. This problem is particularly acute in fields that have long been policy battlegrounds, such as climate, health and education. Many scientists entered such fields because they were already committed to a particular policy agenda.
• Scientists are also interested parties. They stand to gain from policy taking one direction rather than another and will be tempted to support the personally profitable policy direction. Public policy can create demand for their skills and hence drive up the rewards accruing to them. Scientists are natural supporters of policies that draw on their expertise and thus inclined to overstate the credibility and importance of their ideas.
• Expert practitioners in one field may be quite ignorant of other fields, knowing little about either their theory or methods. ‘Expertise slippage’ is the tendency to defer to experts on matters which fall outside their area of expertise. Climate scientists, for example, are experts on hardly any of the issues that determine which climate polices are best. They have no special knowledge of how businesses will respond to taxes or the relative welfare costs of reduced growth.
• Paternalist policies promoted by experts and politicians show contempt for the actual preferences of the general public. People are forced to live according to values that they reject. For example, supporters of ‘happiness policy’ believe the state should coerce people to act against their preferences in ways that policymakers think will increase their wellbeing.

At the heart of argument is an idea central to economics but not to the thinking of many policy makers: trade-offs. Take, as an example, the case of alcohol pricing. It could be true that raising the price of alcohol will reduce the number of alcohol-related injuries, in much the same way that lowering the speed limit will reduce the number of traffic accidents. From this narrow perspective, demands for a minimum price of $0.50, say, for a unit of alcohol and a 20 mph limit on urban roads can be viewed as "evidence-based", both could show a reduction in harms. Which would be a good thing. But, enjoying a drink and getting from A to B in good time are also good things. If the aim of the policy is to have fewer alcohol based injuries then we can have them but it will come at the cost of millions of dollars in higher drink prices and might mean more moonshine and drug use; that is people will substitute cheaper black market alcohol or drugs for more expensive legal alcohol. In the same way we can have fewer traffic accidents but it comes at the cost of driving at a crawl and being less efficient.

In any policy making both costs and benefits have to be taken into account, that is we have to consider both the winners and the losers from a change in policy. Any policy analysis which considers only the bad is not worth the paper it is written on. In Whyte's view the failure to acknowledge trade-offs and competing preferences is endemic in much of the so-called evidence-based policy. By looking at only the "bad side" of a situation you run the very real risk of causing more harm than good. Why not, for example, have a $500 minimum price of alcohol or a 5 mph speed limit. I'm sure that the evidence would show that both policies would reduce harm and thus would pass as "evidence-based policy". But it comes at the cost of denying people the pleases of drinking and the benefits of driving. Would it be a trade-off worth making?

EconTalk this week

Eric Hanushek of Stanford University's Hoover Institution talks with EconTalk host Russ Roberts about his new book, Endangering Prosperity (co-authored with Paul Peterson and Ludger Woessmann). Hanushek argues that America's educational system is mediocre relative to other school systems around the world and that the failure of the U.S. system to do a better job has a significant negative impact on the American standard of living. Hanushek points to improving teacher quality as one way to improve education.

Why is it that the expression "third way" always worries me?

 In the latest issue of "Insights" from the New Zealand Institute Jason Krupp argues for A third way on asset sales.

Krupp argues that

The anti-privatisation camp, rightly or wrongly, have taken glee in pointing out that the Government is selling off assets that generate higher dividend returns than the equivalent interest rate on our public debt.

If true, then it just tells us that the method of sale is wrong, the government is not capturing the full amount of money it could if it used a different method of sale. Answer, change the method of sale.

Also Krupp says,

Critics have also noted retail investors will be paying for these assets twice, since they’re technically owned by all New Zealanders anyway. Plus, those who don’t participate are having part of their national wealth snatched away from them.

This is just plain wrong, New Zealanders do not own the SOEs. Oliver Wendell Holmes Jr. asks the question: What are the rights of ownership? His answer,

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

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

Madsen Pirie at the Adam Smith Institute blog puts it this way

The state sector may have the name of the public filled in on the dotted line, but the public do not own it in any meaningful sense of the word. All of the attributes of ownership, such as control, the right to determine what use is made of it and under what conditions, is determined by the bureaucracy in command of it.

and

Because the public has no choice over whether to pay for state services, or to choose what quality of service is appropriate for them, they have no power over them. In their absence it is the managers and workforce who increasingly direct the services to meet their needs and convenience instead of those of the public.

Krupp continues,

Indeed, it could be argued that the efficiency drag of a single shareholder [the government] can already be seen, with Contact Energy and TrustPower (two private companies with diverse shareholder bases) offering the highest returns on equity in the sector. Returns from the state-owned firms lag behind these two companies by a noticeable margin, even though they’ve been operating as private entities for over a decade.

The issues here isn't so much that there is a single shareholder, its that the shareholder is the government. A firm with a single private shareholder would act differently from the SOEs. This is one reason for not liking partial privatisation, the government keeps control with its 51%.

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

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

When you look at the performance of mixed ownership firms they don't do as well as fully privately owned firms. For example, Aidan Vinning and Anthony Boardman in "Ownership and Performance in Competitive Environments: A Comparison of the Performance of Private, Mixed, and State-Owned Enterprises", Journal of Law and Economics vol. XXXII (April 1989) conclude

'The results provide evidence that after controlling for a wide variety of factors, large industrial MEs [mixed enterprises] and SOEs perform substantially worse than similar PCs [private corporations].'

So fully private firms out-perform mixed ownership firms.

Krupp then asks,

So, given these compromises, has the hybrid privatisation been worth it?

In my view there are at least 6 reasons for thinking hybrid privatisation will not be worth it:

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

Krupp ends by saying,

Frankly, it’s too early to tell, but it’s interesting to consider that there could have been a third option: just giving the shares away (as pointed out by Professor Sinclair Davidson of the Royal Melbourne Institute of Technology).

While the government would give up a dividend stream, that’s traded off against the $10 billion it would inject into the economy at a local level.

It also scratches two other important itches; it instantly creates 4.4 million equity investors, and removes the political temptation to win votes by blow-out spending, knowing you can sell off parts of the balance sheet when the debts come due.

It should be noted that giving shares away has been used before, especially in the old Soviet Union, but its not clear that its outcomes where that successful. You also have to ask, Why do we want "4.4 million equity investors"? What we want is an ownership structure that results in the most efficient use of our resources, How can we know that having "4.4 million equity investors" is that structure? I'm guessing that most people would not want their shares and thus would simply sell them which results in fewer than "4.4 million equity investors", which seems to defeat Krupp's aim of creating these investors in the first place. All it would do is change who gets the rewards from selling the shares. This may, or may not, be a good thing.

As to the aim of removing the "political temptation to win votes by blow-out spending", selling 100% of the SOEs by any means would mean that this is at best a one-off trick.

All in all its not clear that the third way is the right way.

Not thinking like an economist is dangerous

James Zuccollo at the TVHE blog points us to this piece from the Daily Mail in the U.K.

A council is considering urging taxi firms to provide cheaper cab fares for women who wear revealing clothes.

Brentwood Borough Council is considering the bizarre move in a bid to stop women wearing short skirts or low-cut tops becoming a target for sex attackers.

The council is considering discounted taxi prices so that 'provocatively dressed' women can be driven back home and have less of a problem getting a ride.

This is a good example where not thinking like an economist gives rise to the opposite outcome from that intended. The intention seems to be to get more "provocatively dressed women" (whatever that means) home safely in taxis but the effect of this lower fare may well be the opposite. If "provocatively dressed women" were to be charged a lower fare that would mean they are less profitable to carry than a non-provocatively dressed woman or a man. This would mean that taxi drivers would be less likely to drive "provocatively dressed women" home than other women or men thereby reducing the number of such women taken home safely. Also there is the issue of the effect of the lower fare on the number of "provocatively dressed women" out and about.

In short, such a policy would not work.

EconTalk this week

Jagdish Bhagwati of Columbia University talks with EconTalk host Russ Roberts about the economy of India based on his book with Arvind Panagariya, Why Growth Matters. Bhagwati argues that the economic reforms of 1991 ushered in a new era of growth for India that has reduced poverty and improved the overall standard of living in India. While supportive of social spending on the poor, Bhagwati argues that growth should precede higher levels of spending, providing the tax revenue for expanded spending.

One up for a carbon tax

A new NBER working paper looks at Carbon Taxes vs. Cap and Trade: A Critical Review. The paper by Lawrence H. Goulder and Andrew Schein sees advantages in a carbon tax when compared to a cap-and-trade.

The abstract reads:

We examine the relative attractions of a carbon tax, a “pure” cap-and-trade system, and a “hybrid” option (a cap-and-trade system with a price ceiling and/or price floor). We show that the various options are equivalent along more dimensions than often are recognized. In addition, we bring out important dimensions along which the approaches have very different impacts. Several of these dimensions have received little attention in prior literature.

A key finding is that exogenous emissions pricing (whether through a carbon tax or through the hybrid option) has a number of attractions over pure cap and trade. Beyond helping prevent price volatility and reducing expected policy errors in the face of uncertainties, exogenous pricing helps avoid problematic interactions with other climate policies and helps avoid large wealth transfers to oil exporting countries.

EconTalk this week

Barry Weingast, the Ward C. Krebs Family Professor of Political Science at Stanford University and a Senior Fellow at Stanford's Hoover Institution talks with EconTalk host Russ Roberts about the role of violence and the threat of violence in maintaining destructive economic policies that reduce growth and development. Weingast argues that the threat of violence encourages leaders to create monopolies and other unproductive policies to pay off special interests that would otherwise threaten a coup or revolution. Weingast shows there is a surprising amount of violent regime change in modern times and discusses how this discourages growth-enhancing economic policies. The conversation closes with an analysis of similar ideas in Book III of Adam Smith's Wealth of Nations.

Raghuram Rajan on public economic debate

But, for economists who actively engage the public, it is hard to influence hearts and minds by qualifying one’s analysis and hedging one’s prescriptions. Better to assert one’s knowledge unequivocally, especially if past academic honors certify one’s claims of expertise. This is not an entirely bad approach if it results in sharper public debate.

The dark side of such certitude, however, is the way it influences how these economists engage contrary opinions. How do you convince your passionate followers if other, equally credentialed, economists take the opposite view? All too often, the path to easy influence is to impugn the other side’s motives and methods, rather than recognizing and challenging an opposing argument’s points. Instead of fostering public dialogue and educating the public, the public is often left in the dark. And it discourages younger, less credentialed economists from entering the public discourse.

More can be found here.

Raghuram Rajan is a Professor of Finance at the University of Chicago Booth School of Business and the next Governor of the Reserve Bank of India. New Zealand can only dream of having such people running their central bank.

Keynes on "The Road to Serfdom"

It is well known that John Maynard Keynes said of Hayek's "The Road to Serfdom":

In my opinion it is a grand book [...] Morally and philosophically I find myself in agreement with virtually the whole of it: and not only in agreement with it, but in deeply moved agreement.

What was not known, to me at least, is what Keynes said later in the letter from which the above quote comes. At the end of his letter to Hayek, Keynes wrote,

I come finally to what is really my only serious criticism of the book. You admit here and there that it is a question of knowing where to draw the line. You agree that the line has to be drawn somewhere [between free-enterprise and planning], and that the logical extreme is not possible. But you give us no guidance whatever as to where to draw it. In a sense this is shirking the practical issue. It is true that you and I would probably draw it in different places. I should guess that according to my ideas you greatly underestimate the practicability of the middle course. But as soon as you admit that the extreme is not possible, and that a line has to be drawn, you are, on your own argument, done for since you are trying to persuade us that as soon as one moves an inch in the planned direction you are necessarily launched on the slippery path which will lead you in due course over the precipice.

I should therefore conclude your theme rather differently. I should say that what we want is not no planning, or even less planning, indeed 1 should say that we almost certainly want more. But the planning should take place in a community in which as many people as possible, both leaders and followers, wholly share your moral position. Moderate planning will be safe if those carrying it out are rightly orientated in their own minds and hearts to the moral issue. This is in fact already true of some of them. But the curse is that there is also an important section who could almost be said to want planning not in order to enjoy its fruits but because morally they hold ideas exactly the opposite of yours, and wish to serve not God but the devil. [...] What we need is the restoration of right moral thinking - a return to proper moral values in our social philosophy. If only you could turn your crusade in that direction you would not feel quite so much like Don Quixote.

It seems Keynes believed in philosopher-kings, disinterested, public-spirited people working wholly for the public good. I wish him luck with that. But his point about the "slippery path" is one often made with regard to Hayek's argument.

The Tiwai industrial bailout (updated)

Over at the TVHE blog Matt Nolan writes on what he calls The Tiwai industrial subsidy. He points us to two articles from Infometrics that are relevant to the topic:  Tiwai and electricity and on the Southland workforce and a managed exit. These are well worth reading.

I would like to make an additional point about the opportunity cost of the bailout. Let us assume, for no good reason, that the bailout actually works and 800 jobs are "saved". Does this mean that the government has spent your money wisely? May be not, the government could have used the $30m in some other way and these alternative uses could have generated more than 800 jobs. The bailout will stop or at least delay what is most likely a necessary reallocation of resources within the New Zealand economy. Aluminium smelting is an industry that New Zealand doesn't now, if it ever did, have a comparative advantage in. Reallocating resources and people from the smelter closure will in the short term be painful but beneficial over the longer term. This is why Matt's point about the government helping the plant wind-down in an orderly fashion has merit. Thus to show that this particular bailout is a good use of taxpayer's money the government not only has to show that it will work but it also has to show that the bailout is the best use of taxpayer money. What's the bet it can't do either?!

I do, also, find myself wondering - and not in a good way - about the relationship between this deal and the forthcoming partial sale of Meridian.

Update: Seamus Hogan comments here on the politics of all of this.

The why (or why not) of vertical integration

At the Latent Paradigm blog Seth Goldin asks Why would a firm choose vertical integration? Part of Goldin's answer reads,

Why would a profit-maximizing firm choose vertical integration? Recall from Coase that firms exist to minimize transaction costs. If transaction costs between lessors and lessees are high enough, vertical integration is attractive. According to the widely cited 1978 paper by Benjamin Klein, Robert G. Crawford, and Armen A. Alchian, we might see vertical integration from a specific kind of transaction cost: post-contractual opportunistic behavior. A production technology with high fixed costs that cannot be recovered by being scrapped into alternative uses will tend to be vertically integrated into the rest of the product’s production process. What are some implications of this? The paper explains:

• Fisher Body once supplied specialized metal dies that would stamp entire automobile bodies for General Motors. Fisher repeatedly tried to extract monopoly rents from GM, but eventually, in 1926, the companies merged.
• Oil refineries are usually vertically integrated with oil pipelines, but not with oil tankers. An independent oil refinery would be hostage to a monopsonistic pipeline lessor, but an oil tanker has a potential appropriable rent near zero, because an oil tanker could easily be repurposed for shipping other goods.
• Owners of highly perishable crops are quite vulnerable to collective demands by their laborers. Slavery was a form of vertical integration, but now, absent slavery, long-term labor contracts with unions consist of rigid wages with layoff provisions so that employers can’t opportunistically claim false reductions in demand.
• Franchise relationships mimic vertical integration because, although a franchisee is technically an independent firm, the franchisee is essentially renting a brand, and is subject to certain controls by the franchisor.
• Specific capital investments that have high fixed costs and can’t be easily repurposed could be subject to opportunistic behavior by workers, so the owners of firms tend to own specialized capital investments. Owners of firms use detailed employment contracts to prevent the appropriation of specialized capital by their employees. Such detailed employment contracts mimic the function of vertical integration.

The interesting point about the Klein, Crawford and Alchain argument is that Coase rejects it! As Klein himself  summarised the situation,

I have always considered my work with Armen Alchian and Robert Crawford (1978) on vertical integration to represent an extension of Coase's classic article on "The Nature of the Firm." By focusing on the "hold-up" potential that is created when firm-specific investments are made by transactors, or what we called the appropriation of quasi-rents, I believed we had elucidated one aspect of the Coasian concept of transaction costs associated with market exchange. We hypothesized that an increase in firm-specific investments, by increasing the market transaction costs associated with a hold-up, increased the likelihood of vertical integration. This relationship between firm-specific investments, market transaction costs, and vertical integration was illustrated by examining the contractual difficulties that existed when General Motors purchased automobile bodies from Fisher Body and the corresponding benefits that were created when the parties vertically integrated.

It is clear from Coase's lectures that he considers our analysis not to represent an extension of his earlier work, but rather to be an alternative, incorrect explanation for vertical integration (1988: lecture 3). Coase recognizes that an increase in the quasi-rents yielded by firm-specific investments creates a hold-up potential. However, he argues that there is no reason to believe that this situation is more likely to lead to vertical integration than to a long-term contract. Although long-term contracts are imperfect, opportunistic behavior is usually effectively handled in the marketplace, according to Coase, by a firm's need to take account of the effect of its actions on future business. Coase claims that before writing his classic paper he explicitly considered opportunistic behavior as a motive for vertical integration, in particular as it applied to the General Motors-Fisher Body case, and explicitly rejected it.

The Klein, Crawford and Alchain paper has also lend to the soap opera that is the literature on the General Motors-Fisher Body integration. Some people claim hold-up drove the GM takeover of Fisher Body, some say there was no hold-up at all while others say there was hold-up by the Fisher brothers, but only after the takeover by GM and yet others blame the lawyers!

Read Baird (2003), Casadesus-Masanell and Spulber (2000), Coase (2000), Coase (2006), Freeland (2000), Goldberg (2008), Klein (1988), Klein (1996), Klein (2000), Klein (2007), Klein (2008) and Klein, Crawford and Alchian (1978) ... and then decide.

In short vertical integration is complicated. Modern organisational economics offers diverse theories of the boundaries of firms (i.e. theories of vertical integration). Such theories are based around various frictions or transaction costs; Knightian uncertainty, imperfect foresight or bounded rationality, small-numbers bargaining, haggling costs, private information, cost of processing information, costs of inspecting quality or imperfect legal enforcement. Given such costs internalising activities within a firm may be more efficient than relying on market transactions.

(HT: Knowledge Problem.)

Refs.:

• Baird, Douglas G. (2003). ‘In Coase’s Footsteps’, John M. Olin Law & Economics Working Paper No. 175 (2d series), The Law School The University Of Chicago, January.
• Casadesus-Masanell, Ramon and Daniel F. Spulber (2000). ‘The Fable of Fisher Body’, Journal of Law and Economics, 43(1) April: 67-104.
• Coase, Ronald Harry (2000). ‘The Acquisition of Fisher Body by General Motors’, Journal of Law and Economics, 43(1) April: 15-31.
• Coase, Ronald Harry (2006). ‘The Conduct of Economics: The Example of Fisher Body and General Motors’, Journal of Economics & Management Strategy, 15(2) Summer: 255-278.
• Freeland, Robert F. (2000). ‘Creating Holdup Through Vertical Integration: Fisher Body Revisited’, Journal of Law and Economics, 43(1) April: 33-66.
• Goldberg, Victor P. (2008). ‘Lawyers asleep at the wheel? The GM-Fisher Body contract’, Industrial and Corporate Change, 17(5): 1071-84.
• Klein, Benjamin (1988). ‘Vertical Integration as Organizational Ownership: The Fisher Body-General Motors Relationship Revisited’, Journal of Law, Economics, and Organization, 4(1) Spring: 199-213.
• Klein, Benjamin (1996). ‘Why Hold-Ups Occur: The Self-Enforcing Range of Contractual Relationships’, Economic Inquiry, XXXIV, July: 444-63.
• Klein, Benjamin (2000). ‘Fisher-General Motors and the Nature of the Firm’, Journal of Law and Economics, 43(1) April: 105-41.
• Klein, Benjamin (2007). ‘The Economic Lessons of Fisher Body-General Motors’, International Journal of the Economics of Business, 14(1) February: 1-36.
• Klein, Benjamin (2008). ‘The enforceability of the GM-Fisher Body contract: comment on Goldberg’, Industrial and Corporate Change, 17(5): 1085-96.
• Klein, Benjamin, Robert G. Crawford and Armen A. Alchian (1978). ‘Vertical Integration, Appropriable Rents, and the Competitive Contracting Process’, Journal of Law and Economics, 21(2) October: 297-326.

EconTalk this week

Robert Pindyck of MIT talks with EconTalk host Russ Roberts about the challenges of global warming for policy makers. Pindyck argues that while there is little doubt about the existence of human-caused global warming via carbon emissions, there is a great deal of doubt about the size of the effects on temperature and the size of the economic impact of warmer climate. This leads to a dilemma for policy-makers over how to proceed. Pindyck suggests that a tax or some form of carbon emission reduction is a good idea as a precautionary measure, despite the uncertainty.

And Econ 101 dies (updated)

The Stuff website is reporting that Labour's housing spokesperson Phil Twyford said,

"It is based on the notion that increasing supply of houses at any price will somehow bring down prices. This is trickle-down economics at its most dubious."

WTF?!

Yes Phil increasing supply does lower price. Assuming that demand is not totally elastic, just draw a supply and demand diagram and move the supply curve out to the right, price goes down. Its Econ 101 stuff.

And these people want us to vote for them!!

Update: Matt Nolan at TVHE got to this one first. Sorry, what? he rightly asks.

The fair-trade movement does more harm than good

Or so argue Amrita Narlikar and Dan Kim in a recent article in Foreign Affairs. A short summary of the Narlikar and Kim article reads,

Despite the claims of its champions, the fair-trade movement doesn't help alleviate poverty in developing countries. Even worse, it is just another direct farm subsidy of the kind most conscientious consumers despise. In the long term, the world needs free trade, not fair trade.

This article is the one discussed in the most recent EconTalk.

Narlikar and Kim open their essay by noting,

Although the concept of ethical trade has existed for a long time, the institutionalization of the fair-trade movement did not begin in earnest until the late 1980s. In 1989, the World Fair Trade Organization was founded, and in the years that followed, various fair-trade certification and labeling processes emerged. A product is granted a fair-trade label once its producers have met a list of social, economic, and environmental requirements. The stated purpose of the fair-trade movement is to give economic security to producers in developing countries -- often of unprocessed commodities such as fruits, live animals, and minerals -- by requiring companies and consumers to pay a premium on the market price.

Until now, any questioning of the fair-trade movement has been limited to the micro level. The movement has faced repeated criticisms, for example, for the relatively expensive fees that producers must pay to get a fair-trade label, which make it ineffective for many poor farmers. Another area of concern is just how lucrative the process is for middlemen and retailers. Finally, several studies show that very little of the premium that consumers pay actually reaches needy producers. Consumers might be surprised to learn that only one or two percent of the retail price of an expensive cup of “ethical” coffee goes directly to poor farmers.

The adverse effects of fair trade are even more worrying at the macro level. First, fair trade deflects attention from real, long-term solutions to rural poverty in developing countries; and second, it has the potential to fragment the world agricultural market and depress wages for non-fair-trade farm workers.

An interesting statistic is that in 2010, retail sales of fair-trade-labelled products totalled about $5.5 billion, with about $66 million premium -- or about 1.2 percent of total retail sales -- reaching the participating producers. There has to be a better way of helping poor farmers. Having only 1.2 cents out of every dollar spent on fair-trade products reach the target farmers is a hugely inefficient way of helping these people. If people wish to help these farmers there has to be charities out there that can transfer more than 1.2 cents per dollar to them.

Also a more efficient and straightforward way to help poor farmers is to remove the massive OECD subsidies and tariffs we see on agricultural products. In other words, a move towards free trade is needed.

EconTalk this week

Amrita Narlikar of the University of Cambridge talks with EconTalk host Russ Roberts about fair trade and policy issues related to trade. Narlikar argues--based on a recent article with Dan Kim--that the Fair Trade movement hurts workers outside of the fair trade umbrella and does little for those it is trying to help. She advocates free trade, particularly the elimination of agricultural subsidies in the developed world and the best way to help workers in poor nations. Drawing on a recent article with Jagdish Bhagwati, she criticizes the international response to recent deaths in Bangladesh factories. In the last part of the conversation, she defends the World Trade Organization.

Holy credit! 2

In the previous post a little fun was had at the expense of the at the Archbishop of Canterbury, Justin Welby, for his idea that the C of E go up against the payday lenders in the U.K. and put them out of business by out competing them. But there is a positive side to the Archbishop's idea. He wants to out compete the current lenders. And what, you have to ask, is wrong with a bit of competition?

This question is asked by Tim Worstall at the Adam Smith Institute blog and he answers, correctly, nothing.

However, underneath the inherent silliness is something much more welcome, a definite antidote to the increasingly shrill calls from the likes of Stella Creasey that payday lending must be abolished by legislative fiat. For what the Rev Welby is actually saying is that he wants to drive these lenders out of business by competing against them, not by hoodwinking credulous MPs into stealing away someone's livelihood. Welby is insisting that such short term and low value lending can be done at much lower prices than the current companies manage it. This would be to the benefit of the consumer, as competition always is, and this would thus be a good thing. And we around here do have a habit of welcoming goods things, whatever direction they arrive from.

So we have to say, good on you bish!

Holy credit!

It is being reported in the U.K. that the Archbishop of Canterbury, Justin Welby, wants to make the Church of England’s property available for Credit Unions so they can wipe out those dastardly payday loan sharks; evil, nasty people that they are. Jan Boucek writes at the Adam Smith Institute blog that this is a brilliant idea with wide-ranging opportunities for both entrepreneurial clerics and banks.

Boucek explains that

Just consider the convenience for consumers of banking and praying at the same time. After the queue for communion, you simply shuffle over to the bank teller next to the altar to pick up your loan or maybe deposit whatever spare change you have after passing the collection box.

Meanwhile, over in the confessional, the priest can follow up an absolution prayer with a financial product pitch – “Have you considered insurance for seven years of drought?”

Recruitment of young folk into the priesthood has become a real problem for the Church but Credit Unions on site offer an added attraction in the area of branch security. Wearing body armour under cassocks, learning a martial art or designing bank vaults disguised as crypts will broaden the profession’s appeal.

Of course, established banks won’t be sitting still against this new competition on the High Street. Many branches surely have space available for any number of religious sects to set up shop.

What depositor with a bag full of cash could resist first lighting a candle in the hopes his deposits won’t attract the attentions of the taxman? Impatient couples could stop off at the on-site wedding chapel before opening a joint bank account.

Imam calling for midday prayers while you’re stuck in the queue behind the old lady counting out thousands of pennies? No problem – step aside to our prayer rug area and we’ll hold your place in the line.

And what customer wouldn't appreciate an evangelical choir lifting the spirits before meeting the bank manager about those persistent overdrafts?

Its good to see that entrepreneurship is not dead in the Anglican Church after all. What new financial instruments will the Catholic Church offer to compete with the Anglican innovation? And what of the Scottish Presbyterians? How will they react? A free haggis with each new loan?

Can Islam and free markets co-exist?

This question is asked by Benedikt Koehler at the IEA blog. Koehler argues that they can co-exit, in fact he says that the pro-business approach of Mohammed and his successors helped turn early Islamic societies into the most dynamic economies of their time. Koehler goes on to write,

Islam and entrepreneurship

Mohammed was an orphan who had to pay his way in life. Whilst Buddha and Jesus were conspicuously indifferent to acquiring wealth, Mohammed encouraged his adherents to engage in business and deemed acquisition of wealth meritorious. He was born in Mecca, a city located in a barren valley whose population had as its sole useful natural endowment a black rock that attracted pilgrims from all over Arabia because it was believed that Abraham had built an altar on that cube, the kaba. The coming and going of pilgrims offered opportunities to trade and do business. This communal business had been operational for many generations when Mohammed was born in 570.

Mohammed was born into a family of leading Meccan traders. He was around ten years old when his uncle took him on his first caravan journey and married an entrepreneur when he was 25. When Mohammed found his calling as Allah’s Apostle, he emigrated to Medina to set up a community on Islamic lines. One of Mohammed’s first actions in Medina was to set up a market. Raising the standard of living through trade, after all, was what he was familiar with. Indeed the Koran exhorted Believers that gold should be put to productive use.

Mohammed died in 632 and the boundaries of the Islamic empire expanded within decades to encompass the entire Middle East and most of North Africa. A large trade zone emerged governed by Islam’s ruler, the caliph. Long distance trade became easier once borders fell away. By the end of the seventh century, the caliphs introduced a gold standard that powered investment activity. The caliph’s mints used bullion from Arab gold mines, church treasuries in former Byzantine lands, and Pharaonic gravesites in Egypt.

Islam and the rule of law

Market economies cannot thrive without a supportive legal framework and respect for private property. Mohammed’s first successor, the caliph Abu Bakr, made clear in his acceptance speech that his authority was that of a deputy to Mohammed (caliph means deputy) and he did not assert the right to construct laws arbitrarily. He would forfeit his right to govern were he ever to deviate from what the teachings of the Prophet. Abu Bakr thus set a precedent – a ruler is bound by laws too. Medieval Arab lore abounds with anecdotes about Abu Bakr’s and his successor Umar’s integrity. Both were extremely conscientious in avoiding conflicts of interest and pre-empting accusations of nepotism. Umar personally punished his sons in public to show they had to comply with the same laws as every other citizen. Indeed, Umar asked each senior government official to disclose his personal assets before taking up a senior appointment and to explain any sudden increase in wealth. Umar fired corrupt officials on more than one occasion, including the army’s commander-in-chief Khalid al Walid.

Early Islamic judges were known not to countenance even the appearance of accommodating the government. Exemplary anecdotes of judicial independence from the executive were passed from generation to generation reading the classic collection of tales in Arabian Nights. In one such story, the famous jurist Abu Hanifa declined an invitation to work for an administration where he might compromise his standard of integrity, because, as he made it known to the caliph, ‘how can I enter the water without getting wet?’. The Arabian Nights gather many other instructive anecdotes explaining a nuanced understanding of the interdependence between low taxes, entrepreneurial freedom and political liberty. The Arabian Nights’ narrator Shahrazad told her royal husband (and all her readers) how good governments are run: ‘Religion depends on the king, the king on his troops, his troops on money, money on prosperity, and prosperity on justice.’ The Arabian Nights feature many other examples of good and bad governments, showing that early Islamic societies had a very articulate educated class voicing opinions on public affairs. Islam’s fundamental pro-business stance was not controversial. Mohammed was remembered to have given sound investment advice: ‘There is nothing wrong in wealth when a person is God fearing, but health is better than wealth for the God fearing, and cheerfulness is a blessing.’

The rise and fall of the Islamic empire

The early Islamic empire grew very quickly and Arab Muslims were a minority that was vastly outnumbered by Christian and Jewish subjects. The early caliphs had no option but to rely on non-Muslims to staff their administration, collect taxes and negotiate treaties. The integration of a vast region, and the scope for professional advancement of a vast talent pool, engendered dynamic economies and spawned rapid urban growth. Baghdad in the tenth century was the world’s largest city.

Some Islamic scholars and lawyers pined for a return to the simplicity of Islam’s early days and had reservations about the luxurious lifestyle of the Muslim upper classes. But they could not point to a single Koranic injunction to compel Muslims to stop pursuing business opportunities and enjoying the rewards of successful investments.

Tenth century Baghdad afforded a much higher standard of living than European cities. Medieval Islamic societies were the most advanced economies of their time and their prosperity seemed assured. Manufacturing and agricultural innovations from Islamic societies found their way to Europe, including manufacturing paper and growing oranges.

Islam’s golden age ended after crusaders attacked from the West and Mongols from the East. There were economic reasons for decline, too. Once new trade routes were found trade no longer depended on traversing land routes across the Middle East. The drive to build new markets overseas sidelined the Arab world.

But the long-term effect of these external shocks was not as pernicious as the enfeeblement of entrepreneurial energy wrought by a combination of self-inflicted factors. Islamic societies lost the ambition to lead the world in scholarship and science and the loss of integrity of ruling classes was even more damaging. Entrepreneurs had no incentive to build a business once more money could be made from seeking favours from whoever happened to be in power. Rent-seeking became more remunerative than investment. Civil institutions and personal initiative withered.

The reasons for the economic decline of the Islamic world is one of the big questions in economic history. Timur Kuran discusses the issue at length in his book "The Long Divergence: How Islamic Law Held Back the Middle East". When looking for reasons for underdevelopment lets start with what Kuran does not see as causes; he doesn't argue is that colonialism or geography are the causes of underdevelopment or that there is some incompatibility between Islam and capitalism. Roughly what Kuran does argue is that problems started around the tenth century when Islamic legal institutions, which had up until this time benefitted the Middle Eastern economy, began to act as a drag on development by slowing or blocking the emergence of central features of the modern economy. Such slowed or blocked features included private capital accumulation, corporations, large-scale production, and impersonal exchange. Such handicaps gave the West - which did develop these features - the chance to jump ahead in economic terms, an advantage it still has today.

Property rights may mean something after all.

Thanks to Homepaddock I have been alerted to this news item noting that the Court of Appeal has upheld a High Court ruling that the Anglican Church is entitled to demolish the Christ Church Cathedral. This is, as Homepaddock notes, a victory for property rights.

As I have argued before it is up to the owners of a building what happens to the building. The owners have the property rights over the building, which include the right to bring it down, if they so wish, and the Great Christchurch Buildings Trust - the group wanting to stop the cathedral from being demolished - gets no say in the matter. The news item points out that the Court of Appeal has dismissed all the arguments made by the Trust.

Oliver Wendell Holmes Jr. made it clear as to what ownership means,

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

The Anglican Church has these rights and their rightful exercising of them means that the cathedral can be demolished, if they so determine it should be, and that decision is to be "uninterfered with". The Great Christchurch Buildings Trust, or any other such group,  must be excluded "from such interference", the Trust has no right to try and usurp control over the cathedral away from its rightful owners.

Condliffe 2013

Here is the video of the 2013 Condliffe Lecture given recently at the Univeristy of Canterbury by Professor Edward Glaeser under the title "What if... Our cities vanished?"

Kling on non-profits

Arnold Kling writes,

James Piereson writes,

For much of U.S. history, nonprofits have operated as a check on government by providing private avenues to serve the public interest. Unfortunately, American charities—and more broadly, the entire nonprofit sector—have become a creature of big government…

The publication Giving USA, which tracks charitable spending, reports that the government now supplies one-third of all funds raised by not-for-profit organizations.

… According to a recent report by the Chronicle of Philanthropy, government funding of such charities grew by 77% between 2000 and 2010, while private support for such groups grew by just 47%.

I keep emphasizing that the main difference between non-profit and for-profit is that non-profits are accountable to donors and for-profits are accountable to customers.

While I agree that non-profits are not accountable to their "consumers" I don't agree that they are accountable to their donors. If they were for-profit status would work. In fact the use of non-profit status is largely because they are not accountable to donors, the non-profit status is a way of signalling to donors that they will not (or are less likely to) be ripped off.

Imagine that you are a possible donor to a firm the outputs of which you can't easily verify. If the firm is for profit then the profit maximising thing to do is take the donor's money and do nothing at all. Remember the donor can't verify what you have done with their money. The donor's money is then pure profit, you have no costs since you haven't actually done anything. You just tell the donor you have done lots of things. The revenue from the donor is then profit. If you are non-profit then you can't capture profit in this way since there are no profits to be distributed by definition. This gives a lesser incentive to rip a donor off since any rent seeking must be done via other higher costs methods

Now this is just stupid 2

A reading of Henry Hansmann's 1996 book "The Ownership of Enterprise" may be worthwhile for Geoff Bertram. When discussing the Spanish cooperative Mondragon Hansmann writes,

The wage structure has been among the most contentious issues at Mondragon. Initially, the systemwide top pay index-the maximum permissible ratio of highest to lowest rate of pay-was three to one. Over the years, this ratio has been increased to attract and hold talented executives.

Hansmann notes that the ratio had been increased to 4.5 to 1 and then to 6 to 1 in a effort to keep good managers.

A firm with a very constrained  pay scale will not be able to keep its "best and brightest". I used this basic argument in a paper to help explain why you don't see player-owned teams in professional sport,

Another (more usual) example of a human-capital based "firm", but one where labour-owned firms are seldom, if ever, found, due to the heterogeneity of the human-capital involved, is that of the professional sports team. Here we have a situation where human capital, talent at playing a particular sport, is the basis for the “firm” but ownership by the human capital, the players, is extremely rare since a worker-owned team would be at a disadvantage relative to a player-as-employee based team.

Heterogeneity among playing talent and thus earning potential acts as a disincentive to the formation of a worker cooperative, which involves (rough) equality in payment, since those players with the greatest earning potential, the largest outside options, will transfer away from the cooperative to maximise their income stream. Differential payment schemes can occur, especially within partnerships, but they require that the individual employee productivities are sufficiently easy to measure so that a relatively objective method of productivity related pay is possible. Given the team production nature of team sports productivities are difficult, if not impossible, to estimate and thus payment by productivity is not feasible, which argues in favour of equality in payments. Thus a worker-owned team would have few, if any, star players, a handicap in the winner-takes-all world of professional sports.

EconTalk this week

Michael Lind of the New American Foundation talks with EconTalk host Russ Roberts about two recent articles by Lind at Salon.com. In the first article, Lind argues that libertarians are wrong about how to organize a society because they embrace a philosophy that has never been tried. In the second article, Lind argues that the ideas taught in economics principles classes lead to bad public policy. Roberts challenges Lind and along the way they manage to find some areas of agreement.

Now this is just stupid (updated)

Kiwiblog writes,

Simon Collins reports:

The Government should stop giving contracts – and knighthoods – to companies that pay their bosses more than three times their lowest-paid workers, an economist has suggested.

Dr Geoff Bertram, a retired Victoria University economist who inspired a Labour Party plan to force down electricity prices, made the proposal at a conference on inequality in Wellington yesterday.

Seriously I find it hard to believe an economist could come out this such an idea, after all as Steven Landsburg pointed out back in 1993,

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

Has Bertram really thought about the incentives in his idea? If he had he would know that they are all bad. These ideas have been tried and failed. Many worker cooperatives have payment schemes which limit the ratio of the highest paid person to the lowest, e.g. 3 to 1, 6 to 1 etc, in an effort to create a more equal division of the firm's residual. Ricketts (1999: 20) outlines the general problem with this as '[...] to minimise antagonism a rough equality in the division of the residual will be necessary and this may conflict with outside opportunities. Those with high transfer earnings reflecting high productivity elsewhere will desert the co-operative. It is for these reasons that control of the firm by its labour force is usually found in circumstances which permit a high degree of common interest'. Jossa (2009: 709-10) explains the basic issue in terms of the management of capitalistic versus co-operative firms: '[g]iven the tendency of cooperatives to distribute their income equitably among all the members, it is difficult to deny that few cooperatives are in a position to pay the high salaries that able managers can expect to earn in capitalistic firms. Whenever a group of people resolve to work as a team-we may add-the member who outperforms the others in initiative and organizational skills will inevitably take the lead. The crux of the matter is that such a person has no incentive to establish a cooperative and share power and earnings with others. He or she will prefer to found a capitalistic firm, where he or she will hold all authority and, if sole owner, appropriate the whole of the surplus [references deleted]'.

In other words having a payment scheme which imposes a tight limit on the payments to the most able within the firm gives an large incentive for these people to leave. And these are the very people the firm needs to succeed.

Update: Eric Crampton also seems to see some problems with the Bertram suggestion while Matt Nolan thinks Bertram's being "reasonably disingenuous".

Big Mac index

A new interactive Big Mac index is available from the Economist magazine here.

THE Big Mac index was invented by The Economist in 1986 as a lighthearted guide to whether currencies are at their “correct” level. It is based on the theory of purchasing-power parity (PPP), the notion that in the long run exchange rates should move towards the rate that would equalise the prices of an identical basket of goods and services (in this case, a burger) in any two countries. For example, the average price of a Big Mac in America in July 2013 was $4.56; in China it was only $2.61 at market exchange rates. So the "raw" Big Mac index says that the yuan was undervalued by 43% at that time.

Burgernomics was never intended as a precise gauge of currency misalignment, merely a tool to make exchange-rate theory more digestible. Yet the Big Mac index has become a global standard, included in several economic textbooks and the subject of at least 20 academic studies. For those who take their fast food more seriously, we have also calculated a gourmet version of the index.

This adjusted index addresses the criticism that you would expect average burger prices to be cheaper in poor countries than in rich ones because labour costs are lower. PPP signals where exchange rates should be heading in the long run, as a country like China gets richer, but it says little about today's equilibrium rate. The relationship between prices and GDP per person may be a better guide to the current fair value of a currency. The adjusted index uses the “line of best fit” between Big Mac prices and GDP per person for 48 countries (plus the euro area). The difference between the price predicted by the red line for each country, given its income per person, and its actual price gives a supersized measure of currency under- and over-valuation.

By this measure the New Zealand dollar is undervalued by 5.7%.

EconTalk this week

Michael Clemens of the Center for Global Development talks with EconTalk host Russ Roberts about the effects of aid and migration on world poverty. Clemens argues that the effects of aid are positive but small. But emigration has the potential to have a transformative effect on migrants from poor countries who emigrate to richer ones. The discussion concludes with the impact of migrants on the host country.

Education and labour markets

Bill Kaye-Blake writes In praise of liberal arts:

One of the issues we examined was ‘mismatch’. With the NZ data, there wasn’t much we could do. There just isn’t enough information on what happens to students after they leave tertiary education. I know that the pay-off to a liberal arts education for me was a long time coming — it isn’t enough to follow people for two years or five years. To cite our conclusion:

Finally, mismatches between employment and field of study and/or qualification level are often cited as a possible driver of low returns. There is little evidence that observed mismatches are in fact mismatches at all. However, if persistent mismatching is going on due to policy or market failures, this could be having a significant impact on returns. Whether that is the case or not is an open question.

Mismatch actually refers to two separate things. One is qualification mismatch — people getting Bachelor’s degrees when employers really want trade qualifications. The second is subject-matter mismatch — university students studying French literature when employers want computer science grads.

But if there is a mismatch in either sense, isn't the real question, What are prices not adjusting? If there is an excess demand (supply) for a particular qualification/skill why are wages not increasing (decreasing)? Thus is the problem got more to do with labour markets, and their regulation, than it has to do with education as such?

Firms learning without markets

Being able to judge market signals and learn from what they are telling you is important for any firm operating within a market system. But what if your firm worked outside of a market system, Would it still have the skills to respond to market information? The answer appears to be no. A new NBER paper from Thomas Triebs and Justin Tumlinson argues that firms operating outside the market system — the former East Germany in this study — do not have the ability to judge market signals. Triebs and Tumlinson look at firms in East and West German, after unification had taken place, and they find that East German firms did not anticipate, or respond to, market information as well as their West German counterparts. This suggest that firms operating under the Communist system lost, or never had, the ability to function within a market setting.

See "Learning Capitalism the Hard Way—Evidence from Germany’s Reunification" by Thomas P. Triebs and Justin Tumlinson, NBER Working Paper No. 19209, July 2013:

Communism in East Germany sought to dampen the effect of market forces on firm productivity for nearly 40 years. How did East German firms respond to the free market after being thrust into it in 1990? We use a formal learning model and German business survey data to analyze the lasting impact of this far-reaching treatment on the way firms in former East Germany predicted their own productivity relative to firms in former West Germany during the two decades since Reunification. We find in confirmation of our formal model’s predictions, that Eastern firms forecast productivity less accurately, particularly in dynamic and uncertain markets, but that the gap gradually closed over 12 to 13 years. Second, by analyzing the direction of firm level errors in conjunction with contemporaneous market signals we find that, in the years immediately following Reunification, Eastern firms estimate the market’s role as generally less potent than Western firm do, an observation consistent with overweighting experiences from the communist era; however, over roughly 14 years both converge to the same (incorrect) overestimate of the market’s role on their productivity.

A less extreme example of the same issue is adjustment by New Zealand firms to the 1980s reforms. A point noted by Eric on twitter:

It took a long time for NZ firms to adjust to the 80s reforms. But look at East Germany... http://t.co/1C2spvxEcm
— Eric Crampton (@EricCrampton) July 16, 2013

Privatisation in New Zealand

This is a video of a presentation given by Sinclair Davidson a few weeks back at the New Zealand Initiative on privatisation and public choice.

MRUniversity on Edward Gibbon Wakefield

A name known to all in Canterbury since in 1848 Wakefield, with John Robert Godley, set up the Canterbury Association to plan a Church of England colony in New Zealand.

Alex Tabarrok on "How the Dismal Science Got Its Name"

Alex Tabarrok at Marginal Revolution University explains how the dismal science got its name.


Fans of Thomas Carlyle and John Ruskin will not happy to learn this story, but the dismal science no longer looks so dismal.

5 reasons price gouging should be legal

"Price gouging" is meant to describe something bad, something we don't want to see happen, especially in emergencies. But Peter McCaffrey argues that we should like price gouging and gives 5 reasons why:

So-called price gouging is a critical economic tool to ensure that supplies last and so can meet ongoing demand. Making it illegal is ridiculous, and here’s why:

1. Without price increases, many people buy extra supplies “just in case”, regardless of what they have tucked away at home already. If too many people do this, supplies run out and people who need them much more urgently miss out. With price increases, people who don’t really need supplies will leave them on the shelf, not out of the goodness of their heart, but out of concern for their wallet.
2. Price increases encourage conservation of resources people already have. Those who can most easily adjust their consumption will do so, leaving resources free for those who can’t. People might, for example, use their cars more sparingly to avoid having to fill up while prices are inflated.
3. The ability to raise prices encourages businesses to stock excess reserves. Space in stores and warehouses is limited and products (even water) go off over time. If they’re not allowed to raise prices on those items, they’ll use that limited space for other products that have higher profit margins the rest of the time.
4. Allowing price gouging actually encourages citizens to be more prepared for disasters. Do you have enough food and water and other essentials stored at home for you and your family if disaster strikes your town? Or do you just assume you’ll be able to go to the store and buy what you need when something goes wrong? Knowing that prices might double, triple, or more during a disaster is a pretty big incentive to go and stock up now instead of waiting — even for that person who lives right next door to the store!
5. Finally, rising prices attract more resources from outside of the disaster area, where prices are lower. Nearby businesses, small or large, can easily profit by shipping essential supplies in and selling them at a premium. Without the ability to charge that premium, they would actually end up losing money through shipping costs, overtime wages, and inherent risks of operating is a disaster area. Without the profit motive, many don’t take the risk.

McCaffrey suggest that we should use a different term for what is now called price gouging:

“Price gouging” is a derogatory term meant to belittle. A more accurate description would be “sustainable pricing” — pricing that ensures supplies are sustainable to meet the demand of future customers.

So, "price gouging" is dead, long live "sustainable pricing".

Economic freedom and labour market conditions

An interesting new paper on Economic Freedom and Labor Market Conditions: Evidence from the States by Lauren R. Heller and E. Frank Stephenson. The abstract reads:

Using 1981–2009 data for the 50 states, this article examines the relationship between economic freedom and the unemployment rate, the labor force participation rate, and the employment-population ratio. After controlling for a variety of state-level characteristics, the results from most specifications indicate that economic freedom is associated with lower unemployment and with higher labor force participation and employment-population ratios.

The conclusion to the paper states,

Our findings have clear implications for policymakers. Adopting policies that increase economic freedom by one point in the EFNA index would reduce the unemployment rate by as much as 1.3 percentage points. Likewise a one point increase in economic freedom would increase the labor force participation rate by up to 1.9 percentage points and the employment-population ratio by as much as 2.3 percentage points. Moreover, the estimation results for the EFNA sub-components offer policymakers some guidance about the most beneficial ways to improve state EFNA ratings. The effect of area 1 (size of government) is generally larger than the effect for areas 2 or 3. Hence, our results suggest that reducing the size of government would have the largest effect on labor market outcomes.

So economic freedom does decrease unemployment and increase the labour force participation rate but reducing the size of government is the big winner for reducing unemployment.

EconTalk for two weeks

Michael Munger of Duke University talks with EconTalk host Russ Roberts about the role of formal rules and informal rules in sports. Many sports restrain violence and retaliation through formal rules while in others, protective equipment is used to reduce injury. In all sports, codes of conduct emerge to deal with violence and unobserved violations of formal rules. Munger explores the interaction of these forces across different sports and how they relate to insights of Coase and Hayek.

Morris Fiorina, the Wendt Family Professor of Political Science and Hoover Institution Senior Fellow at Stanford University, talks with EconTalk host Russ Roberts about the state of the American electorate and recent election results. Fiorina argues that while the Republican and Democratic parties are more extreme than they were in the past, there has been only modest change in the character of the American electorate. Fiorina discusses these differences in light of recent election results which show an inability of either party to sustain control of the Presidency or the Congress.

The dark side of social capital

We hear much about the wonders of social capital - the dense network of associations facilitating cooperation within a community - of which there are many. It typically leads to positive political and economic outcomes, but is there a "dark side" to social capital? A new NBER working paper suggests there can be.

Bowling for Fascism: Social Capital and the Rise of the Nazi Party in Weimar Germany, 1919-33 by Shanker Satyanath, Nico Voigtlaender and Hans-Joachim Voth

Abstract:

A growing literature emphasizes the potentially "dark side" of social capital. This paper examines the role of social capital in the downfall of democracy in interwar Germany by analyzing Nazi party entry rates in a cross-section of towns and cities. Before the Nazi Party's triumphs at the ballot box, it built an extensive organizational structure, becoming a mass movement with nearly a million members by early 1933. We show that dense networks of civic associations such as bowling clubs, animal breeder associations, or choirs facilitated the rise of the Nazi Party. The effects are large: Towns with one standard deviation higher association density saw at least one-third faster growth in the strength of the Nazi Party. IV results based on 19th century measures of social capital reinforce our conclusions. In addition, all types of associations - veteran associations and non-military clubs, "bridging" and "bonding" associations - positively predict NS party entry. These results suggest that social capital in Weimar Germany aided the rise of the Nazi movement that ultimately destroyed Germany's first democracy.