Category Archives: Economics

Healthcare Expectations

Krugman interprets evidence to show how Obamacare has been a success and has not been the job-killers Republicans said it would be. I have two three questions on his second piece of evidence,

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  1. This series isn’t seasonally adjusted is it? So, it shows a growth in employment leading up to December and then a large drop in employment. And now employment is growing again as we approach summer. So, does this graph really say anything useful at all?
  2. An economist might suspect that the disemployment effect would actually materialize sooner, because surely businesses were expecting Obamacare to roll out before it actually did. Krugman knows this, but he’s still going for the weak version of the argument. Why?
  3. What if, rather than unemployment, Obamacare reduced the rate of employment growth?

The Historical Contingency of Rules and the Immutability of Economic Laws

In a lengthy online discussion on my post on the role of the division of labor within the economics profession, I saw someone make the argument that the historical contingency of rules disproves the immutability economic laws. While I don’t have an argument as to why economic laws are or aren’t timeless, I can say that the historical contingency of rules has nothing to do with the immutability of laws, because institutions and economic laws are not the same thing.

First, an overview of what institutions are. Institutions can be defined as ‘the rules of the game.’ These are constraints on our ability to choose, because we conform to, or follow, them. These rules are important, because they help us overcome ‘inconveniences,’ or aspects of the world that hold us back. For example, the Royal Navy implemented a rule requiring their naval commanders to attack the foe on contact, because prior to the 19th century, it was difficult for them to monitor their officers’ when these were at sea. This rule was enforced by ordering different logs to be kept by different people, often with opposed interests. These logs could be inspected when the ship arrived to port, and captains found avoiding their responsibilities were punished. The Royal Navy had altered the rules of the game to improve its ability to coordinate with its assets at sea.

Another example of an institution are the various methods salespersons use to build a reputation. Certain markets are burdened by the fact that buyers find it difficult to distinguish between similar goods of different quality. Taking advantage of an asymmetry in information, some sellers will put their worse quality goods on the market, because they know buyers have difficulty in telling between different qualities. You might buy a 2002 Honda Civic on Craigslist thinking it runs fine, only for the engine to die two months later (actually, it happened to a friend — although his was one of those Oldsmobile 88s). Consumers eventually learn, lower their expectations of the quality of the average car, which is analogous to shifting the demand curve to the left. This lowers prices, and the process can continue until the market implodes.

It pays sellers within certain industries to distinguish between each other, and especially to build a reputation for trustworthiness. While the used car market still most certainly sucks, nowadays we have things like CARFAX and many sellers are willing to have your mechanic look at the car (although, not all of them — the ones looking to rip you off definitely aren’t, thus the purpose of signalling). Reputation spreads by word-of-mouth, and many customers have preferred sellers whom can be trusted. By changing the rules of the game, markets can often get around obstacles, helping agents coordinate between each other (such as buyers and sellers of used cars).

Many, if not all, institutions, or rules, are historically contingent. The impediments to monitoring naval warfare changed between centuries. Direct and immediate communication made certain rules obsolete. New limitations may require new rules. The anti-ship missile was invented in the middle of the 20th century, and it required a change in world navies’ rules. Fleets had to fight in a different way to win.

The historical contingency argument is not saying that the rules work differently depending on what period of time we’re in, it’s claiming that the relevance of rules changes. ‘Slavery is legal/illegal’ meant the same thing to Hammurabi as it does to you. It’s just that ‘slavery is legal’ was, thank goodness, replaced with ‘slavery is illegal.’ The implication is that the rules’ causal mechanisms are immutable.

How do rules differ from ‘economic laws’? Let’s assume, for the sake of argument, that there are such things as economic laws. One such law could be that of time preference: people prefer X now rather than later, unless they’re compensated. Suppose minimum required compensation is Y, and there is a natural rate of interest equal to (X+Y)/X. This hypothetical law also states that if real world markets have their interest below the natural rate, they will eventually suffer from mass business failure. If the market rate is above the natural rate, there are unused savings. Either way, the result is discoordination. That’s the law.

But, what use is that law to anyone, really? How do we know what the natural rate is? A perfectly coordinated market would have an equilibrium rate of interest (or equilibrium rates, if also considering differences in liquidity). But, markets are not perfectly coordinated. Assets are often overpriced. Ask someone who bought a home before 2007. Other asset are undervalued. There are people who make profits buying undervalued stock. Our estimates of the value of different goods/assets are always off, because society suffers from a knowledge problem. Humans act on imperfect and asymmetric knowledge, and this causes discoordination. Early cavemen may prefer to kill one another, because each one isn’t sure whether the other guy is friendly. We have to develop rules to overcome this limitation.

Humans develop rules that can be followed to gain trust. This makes cooperation attractive, because we can be sure that others will actually cooperate. Much like how the Royal Navy developed rules to work around a knowledge problem of its own, not being able to actually directly control (or track) its assets on the seas. Principal–Agent problems are knowledge problems, and we develop rules to help us get around them. Even if there are immutable laws, historically contingent rules are still absolutely necessary, because these immutable laws don’t speak to humankind’s limited knowledge on how the world works.

What matters most is that saying ‘rules are historically contingent’ is not the same thing as saying that ‘the same rule works differently depending on the year.’ Rules are necessary because our understanding of the world is imperfect, and they help us coordinate despite our cognitive limitations. Rules are historically contingent, because the state of our knowledge is always changing.

Instrumentally Rational People Will Not Follow Social Rules

Instrumentalists such as Gauthier tried to show that the best way to achieve our ends is to reason ourelves into being the sorts of instrumental reasoners who do not reason about the best way to achieve our ends. Although I have shown why this project comes to naught, the core idea needs to be explored: rule-based, cooperative, reasoning is best for us, and it tells us not to always decide on the grounds what is best for us. As Brian Skyrms has demonstrated so well, although rationality cannot explain this uniquely human characteristic, an evolutionary account can do so. Rationality, we have seen, must be a respecter of modularity and dominance reasoning, but evolution is not. Evolution can select strategy T on the grounds that those employing T outperform those who do not employ T in terms of who well they achieve their goals and yet T constitutes an instruction to those employing it not to perform some acts that would achieve their goals. The important lesson that Skyrms has taught us is that evolutionary selection can do for us what our reason cannot.

— Gerald Gaus, The Order of Public Reason (Cambridge: Cambridge University Press, 2011), pp. 104–105.

The Skyrms book Gaus is citing is Evolution of the Social Contract.

Note that Gaus writes that “rule-based, cooperative, reasoning” is a “uniquely human characteristic.” I think he’s mentioned that another time since the above excerpt, except he admits that there may be a few other animals who also evolve social rules. Actually, most animals probably follow social rules, and we’re just not aware of them.

A few months ago, I went to the La Brea Tar Pits, in Los Angeles. There is an underground field of asphaltum, which seeps up through the ground. You can see small puddles of this stuff at the La Brea museum, as it bubbles and evaporates into the air. This has been happening for tens of thousands of years. The museum collects fossils from animals who were trapped in these puddles, or small lakes, of liquid petroleum. The theory is that animals lower on the pecking order would get stuck in the tar, attracting predators. These, in turn, would rush into these tar pits, and get stuck themselves — the heavier the animal is, the more difficult it is to get out.

The museum has quite a few saber-toothed cats,* including a full skeleton on display. I took a guided tour, and when we got to display the guide starting discussing several social welfare instincts groups of these cats would have. I had actually made a comment, in passing, to someone who came with me on the tour about how injured animals must have lived horribly, because they most likely died. Not so, apparently. The guide told us that saber-toothed cats would tend to their wounded, sharing their hunted food with them, and caring for them.

Why would a predator which survives on strength and agility to hunt for its prey care for weak links? Doesn’t that bring down the group as a whole? Well, injuries happened fairly often. She, the tour guide, told us about an injury to the cat’s spine, because they would jump on the backs of larger prey and these would shake violently — this was common. Prey often fought back. And, a dead cat is worth less to your group than an injured cat, especially if you can nurse the latter back to full health. No doubt, groups that could maintain a full strength membership survived over those which allowed their members to gradually die off. Thus, saber-toothed cats adopted evolutionary social rules, just like humans do.

What I wonder is if some saber-toothed cats were frustrated that their hard earned income was being re-distributed to what they saw as a bunch of lazy cats who just didn’t want to work.

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* My memory isn’t 100 percent, so if the animal I have in mind isn’t the saber-toothed cat it’s okay, because the important part of this post is the general point being made.

Perverse Incentive of Armament Procurement?

There are internal economies of scale when average unit costs fall as production increases. One reason this might happen is because it might allow the firm’s workforce to specialize further, increasing their productivity. Businesses with high fixed costs, like research, development, and testing, are also typically enjoy returns to scale. Industries with internal returns to scale are characterized by relatively few and large firms. The armaments industry — e.g. Lockheed Martin, General Dynamics, Northrop Grumman, BAE, Raytheon, et cetera — is one such industry.

The single largest consumer of weapons, especially military-grade arms and vehicles, are national governments. Only select countries, for example, are allowed to field M1 Abrams tanks. Like a good deal of government projects, armament development programs are typically very expensive, and suffer excessive overruns. The F-35 is approximately $160 million over budget. The RAH-66 Commanche consumed $6.9 billion before being canceled. The V-22 Osprey ended up costing 2068% more than originally projected. Yea, military procurement is extremely inefficient. (Actually, for a scientific look into the relationship between the U.S. government and weapons manufacturers, see Arms, Politics, and the Economy, edited by Robert Higgs.)

Longer periods of research and development, more prototypes, testing, and other pre-production steps mean higher fixed costs. Internal economies of scale not only mean that more production will lower average cost per unit, but it also means greater profits for the firm — that high fixed cost is spread over a greater number of units of output. As long as marginal costs are below average costs, there is a strong incentive to keep producing.

For a firm looking to sell their weapon system to the U.S. government, they have to persuade the latter to buy it. If selling more equates with making a higher profit, there will be some amount of money the company will be willing to spend on lobbying. The greater the amount of output necessary to reach “minimum efficient scale” (where average costs are lowest — at some point, marginal costs will pass long-run average cost, and the latter will begin to increase again), the more sales the firm will want to persuade the government to make. The higher the fixed costs, which include budget overruns, the more the contractor will want to sell, the more it will lobby.

Cost overruns are a good signal for waste. When waste attracts more waste, which in this case is buying more military equipment, we call this a perverse incentive. Is the process I sketch out here one such way this manifest itself in the real world?

When is Transitivity Wrong?

Transitivity of preferences is an important assumption in the ‘orthodox’ theory of rational choice. Your preferences fulfill the assumption if you, for example, prefer x to y, y to z, and therefore x to z. Who wouldn’t have transitive preferences?

Failure to recognize relations of transitivity is characteristic of schizophrenics; those disposed to blatantly ignore transitivity are unintelligible to us; we cannot understand their pattern of actions as sensible ways to promote their values.

— Gerald Gaus, The Order of Public Reason (Cambridge: Cambridge University Press, 2011), p. 70.

Quote of the Week

But often rent seeking involves a real waste of resources that lowers the country’s productivity and well-being. It distorts resource allocations and makes the economy weaker. A byproduct of efforts directed toward getting a larger share of the pie is shrinkage of the pie.

— Joseph E. Stiglitz, The Price of Inequality: How Today’s Divided Society Endangers Our Future (New York: Norton, 2012), p. 95.

Of course, it works both ways. Many programs that aim to increase the share of the pie accruing to labor will shrink the total size. But, I doubt that’s what Stiglitz had in mind.

Cartels Against Legalization

Mary O’Hara reports,

“Is it hurting the cartels? Yes. The cartels are criminal organizations that were making as much as 35-40 percent of their income from marijuana,” Nelson said, “They aren’t able to move as much cannabis inside the US now.”

In 2012, a study by the Mexican Competitiveness Institute found that US state legalization would cut into cartel business and take over about 30 percent of their market.

Former DEA senior intelligence specialist Sean Dunagan told VICE News that, although it’s too early to verify the numbers: “Anything to establish a regulated legal market will necessarily cut into those profits. And it won’t be a viable business for the Mexican cartels — the same way bootleggers disappeared after prohibition fell.”

Read the rest of the article. O’Hara makes a good case, implicitly and explicitly, that the DEA’s anti-marijuana policy is not only wrong, but dangerous, and favors the cartels (whether intentionally or unintentionally).

Sound Money

What is “sound money?” The simple answer: a monetary system that best promotes coordination between market agents. Every economist advocates “sound money;” the disagreement is over what exactly constitutes a good monetary system. This is where the issue becomes much more difficult, because we enter the realm of monetary institutions. But, there are some who want you to believe that the problem is much simpler than it actually is. Some of these people are the same who advocate a return to a commodity money (e.g. gold, silver,…).

Will a return to commodity money end the business cycle? Would it end inflation? We can point to the period of U.S. history between, roughly, 1879–1893, and try to answer in the affirmative. After all, that was a period of strong growth and slight deflation (although, there were recurring banking crises). On the other hand, we could just as easily look at just about every other period of history and answer ‘no.’ The European “price revolution” (~1500–1650), for example, is thought to be caused by the large inflow of New World gold and silver. Likewise, it was common for monarchs to debase their currency, whether via clipping, or by replacing valuable content with less valuable metals. So, no, reverting back to commodities will not necessarily make our monetary system any more stable.

What makes, say, gold attractive as money, anyways? It has certain physical characteristics: it is physically scarce (relatively costly to produce), it is durable, and it is divisible, amongst other possible traits. Why do these characteristics matter? Because they help determine the rules that constrain the monetary system.

Suppose we are looking at two isolated societies, each with their own monetary standards. These systems are exactly the same, except for what they are using as money: one uses gold, the other bushels of wheat. We expect the former to outlive the latter. Why? First, wheat is relatively easy to grow, so it does not have that same production constraint as gold — the value of wheat, as money, is easy to drive towards zero. Two, wheat is not as durable. It can be stored, and modern storage methods have allowed us to keep it around for longer, but it doesn’t have the same durability as gold. If the value of wheat is low enough, it would also take a lot of it to buy certain products. These are all factors that determine the rules of the game, or monetary institutions.

What really makes one monetary system better than another, then, are the institutions that constrain it. This should re-frame the terms of the debate, because now we know that what really matters are these rules. And, we can’t just look at some rules over others; we have to consider these institutions in their totality, and how they interact. For example, if the currency is in some way controlled by an extractive government, even if this currency is gold, we can expect a sub-optimal monetary system. Yes, even with commodity money, certain institutions can ruin the game, so to speak.

Another bad rule that could fit with a gold standard — or commodity money, more generally — is full reserve banking. Forcing banks to keep gold in their vaults that they would otherwise somehow get rid of is sub-optimal; that society is forgoing a better use of that gold. Similarly, by constraining a banking system’s ability to expand their liabilities when the demand for money increases, we forgo the opportunity of inter-mediating between a certain group of savers and a certain group of spenders (whether investors or through consumer credit). Finally, a banking system that cannot respond to changes in the demand for money will cause macroeconomic instability.

Despite all the benefits to using certain commodities as money, these benefits alone do not guarantee that they will be “sound money.” You also need good man-made institutions, or additional rules that constrain the monetary system. These rules evolve over time, and in different directions.

One direction is central banking. The Federal Reserve arose to re-write some of the rules that constrain the banking system. Primarily, it serves as the most important clearinghouse, with the ability to expand and contract its liabilities to service its member banks. During times of crisis, a central bank also acts a lender of last resort — a role private clearinghouses also fulfilled. Those who believe that, without a central bank, an economy can be stuck in monetary disequilibrium for long periods of time also advocate for central banking, because it allows for an elastic money supply even in the worst macroeconomic conditions. Of course, central banks — and their rules — evolve over time. One example of this is the general preference for independent central banks, because this weakens the ability of the few to manipulate the money supply at the expense of the many.

Another direction is “free banking,” which refers to financial institutions that arise through a decentralized process of change. This is not all theory; we have seen episodes that come fairly close to completely free banking. This monetary system is still regulated — it is still constrained by rules —, but these rules arise through a decentralized process. Competing systems might have competing rules, and good rules replace bad rules through, for instance, profit and loss. More concretely, if clearinghouses develop sets of rules that they enforce over member banks, separate clearinghouses and their bank networks will compete against each other. Good rules promote a healthier industry, which usually means greater gains, at least over some period of time (a bank that commits fraud might make a high profit at first, but they will certainly lose customers as people catch on). Bad rules promote losses, creating an incentive to replace bad with good.

What’s important here is that what improves the monetary system are rules. Some of these are innate to the type of money being used. But, these institutions might not be strong enough as the market becomes more complex, money is inter-mediated, the pricing process becomes more complicated, et cetera. This is why man-made monetary institutions are ubiquitous: they are experiments to improve monetary systems. In other words, the quest for  “sound money” is really a process of developing sound monetary institutions.

Where does this leave commodity money? Many free bankers do advocate commodity money, along with inside money of a form dictated by the market — classically, we usually think of paper money when we think of “inside money,” but it could just as well be “e-money.” But, we should be open to the idea that maybe commodity money is no longer optimal, because of the other institutions that regulate the monetary system. It could very well be that a modern banking system would prefer alternative safe assets as “outside money,” and that gold is antiquated. In any case, when answering “what is sound money,” gold, or silver, or commodity money are not right answers — what matters are institutions, and monetary rules have developed since the 19th century, so returning to a 19th century monetary system is retrogressive.

Peter Lim, Not the ‘Jeque’ Valencia is Looking For

When I say Valencia, I mean the fans — the club no doubt has more informed expectations.

Peter Lim has completed the buy-out of Valencia C.F., made necessary by the club’s €275 million debt and low income stream. The Singaporean will invest €100 million, probably to reduce the club’s debt with Bankia (that Spanish bank that asked for the largest bailout in the history of Spain — their reported 2012 losses were €19 billion, as well; the largest corporate loss in Spanish history). Being one of the top 40 wealthiest people in the world, many Valencia fans are celebrating his arrival as ushering a new era of millionaire spending.

Maybe, not as many millions as you might think. Spending is now regulated by UEFA Financial Fair Play rules, and UEFA is serious about enforcing these rules: the proof is in the $82 million fine they slapped on Manchester City and Paris Saint Germain. Fair Play rules are designed to force smaller clubs to draw down their debts, by eliminating the incentive. Smaller clubs, which earn smaller revenues, have to lever their spending if they want to compete with larger teams, and especially teams taken over by wealthy men, who then allocate massive cash gifts to the club — e.g. Manchester City, Paris Saint Germain, Chelsea, et cetera. Now, your spending is determined by your revenue.

Valencia’s 2012/13 budget was €103 million, reduced from the previous year. This includes a very large wage bill — which, unfortunately, tends to increase over the years if you want to keep the same backbone (because good players have the market power to get the raises the want). Lim has promised to inject €60 million (additional to the other €100 million) for transfers. But, over the years, Valencia fans should expect a pretty standard transfer strategy, because the rules simply no longer allow for indiscriminate spending by very wealthy moguls. (And, it’s a good thing, too — because either the league would become incredibly uncompetitive, or the majority of the clubs would have had to declare bankruptcy.)

This being said, if Valencia can reduce their debt through Lim, they might very well have the third largest transfer budget in Spain next year. Atlético Madrid has the third highest revenue, after Real Madrid and Barcelona (although, a good ~€400/yr. million less), but it also has one of the largest debts in Spain (over €500 million, I believe). I predict that our transfer budget, on net, will be just about €0, which is what it has been these past few years (we’ve actually made a net return, on transfers, these past two or three years — after many years of spending more than what we earned). Although, I don’t think we’re going to sell any of our big ticket players this year — there is still ambiguity surrounding Diego Costa’s €40 million move to Chelsea.

However, the last time a mogul bought a team in Spain — Malaga C.F. — it did not turn out too well. After two decent seasons: fourth place finish in 2011/12, and then quarter-finals in the Champions League the following year. Then, the club was forced to let go of most of their better players, and is now lingering in the middle of the table. Valencia will hope that their experiment will turn out differently, and I think that will require a tamer transfer strategy. So, I do not expect Valencia spending on par with the Manchesters, Chelsea, Real Madrid, Barcelona, et cetera, simply because they don’t make nearly enough revenue.

Football is on mind mind, because in about half an hour Atlético Madrid and Barcelona will play in Camp Nou, and the winner will take La Liga (Atlético would also win the title with a draw). Next weekend, Atlético play Real Madrid in the UEFA Champions League final. So, I’m excited, although there’s the unfortunate (and nerve-racking) possibility that we might end the season title-less.

Inequality and the Rentier State

Thomas Piketty distinguishes between “hyperpatrimonial” and “hypermeritocratic” societies. The latter is a society where relatively high inequality is caused by wage differentials. In contrast, a hyperpatrimonial society is one in which relatively high inequality is caused by differences in capital ownership. Piketty’s data shows that hyperpatrimonial countries were common prior to 1914, while hypermeritocracies are modern. This reminds me of Douglas Allen’s The Institutional Revolution (my review here). In that book, Allen argues that “pre-modern” English bureaucrats accumulated large stocks of low-return capital as a way of posting collateral against their privilege as bureaucrats.

While Piketty mentions “civil servants” as being in the top income decile, and more-or-less surviving the Great Depression comfortably, one wonders how their relative status changed over time. Between the mid-19th and early 20th centuries, there was a transition from an aristocratic bureaucracy to a merit-based bureaucracy. What made this change possible was the introduction of new technologies, such as watches, that made employee-monitoring more accurate and less expensive. In other words, trust started mattering less, because it became easier to track who was pulling their weight and who was not.

Why did trust matter more when monitoring efficiency was more difficult? Those who head government want their employees to fulfill a certain role. When monitoring is difficult and expensive, employees have more leeway — it’s easier for them to do something other than their official function. Thus, trust has to be established between the aristocrat and the government he or she is serving.

To signal trust, a prospective aristocrat needed capital to post as collateral. This capital was often in the form of large country homes, with sprawling gardens. It was low-return, and apparently low social value. In other words, apart from being what was needed to become an aristocrat, these types of investments were largely worthless. If a bureaucrat was seen to veer away from his proper function, he could be “fired” and this would mean something, because he would now be short a salary that accrues from his past position, and his wealth was mostly low return real estate. For an aristocrat, being “fired” was a lowering of status, and that was also reflected in a further shock to that person’s capital: aristocrats hold large social gatherings on their property, fired aristocrats don’t.

There were auxiliary rules that limited what aristocrats could do with their capital. There were, for example, inheritance laws, where the bureaucrat would leave the capital he posted as collateral against his position to a single family member, typically the eldest son. While in 1614 common law courts made it illegal to enforce perpetual restrictions on property rights, aristocrats would voluntary accept “temporary” (in practice, permanent) restrictions. These constraints guaranteed that a large chunk of a family’s wealth would be tied up, as they were unable to do anything with it other than pass it on to the heir.

Because of the cost of being an aristocrat — the cost of collateral —, “private investment” on their part was discouraged. They were also discouraged to make contacts outside the aristocracy. The rules were set up to sever opportunities for alternative income sources. To attract possible aristocrats/bureaucrats, then, government had to offer a competitive salary. They did this by paying a wage for a position an aristocrat held. Government incomes, those days, were relatively high. Allen writes, “prior to the eighteenth century, being wealthy and being a member of the aristocracy were almost synonymous. That is, the gross rate of return to the aristocracy was greater than to the merchant market for the average wealthy individual” (p. 72). The loss of government income was a big deal, and it disincentivized veering from one’s proper role in their position.

Piketty suggests that high inequality can be politically destabilizing. In the case of pre-modern England, inequality, in part, actually had the exact opposite effect. The rules of the game of the time called for a class of wealthy people, who invested their wealth into assets that signaled intentions of loyalty to the government. If it had been otherwise, there would have been no rules to help maintain some degree of efficiency in government organizations. In that sense, some inequality in pre-modern England was stabilizing — it improved social outcomes.