Category Archives: Economics

Am I the Only One…

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…that finds it shocking that the following was written in the “leading trade theory textbook,”

International Economics (Krugman)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.

NGDP and the Recession

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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.

Question on Slavery

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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,

  1. 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;
  2. 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.

Ryan Murphy on McCloskey

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Ryan Murphy reminds me of why I need to read Deidre McCloskey’s Bourgeois Dignity,

Institutions cannot be viewed merely as incentive-providing constraints.

— “Why Neo-Institutionalism Can’t Explain the Modern World: A Pamplet”

As of late, I’m becoming a huge fan of Douglass North’s work on institutions. If you haven’t already, I recommend his Understanding the Process of Economic Change. It’s not his most in-depth work, but it’s a good summary of his research, and if you like it you can get into his other stuff from there. He also has plenty of articles you may find online. One of the most interesting things about North is that he takes the concept of transaction costs — costs to using the pricing process — to explain the reason we have institutions at all, and this has really informed my view on market failure, what determines the distribution of income, et cetera.

But, McCloskey adds, I guess one could say, a “human touch.” As noted, I have yet to read the book, but as I understand it, McCloskey’s intention is to argue that economists shouldn’t divorce institutions from humanity, since it’s humanity which gives these institutions meaning. It’s actually a very Hayekian point. It reminds me of Hayek’s “The Meaning of Competition.” If you assume institutional constraints as given, or divorced from society, then you miss out on the process of institutional formation. It’s the day-to-day interaction between agents which creates the process of institutional change, based largely on how social norms change based on our experiences. Hayek made the same point with regards to competition, contra the model of perfect competition which assumes away the process. The same could be said of Mises’ theory of economic calculation, which Hayek later expanded upon in his work on knowledge. You can’t divorce price from the day-to-day bidding process.

McCloskey’s book (and the prequel, The Bourgeois Virtues) has been sitting on my shelf for almost a year. It’s been my loss, and it’s a big loss. It’s one of my “must reads” for the summer, where I don’t have any excuses.

The Error of Latin American Market Reform

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Left Behind (Edwards)In the story of Latin American economic reform, then, one variable more than any other plays a crucial role. It is not inflation, wages, or economic growth; it is not privatization or the extent of openness and globalization; it is not even foreign debt. The key variable is the exchange rate, or the value of the local currency — the peso, the bolivar, the quetzal, the real, or the córdoba — in relation to the United States dollar. Repeated mistakes in exchange-rate policy will be singled out as the most important cause behind the region’s economic travails, the waning support for modernizing reforms, and the eventual revival of populism during the twenty-first century.

— Sebastian Edwards, Left Behind: Latin America and the False Promise of Populism (Chicago: University of Chicago Press, 2010), p. 142.

The problem that Edwards brings to our attention is the seeming inability for a fixed exchange rate regime to coexist in a country with independent monetary policy. In a floating exchange rate regime, a fall in the value of a currency will also manifest itself in the exchange rate — the currency becomes cheaper relative to others. If the price of local currency is fixed, however, internal inflation will cause it to become overvalued relative to foreign currencies. This discourages export-oriented growth.

But, the currency and debt crises that struck Latin America in the mid- and late 1990s was more than just a price fixing problem. Latin American assets (except for debt denominated in foreign currency) also required currency exchange to take place, and so the artificially overvalued local currency should also impact capital flows (or, at least, the kind of assets held). But, inflationary environments tend to correlate with — and/or cause, I think — asset price booms, so holding these assets becomes attractive. Most Latin American countries were running large trade deficits, meaning they have capital account surpluses. In my opinion fixed exchange rates in an inflationary environment is part of the problem, but not the whole story.

Guns and Crime

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Following tragedies like shootings, the demand for gun control usually rises. A common objection against greater gun control is that criminals don’t follow the law, and so gun control will only place a greater handicap on law abiding citizens. This isn’t necessarily true, and I can illustrate it with the following two graphs,

Demand Curve Elasticity Gun Control

If we deaggregate the criminal population into two sub-samples, we can see how two different classes of would-be criminals react differently to changes in gun laws. The graph on the left represents supply and demand of guns for “non-professional” criminals. These are people who may be mentally ill, or just happen to be in a state of mind where criminality is likely, but where such criminality isn’t a part of their normal life. Your typical school shooter probably belongs in this group. The graph on the right illustrates demand and supply of guns for “professional” criminals, who are people who earn a living from crime (crime is a normal part of their lives). I don’t think it’s a stretch to assume that the latter group’s demand curve will be inelastic, relative to “non-professional” criminals.

If we assume that more gun control will increase the price of gun acquisition, then we can see that gun control will have a greater effect on “non-professionals.” It’s determined by differences in the elasticity of demand. What elasticity of demand refers to is how the demand for some good will change as the price changes. What this implies is that gun control may indeed be a way of reducing certain kinds of gun violence, like school shootings.

The next relevant question is how gun control impacts defense against “professional” criminals, because the ratio of “civilian” gun ownership to “professional criminal” gun ownership will fall (the former falls to a greater extent than the latter). It may be that the costs attached to a falling civilian to professional criminal gun ownership ratio are greater than the benefits derived from less “non-professional” crime. This is an empirical question, and I don’t have a good handle on the empirical evidence. I’ve seen arguments go both ways: those on the right tend to claim that the data supports them, and those on the left argue the exact opposite. I am biased by the historic inability of the right to make good arguments on these kinds of issues, so I’m more skeptical of the right’s claim — but, the fact is that I really don’t know.

However, I think that reliance on guns amounts to a prehistoric method of the maintenance of peace and order. This isn’t to say that force isn’t sometimes necessary, and that weapons make the use of force more effective. My point is that we have also developed institutions that minimize the need for violence. Arguing for less gun control, in a sense, is putting institutions on the back burner. One reason to do this is distrust of the state, but if we had stateless institutions I doubt that society would be gun control free. In fact, some of the evidence suggests that I’m right. For example (although my memory may be failing me), during the early decades of the U.S. occupation of what is today the mid-Western U.S., it wasn’t uncommon for local law enforcement to restrict the carrying of firearms within the territorial confines of the town.

As institutions evolve, and guns become less important to the enforcement of the rule of law, it makes sense to implement marginal changes in gun control. Society may decide that the benefits of some gun control are greater than the costs. This not only applies to crime, but also to tyranny. As the institutions of governance evolve, so do the means of checks and balances. If guns aren’t as necessary to control the encroachment of the state as they were in the past, we can sacrifice some diminishing sense of security in that area for greater security in other areas (e.g. lowering the crime rate).

It’s also important to realize that gun control doesn’t necessarily mean stripping society of all its guns, and monopolizing the right to the use of arms. It simply means restricting the availability of certain guns to certain people. Not very many people, excepting perhaps extremely uninformed liberals (which must exist, just like extremely uninformed conservatives exist), advocate the corner solution of complete gun control. There’s no reason to implement the extreme defense of “they want to take away all of our guns!” (Although, I’m sure there are people who do; but, we live in a reasonable society, where the average opinion lies somewhere in the middle.)

Edit: The anti-gun control evidence usually looks something like this. These small data sets are susceptible to omitted variables, and so what looks like a straight forward story may not be so straight forward. I’ll have to research for more robust empirical tests.

Edit 2: It’s also worth considering that there are various means of reducing crime. Even if some gun control leads to a net benefit, it doesn’t mean that this level of gun control is optimal. It could be that alternative means of crime reduction suffer from lower opportunity costs.

The Institutions of Crony Capitalism

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Timothy Carney’s Atlantic column, “The Case Against Cronies,” has been making the rounds on the internet. He questions whether the mantra of profit maximization is really what libertarians want to advocate, knowing that profit maximization is not necessarily synonymous with social coordination. I think he misses some of the nuance in the theories of libertarians who have typically defended profit seeking behavior — no libertarian thinks we should monopolize every industry, despite the fact that a firm would maximize profit if it could garner monopoly rights. Also, libertarian economists, especially James Buchanan, have focused on the negative consequences of rent-seeking. But Carney’s main point is a good one nonetheless. I made a similar point in my review of Joseph Stiglitz’ The Price of Inequality, noting that rent seeking is an important dilemma, because it leads to non-market distributions of wealth (i.e. distributions not loosely bounded by productivity).

Before making my main point, I want to reiterate that not all rent-seeking is inefficient (from a social welfare perspective). Firms respond to regulation. Regulation can lead to sub-optimal outcomes. Rent-seeking that aims to reverse these interventions can be a positive social force. In fact, this kind of rent-seeking has been a major historical force for social change. It was the businessmen who “lobbied” the English crown in the 17th and 18th century that gave some impetus to the political movement towards pluralistic governance. They oftentimes managed to break the monopoly rights that the crown would offer certain industries. Nowadays, this is probably not so relevant, but the point remains that some rent-seeking is constructive.

But, as Carney and others point out, there is a lot of rent-seeking that is socially destructive. Carney approaches the issue from an ethical perspective. He makes the case that libertarians should criticize favored firms more vigorously and frequently. I don’t disagree with him. Public criticism goes a long way in restricting the scope of corporate choice. Bad public relations can cost a company much more money than what’s gained through rent-seeking. This is why automobile manufacturers are typically quick to recall malfunctioning product, especially in countries where consumers can quickly access information. This is also why firms don’t always opt to produce in countries where the production costs are lowest — being caught in these types of actions can lead to a large loss of customers.

Ethics can only take us so far, though. The best solutions to social discoordination are institutional (which ethics can, of course, inform). The problem is that for some reason we have not yet developed political institutions which are harmonious with the institution of the market, and vice versa. As it stands, political power can be used to distort markets, and wealth can be used to distort the political process. In his article “Market Non-Neutrality,” Gus DiZerega talks about some of these issues. I disagree with how he frames the problem, and his suggestion to separate these institutional spheres, but he looks at the same issue from a similar perspective. In my opinion, institutional progress isn’t measured by how well we can separate different institutional spheres — because of alleged ethical differences (I’m not sure how ethics can be different, if essentially the same people take part in all of them) —, but by how well these institutions harmonize with each other.

What this means is that there’s more to solving the problem of rent-seeking than just changes in how our ethics influence our actions (e.g. by being more proactive in calling out firms that conduct themselves anti-socially). We should also use our moral compasses to help shape the political process. And, I don’t mean just changes in the legislation. We already see how ineffective regulation can be, or even how burdensome regulation can be.  It also entails changes in the political institutions themselves. We need to develop political processes that, while they’ll suffer weaknesses and costs of their own, institutionalize socially constructive behavior. In econospeak, we need to change the “rules of the game.” In other words, we need to constrain the range of choice, to choices which we can define, just for the sake of conceptualization, as socially constructive.

Political transformations are difficult to fathom. Historically, these changes have tended to occur suddenly, and often very violently. But, we should start to think about them as gradual and peaceful transitions. Take, for example, the development of political pluralism in England (or Great Britain/United Kingdom, more generally). England suffered its fair share of violence, but much of the movement towards democracy was peaceful. There we saw a case of a long-term, gradual, and more-or-less peaceful institutional transition. As institutions improve these kinds of transitions should become more prevalent, because they will be formed with a greater degree of innate flexibility.

Why isn’t the institutional approach typically addressed (except in certain academic environments)? I think that people tend to focus on market institutions. We have a hundred years, or more, of theoretical developments that tells us that markets are often imperfect. It’s accepted that the institutions of markets need to improve. But there exists some relationship between markets and politics, so it doesn’t make sense to separate the two when we are talking about progressive changes in how market agents behave. Many of the rules of markets are set by governments, and if we want to see improvements in these rules, and how these rules are formed and enforced, we also need to see political change.

Once people familiarize themselves with the idea that it’s not just markets which are imperfect, it’s also government, I think we’ll see more flexibility in institutional progress in the sphere of governance. There will always be resistance, but our society is already relatively pluralistic. The extent to which those in power can raise obstacles to change is more limited than it was in the past. This suggests not only that these type of changes are easier, it also implies that they should occur faster. And while institutions have been seen as important facets of society for at least 250 years (since the Scottish enlightenment), it has more recently become a truly flourishing subject area in economics (and in other disciplines, as well). These scientific developments will be transferred to the general public in due time. We have already seen, for instance, how theories like public choice have influenced the public.