Crony Capitalism, Crony Communism, and Crony Anarchism

Over at Bleeding Heart Libertarians, Matt Zwolinski poses a challenge to libertarians who defend capitalism by suggesting that its current iteration is “impure.” He shows that there may be some hypocrisy if we also critique communism because it has historically led to oppressive dictatorships — that communism could be just as “impure” as current capitalism. This is not the first time I have read this challenge, and I feel that it has been largely ignored by libertarians — but, I think there is an intuition behind that choice.

In the comments, I wrote,

You can make a case that the “pure” communist society leads to an authoritarian, extractive dictatorship. You can also make the case that a capitalist system leads to a liberal society. I think the empirical evidence is broadly in favor of this interpretation.

But, I’m not entirely satisfied with my answer. I believe that a welfare state, of a size determined endogenously, is perfectly compatible with capitalism (which does not mean that all welfare states are compatible). But, those who disagree with me will still consider that a state of “impure” capitalism.

One way to look at social change is to interpret (part of) history as a gradual improvement of institutions. These institutions make our weaknesses less relevant, and they promote coordination between agents. Consider institutions such as property and contract rights, the rules that make bad people less relevant in government (there are positive outcomes, regardless of the intentions of a single agent), et cetera. Economists interpreted these institutions, but only within a narrow time frame: ~1700–present. They called the institutional framework they saw “capitalism,” referring to a narrow set of institutions that define “the market.”* Government was seen as exogenous to market institutions, but this probably isn’t right. Institutions of governance form part of the process of social change just as much as institutions of markets, and the often are interrelated.

A critique of communism could be: communism disrupts this process of change for the worst, causing institutions to deteriorate, rather than improve. Capitalism, on the other hand, embraces the process of change, causing institutions to improve. I think the first is right, and the second is wrong. What we define as capitalism today is the product of institutional change, and if we force the process towards a defined end — what some may call “pure” capitalism (anarcho-capitalism?) — we will end up with institutional deterioration. In that sense, “pure capitalism” and “pure communism” may not be that different. Both “pure capitalism” and “pure communism” are ideals we construct, but as such they are both equally weak to the accusation of a “fatal conceit.”

* Marx, however, did not interpret market institutions so narrowly. He thought that capitalism led to a deterioration of political institutions, or crony capitalism.

Frank Hollenbeck’s Parallel Universe

I have a hard time believing that “The Sad State of the Economics Profession” was written by a professional economist. It is entirely wrong, including in its assessment of the profession, and it’s narrow, idealized history of thought. Frank Hollenbeck, the author, makes a number of claims, which are extremely unorganized, making it difficult to write a general comment. I want to address certain specific arguments,

  1. Hollenbeck’s attempt to contrast between economists who specialize in disproving “popular misconceptions” and those who “have sold themselves to the enemy” (government — maybe Hollenbeck should quit the University of Geneva, since it’s a public research school).
  2. The claim that mathematical models are not useful in economics, because “the parameters are not constant, most of the variables are interrelated with constantly changing interrelationships and omitted variables, like expectations, some of which being immeasurable, are conveniently assumed away as unimportant.”
  3. That empiricism is useless, because “it is difficult to distinguish between association and causation or correctly determining the direction of causation.” (Economists must be idiots for missing such a simple fact!)

If there is any element of truth in those three statements, Hollenbeck has done them a great disservice, because his defense of those claims is very weak.

I

The irony in Hollenbeck’s piece is that he accuses his peers of corruption, and supports his theory by building a mythology. All theory — except, I assume, that put forth by economists friendly to Mises — since 1930 is retrogressive, because it was all developed to legitimize false truths. Yes, Hollenbeck makes this argument explicitly,

The profession is always moving forward, right? In economics, we wrongly take the same attitude. Macroeconomics as a profession has not advanced but has regressed. We had a better understanding of macroeconomics 80 years ago. Politicians put Keynes on a pedestal because he gave them the theoretical foundation to justify policies that had been justifiably ridiculed in the past by the classical economists.

Nevermind that the academic popularity of Keynes’ ideas was a result of how well they persuaded his peers, not because of their congruency with public policy of the time. Although, I suppose all of Keynes’ peers were also corrupt, except (conveniently) whichever one of them might have advanced a theory that Hollenbeck actually agrees with (but may just be unaware of, because his history of thought is so poor). But, my intention is not to defend Keynes, just to point out that Hollenbeck mistakes reasonable disagreement for corruption and malice.

Economics is tough, because society is complex. Because of reality’s complexity, economists must build theories, or ideal types, that help us explain what we observe. But, this implies a certain disconnect between theory and the real world, because ultimately the former is only an interpretation. This interpretation was made by someone who only knows only some fraction (0 < x < 1) of the facts. Because we are cognitively limited, which is the reason why complex systems are difficult to understand, the ideal types we build will be similarly limited. And, because we all have asymmetric sets of priors, our posteriors are unlikely to be exactly the same. In English: economics is exactly the kind of subject over which there will be a lot of disagreement.

Hollenbeck’s approach to this disagreement is to dismiss it as corruption. I suppose this option is attractive to someone who does not know much about, or sees no merit, in post-interwar economics. The lack of merit position is hard to square, however, with the undeniably insightful theoretical advancements since 1930: the transaction cost theory of the firm (I forgot, Coase is a socialist), New Trade Theory, asymmetric information, et cetera. Those are three examples of hundreds more. Our understanding of the economy is incomparable to that of the 19th century — it is superior. J.B. Say did not benefit from the same degree of understanding of institutions, for example, or international trade, or price theory. Although, J.B. Say was smart enough to know better than Hollenbeck on monetary theory — so, I guess that some economists’ understanding has indeed retrogressed.

What about disagreement before 1930, was it also caused by intellectual corruption within the profession? Was Adam Smith a pawn of the state for preferring a dynamic, private supply of money? I am assuming that David Hume was the economists’ equivalent of a Jedi, because he advocated for a fixed money supply. Dark forces must have been behind the disagreements between Carl Menger and W.S. Jevons. J.S. Mill’s utilitarianism must have been developed to justify public policy of the mid- and late 19th century. It’s easy to play Hollenbeck’s game, but it’s obvious that the game is bunk.

What makes Hollenbeck’s approach so unfortunate, and so disheartening (as an Austrian sympathizer), is it runs contrary to the other common claim that the mainstream simply ignores what heterodox economists have to offer (and, by heterodox, I mean “Austrian” specifically). The truth is that the ignoring works the other way: heterodox economists like to ignore the mainstream, or dismiss it is as all wrong — which is essentially the same thing. But, how could a serious economist ever take a critique like Hollenbeck’s seriously? I am sure he has good ideas, but he does them an injustice by instead accusing his peers of intellectual corruption. This being an accusation that only someone terribly ignorant of the state of economics could make.

II

Forget, for a second, about mathematics and formal economics. Take any theory, such as Ricardo’s theory of comparative advantage. This theory says that exchange will be organized in such a way to minimize opportunity cost, because people will specialize where they have a comparative advantage. You have a comparative advantage in specializations where your opportunity cost is lower relative to others’. This can be generalized, and we can say that countries will specialize where they have a comparative advantage. Ricardo missed, however, — or at least it was not explicit in his model — that factor endowments help determine comparative advantages, and so initial endowments can go some way in explaining international trade. As it turned out, Ricardo’s model of trade was missing out an entire independent cause! Economies of scale can also explain trade, and it might even do a better job at it! These were factors which Ricardo had omitted from his model.

It’s strange that Hollenbeck does not level the same criticism against all economic theory. If we have to build ideal types, abstractions, to understand the real world, and these ideal types will suffer from incompleteness (because of the incompleteness of our knowledge), then they all are burdened by the same probability of omitted factors. The truth is that all economists, including Hollenbeck, are aware of this and they embrace it. That is why there is an academic process of scientific advancement. We know that our theories are not good enough, so we continue to develop them. Hollenbeck’s critique of mathematical models on account of “omitted factors” is simply nonsense.

The claim that mathematical models are useless, because their parameters are non-constant, is weak, and is equally applicable to theory in general. Theory is about positing, and rationalizing, certain relationships between variables. It’s no different whether you present a theory in words, or whether you present it in math. If you read a good theoretical economics paper, what you find is a model that is largely qualitative, in the way that I think most people understand that word. The model does not say that an increase in price by five percent will lead to a decrease in demand by one. It abstracts from those kind of specifics, focusing instead on the relationships. This is true whether the model is presented in words or in math.

Why use math at all? The problem with the written word is that it’s easy to be vague. An economist might advance a theory, their critiques would respond, and that economist might claim that his critiques completely misunderstood him. Math helps make the model more explicit. This also helps the economist to present a stronger, more complete theory, since he has to figure out the explicit model before he can present it. In other words, math helps the economist think about what he is omitting. In other words, Hollenbeck’s critique is actually stronger against the form of communication he prefers, than it is against math.

While Hollenbeck does not bring this up, one other objection to math might be that the type of assumptions that have to be made are typically much more strict, and less plausible. I think there is merit to this criticism, but it’s also something that most economists are aware of when they are drawing conclusions from their model. Mathematical models have to worry about being tractable, so that they can be worked with. Good models are always very careful about their assumptions, however, and if the simplification is too strong the model is not very useful. Economists often put work into defending their assumptions. And, when it comes to drawing conclusions, economists consider their assumptions when generalizing the results of the model.

If you think there is an “obvious case” against the use of math in economics, you are wrong.

III

This needs to be made clear: all economists know that correlation is not causation.

This is something students are told in the first or second week of an introductory econometrics class. Your model must be informed by theory. There has to be a reason that you assume a relationship between two variables. I mean, duh. It doesn’t make sense to use econometric techniques to test a theory if you aren’t actually basing your model on any theory. But, if your theory says that any increase in the money supply will cause a general rise in prices, then we have good reason to expect correlation between those two variables. We use econometrics to get an idea of what the direction of joint variation is, if there is direction at all. The theorist imputes causation, and the empiricists tests whether there is association at all.

Why would we want to test theory? People can make mistakes in their reason. In fact, they can make mistakes they are unaware of. We all do it all the time. We all have had that experience where we’ve thought something to be true for the longest time, we suddenly see it from another angle, and what was once true is now false. The false belief, at the time, seemed very reasonable. We even looked down on those who disagreed with us, because we thought they were missing something obvious (obvious to us, at any rate). But, it was only we who were missing something! Empiricism cannot definitely disprove or prove theory, but it can help to update our priors. It helps us to see which correlations in the data there actually are, to weed out theories that are irrelevant. And, if we posit a causal relationship between A and B, but we observe that B doesn’t occur, despite A, it might lead us to revise our assumptions. It might cause us to see the world a different way, and to discover something that we previously hadn’t considered.

All in all, Hollenbeck’s article is very confused. His readers deserve better, because they are being misled. That his arguments are very weak, however, doesn’t mean that my beliefs are right. That’s alright. Disagreement is a part of business, and we have to communicate to resolve them. But, accusing me of intellectual dishonesty is not a way to go about that. Neither is leveling a barrage of “obvious” problems at the profession, “obvious” problems that on second look are not problems with the profession at all.

The Coasean State

One justification for property rights is dispute resolution: resources are scarce, and private ownership helps reduce conflict over them. By establishing an enforced system of rules that determine ownership of goods, we can create an environment allowing for the best use of resources (property rights allow for a pricing process — most likely an unintended result of early institutions of property). Who determines these rules? In part, they are determined spontaneously. We are implicitly shaping rules when we trade property rights in a division-of-labor. Oftentimes, however, trade through markets is made unattractive by transaction costs. Thus, we also need, for example, legal and political systems.

When discussing property right exchange, Coase was specifically addressing the problem of negative externalities: costs which are imposed on an unwilling party. A factory, for example, might pollute, damaging neighboring houses. Or, a cattle rancher may not be able to fully control his cattle, which graze on land which does not belong to him. These people are consuming resources which are claimed by others, causing a dispute. The Coase Theorem states that, assuming zero transaction costs, existing property rules are irrelevant, because the parties involved will flesh out their own rules for their own particular situation. But, when transaction costs are positive, disputes may have to be resolved in other ways.

When we think of property disputes with no Coasean solutions we turn to the legal system. At least, this has been the main application of Coase’s theory. When parties cannot privately resolve a conflict, they need someone to arbitrate between them (ignoring the possibility of outright violence). On what basis does the justice system solve these conflicts? Whatever the standard, legal systems are also built on rules — not just rules that minimize inefficiency and injustice within the organization, but also rules which help arbitrators reach solutions. These rules are not the best solution all the time, but we want the ones that maximize the probability of a “good” solution for each trial. But, what if there is a conflict that a court, or a private defense agency, or an arbitrator, can’t resolve?

When a dispute involves a few people, private solutions may be easy. The legal system helps extend the range of private solutions, but it can’t solve everything. While a court might order a factory to build a smokestack, it’s more difficult for a court to impose that ruling on every factory externalizing its costs on its neighbors. These other factories might one day also be brought to court, and the ruling may still usually be on the side of the victim, but the process can be long, expensive, and not very satisfying — and, there may be some factories that aren’t brought to court at all (maybe it’s too expensive, because the externalized costs are too widely dispersed). We may need other organizations, working with a different set of rules, to resolve issues that are too costly for Coasean solutions or the legal system.

One such alternative is the state. There are many kinds of states, so to keep things simple let’s assume we are working with an “ideal” representative democracy. What I mean by ideal is that a constitution, with more-or-less unanimous consent, binds (constrains) a set of institutions and organizations of governance. These may include, for example, a bicameral (multicameral?) legislature, a division of power within governments, a division of power between various local, regional, and national governments, et cetera. Different organizations, such as the House and the Senate, may have asymmetric sets of rules; different legislatures, for example, may have different voter sources, different rules of proceeding, and so on. Decision-making need not be unanimous, as long as there is agreement with the overall rules of the game.

We don’t need to narrow down property rights disputes to things like pollution, there are many social conflicts that an economic imperialist could classify as property disputes. Discrimination imposes costs on the discriminated — psychological costs, for example. Think of the costs to women — not only foregone wages and profits, but also potential psychological burdens — a biased, limiting culture may cause. The “right to discriminate” can come at the expense of the discriminated (which is why it makes dubious sense to believe in an absolute right to discriminate/disassociate). People may also want to impose certain “meta-rules” on other institutional sets, such as markets or the legal system, as well. For example, a division-of-labor may only fully agree to associate if there is a general rule to minimax the position of the worst-off.

If we frame the state in the context of property rights, it no longer seems so alien. Humans develop rules that govern their claim to property, including their claim over each other. Some of these rules are flexible on a very simple level. Some property rights can be defined with a simple exchange between parties. But, costs to these types of transactions make alternative organizations and rules, such as the legal system, attractive. Like the legal system, governments have their own asymmetric set of rules, and they have a comparative advantage when resolving certain property disputes.

It might be worth thinking beyond “property disputes.” Just like property is one way of resolving certain conflicts, maybe there are other ways, or other kinds of conflicts that can’t be resolved through property rights. And, just like there are “private” solutions to these other conflicts, there are “public” solutions as well.

Piketty’s Meat and Bones

I have yet to finish reading Capital in the Twenty-First Century. There are many reviews already out, many of them very much worth reading. Two critical reviews by Ryan Decker and Josh Hendrickson. There is also Paul Krugman’s, probably the most widely discussed review to date; Krugman makes some good points against Piketty, but also covers some of the book’s strengths.

The heuristic the book sells to the reader is r > g. That is, if the return on capital is greater than the rate of economic growth, inequality will increase. The concept, explained like that, is somewhat cryptic. It’s an easy heuristic for those who don’t want to get bogged down in the theoretical argument. The theoretical argument is actually not that complicated (theory makes up a very, very small minority of the book). Piketty makes it near the end of the sixth chapter of his book. His argument is that if the elasticity of substitution between capital and labor is > 1, the share of income accruing to capital will grow relative to that of labor.

You actually don’t have to buy the book to access the theory. In my opinion, the theory is not well communicated in the book. It’s available in the free technical appendix. Here is that appendix for chapter six (in case it doesn’t take you directly, the meat and bones starts on page 37),

Download the PDF file .

Quote of the Week

[P]olitical liberalism supposes that there are many conflicting reasonable comprehensive doctrines with their conceptions of the good, each compatible with the full rationality of human persons, so far as that can be ascertained with the resources of a political conception of justice.2 As noted before, this reasonable plurality of conflicting and incommensurable doctrines is seen as the characteristic work of practical reason over time under enduring free institutions. So the question the dominant tradition has tried to answer has no answer: no comprehensive doctrine is appropriate as a political conception for a constitutional regime.

— John Rawls, Political Liberalism (New York: Colombia University Press, 1993), p. 135.

The footnote,

The point here is that while some would want to claim that given the full resources of philosophical reason, there is but one reasonable conception of the good, that cannot be shown by the resources of a reasonable political conception of justice.

China: Future Migration Hotspot?

China is still a sending state, more migrants leave than come in. According to the World Bank, about 1.5 million people emigrated from China in 2012, on net. I am not sure how much of that includes emigration to Hong Kong and Macau. Still, compared to the United States, which received, on net, 5 million immigrants, China does not seem like a major attraction to migrants. But, will China always be a sending state, or will it soon begin to receive net immigration? Immigration is already an important facet of the Chinese economy, and there is reason to suspect that China, like Western Europe and the United States, will, down the road, become a receiving state.

Historically, China has always been a sending state. The World Bank measures net migration as the number of immigrants minus the number of emigrants. China has had a negative figure since 1962, which is when the data I have starts at. But, net emigration does not imply no immigration, and, as their economy continues to grow, with a growing demand for labor, immigrants have turned into vital means for growing productivity. While the amount of net emigration remains significant — although, the data includes emigration to Hong Kong and Macau (two important net recipients of Chinese migrants) —, the number has been steadily decreasing since the early 2000s: from 2.2 million immigrants, on net, to 1.5 million.

The country, however, is going through a structural change. It is going through a process similar to that of the U.S., between 1820–1910. Industrialization has brought with it one of the largest internal migrations in the world, as large amounts of people move between provinces. This includes movements from rural areas to the cities, and movement from poorer (typically, rural and agricultural) to wealthier regions. While there are not always known opportunities for higher paying jobs in the cities — migrants are often displaced by a falling demand for labor in the rural areas —, it is true that Chinese industry is a sponge, in need of a growing labor supply.

Domestic labor is not always enough, especially given China’s low population growth rate (0.5 percent, in 2012). If the demand for labor increases, and the labor supply is more-or-less stable, we should expect higher wages. According to the “neoclassical” theory of migration, where changes in relative wages cause migration between countries, we expect rising Chinese wages to attract migrants. This does not necessarily mean, though, that immigration will occur up until wage rates between countries are equalized — in fact, emigration to China may push wages up, inviting even more immigration.

If there are economies of scale, larger populations mean higher real wageMonopolistically Competitive Markets. As population grows, all else equal, so does output. This lowers the average cost and price, raising the real wage. Larger population also means a larger amount of firms, greater product diversity, and the accompanying welfare gains to the consumer. This result was formalized by Paul Krugman, in his work on trade theory.

Trade, or the movement of goods and capital, creates the same effect as an increase in population: an increase in the division-of-labor. But, if trade is restricted, or if bad policies elsewhere leads to low growth and high unemployment, the movement of labor may replace the movement of goods. Consider some of the “stylized facts” of sending states: history of low growth, extractive political institutions, and relatively low wages. Sending states each have a division-of-labor which is significantly isolated from the world’s. While China’s political climate may still be unattractive to many, the economic factors may grow in relevance. The country is surrounded by many others which are worse-off, and growing Chinese wage rates will become increasingly attractive.

Other factors, besides relative wages, that determines migration are “linkages.” Think of a linkage as a shared history. For example, many Indians migrated to the United Kingdom, because India is a former colony. Similarly, Spain attracts a disproportionate amount of South American migrants, because of their shared history. Countries with linkages are more likely to be involved in a migration pattern than countries without them, all else equal. China has shared histories with not only its neighbors (many of which, however, are also growing and/or prosperous), but also with populations one might at first suspect. The Chinese have invested heavily throughout Africa, and many Africans have migrated to do business in China. As African networks in China grow, this might attract larger flows in the future.

Growth, however, does not always mean less emigration. The evidence shows that growth may actually lead to increasing emigration rates, below a certain threshold per capita income,

Emigration Flow to GDPPC

In early stages of development, other factors may dominate the marginal increase in relative wage. Since the poor are typically credit constrained, rising incomes will help them finance migration decisions. Networks in other countries may also attract large emigration flows. If early flows were restricted by asymmetric information, where potential migrants were simply unaware of the opportunity, growing networks in receiving states will correct this asymmetry and increase the flow of migration. Changes in relative income are important to consider, too. If early growth raises certain incomes disproportionately, the relative wage rates between countries for the non-affected income groups remain the same. Maybe this explains, in part, why China attracts high-skilled labor from South Korea and Japan, but exports low-skilled labor.

But, China’s GDPPC (GDP per capita) is just about at the threshold in the data. According to the World Bank, China’s 2012 GDPPC, in current U.S. dollars, was about $6,000. Net emigration has fallen since the early 2000s, and real wages in China continue to grow. Is China poised to become an important receiving state in the future? This will bring with it interesting problems. An immigration shock provokes hostility amongst a homogenous local population, leading to civil rights issues — issues the Chinese government will have to deal with. It will also have a significant effect on the global economy. The U.S. became a major industrial power in large part thanks to immigration. But, the U.S. started out with a relatively small population. China is already the largest country on Earth and there is still a growing demand for labor, despite the already large labor force. How will the Chinese government approach the “immigration problem?” How will this affect the United States and Western Europe? By 2070, or sooner, we might see large communities of American workers in Beijing!

Rhetoric of Capitalism

In November 1957, just a month after Russia’s Sputnik satellite blasted into space, causing Americans to fear that they were losing in the space rate, Lawrence gave an optimistic address about America’s strengths to students and faculty at Seton Hall University in South Orange, New Jersey. Lawrence told the assembly, “Spread of shareownership in America brings about a silent revolution, and this people’s capitalism is given impetus by the Stock Exchange.” He continued, “The most dramatic feature of this free-enterprise system has not erupted in newspaper headlines. Nor has it been squeezed into the small talk of ordinary parlor conversation. The phenomenon I’m talking about is the gradual emergence of what we have come to call a People’s Capitalism — the ownership by millions of people everywhere, through their stock investments, of our means of production.”

— Janice M. Traflet, A Nation of Smaller Shareholders: Marketing Wall Street after World War II (Baltimore: Johns Hopkins University Press, 2013), pp. 139–140.