Category Archives: Reviews

Institutional Relativism

[The Institutional Revolution♦ by Douglas Allen ♦ University of Chicago Press, 2012]

Coordination of decentralized human activity requires, amongst other things, institutions. Nature and the limitless scope of human choice can make organizing production and exchange difficult. People, for instance, are often difficult to trust and uncontrolled nature can restrict the precision of human action. To help mitigate these problems, societies developed institutions. These are the structures of rules — whether formal or informal — that guide and constrain decision making. But, institutions vary widely from society to society and, within societies, from era to era. Why? What determines which institutions are relevant and efficient? Douglas Allen, in The Institutional Revolution, helps us approach an answer to this question by looking at some of the institutions of pre-modern England.

Modern institutions began to develop in the late 19th century, and one important facet behind their emergence was the human “conquest of the physical environment.”[1] Growth in scientific knowledge allowed for its application, including innovative new technologies which improved our capacity to reduce much of the variance inherit in nature. We, for example, take for granted that we have an accurate measurement of time, through our wristwatches, cell phones, kitchen appliances, and just about everywhere else. Two hundred years ago, even pocket watches were hard to come by, especially for the non-wealthy, and the technology was not necessarily very precise. It was only after the 1850s that standardized, precise watches began to be mass produced. Imagine the difficulty that the pre-moderns had in establishing exact meeting times or designing shifts. Problems like these conditioned the institutions of that era.

Pre-modern English institutions looked very different to our own today. In fact, from a modern perspective, many of those institutions seem corrupt and inefficient. But, our judgment takes for granted just how much control we exert over nature. We do not face the same problems, or constraints, that pre-moderns did. Their rules, their customs, and their way of doing things have to be interpreted within their proper context. This is what Douglas Allen does in his book. He looks at the English aristocracy, including the custom of dueling, the Royal Navy, the British Army, the private provision of security, roads, and lighthouses, and the organization of the Crown’s tax collectors. He interprets the rules of these systems within their proper context, seeing order where others see corruption, profiteering, and wastefulness.

English governance, between ~1600–1850, provides an interesting example of the peculiarities of the institutions of that era. Before the advent of modern, (ideally) merit-based bureaucracy, governments had to think of alternative ways of mitigating shirking. Wage-based systems make sense when hourly output can be cost-effectively monitored. The pre-moderns, for the most part, did not have this luxury, so they relied on a different system, based on patronage, lavage, but largely illiquid investment, and seemingly benefit-less methods of proving one’s honor, such as dueling. On the surface, such a system does not seem too promising, but, given the constraints of the time, these bureaucratic institutions were actually relatively efficient.

At the time, only the aristocracy had access to the English bureaucracy. This was the era of lavish countryside estates, with sprawling gardens, and large social gatherings. It is easy to doubt the social utility of these types of investments, especially when compared to the various entrepreneurial investments that the aristocracy could have made instead, but Allen argues that they had a purpose within the institutional framework of pre-modern English governance. Without the ability to monitor effort directly, the Crown opted for a profit-and-loss alternative. But, profit-and-loss only works as a disciplining process if people stand to lose. English countryside houses represented that potential loss. Before being accepted into the aristocracy, the wealthy had to invest much of their wealth in things like countryside estates. Outside of the nobility, these homes had little value: they were illiquid assets. Thus, if an aristocrat was caught shirking, he could be effectively banned from the nobility and left with a largely valueless asset — and, of course, without the significant stream of income that came with holding a public position.

Beyond initial investments in illiquid capital, the Crown relied on signaling of trust as a means of gauging the merit of individual aristocrats. Wealthy businessmen could not just buy large estates and call themselves members of the nobility. It was an inner circle, with some opportunity for entry, where the members knew each other, including whether or not they had breached the trust of the Crown. Outside investment was discouraged and looked down upon, and gaining social recognition was a multi-generational project, implying that the decision to invest in the aristocracy had the implication of a large opportunity cost. But, over time, if one could break into the aristocratic circle, there was much wealth to be earned by working for the government.

If a family’s wealth was relatively limited, there were alternative means of gaining social recognition and trust. One of these methods was dueling. It also served as a screen, to weed out those who did not have the social capital to be an aristocrat. Dueling carries some risk of death, and it only makes sense to commit oneself to a duel if there is something to gain. At the same time, however, the gains may provide an incentive for cheating and for non-aristocrats to partake as a means of faking social capital. Therefore, legal restrictions were placed on whom can duel and the rules of dueling minimized the opportunity for activities that created an inequality of advantage between the two people involved. For the most part, as a result of both formal restrictions and an informal structure of incentives, dueling was restricted to the lower gentry — the less well-off nobility —, and the outcome was generally as random as possible. The weapons used were typically not very effective, minimizing the importance of training, and there were official judges present, called seconds, to look over the event. Who lost or won usually did not matter; the very act of dueling was a partial proof of one’s social capital. Not dueling, on the other hand, was proof of a lack of social capital.

With technological changes and the introduction of methods of direct monitoring, the relevance of aristocrats as bureaucrats faded. In, what was by that time, Great Britain, this institutional framework was gradually replaced with a wage- and merit-based bureaucracy, where most members of society had the opportunity for entry. The transition was not only peaceful, but it was largely voluntary, with the landed gentry opting for more financially rewarding opportunities elsewhere.

The other institutions that Douglas Allen explores are equally as interesting, and often just as surprising. The Royal Navy, for example, was structured not necessarily to take advantage of the best military tactics, but to help guarantee that a ship always had an incentive to act in the Crown’s interest. This differed markedly from the institutions of the French navy, which placed a lot of emphasis on tactical finesse and battlefield freedom. Yet, it was the Royal Navy which eventually ruled the waves.

Allen’s theoretical narrative, however, leads us to the question of whether institutions can be efficient. Why did the institutional structure vary between countries? Why was English government so well organized, but still differed in various important respects from their continental counterparts? Why did the French navy not adopt English institutional restrictions? Allen does not offer a very convincing answer. There are, however, some hints towards an explanation, including the idea that institutions are more likely to be efficient — within given constraints (e.g. technology) — if they arise in a competitive environment. One can pair these ideas with those of economists like Daron Acemoglu, who specialize in seeking an explanation for this puzzle. Acemoglu holds that the distribution of power matters, and those with the power often make change very difficult. Maybe England’s success is found in the long struggle between members of the aristocracy themselves, leading to a relatively more equitable distribution of power (even if only within a certain social class).

Another facet of institutional variation is that there is no ideal set of institutions that fits each and every social environment. For example, we have a tendency to argue that those countries which are relatively poor are so, because they have failed to adopt the same institutions as the wealthier, more developed nations. Allen, here, does contribute a very valuable, and often unacknowledged, insight: institutions can be efficient in one place, but inefficient in another. The constraints that condition the rules matter, and before we can advocate the adoption of one rule over another we have to carefully consider the environment. The various examples Allen looks at, apart from being fun to read about, put the point of institutional relativism in perspective. Modern institutions just would not have worked out in pre-modern England; society would have been worse off had they been prematurely developed.

This brings us to a related point: even if, say, democratic institutions are a standard all societies should work towards, the preconditions for an efficient democracy (or whatever other institutional set you seek to adopt) matter. Just like the inability to monitor effort conditioned the incentive structure of the pre-modern world, other constraints may condition the institutions of the world’s poorest societies. The argument is not that the poorest countries may have “efficient institutions,” but that the path towards institutional efficiency is more complicated than we think, and that we may not necessarily know what is efficient. For the institutions that we know have worked elsewhere to succeed, the relevant prerequisites have to develop first.

Although Allen does not make the connection explicitly, this is a theme that runs through the work of Friedrich Hayek, who emphasized spontaneous, rather than planned, order. Hayek was all too aware of the fact that the world’s brightest, always wanting to improve the world around them, are not always cognizant of their ignorance — a weakness only the omniscient avoid —, prone to ignore the various complications that always seem to break down the most elaborate plans. Institutions are complex systems, and complex systems rarely have easy solutions.

Douglas Allen’s The Institutional Revolution is an incredibly fun and interesting book to read. He interprets the various organizations and customs of the pre-modern era through an institutional lens, which allows him to make sense of what others thought to be nonsensical. His explanations will surprise you, but he makes his arguments convincingly. The reader is guaranteed to see the world from a different, more refined perspective — even if you are already aware of what institutions are and why they matter. Beyond the entertainment and wonder, however, Allen makes the much-needed point of caution: the merit of a system is oftentimes hidden in the details, and if we pass judgment too quickly we will likely fall into the trap of the fatal conceit.



[1] Douglass North, Understanding the Process of Economic Change (Princeton: Princeton University Press, 2005), p. 87.

The Price of Inequality: the Good, the Bad, and the Ugly

[The Price of Inequality♦ by Joseph E. Stiglitz ♦ Norton, 2012]

The Price of Inequality (Stiglitz)

[ed.: This review is available as a PDF.]

For those who have read Joseph Stiglitz’ previous popular works, The Price of Inequality is similar in that there is much to love and much to dislike. While this book, like much of Stiglitz’ other work, has received generally positive reviews, it is not unreasonable to feel frustrated at the lack of nuance and the frequent off-the-cuff remarks that would not make it through editing if this were published as a more academic piece. With this being said, there is also plenty to like, and much that should garner universal agreement. Because of the non-linear mixture of different qualities of argument, The Price of Inequality should be picked apart carefully, not just to marginalize the bad, but to make sure that one digests the various worthwhile and prescient points made.

Before looking at the book, we should understand the importance and relevance of studying economic inequality. It is important to acknowledge that not all inequality is “bad,” and that even the most ideal of markets will have some degree of inequality — something that Stiglitz is in agreement with (Stiglitz 2012, 6). As Mises wrote, “The inequality of individuals with regard to wealth and income is an essential feature of the market economy” (Mises 1998, 285). Not only would a reduction of all inequality imply a non-free society, but it would make its standard of living collapse under the pressure of resulting resource misallocation.

Parting with Stiglitz, inequality should not be reduced for the sake of reducing inequality, but for the sake of improving the institutions that partly influence and decide the allocation of resources. Seen in this light, some inequality is a symptom of larger problems. Looking at inequality helps us pinpoint what these problems are and better understand their nature and consequences. While one gets the sense that Stiglitz does not entirely accept, or understand, the distinction between inequality as a central feature and inequality as a symptom of larger issues, some of his insights are undeniably helpful towards developing a better grasp of many of the institutional faults of the current system. These, as the most important aspect of the book, will receive their due weight here.

Some of Stiglitz’ other contributions to the study of inequality are less helpful, and even incredibly harmful. These negative qualities are explained in much more depth below, but they can be split between two categories: bad and ugly. The dramatic rhetoric aside, under “bad” falls issues where there is much to disagree with, but where Stiglitz fails to mention some of the better arguments, with extensive supporting literature, made against several of his ideas. The “ugly” category is much worse, and it is mainly composed of all-too-frequent demonization of those who disagree with Stiglitz, to the point that the author subtly advances the accusation that those who disagree are intellectually dishonest, or are suffering from “cognitive capture” (Stiglitz 2012, 48). While Stiglitz’ better arguments are worth emphasizing, some the book’s worst vices need combating. This review serves as a centrifuge, sorting the good from the bad.

The Good

Two facets of inequality, discussed by Stiglitz, deserve mention: that caused by rent seeking and that caused by inadequate financial institutions. Both of these make up the bulk of Stiglitz’ case, and generally he is quite right in showcasing these two concepts as important culprits in causing inequality that would otherwise not exist.

Rent seeking is given its own chapter in The Price of Inequality, and according to Stiglitz plays one of the most important roles in determining the misallocation of income and the resulting inequality (Stiglitz 2012, 39–51, 107). Rent seeking refers to collusion between private actors and, usually, government, where the outcome involves the latter granting the former a privilege that is otherwise inaccessible. An alternative way of describing rent seeking is as a “loophole” of sorts in the institutional framework that guides choice in the market place. Certain institutions help align private interests with “social interests” by restricting choice; rent seeking represents a circumvention of these restrictions by using the state’s special role — as a monopoly on violence — as a means of securing benefits.

Several examples of rent seeking and the benefits sought are given: monopoly rents, government subsidies and corporate welfare, patent rights, et cetera. Rent seeking can also result in adverse regulation that targets certain firms, but not others (usually the rent seekers), eroding competition. Stiglitz also mentions rent seeking which takes place solely in the market, including things like fraud and the use of market power to extract rents — while Stiglitz goes too far with the latter,[1] it remains true that rent seeking can also help individuals and firms to circumvent the law (which is part of the aforementioned institutional framework). All these benefits are secured at the expense of others, with the implication of a different distribution of income from that which would have arisen without rent seeking.

A caveat to Stiglitz’ discussion is that rent seeking is a response to imposed constraints. Oftentimes these constraints are imposed through legislation, themselves the product of rent seeking or decision making that is not itself constrained by the same institutional framework.[2] Sometimes rent seeking is a defense mechanism that firms use to oppose regulations. Even if we assume that some regulation is ideal, it does not follow that all regulation is ideal, giving the resulting rent seeking some sense of legitimacy. As such, while rent seeking may be used as a means of distorting markets — as it often is —, it also can be used as a way of protecting markets from the predation of the state. Either way, the problem is with government using its power to enforce rules which would otherwise not develop through private institutional change.

The second major thrust of Stiglitz’ analysis is towards the financial sector. Like with his discussion of rent seeking, there is a mixture of good and bad. While some of Stiglitz’ more specific remarks will be scrutinized in the following sections, he gets the overall picture more-or-less right. It is a point well worth repeating: given the current institutional framework, the banking sector helps create inequality that should not exist. Further, the relationship is not only direct, but indirect as well through the effects of the business cycle. It is difficult not to agree with Stiglitz that the financial sector is in desperate need of greater competition (Stiglitz 2012, 46–47, 246–247),[3] even if some of his more specific recommendations are far more disagreeable.

Stiglitz rightly notes that financial liberalization during the 1970s and 80s created an environment ripe for financial instability (Stiglitz 2012, 89–92). While he incorrectly pinpoints why “deregulation” proved unstable (something we will return to), it is nevertheless true that natural outgrowths of our current financial institutions are excessive leverage and industrial fluctuations. The core issue is not with reckless lending, it is the current system of monopolized currency issue and cartelized banking. Without competitive currency issue, the market is denied a major avenue of discipline (the note clearing mechanism), allowing for concerted credit expansion (Selgin 1988, 96). This leads to the associated micro and macroeconomic consequences: relative price changes not in accordance with social preferences, ultimately leading to the business cycle.

How does “financialization” cause unnecessary inequality? Credit based expenditure makes borrowers debtors, representing a transfer of income from debtors to creditors. This transfer is not necessarily inequality inducing, since generally the borrower gets something in return (whatever she purchased with the borrowed credit). However, economic booms associated with excess note issue —bank notes are a form of debt (Gorton 2012, 5–6), implying that excess note issue is synonymous with excess leverage — are characterized by rising asset prices, including that of housing. The run up in housing prices during the 1990s and first decade of the 21st century was unique in magnitude, but not as a trend (Reinhart and Rogoff 2009, 207, 279–281). Those who buy these assets by accumulating debt are particularly vulnerable to the consequent deflation of mispriced assets and durable goods; when housing prices collapsed, creditors tended to enjoy income corresponding to inflated prices, while debtors were burdened with disinflated assets and savings. As Stiglitz notes, a major culprit behind the asymmetric impact of the financial crisis is current bankruptcy law: while large firms are usually afforded some leniency when declaring bankruptcy, unable mortgage owners were not allowed the same luxury (Stiglitz 2012, 193–195).

Besides the two major forces of rent seeking and financialization, there are some other points made in the book that deserve brief mention. Stiglitz (2012, 59–60) argues that globalization has allowed some firms to invest in foreign countries as a means of securing rents by exploiting weak political institutions abroad. This may be true, but one should weigh the benefits to foreign labor of increased investment and, consequently, wages. Benefits or not, it is not clear that the United States should expend resources making up for foreign problems — not just because of the cost, but because of the ample theoretical and empirical evidence which argues that such efforts are misguided and subject to failure, because we simply cannot socially engineer “efficient” institutional frameworks. Many of Stiglitz’ other concerns on globalization are misplaced. He laments the loss of jobs and lowering wages, but the pie is not fixed: there exists a fundamental scarcity of labor (Reisman 1990, 59–61), meaning that those unemployed as a result of globalization can be reallocated towards alternative productive activities. Further, Stiglitz fails to consider the benefits of falling prices of goods, which make consumers better off as a result of rising real wages. Of course, there are always winners and losers, but slowing the pace of the integration of the global division of labor will make everyone worse off in the long run.[4]

The Bad

Many of the disagreements with Stiglitz are predictable, given ideological differences, but there are statements and arguments throughout the book which are particularly egregious.

The clearest example is Stiglitz’ case in favor of a “democratically accountable” central bank, where he questions the benefits of a politically independent Federal Reserve (Stiglitz 2012, 248–256). Nevermind that non-independent central banks are associated with high inflation, brought about by seigniorage (Reinhart and Rogoff 2009, 187). The error is more fundamental: whether run by technocrats or “the masses,” there is simply a lack of knowledge to centrally plan monetary policy. While “cognitive capture” may have something to do with inadequate performance, the more important handicap is the fact that the division of labor is far too complicated for any one person — or even a group of people acting in concert — to understand well enough, especially when one’s understanding must be interpreted through likely, at least partially, erroneous heuristics. (Friedman 2005, 9–11, 21–25 ). The relative rigidities of selection in the democratic process does not provide the same quality of “accountability” that the market process provides.[5] A much better solution is to allow “monetary policy” to be decided by the competitive (therefore flexible) market.

Some of Stiglitz’ statements are at odds with the literature and the evidence. For example, he frequently repeats the claim that the 2007–09 financial crisis was caused by reckless lending, with the implication that banks knew the outcome of their collective actions. Stiglitz fails to differentiate between investment and commercial banks, misleading his readers to believe that the large banks that were bailed out during the crisis were the same banks making the original loans. This is a kind of moral hazard argument, and it simply does not stack up when weighed against the evidence (Friedman and Kraus 2011, 36–42). What is more, Stiglitz does not even bother to mention the evidence, whether for him or against him.[6] One can hold the banks responsible for the crisis without resorting to arguments that have little empirical substance to them.

In a similar situation is Stiglitz’ advocacy of higher marginal tax rates on upper quintile incomes. Here, Stiglitz does cite favorable work, including Diamond and Saez (2011) and Piketty, Saez, and Stantcheva (2011). Both these studies decide “optimal tax rates” by looking at different elasticities, including the elasticity of labor supply and the elasticity of expenditure. But, these analyses can be narrow. For example, suppose a study concludes that the rate of change of investment is much slower than the rate of change of income, where the difference is either consumed or saved. Is this evidence that we should redistribute said income? One can frame the question within the context of the market process: if financial intermediation is seen as a mechanism of distribution, the distribution of savings to other investors is preferable to the distribution of savings by the government, for all the reasons outlined in Finegold (2011). Whatever the merits of these studies, it should be recognized that their limits are bounded by the authors’ ignorance of social complexity — an ignorance that all fallible beings suffer from. Models which focus on certain effects will miss other effects, including those which directly and indirectly affect the ones the authors look at.

There are less controversial and more direct recommendations that have similar effects. Perhaps Stiglitz does not recognize these because he is too focused on income inequality as a cause, rather than a symptom. One of the concerns of Piketty, Saez, and Stantcheva (2011) is that high incomes are often not aligned with “social interests,” referring to things like CEO pay to CEO’s who, intentionally or unintentionally, contributed to the financial crisis. Perhaps rather than a higher tax rate, which punishes both successful and unsuccessful entrepreneurs, a better policy would be to reduce the amount of distortions on the market’s institutional framework, reducing the probability of systemic entrepreneurial failure. While the literature on tax policy is undoubtedly more complicated than what this review may suggest, it nevertheless is true that Stiglitz pays little consideration to alternative and opposing arguments.

There is also a more general argument to be made to the detriment of The Price of Inequality. It would not be inaccurate to describe the book as a collection of arguments meant to barrage the reader with as many causes of inequality as possible. Stiglitz (2012, 79–81) does explicitly explain his rationale, asserting that “much of the debate is beside the point.” His rationale is that inequality “cannot be ignored” and that whatever policy can reduce inequality is a policy that should be implemented. First, this is at odds with his above cited concession that some inequality is inevitable, and even necessary. Second, to dismiss the importance of weighing relevance on account on the difficulty of doing as such is to hand wave away a critical problem. If you do not know to what extent your theory is applicable, or whether it is even accurate, how can you recommend it? This alone should be cause for concern. If you cannot “test” the relevance of a particular theory, how can you pretend to know the effects of a policy recommendation? Stiglitz’ methodological sloppiness seriously damages his and the book’s credibility.

The Ugly

The examples of “the bad” in Stiglitz’ book is not the worst of it. There is a clear lack of academic neutrality, which would be fine if the author at least hinted at valuable dissenting opinions. Not only does Stiglitz not do this, but he essentially characterizes those he disagrees with as either corrupt or intellectually dishonest. He does not offer the “other side(s)” a chance, ultimately making Stiglitz a perpetrator of the same fraud he accuses his opponents of.

For example, an entire chapter, titled “1984 Is Upon Us,” is dedicated to explaining how right-wing ideologues shape common perception and opinion, accusing, in essence, “right-wing ideologues” of brainwashing society — as if people of other ideologies do not use the same tactics that Stiglitz accuses his ideological adversaries of. Sometimes Stiglitz is quite explicit,

The fact that the 1 percent has so successfully shaped public perception testifies to the malleability of beliefs. When others engage in it, we call it “brainwashing” and “propaganda” (Stiglitz 2012, 146)

In the book, the terms “1 percent” and “the right” are almost perfect substitutes. Consider, for instance, the following

The Right has recognized the importance of education in shaping perceptions, which is why it has been active in trying to influence the design of curricula in schools and embarked on an “education” program to make judges more “economic literate,” that is, to see the world through the narrow lens of conservative economics (Stiglitz 2012, 161).

Stiglitz makes this point after invoking some insights from psychology and cognitive science which help explain how individuals form ideas and beliefs. To a considerable extent, these insights are true, and some of Stiglitz’ conclusions do follow: specifically, yes, people can influence others. But, it is disingenuous to rant about how “The Right” does this without acknowledging that everyone else does as well. Indeed, Stiglitz’ The Price of Inequality is an attempt to shape readers’ beliefs. Should Stiglitz be targeted with the same disparaging accusations? Stiglitz goes on to claim that much of “the battle of ideas” is intellectually corrupt (Stiglitz 2012, 161–162) — surely this applies to all sides of the political spectrum?

Later in the same chapter, Stiglitz (2012, 172) downplays academic dissonance by discrediting dissenters: “It is an ideological battle, because economic science — both theory and history — provides a quite nuanced set of answers.” The implication is that economic science is not itself subject to debate and controversy, meaning that those who disagree with the conclusions discussed in the book are not practicing economic science, but are ideologues committed to changing public perception in favor of bad policy. Not only is this insulting, but it is ironic since, as has been exemplified above, Stiglitz himself oftentimes recklessly ignores much of the theoretical and empirical economic literature.

These tactics are used throughout the book, and frequently. Stiglitz’ intentions are to frame the debate as if there is no legitimate controversy surrounding the topic. By doing so he is committing a disservice to his readers, who walk away with an obviously skewed, and unweighted, perception of reality. In fact, Stiglitz is doing exactly what he accuses “The Right” of doing: he is presenting his case in a way that ridicules the notions of academic neutrality or attempted objectivity. For those who read The Price of Inequality because of Stiglitz’ stature as a thinker and an academic, reading the book must end with frustration, because Stiglitz does not showcase any of these qualities. Instead, the book is a roughly 300 page piece of propaganda. What makes the book propaganda is not the controversy surrounding his recommendations, but the fact that his preferred method of disproving the opposition is to discredit them with absurd and insulting accusations.

 

Inequality is a topic worth exploring, and although tackling inequality simply for the sake of inequality is misguided, exploring the subject helps understand important imperfections in current institutions and rules. Stiglitz does provide quite a bit of good insight, including his extensive remarks on rent seeking, corporate welfare, and an inadequate banking system. However, mixed with these good comments are a large number of bad recommendations and conclusions, many of which do not stand up to academic rigor. If this book were being published by a more academic publisher it is difficult to see how some of the remarks would make it beyond the initial drafts. Worse still, Stiglitz undermines dissenters by discrediting them by means of the same tactics he accuses them of. This unfortunate feature of The Price of Inequality brings a book that people should otherwise read, if with a skeptical mind, down to a book that is difficult to recommend. Continue reading

Limits of Universalism

[Note: This was written for my Comparative Public Policy seminar, but I think readers will find it interesting. Conveniently, it also doubles as a brief review of the book.]

Yasemin Soysal’s Limits of Citizenship serves two principal purposes. First, it offers a historical account of how different European countries have dealt with post-Second World War migration and how these State institutions have influenced how migrants interact with, and organize within, the polity (pp. 35–36). Second, by crafting a chronicle which emphasizes the growing irrelevance of traditional citizenship models, largely as a result of maturing cultural eclecticism, Soysal leads us to her “postnational” model. Soysal’s alternative adopts universalism, solving the conflict between the notion of “human rights” and the traditional, nationalist approach to citizenship.

Soysal gives the impression that she is willing to embrace the complexities of social change. In many ways, there is a sense of predetermination in her narrative. The sovereignty of the State is being challenged by the growing irrelevance of borders as migration levees, and the concept of universal human rights is lessening the importance of national discourse which otherwise decides the relationship between the resident and the State. The author portrays this story in a way that stresses the multifaceted reality of interaction between migrants, the State, and how the sociopolitical landscape — and its reflexivity — influences social progress. Yet, at times the reader gets the impression that Soysal does not go far enough. It is almost as if she accepts complexity when it is convenient, but not when it can potentially damage her conclusions.

The nucleus of modern citizenship, or membership, is a set of “human rights” (p. 42). Soysal’s discussion makes “human rights” almost axiomatic, such that her ideal types almost exclusively abstract away from everything except how States have dealt with the provision of these “rights” to non-citizens. Her “postnational” model, in fact, is one which underscores the separation of “rights” from the State, such that certain provisions are no longer privileges of membership; rather, the State is obligated to respect whatever entitlements “human rights” entails.

Soysal fails to distinguish between types of rights. Classically, “human rights” — more often referred to as “natural rights” — refer to a set of liberties meant to restrain the State. The “human rights” Soysal has in mind go beyond this, encompassing “rights” that oblige the State to provide a service (for simplicity’s sake, we can refer to these as “positive rights”). We can, for the sake of argument, accept the legitimacy of both kinds of rights. But, we cannot ignore differences in their nature; there is a political economy aspect to the issue of entitlements. State services are not provided ex nihilo, but come from resources necessarily extracted from society (i.e. taxation). As such, when we think about the individual as someone entitled to various “rights,” we oftentimes have to consider the other side of the coin: the individual as someone obligated to provide for others. Soysal, instead, ignores this aspect of citizenship.

Soysal is clear that, even in her “postnational model,” the State is “the primary unit for dispensing rights and privileges” (p. 143). The State, therefore, has a responsibility that encompasses people even beyond traditional borders — see, for example, the German treatment of repatriated Gypsies (p. 158). The author does not catch the potential for tension between the entitled and the obligated.

Consider a common theme in the narrative: migrants organize and join the arena of political discourse to guarantee for themselves certain sets of entitlements. See, for instance, Soysal’s description of “organized Islam” (pp. 115–116). Naturally, people tend to be more interested in what they can acquire than in what they can provide, and so there exists a friction between the disproportionate growth of entitlements as compared to the volume of tax receipts. The problem is worse if we think about tax contributions, the fact that a large sum of obligations are paid for by an exclusive social caste (“the wealthy”), and that migrants generally add to the much larger pool of the population that more often than not expect more out of welfare than they can pay in (and, if they live in other countries, then they do not pay in at all).

There are benefits to a cosmopolitan world of “postnational” citizenship, but these benefits all too often lead scholars to ignore the very real costs that come attached. There is a tendency for “human rights” to become ever more inclusive. But, little attention is paid to the fact that if specific States are held responsible for the costs, then there may exist an increasingly divergent disconnect between receivers (the entitled) and givers (the obligated). Simply put, everyone is more interested in being the former than in being the latter, and so there is not as much pressure to distribute obligations along with new rights. This creates factors which will influence the trajectory of changes in the concepts of human rights, citizenship, and membership. Soysal, unfortunately, chooses not to deal with these issues; when, finally, she mentions historical episodes which contradict her model (pp. 156–157), she fails to really engage the problem.

Worst of all, the reader does not get the impression that Soysal is unaware of these problems. Limits of Citizenship simply promises more than what the author delivers. There are hints of Soysal’s radicalism, but she restrains it. She, for example, writes that the relevance of the State vis-à-vis the individual is deteriorating (p. 165), and that there is an evident trend in the breakdown of large States into smaller one as the implications of the right to self-determination flower into their own (p.161). It is almost as she envisions a post national political organization — maybe one that solves the friction between entitled and obligated —, but for some reason prefers not to go that far.

The book is disappointing in other ways, as well.

Early on, the author introduces a distinction between assimilation and incorporation (pp. 30–31). Assimilation can be thought of as the process during which a migrant replaces her original culture with the prevailing national ethos of the polity she is joining. Incorporation — “inclusion” may be a preferable term —, in contrast, is about including the individual, regardless of culture, in the political process. We can think about it in terms of the individual either having to change to become part of society (assimilation), or society changing and expanding to accommodate the individual (incorporation). The Dutch term emancipation (pp. 49–50) illustrates incorporation fairly well: the individual is culturally emancipated from the State, such that society shapes government and not the other way around.

Reading on, there is an expectation that Soysal will focus on this distinction in her description of comparative institutions of integration. Instead, she abandons the approach and universal human rights become her main concern. Her “postnational” model might have been better served had she stayed on course, because the idea of incorporation better describes a world where societies are no longer separated into ethnically homogenous nations. Alas, the reader is robbed of the insight which was expected and Soysal could have delivered.

Hutt’s Classical Theory of Unemployment

[The Theory of Idle Resources ♦ by W.H. Hutt ♦ Ludwig von Mises Institute, 2011 (1939)]

More so than any other economist, John M. Keynes decisively shifted academia’s attention from the theory of employment to that of unemployment. He replaced the classical theory of wage determination with his own, stressing the possibility of involuntary unemployment. What interested economists now was the phenomenon of ‘idle resources,’ especially the existence of ‘idle’ employment. New economics, or Keynes’ economics, was beginning to replace, or at least modify, the Classical school’s — the profession was being swept.

It was in response to these changes that W.H. Hutt wrote his 1939 monograph, The Theory of Idle Resources. While going about it in a subtle way, Hutt was clearly contesting Keynes’ critique of the Classical theory of employment. In keeping with the times, he did this by writing a comprehensive essay on the theory of unemployment. In it, he sought to categorize the proximate causes of idleness, or unemployment. These are factors which if removed would eliminate the idleness of a particular resource. Hutt’s results are mixed. While he successfully defended Classical economics from the charge of lacking a theory of involuntary unemployment,[1] Hutt failed to address a much more fundamental argument Keynes made in the second chapter of his General Theory.

Eight factors, or, more accurately, proximate causes, of idleness are recognized and explained: valueless resources, pseudo-idleness, and preferred, participating, enforced, withheld, strike, and aggressive idleness. There is no distinction between labor and other economic goods, except that some forms of idleness — viz., lack of value — are inapplicable to the former. These factors explain both voluntary and involuntary unemployment, although ultimately Hutt’s conception of the involuntary has more to do with restrictions rather than an issue inherent in the market economy.

Valueless resources are those “which at any time it would not pay any individual to employ for any purpose,” even when employment were costless.[2] Hutt’s definition is actually quite exclusive and rigorous. For instance, a machine that cannot produce to cover its depreciation is not valueless. Instead, when thinking of valueless resources it is natural resources that come to mind most easily.[3] Closely paralleling Hutt, Carl Menger made a similar distinction when defining an ‘economic good.’ For Menger, an economic good enjoys four properties — demand, its applicability as a means toward an end, an understanding of its applicability by part of the owner, and ownership —, and the failing of any one property excludes an item from the category.[4] One might get a better idea of Hutt’s ‘valueless resource’ by interpreting his definition from a Mengerian angle: resources, in the objective sense, that are not economic goods, in the subjective sense.

Pseudo-idleness, in contrast, is a voluntarily restriction of output. In the case of a machine, it may arise, for instance, if present additional output comes at a loss, but the machine is maintained idle — and not scrapped — in expectation of future demand for its products. Alternatively, a wage-worker is in pseudo-idleness if she refrains from selling her labor in expectation of being able to find a higher paying job in the future.[5] One immediately sees, as implied by Hutt’s term, that pseudo-idleness is not really idleness at all, but maintenance of availability in expectations of higher income in the future. Goods currently producing, but still maintaining availability in case of superior employment opportunities, are still pseudo-idle, although in this case it is preserving what Hutt calls a ‘double function.’[6] When concerning labor, one should be careful to not confuse pseudo-idleness with preferred idleness, Hutt’s third category. This latter form of idleness is essentially when a worker chooses leisure over employment.[7]

Between explaining these three initial categories and the remaining five, Hutt goes on a brief digression on the concept of ‘irrational preferred idleness.’ If we think about pseudo-idleness in terms of opportunity cost, where the opportunity cost of current employment may be higher than that of preserving availability, it may seem irrational in retrospect if the opportunity costs were reversed and yet the same person still chose pseudo-idleness. When one thinks of irrational idleness it is best to think of it in terms of unfulfilled expectations, where the person simply errs in judgment.[8] Similarly, in the spirit of Keynes, Hutt offers the example of a laborer preferring a higher nominal wage over a higher real wage. This leads him into a six-page criticism[9] of the notion that the Classical economists have overlooked the role of irrationalism in spurring high unemployment, where he makes the case that workers who reject a lowering of their nominal wage (and are let go) are voluntarily unemployed — a case of preferred idleness or pseudo-idleness, to be exact.

Continuing with the exploration of Hutt’s definitions, participating idleness refers to an aspect of monopolization or cartelization. Resources held idle to restrict output so that a firm, or a group of firms, can charge a higher-than-competitive price are in participating idleness. In the realm of labor, an example is work sharing programs where members agree to restrict labor,[10] distributing a limited amount of hours amongst themselves. Unions are another example. Essentially, it refers to an agreement to constrain competition for the sake of charging monopoly, or uncompetitive, prices. Two corollary categories are enforced idleness and withheld capacity. The former is similar to participating idleness, but where it may be more useful to think of it as involuntary — for example, legislation aiming to restrict work hours. Neither can resources under enforced idleness be used towards alternative ends (“disguised unemployment”). Withheld capacity, in contrast, covers voluntary restrictions of output, in the case of participating idleness. Strike and aggressive idleness are related, the former referring to a situation where resources are held idle out of demand for different conditions of exchange. A labor union strike is the most obvious example. Aggressive idleness, on the other hand, refers to the maintenance of idle capacity for the purpose of suddenly ramping up production to crush potential competition.

It is difficult to uncover error in Hutt’s precise logical analysis, but perhaps it is marginally inadequate. While The Theory of Idle Resources is not meant as a direct challenge to Keynes, as much as it is a contribution to economic theory, Hutt nevertheless spends quite a bit of time criticizing certain aspects of The General Theory. Early on, Hutt makes clear that he rejects Keynes’ employment-based variables, where labor is aggregated in terms of wage-units and these last serve as the base unit for various functions which are meant to represent the relationship between employment, output, and income. Similarly, as we have already seen, he disagrees with including those refusing lower nominal wages in the category of involuntary unemployment. While Hutt’s arguments carry weight, he fails to address Keynes’ much more important objection to the Classical theory of employment. He, perhaps, also interprets Keynes’ supply and demand functions much too literally, where it would make more sense to use them as simplified representations of the broader argument.

Specifically, Keynes conceived of a situation where, even if workers consented, a decline in nominal wages will not reduce unemployment.[11] Assume that the price of the marginal unit of output is decided by the cost of the inputs, namely wages. A fall in the nominal price of labor will fail to reduce the real wage if the price of the output falls to the same degree. Thus, when criticizing Keynes, Hutt fails to even properly consider Keynes’ actual definition of involuntary unemployment. According to Keynes, involuntary unemployment occurs when, in the event of a rise in the price of the output, there would be an increase in the supply and demand for labor at the same nominal wage.[12] Of course, it is easy to see that, in the case of falling prices, the relationship between wages, both nominal and real, and the price of the marginal unit of output is not so simple — labor is not the only factor of production. But, Keynes’ point ought to be interpreted within the context of the relationship between employment and output.

Where a fall in nominal wages does not lead to a rise in employment, the same result can be achieved by means of an increase in investment. That is, by inducing entrepreneurs to produce more output, these enterprises can employ a greater quantity of people. Keynes’ nominal–real wage theory is not widely embraced, having been replaced by the notion of price stickiness, but one can conceive of a legitimate close equivalent. Suppose that the economy suffers an industrial fluctuation, forcing a downward adjustment of prices. Firms, for whatever reason, may prefer to maintain nominal wage levels, instead downsizing the number of employees hired, expecting greater productivity from a smaller pool of better paid workers than from a larger pool of lower paid workers. While one ought to be cautious when aggregating firm behavior, there has been a recent surge in empirical evidence confirming the significance of this phenomenon.[13] There may be a situation where an individual seeking employment is not being employed at any wage, and this is essentially Keynes’ contribution to the theory of (un)employment.

In his treatment of The General Theory, Hutt misses the forest for the trees. He gets caught up in the details of Keynes’ formal approach — the specific mathematical modeling that cannot accurately model a specific instance in the real world, but is really meant as an ideal type —, does not succeed in understanding Keynes’ concern, and consequently provides only an inadequate response. Had his interpretation been a bit more forgiving, perhaps Hutt could have envisaged a situation where nominal incomes do not fall even when the worker accepts reduced wages. This could have been Hutt’s ninth proximate cause of idleness. Or, at least, Hutt might have offered a more formidable argument against it.

Nevertheless, Hutt’s treatment of the theory of idleness is powerful, lucid, and timeless. Certainly, it is one of the most meticulous treatments of the subject by a Classical — or Neoclassical, or Austrian — economist. He sought to formulate a web of precise causation to uncover the most direct causes of unemployment. His disaggregated approach is to be commended, as by misdiagnosing the causes of idleness one might equally err in prescribing normative solutions. Whatever shortcomings present in Hutt’s criticism of Keynes, one cannot argue that Keynes’ handling of the subject was equally as defined and concerned for the minutiae — in this sense, Hutt clearly outdoes Keynes. Nevertheless, the reader should consider alternative theories. There may not be a persuasive case against Hutt, but there may certainly be causes that Hutt overlooked. This being said, those who have not read Hutt’s 1939 monograph are risking overlooking one of the most comprehensive examinations, relative to the rest of the literature.



[1] John M. Keynes, The General Theory (BN Publishing, 2008 [1936]), p. 15.

[2] W.H. Hutt, The Theory of Idle Resources (Auburn: Ludwig von Mises Institute, 2011 [1939]), p. 12.

[3] Ibid.

[4] Carl Menger, Principles of Economics (Auburn: Ludwig von Mises Institute, 2007 [1871]), p. 52.

[5] In Neoclassical theory, the laborer will abstain from employment until she finds a wage equal or above her reservation wage.

[6] Hutt (2011 [1939]), p. 27.

[7] Although, the preference does not necessarily need to be for leisure. A worker is categorized under preferred idleness, for example, if she refuses a job offer on the grounds that it is beneath her dignity (pp. 38–39).

[8] Ibid., p. 45, ftn. 1.

[9] Ibid., pp. 46–51.

[10] Note that capital goods can be used towards alternative employment, whereas labor cannot, while still being categorized as being in participating idleness.

[11] Keynes (2008 [1936]), p. 13.

[12] Ibid., p. 15.

[13] For example, Audra Bowlus, Haoming Liu, and Chris Robinson, “Business Cycle Models, Aggregation, and Real Wage Cyclicality,” Journal of Labor Economics 20, 2 (2002), pp. 308–335.

Not-so-Humanitarian Aid

[Dead Aid ♦ by Dambisa Moyo ♦ Farrar, Strous, and Giroux, 2009]

[ed.: This review is available as a PDF.]

While slowly losing its dominance, foreign aid has characterized international efforts to lift Africa out of the poverty quagmire since the immediate post-war era. Monetary assistance, forwarded to the Dark Continent in myriad forms — charity, loans, grants, et cetera —, has not only failed to reach its objectives, but has actually created a trap. It has facilitated economic retrogression, making most Africans worse off than they otherwise would have been. The qualifier ‘most’ is important, because some have greatly profited on the good intentions of the West: corrupt bureaucracies which extract their incomes from inbound streams of money. Despite the harsh reality, providers are seemingly unaware of the deleterious consequences of their actions. In this environment, Dambisa Moyo’s Dead Aid is a welcomed bucket of ice cold water.

Moyo is particularly well suited to write on the topic. Born and raised in Zambia, endowed with a Western education, and with plenty of experience gained as a result of her involvement in the World Bank and with various other financial institutions, Moyo is not lacking in expertise. Dead Aid, though, does not piggy-back on its author’s credentials. Rather, it provides the reader with a set of convincing arguments backed by theory and evidence.

The book is presented in two parts. First, covering the history and effects of foreign aid, it explains why monetary assistance has failed. The reader is also taken through various counter-arguments, including alleged success stories. The second part offers an alternative to aid as a means of financing investment in African economies: inter alias, private finance markets, foreign direct investment, and trade. The opening half of Dead Aid is an indispensable addition to development economics, while the second should be approached with a bit more caution.

International aid on a mass scale began in earnest following the Second World War, originally targeting war-torn Europe. As means to this end, two key organizations were established at the 1944 Bretton Woods Conference: the International Monetary Fund (IMF) and the World Bank (a third was proposed, finally materializing in 1994 as the World Trade Organization [WTO]). Initially, aid to Western Europe piggybacked on the wealth of the United States, and it broadened during the late 1940s and early 1950s under the Marshall Plan. These programs met success, in that their targets experienced a relatively quick economic recrudescence. However, European markets enjoyed extensive existing infrastructure and governments willing to let them flourish. Financial help was not the principal cause of the Old World’s post-war resurgence.

The United States’ decision to take responsibility for Europe’s financial needs freed IMF and World Bank funds, providing these institutions fiscal space to look towards the developing world. It was thought that poorer countries, at that time considered “third world,” lacked infrastructure, physical and human capital, and the financing to spur domestic investment. Additionally, there existed a more sinister motive: the Cold War. Latin America, Africa, and much of Asia was soon embroiled in an oftentimes deadly competition between the Soviet Union and the United States to buy governments’ interest. Similarly, the immediate post war era witnessed the unraveling of colonial empires, and many former colonial governments were interested in maintaining their influence where they once ruled. As such, aid flows were politically shaped, all too often contrary to the interests of broader society.

During the 1960s, African governments began to heavily invest in public works, including such things as dams, roads, and other forms of infrastructure. To fund these programs, they accepted loans and grants from the developed world. This trend accelerated during the 1970s, when credit became more plentiful and relatively inexpensive. The oil shock of the early and mid-70s spilled into related markets, increasing food, energy, and commodity prices. This spurred an increase in focus on aid directed towards rural and agricultural development — more generally, Africa’s poor moved to the forefront of international concern. It was during these decades that aid flows drastically grew by many times their former size. Yet, these programs failed, and poverty became more extensive.

Not only had the opposite occurred of what the aid intended, but financial crises during the early 1980s led to “tight money” and rising interest rates. This inevitably pushed the developing world against the ropes, heavily indebted thanks to the credit that once came so cheap. Several African governments — Angola, Cameroon, and nine others — defaulted on their debt obligations, triggering a response by the IMF and the World Bank. These organizations quickly “restructured” the debt, essentially loaning debtor nations enough money to repay private commercial banks. However, as one can already see, this was merely akin to a debt transfer. The world was on the brink of financial ruin, and African had shown little for all its promise.

As the debt dilemma culminated, relevant politics were soon dominated by what has become known as the “Washington Consensus” — neoliberalism. Whereas previously the dominate model was one where the State allocated resources towards essential outputs, the new mantra became that of “privatization.” Some countries took off, such as South Korea, but not Africa. Increasing debt, coupled with a lack of economic growth, even caused the peculiar situation where outgoing debt payments were greater than incoming aid flows. Failure anew prompted a shift of focus to institutions, motivating impetus for “democratization.” Aid packages became tied to conditions aiming to reduce corruption and increase political pluralism, but these stipulations were only loosely regulated. Moreover, in advocating for democracy, the West seemed to put the cart before the horse — a correlation between greater wealth and democracy does not imply that the latter causes the former.

While the aid story has yet to end, and the latest chapter — what Moyo calls “glamor aid” — continues, we can already see that it revolves around one failure after another. Aid has been a spectacular disappointment, regardless of its form of delivery. Neither has public investment, in infrastructure and human capital, worked nor has public support of private markets. Dead Aid tells us the situation has actually become worse in some ways. Why?

Aid fosters corruption. It has tended to flow to the worst governments, which pocket most of it as income — very little, sometimes none of it, reaches its actual objective. From an institutional perspective, aid gives extractive governments something to extract. It gives shady leaders a means of placating a corrupt bureaucracy and military, allowing them to do so without having to extract through the tax system. High taxes, including relative to income, lead to disgruntled populations, but aid causes a breakdown of this political discipline. As such, not only does aid maintain and nurture corruption, but it undermines potentially positive social processes. There is little incentive for governments to introduce legal frameworks — i.e. protection of property rights — conducive to economic growth.

Where the middle class usually represents the forefront of a market’s productivity, in many African countries it instead represents a relatively small social strata competing for political connections. Aid-dependent corrupt governments also oftentimes attract the best and the brightest. Aid promotes social tension; in Africa, this has led to much civil strife and, very often, outright civil war. During the 1990s, 27 major armed conflicts were recorded to have taken place around the world — 17 took place on the African continent.

Economically, aid has two major undesirable outcomes. First, a large influx of foreign monies might make local currencies more expensive on the exchange market. This follows from the fact that recipients of dollars, or euros, or what have you, must buy local currency with it in order to spend locally. More expensive local money may lead to a fall in exports, constraining the ability of indigenous industries to tap international markets. Second, since most African countries lack the infrastructure and necessary financial services, “surplus” aid is dealt with in two ways. It might be “mopped up” by governments, which issue bonds in return for excess aid — they then have to pay interest both on loan-based aid and on the bond. Otherwise, it may instead be used towards unproductive consumption.

In short, not only is very little aid money actually allotted towards productive activity, but it actually serves to strengthen extractive institutions that hamper economic growth. More bluntly, aid can be counterproductive. What of the “success stories?” Dead Aid tells us that these exist despite of aid, thanks to domestic policies encouraging growth. In fact, successful developing nations are the ones which ultimately give up aid as a source of finance.

What alternatives do African economies have? Moyo offers several:  sovereign and private bond markets, foreign direct investment, international trade, and microfinance. Sovereign debt markets tend to be more disciplined than the institutions responsible for issuing foreign aid loans, meaning that to be considered attractive candidates African governments selling debt must achieve a certain degree of financial stability and maintain it. More than sovereign debt, though, success will come with the internal development of domestic financial industries — banks and stock markets. Microfinance offers an interesting solution, in that it overcomes the major initial issue of finding borrowers with sufficient collateral. This type of institution loans to pools of people, spreading the risk of one loan to an entire community — there is a strong incentive to repay loans.

African nations also benefit greatly from foreign direct investment (FDI). While most Western countries have historically preferred the aid route, or line FDI with political conditions, China has willingly invested billions of dollars without the same restrictions. The Asian giant has invested in infrastructure — roads, energy, et cetera —, in return for claims on some of the surplus. While China cares little about the status of the government, in regards to its humanitarian track record or its domestic policies, by fostering development it unintentionally builds the middle class that ultimately tends to challenge extractive bureaucracies.

Finally, international trade offers an opportunity that few African countries have taken advantage of. While there has been extensive exchange between Africa, the United States, and Europe, recently adding India and China, the continent suffers the great obstruction of internal controls and tariffs. That is, most damaging to individual exchange are the barriers African states place between themselves. This is especially important to note when considering the markets with little to offer other continents. Powerful economies like that of the United States and the European Union have also done much to destroy existing industries in Africa. For instance, agricultural subsidies in these markets hurt African farmers, who can’t compete with subsidized prices (both internationally and domestically). The liberalization of exchange markets is a necessary precondition to vibrant economic growth.

All of this is easier said than done, and this is where the reader should be wary of putting too much faith on Moyo’s solutions. Alternative sources of financing emerge as undeveloped markets grow, which in turn require institutional changes. Political change emerges from a dynamic relationship between markets, society, and bureaucracy, and can be non-linear. There is no neat, packaged plan a country can follow, because the implementation of these ideas are left to politicians interested in maintaining the status quo or furthering their interests, whatever these might be. Those distraught with the fact that foreign aid has failed, looking at Moyo’s alternatives with hope, should understand that the road to development is a long one.

Despite its shortcomings — limitations that bind any book that deals with development economics —, Dambisa Moyo’s Dead Aid is an indispensable addition to the literature. It ought to be required reading, not just for economists, but all those involved with helping the developed world. It is a reality check, but one that if more people took to heart we might be able to stop the vicious circle of aid, corruption, and impoverished stagnation.

Free Markets and Policy

[The Clash of Economic Ideas: The Great Policy Debates and Experiments of the Last Hundred Years ♦ by Lawrence H. White ♦ Cambridge University Press, 2012]

[ed.: This review is available as a PDF.]

Lawrence White’s The Clash of Economic Ideas is not your usual history of economic thought; neither is it a comprehensive review of all the important developments in economic theory nor does it focus exclusively on any specific period.  Instead, White’s focus is on the “great policy debates” of the 20th century: from the socialist calculation debate of ~1920–40 to the austerity/stimulus that characterize the period following the 2007–09 industrial contraction.  Very early on, the purpose of the work is established: its “focus [is] on the policy-relevant parts of economics,” contrasting “with the encyclopedic histories of economic thought.”1

One theme transcends the entire period discussed: market freedom versus interventionism.  As such, in the course of narrating the history of the modern world’s great intellectual discussions White not-so-subtlety works in a policy recommendation of his own.  Indeed, someone already wary of the laissez-faire message would find little to reinforce this position.  Each debate — whether on socialism, business cycle (and response) theory, the New Deal, post-war development theory and monetary order, and the role of government in providing goods and services —  is set up so that the interventionist position is explained and then refuted by the pro-market logic that follows.  Given the hidden agenda of the book, someone already knowledgeable of these topics may not find anything new, since it is not a profound or far-reaching exploration of the contemporaneous academic work that provided the substance to the debates.  Rather, it is a relatively superficial — and this is not meant to belittle its merits — treatment, meant to set the stage for a final policy prescription: liberate the market.

The “thin” treatment of the whole body of the intellectual tradition behind any given theory sometimes leads to a few errors — for example, the author’s interpretation of Mises’ response to the market socialism of the 1930s and Keynes’ business cycle theory —, which are often enough counter-balanced by savvy insights — including a subtle suggestion towards Adam Smith’s true intellectual position towards laissez-faire (pro-consumer rather than pro-business) —, but makes for a far more enjoyable read.  The 412 page chronicle reads quickly and lucidly; the prose in engaging.  The various positions are explained well, and White’s excellent footnotes allow one to quickly jump into further research.  This book is extremely well-suited for those who have relatively little background in the history of economic thought.  It, for instance, is especially well-suited for an undergraduate class and the general public.

The bulk of this review focuses on a few quibbles that, for anybody who has read The Clash of Economic Ideas, prove to be relatively very minor.  The disagreements on interpretation expressed here should not be understood as a major criticism of White’s book.  They are just points that some may find value in further understanding, since they serve to better clarify what exactly some of the characters in White’s narrative argued.  On the whole, as already suggested, White’s effort is commendable and the book is most likely the best in its class.  Apart from providing greater detail — at the expense of the audience — the only major difference perceivable in rival literature is replacing the pro-market glaze with a pro-interventionism one (or shades of in-between); but, one can just take our book and shed it of ideology — that is, take the best of it — and garner greater results.

Minor Quibbles: Mises and Keynes

After setting up the context of the great policy debates to follow by explaining the move away from a laissez-faire consensus during the late-20th century, White dives into the socialist calculation debate led by the Austrians, and a few Neoclassical economists (such as Frank H. Knight), on one side and market socialists (especially Oskar Lange and Abba Lerner) on the other.  The opening salvo is Ludwig von Mises’, who in 1920 and 1922 published two tracts against socialism, explaining that socialism — defined by the collective ownership of the means of production — is unviable given that it lacks of a method by which the means of production can be efficiently distributed throughout the structure of production; this is because socialism dispenses with the market’s process of accomplishing this: the price system.  In the 1930s, Lange fired back with a theory of market socialism, where State planners can find prices through an equilibrating trial-and-error process.  Mises, and his disciple Friedrich Hayek, rejoined the debate right away.  But, the focus of White’s treatment of both of these economists’ arguments leads the reader away from the most important insights of their responses.

Lange’s theory of socialistic price determination is summed up as follows.  Price can be computed if three things are available: a preference scale, the opportunity cost of alternative uses, and the supply of a resource.  With the first and second sets of information given and a least-cost production function, price and opportunity cost can be mathematically found.  As aforementioned, using imperfect information a central planning board can find the market clearing price through trial-and-error.  White’s description of Hayek’s response focuses on the fact that Lange had simply assumed a “given” least cost production function, waving away one of the functions of market competition, and also had presumed all relevant information to be readily available.  In the case of Mises, he rebutted Lange’s argument by positing that central planning committees cannot replicate the profit and loss phenomena of the market, and that without profit there would be no incentive for efficient market activity.2  If true, this would be a major step back for Mises, since in the early 1920s he dismissed the incentive problems of socialism as non-fundamental.3  While both Hayek and Mises provided multifaceted cases against socialism, the insights White draws from are possibly not the most important.  Rather, Mises and Hayek sought to reformulate the Austrian theory of price determination, in light of the now suddenly very apparent shortcomings of the traditional Neoclassical approach.4

Both men took Mengerian/Böhm-Bawerkian price theory for granted.5  The Austrian theory of price formation is not an equilibrium-dominated one, and neither is it one where price is considered an ex-post or a given phenomenon.  Rather, price formation of the Austrian tradition traces the causal processes originating from participating individuals and the derivation of prices based on subjective value.  In light of this, Lange’s case for socialist price formation was absurd.  Lange wrote, “The administrator of a socialist economy will have exactly the same knowledge, or lack of knowledge, of the production function as the capitalist entrepreneur have.”6  Within the Austrian framework, this statement is both true and suggestive of theoretical conclusions lying at the opposite side of those of Lange.  Price is not just set by a single entrepreneur, but by many competing for profits and losses, in turn related to consumer preferences.

Hayek’s work on equilibrium theory highlights the fragmentation of relevant knowledge.  As White writes, Hayek sought to prove to market socialists that none of the “givens” Lange assumed to exist actually do.  This is the origin of Hayek’s well-known “knowledge problem.”  It is not just a lack of knowledge of consumer preferences, but also insufficient knowledge of the various data required to arithmetically compute the various least cost production functions that decide allocative efficiency.7  Thus, the nature of the diffusion of information is better solved through a decentralized market, given that competing entrepreneurs can much more quickly accumulate relevant knowledge and use it towards production.  This is especially important in the dynamic and changing market, where change provides a time constraint on the accumulation and interpretation of information.8  While Hayek’s analysis may not have been perfectly symmetrical with that of Mises, it is clear that the former saw the “price mechanism” as a corrective feature of the market, forcing entrepreneurs to revise their plans in light of new knowledge suggesting that prior plans had inadequately interpreted available information.9

While White, in The Clash of Economic Ideas, seemingly attributes Mises’ rebuttal against Lange’s attack as secondary to Hayek’s (evident in the very superficial treatment of Mises’ contributions to the debate in Human Action), it was perhaps more important than his student’s.  As established in Mises’ 1920 publication, the lack of private property in a socialist economy is just as condemning as the lack of knowledge.  Without private property in the means of production — even while assuming the right to property amongst consumers’ goods — there is no means by which prices can be arrived at, since it disallows entrepreneurs from participating in the continuous process of appraisement.10  This much is contained in Hayek’s rebuttal to Lange, “[W]e much show how a solution is produced by the interactions of people each of whom possesses only partial knowledge.”11  Whereas Hayek went only a little farther than Mises’ original volley, Mises’ 1949 contribution went as far as to provide a consistent, integrated, and comprehensive account of the market’s pricing process.12  In short, it was proof that Lange had by and large missed the mark in his alleged “solution” to the calculation problem.

Another error, important within its own context, is White’s rendition of John M. Keynes’ business cycle theory.  The author borrows the common interpretation of Keynes’ argument that there is a disconnect of a connection between savings and investment.13  At fault, according to White, is the disappearance of the role of the loanable funds market, which in Classical economic theory is the main artery that distributes savings to entrepreneurs.14  Strangely, White offers little on Keynes’ theory of interest, which recognizes that savings can be held in various forms.15  Most surprisingly, considering Keynes’ theory of interest, White does not recognize that this is not the principal cause — at least, on its own — for deficient effective demand.  It much less surprising, therefore, that White misses the mark in his analysis of Keynes’ statement that “[the Classical economists] are fallaciously supposing that there is a nexus which units decisions to abstain from present consumption with decisions to provide for future consumption; whereas the motives which determine the latter are not linked in any simple way with the motives which determine the former.”16

Very early in The General Theory, Keynes establishes the fact that entrepreneurial actions are guided by expectations (his aggregate supply function).17  The above-quoted passage ought to be interpreted within this context; entrepreneurial expectations are endogenous to themselves, and not only reliant on the decision to save by those who they presumably can borrow from.  The disconnect between savings and production, therefore, is a product of divergent expectations, where entrepreneurs no longer feel that they can profit from a use of saved resources.  The rate of interest of loanable funds no longer serves to coordinate only because the rate of interest is higher than the marginal efficiency of capital, or, more broadly, the expectations of income.  It is no less unsurprising that The Clash of Economic Ideas’s index lacks an entry for “expectations.”

Related, White argues that Keynes holds that any act of savings is detrimental to the economy during periods of idle employment, because it decreases effective demand.18  Presumably, this is related to Keynes’ alleged ignorance of the “Austrian” theory of multi-stage production.19  Samuelson’s work is used as an affirmation of this interpretation, but if this understanding of Samuelson is correct then Samuelson too misinterpreted Keynes.  While it may be the case that Keynes did not recognize Hayek’s “Ricardo effect,”20 which stated that increased consumption during periods of less than full employment will lead to even greater unemployment, White’s assertion is not true insofar that Keynes also accepted the “socialization of investment” and artificially decreased rates of interest as alternative, possibly superior, solutions.  While it was still far from perfect, the rendition of Keynes’ theory made in The Clash of Economic Ideas make it seem as if they are elementary and devoid of basic economic knowledge.  In other words, The General Theory is a more advanced treatise than many non-Keynesians acknowledge.  By characterizing Keynes’ work in a way that makes him seem almost like an ignoramus, White does his audience a disservice.

Hopefully, elucidating upon these two errors does not send the message that White’s book is replete with others.  Again, these errors should be seen as individual and unique (although, admittedly, quite major within the context of their respective specific debates); they are a product of attempting to package decades of intellectual evolution within the space of a single chapter of a space-constrained book.  At some points, actually, White does a great job at making subtle remarks that seemingly favor the policies which he opposes.21

Adam Smith’s Distrust of Business

While The Clash of Economic Ideas does not put too great of stress on it, White does go to some length to make sure the reader walks away knowing that Smith placed value on laissez-faire only because he saw it as a restraint on the evils of the businessman.22  To some, this seems difficult to fit in with the idea that Smith stands for, essentially, an unbridled market, the classical conception of freedom and liberty, and the pursuit of self-interest.  One explanation might be the “bleeding heart” one, showing the compatibility between capitalism and the welfare of society’s poorest members.  Certainly, this was one of Smith’s interests when defending the market economy in The Wealth of Nations.  But, his general support of the market follows a much more fundamental insight.

Smith saw mercantilism as a process of collusion between the State and merchants, allowing the latter to take advantage of the former’s monopoly on force for their own benefit and against the well-being of the average consumer.  He did not recognize the State as an effective tool to restrain the potential damages that self-interest could wreak in a completely unrestrained environment.  Rather, Smith saw the market as the mechanism of restraint; it is the market which increases competition between merchants, figuratively enslaving them to the wants of the consumer.  This “macroeconomic” interpretation may stem from his views on the division of labor, which he also saw as a restraint on the actions of men.  Indeed, the division of labor makes all dependent on others, meaning that one needs to produce to the benefit of others in order to earn the income to consume for one’s own wellbeing.  Inter-dependency and competition jointly restrain the producer in favor of the welfare of society as a whole.

While Smith may be rightfully invoked against some of the modern arguments in favor of intervention, as does White,23 one must be wary of overuse.  Our author notes at least one exception to Smith’s support for capitalism: public goods.24  In cases where the market cannot guarantee the existence of competition — as disputed as these are — Smith may have readily supported interventionism.  During his time, he may not have recognized a great many examples (although, Smith did argue in favor of various forms of interventionism25), but the modern rise of welfare economics26 may be seen as just as Smithian as any modern free-market theory.

Clash of Economic Ideas as a Contribution to the Literature

The bulk of this review is not a review as such, but a look at two errors and one insightful accuracy.  As such, it also unfortunately detracts from the overarching contributions the book does make.  Some of these have been listed in the opening paragraphs of the present essay: White’s book is engaging, easy to read, and it introduces the reader to the important debates that characterize economics-related public policy of the 20th and 21st centuries.  Another is that, while White attempts to distinguish between the academic and policy debates, the book shows that these two are not entirely separable.  Indeed, the latter can only be informed by the former.  This is exemplified by the great many references White makes to the support, academic, literature.  In this way, Clash of Economic Ideas spurs the reader to look forward to further research into the academic texts which gave rise to the substance of the popular debates.  The book also suggests that with regards to many of the debates, further academic research is needed to be able to make conclusive statements with regards to policy (or whether there should be no public policy at all!).

As aforementioned, in the course of reviewing the history of these debates, White makes an undeniable policy statement of his own: liberate markets.  This is, for example, almost very nearly explicit in his use of two chapters, illustrating the case of post-war Germany and India, to prove via empirical evidence the merits of the free market and the demerits of interventionism (influenced directly and indirectly, according to White, by English Fabian socialism and German Historicism27).  India, of course, was a failed case, until the relative liberalization of its markets during the 1990s; Germany, on the other hand, was a great post-war success, led by German “ordoliberalism.”  Whatever interventionist tendencies “ordoliberalists” had, these are framed as inconsistencies and wrinkles.  In the book, interventionist policies in Germany are not presented as possible factors behind this country’s post-war growth.28  This is not to say that one ought to disagree with White’s implicit policy recommendations, rather only to show that behind a thin and transparent veneer of academic neutrality is a clear favoring of the free-market.

One should not interpret the above, a priori, as error.  Surely, those convinced of the merits of socialism or extreme interventionism are not likely to gain anything by reading White’s book.  But, for the rest, the examples and literature used convincingly suggest that at the very least one should adopt a Smithian stance.  Markets ought to remain free, and divergence in the opposite direction should not be taken for granted.  Rather, arguments in favor of interventionism suffer the burden of proof and should be approached with delicacy.  While, of course, White, et. al., may disagree in the details with economists such as Bradfrod Delong and Paul Krugman, the last two accept in principle the before-defined “Smithian stance” (they just believe, whether rightly or wrongly, that the necessary proof has been provided).  Once it is admitted that pro-market economics allows for a very broad range of opinion, and in theory admits the possibility of beneficial interventionism, then White’s policy conclusions — when broadly considered — are not so disputable.

While, again, one is likely to disagree with some of the details presented in The Clash of Economic Ideas, all except extreme left-wing ideologues (and, believe it or not, I do not mean to use this term is a necessarily derogatory manner) should find the book an extremely interesting read.

Notes

1. White (2012), p. 2.

2. “Completely taxing profits away would completely suppress entrepreneurial activity;” ibid., p. 52; White cites Mises, Human Action, 3rd rev. ed. (Chicago: Henry Regnery, 1966), p. 709.

3. White (2012), p. 46.

4. This is apparent in Hayek’s critique of Schumpeter’s Capitalism, Socialism, and Democracy.  Schumpeter had claimed that the law of price imputation makes the derivation of input prices easy to determine, since the prices of outputs reveals the preferences of the consumers.  Hayek’s response illustrates the essence of the Mises/Hayek rebuttal to Lange: the market is complex and dynamic, and thus the price of one producers’ good cannot be inputed from an output since there are a range of alternative possible outputs.  The purpose of market competition is to “discover” the least cost use of a particular producers’ good, and this is done with uncertain expectations; ibid., p. 57.

5. Carl Menger, Principles of Economics (Auburn, Alabama: Mises Institute, 2007), pp. 171–225; Eugene von Böhm-Bawerk, Capital and Interest, Volume II: The Positive Theory of Capital (New York City: G.E. Stechert and Co., 1930), pp. 166–234.  Literature differentiating between Mengerian price theory and that of Walras and Jevons, the two other originators of the subjective doctrine, is extensive; see, for example, A.M. Endres, “Carl Menger’s Theory of Price Formation Reconsidered,” History of Political Economy 27, 2 (1995), pp. 261–287.  Also, see Joseph Salerno, “Varieties of Austrian Price Theory: Rothbard Reviews Kirzner,” Libertarian Papers 3, 25 (2011).  For an attempted de-homogenization of the Misesian and Hayekian approaches to price formation and the market process see Salerno, “Mises and Hayek De-Homogenized,” The Review of Austrian Economics 6, 2 (1993), pp. 113–146; also, Leland B. Yeager, “Mises and Hayek on Calculation and Knowledge,” Review of Austrian Economics 7, 2 (1994), pp. 93–109.

6. White (2012), p. 49; Oskar Lange, “On the Economic Theory of Socialism: Part I,” The Review of Economic Studies 4, 1 (1936), p. 55.

7. White (2012), p. 53–54.

8. See especially Friedrich A. Hayek, “The Use of Knowledge in Society,” The American Economic Review 35, 4 (1945), pp. 522–526.

9. “It is more than a metaphor to describe the price system as a kind of machinery for registering change, or a system of telecommunications which enables individual producers to watch merely movement of a few pointers, as an engineer might watch the hands of a few dials, in order to adjust their activities to changes of which they may never know more than is reflected in the price movement;” Hayek (1945), p. 527.

10. Jörg Guido Hülsmann, “Knowledge, Judgment, and the Use of Property,” Review of Austrian Economics 10, 1 (1997), pp. 23–24; Salerno, “Postcript: Why a Socialist Economy is ‘Impossible’,” in Mises, Economic Calculation in the Soviet Commonwealth, pp. 35–37.

11. Hayek (1945), p. 530.

12. Joseph Salerno, “The Place of Mises’s Human Action in the Development of Modern Economic Thought,” The Quarterly Journal of Austrian Economics 2, 1 (1999), pp. 57–58.

13. This line of reasoning, for instance, is explicit in Roger Garrison, Time and Money (New York City: Routledge, 2001).

14. White (2012), p.135.

15. The Selgin/White theory of free banking holds that even money saved in the form of holding it is manifested in the interest rate of the loanable funds market, because it allows relevant banks to expand the quantity of fiduciary media (maintaining the quantity of currency in circulation stable).  But, in Keynes’ theory of interest holding money under a mattress or brick is not the only alternative method of saving.  One, for instance, could easily imagine the purpose of the bond and stock markets.  This is what is contained in the passage White quotes of Keynes’ book dealing with his theory of interest (Ibid., pp. 136–137).

16. Ibid., p. 147.

17. John M. Keynes, The General Theory of Employment, Interest, and Money (BN Publishing, 2008), pp. 23–26.

18. White (2012), pp. 135–136.  Regarding Keynes’ view of the role of savings, consider the following passage, “[E]mployers would make a loss if the whole of the increased employment were to be devoted to satisfying the increased demand for immediate consumption” (Keynes [2008], p. 27).

19. Ibid., p. 133.  Keynes actually uses a two-stage structure of production, meaning that the second (or earlier) stage directly derives profits from other entrepreneurs and indirectly from consumers (i.e. the imputation of price).  It is implicit, also very early on, in his discussion of long-term expectations and income (Keynes [2008], pp. 46–47, 52).

20. See Friedrich A. Hayek, Profits, Interest, and Investment and Other Essays on the Theory of Industrial Fluctuations (Clifton, United Kingdom: Augustus M. Kelley, 1975 [1939]), pp. 3–71; Hayek, “The Ricardo Effect,” Economica 9, 34 (1942), pp. 127–152.

21. For the nitpicker and Cantillon-advocate, one additional error may be the fact that White does not cite Richard Cantillon as one of Adam Smith’s intellectual predecessors and major influences.  The economics of Cantillon ought to be recognized as one of the earliest, if not the earliest, complete bodies of economic (and anti-mercantilist) theory; Cantillon’s Essai is one of the few works cited by Smith in The Wealth of Nations.  See Jonathan M. Finegold Catalán, “Richard Cantillon: Founder of Political Economy.”  Of course, and in all seriousness, White’s book is not meant as a textbook introduction to the history of economic thought.  But, White does write on Smith’s influences between pages 219–221, even mentioning French economist François Quesnay.

22. White (2012), pp. 194, 219; “Businessmen are ‘an order of men, whose interest to deceive and even to oppress the publick, and who accordingly have an interest to deceive and even to oppress the publick, and who accordingly have, upon many occasions, both deceived and oppressed it.’”

23. Take, for example, White’s use of Smith against the “infant industry” argument for protectionism (pp. 372–373).

24. Ibid., pp. 216–217.

25. Murray N. Rothbard, An Austrian Perspective on the History of Economic Thought, Volume 1: Economic Thought Before Adam Smith (Auburn, Alabama: Mises Institute, 2006), pp. 465–469.

26. Discussion of welfare economics, including the argument in favor of the existence of public goods, is made on pp. 332–355 of White (2012).

27. White’s discussion of American Institutionalism, and its influence on modern American economics, should prove extremely interesting to the Austrian reader; see Ibid., pp. 18–25, 99–125.  While White does not elucidate more in this direction, it is evident from some of the discussion that Institutionalism had a profound impact on the development of American economics.  While its branches may be less visible in modern American macroeconomics, one wonders whether some of today’s prevalent methodologies — for instance, econometrics and “Friedmanite” positivism — would have existed otherwise.  American Institutionalism is relevant in this case, because it originated in German Historicism; it is, in fact, the American arm of historicism, and it was very popular in American economics.  German Historicism, of course, composed the opposite side of Menger’s methodenstreit, where Menger famously made the case for pure theory.

28. See, for one example, discussion on “competition policy;” Ibid., pp. 243–244.

Regulating Towards Depression

Ed.: This review was originally published at the Cobden Cetre and re-published at Mises.ca.

[Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation ♦ by Jeffrey Friedman and Wladimir Kraus ♦ University of Pennsylvania Press, 2011]

There have been a good deal of books attempting to find and explain the causes of the ongoing financial crisis.  Authors have approached the issue from all sorts of ideological perspectives and with different sets of evidence.  Most of these works are lacking, incomplete, or even flat-out wrong.  Many of them do not even care for the facts, instead using vague generalizations to justify the application of broad economic theories.  There has not, until recently, really been a meticulous analysis of the mechanics of the causes of the Great Recession, despite the enormous interest displayed by the economics profession in the subject.

This lacuna has been filled by Jeffrey Friedman, editor of Critical Review, and Wladimir Kraus, in their recently published book: Engineering the Financial Crisis.   The authors make the purpose of their study evident from the very beginning.  They shed themselves of any ideological priors which may have otherwise impaired their analysis, even going as far as to disprove a number of general theories from either side of the spectrum (insufficient regulation versus insufficient economic freedom), and task themselves simply with accumulating, analyzing, and interpreting the evidence.  The data they look at has to do with the regulations which governed the financial institutions which presided over the network of financial instruments which suddenly lost the bulk of their value.  The question they ask is a simple one: based on the facts, was the recession caused by under-regulation or was it something in the regulation itself which may have influenced the ways banks invested?

Friedman and Kraus give reason to believe that it was the latter — perverse regulations — which gave way to the great contraction which took place between 2007 and 2009.  Looking through the relevant legislature which dictates the laws governing the banking industry, the authors find that it was this regulatory web which led banks to invest into the specific financial assets that would soon after be deemed nearly worthless. Continue reading