The Filter^

Corporate Fraud

I've just been re-reading Malcolm Gladwell's New Yorker article on the collapse of Enron. He utilises a distinction between 'puzzles' and 'mysteries':

Osama bin Laden’s whereabouts are a puzzle. We can’t find him because we don’t have enough information. The key to the puzzle will probably come from someone close to bin Laden, and until we can find that source bin Laden will remain at large.

The problem of what would happen in Iraq after the toppling of Saddam Hussein was, by contrast, a mystery. It wasn’t a question that had a simple, factual answer. Mysteries require judgments and the assessment of uncertainty, and the hard part is not that we have too little information but that we have too much. The C.I.A. had a position on what a post-invasion Iraq would look like, and so did the Pentagon and the State Department and Colin Powell and Dick Cheney and any number of political scientists and journalists and think-tank fellows. For that matter, so did every cabdriver in Baghdad.

His point is that treating Enron as a puzzle means an increase in information, however the problem arose because of a lack of judgment about the content of existing information. As he points out, a 1998 business school project at Cornell reported that:

Enron was pursuing a far riskier strategy than its competitors. There were clear signs that “Enron may be manipulating its earnings.” The stock was then at forty-eight dollars—at its peak, two years later, it was almost double that—but the students found it over-valued.

This information was in the public domain

My immediate reaction it to tie this into the work of Henry Manne, who's work on insider-trading has greatly influenced my thoughts on accounting regulation. But the Gladwell article also brought up the role of the taxation system:

one of the critical clues about Enron’s condition lay in the fact that it paid no income tax in four of its last five years... Enron wasn’t paying any taxes because, in the eyes of the I.R.S., Enron wasn’t making any money.

If you looked at Enron from the perspective of the tax code, that is, you would have seen a very different picture of the company than if you had looked through the more traditional lens of the accounting profession. But in order to do that you would have to be trained in the tax code and be familiar with its particular conventions and intricacies, and know what questions to ask. “The fact of the gap between [Enron’s] accounting income and taxable income was easily observed,” Fleischer notes, but not the source of the gap. “The tax code requires special training.”

I recently asked a senior accountant at a large US company about Enron, and his response was intruiging: they had become suspicious about Enron's reporting and had long since stopped doing business with them. The real issue isn't how to improve the level of information, but to better utilise it. Those who looked could tell that Enron was overvalued, and yet it persevered. The question is how we can better utilise knowledge, so that the general public - the man on the street - is as close to the action as the professional. Insider-trading and a simpler tax code might help.

Charles Tilly (1929-2008)

I'm sorry to learn from Tyler Cowen that Charles Tilly has died. Permit me to repost:

• Personal Website
• Why? (2006) Buy from Amazon
  
• Lecture: Why (and How) Things Happen
• "How I Work" by Charles Tilly
• Major Works by Charles Tilly
• The Ideas Interview: Charles Tilly, The Guardian

Here's the Columbia announcement. Here's the NYTimes obituary. I like this:

Dr. Tilly once said his goal was to do sociology, history and political analysis at the same time, but he said it with what colleagues said was his typical intellectual humility.

“My efforts to harmonize all three have always failed in one way or another,” he said in an interview with Contemporary Authors, “but the failures, happily, are usually of the kind from which one learns something useful.”

Somebody shoot me!!

Will Wilkinson is investing heavily in 'Happiness research', and approvingly cites Alex Singleton for making the Misesian point that:

Far from being a major problem, there is something virtuous about being unhappy with our present circumstances.

Indeed it is uneasiness with our present situation that motivates us to act. If we were happy, we'd have no need for action.

A famous story:

I remembered reading something Kurt Vonnegut wrote about people actually wanting to die during peak experiences. He described a piano player during a great performance, screaming "Quick, somebody shoot me while I'm happy!!" As bizarre as it sounds, this all suddenly made sense.

Apparently that pianist was Fats Waller, but it's somewhat mythical.

This graphic demonstrating that material wealth is correlated to happiness, but there's one country that really stands out - Finland. Interestingly, students have pointed out to me that Finland has a high suicide rate (although it seems this is falling). I usually debunk happiness research by either pointing to evidence that material wealth improves subjective perceptions of happiness, or challenging the methodoligical foundation - but this deeper, philosophical point is also worth considering: what would a world look like where people had no uneasiness?

Economics is the pith of civilization

I've already mentioned Israel Kirzner's inspirational speech at the 2006 Southerns, but would like to share a similar quote:

Economics must not be relegated to classrooms and statistical offices and must not be left to esoteric circles. It is the philosophy of human life and action and concerns itself with every-body and everything. It is the pith of civilisation and of man's human existence
Mises, 1966[1949], p.878

Back to work...

Economic Rhetoric

If people mean "centrally-planned" why can't they just say it?

Dani Rodrick says:

the rapid rise in food prices is creating a severe problem for some of the world's poor and does require urgent, and coordinated response

What does he mean by "coordinated"? I read it to mean some for of government intervention, rather than a focus on free market forces. But is that a proper use of the term coordination? What about:

• Calculation and Coordination: Essays on Socialism and Transitional Political Economy

It reminds me of how bureaucrats so often like to use the term "robust". If "robustness" means that it works away from ideal conditions, then what about:

• Liberalism, Socialism, and Robust Political Economy

I'm not saying that there's a single "right" definition here, just expressing concern that people have developed a secret language I'm not aware of, where innuendo towards government is made and understood, despite using words that might also imply laissez-faire.

Liquidity Trap

I just saw the news and wanted to pre-empt the morons who in a couple of months time will start referring to a liquidity trap.

Sunday musings

This weekend I'm taking a foray into the print media, and two things have got my goat. Firstly, the Archbishop of Canterbury has expressed concerns about growing wealth inequalities:

He said that the disproportionate gap between rich and poor was causing envy and cynicism and that government ministers should be “a little more worried” about the high salaries of City high-flyers

Please, can someone explain this to me. The last time I check envy was a sin:

"Thou shalt not covet thy neighbour’s house; neither shalt thou desire his wife, nor his servant, nor his handmaid, nor his ox, nor his ass, nor any thing that is his." Exodus (20:17)

When I read the Sunday Times Rich List I do feel somewhat jealous of the wealth that's been accumulated. In many cases the economist in me reminds me that economic exchange is positive sum, and therefore their wealth has more likely increased my quality of life, than detracted from it. I also remember that most people work bloody hard for their wealth, and are highly skilled. Put simply, I wouldn't be able to do what they do even if I had the opportunity (which, of course, I do). But there's also those who've inherited their wealth, or come across it in some other fortuitous means. Again, it's easy to feel envious, but I remind myself that their wealth might be a mixed blessing. It looks a good deal in the glossy pages of a Sunday magazine but is money the root of happiness? If you think of the pressures and woe that so many of those people have to face, I don't think it's an unambiguous dilemma. Those who do seem quite content, but have just been born into a title, or born into an easy life - I don't even envy them, because I'm richer than the majority of the planet, and the majority of human history - as we all are. So yes, there is this slight tinge of envy as I read the Rich List, but it doesn't last long.

That's my secular, anti-theistic/agnostic worldview operating. I would have thought a Christian would find it even easier to cope with envy. But what do we see? The Archbishop of Canterbury positively encouraging it! He's propagating the myth that "high net worth" in a financial sense equates to "high net worth" in a moral one. He's not only validating people's envy, he's campaigning for the State to reward it. If you're neighbour comes home with a new ox - one that's bigger and better than yours = the State should confiscate it and give it to you. Incredible.

And secondly, why has every news flash on 5 Live this afternoon been telling me that some petrol stations in Scotland have started to run out of petrol? I was quietly minding my own business, oblivious to events in a separate country, but have been repeatedly told not to panic. What does one do when someone keeps telling you not to panic? Put it this way - I have about half a tank of petrol which should last about a week.

• If local petrol stations were able to anticipate a possible shortage and begin to ration existing stocks through a price rise, it wouldn't be worth me filling up. I'd figure that even if it takes more than a week to sort out, I'll just get the train into work. I'd leave my car in the garage.
• If, on the other hand, local petrol stations don't raise their prices, then it'd be sensible for me to fill up just in case. That means less petrol for you.

We thus see a self-fulfilling prophecy, brought about by (i) a hysterical media looking for a crisis; (ii) a government that at the hint of a move away from "ideal conditions" reduces the scope for markets to allocate resources; (iii) a general public who's negative attitude towards "profiteering" underlies the entire situation. So let me get this off my chest:

Dear People of Hertfordshire,
The reason that I have contributed to a possible petrol shortage by filling up my car even though I don't really need to is because we're ignoring Econ 101. If prices are free to fluctuate there cannot be a shortage. No-one likes to see the price of something rise, and it's tempting to believe that preventing this from happening will cure the underlying problem. But it won't. When a petrol station needs to replace it's fuel it must do so in the current market conditions, therefore if fuel becomes scarcer, the stuff in his forecourt is more valuable. By raising his price people that don't really need it - people like ME - won't buy it, and there'll be some available for those that really do. He doesn't owe us petrol at yesterday's price. We don't have a right over his property.
If you happen to waste your time queuing for petrol, or if you become massively inconvenienced because of a shortage, please help to avoid it happen again and support profiteering
Ever,
aje

Consumer Surplus

"Consumer Surplus" is the difference between how much you pay for something, and how much you'd be willing to pay for it. I ask my students to remember this concept when they're doing their shopping - it certainly helps to put you in a cheerful mood. For instance, I just bought Curb Your Enthusiasm series 3,4 and 5 through Amazon. We don't have television at the moment and have been re-watching series 1 and 2. Having just christened my new American Express I've realised that there's 10 episodes per series, and it's cost me under £30. That's less than a pound per episode. My consumer surplus might not quite be as high as Bryan Caplan's, but happy days...

Enterprising Britain

Here's a deeply frustrating anecdote via Jeff Frankel:

A woman called me out of the blue last week and told me her self-sufficiency counselor had suggested she get in touch with me. She had moved from a $25,000 a year job to a $35,000 a year job, and suddenly she couldn’t make ends meet any more.

It's a sad case where someone is seeking to create wealth, but facing financial incentives not to do so, and these real examples are important because it's rare to see such concrete figures. Indeed barriers to growth can become so embedded that we don't even notice them. The counterfactual possibility of wealth-creation and growth is never realised, and thus ignored.

I recently co-authored a policy paper on entrepreneurship, called "Enterprising Britain" (press release), in which we sought to uncover the barriers that exist to growth. One of the biggest misapplications of economic theory is to associate a healthy entrepreneurial environment with a high number of business start ups. In short, the UK is a fine environment to start a new company, but as soon as you need to employ people, pay taxes, and expand into genuine wealth/job creation, it becomes very difficult. The report seeks to uncover some of these key barriers, and by reducing barriers policymakers can effect the entrepreneurial culture and expectations of potential entrepreneurs.

I appreciate that writing an independent report for a political party isn't the best way to generate consensus, but I was disappointed to hear the response of the Treasury spokesman (from The Telegraph):

The World Bank rates the UK as one of the best places in the world to do business and we have the lowest corporation tax rate of any G7 country.

I don't expect the Treasury spokesman to actually read the report prior to commenting, but we had highlighted those very facts and discussed why they were complacent and misleading:

• Where suitable we compared the UK environment to relevant benchmark countries, however it is important to realise that our motivation is not to improve the UK’s relative ranking. We do not feel that our objective is to “compete” with rival nations. Rather, the guidelines being discussed should be compared to the state of the country if these policies are not introduced. There are two visions of British policy: one that merely reacts to competitive pressures, and one that leads the way on facilitating enterprise. Regardless of the situation in other countries, whether the UK is ranked first in the world or last, these policies should be introduced because they will improve the entrepreneurial climate and thus facilitate social development. (p.8-9)
• Although the UK rate of corporate taxation is not significantly higher than other G7 countries (28% from April 2008), global tax competition is increasing and the UK is losing ground to European neighbours (p.50)
• Headline rates of corporation tax mask an increase in other forms of indirect taxation that stifle business growth (p.55)

The report has had more positive feedback from other places: Dan Martin (Editor of BusinessZone) used the report as evidence to challenge the Chancellor over the CGT furore; and the FPB’s national chairman Len Collinson used it to accuse the government of fudging numbers (here, here). It's providing an interesting glimpse into the role of research in politics.

Inflation

I wish the general public had enough economic literacy to demand that journalists and politicians use - where relevant - the term 'CPI' instead of 'inflation'.
Mike Moffat reports a readers unhappiness with About.com's definition of 'inflation':

I suppose if you are using the new definition, according to Merriam Webster’s dictionary, inflation is the increase in the price of a basket of goods. However, for hundreds of years the inflation – even in Webster’s, was increasing the money supply. It seems like an odd coincidence that the definition was changed and that it just happens to prevent inquiring minds from figuring out that inflation is something the Federal Reserve knowingly does, rather than something that “just happens.”

If you seek proof of this claim, simply look in an old dictionary. I know that as late as the 1980’s, inflation was still defined there as “increasing the money supply.” You will find the same definition in dictionaries from the 1950’s, 1930’s, 1913, and so on. It is only recently that the definition has changed. Didn’t George Orwell write about changing the meaning of words as a tool of the totalitarian state to prevent people from having ideas that were dangerous to the state?

I've previously mentioned Gordon Brown's decision to use the CPI as the proxy for inflation instead of the RPI (here and here).

Addendum: Here's a graphic from a recent Economist, "If RPIX and the former target of 2.5% were still being used, Mr King would once again have had to explain an embarrassing overrun."

 

Cultural Theory in a Nutshell

The Spectator:

If you want Dame Mary's Cultural Theory in a nutshell, it takes only two ideas and a pencil to understand. With the pencil, draw a vertical axis marked Grid and a horizontal axis marked Group. Group is the force that holds people together (either by defining themselves in opposition to the outside world, or through the pressure on them from the outside). Grid is the amount of classification that is imposed on people - what they wear or eat, where they live. So, high up on the axes of both Grid and Group, you find hierarchical societies. Low down, with little evidence of either Group or Grid influences, are the free-moving entrepreneurs. Where Grid is weak but Group is strong you find the sectarians, the enclavists.

I'm writing some early drafts on applying Cultural Theory (CT) to organistional management (an ultimate ambition is to come up with something similar to Hood's "The Art of the State"), and struggle with definition slippage. Since Mary first introduced the terms "Grid" and "Group", through to when the Grid-Group framework became known as "Cultural Theory", to the many applications of CT - I am struck by a lack of uniform usage. It is only slight deviations, but if one sits down with 10 books on CT it's not impossible to find slight contradictions. I'm sure these are unintended. My claim is that it stems from a desire for empirical application, and attention to the issue at hand rather than pursuing truth-maintaining statements. Ultimately, any use is a restatement. Conflict is inevitable. What to do?

the Land Problem

In a comment to my post on supermarkets, Jim makes a point about the extent to which historical land policies undermine the potential for a free market:

I'm finding it hard picturing a free market in urban land when you define 'free' in terms of absence of government. How can a market in which every land owner is a monopolist (because each plot of land is unique), in which the existing distribution of resources in large part reflects historic conquest and theft, which is inherently riddled with a vast range of externalities and spillovers unamenable to Coasean bargaining, and in which much of the value of land is effectively created by government intervention (eg infrastructure planning and investment) ever be 'free'? You talk about a free market as if you know what it would be like, but if you define it as the absence of government you can't possibly know what it would be like (apart from 'completely different from what we have today') since today's markets have largely co-evolved with government, and land is perhaps the pre-eminent example. I'm certainly not claiming the way land use markets are regulated is perfect but I'm far from persuaded we should throw it all out.

Land use is an area of economics that I'm sure has the potential to fundamentally alter my thinking across political economy, but I haven't explored in great detail. That said, my instinctive thoughts are:

• We can define landowners as being monopolists, but by that definition every business is a monopoly (since it sells a unique product). The neoclassical conclusions about the welfare costs of monopoly are therefore misapplied and irrelevant - these are the domain of profit searching, not rent-seeking
• Historic conquest and theft are indeed the historical situation. But that doesn't mean that people in the present should be bound by it, and liberalism does not necessarily imply regulation on these grounds. This is for (at least) two reasons:
  • Forgiveness: "the demand for justice, if given full play, can undermine the fragile political conditions for the powerful development of a liberal constitution. The better part of wisdom is to keep the demand for corrective justice under control while channelling energy toward the construction of an enduring constitutional order"
    Ackerman (1992:4)
  • Many libertarians would be willing to engage in a one-off redistribution of resources on the condition of imposing constitutional constraints on further redistribution. In other words imagine two groups: capitalists and labour. It is possible to have a free market if both sides agreed to a grand bargain where the capitalists pay off labour to accept a free market
• I think it's meaningless to say that "much of the value of land is effectively created by government intervention" because the word "value" is being used differently in the political and economic spheres. Without willingness to pay, "value" seems empty. But just because government has historically provided transport links, it doesn't mean that we're bound by this. The recent examples of transport policy that seem to work - the M6 toll, the Congestion Charge - seem to be moving into the institutional structure associated with markets. It's become untenable to say "the government must build roads because they're a public good".

So I agree that today's markets have co-evolved with government, but that doesn't mean either (i) more government provision; or (ii) more market provision would make things worse. Clearly I believe that a freer market would lead to greater prosperity, but I'm not claiming that there was a golden age without intervention. Far from it - the historical narrative is one from rape, pillage and plunder to truck, barter and exchange. From theft and conquest to peaceful exchange. In other words, from government to markets.

Chris Dillow - Marxist freedom fighter

This is not a question of improving the "work-life balance". The very phrase captures one of the evils of capitalism - that work and life are opposites. Instead, it's about integrating work into life; in not having to travel into an office, I'm smashing one of the big dividing walls between the two, and moving towards the Marxian ideal of unalienated labour.

Good luck with the move.

Grading the Fed

Here's Allan Meltzer (Via Greg Mankiw):

The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure.

I do not believe the present system can remain if the bankers make the profits and the taxpayers share the losses.

Also, Alex Tabarrok points out the Austrian nature of some mainstream critiques. This is Sachs:

the US crisis was actually made by the Fed... the Fed turned on the monetary spigots to try to combat an economic slowdown. The Fed pumped money into the US economy and slashed its main interest rate...the Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers the costs of doing so, throughout the economy. It also tends to weaken the currency and increase inflation. All of this began to happen in the US.

What was distinctive this time was that the new borrowing was concentrated in housing....the Fed, under Greenspan's leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.

Main question: should we file this under the "halfway there" argument?

The Arbitrary Nature of Nationhood, the Sadness and Folly of Nationalism

From nocaptionneeded.com:

The arbitrary and political nature of the boundary between the two nation-states and of the location and exercise of power to enforce the separation is thus pronounced. And more, the very thought that such a physical boundary can be sustained for any extended period of time seems to be mocked by the natural landscape of the desert which promises to encompass and contain all that would disturb its contours.

London Metal Exchange

I'm on the look out for free things to do in London (other than the usual cultural cliches), especially with educational value. A fortnight ago I visited the London Metal Exchange with colleagues, and recommend it to anyone interested in expanding their horizons. The LME is a commodities market that exchanges futures contracts on an array of non-ferrous metals. The company was founded in the late c19th, and is now trading about £20bn a day. It has an established viewing procedure that allows visitors to observe events from the public viewing gallery. It is one of the few remaining open outcry trading floors in the world:

There is constant inter-office trading but some trading is still done by open outcry in the Ring. There is a morning and an afternoon trade, where each of the eight metal contracts are traded in two blocks with a five minute session for each contract (the sessions last from 11.40 until 13.15 and from 15.10 until 16.35, each session includes a ten minute break). The second trading block in the morning is key to setting the Daily Official Exchange rates (Wikipedia).

Well worth a visit, especially in today's climate. It's a reminder that:

• Casinos generate risk for the purpose of entertainment
• Futures markets convert uncertainty into risk for the purpose of market coordination

Books took to DC

Allow me to indulge in a little autobiograpy. The following is an exhaustive list of the books I brought with me to Washington when I started my PhD. I took a battered suitcase full of clothes, and a hold all full of books.

• Principals of Political Economy
  J.S. Mill
• Socialism
  LV Mises
• Human Action
  LV Mises
• The General Theory of Employment, Interest and Money
  J M Keynes
• The Economics of Time and Ignorance
  G O’Driscoll & M. Rizzo
• A History of Economic Theory
  J Niehans
• On Human Conduct
  M Oakeshott
• Globalization and its Discontents
  Joseph Stiglitz
• Claudio Monteverdi
  Christmas Vespers
• The Autobiography of Bertrand Russell 1872-1914
  Bertrand Russell
• The Autobiography of Bertrand Russell 1914-1944
  Bertrand Russell
• The Great Gatsby
  F. Scott Fitzgerald
• The Catcher in the Rye
  JD Salinger
• Lucky Jim
  Kingsley Amis
• Arcadia
  Tom Stoppard
• Anthony Blunt – His Lives
  Miranda Carter
• The Liver Birds
  (anthology)
• Friends Voters Countrymen
  Boris Johnson
  

Injecting subjectivism into the Supermarket debate

Subjectivism implies making a distinction between your preferences and the preferences of those who you're studying. It therefore necessitates a degree of realism and humility when conducting analysis. For example I dislike Asda, and usually shop at Sainsbury's. I prefer the aesthetic feeling, the layout, the range of products, the relative simplicity and the architecture. But it would be arrogant, elitist, and analytically naive for me to believe that if the Asda across the road is busier it represents some form of market failure. As Paul Piccone said:

“The market is a democratic institution aggregating the decision of whomever participates in it. When all is said and done, complaints about the market are nothing but complaints about the people themselves”

When markets generate outcomes that contradict my personal tastes*, one of two things might be happening:

1. There is some form of distortion that prevents the market from working effectively
2. There is a fundamental clash in preferences, and entrepreneurs are merely responding to the greater demand

It's my impression that many people use the first argument when the second is more appropriate, and rely upon faulty neoclassical theory when doing so. As I've said many times, the argument in favour of free markets does not rest upon an assumption of perfect competition, and the argument that markets fail due to asymmetric information, lack of firms, degree of market power comes from a position of ignorance. It should also be obvious that most economists accept statement 1 - it's the investigation of these distortions that constitute our job - but it's widely agreed that government intervention is a greater source of distortion than any natural state of affairs.

What annoys me is those who use argument 1 to cover for argument 2, when that stems from snobbery. In other words, if I complain about the "distortions" that give Asda an advantage over Sainsbury's (or indeed smaller supermarkets), and use economic reasons to mask the underlying problem of me not respecting the pressing needs of other people. I might patronise Asda shoppers by arguing that they don't have full information. I might insult them by advocating some form of "aesthetic tax" where the majority should fund the pursuits of the elite (and then patronise them further by subsidising their participation).

The supermarket debate would be a lot more pleasant if we could all agree that some people don't mind shopping at Asda, and whether you think they're "wrong" to do so is irrelevant. This way we might be able to strip away the rhetoric and expose the snobs who claim to be for "the man on the street" but are actually his opponent. I am in favour of market outcomes that reflect consumer choice, as opposed to market outcomes that reflect my choice. It would be hypocritical to profess to be on the side of the people, whilst preventing their freedom to choose.

As an example of my point, consider Asda's parent company, the equally loathed Wal-Mart. This is an organisation that has provided so much value to ordinary people that if it were a non-profit it would be viewed as a triumph of humanity.

The left panel shows customers queuing for 3 hours just to shop at a new Wal-Mart, and the right panel shows an area of land that politicians are preventing Wal-Mart from building upon (via Russ Roberts). Whilst bureaucrats wrangle about what the land *should* be used for, it's pretty obvious that this is harming ordinary people. It was 2006 when Wal-Mart were finally granted the ability to operate in Chicago, and as Russ Roberts reported at the time:

FIFTEEN THOUSAND people applied for the 400 jobs.

Again, I'm not a fan of Wal-Mart. I'd prefer to shop at Wegmans and/or Target any day of the week but that's only because I can afford to. When I lived in Liverpool Kwik Save was mint. The one thing I try not to do is argue - with a straight face - that those people that queue up just to shop at Wal-Mart are fools. I respect their choices.

*Note that I'm conceding ground even to accept this point, since market outcomes are diverse and multifaceted. The whole purpose of niche products is to cater to minority preferences. The good thing about cultural diversity is the choice we have over the types of community we wish to live in. Markets will never deliver precisely what we want because it's the interaction of supply and demand that  generates social order.

Rodrik on financial globalisation

Here:

In investment-constrained economies--where investment is low not because of poor access to credit but because of low perceived return--capital inflows are at best ineffective, at worst harmful.

Isn't that what a neo-liberal would say?

Adverse Selection in the Mortgage Market

Economists' View:

The basic point of the model is to illustrate two things. First, how an increase in the interest rate can increase defaults. This is the main point. Second, how equilibrium credit rationing can occur, i.e. how financial markets can settle on an equilibrium where there are buyers willing to take out loans at the going interest rate, but nobody willing to lend them money at that rate, and the excess demand for loans is not resolved through rising interest rates.

Brad DeLong:

that when the major cause of large-scale defaults is not the fecklessness of the borrowers but rather the fact that the market equilibrium has high interest rates that are themselves both the consequence and cause of high default rates, that the government has a market-making role to play by providing guarantees. This seems to me to be a good logic.

This ties into a paper I recently presented at the Southern's, and I quote from the abstract:

the main harm from loose monetary policy is not that it encourages entrepreneurs to behave more recklessly with capital, but that it encourages precisely the people who can’t afford capital at the market rate to borrow, and makes them the marginal trader. This suggests that adverse selection is a more important issue than moral hazard.

Using income per natural

Will Wilkinson asks us to "absorb this extremely important advance in economic methodology and basic intellectual rigor":

migration is one of the most important sources of poverty reduction for a large portion of the developing world. If economic development is defined as rising human well being, then a residence-neutral measure of well-being emphasizes that crossing international borders is not an alternative to economic development, it is economic development.

The paper measures the income levels of Americans rather than the income levels of people in America. I've not got my head around it yet (either it's claims or implications) but Will knows his stuff. Jim - any thoughts?

The Current Economic Problems

I've not really commented on the current developments in the sub prime crisis, and there's a lot of interesting articles out there. However I do want to correct a fear I have about the mis-characterisation of what Austrian Economics has to say about these events, and use as evidence comments I've made before things started to turn bleak.

My motivation stems from this piece in the Guardian by Larry Elliot, their economics editor. He says:

The libertarian right comes to a similar conclusion but for a different reason. Using the analysis developed by the Austrian school of economists - Ludvig von Mises and Friedrich von Hayek - it argues that markets will cure themselves, with state intervention not only in vain but ultimately damaging. The analogy is of a forest fire, which if allowed to burn itself out allows healthy new growth to emerge.

Imagine if an alcoholic is admitted to hospital and the doctors have a conversation:

Dr A (representing the consensus of doctors in this area): He's been drinking heavily for the last few years, he's going to be really upset if we don't let him drink. Best thing is to get a few cans of Special Brew

Dr B (an obscure maverick people often mention but never take the time to understand): Erm, alcoholism is bad. He needs to stop drinking and those who've kept giving him a drink should be struck off

It would be pretty ridiculous to paint Dr B as a callous bastard for wanting to create hardship for the patient. He's the only one who seems to have actually diagnosed the underlying problem, and come up with a solution to cure it (rather than just prolong things and hope for the best). As a commentator to Elliot says:

Larry, the Austrians would let the banks burn in a virtual forest fire, and the directors would go into the fire and not escape with the loot. But, the Austrians measures would never have let the situation reach this stage. Without Central Bank distortion of the money supply and non-market setting of the interest rates, causing malinvestment from these bad economic signals, and without the credit created by overt fractional reserve banking and derivatives(another form of fractional reserves), there would never have been enough credit to ignite this unsustainable boom and now the proportionate bust. Prevention is the best cure, but nothing can remedy where we are now.

I think it's intellectually misleading to say that the Austrian's contribution is to simply blurt out "creative destruction". There is strong and robust evidence to show that Austrian's diagnosed this problem in the 1920s (and I''ve alluded to it on many occasions) and nothings changed. Governments still monetise their debt to create asset bubbles, and monetary policy isn't how government controls the economy, it's how (good) economists control government - i.e. dynamic inconsistency, Lucas critique etc.

The problem is that when the FRC accept responsibility for the current credit crunch, us consumers let them off the hook by retaining our support for the underlying regulatory system. In other words they say "ok we messed up, but we'll do better next time" and we respond "ok, have some more powers". We should be sacking these guys, not rewarding them!

My concern is that we're not learning the real reasons for what's happened, and are opting for the simplistic "sweep it under the rug" solution of opting for greater regulatory zeal. This is problematic for at least two reasons:

1. The people in the finance industry who invent complex financial instruments are probably more knowledgeable than regulators, and this poses a real difficulty for a "if we don't understand it, regulate it" mentality. High finance is complex, and will inevitably become more so
2. There will always be off balance sheet activity, and evasion. Since we cannot create a system of full transparency we have to accept that firms will engage in activity that is difficult to monitor. Indeed that's often the source of their competitive advantage! So the greater the regulatory burden on balance sheet activities, the greater the incentives to push normal, value-creating enterprise into off balance sheet activities.

As John Kay recently said:

The state cannot ensure the stability of the financial system and a serious attempt to do so would involve intervention on an unacceptable scale.

At the moment investors expect and demand for activity to be occurring off balance sheet because of the scale of ordinary regulation. Attempts to reach deeper and deeper into the complexities of the system will simply incentivise more complexity and this is untenable. Ideally the regulatory system would scale back, and reduce the burden on those institutions that wish to operate with transparency. That would give us all a reasonable choice as to how we wish to manage our investments, and the risks that they entail.

Career Advice

If you have the benefit of youth, entrepreneurial vision, and a commitment to ideas I strongly suggest the following:

• Koch Associate Program
• Mercatus Master's Fellowship

British CEOs for British companies?

This weeks Economist:

The jobs of running Rolls-Royce and BAE Systems—Britain's biggest aerospace and defence firms—are reserved for British citizens, an anomaly that both firms are lobbying hard to end.

Letting the firms choose their own chiefs would be good not just for them and their shareholders but for taxpayers too, many argue. Defence firms are notorious for extracting handouts from governments in the name of national interest. The more they look like any other firm operating in a competitive market, the easier it will be to turn a deaf ear to special pleading.

I've previously asked:

Might transition be more effective if countries appointed foreign experts to ministerial positions, rather than pay them to consult?

The efficiency costs of nationalism really do run deep.

Globalisation and Football

Dani Rodrik has an article at Project Syndicate called Globalisation and the Beautiful Game. I confess to struggling to understand Rodrik's precise position on international trade, feeling that he acts as an exemplary critic but a somewhat vague adviser. I don't think he gives his intellectual opponents an honest reading, and revels in being contrary. I also confess to being unsure of how the economic effects of globalisation can be seen through the lens of professional football, and whether it simply gives rise to armchair punditry. So I read his article with interest.

My main criticism is that Rodrik seems to suffer from his own complaint:

instead of sticking to what they are good at--analyzing trade-offs--economists typically engage in amateur normative political theorizing about what is good for society.

There is a robust, enduring and (relatively) straightforward theoretical framework that demonstrates the positive-sum gains of comparative advantage, and thus an economic rationale for unilateral international trade. I am routinely frustrated by the fragmentary, anecdotal, conspiracy-led,  rhetoric-laced specific cases that mask as a critique. Thus the anti-globalisation crowd seem wedded to complex theory to support their stories, even though the more complicated the economic theory, the lower our confidence in it should be. Rodrik is a prime example of an economist who over-complicates theory (formalism being a convenient way to do this), but in this article he also seems to fall victim to casual empiricism. After a lengthy list of the benefits of greater globalisation (better quality football, higher wages to skilled footballers), he attempts to undermine these unambiguous advances with the costs:

• Many fear that the quality of national teams is harmed by the availability of foreign players
• Many blame the country’s [England's] failure to qualify for this summer’s European championship on the preponderance of foreign players in English club teams
• There is also a broader backlash under way. Sepp Blatter, the president of FIFA, soccer’s global governing body, has been pushing a plan to limit to five the number of foreign players that club teams would be allowed to have on the field

Is that really the best we can do? Are there no greater costs that this ramshackle list of blind assertions and scare-mongering? Where's the evidence to say that national teams are harmed by foreign players? Who are blaming these foreigners for England's ineptitude? The irony is that England were relatively successful under Eriksson (a Swede). We were woeful under his predecessor (Keegan, an Englishman) and his successor (McClaren, an Englishman). And since when did anyone believe that sharing an opinion with Sepp Blatter was a good thing?!

Rodrik takes as given that the quality of the Yaoundé domestic league has fallen as a result of globalisation, and I'd like to see evidence. Since jobs and skills aren't fixed, for every player that leaves their domestic league to follow the money to England, Spain or Italy, the incentive to become a professional footballer, and for domestic clubs to improve their scouting and coaching improves dramatically. This might rest on an assumption of a sufficient rule of law that contracts are written and enforced, but even if this doesn't exist, it increases the benefit from legal reform.

Ultimately the only 'losers' from globalisation are, as Rodrik says, those who value their national team. If all players benefit through globalisation, and all club supporters, then to find losers you must implicitly accept the validity of their preferences. The logic of economics supersedes arbitrary political boundaries - the fact that nationalists lose out through economic liberalism is obvious. Rather than take preferences as given, political economist should explicitly deal with normative judgments; *if* your aim is X then policy A is the most appropriate. *If* you desire Y, then go for policy B. There's nothing more amateur and normative than attempting to provide unambiguous, pseudo-positive answers. The debate should be a normative clash between nationalists and European liberals, and economists should be honest enough to explain how the logic of globalisation supports the latter, not the former.

And finally, notice that by it's nature football is a zero-sum game. By definition any change to the sport will leave some sides better off and some worse off. I was hoping Rodrik would shed light on both his own insights, and also the issue at hand. Sadly, my conclusion is that it's a false analogy, with little implication. Maybe you can do better.

Consumer sovereignty

"The consumer is not at the mercy of the shopkeeper. He is free to patronize another shop if he likes. Nobody must kiss other people's hands or fear their disfavor"
Mises 1949, p. 286

"There is only one boss. The customer. And he can fire everybody in the comopany from the chairman on down, simply by spending his money somewhere else"
Sam Walton, founder of Wal-Mart

Sean Gabb on non-doms

A free society is not Tesco minus the State. It is a place of small craftsmen and farmers and traders, of artists and of unlicensed doctors and lawyers, and of others needed if individuals and free associations of individuals are to live well. We cannot say much more than this about the arrangements of a free society. But we can be sure it would have no place for big business as it now is found.

More here.

张五常Steven N.S. Cheung

Now I realise why Steve hasn't been blogging much. (From Peter Klein)

What about Cuba?

"If you believe in freedom, justice and equality you have no choice but to support Fidel Castro!" - Harry Belafonte.

Cuba has obviously been in the news recently, and it poses an interesting challenge to those of us who conduct research in the field of comparative political economy. Does the case of Cuba contradict the claim that socialism is an incoherent means to organise society?

I confess that I know little about Cuba, and have no direct experience. However over the last few weeks a number of interesting empirical issues have been raised, that seem to confirm my theoretical expectations. I find them plausible, but wonder about any potential counter claims.

Michael Statsny offers some personal views on the situation in Havana: "the misery and decay I encountered  in Havana (Habana Vieja) exceeded my expectations by a wide margin". His account is disturbing, but he does add that "the people I talked with were actually quite happy with their situation ("We don't earn much, but as opposed to other countries education and health care is for free!")"
This raises the issue of travelers visiting Havana and encountering people who say they're happy. It's important to be skeptical about these claims, since I think Michael's being naive. This doesn't rest on any "false consciousness", merely the genuine threats associated with free speech. Consider the following:

ONE evening, a Soviet joke relates, Stalin decided to see if he was as beloved as his cronies insisted, so went to a Moscow cinema in disguise. Sitting in the dark as the newsreels began, the tyrant was moved to tears as the audience stood—apparently unbidden—and wildly applauded his image on screen. His reverie was cut short when his neighbour leaned down and hissed: “Comrade, we all hate him too. But it's safest to stand and clap.” Charlemagne

If you get 18 months in jail for joking about the Dictator, would you??

 

So allow me to put together some of the crude information that's out there which directly confronts some of the more common popular sentiments about Cuba. (But don't let that stop you reading this article by Humberto Fontova)

Knobhead statement 1: But Cuba is relatively prosperous!

• What's the appropriate benchmark here? As Brad DeLong shows, in 1950 Cuba was (i) rich compared to Latin America; (ii) quickly approaching Western living standards. To look at Cuba under communism (post 1959) we need to imagine what it would have been like had it continued on it's original path.
• What is the evidence to say that Cuba has high living standards? Scholars learnt a tough lesson in 1989, which was that official statistics in countries without free information are dubious at best. As Ilya Somin says, "the UN and the others depend on information provided by the Cuban government. You can't do independent data collection in a totalitarian dictatorship. Thus, the UN numbers are derivative of Cuban official statistics."
• In other words, the data is somewhat meaningless but even if we believe it, Cuba has gone backwards

Knobhead statement 2: But Havana is cool!

• We should expect Havana to be an inacurate indicator of national living standards - even more so than in free societies: "Like other communist regimes, the Cuban government pours a disproportionate share of its resources and public investment into the capital and areas likely to be frequented by foreigners." (Ilya Somin)
• Most of the impressive buildings in Havana are colonial and pre-date communism.
• As Megan McArdle says, "Deep poverty is much more picturesque than moderate poverty." Progress is ripping down old and decaying buildings and replacing them with more functional, safer ones.
• Havana is a potemkin village, built for your amusement

Knobhead statement 3: But Cuba has good healthcare!

• Here the data issues really come to the fore. Consider some photographic evidence of the actual hospitals that Cubans face. Are these fake? An unbiased sample? How would we know??

Knobhead statement 4: But Cuba stands for something beyond material prosperity

As The Times points out,

• "Cuba sent homosexuals to forced labour camps"
• "In 2003, Castro oversaw the execution of three men who had hijacked a ferry in a bid to escape from the island"
• "According to the Cuban Commission for Human Rights and National Reconciliation, in 2006 there were 316 political prisoners in Cuba.
• The purchase of computers and access to the internet is severely restricted with many citizens using black market sources.
• In 2003, state security forces raided 22 independent libraries and sent 14 librarians to jail with terms of up to 26 years.

Conclusion: when can we learn the lessons of history? A country where people risk their lives to leave is no model for society. I'm a subjectivist - my values count for nothing. If someone risks their life to flee a country, that's the only indicator I need. If you value freedom, Cuba is a political and economic disaster.

Quick roundup...

• "The Philosophy of Liberty" a useful flash animation
• Communist and capitalist stupidity (and why there's different forms)
• A graphic novel of the subprime crisis
• What should tax rates look like? (I asked this question previously, also see Chris Dillow's response)

There will be profit

WARNING: Spoilers included

If you're even considering watching 'There Will Be Blood' than I implore you to do so (Wikipedia page, Rolling Stone review). The film mirrors Day-Lewis' lead: engaging, mesmorising, and ultimately shocking. I came away feeling that like any great protagonist Plainview was morally ambiguous, and only come to write this post having since suspected that I hold a minority view. Many people, it seems, take a dim view of Plainview.

Consider this review, which seems to approach what friends complain about:

"a mesmerizing meditation on the American spirit in all its maddening ambiguities: mean and noble, angry and secretive, hypocritical and more than a little insane in its aspirations" (cite)

That doesn't sound ambiguous at all, so I wonder, To what extent does his characterisation depend on an aversion to profiteering?

The plot is a rags to riches tale of an oil tycoon, and the ideological undertone is evident when we see the alcoholism, mental disintegration, and ultimate violence associated with the accumulation of vast wealth. Ignore the fact that commercial pioneers used their profits to fund America's cultural heritage, ignore the sobering and maturing effects that portfolio development typically brings about: Plainview's torment is supposed to tell us something about that elusive quest for growth.

But it's all too easy to use fiction as an ideological weapon, and all too easy to sit back smugly and lament how the arts industry monumentally fail to understand the capitalist process. Even if Plainview is an accurate depiction about the role of capitalism, is he really such a villain?

Exhibit A in the anti-capitalists case is Plainview's treatment of HW. This is a child (orphaned following a drilling accident) that Plainview uses as a business partner, to - supposedly with ruthless efficiency - signal a family firm and thus swing delicate business deals in his favour. These original motives are ultimately confirmed when Plainview bellows "bastard in a basket" to a now deaf HW (following another drilling accident), and reveals all. Does anyone buy this? An alternative history is that a mentally fragile, cruel man hurts his now ex-partner by whatever means he can, belying several years of tenderness and care.

Exhibit B might well be these accidents that routinely emerge and are depicted with devastating brutality. But the initial (and most formative) accident occurs in the first 10 minutes of the film, as we see Plainview himself digging for silver. He falls from his hand built ladder shattering his leg, and crawls back to civilisation with a limp that never leaves him. This physical deformity demonstrates the personal risk and sacrifice that he made. But for what? Profit?

In a telling scene Plainview and HW sit atop a hill, and Plainview outlines his vision of a pipeline running to the sea, freeing the company from their existing distribution network. But realise that he's not competing with consumers for that bounty, he's skimming it from rival producers to the benefit of the end user. The silent story throughout the entire picture is the scores of poverty-ridden consumers who benefit immeasurably from the production of cheaper gas. It's all too easy to presume that entrepreneurs capture rents. They do not, they create profit and this create social prosperity.

I personally found that the moral ambiguity of the film is embodied in the delightfully enthralling relationship between Plainview and local churchman Eli Sunday. The reciprocal nature of their contest suggests ambiguity. The victor is a function of physical strength. Both end up as detestable creatures. But good versus evil? Far from it.

Watching the film reminded me of Viktor Schreckengost (Don Boudreaux, Steve Horwitz), an entrepreneur who created an array of household products that we now take for granted. He was a silent hero, rewarded with profit, yet less famous and less well known than even a minor political figure. Perhaps we return to the fundamental conflict between left and right, which is weather arguments about wealth redistribution should prevent wealth creation. Perhaps the inevitability of bloodshed is a function of economic education.

I'm sure that if I'd read the book, or read a large number of film reviews I'd realise that these 'undercurrents' are actually transparent and obvious public debates. I might well have misinterpreted other people's interpretations. But for those who do see Plainview as an unambiguous villain, I worry that you're letting economic ignorance interfere in your enjoyment of a fine, sublime movie. There will be profit. There needn't be blood.

More on GMU

I've previously demonstrated my grad school pride by linking to Walter William's piece: "A dynamite economics department", and also the Slate article by Boettke and Tabarrok. Next up is "The Virginia School" in Doublethink:

Northern Virginia’s GMU was once known mainly as a commuter school, but its economics department has risen to national prominence in part because of the two Nobels awarded to faculty members in the past 20 years*, and also because of its brand of “interesting economics,” which has helped make it one of the most-quoted economics departments in the world.

It even comes with photos.

*Shouldn't that be 22 years?

Sautet on inflation

Take a look at Fred Sautet's latest on inflation: The Disastrous Effects of Central Banking: Let’s Get the Story about Inflation in New Zealand Straight. I've always struggled with the exact point at which Keynesian's feel the Quantity Theory breaks down, and Fred acknowledges a tricky issue:

It is surprising to read that both the current governor, Alan Bollard, and the ex-governor, Don Brash, believe that inflationary pressures are, to some extent, outside the control of the RBNZ... Don Brash has recently published an article on petrol tax as a means to control inflationary pressures (see here). The idea is that the tax would reduce the general level of spending in the economy without the central bank having to change its monetary policy. For Brash, taxation is a means to control inflation.

Considering that Don Brash is one of the heroes of late Milton Friedman (see here) and that he presided over the establishment of one of the best monetary policies in the world, his view is really surprising to say the least!

Read the whole piece for a sharp, succinct overview of the credibility issues, wavering targets, quasi-independence, the "D" word... but most importantly the "optical least sqaures" record of c20th Central Banking

Julian Simon and the Ultimate Resource

Don Boudreaux on Julian Simon:

Simon's most important contribution was to crystallize and explain an insight that even the best economists before him only glimpsed -- namely, that human beings in free societies are "the ultimate resource." Nothing -- not oil, not land, not gold, not microchips, nothing -- is as valuable to the material well-being of people as is human creativity and effort. 

Petroleum didn't become a resource until human beings creatively figured out how to use it to satisfy some human desires and other human beings figured out how to extract it cost-effectively from the ground.

An important implication of this realization that humans are "the ultimate resource" is that high and growing population -- in societies with sufficient freedom to allow individuals to experiment and create -- is desirable. If human creativity and effort are not only resources, but also the ultimate resource, surely it's foolish to lament large and growing supplies of it.

Quick roundup...

...from various sources:

• What can Einstein tell us about management?
• Does Ronald MacDonald work for ther Bank of England?
• What book should I recommend?
• What does the Detroit public schools book depository look like?
• What should I do on March 12th?

Finland and Estonia

I've been racking my brains trying to think of something interesting to say about the Finnish economy for our ongoing Finnlter^ series, and have finally realised: Finland is interesting, not necessarily for what it is, but also for what it is not. Curiously, the relative moribund nature of Finland is a powerful reminder of the effect of comparative economic systems. According to Mart Laar*:

In 1939, it was hard to find two more similar countries as Finland and Estonia. We were very similar in language, culture, and living standards. Our economies were more or less the same. Then in 1940, Estonia was occupied by the Soviet Union and Finland successfully protected its independence. Look at what happened in this context during these fifty years and then you can understand how terrible the communist system really is. And it’s not only in the economy. This is in all fields of life—the social structure, cultural standards, education, healthcare, or whatever. When you compare those two countries, which were exactly the same in 1939[,] in 1989, then you will find what communism really means, and how bad it is. Our economy, our nature, and our environment was [sic] destroyed

The use of Finland and Estonia as a natural experiment has also been made by Robert Higgs, in his series of "Experiments in Political Economy" for the Independent Review. His conclusion**:

The conclusion:

their economic and social differences grew so large that no informed person could honestly dispute the pernicious effect that communist rule had on occupied Estonia.

* Laar, Mart. 2006. Exporting Hope: An Interview with Mart Laar. Religion and Liberty: A Journal of
** Higgs,Robert "Results of Still Another Experiment in Political Economy" The Independent Review Volume 12 Number 1 Summer 2007) Religion, Economics, and Culture 16 (fall):3,12–13. p.12

Prosperity and Child Mortality

According to a BBC report, "wealth 'may not lead to health'". It's based on a report by Save the Children, but doesn't provide any link so it's hard to tell whether my criticisms should be levied at the BBC or both. However the claim seems to be that:

UNDP statisticians calculate that more than half of the babies who die in Angola could be saved were the country to spread its wealth more fairly.

Which is interesting, given that the report confirms that:

• Wealthier countries have lower rates of child mortality than poorer countries
• Within poor countries, wealthy people have lower rates of child mortality than poorer people

...and yet the conclusion is that:

wealth 'may not lead to health'

This is shockingly poor research/reporting - emphasising the opposite conclusion than the evidence suggests. For those of us who put infant mortality before ideological dogma, here's the bottom line:

Bubbles refer to countries, colours show continent, size of bubble is the population. Note the ridiculously strong negative correlation: prosperity = low child mortality

Source: http://www.gapminder.org/world

Grad School Tips

I've just put a link to Fabio Rojas' "Grad Skool Rules" on my resources page, and have also seen Matthew Pearson’s (UC Davis) guide to Surviving the First-Year of grad school.pdf (via Gabriel). A nice quote:

Thriving during your first year is highly correlated with passing your prelims. And as such, the sage advice herein is designed to help you become the best grad student you can be, to get the most out of your classes, to develop your intuition, to master the core theory, and most of all, to pass your prelims, all the while maintaining a loose grip on your sanity.

My advice for grad students is more straightforward:

1. Study
2. Sleep
3. Social life

Pick two

I'm still not sure how I managed to complete my PhD in 4 years and get married in that time, but it must come down to:

• Pick the right school - I was immensely fortunate to go to the dynamite George Mason (that dares to be different), and it meant that I was surrounded by knowledgeable people who shared my passions. If you study in an environment like that, you can't go wrong
• Preparing well - find out the textbooks for the core subjects and read them before you start
• Find/create a good study group and stick with it - I find that learning is a social process and therefore a stable group of close colleagues is gold dust
• Have realistic expectations - for me the first year was about survival. I'm consistently told that ambition and aspiration should exceed merely "survival" but for me it works
• Drink productively^
• Love what you do - my PhD mattered to me. I was willing to sacrifice a great deal. If it's a chore then it's a struggle, but I never grew tired of my subject and still want to discuss and develop the ideas I pursued.
• Change the title at the