I’ve always defended Cristiano Ronaldo from haters, but today I’m one of those haters. And, I’m not exaggerating just how much of a hater I’ve become.
…that finds it shocking that the following was written in the “leading trade theory textbook,”
When they were first proposed, market failure arguments for protection seemed to undermine much of the case for free trade. After all, who would want to argue that the real economies we live in are free from market failures? In poorer nations, in particular, market imperfections seem to be legion. For example, unemployment and massive differences between rural and urban wage rates are present in may less-developed countries.
— p. 227.
To be clear, this is part of a single paragraph, and by no means represents the entire book. The book is very good, and if you’re looking for a textbook introduction to trade theory and international monetary policy, I definitely recommend it. And, no, it’s not anti-free trade, although not everything would be found in a hypothetical analogous textbook by Mises or Rothbard (e.g. optimal tariff theory, market failure arguments for tariffs, et cetera — and my intention isn’t to disparage the latter two authors, especially since I’d mostly agree with them).
However, in my opinion, that’s a shocking statement. There are market failures. The market often fails to coordinate. But, to blame poverty and mass unemployment in the developing world on market failure seems disingenuous, and I mean that word with all of its implications. Many of these problems are caused by failures of those countries’ political institutions, and this shouldn’t be controversial. Economists have blamed bad policy on poor economic performance since the birth of the discipline. More formal and more recent research on institutions has expanded on our intuitions. Market failure probably explains very little of poverty in the developing world. What those economies need are freer markets.
Believe it or not, after what will soon be a year and a half, I have something planned for economicthought.net. To some extent, it will act as a personal website — I will probably have my CV there. But, more than that, I’ve always wanted to have something like the Mises Daily system. At first, I might run a column once a week. If at some point I can interest others to write for the website, I’ll gradually work it up to an article per day (or more!). It would be mostly dedicated to economics, but other social sciences may be featured, as well: sociology, political science, philosophy, et cetera. Neither would it be restricted to a particular ideology or school of thought. I’m looking for some plurality in the points of view expressed in the articles (of course, for as long as I’m the only writer, the articles will reflect my own beliefs).
I’m not sure when the website will be up. I had a stroke of luck when my girlfriend just happened to have a degree in graphic design, with the added plus of plenty of webdesign experience. I’m having her design it for me. Then I have to negotiate with one of her co-workers, who does the actual coding, to see if I can get it done for an affordable price. I’m hoping that it will be done on the WordPress platform, as well, so that it’s easier for me to update then when I need to, and it’s easier to publish. At first, the website is going to be relatively basic: an article system and this blog. Even with only these two features, it might take some time to piece the whole thing together, given the shoestring budget. I originally thought of some kind of discussion forum, but those are always a pain to moderate, and there’s already one that seems to be taking off after the Mises.org forums were closed.
But, I’m glad I finally figured something out, because otherwise the economicthought.net page would probably indefinitely keep looking the way it does right now. At first, especially since this is my blog, the website is meant to sell me, in the sense that I can network through it. But, ultimately, I really want this to be a significant part of the Lachmannian “commerce of ideas.” And not one just restricted to academia, but one open to all and designed for all.
One of the biggest reasons I don’t find much merit in the idea of NGDP targeting is that it’s not clear to me that changes in real GDP (RGDP) always follow changes in nominal GDP (NGDP). Likewise, I’m convinced that downward shocks to RGDP lead to downward shocks in the money supply, as opposed to vice versa. While I advocate a counter-cyclically elastic money supply, I don’t think that monetary stimulus can help avoid the correction of the real economy that results from fiduciary over-expansion. Scott Sumner’s recent post on what he would expect had the Federal Reserve begun targeting NGDP by mid-2008 only deepens my suspicions.
Sumner thinks that had the Fed been targeting NGDP in mid-2008, the financial crisis wouldn’t have happened. I find this claim very unconvincing. If we are to believe Gary Gorton, the financial crisis was mainly caused by a breakdown in wholesale credit channels, because the bulk of the collateral being used in these markets had become information sensitive. What this means is that the collateral began losing value, or trading below par, forcing investment banks, and other wholesale debtors, to increase the amount of collateral to maintain the same level of short-term borrowing. For Sumner to be right, NGDP targeting would have to, somehow, maintain the value of the collateral. The main asset acting as collateral, at the time, was the mortgage backed security (MBS), and related assets (i.e. the collateralized debt obligation [CDO]). The value of these assets were dependent on the nominal demand for housing.
Could NGDP targeting have maintained the demand for housing? The answer, in my opinion unambiguously, is ‘no.’ MBS’ are financial assets composed of mortgage debt, where the pooling of loans allows asset holders to spread the risk of loans with higher probabilities of default. Prior to the financial crisis, MBS’ were considered to be some of the safest, or relatively information insensitive, assets. Their safety, however, relied on the expectation that the default rate, on average, would be below a certain percentage. The default rate is a factor of various variables, such as homeowner income, the cost of the home, et cetera. But, during the boom, continuously rising prices effectively decreased the real cost of debt, since homeowners who couldn’t afford their mortgage could simply re-sell the house for a higher price than they bought it for — they would earn a profit! The rise in the home prices, in turn, was fed by continuous loan origination, but by 2005–06 loan originators were running out of people to loan money to.
There’s only so much room to lower lending standards. Thus, by 2005, the pace of loan origination starting to fall, and with it home prices began to plateau, then stagnate, and finally gradually fall. As home prices fell, the default rate increased. While it took roughly two years for it be obvious, the securitized assets based on these loans were also losing value — that is, the supply of safe assets shifted to the left (supply decreased). Financial firms which relied on MBS’ and CDO’s as collateral for short-term borrowing quickly saw the assets side of their balance sheet deteriorating, and this is what caused the financial crisis of 2007–09. There was a bank run. It didn’t look like a bank run, because it wasn’t ordinary depositors who were worried about banks making good of their deposit liabilities. Rather, it was wholesale depositors worried about being repaid, because it suddenly became obvious that banks simply didn’t have the assets to sell to access the liquidity to repay their debts.
The point is, for the financial crisis to have been avoided, it would have been necessary for the Fed to continue the housing boom. We normally think of Fed policy affecting asset prices more directly, but in this case the boom in asset prices was directly linked to the boom in home prices. Given the lack of a sufficient volume of new mortgage debtors, I don’t think it was possible to maintain the housing boom (not to mention it would have been undesirable).
We would have still seen the significant fall in real incomes (because of falling home prices and large household debt), and we would have still suffered from a dramatic fall in output. Wholesale credit markets would have still dried up, and banks’ would still be forced to deleverage. But, I agree with Sumner that the recession would probably have been milder had the Fed better accommodated the rise in the demand for money. This being said, I’m also sympathetic to a certain aspect of the Post Keynesian endogenous theory of money — well, actually, this is an aspect of mainstream banking theory, too (even if Post Keynesians think they’re the only ones who acknowledge it). The Fed can only accommodate the demand for money indirectly, by inducing banks to make loans. If the banking system is damaged and credit channels are dried up, then this channel becomes less effective. The same is true if uncertainty makes borrowing too costly, which is Richard Koo‘s major argument against monetary policy.
Historically (see Gorton’s Misunderstanding Financial Crises), to avoid the problem of moribund banks, there has been some process of balance sheet strengthening. For example, prior to the Federal Reserve, clearinghouses would pool member banks’ assets and issue their own currencies, almost as a temporary bailout. Following the financial crisis, the Federal Reserve bought large quantities of MBS’, but I’m not sure how effective this tactic actually was. It seemed to have a greater impact only years after the brunt of the damage had already happened.
Thus, my main concern with NGDP targeting is that the theory papers over concerns of resource misallocation. Typically, when we think of misallocation we think of too large of a housing sector, or too many construction workers, but there was also a massive misallocation of financial capital. Even if the Fed were targeting NGDP, the likelihood that the assets people had invested in at the time were going to see a large drop in value would be enough to cause a shock to RGDP, and therefore a shock to NGDP. It was out of the Fed’s control. I do think that accommodating the rise in demand for money would have eased the transition, but I don’t think this is a panacea. Also, I think there’s merit in the broad “regime uncertainty” story. I don’t believe our government suddenly became more interventionist than it was before, but I’m of the opinion that a lot of the transaction costs that make structural adjustments more difficult went, in a sense, unseen during the boom — fiduciary overexpansion made transaction costs less expensive. This is one reason why I find the “evidence” against fiscal austerity superficial and unconvincing. NGDP targeting is only a little bit less unconvincing than the case for fiscal stimulus. I prefer a Hayekian, microfounded explanation of the business cycle.
Historically, how does private policing compare to public policing? Gene Callahan answers this question by looking at a homicide rate time series for England, pointing out that roughly 800 years ago the crime rate was roughly “20 times today’s rate.” He notes that the decline in the homicide rate coincides with a continuous growth of the state. He admits that correlation is not causation, but he thinks it’s fairly clear that the correlation is not mere coincidence. I sympathize with the argument, but it suffers from an omitted variable bias, and in fact the number of omitted variables is probably very large. Further, what did directly cause the decline in crime could be things that would coincide with both public or private security. But, in the end, I say all of this as someone who believes that public security has provided society a net benefit.
I’m of the opinion that private security makes sense in a world where the distribution of force is relatively equitably distributed, such that the costs of violence are, on average, too high. This means that private security hasn’t been viable for most of human history, and it’s not obvious that it’s possible today. This implies that the state, so far, has most likely been the most efficient means of maintaining peace. While its present viability is not obvious, I do think the case for the superiority of private security is pretty high, but only by making one very likely erroneous assumption. I think the kind of justice and the means its enforced by would be very different from present day. An immediate change, I think, would cause a cultural shock. If we do away with the assumption that people will deal with this shock, then private security can’t work until institutions — including culture — develop to that point. This implies a transition over a large number of years.
But, it’s not difficult to see how Gene’s comment is not convincing to the anarchist. Consider the following possible causes of the long-term decline in homicides,
- Better communication technology, allowing more crime to be reported to the authorities;
- Faster means of transportation, allowing the authorities to more quickly respond to reported crimes;
- Better, more expensive weaponry, giving authorities an advantage with economies of scale — individual criminals may not be able to afford them;
- Growing economic wealth gradually increased the opportunity cost of crime, shifting the supply of crime to the left;
- Better non-violent home protection systems, including homes that are more difficult to break into, home alarms, et cetera;
- Criminals typically have non-random backgrounds, meaning that improvements in wealth also reduce the size of environments which are more likely to induce criminality;
- Changes in weapon technologies make it easier for non-skilled users to fire more lethal weapons, making it easier to stop assailants (raising the cost of crime);
- Various things that are extremely counter-intuitive that we may not recognize. I have in mind, as an example, Donohue’s and Levitt’s work on the relationship between abortion and falling crime rates. I understand that there are convincing arguments that show a number of problems with their methodology. But, my point is that there are things that are extremely non-obvious, and in fact until someone is creative enough to come up with a novel causal relationship we may even be convinced that there is no causal relationship whatsoever.
I can think of a lot of other plausible explanations for declining homicide rates in England. But, if you assume that private security is possible, none of these things are factors which are preferable to state security, but not to private security. That is, if we strictly model the security industries, the list is entirely composed of variables exogenous to the model. They are all changes with positive externalities, which affected the provision of security. If we assume private security was possible in 1200, then the time series may show exactly the same relationship. In fact, if private security is really more efficient than public security, then we’d see a superior trend.
There are a lot of anarchists that strongly believe private security is possible. If a lot of the reasons for a decline in crime are unrelated to actual institutions of justice, then it’s not difficult to see that the use of the trend line to argue in favor of public security is not convincing. I suspect that the issue that many anarchists have with Steve Pinker’s The Better Angels of our Nature. (In Pinker’s case, though, I think most are underestimating the book.) But, it’s not obvious that all increases in world peace have been caused by the state itself, rather than concurrent cultural, economic, institutional changes which bestowed upon society the benefit of greater peace. Maybe increases in the cost of weaponry, especially when we consider military-grade weaponry, induced economies of scale, by increasing the initial cost of warfare (weaponry, military training, deployment, et cetera). This forced governments to wage larger wars, but at much fewer intervals, and at higher costs (in price and, especially, in human life). These are all externalities that private institutions of justice would also benefit from, if they were possible.
It’s also worth considering that most modern-day anarchists don’t care about what was possible 800 years ago. They care more about what kind of institutions are possible today, or even in the near future. And, so, while there is a high probability that the state was absolutely necessary for most of human history, it doesn’t take away from the likelihood that none of the major factors that reduced the crime rate would cease to exist in a world of private justice. That being said, there are also many anarchists who believe that the state was never necessary. These people are even more likely to dismiss Gene’s argument, and even a weak version of Pinker’s. Although, to these people I’d show the differences in income growth rates between historical stateless, or relatively stateless, societies and societies with centralized governments. The latter, without a doubt, has, to date, shown the most possible results. In any case, what I’m trying to say with respect to Gene, is that it’s not clear that the evidence is so evidently in favor of public security.
On a tangentially related note, the case for the state became clearer to me in a short conversation with a professor on Daron Acemoglu’s and James Robinson’s Why Nations Fail. I mentioned my disagreements with the authors’ assumptions on the benefits of centralized states. He asked me if I knew what they had in mind when they made the claim, and in that exact moment I realized that the benefit they have in mind is that as the number of governments decrease, the probability of inter-state warfare falls. This also means that there are less governments to fight over extractive institutions, which may otherwise suffer from even stronger temporal rigidities. Maybe this already seems obvious to you, but I think the point was poorly articulated in the book. The authors, for example, cite tax increases as evidence of stronger, more inclusive political institutions. And, they fail to acknowledge that Somalia, during its years as an economically growing, virtually stateless society, actually did relatively well (in pace of improvement). They make other assumptions, as well. At one point they make the claim, at least in my interpretation, that relatively centralized governments are necessary prerequisites for vibrant urban trade centers. The claim was made with regards to early cities. But, maybe other factors — such as factor endowments, geographical location, et cetera — invited greater merchant activity, which in turn made extractive institutions like state bureaucracy possible. The way they present the case for centralized governments is not as strong as it could be.
But, look at the case for centralized governments this way. When there are many small geographical jurisdictions, with the assumption that the market is till too uncompetitive to fully discourage war and conquest through private security, the probability of war grows. As governments come to control larger quantities of land, forcing many governments to cease existing, there is a lower probability of border conflict, and war in general. In this sense, the centralized state can be seen as a net benefit. I feel that this is actually what Acemoglu and Robinson actually have in mind. I think it’s a strong argument.
Coming back to the main point on omitted variables, it’s not at all obvious that the decline in England’s homicide rate is directly attributable to the provision of public security. In all actuality, it’s more likely that the market for security benefited from a long list of positive externalities, mostly associated with economic and technologies improvements. But, there are strong arguments for the existence of the state, such as institutional concerns, that would enrich the debate if they were more regularly addressed.
Elsewhere, I’ve been involved in a discussion on the economics of slavery. I mentioned Robert Fogel’s and Stanley Engerman’s Time on the Cross, which argues — and this is a very simplified paraphrase — that slavery is not everywhere and always unprofitable. In fact, Engerman co-authored a paper with Kenneth Sokoloff, “Institutions, Factor Endowments, and Paths of Development in the New World,” where they use a similar argument to explain institutional divergence in different parts of the Americas. The argument is that industries affected by economies of scale, where fixed costs are relatively high, are better suited for slave labor (or, otherwise, low-paid wage labor).
The intuition is that, given economies of scale, comparatively large quantities of output are necessary to push down average costs, thereby requiring relatively large labor inputs. This is especially true where the industry is relatively labor intensive, which was the case during the early colonization of the Americas (relatively capital intensive industry began to appear around the 1840s, and then took off in the United States following the U.S. Civil War). Engerman and Sokoloff posit that the geographic distribution of these different industries is decided by geographic factor endowments. Further, producers in these geographic areas will tend to specialize in industries that are intensive in the good that is locally abundant. This follows from the Heckscher–Ohlin trade model (the idea is that local abundance drives the opportunity cost of these resources down, giving that area a comparative advantage).
I suggest that Fogel and Engerman’s book is the definitive study on American slavery. Not everyone agrees, I guess; I was pointed to a crical review of the book by Mark Thornton, “Slavery, Profitability, and the Market Process.”
In any case, I made a number of points as to why it’s not probable that slavery is a profitable means of employment, for the employer, in an advance economies,
- There is the classic incentives argument, which says that differences in payment will alter incentives, implying that low wage (or, in our case, unpaid) labor has less of an incentive to maximize productivity;
- Influenced by George Reisman’s argument, elucidated in his book Capitalism, on the fundamental scarcity of labor, I suggest that as the division of labor grows, and the competition for labor rises, the option of enslavement — unless slavery is institutionalized through law — disappears. As the marginal productivity of labor rises, and therefore so do wages, workers will simply opt to move to industries where wages are highest.
These are the typical, superficial arguments as to why slavery eventually peters out as a viable means of employment. But, inspired by an excerpt from Don Lavoie’s Rivalry and Central Planning, I wonder if Mises’ calculation argument offers a different path to explaining the downfall of slavery’s viability (in relatively advanced divisions of labor). Mises’ case against socialism boils down to a knowledge problem, but one that specifically deals with the problem of imputation. In a nutshell, Carl Menger, in Principles of Economics, develops a subjective theory of value, where factor of productions’ value is determined by means of imputation, which means that they’re derived from the values attached to the final consumer goods, whose values are directly determined by their (subjective) benefits. The problem was that there was no convincing price theory which explains how exactly these values come to be known. Friedrich von Wieser thereafter developed his own theory of “natural value,” where, as I understand it, these values are exogenous to the market process. Unconvinced by this theory, Mises (Boris Brutzkus, Nicolas Pierson, and Max Weber developed similar theories independently — see Hayek’s Collectivist Economic Planning and Individualism and Economic Order) advanced a novel alternative hypothesis, which argues that only a competitive market process, based on the institution of private property, can allow for price formation. And, only through price formation can the values of factors of production be known to firms, who can use these prices to choose between alternative means, and also rely on profit and loss accounting to track their efficiency.
Labor is a factor of production, so its value must be imputed from the final product. Specifically, following Böhm-Bawerk’s law of costs, since labor — to an imperfect extent — is a relatively mobile factor, the value of the marginal worker will be imputed from the least valuable alternative end (because, if this worker were drop out of the labor market, the firm would sacrifice the least valuable attainable end, rather than the most — in other words, the opportunity cost is the alternative end with the lowest value). The price of labor gives firms added information regarding the value of the labor they employ, allowing firms (and labor itself) to allocate its employees in a relatively efficient way. Where the marginal productivity of labor is very low, this issue loses some relevance. But, as the marginal productivity of labor rises, if slavery is institutionalized in such a way that it sacrifices the bidding process allowed by a frequent movement of labor, it suffers from the fact that the lack of market prices (apart from the initial cost of acquisition) will make it much more difficult, if not impossible, for firms to efficiently allocate their labor. The result is that slave-employing firms will be at a competitive disadvantage relative to wage-paying firms producing the same goods.
Does this sound like a plausible thesis? Skimming over the above-linked Thornton article, he advances a similar argument. Has anybody else made the same argument? I think this theory fits nicely with the work done by Engerman and Fogel. Their theory, as aforementioned, relies on the assumption of economies of scale and labor-intensive industries. Imagine labor intensity as a ratio between the quantity of labor employed to the quantity of capital employed (L/K). With capital accumulation, this ratio should become smaller (L/K↑), meaning the capital intensity of the industry is increasing. Capital is what raises the productivity of labor, and therefore raises wages. With capital accumulation, and therefore economic growth, slavery becomes gradually more uncompetitive. As argued in, for example, Acemoglu’s and Robinson’s Why Nations Fail, southern production remained relatively labor intensive, even as northern industry became more-and-more capital intensive. This is probably why the profitability of slavery, in the south, was not drastically challenged during the first half of the 19th century.
Finally, in passing, what this all suggests is that, in the context of perfect markets, slavery should become nonviable with industrialization and mechanization. The problem is institutional. Not only was slavery institutionalized in the South, but Southern institutions were generally more extractive than those of the North. The South, relative to their Northern brethren, were less innovative, and the economy was less competitive. This is related to the factor endowments argument, but that slavery didn’t fade on its own is also a product of the effort that entrenched interests put in to make sure that their way of doing business isn’t forced into irrelevancy through competition. In other words, there’s also a political dimension to the problem of slavery. I don’t think we can divorce markets from politics (or, institutions more broadly), but this is a point consider.
Self-organizing social systems economize on the knowledge people need to pursue their goals successfully. Science, the market, and democracy are so complex that no human being can grasp them except by using a theory divorced from concrete details. Such a theory, however, can provide little or no guidance in making specific decisions within such an order. Few economists are successful entrepreneurs, few political scientists win public office, and few philosophers of science do valuable scientific research. The skills required to succeed within a spontaneous order are little connected to the skills needed to understand it.
— Gus diZerega, “Market Non-Neutrality: Systemic Bias in Spontaneous Orders,” Critical Review 11, 1 (1997), p. 123.