Category Archives: Books

Secular Stagnation Modeled

Gauti Eggertsson and Neil Mehrotra provide a formal model of secular stagnation, a theory recently revived by Larry Summers and Paul Krugman. The theory was first proposed by Alvin Hansen in the late 1930s. It’s probably not coincidence that the theory is popular again during a period in which the economic situation — deep contraction followed by a slow recovery (low growth) — is similar. I wonder if the long-term shape of the economy will also turn out to be similar to that of 1929–2001, and if the theory will simply fade out again.

The abstract,

In this paper we propose a simple overlapping generations New Keynesian model in which a permanent (or very persistent) slump is possible without any self-correcting force to full employment. The trigger for the slump is a deleveraging shock which can create an oversupply of savings. Other forces that work in the same direction and can both create or exacerbate the problem are a drop in population growth and an increase in income inequality. High savings, in turn, may require a permanently negative real interest rate. In contrast to earlier work on deleveraging, our model does not feature a strong self-correcting force back to full employment in the long-run, absent policy actions. Successful policy actions include, among others, a permanent increase in inflation and a permanent increase in government spending. We also establish conditions under which an income redistribution can increase demand. Policies such as committing to keep nominal interest rates low or temporary government spending, however, are less powerful than in models with temporary slumps. Our model sheds light on the long persistence of the Japanese crisis, the Great Depression, and the slow recovery out of the Great Recession.

(H/T Mark Thoma)

Post-Introduction Reaction, Piketty Edition

I am just starting to read Thomas Piketty’s Capital in the Twenty-First Century. Last weekend, a commenter asked what led me to pick up this book. The reason I gave is simply that the author is an authority on the topic, and the book has received wide acclaim, both complimenting and critical. But, there is another reason, and the book’s introduction embodies it. To me — someone with strong free market priors —, certain statements made in the introduction are very controversial (I will excerpt some of these, below). However, the force behind Piketty’s main arguments causes me to re-think my priors, and through this force he successful “sells” these arguments as ones you need to know if you really want to understand the inequality issue. In ways, Piketty’s book reminds me of The General Theory.

Some arguments I thought libertarians will find controversial, but also often thought-provoking,

Consider first the mechanisms pushing toward convergence, that is, toward reduction and compression of inequalities. The main forces for convergence are the diffusion of knowledge and investment in training and skills… [B]ut it is fundamentally a process of the diffusion and sharing of knowledge — the public good par excellence — rather than a market mechanism.

— p. 21.

I know where Piketty is coming from: something like education is oftentimes seen as a public good. But, I’m not sure if the public good aspect is related to what Piketty has in mind here. The market process is, in large part, “built” around the diffusion and sharing of knowledge. The market makes possible a division of labor by creating institutions, such as prices, that communicate specific and localized knowledge. It is true that Piketty, in part, is referring to something more specific, like training. I can see a possible, but I think weak, externality argument in reference to general training, but I don’t see it for specific training, which the firm can better internalize. And, when we talk about training workers to use new, specific capital, the type of training that matters is specific.

Moving on,

When the rate of return on capital significantly exceeds the growth rate of the economy (as it did through much of history until the nineteenth century and as is likely to be the case again in the twenty-first century), then it logically follows that inherited wealth grows faster than output and income. People with inherited wealth need save only a portion of their income from capital to see that capital grow more quickly than the economy as a whole. Under such conditions, it is almost inevitable that inherited wealth will dominate wealth amassed from a lifetime’s labor by a wide margin, and the concentration of capital will attain extremely high levels — levels potentially incompatible with the meritocratic values and principles of social justice fundamental to modern democratic societies.

— p. 26.

I have three “brief” comments on the above paragraph,

  1. The most important idea Piketty introduces in this concept of the rate of return on capital, r, exceeding the rate of growth, g. Usually, when free-market economists talk about inequality, they like to make the point that, despite growing inequality, the market raises the absolute real incomes of all members of the division of labor. But, when r > g, the implication seems to be that certain capitalists — Piketty includes under capital things like machinery and financial assets — are gaining at the expense of others. This may be premature, but I wonder if one could relate this to Austrian business cycle theory and asset bubbles.
  2. But, if r exceeding g is a purely market phenomenon, then that should cause us to reconsider Rawls’ Difference Principle, where — if we shed ourselves from social position-contingent biases — we agree that growth and inequality is okay, but only if we maximize the minimum social (income) position.
  3. Piketty refers to the “meritocratic values of democracy.” What does inequality, on its own, have anything to do with meritocracy? In fact, if all agents received their marginal product, and there was still extensive inequality, this would still be a distribution of income based on merit. But, inheritance goes beyond merit — it’s arbitrary. But, it’s just as arbitrary, at least in the context of merit, to claim that inheritance should not be redistributed as it is to argue the other way. What Piketty wants is a just distribution, which is not necessarily consistent with merit.

So far, I am loving Piketty’s book. The above are two paragraphs out of 35 pages worth of introduction. Imagine how provocative, engaging, and puzzling the rest of Capital is.

What I’m Reading

I have the good fortune to be able to attend one of this year’s Liberty Fund symposia, here in San Diego. I attended last year’s, as well, which was on the political thought of Hayek and Keynes. This year’s covers Nozick’s Anarchy, State, and Utopia. So, I am reading that, and there is another book I’d like to read by the end of the month: Rawls’ A Theory of Justice. Somewhere I will have to find the time to read Pinker’s The Better Angels of our Nature, but that is a long-term project. For the next month and a half, or so, economics will have to take a back seat to political science.

Please share what you are currently reading, or what you are planning to read.

New Introductory Econometrics Textbook

My undergrad econometrics professor, Tia Hilmer, and Michael Hilmer have recently come out with the first edition of their new textbook: Practical Econometrics. I used an unpublished version of the book in her class, as well as Jeffrey Wooldridge’s Introductory Econometrics. I think Wooldridge’s book is great, but Hilmer and Hilmer, in my opinion, manage to make the content more engaging and easier to understand. I don’t just mean that it makes it easier for the student to grasp the material; it makes it easier for the student to have a deeper understanding of the basics than they would otherwise.

One great advantage to Wooldridge’s textbook is that it’s great for both an undergraduate and a graduate level econometrics course. But, for undergrads, I much prefer Practical Econometrics. In fact, I still use it as a reference, mostly because the points are made very easy to “get.” I never had Michael Hilmer as a professor — I never took his economics of sports course —, but Tia Hilmer was one of the best teachers I had at San Diego State. The book reflects her teaching abilities: the ability to communicate complicated ideas to students in a way that makes the material intuitive.

If you teach an undergrad econometrics course, you should consider using Practical Econometrics. If you’re interested in teaching yourself econometrics, use Practical Econometrics.

“100 Best Economics Books”

I shared this list on Facebook a few days ago. I commented that this isn’t what my list would look like. There is a “left” bent to the list, but, of course, you’d see the opposite bias in mine.

Disagreements:

  1. Including Marx’s Das Kapital is okay, although it’s on the margin and it would be one of the first magna opera that I’d take off the list. Nevertheless, it was influential in shaping economics — not just Marxian theory, but motivating, in part, the subjectivist revolution of the late 19th century.
  2. Joseph Stiglitz is a great economist who contributed greatly to the science. Still, I don’t think I’d include any of his books in a “100 best” list. His books are entertaining, to be sure. But, they tend to be light on the science and heavy on the bias (see, for example, my review of The Price of Inequality). The best of Stiglitz is found in his academic papers. Most of his books are meant for non-expert audiences.
  3. This is going to be controversial, but I’m not sure if I’d include Hayek on the list. Hayek has been one of my greatest influences, but it’s hard to think of an economics book of his that deserves to be on the list, but has been widely read. The Pure Theory of Capital, for instance, should easily make the list, except that only a handful of people have actually read it. The Road to Serfdom is not an economics book and shouldn’t be on the list. The only economics book that could make the list is Prices and Production.
  4. Books 13–23, 25, 27–30, 32–37, 40–41,…, and many more are either books meant for non-expert audiences, or are “dime a dozen” books that deal with topics that the list’s author probably associates with. I have a feeling that 40–50 percent of the books shouldn’t even be in a “top 1,000” list.
  5. Steve Keen should not be on the list. Debunking Economics is an entertaining book; in retrospect, the opportunity cost of reading it was probably too high, although it’s a sunk cost now. Keen’s book, in any case, has done nothing to contribute to the science. I’m surprised the list doesn’t include Piero Sraffa’s Production of Commodities By Means of Commodities, which is certainly a book that could probably make it to a “100 best” list.

Where are (books that should be on the list, but aren’t):

  1. Eugene von Böhm-Bawerk, Capital and Interest;
  2. Carl Menger, Principles of Economics;
  3. Instead of Eichengreen’s Globalizing Capital, I would have included Golden Fetters;
  4. Milton Friedman and Anna J. Schwartz, A Monetary History of the United States;
  5. Fogel and Engerman, Time on a Cross;
  6. Israel Kirzner, Competition and Entrepreneurship;
  7. Lawrence Klein, The Keynesian Revolution;
  8. Oliver Williamson, The Economic Institutions of Capitalism;
  9. James Buchanan, The Calculus of Consent;
  10. Ludwig von Mises, Human Action;
  11. Ostrom, Governing the Commons;
  12. Card and Krueger, Myth and Measurement (because it represents a change in how economists began to think about the minimum wage).

Those are books that I have in front of me, all of which would come before ~75 percent of the books listed on listmuse. Other books that come to mind: apart from Sraffa’s book, I don’t know Post Keynesian literature well enough to suggest something from that pool. I think the listmuse list has a few Post Keynesian books that I agree would be in a top 100. Also, other books that should make the list: Arrow’s Social Choice and Individual Values; Frank Knight, Risk, Uncertainty, and Profit; von Neumann and Morgenstern, Theory of Games; Douglass North, Structure and Change;… more than I can list. (Would Michael Woodford’s Interest and Prices make it, given how influential he has been during the past decade or so?)

Ironically, as important as these books were in their day, nowadays some wonder whether they’re worth reading at all. I think that, for the most part, they are, although I wouldn’t necessarily say that’s because you’ll learn more from them than from a modern textbook (although, you will learn things textbooks don’t teach). But, who are the economists moderns are turning to today? Keynes, Minsky, Hawtrey, Hayek,… That seems to be reason enough to explore some of their books.

Book Recommendations, 2013

What follows are some books that I’ve read this year and I thought worth recommending.

1. Bruce Caldwell, Hayek’s Challenge: An Intellectual Biography of F.A. Hayek (Chicago: University of Chicago Press, 2003).

I enjoyed this book, in large part because, while I’ve read plenty of Hayek, there’s still a lot of Hayek I have yet to touch. Caldwell gives an excellent overview of much of this work, and develops a common theme: how Hayek viewed economic science and human fallibility. The book, if I remember correctly, does not deeply discuss Hayek’s contributions to economic science, but what it does talk about is incredibly fascinating. Besides, there are a lot of insights that will influence you see economic science, at least if you’re not already intimately familiar with Hayek’s work outside of business cycle theory.

2. Jörg Guido Hülsmann, Mises: The Last Knight of Liberalism (Auburn: Mises Institute, 2007).

This is another biography of a major Austrian economist, but it’s not similar to Caldwell’s book. It’s a more comprehensive biography that focuses, for the most part, on Mises’ life. It also discusses Mises’ contributions to economics, methodology, political science, et cetera — it’s also ca. three times the length of Caldwell’s book. I think the book is less on the mark when it treads outside the immediate area of Mises, but it’s nevertheless a great contribution to history of thought. Obviously, if you don’t care much about Mises, the book may not be much of value to you. But, if you are interested in Mises, his work, and his life then this is a five star, out of five, book.

3. Ronald Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988).

I’m a big fan of Ronald Coase. Before reading this book — a collection of his major academic papers — I had read his “The Nature of the Firm” and “The Problem of Social Cost.” This book gave me an opportunity to re-read those two essays, as well as some of his other work. Coase is an incredible thinker. His research are in areas where, I think, there are increasing returns to research. But, his ideas are so subtle that many people missed them beforehand, and it was Ronald Coase who finally sparked interest in them. The main example are transaction costs, which permeate his writings, and which have influenced a large research program (not just on the firm and on the economics of law, but also on institutions, economic growth, et cetera). This book is definitely a must read for any young economist.

4. Daniel Kahneman, Thinking, Fast and Slow (New York: Farrar, Straus, and Giroux, 2011).

Unlike most of the books listed here, this is an economics book (although, Kahneman has contributed to economics, and many of these contributions are discussed in the book). This is a work in psychology, and it deals with how the human brain thinks. Are we rational, in the sense that we think through the details in every decision we make? No, we’re lazy, and for most decision-making we rely on heuristics that allow us to make quick decisions, which can be right many times, but also wrong on other occasions. We also suffer from various biases, are bad at statistics, and are mostly unaware of just how off the mark we can often be. Many have their reservations about “behavioral economics,” but I invite you to read the book (if you haven’t already). It is definitely one of the most interesting books (top three) I’ve read this year.

5. Peter T. Leeson, The Invisible Hook (Princeton: Princeton University Press, 2009), and Douglas W. Allen, The Institutional Revolution (Chicago: University of Chicago Press, 2012).

I put these two books together, because while they’re not entirely the same, they are very similar. Both look at pre-modern institutions. Leeson’s The Invisible Hook discusses pirates, specifically the various institutions that came to define the piracy of that age: democracy on their ships, why they carried pirate flags, their treatment of captives, et cetera. Allen takes the same route, but as a means of explaining a different set of institutions: those of pre-modern England (the aristocracy, the Royal Navy, the army, et cetera). I review The Institutional Revolution here. Both books are incredibly entertaining. They’re also on a subject that I think isn’t explored often enough: the application of institutional theory to economic history.

6. James Buchanan and Gordon Tullock, The Calculus of Consent (Indianapolis: Liberty Fund, ).

My cousin, an economics major at San Diego State, asked me, about two weeks ago, if he could borrow a book of mine. I recommended and gave him Buchanan and Tullock’s The Calculus of Consent. I don’t know who I’ve mentioned more on this blog over the past year: Coase or Buchanan. To say that The Calculus of Consent has influenced my way of thinking is an understatement. In fact, the final nail in the coffin of my advocacy of anarcho-capitalism was this very book. The book deals with the various costs that political institutions have to minimize, and how these develop to provide Pareto optimal improvements by decreasing the costs of and the costs to decision-making. Buchanan’s and Tullock’s book has also influenced my views on how political institutions can act as supplements to those of the market in resource allocation.

7. Israel Kirzner, Competition and Entrepreneurship (Indianapolis: Liberty Fund, 2013 [1973]).

The most common answer to “how do markets coordinate” are prices. Basic allocational models show this logic. Agents allocate their budget in accordance with market prices, and optimal resource allocation requires optimal pricing. Kirzner’s story is a bit different. For Kirzner, the coordinator is the entrepreneur, since it’s only by entrepreneurial action that we can gradually come to learn what the optimal allocations are. Thus, he makes a distinction between the “Robbinsian maximizing” of the pure logic of choice and entrepreneurship. From this perspective, broader Austrian price theory stands in contrast to what you learn in a microeconomics course. What matters is entrepreneurship, and profit and loss (the ex post, rather than ex ante, role of prices) act as disciplining mechanisms for this process of discovery. This is another must read for any young economist.

8. Lincoln Paine, The Sea and Civilization (New York: Alfred A. Knopf, 2013).

This is not an economics book, and I actually just read it recently. It’s a history book that focuses on maritime history. While I’m not as interested in the military history it covers, it does provide a great deal of coverage on commercial maritime history. I think a book that deals specifically with pre-modern commercial maritime history (or applied economics) would be even more interesting, but in lieu of something like that I recommend Paine’s The Sea and Civilization. If nothing else, it’s very entertaining to read.

9. Gerald P. O’Driscroll and Mario J. Rizzo, The Economics of Time and Ignorance (London: Routledge, 1996 [1985]).

This book is well known and is already widely recommended. While I want to avoid talking the book down, I don’t think it was up to the standards that were set by how the book was described to me. But, we have to consider the fact that a lot of the themes discussed by the authors are still vibrantly discussed in the current Austrian community. It is still a very good book, and I recommend it to anybody interested in Austrian economics. Some of the more unique topic it covers are the concept of pattern coordination, competition and discovery (related to Kirzner’s book), uncertainty, and it offers a theory of monopoly. This is a book that I will definately find myself re-reading either in this next year or the one after that. It’s packed with a lot of information, and it covers the Austrian research program up to 1985 (the book was also re-published in 1996).

______

What are some books I wished I would have gotten to? R.W. Clower (ed.), Monetary Theory; Israel Kirzner, Essays on Capital and Interest;  Fred Foldvary, Public Goods and Private Communities; Oliver Williamson, The Economic Institutions of Capitalism; Donald Wittman, The Myth of Democratic Failure;…and dozens of others.

Comment on Smith’s Critique of Why Nations Fail

Nathan Smith (via Bryan Caplan and Ryan Murphy) describes Daron Acemoglu’s and James Robinson’s Why Nations Fail as “one of the most over-rated books [he] has ever read.” I first read the book in the summer of 2012, so over a year has elapsed since then. I remember that there were parts of it I disliked. However, I don’t think Smith is being entirely fair in his critique.

Summing up Smith’s three main complaints,

  1. There is a lack of rigor (no formal theory or econometric evidence);
  2. Acemoglu and Robinson present a naïve view of democracy;
  3. The “inclusive” and “exclusive” terminology is “bizarre” (e.g. property rights are considered to be part of an inclusive set of institutions, but they’re actually designed to exclude).

Starting with (3), I think it’s best to interpret Why Nations Fail through a Buchananite (? Buchananian?) lens. When Acemoglu and Robinson refer to institutions, I have the feeling that they’re specifically thinking about political institutions — as opposed to things like property rights, the price system, et cetera. An inclusive institution, in this constricted context, is essentially synonymous with a pluralist institution. In public choice theory terms, inclusive institutions are those which approach unanimity at the constitutional level (and maybe also the decision-making level). This is what the authors most likely mean when they define inclusive and exclusive institutions in terms of the distribution of power.

Before discussing (2), I think we should quickly address (1). Why Nations Fail is not a scholarly book; it was not written for an academic audience. Rather, the book is intended to present the authors’ academic research to a non-expert audience. Looking at the authors’ academic work, there is an obvious difference in approach: the bulk of book is made up of historical illustrations of the authors’ main points, which are watered down versions of what they already presented to the scientific community. The academic piece that comes closest to the scope of the book is “Institutions as the Fundamental Cause of Long-Run Growth” (ungated), co-authored between Robinson, Acemoglu, and Simon Johnson. Other academic work that goes beyond the simple model presented in Why Nations Fail, includes: “Why Do Voters Dismantle Checks and Balances” (co-authored with Ragnar Torvik); “Why Not a Political Coase Theorem?” (ungated; a much simplified outline of the argument here); and (relevant to the authors’ discussion of political centralization) “The Monopoly on Violence: Evidence from Colombia” (ungated), co-authored with Rafael Santos. It’s also worth mentioning Acemoglu’s textbook, “An Introduction to Modern Economic Growth,” where the last 50 pages or so (not counting the appendixes and index) develop a mathematical model of institutions and growth. If we’re going to judge Acemoglu’s and Robinson’s contributions to growth theory (Smith calls Acemoglu “a disaster to the field”), we should look at their academic work, not at a book designed to popularize what otherwise would be unintelligible to the general public.

Smith might be right that Acemoglu and Robinson present a naïve theory of democracy in their book, but the value of the model has to be interpreted within the context of the objective of the book. It’s hard to think of relatively pluralistic political institutions that differ from democracy (which, I think, takes on a more general definition that includes representative rule), because society hasn’t experienced them yet. They do hint — although, perhaps, never explicitly tie together — towards several nuances which inform the readers’ understanding of what makes one set of political institutions more inclusive than another (which seem to support the interpretation I laid out above, when addressing point (3)). Take, for example, their discussion of the origins of Mexico’s and the United States’ respective constitutions (pp. 28–32 [all pages refer to the 2012 hardback edition]). Not only do they distinguish between the degree of unanimity at the constitutional-level, but they also compare the northern U.S. states with their southern counterparts. Democracy is a class of institutional sets, but the specific elements are relevant to the comparative success of one set over another. Consider also their reference to political instability in Latin America, despite democracy (pp. 37–38).

Consider the following,

Political institutions include but are not limited to written constitutions and to whether the society is a democracy. They include the power and capacity of the state to regulate and govern society. It is also necessary to consider more broadly the factors that determine how political power is distributed in society, particularly the ability of different groups to act collective to pursue their objectives or to stop other people from pursuing theirs (pp. 42–43).

Smith makes it seem as if Acemoglu and Robinson hold democracy as the ultimate standard of political institutions that induce (or, do not restrain) economic growth. But, in reality the authors’ argument is much more nuanced than that. Another example that contradicts Smith’s summation of their position is the reference to Syngman Rhee and Park Chung-Hee, who were autocratic rulers of South Korea (pp. 71–72). The authors mention the superior rate of growth, as compared to North Korea, despite both countries being autocracies.

The causal relationship between democracy and growth, however, is not clear, as Smith points out. He links to Robert Barro’s “Democracy and Growth.” The paper suggests that higher standards of living may lead to democracy, rather than the other way around. But, democracies don’t arise suddenly, being products of a spontaneous development of political institutions that often originate at the local level. It may be that a certain income level has to be attained to support a modern democracy, but this doesn’t mean that gradual changes in political institutions — that make them more inclusive — don’t positively affect standards of living. My guess is that the two phenomena are mutually reinforcing. Barro also argues that democratization, at some point, seems to have diminishing returns. (I’d say that widening the scope of collective action suffers from diminishing returns.)  This is consistent with the findings in the paper that Ryan Murphy cites.

Why Nations Fail does not discuss these problems. Here Smith is right. There is no discussion of knowledge problems that impact democratic decision-making. Neither is there an in-depth discussion of the advantages of smaller pluralistic governments versus larger ones, or the interaction of political institutions that make up a Federalist system. This was one of the problems I had with the book, specifically with the authors’ reference to “centralization.” They argue that centralization positively impacts growth. My understanding is that they’re comparing a state that governs over a territory with competing states (or governments) that violently compete for territory — in other words, territorial consolidation. But, this doesn’t really speak to the decision-making decentralization that characterizes most successful democracies. Neither does it consider that the optimal (territorial) size of nations may be a dynamic function.

However, I don’t think it’s fair to criticize Acemoglu’s and Robinson’s position on democracy by pointing to the public choice literature. Problems that weaken democratic decision-making may also be relevant when looking at autocratic decision-making. Similarly, while there are problems with democracy that may not exist in autocracies, there are problems with the latter that aren’t relevant to the former. The public choice literature, some of which is still in dispute (e.g. rational ignorance), does not say that monarchies, dictatorships, or other forms of past governance are superior, or equal, in economic performance to democracies. Neither do I think that Acemoglu and Robinson would deny that modern democratic institutions are improvable.

Finally, consider that the authors’ main argument is to explain the difference in national income between modern nations. It may be that the wealthier countries may need to develop new, more inclusive, more constraining institutions to improve their own standard of living after a certain point (or to breakthrough some growth rate threshold), but the typical undeveloped country has yet to transition from relatively exclusive governance to pluralistic, and institutionally-strong, democracy. Thus, their pro-democracy message, understood within a proper context, shouldn’t be as controversial as Smith makes it out to be.

Is Why Nations Fail overrated? Maybe; it depends on what the average sentiment is. If the average person thinks it’s the best resource on economic growth, then, yes, it’s overrated. Someone looking for rigorous theory and empirical evidence is better off looking at the authors’ academic work. But, it’s still a very good book. If you are a non-expert, it serves as a good overview of the authors’ research in the field. Is the book perfect? No. There is a lot missing. For instance, the authors consider institutions the fundamental cause of long-run growth, but they deal almost exclusively with political institutions. There is no discussion of economic institutions that have, at best, an indirect relationship with their political counterparts. But, I don’t think that the criteria Nathan Smith mention are good ones to judge the book by.

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.

Introductory Economics Books

Isaac Morehouse lists his five favorite introductory economics books. The only book on the list that I’ve read is Mises’ Human Action, and I would say that it’s on my top five, as well. I’m surprised Henry Hazlitt’s Economics in One Lesson isn’t mentioned, although I suppose that he and Bastiat are somewhat interchangeable. Hazlitt was my first economics book, and right after I, prematurely, dove into Jesus Huerta de Soto’s Money, Bank Credit, and Economic Cycles (because he’s Spanish, and I thought it was cool that a Spanish author had written a major treatise in Austrian economics). By the way, I don’t recommend Huerta de Soto’s book. You would get more out of a substitute, like Man, Economy, and State — and the latter isn’t riddled with errors (edit: maybe I’m being too hard on Huerta de Soto’s book; it’s been four or so years since I read it).

But, if you’re seriously interested in getting into economics I would look into buying a good introductory, and then intermediate, textbook on microeconomics. Yes, these books present economics as a set of abstract models, but these models are pedagogical tools meant to start getting you to think like an economist. Think of them as analogies, or parables, that you can apply to economic problems. Once you have an introduction to microeconomics, and you prefer to stay within a certain group of authors, you can study books like David Friedman’s Price Theory (he has a free version on his website) or Israel Kirzner’s Market Theory and the Price System. I used Pindyck’s and Rubinfeld’s Microeconomics in my undergraduate intermediate microeconomics class, and I think it’s pretty good. You might also enjoy a textbook on economics and law. I used Cooter and Ulen’s Law and Economics, but there’s also David Friedman’s Law’s Order (free version here). Learning how economics is applied to law is another great way of learning how to think like an economist.

What I like about textbooks is that they present the information in a way that makes it more accessible than other types of books. They give it to you straight, without fluff and background, and they offer the information in two ways — graphics and text —,for different kinds of learners. And don’t worry, most introductory and intermediate textbooks don’t use much math. I wouldn’t say that I learned the most economics from textbooks (except, most of what I know of trade theory is through Krugman’s textbook), but I would say that all the basic courses I took helped me to better understand what I was reading outside of class. So, while textbooks certainly wouldn’t make my list of “favorite” books, they would make my list of indispensable books.