Category Archives: Institutions

Crony Capitalism, Crony Communism, and Crony Anarchism

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

In the comments, I wrote,

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

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

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

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

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

Spain’s Cyclical Disorder

I like to read the comments people leave in articles in Spanish sports papers. I find them funny. There’s typically a decent mix of inter-team hate, intra-team hate, and general conspiracy theory. One can find a similar mix in the press of other countries, but not nearly to the same extent as in Spain. What these comments reveal — although there may be some sample bias — is an emerging culture of mistrust, caused in large part by ongoing depression in Spain and political corruption. Strong economies are built on trust, and this emerging culture in Spain can undermine forces of recovery in a country already handicapped by bad structural and counter-cyclical policy.

In “Economics and Knowledge,” Hayek developed a theory of equilibrium incorporating the role of expectations. In a division-of-labor where each agent relies in large part on others, an equilibrium occurs when the expectations of these agents coincide. For example, you, generally speaking, would only continue to work if you were certain that you would receive a paycheck at the end of the week. Businesspeople have certain expectations of the demand for their product, and of profitability. In the real world, expectations are often wrong — businesses fail, stock markets crash, et cetera. In equilibrium expectations are in harmony, so that everyone’s plans coincide.

The term “coordination” is essentially synonymous with “equilibrium.” For disparate expectations to jive, plans must be coordinated. When plans don’t coincide, there’s discoordination. Coordination differs from equilibrium, however, in that it has a more ambiguous definition. It might be useful to think about it as a spectrum. Plans may not be perfectly coordinated, but people’s actions are not always total failures. In fact, most of the time, things work out. When you take your car to the mechanic, he’s there; your paycheck arrives on time; your landlord expects and gets his rent by the monthly deadline; et cetera. We can also think about an economy having a certain degree of order, where equilibrium is maximum order. The better coordinated plans are, the higher the degree of order.

The concept of order can be applied to business cycle theory. Expectations have played a central role in business cycle research since the 1930s. Most firms do not expect a sharp decline in demand. Those that do typically mistime their preparation. A clear example is the 2007–09 financial crisis. Investment banks’ plans did not work out when a significant fraction of their assets dropped in value. The small businesses which went bankrupt had their expectations reverse. In mid-2006, few people thought that they had a large probability of losing their jobs in 2008–09. The business cycle is a period of discoordination — a loss of order.

Spain’s recession, following a housing bubble, has been particularly bad. Indeed, it feels more like a depression. Spain’s unemployment rate is over 26 percent. Much like during the Great Depression, a large fraction of unemployment is the result of bad policy. The IMF estimates Spain’s average outgap gap for 2013 at –4.338, which is comparable to that of the United States. Yet, the U.S.’ unemployment rate is “only” at 6.7 percent. Bad supply-side policy, in conjunction with bad demand-side policy, has made a disaster of an already bad situation. Spain’s structural problems, of course, have existed for a long time, but they were partly hidden by the boom of the early and mid-2000s. Schneider (2011) estimates that the value of production in Spain’s informal (extralegal) sector has been greater than one fifth of Spain’s GDP since ~1994, falling to 19.3 percent of GDP in 2007 — but, no doubt larger after the crash (although, in part because of a decline in GDP). Large extralegal sectors are typically a sign of bad supply-side policy.

Problems in Iberia go beyond bad policy. Spain’s democracy is more fragile than some people realize. The country has passed a few tests for robustness — such as the (quasi-abortive) February 1981 coup —, and high growth during the late 1990s and for much of the 2000s seemed promising. Indeed, many in Spain were looking forward to the day that the country would replace Canada in the G8! But, the country’s economic woes have been joined with corruption issues in government — and the problem crosses party lines: bribery, illegal payments, money laundering, et cetera. Further, regional banks funded local programs, and the relationship between these banks’ balance sheets, their health, and the political support they receive is unclear. These scandals have made it hard for Spaniards to trust their governments, whether national or local. The range of this distrust has spread to the royal family — especially after legitimate corruption charges against some of its members — and elsewhere.

The extent of distrust can be seen in Spain’s changing football (soccer) culture. Referees are always criticized. It’s hard to find an article on a big Premier League game without reading one manager’s criticism of the referee’s handling of a game. There are constant complaints against refereeing in all sports. But, in Spain, it’s especially bad, because complaints have given way to conspiracy theories. There is this notion that the governing body in Spain, RFEF, implicitly or explicitly supports a status quo that favors Barcelona and Real Madrid, the two highest earning football teams in Spain. The theories go as far as to claim that referees make their calls to purposefully help the the two “big teams” (los grandes). And, of course, between the two big teams fans accuse the other club of corruption. Even players have made these accusations — Cristiano Ronaldo and Sergio Ramos, players for Real Madrid, made comments to this effect after last weekend’s match against Barcelona.

There is, in general, an emerging culture that sees corruption and scandal everywhere. Bonds of trust are disintegrating. This can have dire long-term consequences. Trust, in some sense, is an institution; or, it’s a value manifested in certain institutions. Businessmen spend a lot of time and money establishing a relationship of trust with their clients. They offer warranties, they make sure to always leave their customer satisfied (hoping for the relationship to be repeated over time), et cetera. When there is no trust, the economy suffers. The transaction costs to some exchanges can become too high, and trades which would have led to gains for all parties involved simply don’t take place. To put the role of trust into perspective, recall the 2011 paper by Nunn and Wantchekon, finding evidence that slavery created a culture of mistrust, holding development in sub-Saharan Africa back. This is happening in Spain. While political corruption is hard to compare to slavery, the emerging culture in Spain may have dire economic (and political) consequences for years to come.

Mistrust might make political reform more difficult. Note how untrustworthy Ukrainian protestors have been of the “reformed” Ukrainian government. The same is true of Spain, although in different areas and to a different degree. Governments with fragile relationships with their people are going to have a hard time passing structural reforms that may not produce immediate results. Mistrust also makes a situation ripe for regime uncertainty. Uncertainty over the political climate makes business more difficult and less attractive, especially if this business requires large investments. Mistrust can spill over into the private sector in other ways around. Large businesses — which tend to be villainized when it’s the worst off who suffer the most — can lose demand for their product, even if their product confers to the consumer the highest satisfaction relative to other choices. Mistrust can even hurt relationships between small businesses, and even between small time vendors and their customers.

The effects of the business cycle, especially if these effects are made worse by bad policy and political corruption, can influence an economy for many years thereafter. They can make recovery more difficult. When a people lose faith in their institutions of governance, this mistrust tends to spread to other sectors of life, including business. It itself is corrupting, because it changes the institutions which guide economic processes. It limits trade, and when trade is limited we lose out on gains from trade. Countries like Spain (and Greece) are undergoing this transformation, and if this process isn’t reversed, the consequences can become more dire than they already are.

Institutional Comparisons and Growth

This post is really a comparison of three books: Peter Leeson’s The Invisible Hook, Douglas Allen’s The Institutional Revolution (review), and Daron Acemoglu’s and James Robinson’s Why Nations Fail. All three talk about institutions, and the latter two talk about institutions in the context of economic growth. I sense a friction between the Acemoglu–Robinson and the Leeson–Allen narratives. Leeson and Allen tell us that we have to look at institutions in the context of constraints. Acemoglu and Robinson look at various institutions, historically and internationally, and try to compare them directly, but they don’t consider constraints. I wonder whether the Acemoglu–Robinson narrative tells us less than they think it does.

Allen’s and Leeson’s books share a similar purpose. The Institutional Revolution attempts to explain various customs by looking at the rules of the game and what ends these rules seek to accomplish. Specifically, Allen explains a set of the institutions of ~1600–1850 England, including several aspects of the institutions of governance. Leeson, in the Invisible Hook, does much of the same, but focuses on the golden age of piracy. They both find that the institutions they look at make sense within the context of the ends of the agents and technological (exogenous) constraints. In the real world nothing is perfect, but we could think of these institutions as optimal. Replacing them with an alternative set of institutions, even if this set works well in certain situations (e.g. the institutions of governance of the modern developed world), would most likely lead to inferior outcomes.

In their book, Acemoglu and Robinson look at global income inequality between nations and argue that institutions are the cause of this inequity. They look at, for example, North and South Korea, two countries with similar cultures and geography, and explain the divergence in income growth through institutional comparison. North Korea is governed by an extractive dictatorship, while South Korea is an inclusive democracy (nevermind that this political dichotomy was probably not so clear in the late 1950s and 1960s). Their general argument is that extractive regimes slow income growth and inclusive (plural) regimes promote growth. An easy policy recommendation, then, is that developing nations should embrace inclusive institutions of governance.

Is economic growth as easy as embracing inclusive politics? The Leeson–Allen narrative warns us against settling for the easy answer. Oftentimes, institutional sets are not directly comparable. Suppose, for the sake of argument, that North and South Korea have two different sets of exogenous constraints. If this is the case, then it’s much harder to argue that the South’s political institutions are responsible for the income disparity. Replacing the North Korean state with that of the South may lead to another sub-optimal outcome, and not to the growth that Acemoglu and Robinson predict.

I’m not going as far as to argue that, given North Korean constraints, the current state is optimal. In fact, I think the opposite is true. Still, the optimal set of political institutions in North Korea could be very different to those of South Korea. This means that South Korea tells us very little about North Korea, and that direct comparison of institutions is misleading.

Do institutions explain global economic growth since the mid-19th century? They may, but perhaps not in the way Acemoglu and Robinson predict. Consider The Institutional Revolution. If Allen is right, modern political institutions just would not have worked out in premodern England, because the constraints were so that modern institutions just wouldn’t fit. He argues, for instance, that modern bureaucracy was made possible because of technological changes during the 19th century that allowed organizations to monitor their employees and offer them a wage based on the marginal value of their labor. Before these technological changes, it made sense to develop an aristocracy based on the accumulation of capital, which was invested into illiquid assets — assets that lost their value if aristocrats did their job poorly and were removed from office. These were the institutions in place when England went through the first industrial revolution, in the late 18th century.

The implication is that Robinson and Acemoglu might be looking at a symptom of economic growth, mistaking it for a cause. The transition to modern democracy may not have been an issue based only on the distribution of power; the emergence of modern democracy may have more to do than just the withering of extractive regimes. It might have required other things to come into place, as well, including technological developments and changes in the preferences of society. Typically, we relate technological advancement with economic growth, which implies that there is an element to growth that is independent of institutional transition.

I like the argument made in Why Nations Fail. I think there is something to the theory that extractive institutions restrain growth and inclusive institutions promote growth. My interpretation of these terms is that inclusiveness refers to the degree of plurality. Plurality is important, because the greater the fraction of society whose preferences are communicated through the political process, the smaller the externalized costs of governance (see Buchanan and Tullock, The Calculus of Consent1). If the current U.S. government were replaced by a dictatorship, I think the most likely outcome is a reduction in the rate of growth of our well-being. But, this theory loses explanatory power when we are making comparisons between institutions that exist within different sets of constraints.

Admittedly, despite my affinity for them, the terms “extractive” and “inclusive” lose concreteness. Suppose we think about these terms in the context of a spectrum, where extractive and inclusive are polar opposites — extractive on the left end, inclusive on the right. Can we put, for instance, modern U.S. democracy to the right of premodern English aristocracy? If we do, we have to accept that a more inclusive system of governance might have made premodern England worse off. If we say that the degree of inclusiveness is not directly comparable, we arrive at the problem I’ve been trying to explain throughout this post: direct institutional comparisons oftentimes tell us very little about why one society is poor and another very well-off.

The Acemoglu–Robinson narrative, however, might say a lot in certain situations. Above, I used the example of North and South Korea. I was trying to illustrate a point. I don’t know if the constraints on each country are different. If they aren’t, then directly comparing institutions might tell us something useful. In fact, I think that much of North Korean poverty is directly explained by their institutions of governance. The North Korean state is a perfect example of what Acemoglu and Robinson mean by extractive institutions. I think it also fits the model (“Why Not a Political Coase Theorem“) Acemoglu built to explain why political institutions remain extractive: North Korean leaders are afraid that economic growth will threaten their hold on power. I am not arguing that the story in Why Nations Fail explains nothing; it probably explains quite a bit, but only if we restrict institutional comparison in accordance with variations in the relevant constraints.

In a nutshell, the point I am making is as follows: which set of institutions are optimal depends on the relevant set of constraints. Therefore, a government that is optimal in one situation may be sub-optimal in another. If this is the case, the straightforward comparison between inclusive and extractive institutions does not lend us much help in pinpointing the causes of global wealth inequality. An inclusive institution that correlates with high growth in the U.S. may correlate with low growth in Laos, and the optimal set of institutions in Laos may look relatively extractive on a simple extractive–inclusive spectrum. The implication is that there is quite a bit to long-run economic growth that the narrative in Why Nations Fail can’t explain, and it may be that this aspect to growth is only indirectly related to institutional change — this change may come as a result of growth, as opposed to being a cause of it.


1. To relate The Calculus of Consent directly, Buchanan and Tullock model two sources of costs to governance: the externalized costs of imperfect plurality and decision-making costs, which increase as the number of people involved in the decision-making process rises. They come up with a combined cost curve that looks like a parabola that opens upwards, where the x-axis plots cost and the y-axis plots the number of individuals involved in decision-making. Optimal plurality is where costs are minimized, which is not necessarily 100 percent plurality. Changes in the mapping of the curve can about with technological changes, and this may push optimal governance towards a greater degree of plurality, but without these technological changes it doesn’t make sense to advocate for a more inclusive government than what’s optimal.

Taking Knowledge Problems Seriously

Peter Boettke draws a distinction in the history of thought between those who are optimistic about markets, and pessimistic about government intervention, and those who are pessimistic about markets, and therefore optimistic about government intervention. Taking a look at the comments, not a lot of people wholly agree with Boettke. But, I think that he’s at least partly right. The Austrian theory of the market process is built on this idea that knowledge is decentralized and that human beings are radically ignorant and fallible, taking therefore an institutional approach to social coordination — how institutions help us overcome these issues. There is a symmetric approach to governance. But, typically, this isn’t what “interventionists”1 care about.

Most economists, it needs to be said, have always acknowledged many of the weaknesses of government. One of these is a subtle trait that characterizes all parts of society, which is that social coordination is impossible unless there are ways by which individuals can communicate to each other unique sets of knowledge/information. In markets, for example, the clearest example are prices. But, apart from prices, we should also stress the role of the entrepreneur as a “discoverer” — someone who has to grapple with the unknown, and communicate new knowledge on a trial-and-error basis. Austrians are well-known for recognizing this problem very early on, and it shapes how they view markets. As a result, they also appreciate social complexity, developing the theory that these institutions are developed spontaneously; they grow out of the interaction of agents, and are not designed by a single mind.

We can apply the same approach to governance, and economists have. This is the common thread that ties up, for example, the literature on voting as an allocational device — see for example Bowen (1943) and Barzel and Sass (1990) —, or the use of migration as a profit–and–loss mechanism — e.g. Tiebout (1956) or my rough idea of competitively choosing between governments. Thus, to one extent or another government’s knowledge problem is recognized, and we can look at the institutions which have developed over time that help us achieve superior coordination through collective action.

I have criticized libertarians who are extremely skeptical of government for suffering their own “fatal conceit” — sometimes they don’t appreciate the complexity of the institutions of governance. This is not to say that libertarians don’t consider this issue at all; after all, my opinion on this matter has been shaped, in large part, by James Buchanan and Gordon Tullock. But, I think it’s true that, in general and especially outside of the journals, much of the benefits to social coordination that the right institutions of governance can bring are recognized too little by critics. They don’t take the knowledge problem as seriously as they should when they judge the government, or some part of it. As Boettke writes, the market optimism, government pessimism, tends to lead economists to put different weights on what they consider to be important, at the risk of ignoring something, that you otherwise know very well, in your analysis — especially as it concerns policy (e.g. the policy of reducing government involvement).

But, the same can be said of those who are market pessimists, government optimists. Oftentimes the knowledge problem of coordinating markets is not taken seriously. Boettke brings up Janet Yellen and monetary policy, and I think he’s absolutely right. It’s not just Yellen, but the entire institution of the Federal Reserve. Consider this excerpt from a recent Stephen Williamson post,

The Fed does indeed have a credibility problem. That credibility problem comes in part from implementing policies — quantitative easing (QE) in particular — the effects of which are imperfectly understood by economists inside or outside of the Federal Reserve System. We don’t know what mechanism is at work, we don’t have any idea what the quantitative effects are, and yet Fed officials confidently support the use of QE in public, as if they knew exactly what is going on. Further, it is well-known that the real effects of monetary policy are at best temporary, but Fed officials like Kocherlakota seem to want to argue that the failure of policy to “cure the problem” is just a license for doing more.

The limits of the Fed are rarely taken seriously. Yes, economists acknowledge that the effects of some policy or another are imperfectly understood. But, rather than seeking new “optimal” monetary policies, there is very little talk of alternative institutions. To help put the problem in perspective, consider Scott Sumner’s NGDP targeting proposal. If the Fed sets up an NGDP futures market, they can track NGDP expectations and correct monetary policy. But, this is only a very superficial solution to the knowledge problem (using the futures market as an informational channel). There needs to be more discussion on what happens when a policy fails and how to measure the success or failure of a policy. More generally, there is no serious discussion on what kind of institutions would make monetary policy more efficient.

To continue with the Fed example, consider the growing literature on free banking. We know that a privatized banking system induces competition between banks and money, constraining credit growth. But, we also know that private banking systems practiced monetary and regulatory policy of their own. For example, clearing houses established rules for membership, removing banks that did not follow them. During periods of crisis, when individual banks suffered from shocks to their assets, clearinghouses would often pool assets and issue temporary notes of their own, either to facilitate inter-bank clearings or to circulate amongst the public. When the banking system was reorganized in the 20th century, we sacrificed, to one extent or another, the possible improvements to banking institutions that would have continued to be developed, tested, and implemented by a competitive banking system (more accurately, a competitive currency market). I’m not saying that a purely private banking system is best (it may, or it may not be), but there is evidence that the Fed is inferior in many respects to alternative institutions. Yet these weaknesses  — especially as it concerns its place in the division of knowledge — are taken seriously by a smaller lot of economists than it should be.

We can say the same thing about other aspects of government. Take the recent paper on the cash for clunkers program, which argues that it was comparatively poor stimulus. The common approach to this finding is that we should use our intelligence to figure out better policies. But, to stop there is to only scratch the surface of the problem. We also need to think about what kind of institutions of governance would help increase the probability of good fiscal programs, without relying entirely on human intelligence (which is limited and fallible). Markets, for example, don’t rely on entrepreneurs who always succeed at finding good investment. The market has developed institutions to weed out failure and minimize the costs of these failures. Economists who advocate for fiscal policy rarely consider this issue; it’s not a problem that informs their policy recommendations.

I agree with Boettke that there seems to be a line of separation between two groups of economist. But, rather than market optimist/pessimist and government pessimist/optimist, we should classify economists by those who take the knowledge problem seriously and those who don’t. Austrians are very good at recognizing the knowledge problem — even if they sometimes forget to apply it fairly to governance —, and I think that other economists are oftentimes, unjustifiably, less worried about it and therefore consider it less.


1.”Interventionists” is a loaded term, but I use it only to help distinguish one class of economists. I don’t mean to imply that being an interventionist is necessarily bad.

Public Police and Violent Crime

The following passage reminds me of Steven Pinker’s The Better Angels of Our Nature,

Today police are invariably linked to violent crime, but their history would suggest otherwise. England, in the thirteenth century, was a rather violent country: the homicide rate was 18–23 per 100,000 population, and violent deaths accounted for 18.2 percent of all criminal indictments. However, the trend in violence from this period until World War I was steadily downward. By the seventeenth century, homicide rates had fallen by half, and the fall continued throughout the eighteenth century. By 1890, “only three people in all of England and Wales were sentenced to death for murder committed with a revolver.” All of this was done in the context of private provision of police and justice. It was not until the nineteenth century that policing in England became publicly provided. The steady decline in violent offenses from the Middle Ages on is evidence that the emergence of the public police in the first half the nineteenth century was not in response to a sudden increase, or continuing high levels, in violent crime.

— Douglas Allen, The Institutional Revolution (Chicago: University of Chicago Press, 2012).

Allen makes a convincing case that it was product standardization that made public policing relevant. During the late 17th century and throughout the 1800s, new technologies made capable the production of non-variable output, because methods of production became more precise. Previously, output was largely artisan in nature, and the final product was variable (different units of output varied in quality and characteristics). In the case of theft, private justice was relatively efficient, because it was easier to link product with owner. Related, the lack of a public road system made it less likely that stolen wares would be taken to distant markets. However, standardization made it more difficult to know who owns what and a well-maintained public road system arose, with consequent long-distance markets, made private justice less effective, leading to the establishment of a public police force.

Why Are Institutions Inefficient?

In answering why some countries are much better off than others, the popular answer has become “institutional differences.” More specifically, some governments are better than others at promoting growth. This is so, not out of ignorance, but because the incentives and rules which guide political action differ between governments. Where the institutions of governments are poor, politicians find it within their interests to plunder, or extract, wealth from their citizenry, usually indirectly — seigniorage, exploitation of natural resources, et cetera —, because income taxes and the like don’t produce much income when those you are taxing are near the poverty line. The question that persists is, why do political institutions remain inefficient? Daron Acemoglu offers a preliminary answer in a 2003 paper, “Why Not a Political Coase Theorem: Social Conflict, Commitment, and Politics” (gated, ungated).

In theory, with certain assumptions, we can posit a world where political agents and non-political agents can agree to a stream of side payments to allow for policy changes. To quickly illustrate the idea, suppose there is a single-person government, which extracts $100 over some period of time t, and one non-political agent, who earns $20/t. A policy change can lead to the latter increasing her income to $200/t, but reducing the politician’s revenue stream to $50/t. Assuming, for simplicity’s sake, that these are the only figures we need to worry about, it behooves the non-politician to pay the politician anywhere between $50.00…01 and $179.999…9 to enact the policy change, because both of them are now better off. We can call this the Political Coase Theorem (PCT). Why don’t we typically observe this behavior in the real world?1 The Coasean answer: transaction costs. Acemoglu’s answer, which is a subset of transaction costs: commitment problems.

If governments and their citizenry were to engage in side payments, we stumble upon the problem of enforceability. A Coasean solution, in this case, requires one party to promise a future sum or stream of income to another — the payment is made after the policy change. Suppose you establish a contract with a plumber to fix your kitchen sink, with the agreement to pay him a certain amount of money when the job is finished. If, at that time, you renege on your obligation, the plumber can count on government to enforce the contract for him. But, between governments and citizenry there is no “higher power” that can enforce the promise of side payments. Thus, any contract must be self-enforcing; there have to be built-in incentives for both parties to fulfill their obligations. The trouble is, in these hypothetical government–citizen agreements, there are strong incentives to break the contract.

The idea of the policy change is that if a government lifts constraints — by reducing extraction, respecting property rights, et cetera — on the private sector’s ability to invest and innovate, the latter will achieve some increase in income. That is, the private sector will produce more. But, the private sector is only interested in producing more if it reaps the rewards of its effort; more technically, they must be better off than they were under the old set of rules. If a government is expected to renege on its promise to allow its citizens to keep whatever fraction of income necessary to incentivize the investment, clearly the private sector will prefer to not invest at all.

Likewise, a government is only interested in enacting the policy change if it is better off as a result. If it retains its power to extract at will, it can simply tax the agreed side payment at will, but we run into the commitment problem described in the previous paragraph. What if the government agrees to relinquish power? To induce a ruler to give up power, the private sector has to pay her. But, once power is surrendered, that ruler has no way of guaranteeing the agreed upon income.

We can think of ways of making the contract self-enforceable. For example, if the ruler does not carry through with her promise, the group of citizens may decide to replace her. But, this incentive is weakened if a ruler expects replacement — say, if the citizens can replace the ruler with another one, at a cheaper cost than fulfilling the agreement. Another possible solution is an expectation of repetition, where if both parties are promised a stream of future income over multiple periods of time, the incentive to renege falls. For example, at time t the ruler can either keep her promise or, instead, extract all wealth. If she does the latter, though, she lets go of potential future payments at times t+1, t+2,….,t+n. However, the probability of replacement can increase as investment, and therefore output, rises, because it threatens the distribution of power.

Ultimately, the argument is not that there will be no political change without a perfect contract, but that, in the real world, institutional change will be imperfect, or inefficient. More importantly, Acemoglu seeks to show that the distribution of power matters. How power is distributed between the various agents is a determinant of the outcome, because it affects the incentives to commit to a contract, and therefore bears some relationship to the rate of economic growth. This being said, it should be clarified that Acemoglu is not claiming that the distribution of power is the only, or even the main, determinant — a more complete picture is left to future research. Nevertheless, the framing of the problem is an interesting angle from which to approach the question of why some political institutions are more extractive than others, and why they remain so.


1. The side payment language may seem to constrict the way that citizens can recompense their rulers for making a policy change. But, we can think of a more realistic method: an agreement to a future level of taxation.

How to Read “Market for Lemons”

I like to think that creative people think non-linearly. So, if you’re one of those people who were induced to debate the merits and demerits of George Akerlof’s “The Market for Lemons” (1970 [gated], [ungated]) because you read the Janet Yellet news,1 you can consider that a good thing. A not so good thing is to reject the lessons from Akerlof’s paper, because (a) he advocated intervention as a means of mitigating uncertainty-related welfare losses, and/or (b) for something like “he didn’t consider preference subjectivity and heterogeneity,” and/or (c) for whatever other reason. This is a good opportunity to stress some of the interesting things that come out of Akerlof’s model.

I think it safe to assume four groups of Akerlof readers.

  1. Group 1 are those who read the paper and favor interventionism predominately over private solutions.
  2. Group 2 are those who favor both interventionism and private solutions — there may be scope for both.
  3. Group 3 are those who don’t think much of government solutions, but accept the conclusions of the paper and focus attention on private solutions.
  4. Group 4 are those who look at Group 1 and 2, assume something must be wrong with the paper, and reject the conclusions altogether.

The point I hope readers take away is that you don’t want to be in Group 4, or even near it, and that, for the most part, it’s more interesting to be in Group 3 than in any other group. I’m somewhere between Group 2 and Group 3. I suspect that most economists are in Group 2, but that Austrians, Market Monetarists, and economists with similar (skeptical) priors on government are more-or-less where I am (maybe most are relatively closer to Group 3).

I won’t discuss (b), other than to suggest to read the article, because in his model — while still simplified — he does assume two different utility functions (for two “groups of traders”). Actually, the assumption of heterogeneity is important, because it helps explain why, at the extreme, a market might breakdown as a result of uncertainty over the quality of some good. Differences in people’s (subjective) utility functions helps us illustrate why, even if “objectively” (if there were perfect information) there is opportunity for gains from trade, two people may still not undertake the exchange.3 Also, I saw some discussion on whether or not we can really say what is an “average quality car,” or at least if we can say that one car is really of poorer quality than another. After all, one man’s trash is another man’s treasure. But, I think we can reasonably assume that the average person prefers a car with a working engine than a car with a non-working engine (assuming the same general end of, say, wanting to drive the car).

Before talking about (a), which will really be about talking about the interesting aspects of the paper, I will summarize Akerlof’s argument. He makes a good analogy to Gresham’s Law, although after explaining his theory, but I think it’s a good thing to think about Gresham’s Law beforehand, because it might make Akerlof’s argument clearer. Gresham’s Law is commonly summarized as “bad money drives out good money.” The assumption behind the theory is that “bad money” (say, a coin that is 50% gold and 50% copper) trades at par, meaning it trades at the same value as “good money” (say, as pure a gold coin as possible). Why would this happen? Assume the government enforces the at par value of “bad money.” People, who know that “good money,” despite the enforcement (by fiat, here), is really worth more than “bad money,” will get rid of the latter first. As a result, the average quality of circulating coin falls.

Akerlof’s theory differentiates itself from Gresham’s Law in that, while the latter assumes people can tell the difference in quality, the former is all about an inability to perfectly distinguish between goods by quality.4 In other words, it assumes imperfect information; more importantly, it assumes that different people know different sets of information, allowing one to take advantage of the other.5 Why does information asymmetry exist in the car market? Suppose someone has owned a car for n time, and that a buyer has no experience with that same car. It’s reasonable to suspect that the owner, who has n time experience with the car, will know more about it than the buyer, who has 0 time experience with the car. I am a real world example. A drunk driver recently hit my, now ex-, car, forcing me to buy another one. I first looked on Craigslist for another used car, but it was very difficult for me to know the history of the different options. One guy was selling a 2002 Honda Civic, but he has an incentive to withhold information I find crucial (accident history, et cetera). I opted not to buy the car, even if I would have actually gained from the exchange.

Because I can’t tell the difference between the various 2002 Honda Civics on the market — as far as I know, they are all of similar quality —, I have to accept a more-or-less uniform price for this good. At this price, p, sellers have an incentive of getting rid of their worst quality goods first. On average, this drives down the quality of the supply of that good. Furthermore, sellers of good quality goods, even if they don’t have bad quality goods, have an incentive to not put their goods for sale on the market. Let’s say that price, p, is a function of the expected average quality of the good, such that the poorer the quality — as people come to recognize it — the lower p will be (what Akerlof calls the price level). If a seller of high quality goods enters the market, raising the expected average quality and therefore p, she’s not guaranteed the benefits of providing a higher quality product. Because people can’t distinguish between goods (again, in reference to their quality), that seller of the good product will raise p not just for her goods, but also for other sellers, who are offering a lower quality product.6

Using Akerlof’s model, we can predict that, under these conditions, there could be no market at all! Akerlof illustrates this using some quick algebra, but I will try to summarize the argument without any math (the math is not difficult, so you will probably be able to get the clearest idea if you just read that part of the article — part II, section B, pp. 490–492). Remember that the argument is that at any given “price level,” or price p, the average quality of the good for sale will be lower than if buyers could differentiate by quality. The result is a feedback loop of sorts, where the average quality continues to fall, bringing down p with it. This is because as the expected quality of the average car falls, people will be willing to buy it only at a lower price. As this process takes place, at any given p the expected quality can be so low as to dissuade any purchase at all. This is true even if, if people knew better, there is a car out there that is worth price p (according to their subjective preference).

The result is what economists call a market failure, but is probably better called simply a market imperfection. There will be trades that are pareto optimal, but won’t take place because the traders in question are uncertain as to whether they will really gain from trade. We can use this theory to help understand why certain markets — e.g. health insurance,7 cars, labor markets, et cetera — take the form they do. Then we can take two routes: (a) give a policy recommendation, or (b) use this information to explain private solutions. Those in the aforementioned group 4 of Akerlof (1970) readers reject the article because they assume the only option is (a). But, there is also option (b), which is the more interesting one. And, contrary to the claims of some,8 Akerlof does discuss (b), mentioning (a) only in passing, really (see section IV, pp. 499–500).

Humans, being extremely clever animals, have come up with a number of ways of mitigating the problem of quality uncertainty. This is why, in real life, we see functioning markets selling goods that are subject to the conditions of Akerlof’s theory. A seller, for example, can offer a guarantee for her product. If the quality of a car is higher than the expected average quality, the seller might command a higher price if she offers a guarantee to refund the customer if the quality is less than that promised. Those selling worse quality cars won’t offer the same guarantee, because their expected probability of pay-out is higher. Brand names also help mitigate this type of uncertainty, since brands can act as a proxy for the quality of a good, and consumers can discriminate between brands. Licensing also serves as remedy. These are all institutions that arise to help mitigate market imperfections, and they can all be private solutions.

What makes Akerlof’s theory interesting, then, is that we can explain why certain markets look the way they do, including the institutions that arise. These institutions would otherwise look very strange to us, because we couldn’t explain them under different assumptions (e.g. under the assumption of perfect information). This allows us to more accurately describe the world around us. For those of us skeptical of intervention, it also allows us to propose alternatives to policy recommendations. If the net benefit of a private solution (multiplied by the probability of it occurring) is greater than the net benefit of collective action, the latter is not an attractive option. Here is where we distinguish group 2 from group 3. If we think that we can accurately make these types of computations, we will belong to group 2 — whether we opt for private solutions or collective action depends on their comparative merits and demerits. If we’re skeptical of the accuracy of these computations, and inclined to think that it’s safer to avoid collective action altogether, we will belong to group 3. Like I said, I’m somewhere in between those two groups. But, for no reason should you be in group 4.


1. If you haven’t read the news, Yellen is the candidate with the highest probability of succeeding Ben Bernanke as chairman of the Federal Reserve. Edit: She is for sure going to be the next chairman (chairwoman) of the Federal Reserve.

2. Although, on the other hand, maybe that’s not such good news, since Yellen has made plenty of interesting contributions to economic science that deserve to be discussed more so than those of her husband, since she’s in the news and not her husband.

3. Not to mention, it would be absurd to talk about gains from trade without assuming subjective and heterogeneous utility functions.

4. Although, I’m not sure why we can’t upgrade Gresham’s Law to consider the impact of uncertainty on money — whether empirically relevant or not (and, my guess is that it is relevant, since some of the institutions discussed later in this post emerged in competitive money markets).

5. To be clearer, there is a difference between imperfect information and asymmetric information. Say that a set of perfect information looks like (x, y, z), and that there are two people in the market. These two people are imperfectly, but symmetrically, informed if both know the knowledge set (x, y). They are imperfectly, and asymmetrically, informed if one knows (x, y) and the other (y, z).

6. If people could distinguish goods by quality, then the seller of the higher quality product will command a higher price, while competitors will still be selling their goods at a lower price.

7. Kenneth Arrow actually made a similar argument to Akerlof’s, about seven years earlier, in “Uncertainty and the Welfare Economics of Medical Care” ([gated], [ungated]). Arrow, however, explains something slightly different (medical care v. healthcare).

8. Specifically, this is untrue,

According to Akerlof and others, market participants, facing the realities of imperfect information, have little or no incentive to gain more information for themselves. They are “stuck” in a disequilibrium trap with no way out unless Uncle Sam comes to the rescue. Yet, we know just from simple observation that Akerlof is wrong.