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The Library of Economics and Liberty carries the podcast EconTalk, hosted by Russ Roberts. The weekly talk show features one-on-one discussions with an eclectic mix of authors, professors, Nobel laureates, entrepreneurs, leaders of charities and businesses, and people on the street. The emphases are on using topical books and the news to illustrate economic principles. Exploring how economics emerges in practice is a primary theme.

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Recent Posts

Here are the 10 latest posts from EconLog.

EconLog July 11, 2020

Progressivism goes off the rails

Here’s Tyler Cowen:

But what struck me most of all was how much the “Old New Left” — whatever you think of it — had more metaphysical and ethical and aesthetic imagination — than the New New Left variants running around today.

Bob Dylan wrote My Back Pages at age 23.  Here are a few stanzas:

Half-wracked prejudice leaped forth “Rip down all hate,” I screamed Lies that life is black and white Spoke from my skull. I dreamed Romantic facts of musketeers Foundationed deep, somehow Ah, but I was so much older then I’m younger than that now

. . .

A self-ordained professor’s tongue Too serious to fool Spouted out that liberty Is just equality in school “Equality,” I spoke the word As if a wedding vow Ah, but I was so much older then I’m younger than that now

In a soldier’s stance, I aimed my hand At the mongrel dogs who teach Fearing not that I’d become my enemy In the instant that I preach My pathway led by confusion boats Mutiny from stern to bow Ah, but I was so much older then I’m younger than that now . . .

This seems to speak to the current moment—read the whole set of lyrics.  (And how does someone get that wise at age 23?)

It occurs to me that you could put together a 10-page essay composed of almost nothing but quotes from Dylan, Martin Luther King, Barack Obama, etc., and in the end get accused of being the worst kind of reactionary.  That’s an indication that one segment of the left may have lost its compass.

Over at Law and Liberty, Henry Edmondson has a nice essay on this and a few other Dylan songs. Highly recommended.

PS.  No need for commenters pointing out that the conservative movement has also lost its bearings, drifting into nationalism.  I’ve discussed that in other posts.

(9 COMMENTS)

EconLog July 10, 2020

Bob Murphy on How Identity Politics Hurts Everyone

I rarely find time to listen to podcasts that are longer than 10 minutes. But I found the following description intriguing:

Pointing to a recent Twitter thread from a progressive detailing his white male cisness, Bob shows how narrow the focus is on only particular “privileges” and not others. More generally, the effort to demonize white men is causing young people great harm, whether white or otherwise. The movement is based on power politics and relies on economic ignorance.

Bob Murphy is a friend but that’s not typically enough to get me listening. In this case I was glad I did.

The podcast is titled “Identity Politics Is Hurting Young People–Of all Colors,” July 9, 2020.

If you’re in a hurry, start at about 1:30 and go to about 15:00. You’ll get his most important message. But also I thought that the material in the last 5 or 6 minutes, where he discusses the U.S. women’s soccer team, was very good also.

UPDATE:

Once the diversity trainers have established this basic conceptual framework, they encourage white employees to “practice self-talk that affirms [their] complicity in racism” and work on “undoing [their] own whiteness.” As part of this process, white employees must abandon their “white normative behavior” and learn to let go of their “comfort,” “physical safety,” “social status,” and “relationships with some other white people.” As writer James Lindsay has pointed out, this is not the language of human resources; it is the language of cult programming—persuading members they are defective in some predefined manner, exploiting their emotional vulnerabilities, and isolating them from previous relationships.

This is from Christopher F. Rufo, “Cult Programming in Seattle,” City Journal, July 8. It supports Murphy’s claim that it isn’t just about privilege and advantage but is also about guilt. That relates to the discussion in the comments below between Mark Z and me.

(12 COMMENTS)

EconLog July 10, 2020

Escaping Paternalism Book Club Starts Next Week

The Escaping Paternalism Book Club starts next week.  Get your copy now and read this profound work of scholarship!

(1 COMMENTS)

EconLog July 9, 2020

The start of a new month means new articles at Econlib!

Gina Miller Johnson warns of the Danger of Benevolent Paternalism. Concerned by the increase in calls from her students and from the population as a whole for “The government to do something” almost regardless of what the “something” might be, Miller Johnson observes that this rapidly leads to government overreach. 

In a crisis like a pandemic, these dangers are heightened. “Whatever one’s view of the proper role of government as it relates to public health, another question must be posed: when, if ever, does public health provision as a public good supersede the protection of civil liberties as a fundamental role of the state? The initial wake of the pandemic saw disturbing support for sacrificing civil liberties in the name of public health.’

Michael L. Davis asks How Can Economists Help? “The question of whether economists help people has been on my mind a lot lately. This is an extraordinary time. People need help and, as Russ [Roberts] likes to remind us, one of Adam Smith’s most important insights is that “man naturally desires not only to be loved but to be lovely.” Most of us genuinely want to help. But we don’t know how to hook up a ventilator, we don’t have the local knowledge necessary to deliver fresh milk to the store and most of us wouldn’t even be very good at stocking the cooler once the milk arrives. Do economists have anything to offer?”

Don’t worry! Davis has nine suggestions for economists who want to use their skills to help out right now.

Arnold Kling reviews Mending America’s Political Divide by René H. Levy. The book offers “a neuroscientist’s perspective on the phenomenon of political polarization. Our politics is stimulating our tribal instincts, which lead us to lose empathy with the other side. This lack of empathy has dangerous consequences.” While Kling feels that the book “offers a sound diagnosis of our political ills. It offers a prescription that I wish more people would take to heart” he has some concerns about a lack of balance in Levy’s arguments.

EconLog July 8, 2020

USMCA Is a Net Move AWAY From Free Trade

The reduction of trade barriers among the USMCA’s parties will strengthen U.S., Mexican and Canadian supply chains, returning manufacturing jobs to North America from China. Even before the Covid-19 pandemic exposed how North America had become too dependent on China for medical equipment and drugs, Beijing’s campaign of intimidation and censorship was already hurting international companies.

So write H.R. McMaster and Pablo Tortolero in “The North American Trade Dividend,” Wall Street Journal, July 6. (Print edition: July 7.)

The above paragraph suggests that the new United States Mexico Canada Agreement (USMCA) is a move to freer trade. Otherwise how could the authors claim that there’s a reduction of trade barriers.

It’s not.

I wrote about the USMCA at length in a Hoover publication, Defining Ideas, on December 20. My article is titled “NAFTA 0.0.” Here’s how I explained the title:

Some people are referring to the USMCA as NAFTA 2.0. When we use such a numbering system for software, the higher the number the better the product. So software 2.0 is presumably better than software 1.0. In this case, though, USMCA is likely inferior to NAFTA. So USMCA could reasonably be labeled NAFTA 0.0.

In other words, in most important respects, USMCA is a move away from the free trade aspects of NAFTA.

I elaborated in the piece:

There are some improvements. One is in agriculture. Governments in Canada have been notorious for restricting agriculture imports from the United States. Those include dairy products, eggs, wheat, poultry, and wine. The USMCA would lighten these restrictions. That’s particularly important for the U.S. dairy industry right now because of the decades-long decline in the amount of milk that the average American consumes. To put this in perspective, though, this is nothing like free trade; it simply increases, in small steps, the amount of various agricultural products that can be imported into Canada from the United States. Take a look at the  U.S. Trade Representative’s bragging Fact Sheet on agriculture under the USMCA and see if it doesn’t make you think about a central planner grudgingly allowing slightly more freedom. Robert Lighthizer, the U.S. Trade Presentative and a vocal advocate of managed trade, might be proud. Neither Canadians nor Americans should be.

Another improvement is in the area of digital trade. The U.S. government’s International Trade Commission (ITC), in its April 2019 analysis, claimed that the USMCA would, after six years, actually increase U.S. real GDP, relative to the NAFTA baseline, by 68.2 billion, or 0.35 percent. That’s a substantial number, amounting to about 200 annually per American. But, the ITC admits, that estimate leans heavily on the assumption that the digital trade rules would be clear enough that digital trade would expand substantially. Simon Lester, associate director of the Cato Institute’s Herbert A. Stiefel Center for Trade Policy Studies, expresses a well-founded skepticism. He grants that this part of the wording is good: “No Party shall prohibit or restrict the cross-border transfer of information, including personal information, by electronic means if this activity is for the conduct of the business of a covered person.” But Lester notes lots of exceptions, such as for government measures that are “necessary to achieve a legitimate public policy objective.” Legitimate in whose eyes?

But here is where USMCA is a strong move away from free trade:

Unfortunately, the USMCA has two big negatives. The first is the rollback of free trade in the auto industry. Under NAFTA, the way to avoid the 2.5 percent tariff that the U.S. government imposes on cars from other countries is to make sure that at least 62.5 percent of the value of a car is produced in North America. The USMCA raises that to 66 percent and then, over a period of three years, to 75 percent. In short, that’s a 20 percent increase in the amount of value that must be produced in North America. Another restriction on trade is that 70 percent of the aluminum and steel used in North American auto production must originate in North America. Both provisions will raise the prices of cars, as even the ITC admits.

The other big USMCA rollback of free trade in the auto industry is the imposition of a minimum wage in the Mexican auto industry. You read that right. The Trump administration, which to its credit, has refused to support a bill to raise the U.S. minimum wage from its July 2009 level of 7.25 an hour, wants a minimum wage of 16 an hour in its neighbor’s auto industry. Trump’s economic advisers understand that one of the effects of a big increase in the U.S. minimum wage would be to hurt the employment prospects of unskilled workers. Remember that a minimum wage law doesn’t guarantee a job at the minimum wage. All it guarantees is that someone who gets a job will be paid the minimum wage. But as left-of-center Nobel economist Paul Samuelson pointed out years ago, it is the requirement that a young unskilled worker be paid the minimum wage that makes him less likely to get a job.

The 16 minimum wage will have little effect in the U.S. and Canadian auto industries because the vast majority of auto workers in those industries already are paid at least 16 an hour. But the effect in the Mexican auto industry, absent other adjustments, would be devastating. According to a 2018 study by the Center for Automotive Research, based in Ann Arbor, Michigan, in 2017 the Mexican wage for auto assembly averaged 7.34 an hour. The auto producers in Mexico aren’t about to more than double the wage.

Disclosure: H.R. McMaster is a Hoover colleague.

HT2 Don Boudreaux and Dan Griswold.

(5 COMMENTS)

EconLog July 8, 2020

Monetary economics: The three heresies

In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.

In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model.  This leads to a period of crisis, and new models are developed to address the empirical anomalies.  I believe that this has happened in monetary economics.

Consider the following claim (my words), which reflects the views of most mainstream economists, circa 2007:

“A policy of reducing interest rates to very low levels is highly expansionary.  When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”

Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above.  And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.

At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:

1.  MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow.  They recommend that central banks in those countries set interest rates at zero.  Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.

  1. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.

  2. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.”  Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.

So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other.  How did we end up with such a mess?

The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed.  But why three?  The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.

Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy.  In one sense, MMT can be seen as the most anti-quantity theory model ever developed.  Its tenets are almost the polar opposite of monetarism on a wide range of issues.

A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics.  In these models, the Fisher effect is far more important than the liquidity effect.  Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates.  This eventually led to the NeoFisherian model.

A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects.  This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes.  It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.

Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here.  (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics.  It has caused all sorts of confusion, and gave birth to three very heterodox models.

This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters.  Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.

(18 COMMENTS)

EconLog July 8, 2020

Health Care in the Headwinds of Capitalism

You’ve heard EconTalk host Russ Roberts argue that the central problem in American health care is that doctors get paid to do stuff to us, rather than take care of us. In this episode, Roberts welcomes physician and author Vivian Lee to talk about her new book, The Long Fix, to continue this conversation.

Roberts and Lee discuss the rising cost of health care, the trend of over-treatment and diagnosis at the expense of better health, and sources of optimism for the future of health care, including possible “silver linings” to the COVID-19 pandemic. Health care, asserts Lee, is “flying into the headwinds of capitalism,” and unless the incentives inherent in the system can be changed, there is little chance for relief.

After listening to this episode, we hope you’ll use the questions below to start your own conversation, either on- or offline. You might be interested in looking back at the many previous EconTalk episodes on health care for even more conversational inspiration.

 

 

1- We’re used to Roberts saying that “we” don’t pay for our health care. Lee disagrees. How does Lee explain her position? How does her catering analogy contribute to her explanation?

 

2- What is the “Chargemaster,” and how does this often result in differential prices for different kinds of patients? In what ways does Lee believe that standardizing the Chargemaster could have a big effect on the price we pay for health care? How should this standardization be accomplished?

 

3- Roberts asks Lee for her sources of optimism, and she enthusiastically describes the Medicare Advantage programs. What is it she likes about them? How do they change doctors’s incentives positively?

 

4- What are some of the disruptive forces in primary care discussed in this episode that strike you as promising? Lee says,”What’s going to be really interesting in the next few years is the degree to which this kind of mindset can extend to secondary, tertiary care, to hospitalizations, and to rehabilitation. That’s really where more of the dollars are spent right now.” What are some of the challenges in these areas? To what extent do you think COVID-19 will inspire innovation in health care?

 

5- Lee’s professional focus now is on creating a “learning health system?” What does she mean when she says of the future, “We are going to pay for better health. We’re not going to be fee-for-service anymore. The days of fee-for-service are numbered. Let the tailwinds of capitalism push this forward.” To what extent do you share Lee’s optimism?

 

(1 COMMENTS)

EconLog July 8, 2020

Will Italy get the “upside” of COVID?

In many assessments of the changes brought by COVID-19, I notice some classical liberal scholars are putting on the upside a certain degree of deregulation, which apparently governments are accepting in order to cope with the healthcare challenge and to ease the way towards recovery.

I am afraid that won’t happen in Italy. I have an article on the matter in Politico.eu.

As I recall in the piece,

The first time I heard an Italian politician promise to slash red tape, I was 13. It was 1994 and, with great fanfare, Silvio Berlusconi had injected the Reagan-esque language of bureaucratic reform into Italian politics.

It was a theme the four-time prime minister and his successors would return to over and over again. As the economist Nicola Rossi recently noted, over the last 30 years, Italy has introduced 10 much-talked-about “simplification reforms” and “reforms of the public administration” in 1990, 1993, 1997, 1998, 1999, 2000, 2003, 2005, 2009, 2014.

And yet, none of these resulted in an actual, substantive deregulation effort.

The article is here.

(2 COMMENTS)

EconLog July 8, 2020

Krikorian’s “Category Error”

During our last debate, an audience member asked Mark Krikorian if his arguments for restricting immigration of foreigners were also arguments for restricting the child-bearing of natives.  You might think that Mark would insist that native babies are somehow better than foreign adults.  How hard could it possibly be to craft such an argument?  However, Mark adamantly refused to compare the worths of different kinds of people.  Instead, he informed the questioner that his question was based on a “category error.”

In so doing, Mark signaled high IQ, because smart people love to announce that someone has made a “category error.”  But precisely what is a category error?  Here’s a standard definition:

To show that a category mistake has been committed one must typically show that once the phenomenon in question is properly understood, it becomes clear that the claim being made about it could not possibly be true.

Here’s a more detailed discussion:

Category mistakes are sentences such as ‘The number two is blue’, ‘The theory of relativity is eating breakfast’, or ‘Green ideas sleep furiously’. Such sentences are striking in that they are highly odd or infelicitous, and moreover infelicitous in a distinctive sort of way. For example, they seem to be infelicitous in a different way to merely trivially false sentences such as ‘225″ or obviously ungrammatical strings such as ‘The ran this’.

Which raises a big question: How could the audience member’s perfectly intelligible question possibly be a “category error”?!  If you say, “We should restrict immigration because immigrants burden taxpayers,” what on Earth is wrong with responding, “In that case, should we restrict child-bearing if babies burden taxpayers?”  The answer, of course, is: Nothing at all.  Not only is the latter question in the same “category” as the former question; it is the textbook way to check the logic of Mark’s position.  And it starkly reveals the inadequacy of Mark’s original argument.  Whatever your views on immigration, Mark definitely needs to assert something like, “We should restrict immigration because immigrants burden taxpayers and only natives are entitled to burden taxpayers.”

This in turn shifts the argument over to the fundamental question: What is morally permissible to do to foreigners but not natives – and why?  Which recalls a previous Krikorian-Caplan dialogue.  I asked Mark: “Suppose you can either save one American or x foreigners. How big does x have to be before you save the foreigners?__”  And Mark responded:

Another meaningless hypothetical.

Not only is this a meaningful question; it gets to the heart of what Mark needs to formulate a coherent position on immigration.  I’m confident that Mark, as an avowed Christian, thinks we have no right to murder or enslave foreigners.  And an avowed restrictionist, Mark clearly thinks we have a right to prohibit foreigners from domestic labor and residential markets – even though plenty of natives are eager to trade with them.  Why, though, does Mark draw the line there?  While it is rhetorically convenient for him to dodge the question by calling it a “category error” or “meaningless,” he intellectually doesn’t have a leg to stand on.

So why not face the question instead of stonewalling?  I stand by my previous explanation: Mark thinks like a politician, not a truth-seeker.  To make his position intellectually credible, he’d have to say, “Foreigners’ welfare is of near-zero value.”  Unfortunately for him, this sounds terrible – and like most politicians, Mark hates to utter anything that sounds terrible.  Occasionally bullet-biting is essential for truth, but it’s bad for winning popularity contests.

I’m never nervous when I debate Mark; he has good manners and reminds me of my dad.  In contrast, I would be quite nervous even to be in the same room as a white nationalist.  They seem like sociopaths.  In terms of intellectual rigor, however, leading white nationalists far exceed Mark.  I naturally think they’re deeply wrong.  Still, if you want to construct an airtight argument for immigration restriction, your best bet is to build on the twin premises that (a) almost all immigrants are inferior to natives, and (b) the well-being of these inferior people is of little worth.

 

(29 COMMENTS)

EconLog July 7, 2020

I “Win” My Bet

In mid-March I made a bet with my good friend and co-author Charley Hooper about the number of U.S. deaths there would be from COVID-19. The terms of the bet are here. In my post, I said why I thought he might win. Of course I hoped he would win. Unfortunately, he lost. And over 100,000 U.S. residents lost much, much more.

I waited this long because he and I both agreed that there could be a substantial number of deaths of people with the disease but not of the disease. We both agree, though, that of the 133,844 U.S. deaths so far, at least 100,000 of them are due to COVID-19.

I actually had bought much of Charley’s reasoning, which is why I titled my March 16 post “My Bet on Covid-19 and Why I Might Lose.” I asked Charley last week, when we both were becoming convinced that he lost, what he attributed his loss to. He answered that he didn’t expect various governments to be so incompetent, and he highlighted the role of New York’s governor Andrew Cuomo and some other northeast governments in making the problem much worse by insisting that nursing homes admit people with the disease.

(34 COMMENTS)

Here are the 10 latest posts from EconTalk.

EconTalk July 6, 2020

Robert Lerman on Apprenticeships

apprenticeship.jpg Economist Robert Lerman of the Urban Institute talks about apprenticeships with EconTalk host Russ Roberts. Lerman argues that apprenticeships–a combination of work experience and classroom learning–have the potential to expand opportunities for young people who don’t want to attend college.

EconTalk June 29, 2020

Vivian Lee on The Long Fix

wisdom.jpg Physician and author Vivian Lee talks about her book The Long Fix with EconTalk host Russ Roberts. Lee argues that we can transform health care in the United States, though it may take a while. She argues that the current fee-for-service system incentivizes doctors to provide services rather than keep patients healthy and that these […]

EconTalk June 22, 2020

Agnes Callard on Philosophy, Progress, and Wisdom

Flammarion.jpg Philosopher and author Agnes Callard talks with EconTalk host Russ Roberts about the state of philosophy, the power of philosophy, and the search for wisdom and truth. This is a wide-ranging conversation related to the question of how we learn, how to behave ethically, and the role of religion and philosophy in encouraging good behavior.

EconTalk June 15, 2020

Diane Ravitch on Slaying Goliath

Author and historian Diane Ravitch of New York University talks about her book, Slaying Goliath, with EconTalk host Russ Roberts. Ravitch argues that the charter school movement is a failure and that it drains needed money from public schools.

The post Diane Ravitch on Slaying Goliath appeared first on Econlib.

EconTalk June 8, 2020

Rebecca Henderson on Reimagining Capitalism

Reimagining-Capitalism-194x300.jpg Author and economist Rebecca Henderson of the Harvard Business School talks about her book Reimagining Capitalism in a World on Fire with EconTalk host Russ Roberts. Henderson argues that the focus on shareholder value threatens to destroy capitalism from within. Henderson argues that business leaders need to manage their companies differently in order to create […]

EconTalk June 1, 2020

Sarah Carr on Charter Schools, Educational Reform, and Hope Against Hope

Hope-Against-Hope-200x300.jpg Journalist and author Sarah Carr talks about her book Hope Against Hope with EconTalk host Russ Roberts. Carr looked at three schools in New Orleans in the aftermath of Hurricane Katrina and chronicled their successes, failures, and the challenges facing educational reform in the poorest parts of America.

EconTalk May 25, 2020

Martin Gurri on the Revolt of the Public

revolt-of-the-public-203x300.jpg Author Martin Gurri, Visiting Fellow at George Mason University’s Mercatus Center, talks about his book The Revolt of the Public with EconTalk host Russ Roberts. Gurri argues that a digital tsunami–the increase in information that the web provides–has destabilized authority and many institutions. He talks about the amorphous nature of recent populist protest movements around […]

EconTalk May 18, 2020

Robert Pondiscio on How the Other Half Learns

HowOtherHalfLearns-199x300.jpg Author and teacher Robert Pondiscio of the Thomas B. Fordham Institute talks about his book How the Other Half Learns with EconTalk host Russ Roberts. Pondiscio shares his experience of being embedded in a Success Academy Charter School in New York City for a year–lessons about teaching, education policy, and student achievement.

The post Robert Pondiscio on How the Other Half Learns appeared first on Econlib.

EconTalk May 15, 2020

Paul Romer on the COVID-19 Pandemic

In this Bonus Episode of EconTalk, economist and Nobel Laureate Paul Romer discusses the coronavirus pandemic with EconTalk host Russ Roberts. Romer argues that the status quo of shutdown and fear of infection is unsustainable. Returning to normal requires an inexpensive, quick, and relatively painless test. Such tests are now available. The challenge is in […]

The post Paul Romer on the COVID-19 Pandemic appeared first on Econlib.

EconTalk May 11, 2020

Branko Milanovic on Capitalism, Alone

Capitalism-Alone-199x300.jpg Economist and author Branko Milanovic of the Graduate Center, CUNY, talks about his book, Capitalism, Alone, with EconTalk host Russ Roberts. They discuss inequality, the challenge of corruption in the Chinese system, and Milanovic’s claim that in American capitalism, the texture of daily life is increasingly affected by the sharing economy and other opportunities.

Here are the 10 latest posts from CEE.

CEE July 1, 2020

Israel Kirzner

Israel Kirzner is a prominent member of the Austrian School of economics. His major contribution is his work on the meaning and importance of entrepreneurship.

Kirzner’s view is that mainstream neo-classical economics omits the role of the entrepreneur. The standard neoclassical models of markets, whether perfect competition, monopolistic competition, or monopoly, argues Kirzner, are equilibrium models. They omit the crucial role of the entrepreneur, which is to bring markets to equilibrium. In Kirzner’s view, which he and others refer to as a distinct viewpoint of the Austrian school of economics, the main characteristic of the entrepreneur is alertness. The entrepreneur is alert to price differences that others have not noticed and makes a profit by acting on this alertness. So, for example, the entrepreneur notices that goods selling for 10 in one market are fetching 15 in another market. He also notices that the shipping, insurance, and interest costs of buying where it sells for 10 and selling where it sells for 15 are less than 5. So he buys in the cheaper market, sells in the dearer market, and makes a profit. As long as others are not aware of this difference, the entrepreneur continues to make money. But other entrepreneurs are also alert. When they notice the difference in prices, they seek to do what the first entrepreneur did. As they enter the market—buying in the cheaper market and selling in the dearer market—they drive the price of the good that they buy above 10 and drive the price where they are selling below 15. This continues until the price difference covers the shipping, insurance, and interest costs.

CEE March 24, 2020

Harold Demsetz

Harold Demsetz made major contributions to the economics of property rights and to the economics of industrial organization. He also coined the term “the Nirvana approach.” Economists have altered it slightly but use it widely. Demsetz was one of the few top economists of his era to communicate almost entirely in words and not math. Demsetz also defended both economic freedom and civil liberties.

Drawing on anthropological research, Demsetz noted that, although the native Canadians (Canadians often call them First Nations people) in Labrador had property rights in the early 18supth/sup century, they did not have property rights in the mid-17supth/sup century. What changed? Demsetz argued that the advent of the fur trade in the late 17supth/sup century made it more valuable to establish property rights so that the beavers were not overtrapped. By contrast, native Americans on the southwestern plains of the United States did not establish property rights; Demsetz reasoned that it was because the animals they hunted wandered over wide tracts of land and, therefore, the cost of establishing property rights was prohibitive. One of Demsetz’s most important contributions was a 1967 article, “Toward a Theory of Property Rights.” In it, he argued that property rights tend to develop where the gains from defining and enforcing those rights exceed the costs. He found confirming evidence in the presence or absence of property rights among native Americans and native Canadians, and he dismissed the idea that they were primitive people who couldn’t understand or appreciate property rights. Instead, he argued, they developed property rights in areas of North America where the property was worth defending.

In the 1960s, the dominant view in the area of economics called industrial organization was that concentration in industries was bad because it led to monopoly. In the 1970s, Demsetz challenged that view. He argued that the kind of monopoly to worry about is caused by government regulation that prohibits firms from entering an industry. He pointed to the Civil Aeronautics Board’s restrictions on entry by new airlines and the Federal Communication Commission’s hobbling of cable TV as examples. He wrote, “The legal route of monopoly runs through Washington and the state capitals.” But, he argued, if a few firms achieved a large market share through economies of scale or through superior performance, we should not worry, and the antitrust officials should not go after such firms. As long as the government doesn’t restrict new competitors, firms with a large market share will face competition in the future.

In a 1969 article, “Information and Efficiency: Another Viewpoint,” Demsetz accused fellow economist Kenneth Arrow of taking the “Nirvana approach” and recommended instead a “comparative institutions approach.” He wrote, “[T]hose who adopt the nirvana viewpoint seek to discover discrepancies between the ideal and the real and if discrepancies are found, they deduce that the real is inefficient.” Specifically, Arrow showed ways in which the free market might provide too little innovation, but then simply assumed that government intervention would get the economy closer to the optimum. Demsetz conceded that ideal government intervention might improve things, but he noted that Arrow, like many economists, had failed to show that actual government intervention would do so. Economists have slightly changed the label on Demsetz’s insight: they now refer to it as the “Nirvana fallacy.”

Another major Demsetz contribution was his thinking about natural monopoly, evidenced best in his 1968 article “Why Regulate Utilities?” In that article, Demsetz stated that the theory of natural monopoly “is deficient for it fails to reveal the logical steps that carry it from scale economies in production to monopoly price in the market place.” How so? Demsetz argued that competing providers could bid to be the single provider and that consumers, if well organized, could choose among competing providers. The competition among potential providers would prevent the winning provider from charging a monopoly price.

Economists often use negative externalities as a justification for government regulation. One standard example is pollution; in their actions, polluters do not take into account the damage imposed on others. Demsetz pointed out that governments also impose negative externalities. In the above-mentioned 1967 article on property rights, Demsetz wrote, “Perhaps one of the most significant cases of externalities is the extensive use of the military draft. The taxpayer benefits by not paying the full cost of staffing the armed services.” He added, “It has always seemed incredible to me that so many economists can recognize an externality when they see smoke but not when they see the draft.” Demsetz was a strong opponent of the draft.

One of Demsetz’s other contributions, co-authored with Armen A. Alchian, was his 1972 article “Production, Information Costs, and Economic Organization.” A 2011 article written by three Nobel Prize winners—Kenneth J. Arrow, Daniel L. McFadden, and Robert M. Solow—and three other economists—B. Douglas Bernheim, Martin S. Feldstein, and James M. Poterba, stated that this article was one of the top 20 articles publishes in the American Economic Review in the first 100 years of its existence. In it, Alchian and Demsetz proposed the idea that the reason to have firms is that team production is important and monitoring the productivity of team members is difficult. Therefore, they argued, firms, to be effective, must have people in the firm who monitor and who are residual claimants. These people, often, but not always, the owners, get some fraction of the profits of the firm and, therefore, have an incentive to monitor effectively. That helps solve the classic principal-agent problem.

In a famous 1933 book titled The Modern Corporation and Private Property, Adolf A. Berle and Gardiner C. Means had argued that diffusion of ownership in modern corporations gave managers of large corporations more control, shifting it from the owners. These managers, they argued, would use that control to benefit themselves. Demsetz and co-author Kenneth Lehn questioned that reasoning. They argued that owners would not give up control without getting something in return. If Berle and Means were correct, they wrote, then one should observe a lower rate of profit in firms with highly diffused ownership. But if Demsetz and Lehn were correct, one should see no such relationship because diffused ownership would happen where there were profitable reasons for it to happen. They wrote:

A decision by shareholders to alter the ownership structure of their firm from concentrated to diffuse should be a decision made in awareness of its consequences for loosening control over professional management. The higher cost and reduced profit that would be associated with this loosening in owner control should be offset by lower capital costs or other profit-enhancing aspects of diffuse ownership if shareholders choose to broaden ownership.

Demsetz and Lehn found “no significant relationship between ownership concentration and accounting profit rate,” just as they expected.

In a 2013 tribute to Demsetz’s co-author Alchian, economist Thomas Hubbard highlighted their 1972 article, writing:

This paper may be the most influential paper in the economics of organization, catalyzing the development of the field as we know it. It is the most-cited paper published in the AER [American Economic Review] in the past 40 years. (If one takes away finance and econometrics methods papers, it is the most-cited ‘economics’ paper, period.) It is truly a spectacular piece. It is a theory not only of firms’ boundaries, but also the firm’s hierarchical and financial structure.[1]

He was also an early defender of the rights of homosexuals. At the September 1978 Mont Pelerin Society meetings in Hong Kong, Demsetz criticized, on grounds of individual rights, the Briggs Initiative, on the November 1978 California ballot. This initiative would have banned homosexuals from teaching in public schools.  The initiative was defeated, helped by the opposition of Demsetz’s fellow Californian Ronald Reagan.

For more on Demsetz’s life and work, see A Conversation with Harold Demsetz, an Intellectual Portrait at Econlib Videos.

Demsetz, a native of Chicago, earned his undergraduate degree in economics at the University of Illinois in 1953 and his Ph.D. in economics at Northwestern University in 1959. He taught at the University of Michigan from 1958 to 1960, at UCLA from 1960 to 1963, at the University of Chicago from 1963 to 1971, and then again at UCLA from 1971 until his retirement. In 2013, he was made a Distinguished Fellow of the American Economic Association.

In 1963, when Demsetz was on the UCLA faculty, a University of Chicago economist named Reuben Kessel asked him if he was happy there. Demsetz, sensing an offer in the works, answered, “Make me unhappy.” The University of Chicago did just that, and Demsetz moved to Chicago for eight productive years.

 

 

Selected Works

  1. . “Minorities in the Marketplace.” North Carolina Law Review, Vol. 43, No. 2: 271-97.

  2. . “Toward a Theory of Property Rights.” American Economic Review, Vol. 57, No. 2, (May, 1967): 347-59.

  3. . “Why Regulate Utilities?” Journal of Law and Economics,Vol. 11, No. 1, (April, 1968): 55-65.

1972 (with Armen A. Alchian). “Production, Information Costs, and Economic Organization,” American Economic Review, Vol. 62, No. 5, (December 1972): 777-95.

  1. . “Industry Structure, Market Rivalry, and Public Policy,” Journal of Law and Economics,Vol. 16, No. 1 (April, 1973): 1-9.

  2. . ‘Two Systems of Belief about Monopoly,” in Industrial Concentration: The New Learning, edited by H. J. Goldschmid, H. M. Mann and J. F. Weston, Little, Brown.

1985 (with Kenneth Lehn). “The Structure of Corporate Ownership: Causes and Consequences,” Journal of Political Economy, Vol. 93, No. 6 (December, 1985): 1155-1177.

  1. . Ownership, Control, and the Firm. Cambridge, MA: Basil Blackwell.

  2. . Efficiency, Competition, and Policy. Cambridge, MA: Basil Blackwell.


[1] Thomas N. Hubbard, “A Legend in Economics Passes,” Digitopoly, February 20, 2013. At: https://digitopoly.org/2013/02/20/a-legend-in-economics-passes/

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CEE July 19, 2019

Richard H. Thaler

 

Richard H. Thaler won the 2017 Nobel Prize in Economic Science for “his contributions to behavioral economics.”

In most of his work, Thaler has challenged the standard economist’s model of rational human beings.  He showed some of the ways that people systematically depart from rationality and some of the decisions that resulted. He has used these insights to propose ways to help people save, and save more, for retirement. Thaler also advocates something called “libertarian paternalism.”

Economists generally assume that more choices are better than fewer choices. But if that were so, argues Thaler, people would be upset, not happy, when the host at a dinner party removes the pre-dinner bowl of cashews. Yet many of us are happy that it’s gone. Purposely taking away our choice to eat more cashews, he argues, makes up for our lack of self-control. This simple contradiction between the economists’ model of rationality and actual human behavior, plus many more that Thaler has observed, leads him to divide the population into “Econs” and “Humans.” Econs, according to Thaler, are people who are economically rational and fit the model completely. Humans are the vast majority of people.

Thaler (1980) noticed another anomaly in people’s thinking that is inconsistent with the idea that people are rational. He called it the “endowment effect.” People must be paid much more to give something up (their “endowment”) than they are willing to pay to acquire it. So, to take one of his examples from a survey, people, when asked how much they are willing to accept to take on an added mortality risk of one in one thousand, would give, as a typical response, the number 10,000. But a typical response by people, when asked how much they would pay to reduce an existing risk of death by one in one thousand, was 200.

One of Thaler’s most-cited articles is Werner F. M. De Bondt and Richard Thaler (1985). In that paper they compared the stocks of “losers” and “winners.” They defined losers as stocks that had recently dropped in value and winners as stocks that had recently increased in value, and their hypothesis was that people overreact to news, driving the prices of winners too high and the prices of losers too low. Consistent with that hypothesis, they found that the portfolio of losers outperformed the portfolio of winners.

One of the issues to which Thaler applied his thinking is that of saving for retirement. In his book Misbehaving, Thaler argues that if everyone were an Econ, it wouldn’t matter whether employers’ default option was not to sign up their employees for tax-advantaged retirement accounts and let them opt in or to sign them all up and let employees opt out. There are transactions costs associated with getting out of either default option, of course, but they are small relative to the stakes involved. For that reason, argued Thaler, either option should lead to about the same percentage of employees taking advantage of the program. Yet Brigitte G. Madrian and Dennis F. Shea found[1] that before a company they studied had tried automatic enrollment, only 49 percent of employees had joined the plan. When enrollment became the default, 84 percent of employees stayed enrolled. That is a large difference relative to what most economists would have expected.

Thaler and economist Shlomo Benartzi, arguing that people tend to be myopic and heavily discount the future, helped design a private pension plan to enable people to save more. Called Save More Tomorrow, it automatically increases the percent of their gross pay that people save in 401(k) plans every time they get a pay raise. That way, people can save more without ever having to cut their current consumption expenditures. Many “Econs” were presumably already doing that, but this plan helps Humans, as well. When a midsize manufacturing firm implemented their plan, participants, at the end of four annual raises, had almost quadrupled their saving rate.

In their book Nudge, Thaler, along with co-author Cass Sunstein, a law professor, used behavioral economics to argue for “nudging” people to make better decisions. In each person, they argued, are an impulsive Doer and a farsighted Planner. In the retirement saving example above, the Doer wants to spend now and the Planner wants to save for retirement. Which preferences should be taken account of in public policy?

As noted earlier, Thaler believes in “libertarian paternalism.” In Nudge, he and Sunstein lay out the concept. The basic idea is to have the government set paternalist rules as defaults but let people choose to opt out at low cost. One example is laws requiring motorcyclists to wear helmets. That is paternalism. How to make it “libertarian paternalist?” They favorably cite New York Times columnist John Tierney’s proposal that motorcyclists who don’t want to wear helmets be required to take an extra driving course and show proof of health insurance.

In a review of Nudge, Thomas Leonard writes:

The irony is that behavioral economics, having attacked Homo Economicus as an empirically false description of human choice, now proposes, in the name of paternalism, to enshrine the very same fellow as the image of what people should want to be. Or, more precisely, what paternalists want people to be. For the consequence of dividing the self has been to undermine the very idea of true preferences. If true preferences don’t exist, the libertarian paternalist cannot help people get what they truly want. He can only make like an old fashioned paternalist, and give people what they should want.[2]

In some areas, Thaler seems to have departed from the view that long-term considerations should guide economic policy. A standard view among economists is that after a flood or hurricane, a government should refrain from imposing price controls on crucial items such fresh water, food, or plywood. That way, goes the economic reasoning, suppliers in other parts of the country have an incentive to move goods to where they are needed most and buyers will be careful not to stock up as much immediately after the flood or hurricane. In 2012, when asked about a proposed anti-price-gouging law in Connecticut, Thaler answered succinctly, “Not needed. Big firms hold prices firm. ‘Entrepreneurs’ with trucks help meet supply. Are the latter covered? If so, [the proposed law is] bad.”[3] What he was getting at is that, to some extent, we get the best of both worlds. Companies like Wal-Mart, worried about their reputation with consumers, will refrain from price gouging but will stock up in advance; one-time entrepreneurs, not worried about their reputations, will supply high-priced items to people who want them badly. But in a Marketplace interview in September 2017,[4] Thaler said, “A time of crisis is a time for all of us to pitch in; it’s not a time for all of us to grab.” He seemed to have moved from the mainstream economists’ view to the popular view.

One relatively unexplored area in Thaler’s work is how government officials show the same irrationality that many of us show and the implications of that fact for government policy.

Thaler earned his Bachelor of Arts degree with a major in economics at Case Western Reserve University in 1965, his Masters degree in economics from the University of Rochester in 1970, and his Ph.D. in economics from the University of Rochester in 1974. He was a professor at the University of Rochester’s Graduate School of Management from 1974 to 1978 and a professor at Cornell University’s Johnson School of Management from 1978 to 1995. He has been a professor at the University of Chicago’s Booth School of Business since 1995.

 

 

Selected Works

  1. . Toward a Positive Theory of Consumer Choice,” Journal of Economic Behavior and Organization 1, No. 1, pp. 39-60.

  2. . (with Werner F.M. De Bondt.) “Does the Stock Market Overreact?,” Journal of Finance, Vol. 40, pp. 793-805.

  3. . The Winner’s Curse: Paradoxes and Anomalies of Economic Life. Princeton University Press.

  4. . (with Cass R. Sunstein.) “Libertarian Paternalism,” American Economic Review, Vol. 93, No. 2, pp. 175-179.

  5. . (with Shlomo Benartzi.) “Save More TomorrowsupTM/sup: Using Behavioral Economics to Increase Employee Saving,” Journal of Political Economy, Vol. 112, No. S1, pp. S164-87.

  6. . (with Cass Sunstein.) Nudge: Improving Decisions About Health, Wealth, and Happiness, New Haven: Yale University Press.

  7. . Misbehaving: The Making of Behavioral Economics, New York: W.W. Norton.

 

 

 

[1] Brigitte C. Madrian and Dennis F. Shea, “The Power of Suggestion: Inertia in 401(k) Participation and Savings Behavior,” Quarterly Journal of Economics, Vol. CXVI, Issue 4, November 2001, pp. 1149-1187. At: https://www.ssc.wisc.edu/scholz/Teaching_742/Madrian_Shea.pdf

[2] Thomas Leonard, “Review of Richard Thaler and Cass Sunstein, Nudge: Improving Decisions about Health, Wealth, and Happiness.” Constitutional Political Economy 19(4): 356-360.

[3] http://www.igmchicago.org/surveys/price-gouging

[4] https://www.marketplace.org/shows/marketplace/09012017

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CEE May 28, 2019

William D. Nordhaus

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William D. Nordhaus was co-winner, along with Paul M. Romer, of the 2018 Nobel Prize in Economic Science “for integrating climate change into long-run macroeconomic analysis.”

Starting in the 1970s, Nordhaus constructed increasingly comprehensive models of the interaction between the economy and additions of carbon dioxide to the atmosphere, along with its effects on global warming. Economists use these models, along with assumptions about various magnitudes, to compute the “social cost of carbon” (SCC). The idea is that past a certain point, additions of carbon dioxide to the atmosphere heat the earth and thus create a global negative externality. The SCC is the net cost that using that additional carbon imposes on society. While the warmth has some benefits in, for example, causing longer growing seasons and improving recreational alternatives, it also has costs such as raising ocean levels, making some land uses obsolete. The SCC is the net of these social costs and is measured at the current margin. (The “current margin” language is important because otherwise one can get the wrong impression that any use of carbon is harmful.) Nordhaus and others then use the SCC to recommend taxes on carbon. In 2017, Nordhaus computed the optimal tax to be 31 per ton of carbon dioxide. To put that into perspective, a 31 carbon tax would increase the price of gasoline by about 28 cents.

CEE May 28, 2019

William D. Nordhaus

William D. Nordhaus was co-winner, along with Paul M. Romer, of the 2018 Nobel Prize in Economic Science “for integrating climate change into long-run macroeconomic analysis.”

Starting in the 1970s, Nordhaus constructed increasingly comprehensive models of the interaction between the economy and additions of carbon dioxide to the atmosphere, along with its effects on global warming. Economists use these models, along with assumptions about various magnitudes, to compute the “social cost of carbon” (SCC). The idea is that past a certain point, additions of carbon dioxide to the atmosphere heat the earth and thus create a global negative externality. The SCC is the net cost that using that additional carbon imposes on society. While the warmth has some benefits in, for example, causing longer growing seasons and improving recreational alternatives, it also has costs such as raising ocean levels, making some land uses obsolete. The SCC is the net of these social costs and is measured at the current margin. (The “current margin” language is important because otherwise one can get the wrong impression that any use of carbon is harmful.) Nordhaus and others then use the SCC to recommend taxes on carbon. In 2017, Nordhaus computed the optimal tax to be 31 per ton of carbon dioxide. To put that into perspective, a 31 carbon tax would increase the price of gasoline by about 28 cents per gallon.

Nordhaus noted, though, that there is a large amount of uncertainty about the optimal tax. For the 31 tax above, the actual optimal tax could be as little as 6 per ton or as much as 93.

Interestingly, according to Nordhaus’s model, setting too high a carbon tax can be worse than setting no carbon tax at all. According to the calibration of Nordhaus’s model in 2007, with no carbon tax and no other government controls, the present value of damages from environment damage and abatement costs would be 22.59 trillion (in 2004 dollars). Nordhaus’s optimal carbon tax would have reduced damage but increased abatement costs, for a total of 19.52 trillion, an improvement of only 3.07 trillion. But the cost of a policy to limit the temperature increase to only 1.5 C would have been 37.03 trillion, which is 16.4 trillion more than the cost of the “do nothing” option. Those numbers will be different today, but what is not different is that the cost of doing nothing is substantially below the cost of limiting the temperature increase to only 1.5 C.

One item the Nobel committee did not mention is his demonstration that the price of light has fallen by many orders of magnitude over the last 200 years. He showed that the price of light in 1992, adjusted for inflation, was less than one tenth of one percent of its price in 1800. Failure to take this reduction fully into account, noted Nordhaus, meant that economists have substantially underestimated the real growth rate of the economy and the growth rate of real wages.

Nordhaus also did pathbreaking work on the distribution of gains from innovation. In a 2004 study he wrote:

Only a minuscule fraction of the social returns from technological advances over the 1948-2001 period was captured by producers, indicating that most of the benefits of technological change are passed on to consumers rather than captured by producers.

Nordhaus earned his B.A. degree at Yale University in 1963 and his Ph.D. in economics at MIT in 1967. From 1977 to 1979, he was a member of President Carter’s Council of Economic Advisers.

 

 


Selected Works

  1. . “Economic Growth and Climate: The Case of Carbon Dioxide.” American Economic Review, Vol. 67, No. 1, pp. 341-346.

  2. . “Do Real-Output and Real-Wage Measures Capture Reality? The History of Lighting Suggests Not,” in Timothy F. Bresnahan and Robert J. Gordon, editors, The Economics of New Goods. Chicago: University of Chicago Press, 1996.

  3. . (with J. Boyer.) Warming the World: Economic Models of Global Warming. Cambridge, MA: MIT Press.

  4. . “Schumpeterian Profits in the American Economy: Theory and Measurement,” NBER Working Paper No. 10433, April 2004.

  5. . “Projections and Uncertainties about Climate Change in an Era of Minimal Climate Policies,” NBER Working Paper No. 22933.

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CEE May 28, 2019

Paul M. Romer

In 2018, U.S. economist Paul M. Romer was co-recipient, along with William D. Nordhaus, of the Nobel Prize in Economic Science for “integrating technological innovations into long-run macroeconomic analysis.”

Romer developed “endogenous growth theory.” Before his work in the 1980s and early 1990s, the dominant economic model of economic growth was one that MIT economist Robert Solow developed in the 1950s. Even though Solow concluded that technological change was a key driver of economic growth, his own model made technological change exogenous. That is, technological change was not something determined in the model but was an outside factor. Romer made it endogenous.

CEE May 28, 2019

Paul M. Romer

In 2018, U.S. economist Paul M. Romer was co-recipient, along with William D. Nordhaus, of the Nobel Prize in Economic Science for “integrating technological innovations into long-run macroeconomic analysis.”

Romer developed “endogenous growth theory.” Before his work in the 1980s and early 1990s, the dominant economic model of economic growth was one that MIT economist Robert Solow developed in the 1950s. Even though Solow concluded that technological change was a key driver of economic growth, his own model made technological change exogenous. That is, technological change was not something determined in the model but was an outside factor. Romer made it endogenous.

There are actually two very different phases in Romer’s work on endogenous growth theory. Romer (1986) and Romer (1987) had an AK model. Real output was equal to A times K, where A is a positive constant and K is the amount of physical capital. The model assumes diminishing marginal returns to K, but assumes also that part of a firm’s investment in capital results in the production of new technology or human capital that, because it is non-rival and non-excludable, generates spillovers (positive externalities) for all firms. Because this technology is embodied in physical capital, as the capital stock (K) grows, there are constant returns to a broader measure of capital that includes the new technology. Modeling growth this way allowed Romer to keep the assumption of perfect competition, so beloved by economists.

In Romer (1990), Romer rejected his own earlier model. Instead, he assumed that firms are monopolistically competitive. That is, industries are competitive, but many firms within a given industry have market power. Monopolistically competitive firms develop technology that they can exclude others from using. The technology is non-rival; that is, one firm’s use of the technology doesn’t prevent other firms from using it. Because they can exploit their market power by innovating, they have an incentive to innovate. It made sense, therefore, to think carefully about how to structure such incentives.

Consider new drugs. Economists estimate that the cost of successfully developing and bringing a new drug to market is about 2.6 billion. Once the formula is discovered and tested, another firm could copy the invention of the firm that did all the work. If that second firm were allowed to sell the drug, the first firm would probably not do the work in the first place. One solution is patents. A patent gives the inventor a monopoly for a fixed number of years during which it can charge a monopoly price. This monopoly price, earned over years, gives drug companies a strong incentive to innovate.

Another way for new ideas to emerge, notes Romer, is for governments to subsidize research and development.

The idea that technological change is not just an outside factor but itself is determined within the economic system might seem obvious to those who have read the work of Joseph Schumpeter. Why did Romer get a Nobel Prize for his insights? It was because Romer’s model didn’t “blow up.” Previous economists who had tried mathematically to model growth in a Schumpeterian way had failed to come up with models in which the process of growth was bounded.

To his credit, Romer lays out some of his insights on growth in words and very simple math. In the entry on economic growth in The Concise Encyclopedia of Economics, Romer notes the huge difference in long run well being that would result from raising the economic growth rate by only a few percentage points. The “rule of 72” says that the length of time over which a magnitude doubles can be computed by dividing the growth rate into 72. It actually should be called the rule of 70, but the math with 72 is slightly easier. So, for example, if an economy grows by 2 percent per year, it will take 36 years for its size to double. But if it grows by 4 percent per year, it will double in 18 years.

Romer warns that policy makers should be careful about using endogenous growth theory to justify government intervention in the economy. In a 1998 interview he stated:

A lot of people see endogenous growth theory as a blanket seal of approval for all of their favourite government interventions, many of which are very wrong-headed. For example, much of the discussion about infrastructure is just wrong. Infrastructure is to a very large extent a traditional physical good and should be provided in the same way that we provide other physical goods, with market incentives and strong property rights. A move towards privatization of infrastructure provision is exactly the right way to go. The government should be much less involved in infrastructure provision.[1]

In the same interview, he stated, “Selecting a few firms and giving them money has obvious problems” and that governments “must keep from taxing income at such high rates that it severely distorts incentives.”

In 2000, Romer introduced Aplia, an on-line set of problems and answers that economics professors could assign to their students and easily grade. The upside is that students are more prepared for lectures and exams and can engage with their fellow students in economic experiments on line. The downside of Aplia, according to some economics professors, is that students get less practice actually manually drawing demand and supply curves.

In 2009, Romer started advocating “Charter Cities.” His idea was that many people are stuck in countries with bad rules that make wealth creation difficult. If, he argued, an outside government could start a charter city in a country that had bad rules, people in that country could move there. Of course, this would require the cooperation of the country with the bad rules and getting that cooperation is not an easy task. His primary example of such an experiment working is Hong Kong, which was run by the British government until 1997. In a 2009 speech on charter cities, Romer stated, “Britain, through its actions in Hong Kong, did more to reduce world poverty than all the aid programs that we’ve undertaken in the last century.”[2]

Romer earned a B.S. in mathematics in 1977, an M.A. in economics in 1978, and a Ph.D. in economics in 1983, all from the University of Chicago. He also did graduate work at MIT and Queen’s University. He has taught at the University of Rochester, the University of Chicago, UC Berkeley, and Stanford University, and is currently a professor at New York University.

He was chief economist at the World Bank from 2106 to 2018.

 

 

[1] “Interview with Paul M. Romer,” in Brian Snowdon and Howard R. Vane, Modern Macroeconomics: Its Origins, Development and Current State, Cheltenham, UK: Edward Elgar, 2005, p. 690.

[2] Paul Romer, “Why the world needs charter cities,” TEDGlobal 2009.

 


Selected Works

  1. “Increasing Returns and Long-Run Growth.” Journal of Political Economy, Vol. 94, No. 5, pp. 1002-1037.
  2. “Growth Based on Increasing Returns Due to Specialization.” American Economic Review, Papers and Proceedings, Vol. 77, No. 2, pp. 56-62.
  3. “Endogenous Technological Change.” Journal of Political Economy. Vol. 98, No. 5, S71-S102.
  4. “Mathiness in the Theory of Economic Growth.” American Economic Review, Vol. 105, No. 5, pp. 89-93.

 

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CEE March 13, 2019

Jean Tirole

In 2014, French economist Jean Tirole was awarded the Nobel Prize in Economic Sciences “for his analysis of market power and regulation.” His main research, in which he uses game theory, is in an area of economics called industrial organization. Economists studying industrial organization apply economic analysis to understanding the way firms behave and why certain industries are organized as they are.

From the late 1960s to the early 1980s, economists George Stigler, Harold Demsetz, Sam Peltzman, and Yale Brozen, among others, played a dominant role in the study of industrial organization. Their view was that even though most industries don’t fit the economists’ “perfect competition” model—a model in which no firm has the power to set a price—the real world was full of competition. Firms compete by cutting their prices, by innovating, by advertising, by cutting costs, and by providing service, just to name a few. Their understanding of competition led them to skepticism about much of antitrust law and most government regulation.

In the 1980s, Jean Tirole introduced game theory into the study of industrial organization, also known as IO. The key idea of game theory is that, unlike for price takers, firms with market power take account of how their rivals are likely to react when they change prices or product offerings. Although the earlier-mentioned economists recognized this, they did not rigorously use game theory to spell out some of the implications of this interdependence. Tirole did.

One issue on which Tirole and his co-author Jean-Jacques Laffont focused was “asymmetric information.” A regulator has less information than the firms it regulates. So, if the regulator guesses incorrectly about a regulated firm’s costs, which is highly likely, it could set prices too low or too high. Tirole and Laffont showed that a clever regulator could offset this asymmetry by constructing contracts and letting firms choose which contract to accept. If, for example, some firms can take measures to lower their costs and other firms cannot, the regulator cannot necessarily distinguish between the two types. The regulator, recognizing this fact, may offer the firms either a cost-plus contract or a fixed-price contract. The cost-plus contract will appeal to firms with high costs, while the fixed-price contract will appeal to firms that can lower their costs. In this way, the regulator maintains incentives to keep costs down.

Their insights are most directly applicable to government entities, such as the Department of Defense, in their negotiations with firms that provide highly specialized military equipment. Indeed, economist Tyler Cowen has argued that Tirole’s work is about principal-agent theory rather than about reining in big business per se. In the Department of Defense example, the Department is the principal and the defense contractor is the agent.

One of Tirole’s main contributions has been in the area of “two-sided markets.” Consider Google. It can offer its services at one price to users (one side) and offer its services at a different price to advertisers (the other side). The higher the price to users, the fewer users there will be and, therefore, the less money Google will make from advertising. Google has decided to set a zero price to users and charge for advertising. Tirole and co-author Jean-Charles Rochet showed that the decision about profit-maximizing pricing is complicated, and they use substantial math to compute such prices under various theoretical conditions. Although Tirole believes in antitrust laws to limit both monopoly power and the exercise of monopoly power, he argues that regulators must be cautious in bringing the law to bear against firms in two-sided markets. An example of a two-sided market is a manufacturer of videogame consoles. The two sides are game developers and game players. He notes that it is very common for companies in such markets to set low prices on one side of the market and high prices on the other. But, he writes, “A regulator who does not bear in mind the unusual nature of a two-sided market may incorrectly condemn low pricing as predatory or high pricing as excessive, even though these pricing structures are adopted even by the smallest platforms entering the market.”

Tirole has brought the same kind of skepticism to some other related regulatory issues. Many regulators, for example, have advocated government regulation of interchange fees (IFs) in payment card associations such as Visa and MasterCard. But in 2003, Rochet and Tirole wrote that “given the [economics] profession’s current state of knowledge, there is no reason to believe that the IFs chosen by an association are systematically too high or too low, as compared with socially optimal levels.”

After winning the Nobel Prize, Tirole wrote a book for a popular audience, Economics for the Common Good. In it, he applied economics to a wide range of policy issues, laying out, among other things, the advantages of free trade for most residents of a given country and why much legislation and regulation causes negative unintended consequences.

Like most economists, Tirole favors free trade. In Economics for the Common Good, he noted that French consumers gain from freer trade in two ways. First, free trade exposes French monopolies and oligopolies to competition. He argued that two major French auto companies, Renault and Peugeot-Citroen, “sharply increased their efficiency” in response to car imports from Japan. Second, free trade gives consumers access to cheaper goods from low-wage countries.

In that same book, Tirole considered the unintended consequences of a hypothetical, but realistic, case in which a non-governmental organization, wanting to discourage killing elephants for their tusks, “confiscates ivory from traffickers.” In this hypothetical example, the organization can destroy the ivory or sell it. Destroying the ivory, he reasoned, would drive up the price. The higher price could cause poachers to kill more elephants. Another example he gave is of the perverse effects of price ceilings. Not only do they cause shortages, but also, as a result of these shortages, people line up and waste time in queues. Their time spent in queues wipes out the financial gain to consumers from the lower price, while also hurting the suppliers. No one wins and wealth is destroyed.

Also in that book, Tirole criticized the French government’s labor policies, which make it difficult for employers to fire people. He noted that this difficulty makes employers less likely to hire people in the first place. As a result, the unemployment rate in France was above 7 percent for over 30 years. The effect on young people has been particularly pernicious. When he wrote this book, the unemployment rate for French residents between 15 and 24 years old was 24 percent, and only 28.6 percent of percent of those in that age group had jobs. This was much lower than the OECD average of 39.6 percent, Germany’s 46.8 percent, and the Netherlands’ 62.3 percent.

One unintended, but predictable, consequence of government regulations of firms, which Tirole pointed out in Economics for the Common Good, is to make firms artificially small. When a French firm with 49 employees hires one more employee, he noted, it is subject to 34 additional legal obligations. Not surprisingly, therefore, in a figure that shows the number of enterprises with various numbers of employees, a spike occurs at 47 to 49 employees.

In Economics for the Common Good, Tirole ranged widely over policy issues in France. In addressing the French university system, he criticized the system’s rejection of selective admission to university. He argued that such a system causes the least prepared students to drop out and concluded that “[O]n the whole, the French educational system is a vast insider-trading crime.”

Tirole is chairman of the Toulouse School of Economics and of the Institute for Advanced Study in Toulouse. A French citizen, he was born in Troyes, France and earned his Ph.D. in economics in 1981 from the Massachusetts Institute of Technology.


Selected Works

 

  1. . (Co-authored with Jean-Jacques Laffont).“Using Cost Observation to Regulate Firms”. Journal of Political Economy. 94:3 (Part I). June: 614-641.

  2. . The Theory of Industrial Organization. MIT Press.

  3. . (Co-authored with Drew Fudenberg).“Moral Hazard and Renegotiation in Agency Contracts”, Econometrica, 58:6. November: 1279-1319.

  4. . (Co-authored with Jean-Jacques Laffont). A Theory of Incentives in Procurement and Regulation. MIT Press.

2003: (Co-authored with Jean-Charles Rochet). “An Economic Analysis of the Determination of Interchange Fees in Payment Card Systems.” Review of Network Economics. 2:2: 69-79.

  1. . (Co-authored with Jean-Charles Rochet). “Two-Sided Markets: A Progress Report.” The RAND Journal of Economics. 37:3. Autumn: 645-667.

2017, Economics for the Common Good. Princeton University Press.

 

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CEE November 30, 2018

The 2008 Financial Crisis

It was, according to accounts filtering out of the White House, an extraordinary scene. Hank Paulson, the U.S. treasury secretary and a man with a personal fortune estimated at 700m (380m), had got down on one knee before the most powerful woman in Congress, Nancy Pelosi, and begged her to save his plan to rescue Wall Street.

    The Guardian, September 26, 20081

The financial crisis of 2008 was a complex event that took most economists and market participants by surprise. Since then, there have been many attempts to arrive at a narrative to explain the crisis, but none has proven definitive. For example, a Congressionally-chartered ten-member Financial Crisis Inquiry Commission produced three separate narratives, one supported by the members appointed by the Democrats, one supported by four members appointed by the Republicans, and a third written by the fifth Republican member, Peter Wallison.2

It is important to appreciate that the financial system is complex, not merely complicated. A complicated system, such as a smartphone, has a fixed structure, so it behaves in ways that are predictable and controllable. A complex system has an evolving structure, so it can evolve in ways that no one anticipates. We will never have a proven understanding of what caused the financial crisis, just as we will never have a proven understanding of what caused the first World War.

There can be no single, definitive narrative of the crisis. This entry can cover only a small subset of the issues raised by the episode.

Metaphorically, we may think of the crisis as a fire. It started in the housing market, spread to the sub-prime mortgage market, then engulfed the entire mortgage securities market and, finally, swept through the inter-bank lending market and the market for asset-backed commercial paper.

Home sales began to slow in the latter part of 2006. This soon created problems for the sector of the mortgage market devoted to making risky loans, with several major lenders—including the largest, New Century Financial—declaring bankruptcy early in 2007. At the time, the problem was referred to as the “sub-prime mortgage crisis,” confined to a few marginal institutions.

But by the spring of 2008, trouble was apparent at some Wall Street investment banks that underwrote securities backed by sub-prime mortgages. On March 16, commercial bank JP Morgan Chase acquired one of these firms, Bear Stearns, with help from loan guarantees provided by the Federal Reserve, the central bank of the United States.

Trouble then began to surface at all the major institutions in the mortgage securities market. By late summer, many investors had lost confidence in Freddie Mac and Fannie Mae, and the interest rates that lenders demanded from them were higher than what they could pay and still remain afloat. On September 7, the U.S. Treasury took these two GSEs into “conservatorship.”

Finally, the crisis hit the short-term inter-bank collateralized lending markets, in which all of the world’s major financial institutions participate. This phase began after government officials’ unsuccessful attempts to arrange a merger of investment bank Lehman Brothers, which declared bankruptcy on September 15. This bankruptcy caused the Reserve Primary money market fund, which held a lot of short-term Lehman securities, to mark down the value of its shares below the standard value of one dollar each. That created jitters in all short-term lending markets, including the inter-bank lending market and the market for asset-backed commercial paper in general, and caused stress among major European banks.

The freeze-up in the interbank lending market was too much for leading public officials to bear. Under intense pressure to act, Treasury Secretary Henry Paulson proposed a 700 billion financial rescue program. Congress initially voted it down, leading to heavy losses in the stock market and causing Secretary Paulson to plead for its passage. On a second vote, the measure, known as the Troubled Assets Relief Program (TARP), was approved.

In hindsight, within each sector affected by the crisis, we can find moral hazard, cognitive failures, and policy failures. Moral hazard (in insurance company terminology) arises when individuals and firms face incentives to profit from taking risks without having to bear responsibility in the event of losses. Cognitive failures arise when individuals and firms base decisions on faulty assumptions about potential scenarios. Policy failures arise when regulators reinforce rather than counteract the moral hazard and cognitive failures of market participants.

The Housing Sector

From roughly 1990 to the middle of 2006, the housing market was characterized by the following:

  • an environment of low interest rates, both in nominal and real (inflation-adjusted) terms. Low nominal rates create low monthly payments for borrowers. Low real rates raise the value of all durable assets, including housing.
  • prices for houses rising as fast as or faster than the overall price level
  • an increase in the share of households owning rather than renting
  • loosening of mortgage underwriting standards, allowing households with weaker credit histories to qualify for mortgages.
  • lower minimum requirements for down payments. A standard requirement of at least ten percent was reduced to three percent and, in some cases, zero. This resulted in a large increase in the share of home purchases made with down payments of five percent or less.
  • an increase in the use of new types of mortgages with “negative amortization,” meaning that the outstanding principal balance rises over time.
  • an increase in consumers’ borrowing against their houses to finance spending, using home equity loans, second mortgages, and refinancing of existing mortgages with new loans for larger amounts.
  • an increase in the proportion of mortgages going to people who were not planning to live in the homes that they purchased. Instead, they were buying them to speculate. 3

These phenomena produced an increase in mortgage debt that far outpaced the rise in income over the same period. The trends accelerated in the three years just prior to the downturn in the second half of 2006.

The rise in mortgage debt relative to income was not a problem as long as home prices were rising. A borrower having difficulty finding the cash to make a mortgage payment on a house that had appreciated in value could either borrow more with the house as collateral or sell the house to pay off the debt.

But when house prices stopped rising late in 2006, households that had taken on too much debt began to default. This set in motion a reverse cycle: house foreclosures increased the supply of homes for sale; meanwhile, lenders became wary of extending credit, and this reduced demand. Prices fell further, leading to more defaults and spurring lenders to tighten credit still further.

During the boom, some people were speculating in non-owner-occupied homes, while others were buying their own homes with little or no money down. And other households were, in the vernacular of the time, “using their houses as ATMs,” taking on additional mortgage debt in order to finance consumption.

In most states in the United States, once a mortgage lender forecloses on a property, the borrower is not responsible for repayment, even if the house cannot be sold for enough to cover the loan. This creates moral hazard, particularly for property speculators, who can enjoy all of the profits if house prices rise but can stick lenders with some of the losses if prices fall.

One can see cognitive failure in the way that owners of houses expected home prices to keep rising at a ten percent rate indefinitely, even though overall inflation was less than half that amount.4Also, many house owners seemed unaware of the risks of mortgages with “negative amortization.”

Policy failure played a big role in the housing sector. All of the trends listed above were supported by public policy. Because they wanted to see increased home ownership, politicians urged lenders to loosen credit standards. With the Community Reinvestment Act for banks and Affordable Housing Goals for Freddie Mac and Fannie Mae, they spurred traditional mortgage lenders to increase their lending to minority and low-income borrowers. When the crisis hit, politicians blamed lenders for borrowers’ inability to repay, and political pressure exacerbated the credit tightening that subsequently took place

The Sub-prime Mortgage Sector

Until the late 1990s, few lenders were willing to give mortgages to borrowers with problematic credit histories. But sub-prime mortgage lenders emerged and grew rapidly in the decade leading up to the crisis. This growth was fueled by financial innovations, including the use of credit scoring to finely grade mortgage borrowers, and the use of structured mortgage securities (discussed in the next section) to make the sub-prime sector attractive to investors with a low tolerance for risk. Above all, it was fueled by rising home prices, which created a history of low default rates.

There was moral hazard in the sub-prime mortgage sector because the lenders were not holding on to the loans and, therefore, not exposing themselves to default risk. Instead, they packaged the mortgages into securities and sold them to investors, with the securities market allocating the risk.

Because they sold loans in the secondary market, profits at sub-prime lenders were driven by volume, regardless of the likelihood of default. Turning down a borrower meant getting no revenue. Approving a borrower meant earning a fee. These incentives were passed through to the staff responsible for finding potential borrowers and underwriting loans, so that personnel were compensated based on “production,” meaning the new loans they originated.

Although in theory the sub-prime lenders were passing on to others the risks that were embedded in the loans they were making, they were among the first institutions to go bankrupt during the financial crisis. This shows that there was cognitive failure in the management at these companies, as they did not foresee the house price slowdown or its impact on their firms.

Cognitive failure also played a role in the rise of mortgages that were underwritten without verification of the borrowers’ income, employment, or assets. Historical data showed that credit scores were sufficient for assessing borrower risk and that additional verification contributed little predictive value. However, it turned out that once lenders were willing to forgo these documents, they attracted a different set of borrowers, whose propensity to default was higher than their credit scores otherwise indicated.

There was policy failure in that abuses in the sub-prime mortgage sector were allowed to continue. Ironically, while the safety and soundness of Freddie Mac and Fannie Mae were regulated under the Department of Housing and Urban Development, which had an institutional mission to expand home ownership, consumer protection with regard to mortgages was regulated by the Federal Reserve Board, whose primary institutional missions were monetary policy and bank safety. Though mortgage lenders were setting up borrowers to fail, the Federal Reserve made little or no effort to intervene. Even those policy makers who were concerned about practices in the sub-prime sector believed that, on balance, sub-prime mortgage lending was helping a previously under-served set of households to attain home ownership.5

Mortagage Securities

A mortgage security consists of a pool of mortgage loans, the payments on which are passed through to pension funds, insurance companies, or other institutional investors looking for reliable returns with little risk. The market for mortgage securities was created by two government agencies, known as Ginnie Mae and Freddie Mac, established in 1968 and 1970, respectively.

Mortgage securitization expanded in the 1980s, when Fannie Mae, which previously had used debt to finance its mortgage purchases, began issuing its own mortgage-backed securities. At the same time, Freddie Mac was sold to shareholders, who encouraged Freddie to grow its market share. But even though Freddie and Fannie were shareholder-owned, investors treated their securities as if they were government-backed. This was known as an implicit government guarantee.

Attempts to create a market for private-label mortgage securities (PLMS) without any form of government guarantee were largely unsuccessful until the late 1990s. The innovations that finally got the PLMS market going were credit scoring and the collateralized debt obligation (CDO).

Before credit scoring was used in the mortgage market, there was no quantifiable difference between any two borrowers who were approved for loans. With credit scoring, the Wall Street firms assembling pools of mortgages could distinguish between a borrower with a very good score (750, as measured by the popular FICO system) and one with a more doubtful score (650).

Using CDOs, Wall Street firms were able to provide major institutional investors with insulation from default risk by concentrating that risk in other sub-securities (“tranches”) that were sold to investors who were more tolerant of risk. In fact, these basic CDOs were enhanced by other exotic mechanisms, such as credit default swaps, that reallocated mortgage default risk to institutions in which hardly any observer expected to find it, including AIG Insurance.

There was moral hazard in the mortgage securities market, as Freddie Mac and Fannie Mae sought profits and growth on behalf of shareholders, but investors in their securities expected (correctly, as it turned out) that the government would protect them against losses. Years before the crisis, critics grumbled that the mortgage giants exemplified privatized profits and socialized risks.6

There was cognitive failure in the assessment of default risk. Assembling CDOs and other exotic instruments required sophisticated statistical modeling. The most important driver of expectations for mortgage defaults is the path for house prices, and the steep, broad-based decline in home prices that took place in 2006-2009 was outside the range that some modelers allowed for.

Another source of cognitive failure is the “suits/geeks” divide. In many firms, the financial engineers (“geeks) understood the risks of mortgage-related securities fairly well, but their conclusions did not make their way to the senior management level (“suits”).

There was policy failure on the part of bank regulators. Their previous adverse experience was with the Savings and Loan Crisis, in which firms that originated and retained mortgages went bankrupt in large numbers. This caused bank regulators to believe that mortgage securitization, which took risk off the books of depository institutions, would be safer for the financial system. For the purpose of assessing capital requirements for banks, regulators assigned a weight of 100 percent to mortgages originated and held by the bank, but assigned a weight of only 20 percent to the bank’s holdings of mortgage securities issued by Freddie Mac, Fannie Mae, or Ginnie Mae. This meant that banks needed to hold much more capital to hold mortgages than to hold mortgage-related securities; that naturally steered them toward the latter.

In 2001, regulators broadened the low-risk umbrella to include AAA-rated and AA-rated tranches of private-label CDOs. This ruling helped to generate a flood of PLMS, many of them backed by sub-prime mortgage loans.7

By using bond ratings as a key determinant of capital requirements, the regulators effectively put the bond rating agencies at the center of the process of creating private-label CDOs. The rating agencies immediately became subject to both moral hazard and cognitive failure. The moral hazard came from the fact that the rating agencies were paid by the issuers of securities, who wanted the most generous ratings possible, rather than being paid by the regulators, who needed more rigorous ratings. The cognitive failure came from the fact that that models that the rating agencies used gave too little weight to potential scenarios of broad-based declines in house prices. Moreover, the banks that bought the securities were happy to see them rated AAA because the high ratings made the securities eligible for lower capital requirements on the part of the banks. Both sides, therefore, buyers and sellers, had bad incentives.

There was policy failure on the part of Congress. Officials in both the Clinton and Bush Administrations were unhappy with the risk that Freddie Mac and Fannie Mae represented to taxpayers. But Congress balked at any attempt to tighten regulation of the safety and soundness of those firms.8

The Inter-bank Lending Market

There are a number of mechanisms through which financial institutions make short-term loans to one another. In the United States, banks use the Federal Funds market to manage short-term fluctuations in reserves. Internationally, banks lend in what is known as the LIBOR market.

One of the least known and most important markets is for “repo,” which is short for “repurchase agreement.” As first developed, the repo market was used by government bond dealers to finance inventories of securities, just as an automobile dealer might finance an inventory of cars. A money-market fund might lend money for one day or one week to a bond dealer, with the loan collateralized by a low-risk long-term security.

In the years leading up to the crisis, some dealers were financing low-risk mortgage-related securities in the repo market. But when some of these securities turned out to be subject to price declines that took them out of the “low-risk” category, participants in the repo market began to worry about all repo collateral. Repo lending offers very low profit margins, and if an investor has to be very discriminating about the collateral backing a repo loan, it can seem preferable to back out of repo lending altogether. This, indeed, is what happened, in what economist Gary Gorton and others called a “run on repo.”9

Another element of institutional panic was “collateral calls” involving derivative financial instruments. Derivatives, such as credit default swaps, are like side bets. The buyer of a credit default swap is betting that a particular debt instrument will default. The seller of a credit default swap is betting the opposite.

In the case of mortgage-related securities, the probability of default seemed low prior to the crisis. Sometimes, buyers of credit default swaps were merely satisfying the technical requirements to record the underlying securities as AAA-rated. They could do this if they obtained a credit default swap from an institution that was itself AAA-rated. AIG was an insurance company that saw an opportunity to take advantage of its AAA rating to sell credit default swaps on mortgage-related securities. AIG collected fees, and its Financial Products division calculated that the probability of default was essentially zero. The fees earned on each transaction were low, but the overall profit was high because of the enormous volume. AIG’s credit default swaps were a major element in the expansion of shadow banking by non-bank financial institutions during the run-up to the crisis.

Late in 2005, AIG abruptly stopped writing credit default swaps, in part because its own rating had been downgraded below AAA earlier in the year for unrelated reasons. By the time AIG stopped selling credit default swaps on mortgage-related securities, it had outstanding obligations on 80 billion of underlying securities and was earning 1 billion a year in fees.10

Because AIG no longer had its AAA rating and because the underlying mortgage securities, while not in default, were increasingly shaky, provisions in the contracts that AIG had written allowed the buyers of credit default swaps to require AIG to provide protection in the form of low-risk securities posted as collateral. These “collateral calls” were like a margin call that a stock broker will make on an investor who has borrowed money to buy stock that subsequently declines in value. In effect, collateral calls were a run on AIG’s shadow bank.

These collateral calls were made when the crisis in the inter-bank lending market was near its height in the summer of 2008 and banks were hoarding low-risk securities. In fact, the shortage of low-risk securities may have motivated some of the collateral calls, as institutions like Deutsche Bank and Goldman Sachs sought ways to ease their own liquidity problems. In any event, AIG could not raise enough short-term funds to meet its collateral calls without trying to dump long-term securities into a market that had little depth to absorb them. It turned to Federal authorities for a bailout, which was arranged and creatively backed by the Federal Reserve, but at the cost of reducing the value of shares in AIG.

With repos and derivatives, there was moral hazard in that the traders and executives of the narrow units that engaged in exotic transactions were able to claim large bonuses on the basis of short-term profits. But the adverse long-term consequences were spread to the rest of the firm and, ultimately, to taxpayers.

There was cognitive failure in that the collateral calls were an unanticipated risk of the derivatives business. The financial engineers focused on the (remote) chances of default on the underlying securities, not on the intermediate stress that might emerge from collateral calls.

There was policy failure when Congress passed the Commodity Futures Modernization Act. This legislation specified that derivatives would not be regulated by either of the agencies with the staff most qualified to understand them. Rather than require oversight by the Securities and Exchange Commission or the Commodity Futures Trading Commission (which regulated market-traded derivatives), Congress decreed that the regulator responsible for overseeing each firm would evaluate its derivative position. The logic was that a bank that was using derivatives to hedge other transactions should have its derivative position evaluated in a larger context. But, as it happened, the insurance and bank regulators who ended up with this responsibility were not equipped to see the dangers at firms such as AIG.

There was also policy failure in that officials approved of securitization that transferred risk out of the regulated banking sector. While Federal Reserve Officials were praising the risk management of commercial banks,11risk was accumulating in the shadow banking sector (non-bank institutions in the financial system), including AIG insurance, money market funds, Wall Street firms such as Bear Stearns and Lehman Brothers, and major foreign banks. When problems in the shadow banking sector contributed to the freeze in inter-bank lending and in the market for asset-backed commercial paper, policy makers felt compelled to extend bailouts to satisfy the needs of these non-bank institutions for liquid assets.

Conclusion

In terms of the fire metaphor suggested earlier, in hindsight, we can see that the markets for housing, sub-prime mortgages, mortgage-related securities, and inter-bank lending were all highly flammable just prior to the crisis. Moral hazard, cognitive failures, and policy failures all contributed the combustible mix.

The crisis also reflects a failure of the economics profession. A few economists, most notably Robert Shiller,12warned that the housing market was inflated, as indicated by ratios of prices to rents that were high by historical standards. Also, when risk-based capital regulation was proposed in the wake of the Savings and Loan Crisis and the Latin American debt crisis, a group of economists known as the Shadow Regulatory Committee warned that these regulations could be manipulated. They recommended, instead, greater use of senior subordinated debt at regulated financial institutions.13Many economists warned about the incentives for risk-taking at Freddie Mac and Fannie Mae.14

But even these economists failed to anticipate the 2008 crisis, in large part because economists did not take note of the complex mortgage-related securities and derivative instruments that had been developed. Economists have a strong preference for parsimonious models, and they look at financial markets through a lens that includes only a few types of simple assets, such as government bonds and corporate stock. This approach ignores even the repo market, which has been important in the financial system for over 40 years, and, of course, it omits CDOs, credit default swaps and other, more recent innovations.

Financial intermediaries do not produce tangible output that can be measured and counted. Instead, they provide intangible benefits that economists have never clearly articulated. The economics profession has a long way to go to catch up with modern finance.


About the Author

Arnold Kling was an economist with the Federal Reserve Board and with the Federal Home Loan Mortgage Corporation before launching one of the first Web-based businesses in 1994.  His most recent books areSpecialization and Trade and The Three Languages of Politics. He earned his Ph.D. in economics from the Massachusetts Institute of Technology.


Footnotes

1

“A desperate plea – then race for a deal before ‘sucker goes down’” The Guardian, September 26, 2008. https://www.theguardian.com/business/2008/sep/27/wallstreet.useconomy1

 

2

The report and dissents of the Financial Crisis Inquiry Commission can be found at https://fcic.law.stanford.edu/

3

See Stefania Albanesi, Giacomo De Giorgi, and Jaromir Nosal 2017, “Credit Growth and the Financial Crisis: A New Narrative” NBER working paper no. 23740. http://www.nber.org/papers/w23740

 

4

Karl E. Case and Robert J. Shiller 2003, “Is there a Bubble in the Housing Market?” Cowles Foundation Paper 1089 http://www.econ.yale.edu/shiller/pubs/p1089.pdf

 

5

Edward M. Gramlich 2004, “Subprime Mortgage Lending: Benefits, Costs, and Challenges,” Federal Reserve Board speeches. https://www.federalreserve.gov/boarddocs/speeches/2004/20040521/

 

6

For example, in 1999, Treasury Secretary Lawrence Summers said in a speech, “Debates about systemic risk should also now include government-sponsored enterprises.” See Bethany McLean and Joe Nocera 2010, All the Devils are Here: The Hidden History of the Financial Crisis Portfolio/Penguin Press. The authors write that Federal Reserve Chairman Alan Greenspan was also, like Summers, disturbed by the moral hazard inherent in the GSEs.

 

7

Jeffrey Friedman and Wladimir Kraus 2013, Engineering the Financial Crisis: Systemic Risk and the Failure of Regulation, University of Pennsylvania Press.

 

8

See McLean and Nocera, All the Devils are Here

 

9

Gary Gorton, Toomas Laarits, and Andrew Metrick 2017, “The Run on Repo and the Fed’s Response,” Stanford working paper. https://www.gsb.stanford.edu/sites/gsb/files/fin_11_17_gorton.pdf

 

10

Talking Points Memo 2009, “The Rise and Fall of AIG’s Financial Products Unit” https://talkingpointsmemo.com/muckraker/the-rise-and-fall-of-aig-s-financial-products-unit

 

11

Chairman Ben S. Bernanke 2006, “Modern Risk Management and Banking Supervision,” Federal Reserve Board speeches. https://www.federalreserve.gov/newsevents/speech/bernanke20060612a.htm

 

12

National Public Radio 2005, “Yale Professor Predicts Housing ’Bubble’ Will Burst” https://www.npr.org/templates/story/story.php?storyId4679264

 

13

Shadow Financial Regulatory Committee 2001, “The Basel Committee’s Revised Capital Accord Proposal” https://www.bis.org/bcbs/ca/shfirect.pdf

14

See the discussion in Viral V. Acharya, Matthew Richardson, Stijn Van Nieuwerburgh and Lawrence J. White 2011, Guaranteed to Fail: Fannie Mae, Freddie Mac, and the Debacle of Mortgage Finance, Princeton University Press.

 

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CEE September 18, 2018

Christopher Sims

Christopher Sims was awarded, along with Thomas Sargent, the 2011 Nobel Prize in Economic Sciences. The Nobel committee cited their “empirical research on cause and effect in the macroeconomy.” The economists who spoke at the press conference announcing the award emphasized Sargent’s and Sims’ analysis of role of people’s expectations.

One of Sims’s earliest famous contributions was his work on money-income causality, which was cited by the Nobel committee. Money and income move together, but which causes which? Milton Friedman argued that changes in the money supply caused changes in income, noting that the supply of money often rises before income rises. Keynesians such as James Tobin argued that changes in income caused changes in the amount of money. Money seems to move first, but causality, said Tobin and others, still goes the other way: people hold more money when they expect income to rise in the future.

Which view is true? In 1972 Sims applied Clive Granger’s econometric test of causality. On Granger’s definition one variable is said to cause another variable if knowledge of the past values of the possibly causal variable helps to forecast the effect variable over and above the knowledge of the history of the effect variable itself. Implementing a test of this incremental predictability, Sims concluded “[T]he hypothesis that causality is unidirectional from money to income [Friedman’s view] agrees with the postwar U.S. data, whereas the hypothesis that causality is unidirectional from income to money [Tobin’s view] is rejected.”

Sims’s influential article “Macroeconomics and Reality” was a criticism of both the usual econometric interpretation of large-scale Keynesian econometric models and ofRobert Lucas’s influential earlier criticism of these Keynesian models (the so-called Lucas critique). Keynesian econometricians had claimed that with sufficiently accurate theoretical assumptions about the structure of the economy, correlations among the macroeconomic variables could be used to measure the strengths of various structural connections in the economy. Sims argued that there was no basis for thinking that these theoretical assumptions were sufficiently accurate. Such so-called “identifying assumptions” were, Sims said, literally “incredible.” Lucas, on the other hand, had not rejected the idea of such identification. Rather he had pointed out that, if people held “rational expectations” – that is, expectations that, though possibly incorrect, did not deviate on average from what actually occurs in a correctable, systematic manner – then failing to account for them would undermine the stability of the econometric estimates and render the macromodels useless for policy analysis. Lucas and his New Classical followers argued that in forming their expectations people take account of the rules implicitly followed by monetary and fiscal policymakers; and, unless those rules were integrated into the econometric model, every time the policymakers adopted a new policy (i.e., new rules), the estimates would shift in unpredictable ways.

While rejecting the structural interpretation of large-scale macromodels, Sims did not reject the models themselves, writing: “[T]here is no immediate prospect that large-scale macromodels will disappear from the scene, and for good reason: they are useful tools in forecasting and policy analysis.” Sims conceded that the Lucas critique was correct in those cases in which policy regimes truly changed. But he argued that such regime changes were rare and that most economic policy was concerned with the implementation of a particular policy regime. For that purpose, the large-scale macromodels could be helpful, since what was needed for forecasting was a model that captured the complex interrelationships among variables and not one that revealed the deeper structural connections.

In the same article, Sims proposed an alternative to large-scale macroeconomic models, the vector autoregression (or VAR). In Sims’s view, the VAR had the advantages of the earlier macromodels, in that it could capture the complex interactions among a relatively large number of variables needed for policy analysis and yet did not rely on as many questionable theoretical assumptions. With subsequent developments by Sims and others, the VAR became a major tool of empirical macroeconomic analysis.

Sims has also suggested that sticky prices are caused by “rational inattention,” an idea imported from electronic communications. Just as computers do not access information on the Internet infinitely fast (but rather, in bits per second), individual actors in an economy have only a finite ability to process information. This delay produces some sluggishness and randomness, and allows for more accurate forecasts than conventional models, in which people are assumed to be highly averse to change.

Sims’s recent work has focused on the fiscal theory of the price level, the view that inflation in the end is determined by fiscal problems—the overall amount of debt relative to the government’s ability to repay it—rather than by the split in government debt between base money and bonds. In 1999, Sims suggested that the fiscal foundations of the European Monetary Union were “precarious” and that a fiscal crisis in one country “would likely breed contagion effects in other countries.” The Greek financial crisis about a decade later seemed to confirm his prediction.

Christopher Sims earned his B.A. in mathematics in 1963 and his Ph.D. in economics in 1968, both from Harvard University. He taught at Harvard from 1968 to 1970, at the University of Minnesota from 1970 to 1990, at Yale University from 1990 to 1999, and at Princeton University from 1999 to the present. He has been a Fellow of the Econometric Society since 1974, a member of the American Academy of Arts and Sciences since 1988, a member of the National Academy of Sciences since 1989, President of the Econometric Society (1995), and President of the American Economic Association (2012). He has been a Visiting Scholar for the Federal Reserve Banks of Atlanta, New York, and Philadelphia off and on since 1994.


Selected Works

  1. . “Money, Income, and Causality.” American Economic Review 62: 4 (September): 540-552.

  2. . “Macroeconomics and Reality.” Econometrica 48: 1 (January): 1-48.

1990 (with James H. Stock and Mark W. Watson). “Inference in Linear Time Series Models with some Unit Roots.” Econometrica 58: 1 (January): 113-144.

  1. . “The Precarious Fiscal Foundations of EMU.” De Economist 147:4 (December): 415-436.

  2. . “Implications of Rational Inattention.” Journal of Monetary Economics 50: 3 (April): 665–690.

(0 COMMENTS)

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Econlib July 11, 2020

Progressivism goes off the rails

Here’s Tyler Cowen:

But what struck me most of all was how much the “Old New Left” — whatever you think of it — had more metaphysical and ethical and aesthetic imagination — than the New New Left variants running around today.

Bob Dylan wrote My Back Pages at age 23.  Here are a few stanzas:

Half-wracked prejudice leaped forth “Rip down all hate,” I screamed Lies that life is black and white Spoke from my skull. I dreamed Romantic facts of musketeers Foundationed deep, somehow Ah, but I was so much older then I’m younger than that now

. . .

A self-ordained professor’s tongue Too serious to fool Spouted out that liberty Is just equality in school “Equality,” I spoke the word As if a wedding vow Ah, but I was so much older then I’m younger than that now

In a soldier’s stance, I aimed my hand At the mongrel dogs who teach Fearing not that I’d become my enemy In the instant that I preach My pathway led by confusion boats Mutiny from stern to bow Ah, but I was so much older then I’m younger than that now . . .

This seems to speak to the current moment—read the whole set of lyrics.  (And how does someone get that wise at age 23?)

It occurs to me that you could put together a 10-page essay composed of almost nothing but quotes from Dylan, Martin Luther King, Barack Obama, etc., and in the end get accused of being the worst kind of reactionary.  That’s an indication that one segment of the left may have lost its compass.

Over at Law and Liberty, Henry Edmondson has a nice essay on this and a few other Dylan songs. Highly recommended.

PS.  No need for commenters pointing out that the conservative movement has also lost its bearings, drifting into nationalism.  I’ve discussed that in other posts.

(9 COMMENTS)

Econlib July 10, 2020

Bob Murphy on How Identity Politics Hurts Everyone

I rarely find time to listen to podcasts that are longer than 10 minutes. But I found the following description intriguing:

Pointing to a recent Twitter thread from a progressive detailing his white male cisness, Bob shows how narrow the focus is on only particular “privileges” and not others. More generally, the effort to demonize white men is causing young people great harm, whether white or otherwise. The movement is based on power politics and relies on economic ignorance.

Bob Murphy is a friend but that’s not typically enough to get me listening. In this case I was glad I did.

The podcast is titled “Identity Politics Is Hurting Young People–Of all Colors,” July 9, 2020.

If you’re in a hurry, start at about 1:30 and go to about 15:00. You’ll get his most important message. But also I thought that the material in the last 5 or 6 minutes, where he discusses the U.S. women’s soccer team, was very good also.

UPDATE:

Once the diversity trainers have established this basic conceptual framework, they encourage white employees to “practice self-talk that affirms [their] complicity in racism” and work on “undoing [their] own whiteness.” As part of this process, white employees must abandon their “white normative behavior” and learn to let go of their “comfort,” “physical safety,” “social status,” and “relationships with some other white people.” As writer James Lindsay has pointed out, this is not the language of human resources; it is the language of cult programming—persuading members they are defective in some predefined manner, exploiting their emotional vulnerabilities, and isolating them from previous relationships.

This is from Christopher F. Rufo, “Cult Programming in Seattle,” City Journal, July 8. It supports Murphy’s claim that it isn’t just about privilege and advantage but is also about guilt. That relates to the discussion in the comments below between Mark Z and me.

(12 COMMENTS)

Econlib July 10, 2020

Escaping Paternalism Book Club Starts Next Week

The Escaping Paternalism Book Club starts next week.  Get your copy now and read this profound work of scholarship!

(1 COMMENTS)

Econlib July 9, 2020

The start of a new month means new articles at Econlib!

Gina Miller Johnson warns of the Danger of Benevolent Paternalism. Concerned by the increase in calls from her students and from the population as a whole for “The government to do something” almost regardless of what the “something” might be, Miller Johnson observes that this rapidly leads to government overreach. 

In a crisis like a pandemic, these dangers are heightened. “Whatever one’s view of the proper role of government as it relates to public health, another question must be posed: when, if ever, does public health provision as a public good supersede the protection of civil liberties as a fundamental role of the state? The initial wake of the pandemic saw disturbing support for sacrificing civil liberties in the name of public health.’

 

Michael L. Davis asks How Can Economists Help? “The question of whether economists help people has been on my mind a lot lately. This is an extraordinary time. People need help and, as Russ [Roberts] likes to remind us, one of Adam Smith’s most important insights is that “man naturally desires not only to be loved but to be lovely.” Most of us genuinely want to help. But we don’t know how to hook up a ventilator, we don’t have the local knowledge necessary to deliver fresh milk to the store and most of us wouldn’t even be very good at stocking the cooler once the milk arrives. Do economists have anything to offer?”

Don’t worry! Davis has nine suggestions for economists who want to use their skills to help out right now.

 

Arnold Kling reviews Mending America’s Political Divide by René H. Levy. The book offers “a neuroscientist’s perspective on the phenomenon of political polarization. Our politics is stimulating our tribal instincts, which lead us to lose empathy with the other side. This lack of empathy has dangerous consequences.” While Kling feels that the book “offers a sound diagnosis of our political ills. It offers a prescription that I wish more people would take to heart” he has some concerns about a lack of balance in Levy’s arguments.

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Econlib July 8, 2020

USMCA Is a Net Move AWAY From Free Trade

The reduction of trade barriers among the USMCA’s parties will strengthen U.S., Mexican and Canadian supply chains, returning manufacturing jobs to North America from China. Even before the Covid-19 pandemic exposed how North America had become too dependent on China for medical equipment and drugs, Beijing’s campaign of intimidation and censorship was already hurting international companies.

So write H.R. McMaster and Pablo Tortolero in “The North American Trade Dividend,” Wall Street Journal, July 6. (Print edition: July 7.)

The above paragraph suggests that the new United States Mexico Canada Agreement (USMCA) is a move to freer trade. Otherwise how could the authors claim that there’s a reduction of trade barriers.

It’s not.

I wrote about the USMCA at length in a Hoover publication, Defining Ideas, on December 20. My article is titled “NAFTA 0.0.” Here’s how I explained the title:

Some people are referring to the USMCA as NAFTA 2.0. When we use such a numbering system for software, the higher the number the better the product. So software 2.0 is presumably better than software 1.0. In this case, though, USMCA is likely inferior to NAFTA. So USMCA could reasonably be labeled NAFTA 0.0.

In other words, in most important respects, USMCA is a move away from the free trade aspects of NAFTA.

I elaborated in the piece:

There are some improvements. One is in agriculture. Governments in Canada have been notorious for restricting agriculture imports from the United States. Those include dairy products, eggs, wheat, poultry, and wine. The USMCA would lighten these restrictions. That’s particularly important for the U.S. dairy industry right now because of the decades-long decline in the amount of milk that the average American consumes. To put this in perspective, though, this is nothing like free trade; it simply increases, in small steps, the amount of various agricultural products that can be imported into Canada from the United States. Take a look at the  U.S. Trade Representative’s bragging Fact Sheet on agriculture under the USMCA and see if it doesn’t make you think about a central planner grudgingly allowing slightly more freedom. Robert Lighthizer, the U.S. Trade Presentative and a vocal advocate of managed trade, might be proud. Neither Canadians nor Americans should be.

Another improvement is in the area of digital trade. The U.S. government’s International Trade Commission (ITC), in its April 2019 analysis, claimed that the USMCA would, after six years, actually increase U.S. real GDP, relative to the NAFTA baseline, by 68.2 billion, or 0.35 percent. That’s a substantial number, amounting to about 200 annually per American. But, the ITC admits, that estimate leans heavily on the assumption that the digital trade rules would be clear enough that digital trade would expand substantially. Simon Lester, associate director of the Cato Institute’s Herbert A. Stiefel Center for Trade Policy Studies, expresses a well-founded skepticism. He grants that this part of the wording is good: “No Party shall prohibit or restrict the cross-border transfer of information, including personal information, by electronic means if this activity is for the conduct of the business of a covered person.” But Lester notes lots of exceptions, such as for government measures that are “necessary to achieve a legitimate public policy objective.” Legitimate in whose eyes?

But here is where USMCA is a strong move away from free trade:

Unfortunately, the USMCA has two big negatives. The first is the rollback of free trade in the auto industry. Under NAFTA, the way to avoid the 2.5 percent tariff that the U.S. government imposes on cars from other countries is to make sure that at least 62.5 percent of the value of a car is produced in North America. The USMCA raises that to 66 percent and then, over a period of three years, to 75 percent. In short, that’s a 20 percent increase in the amount of value that must be produced in North America. Another restriction on trade is that 70 percent of the aluminum and steel used in North American auto production must originate in North America. Both provisions will raise the prices of cars, as even the ITC admits.

The other big USMCA rollback of free trade in the auto industry is the imposition of a minimum wage in the Mexican auto industry. You read that right. The Trump administration, which to its credit, has refused to support a bill to raise the U.S. minimum wage from its July 2009 level of 7.25 an hour, wants a minimum wage of 16 an hour in its neighbor’s auto industry. Trump’s economic advisers understand that one of the effects of a big increase in the U.S. minimum wage would be to hurt the employment prospects of unskilled workers. Remember that a minimum wage law doesn’t guarantee a job at the minimum wage. All it guarantees is that someone who gets a job will be paid the minimum wage. But as left-of-center Nobel economist Paul Samuelson pointed out years ago, it is the requirement that a young unskilled worker be paid the minimum wage that makes him less likely to get a job.

The 16 minimum wage will have little effect in the U.S. and Canadian auto industries because the vast majority of auto workers in those industries already are paid at least 16 an hour. But the effect in the Mexican auto industry, absent other adjustments, would be devastating. According to a 2018 study by the Center for Automotive Research, based in Ann Arbor, Michigan, in 2017 the Mexican wage for auto assembly averaged 7.34 an hour. The auto producers in Mexico aren’t about to more than double the wage.

Disclosure: H.R. McMaster is a Hoover colleague.

HT2 Don Boudreaux and Dan Griswold.

(5 COMMENTS)

Econlib July 8, 2020

Monetary economics: The three heresies

In the wake of the Great Recession, the field of monetary economics has developed at least three heresies—schools of thought that reject mainstream monetary models. In my view, all three models are largely reactions to an important failure in mainstream models. The fact that these three heresies differ from each other largely reflects the fact that they came from different ideological perspectives.

In Thomas Kuhn’s theory of scientific progress, a widely accepted model may run into problems when faced by empirical facts that seem inconsistent with the prediction of the model.  This leads to a period of crisis, and new models are developed to address the empirical anomalies.  I believe that this has happened in monetary economics.

Consider the following claim (my words), which reflects the views of most mainstream economists, circa 2007:

“A policy of reducing interest rates to very low levels is highly expansionary.  When combined with massive fiscal stimulus it can lead to high inflation and/or a sovereign debt crisis.”

Over the past three decades, the Japanese have done something quite similar to the hypothetical policy mix described above.  And yet there has been no significant inflation and no debt crisis. That’s an anomaly that needs to be explained.

At the risk of oversimplification, here’s how three new schools of thought addressed this anomaly:

1.  MMTers suggest that governments of countries with their own fiat money face no limits on how much they can borrow.  They recommend that central banks in those countries set interest rates at zero.  Inflation would only become a problem if spending exceeded the capacity of the economy to produce, in which case higher taxes were the solution.

  1. NeoFisherians argue that low interest rates are not an expansionary monetary policy; rather they represent a contractionary policy that will lead to lower rates of inflation.

  2. Market monetarists argue that lower interest rates are not expansionary or contractionary, indeed to suggest that interest rates constitute a monetary policy is to “reason from a price change.”  Japanese rates were low because previous tight money policies had reduced trend NGDP growth to near zero.

So there are three new heterodox models, none of which agree with the mainstream model, and none of which agree with each other.  How did we end up with such a mess?

The important anomalies that were observed in Japan, Switzerland and elsewhere after 2008 made it almost inevitable that alternative models would be developed.  But why three?  The answer lies in that fact that even prior to 2008, there were important splits in the field of monetary economics.

Those who favored a more left wing interpretation of the Keynesian model (including so-called “Post Keynesians”) tended to strongly reject quantity theory oriented approaches to monetary policy.  In one sense, MMT can be seen as the most anti-quantity theory model ever developed.  Its tenets are almost the polar opposite of monetarism on a wide range of issues.

A more right-leaning group were used to employing a somewhat more classical (flexible price) model of macroeconomics.  In these models, the Fisher effect is far more important than the liquidity effect.  Thus it was natural for more classically inclined economists to gravitate toward an explanation of the Japanese anomaly that emphasized the Fisher effect—the way that changes in inflation expectations are strongly correlated with changes in nominal interest rates.  This eventually led to the NeoFisherian model.

A middle group coming out of the monetarist tradition, dubbed market monetarists, emphasized the importance of a wide range of linkages between money and interest rates, including the liquidity, income and Fisher effects.  This group accepted the monetarist view that changes in interest rates were a sort of epiphenomenon of monetary policy changes.  It rejected the assumption that changes in interest rates can tell us anything useful about changes in the stance of monetary policy.

Elsewhere I’ve described why I prefer market monetarism to mainstream models, MMT, and NeoFisherism, so I won’t repeat those points here.  (I am currently writing a paper on the Keynesian/NeoFisherian dispute.) But I will say that the mistake of equating interest rate changes with monetary policy is something like the original sin of macroeconomics.  It has caused all sorts of confusion, and gave birth to three very heterodox models.

This post is illustrated with the famous Goya print entitled “The Sleep of Reason Produces Monsters.  Let me just say that in my view the failure of mainstream economists to accurately describe the relationship between interest rates and monetary policy produced two quite misshapen beasts and one very beautiful baby.

(18 COMMENTS)

Econlib July 8, 2020

Health Care in the Headwinds of Capitalism

You’ve heard EconTalk host Russ Roberts argue that the central problem in American health care is that doctors get paid to do stuff to us, rather than take care of us. In this episode, Roberts welcomes physician and author Vivian Lee to talk about her new book, The Long Fix, to continue this conversation.

Roberts and Lee discuss the rising cost of health care, the trend of over-treatment and diagnosis at the expense of better health, and sources of optimism for the future of health care, including possible “silver linings” to the COVID-19 pandemic. Health care, asserts Lee, is “flying into the headwinds of capitalism,” and unless the incentives inherent in the system can be changed, there is little chance for relief.

After listening to this episode, we hope you’ll use the questions below to start your own conversation, either on- or offline. You might be interested in looking back at the many previous EconTalk episodes on health care for even more conversational inspiration.

 

 

1- We’re used to Roberts saying that “we” don’t pay for our health care. Lee disagrees. How does Lee explain her position? How does her catering analogy contribute to her explanation?

 

2- What is the “Chargemaster,” and how does this often result in differential prices for different kinds of patients? In what ways does Lee believe that standardizing the Chargemaster could have a big effect on the price we pay for health care? How should this standardization be accomplished?

 

3- Roberts asks Lee for her sources of optimism, and she enthusiastically describes the Medicare Advantage programs. What is it she likes about them? How do they change doctors’s incentives positively?

 

4- What are some of the disruptive forces in primary care discussed in this episode that strike you as promising? Lee says,”What’s going to be really interesting in the next few years is the degree to which this kind of mindset can extend to secondary, tertiary care, to hospitalizations, and to rehabilitation. That’s really where more of the dollars are spent right now.” What are some of the challenges in these areas? To what extent do you think COVID-19 will inspire innovation in health care?

 

5- Lee’s professional focus now is on creating a “learning health system?” What does she mean when she says of the future, “We are going to pay for better health. We’re not going to be fee-for-service anymore. The days of fee-for-service are numbered. Let the tailwinds of capitalism push this forward.” To what extent do you share Lee’s optimism?

 

(1 COMMENTS)

Econlib July 8, 2020

Will Italy get the “upside” of COVID?

In many assessments of the changes brought by COVID-19, I notice some classical liberal scholars are putting on the upside a certain degree of deregulation, which apparently governments are accepting in order to cope with the healthcare challenge and to ease the way towards recovery.

I am afraid that won’t happen in Italy. I have an article on the matter in Politico.eu.

As I recall in the piece,

The first time I heard an Italian politician promise to slash red tape, I was 13. It was 1994 and, with great fanfare, Silvio Berlusconi had injected the Reagan-esque language of bureaucratic reform into Italian politics.

It was a theme the four-time prime minister and his successors would return to over and over again. As the economist Nicola Rossi recently noted, over the last 30 years, Italy has introduced 10 much-talked-about “simplification reforms” and “reforms of the public administration” in 1990, 1993, 1997, 1998, 1999, 2000, 2003, 2005, 2009, 2014.

And yet, none of these resulted in an actual, substantive deregulation effort.

The article is here.

(2 COMMENTS)

Econlib July 8, 2020

Krikorian’s “Category Error”

During our last debate, an audience member asked Mark Krikorian if his arguments for restricting immigration of foreigners were also arguments for restricting the child-bearing of natives.  You might think that Mark would insist that native babies are somehow better than foreign adults.  How hard could it possibly be to craft such an argument?  However, Mark adamantly refused to compare the worths of different kinds of people.  Instead, he informed the questioner that his question was based on a “category error.”

In so doing, Mark signaled high IQ, because smart people love to announce that someone has made a “category error.”  But precisely what is a category error?  Here’s a standard definition:

To show that a category mistake has been committed one must typically show that once the phenomenon in question is properly understood, it becomes clear that the claim being made about it could not possibly be true.

Here’s a more detailed discussion:

Category mistakes are sentences such as ‘The number two is blue’, ‘The theory of relativity is eating breakfast’, or ‘Green ideas sleep furiously’. Such sentences are striking in that they are highly odd or infelicitous, and moreover infelicitous in a distinctive sort of way. For example, they seem to be infelicitous in a different way to merely trivially false sentences such as ‘225″ or obviously ungrammatical strings such as ‘The ran this’.

Which raises a big question: How could the audience member’s perfectly intelligible question possibly be a “category error”?!  If you say, “We should restrict immigration because immigrants burden taxpayers,” what on Earth is wrong with responding, “In that case, should we restrict child-bearing if babies burden taxpayers?”  The answer, of course, is: Nothing at all.  Not only is the latter question in the same “category” as the former question; it is the textbook way to check the logic of Mark’s position.  And it starkly reveals the inadequacy of Mark’s original argument.  Whatever your views on immigration, Mark definitely needs to assert something like, “We should restrict immigration because immigrants burden taxpayers and only natives are entitled to burden taxpayers.”

This in turn shifts the argument over to the fundamental question: What is morally permissible to do to foreigners but not natives – and why?  Which recalls a previous Krikorian-Caplan dialogue.  I asked Mark: “Suppose you can either save one American or x foreigners. How big does x have to be before you save the foreigners?__”  And Mark responded:

Another meaningless hypothetical.

Not only is this a meaningful question; it gets to the heart of what Mark needs to formulate a coherent position on immigration.  I’m confident that Mark, as an avowed Christian, thinks we have no right to murder or enslave foreigners.  And an avowed restrictionist, Mark clearly thinks we have a right to prohibit foreigners from domestic labor and residential markets – even though plenty of natives are eager to trade with them.  Why, though, does Mark draw the line there?  While it is rhetorically convenient for him to dodge the question by calling it a “category error” or “meaningless,” he intellectually doesn’t have a leg to stand on.

So why not face the question instead of stonewalling?  I stand by my previous explanation: Mark thinks like a politician, not a truth-seeker.  To make his position intellectually credible, he’d have to say, “Foreigners’ welfare is of near-zero value.”  Unfortunately for him, this sounds terrible – and like most politicians, Mark hates to utter anything that sounds terrible.  Occasionally bullet-biting is essential for truth, but it’s bad for winning popularity contests.

I’m never nervous when I debate Mark; he has good manners and reminds me of my dad.  In contrast, I would be quite nervous even to be in the same room as a white nationalist.  They seem like sociopaths.  In terms of intellectual rigor, however, leading white nationalists far exceed Mark.  I naturally think they’re deeply wrong.  Still, if you want to construct an airtight argument for immigration restriction, your best bet is to build on the twin premises that (a) almost all immigrants are inferior to natives, and (b) the well-being of these inferior people is of little worth.

 

(29 COMMENTS)

Econlib July 7, 2020

I “Win” My Bet

In mid-March I made a bet with my good friend and co-author Charley Hooper about the number of U.S. deaths there would be from COVID-19. The terms of the bet are here. In my post, I said why I thought he might win. Of course I hoped he would win. Unfortunately, he lost. And over 100,000 U.S. residents lost much, much more.

I waited this long because he and I both agreed that there could be a substantial number of deaths of people with the disease but not of the disease. We both agree, though, that of the 133,844 U.S. deaths so far, at least 100,000 of them are due to COVID-19.

I actually had bought much of Charley’s reasoning, which is why I titled my March 16 post “My Bet on Covid-19 and Why I Might Lose.” I asked Charley last week, when we both were becoming convinced that he lost, what he attributed his loss to. He answered that he didn’t expect various governments to be so incompetent, and he highlighted the role of New York’s governor Andrew Cuomo and some other northeast governments in making the problem much worse by insisting that nursing homes admit people with the disease.

(34 COMMENTS)

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