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If the Only Way You Can Get Your Great Idea Implemented…

Economics textbooks are full of clever-and-appealing policy proposals.  Proposals like: “Let’s redistribute money to the desperately poor” and “Let’s tax goods with negative externalities.”  They’re so clever and so appealing that it’s hard to understand how any smart, well-meaning person could demur.  When critics appeal to “public choice problems,” it’s tempting to tell the critics that they’re the problem.  The political system isn’t that dysfunctional, is it?  In any case, reflexively whining, “The political system will muck up your clever, appealing policy proposal,” hardly makes that system work better.  The naysayers should become part of the solution: Endorse the clever-and-appealing policy proposals – and strive to bring them to life.

When you look at the real world, though, you see something strange: Almost no one actually pushes for the textbooks’ clever-and-appealing policy proposals.  Instead, the people inspired by the textbooks routinely attach themselves to trendy-but-awful policy proposals.  If you point out the discrepancy, they’re often too annoyed to respond.  When they do, reformers shrug and say: “The clever-and-appealing policy never has – and probably never will – have much political support.  So we have to do this instead.”

Examples?  You start off by advocating high-impact redistribution to help poor children and the severely disabled… and end defending the ludicrously expensive and wasteful Social Security program.  “Unfortunately, the only politically viable way to help the poor is to help everyone.”  Or you start off advocating Pigovian taxes to clean the air, and end up defending phone books of picayune environmental regulations.  “Unfortunately, this is the way pollution policy actual works.”

Don’t believe me?  Here’s a brand-new example courtesy of Paul Krugman:

But if a nation in flames isn’t enough to produce a consensus for action — if it isn’t even enough to produce some moderation in the anti-environmentalist position — what will? The Australia experience suggests that climate denial will persist come hell or high water — that is, through devastating heat waves and catastrophic storm surges alike…

[…]

But if climate denial and opposition to action are immovable even in the face of obvious catastrophe, what hope is there for avoiding the apocalypse? Let’s be honest with ourselves: Things are looking pretty grim. However, giving up is not an option. What’s the path forward?

The answer, pretty clearly, is that scientific persuasion is running into sharply diminishing returns. Very few of the people still denying the reality of climate change or at least opposing doing anything about it will be moved by further accumulation of evidence, or even by a proliferation of new disasters. Any action that does take place will have to do so in the face of intractable right-wing opposition.

This means, in turn, that climate action will have to offer immediate benefits to large numbers of voters, because policies that seem to require widespread sacrifice — such as policies that rely mainly on carbon taxes — would be viable only with the kind of political consensus we clearly aren’t going to get.

What might an effective political strategy look like? … [O]ne way to get past the political impasse on climate might be via “an emphasis on huge infrastructural projects that created jobs” — in other words, a Green New Deal. Such a strategy could give birth to a “large climate-industrial complex,” which would actually be a good thing in terms of political sustainability.

Notice the pattern.

Step 1: Economics textbooks offer a clever-and-appealing policy proposal: Let’s tax carbon emissions to curtail the serious negative externalities of fossil fuels.  It’s cheap, it’s effective, it provides great static and dynamic incentives.  Public choice problems?  Don’t listen to those naysayers.

Step 2: Argh, Pigovian taxes are going nowhere.

Step 3: Let’s have a trendy-but-awful populist infrastructure program to get the masses on board.

So what?  For starters, any smart activist who reaches Step 3 tacitly concedes that public choice problems are dire.  You offer the public a clever-and-appealing remedy for a serious social ill, and democracy yawns.  To get action, you have to forget about cost or cost-effectiveness – and just try to drug the public with demagoguery.

Note: I’m not attacking Krugman for having little faith in democracy.  His underlying lack of faith in democracy is fully justified.  I only wish that Krugman would loudly embrace the public choice framework that intellectually justifies his lack of faith.  (Or better yet, Krugman could loudly embraced my psychologically-enriched public choice expansion pack).

Once you pay proper respect to public choice theory, however, you cannot simply continue on your merry way.  You have to ponder its central normative lesson: Don’t advocate government action merely because a clever-and-appealing policy proposal passes a cost-benefit test.  Instead, look at the trendy-but-awful policies that will actually be adopted – and see if they pass a cost-benefit test.  If they don’t, you should advocate laissez-faire despite all those shiny ideas in the textbook.

Krugman could naturally reply, “I’ve done the math.  Global warming is so terrible that trendy-but-awful policies are our least-bad bet.”  To the best of my knowledge, though, this contradicts mainstream estimates of the costs of warming.  That aside, why back a Green New Deal instead of deregulation of nuclear power or geoengineering?  If recalcitrant public opinion thwarts your clever-and-appealing remedy, maybe you started out on the wrong path in the first place.

Unfair?  Well, this is hardly the first time that Krugman has rationalized destructive populism when he really should have reconsidered.  Krugman knows that immigration is the world’s fastest way to escape absolute poverty.  He knows that standard complaints about immigration are, at best, exaggerated.  But he’s still an immigration skeptic, because:

The New Deal made America a vastly better place, yet it probably wouldn’t have been possible without the immigration restrictions that went into effect after World War I. For one thing, absent those restrictions, there would have been many claims, justified or not, about people flocking to America to take advantage of welfare programs.

Notice the pattern.

Step 1: You start with the textbook case for a welfare state to alleviate domestic poverty.  Public choice problems?  Bah.

Step 2: Next, you decide that you can’t get that welfare state without horrible collateral damage.

Step 3: So you casually embrace the status quo, without seriously engaging obvious questions, like: “Given political constraints, perhaps its actually better not to have the New Deal?” or even “How close can we get to the New Deal without limiting immigration?”

The moral: If the only way you can get your great idea implemented is to mutilate it and/or package it with a pile of expensive junk, you really should wonder, “Is it still worth it?”

Well, is it?

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Tribute to Anna J. Schwartz

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Marginal Revolution University (MRU) has put out an excellent video on the late Anna J. Schwartz, one of the first really successful female economists.

I started to write down some reminiscences, but realized that I did so in 2012 when she died. I’ll mention one thing and then hit some highlights in this 8-minute video.

One of my upsets is hearing people refer to Milton Friedman‘s book A Monetary History of the United States, 1867-1960, rather than the correct way to refer to it: Milton Friedman’s and Anna J. Schwartz’s A Monetary History of the United States, 1867-1960. She wasn’t just some bit player, as the video makes clear.

Now to the highlights: Christina Romer, Claudia Goldin, and Michael Bordo all have nice meaty comments about Anna’s work and its effects on our thinking. All, by the way, have articles in The Concise Encyclopedia of Economics. Christina’s is “Business Cycles,” Claudia’s is “Gender Gap,” and Michael’s is “Gold Standard.”

I have one main criticism. At the 5:36 point, Claudia Goldin says that our learning from Anna’s and Milton’s work on the monetary causes of the Great Depression helped us avoid the financial crisis of 2007-2008 being even more serious. Not quite. In fact, it was Bernanke’s decision to pour liquidity into the economy with one hand and sterilize it with the other that caused there not to be a big increase in the money supply. Michael Bordo pointed this out at the annual Kansas City Fed meeting at Jackson Hole in 2008 and Jeff Hummel elaborated on it in 2011.

Had they really learned the lesson, Americans would have avoided a lot of pain.

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Yes, the system is rigged. But how?

The Atlantic has a recent piece on how the optometrist industry is rigged against consumers:

In every other country in which I’ve lived—Germany and Britain, France and Italy—it is far easier to buy glasses or contact lenses than it is here. In those countries, as in Peru, you can simply walk into an optician’s store and ask an employee to give you an eye test, likely free of charge. If you already know your strength, you can just tell them what you want. You can also buy contact lenses from the closest drugstore without having to talk to a single soul—no doctor’s prescription necessary.

Another Atlantic article finds similar problems in dentistry.  The NYT finds similar problems in health care:

Much of what we accept as legal in medical billing would be regarded as fraud in any other sector.

And NPR provides an example:

# For Her Head Cold, Insurer Coughed Up 25,865

If you think these are isolated incidents, think again.  I personally know of similar examples (one involved an 8,000 bill for a mild cold, paid by taxpayers), so I very much doubt that they are unusual.

It’s not just health care.  Consumers buying cars are ripped off by a car dealer cartel, which prevents direct sales from manufacturers.  The fireman industry is a huge rip-off, with America having roughly twice as many fire stations as needed, as a huge cost to taxpayers.  Young homebuyers are ripped off by older homeowners who prevent new construction in towns like Reston, Virginia.There are similar examples in dozens of other industries, perhaps hundreds of others.

Politicians often complain that middle-class Americans are lagging behind because the system is rigged against them.  They are right.  But the politicians don’t tell the entire story.  Only a modest portion of the rigging is done by big corporations like Facebook, Google, Goldman Sachs and JP Morgan.  The biggest problem is various interest groups comprised of middle class people, who rip off the general public.

If we had free markets in health care, dentistry, optometry, fire protection, home building, car retailing and many other industries, then we could shed enormous numbers of workers from useless activities.  These workers could then produce useful output elsewhere, dramatically boosting real GDP and living standards.  The WSJ reports that our living standards are being depressed by a lack of workers:

# The U.S. Furniture Industry Is Back—but There Aren’t Enough Workers

If a politician promised to crack down on doctors, dentists, teachers, firemen, and older homeowners (like me), they’d certainly get my vote.  Unfortunately, that’s pretty much the only vote they would get.

And yet, we should not despair.  There is a great deal of ruin in a nation.  Despite all of these inefficiencies, living standards continue to rise:

Median family income adjusted for inflation was 29,000 in 1955. Today it’s just over 63,000, an all-time high. . . .

In the 1950s camping was an acceptable vacation. Hand-me-downs were acceptable clothes. A 983 square foot house was anacceptable size. Kids sharing a room was an acceptable arrangement. A tire swing was acceptable entertainment. Few of those things are acceptable baselines for most households today. The average new home now has more bathrooms than occupants.

In 1971, I stayed in a hotel for the first time in my life, at age 16.  I shared a bedroom with my brother, and we had a tire swing in the backyard.  No computer games in those days.  And yet you’ll hear “experts” tell you that living standards haven’t risen since the early 1970s.

We could do much better, but we are still doing pretty well.

HT: Aaron Renn, Tyler Cowen

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Carow Hall Reviews Open Borders

You need a thick skin here at Carow Hall.  If you’re wrong, your colleagues aren’t afraid to tell you.  The upside: When you receive praise, you know it’s the real thing.  So what’s the buzz here for Open Borders: The Science and Ethics of Immigration?

Tyler Cowen:

That is the already-bestselling graphic novel by Bryan Caplan and Zach Weinersmith, and I would just like to say it is a phenomenal achievement.  It is a landmark in economic education, how to present economic ideas, and the integration of economic analysis and graphic visuals.  I picked it up not knowing what to expect, and was blown away by the execution.

Robin Hanson:

In their new book Open Borders: The Science and Ethics of Immigration, Bryan Caplan and Zach Weinersmith do everything you’d think that good policy pundits should do.

They don’t just track trends or scold rivals, they identify and focus on a feasible positive policy change. They don’t just pick any old change, but focus on one of the biggest possible gains they can identify. And it isn’t a complex fragile proposal that most people couldn’t understand, or that would go badly if not implemented exactly as recommended; their proposal is simple and robust. They don’t pick a topic that has little emotional-resonance, regarding which few would act even if they were persuaded; their topic is quite emotionally-engaging. They don’t pick a change so abstract (like futarchy) that few can concretely imagine it; one can create concrete vivid images of what would happen if their proposal were implemented.

They don’t use complex technical prose, they write in simple clear language, and even add engaging pictures; their book is actually a well-done “graphic novel”. They don’t just present one side of an argument, but instead respond to many major counter arguments. They don’t just use one favored framework of analysis, they consider the issue from many possible frameworks. They don’t just focus on their favorite policy choice, they consider many possible ways to compromise with others. They aren’t overly confident in their claims. And while they consider many possible details and complexities, their main argument, regarding the main effect of their proposal, is simplicity itself.

Most important, their arguments seem solid and correct.

Alex Tabarrok:

I expected the ideas to be good. What I didn’t expect was how well the graphic-novel format works to convey those ideas. It’s a joy to read. Bryan’s personality–friendly, welcoming, honest but also analytic, numerate and morally and factually serious–comes through on every page. Every page also contains something interesting. The interplay of graphics and words shows two craftsmen at the top of their game–the pictures offer wry commentary, cameos, and emphases and bear careful viewing. What’s phenomenal is that in addition to being fun to read this is also the most serious book on freedom of movement that has ever been written.

P.S. Garett Jones, who also has an office at Carow Hall, is more critical.  Here are his critiques and my replies.  We also debated the issue back in 2015.

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Monnery on Hong Kong and Cuba

On our sister website, Law and Liberty, I’ve reviewed Neil Monnery’s A Tale of Two Economies.

Monnery was interviewed by Russ Roberts on the occasion of the publication of his previous book, an engaging biography of John Cowperthwaite, whom he sees as the “architect” of Hong Kong’s prosperity.

In this book, he compares Cowperhwaite with Ernesto “Che” Guevara. One was the man behind the key economic choices in Hong Kong, the other the man behind the key economic choices in Cuba. The two countries both “sit at a latitude of around 22 or 23 degree north, just south of the Tropic of Cancer.” In spite of geography, “each came to represent the beacon of a peculiar political theory in the 1960s and after: Hong Kong, what Milton Friedman and many others called an experiment in “free enterprise and free markets”; and Cuba, the last bastion of socialism after the Soviet Union faltered and China reformed.”

Monnery’s book is a fun, engaging read. I highly recommend him, if you are searching for a book to persuade a friend of the benefits of free enterprise.

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Which contentious issues are not partisan?

With America’s politics being increasingly polarized, it’s worth giving some thought to the issues are not partisan. What makes an issue cross party lines?  In San Diego, a proposal to limit growth has split the Democratic party:

“The ‘Yes on A’ side was unable to address the racial problem, in a way that clearly made our African-American voting members very uncomfortable,” he said. “Some language in the initiative seemed coded, things like defending neighborhood character and preventing urbanization – those are words long associated with communities of color. The optics of their case just were not good.” . . .

A watershed moment?  As Democrats are ascendant in local politics, we’ve been keeping a close eye for clues that traditionally right-of-center groups are reorienting themselves.

Is this the start of a relationship between the Democratic Party, and the Building Industry Association, which vehemently opposes Measure A?

Count Dracula and the Chamber of Wonders

[This post contains spoilers for the final episode of the 2020 Netflix series, Dracula. Proceed with caution.]

The current rendition of Dracula on Netflix, created by Mark Gatiss and Steven Moffat, was providing me with a delightfully gory evening of blood and horror when it stopped me dead. Out of nowhere, Count Dracula himself delivered one of the finest descriptions of the miracle of modern progress since Adam Smith marvelled that the greatest monarch of his time was not as far removed from the peasantry in terms of wealth than the peasant was from the monarch of an undeveloped country.

Adam Smith was able to make progress visible by comparing the rapidly industrializing England and Scotland with countries that had not yet experienced the rapid increase in wealth brought on by the division of labor and the increase of specialization and mechanization. These changes are so widespread and rapid in the 21st century, however, that we are liable to let them go unnoticed. As GK Chesterton noted, “We are perishing for want of wonder, not for want of wonders.” Or, if you prefer, George Will observed more recently in his 2019 book The Conservative Sensibility that “It is astonishing that we do not live in a state of perpetual astonishment.”

Profligacy for Austerity?

Suppose you strongly desire to drastically increase the amount of education that people consume.  What should you do?

The obvious answer: Make education completely free of charge – and have the government pay the the entire cost.

I say this obvious answer is obviously right.  As I explain in The Case Against Education, I favor extreme educational austerity, because I think the education system is a waste of time and money.  Nevertheless, given the goal of drastically increasing educational attainment, completely shifting the cost burden from consumers to taxpayers is highly effective.

Yes, there is some “crowding out” – when the U.S. government spends an extra billion dollars on education, consumption of education probably rises by less than a billion dollars.  Still, total U.S. consumption of education has ultimately increased by trillions of dollars as a result of past government subsidies.

This seems undeniable, but Tyler Cowen now suggests that free college is a way to restrain education spending!

7.  College free for all : Would wreck the relatively high quality of America’s state-run colleges and universities, which cover about 78 percent of all U.S. students and are the envy of other countries worldwide and furthermore a major source of American soft power.  Makes sense only if you are a Caplanian on higher ed., and furthermore like student debt forgiveness this plan isn’t that egalitarian, as many of the neediest don’t finish high school, do not wish to start college, cannot finish college, or already reject near-free local options for higher education, typically involving community colleges.

Tyler graciously acknowledges that I personally oppose free college.  (Come on, my book even has a section called “The Hidden Wonder of High Tuition and Student Debt”!)  Still, Tyler thinks that one viable way to achieve my austerian goal is to make college free.

I could understand Tyler’s claim if Warren were calling for draconian price controls on tuition.  That would be a wonderful way to shrink the sector, though I’m confident that state and local taxpayers would make up much of the shortfall.

I could understand Tyler’s claim if Warren were calling for educational rationing – to deny access to large swaths of would-be students.  That, too, might shrink the education sector.

Warren’s actual proposal, however, imposes neither price controls nor rationing.  Instead, she offers mountains of money to both students and states.  Students will have extra Pell Grants (not loans!) that pay for not only tuition, but housing, transportation, food, and books.  States that agree to eliminate tuition will receive a further bounty:

Warren’s vision calls for the federal government to partner with states that want to invest more in their public universities and match that state investment. While other plans have been dollar-for-dollar, or a 2-to-1 federal match, Warren wants the federal government to kick in two-thirds of the funding, making it a deal states would be hard-pressed to turn down.

Of course, all these plans have a catch; if states don’t want to take the money, their universities are left out of the equation.

Tyler could protest, “The U.S. has the best colleges in the world, thanks to our combination of public and private support.  Warren’s plan starves many of our best schools.”  This would be a fine argument if Warren proposed eliminating private support while keeping public support constant.  What she’s actually proposing, though, is to increase public spending so much that total education spending rises.  Probably by a lot.

Given budget constraints, I’d expect Warren’s plan to be heavily watered-down if it happens at all.  That hardly shows, however, that the watered-down version will work in the opposite of the original plan’s intended direction.  Worse comes to worse, states will turn down her offer and keep tuition where it is.

I know why I oppose Warren’s plan: I love austerity – and so should you.  Yet anyone who remains convinced that even more kids should go to college should be intrigued by her profligate proposal.

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A Simple Argument Against Ex-Im

Ex-Im’s mandate in financing American exports has been reconducted by Congress with the blessing of President Donald Trump, who first appeared to be against but changed his mind because, apparently, exports are important and cannot be left to the market. The law’s instigators won by “tucking it into a large must-pass spending package,” to use the terms of the Wall Street Journal, making sure that it would not be debated by the glorious representatives of the people. Here is a simple case against Ex-Im.

If Ex-Im increases American exports and if that is good, why not boost the agency’s subsidies enough for exports to increase until the whole American GDP is exported? (Whatever Americans needed for subsistence or more would be imported.) If the answer to this question is that subsidizing exports is only good up to a certain point, the question becomes: How are politicians and government bureaucrats as central planners capable of determining that nirvana threshold, as opposed to just laissez-faire the interplay of the decentralized actions of producers and consumers? Can Nancy Pelosi or Mitch McConnell find the nirvana threshold?

The real-world answer comes from what economists call the logic of collective action. Concentrated special interests, represented by the cronies who get the subsidies, win the political competition against the diffuse interests of taxpayers and consumers. Some call that “the swamp.” The government will subsidize cronies’ exports as much as the market will bear, that is, as long as taxpayers will not revolt and the mechanics of politics and bureaucracy will permit.

The opposite approach lies in the Marquis d’Argenson’s interjection: “Laissez faire, morbleu! Laissez faire!” (“Morbleu” is a French swear word, derived from “death of God.”)

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The Dream of Open Borders

Like Martin Luther King, I have a dream: that my four children will one day live in a world where human beings will not be judged by the nation of their birth, but by the content of their character.

My dream, in short, is that my sons and daughter will live to see a world of open borders.  If the arc of the moral universe bends toward justice, our descendants will view the immigration restrictions we continue to casually accept with the same horror that we now reserve for Jim Crow.

I wrote Open Borders hoping to make that arc bend a little sooner – to show everyone ages seven and up that radical liberalization of immigration is not just our moral duty, but an amazing policy opportunity for all humanity.

Happy MLK Day!

(3 COMMENTS)

Janine Barchas on the Lost Books of Jane Austen

Author and professor Janine Barchas of the University of Texas talks about her book, The Lost Books of Jane Austen, with EconTalk host Russ Roberts. The conversation explores Austen’s enduring reputation, how the cheap reprints of her work allowed that reputation to thrive, the links between Shakespeare and Austen, how Austen has thrived despite the […]

Adam Minter on Secondhand

[Listener Survey of 2019: https://www.surveymonkey.com/r/9Q97F9V. Vote for your favorites!] Journalist and author Adam Minter talks about his book Secondhand with EconTalk host Russ Roberts. Minter explores the strange and fascinating world of secondhand stuff–the downsizing that the elderly do when they move to smaller quarters, the unseen side of Goodwill Industries, and the global market […]

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Melanie Mitchell on Artificial Intelligence

Computer Scientist and author Melanie Mitchell of Portland State University and the Santa Fe Institute talks about her book Artificial Intelligence with EconTalk host Russ Roberts. Mitchell explains where we are today in the world of artificial intelligence (AI) and where we might be going. Despite the hype and excitement surrounding AI, Mitchell argues that […]

Kimberly Clausing on Open and the Progressive Case for Free Trade

Economist and author Kimberly Clausing of Reed College talks about her book Open with EconTalk host Russ Roberts. Clausing, a self-described progressive, argues that the United States should continue to embrace free trade but she argues for other interventions to soften the impact of trade on workers and communities.

Joe Posnanski on the Life and Afterlife of Harry Houdini

Journalist and author Joe Posnanski talks about his book, The Life and Afterlife of Harry Houdini, with EconTalk host Russ Roberts. Posnanski explores the enduring fame of Houdini who remains an iconic cultural figure almost a century after his death. Topics discussed include the nature of celebrity, the nature of ambition, parenting, magic, and the […]

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Binyamin Appelbaum on the Economists’ Hour

Journalist and author Binyamin Appelbaum of the New York Times talks about his book, The Economists’ Hour, with EconTalk host Russ Roberts. Appelbaum blames the triumph of free-market ideology for the rise in inequality and the decline in growth rates over the last half-century. The result is a lively, civil conversation about the economic events […]

Terry Moe on Educational Reform, Katrina, and Hidden Power

Political Scientist and author Terry Moe of Stanford University talks about his book, The Politics of Institutional Reform with EconTalk host Russ Roberts. Moe explores the politics and effectiveness of educational reform in the New Orleans public school system in the aftermath of Hurricane Katrina. Moe finds that policy-makers turned to charter schools for pragmatic […]

Gerd Gigerenzer on Gut Feelings

Psychologist and author Gerd Gigerenzer of the Max Planck Institute for Human Development talks about his book Gut Feelings with EconTalk host Russ Roberts. Gigerenzer argues for the power of simple heuristics–rules of thumb–over more complex models when making real-world decisions. He argues that many results in behavioral economics that appear irrational can be understood […]

Susan Mayer on What Money Can’t Buy

Sociologist Susan Mayer of the University of Chicago talks about her book What Money Can’t Buy with EconTalk host Russ Roberts. Mayer reports on her research which found that giving poor parents money had little measured effect on improving the lives of their children. She emphasizes the importance of accurately understanding the challenges facing children […]

Keith Smith on Free Market Health Care

Entrepreneur and Anesthesiologist Keith Smith of the Surgery Center of Oklahoma talks with host Russ Roberts about what it’s like to run a surgery center that posts prices on the internet and that does not take insurance. Along the way, he discusses the distortions in the market for health care and how a real market […]

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.

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.

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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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.

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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Jean Tirole

.jpg "Ecole polytechnique Université Paris-Saclay [CC BY-SA 2.0 (https://creativecommons.org/licenses/by-sa/2.0)], via Wikimedia Commons") 

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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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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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.

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Gordon Tullock

Gordon Tullock, along with his colleague James M. Buchanan, was a founder of the School of Public Choice. Among his contributions to public choice were his study of bureaucracy, his early insights on rent seeking, his study of political revolutions, his analysis of dictatorships, and his analysis of incentives and outcomes in foreign policy. Tullock also contributed to the study of optimal organization of research, was a strong critic of common law, and did work on evolutionary biology. He was arguably one of the ten or so most influential economists of the last half of the twentieth century. Many economists believe that Tullock deserved to share Buchanan’s 1986 Nobel Prize or even deserved a Nobel Prize on his own.

One of Tullock’s early contributions to public choice was The Calculus of Consent: Logical Foundations of Constitutional Democracy, co-authored with Buchanan in 1962. In that path-breaking book, the authors assume that people seek their own interests in the political system and then consider the results of various rules and political structures. One can think of their book as a political economist’s version of Montesquieu.

One of the most masterful sections of The Calculus of Consent is the chapter in which the authors, using a model formulated by Tullock, consider what good decision rules would be for agreeing to have someone in government make a decision for the collective. An individual realizes that if only one person’s consent is required, and he is not that person, he could have huge costs imposed on him. Requiring more people’s consent in order for government to take action reduces the probability that that individual will be hurt. But as the number of people required to agree rises, the decision costs rise. In the extreme, if unanimity is required, people can game the system and hold out for a disproportionate share of benefits before they give their consent. The authors show that the individual’s preferred rule would be one by which the costs imposed on him plus the decision costs are at a minimum. That preferred rule would vary from person to person. But, they note, it would be highly improbable that the optimal decision rule would be one that requires a simple majority. They write, “On balance, 51 percent of the voting population would not seem to be much preferable to 49 percent.” They suggest further that the optimal rule would depend on the issues at stake. Because, they note, legislative action may “produce severe capital losses or lucrative capital gains” for various groups, the rational person, not knowing his own future position, might well want strong restraints on the exercise of legislative power.

Tullock’s part of The Calculus of Consent was a natural outgrowth of an unpublished manuscript written in the 1950s that later became his 1965 book, The Politics of Bureaucracy. Buchanan, reminiscing about that book, summed up Tullock’s approach and the book’s significance:

The substantive contribution in the manuscript was centered on the hypothesis that, regardless of role, the individual bureaucrat responds to the rewards and punishments that he confronts. This straightforward, and now so simple, hypothesis turned the whole post-Weberian quasi-normative approach to bureaucracy on its head. . . . The economic theory of bureaucracy was born.1

Buchanan noted in his reminiscence that Tullock’s “fascinating analysis” was “almost totally buried in an irritating personal narrative account of Tullock’s nine-year experience in the foreign service hierarchy.” Buchanan continued: “Then, as now, Tullock’s work was marked by his apparent inability to separate analytical exposition from personal anecdote.” Translation: Tullock learned from his experiences. As a Foreign Service officer with the U.S. State Department for nine years Tullock learned, up close and “personal,” how dysfunctional bureaucracy can be. In a later reminiscence, Tullock concluded:

A 90 per cent cut-back on our Foreign Service would save money without really damaging our international relations or stature.2

Tullock made many other contributions in considering incentives within the political system. Particularly noteworthy was his work on political revolutions and on dictatorships.

Consider, first, political revolutions. Any one person’s decision to participate in a revolution, Tullock noted, does not much affect the probability that the revolution will succeed. Therefore, each person’s actions do not much affect his expected benefits from revolution. On the other hand, a ruthless head of government can individualize the costs by heavily punishing those who participate in a revolution. So anyone contemplating participating in a revolution will be comparing heavy individual costs with small benefits that are simply his pro rata share of the overall benefits. Therefore, argued Tullock, for people to participate, they must expect some large benefits that are tied to their own participation, such as a job in the new government. That would explain an empirical regularity that Tullock noted—namely that “in most revolutions, the people who overthrow the existing government were high officials in that government before the revolution.”

This thinking carried over to his work on autocracy. In Autocracy, Tullock pointed out that in most societies at most times, governments were not democratically elected but were autocracies: they were dictatorships or kingdoms. For that reason, he argued, analysts should do more to understand them. Tullock’s book was his attempt to get the discussion started. In a chapter titled “Coups and Their Prevention,” Tullock argued that one of the autocrat’s main challenges is to survive in office. He wrote: “The dictator lives continuously under the Sword of Damocles and equally continuously worries about the thickness of the thread.” Tullock pointed out that a dictator needs his countrymen to believe not that he is good, just, or ordained by God, but that those who try to overthrow him will fail.”

Among modern economists, Tullock was the earliest discoverer of the concept of “rent seeking,” although he did not call it that. Before his work, the usual measure of the deadweight loss from monopoly was the part of the loss in consumer surplus that did not increase producer surplus for the monopolist. Consumer surplus is the maximum amount that consumers are willing to pay minus the amount they actually pay; producer surplus, also called “economic rent,” is the amount that producers get minus the minimum amount for which they would be willing to produce. Harberger3 had estimated that for the U.S. economy in the 1950s, that loss was very low, on the order of 0.1 percent of Gross National Product. In “The Welfare Cost of Tariffs, Monopolies, and Theft,” Tullock argued that this method understated the loss from monopoly because it did not take account of the investment of the monopolist—and of others trying to be monopolists—in becoming monopolists. These investments in monopoly are a loss to the economy. Tullock also pointed out that those who seek tariffs invest in getting those tariffs, and so the standard measure of the loss from tariffs understated the loss. His analysis, as the tariff example illustrates, applies more to firms seeking special privileges from government than to private attempts to monopolize via the free market because private attempts often lead, as if by an invisible hand, to increased competition.”

One of Tullock’s most important insights in public choice was in a short article in 1975 titled “The Transitional Gains Trap.” He noted that even though rent seeking often leads to big gains for the rent seekers, those gains are capitalized in asset prices, which means that buyers of the assets make a normal return on the asset. So, for example, if the government requires the use of ethanol in gasoline, owners of land on which corn is grown will find that their land is worth more because of the regulatory requirement. (Ethanol in the United States is produced from corn.) They gain when the regulation is first imposed. But when they sell the land, the new owner pays a price equal to the present value of the stream of the net profits from the land. So the new owner doesn’t get a supra-normal rate of return from the land. In other words, the owner at the time that the regulation was imposed got “transitional gains,” but the new owner does not. This means that the new owner will suffer a capital loss if the regulation is removed and will fight hard to keep the regulation in place, arguing, correctly, that he paid for those gains. That makes repealing the regulation more difficult than otherwise. Tullock notes that, therefore, we should try hard to avoid getting into these traps because they are hard to get out of.

Tullock was one of the few public choice economists to apply his tools to foreign policy. In Open Secrets of American Foreign Policy, he takes a hard-headed look at U.S. foreign policy rather than the romantic “the United States is the good guys” view that so many Americans take. For example, he wrote of the U.S. government’s bombing of Serbia under President Bill Clinton:

[T]he bombing campaign was a clear-cut violation of the United Nations Charter and hence, should be regarded as a war crime. It involved the use of military forces without the sanction of the Security Council and without any colorable claim of self-defense. Of course, it was not a first—we [the U.S. government] had done the same thing in Vietnam, Grenada and Panama.

Possibly Tullock’s most underappreciated contributions were in the area of methodology and the economics of research. About a decade after spending six months with philosopher Karl Popper at the Center for Advanced Studies in Palo Alto, Tullock published The Organization of Inquiry. In it, he considered why scientific discovery in both the hard sciences and economics works so well without any central planner, and he argued that centralized funding by government would slow progress. After arguing that applied science is generally more valuable than pure science, Tullock wrote:

Nor is there any real justification for the general tendency to consider pure research as somehow higher and better than applied research. It is certainly more pleasant to engage in research in fields that strike you as interesting than to confine yourself to fields which are likely to be profitable, but there is no reason why the person choosing the more pleasant type of research should be considered more noble.4

In Tullock’s view, a system of prizes for important discoveries would be an efficient way of achieving important breakthroughs. He wrote:

As an extreme example, surely offering a reward of 1 billion for the first successful ICBM would have resulted in both a large saving of money for the government and much faster production of this weapon.5

Tullock was born in Rockford, Illinois and was an undergrad at the University of Chicago from 1940 to 1943. His time there was interrupted when he was drafted into the U.S. Army. During his time at Chicago, though, he completed a one-semester course in economics taught by Henry Simons. After the war, he returned to the University of Chicago Law School, where he completed the J.D. degree in 1947. He was briefly with a law firm in 1947 before going into the Foreign Service, where he worked for nine years. He was an economics professor at the University of South Carolina (1959-1962), the University of Virginia (1962-1967), Rice University (1968-1969), the Virginia Polytechnic Institute and State University (1968-1983), George Mason University (1983-1987), the University of Arizona (1987-1999), and again at George Mason University (1999-2008). In 1966, he started the journal Papers in Non-Market Decision Making, which, in 1969, was renamed Public Choice.

Selected Works

1. . The Calculus of Consent. (Co-authored with James M. Buchanan.) Ann Arbor, Michigan: University of Michigan Press.

2. . The Politics of Bureaucracy. Public Affairs Press. Washington, D.C.: Public Affairs Press.

3. . The Organization of Inquiry. Durham, North Carolina: Duke University Press.

4. . “The Welfare Costs of Tariffs, Monopolies, and Theft,” Western Economic Journal, 5:3 (June): 224-232.

5. . Toward a Mathematics of Politics. Ann Arbor, Michigan: University of Michigan Press.

6. . “The Paradox of Revolution.” Public Choice. Vol. 11. Fall: 89-99.

1975: “The Transitional Gains Trap.” Bell Journal of Economics, 6:2 (Autumn): 671-678.

1987: Autocracy. Hingham, Massachusetts: Kluwer Academic Publishers.

1. . Open Secrets of American Foreign Policy. New Jersey: World Scientific Publishing Co.

Footnotes

James M. Buchanan. 1987. The qualities of a natural economist. In Charles K. Rowley, (Ed.) (1987). Democracy and public choice. Oxford and New York: Basil Blackwell, 9-19.

Gordon Tullock. 2009. Memories of an unexciting life. Unfinished and unpublished manuscript. Tucson, 2009. Quoted in Charles K. Rowley and Daniel Houser. “The Life and Times of Gordon Tullock.” 2011. George Mason University. Department of Economics. Paper No. 11-56. December 20.

Arnold C. Harberger. 1954 “Monopoly and Resource Allocation.” American Economic Review. 44(2): 77-87.

Tullock. 1966. P. 14.

Tullock. 1966. P. 168.

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Division of Labor

Division of labor combines specialization and the partition of a complex production task into several, or many, sub-tasks. Its importance in economics lies in the fact that a given number of workers can produce far more output using division of labor compared to the same number of workers each working alone. Interestingly, this is true even if those working alone are expert artisans. The production increase has several causes. According to Adam Smith, these include increased dexterity from learning, innovations in tool design and use as the steps are defined more clearly, and savings in wasted motion changing from one task to another.

Though the scientific understanding of the importance of division of labor is comparatively recent, the effects can be seen in most of human history. It would seem that exchange can arise only from differences in taste or circumstance. But division of labor implies that this is not true. In fact, even a society of perfect clones would develop exchange, because specialization alone is enough to reward advances such as currency, accounting, and other features of market economies.

In the early 1800s, David Ricardo developed a theory of comparative advantage as an explanation for the origins of trade. And this explanation has substantial power, particularly in a pre-industrial world. Assume, for example, that England is suited to produce wool, while Portugal is suited to produce wine. If each nation specializes, then total consumption in the world, and in each nation, is expanded. Interestingly, this is still true if one nation is better at producing both commodities: even the less productive nation benefits from specialization and trade.

If the Only Way You Can Get Your Great Idea Implemented…

Economics textbooks are full of clever-and-appealing policy proposals.  Proposals like: “Let’s redistribute money to the desperately poor” and “Let’s tax goods with negative externalities.”  They’re so clever and so appealing that it’s hard to understand how any smart, well-meaning person could demur.  When critics appeal to “public choice problems,” it’s tempting to tell the critics that they’re the problem.  The political system isn’t that dysfunctional, is it?  In any case, reflexively whining, “The political system will muck up your clever, appealing policy proposal,” hardly makes that system work better.  The naysayers should become part of the solution: Endorse the clever-and-appealing policy proposals – and strive to bring them to life.

When you look at the real world, though, you see something strange: Almost no one actually pushes for the textbooks’ clever-and-appealing policy proposals.  Instead, the people inspired by the textbooks routinely attach themselves to trendy-but-awful policy proposals.  If you point out the discrepancy, they’re often too annoyed to respond.  When they do, reformers shrug and say: “The clever-and-appealing policy never has – and probably never will – have much political support.  So we have to do this instead.”

Examples?  You start off by advocating high-impact redistribution to help poor children and the severely disabled… and end defending the ludicrously expensive and wasteful Social Security program.  “Unfortunately, the only politically viable way to help the poor is to help everyone.”  Or you start off advocating Pigovian taxes to clean the air, and end up defending phone books of picayune environmental regulations.  “Unfortunately, this is the way pollution policy actual works.”

Don’t believe me?  Here’s a brand-new example courtesy of Paul Krugman:

But if a nation in flames isn’t enough to produce a consensus for action — if it isn’t even enough to produce some moderation in the anti-environmentalist position — what will? The Australia experience suggests that climate denial will persist come hell or high water — that is, through devastating heat waves and catastrophic storm surges alike…

[…]

But if climate denial and opposition to action are immovable even in the face of obvious catastrophe, what hope is there for avoiding the apocalypse? Let’s be honest with ourselves: Things are looking pretty grim. However, giving up is not an option. What’s the path forward?

The answer, pretty clearly, is that scientific persuasion is running into sharply diminishing returns. Very few of the people still denying the reality of climate change or at least opposing doing anything about it will be moved by further accumulation of evidence, or even by a proliferation of new disasters. Any action that does take place will have to do so in the face of intractable right-wing opposition.

This means, in turn, that climate action will have to offer immediate benefits to large numbers of voters, because policies that seem to require widespread sacrifice — such as policies that rely mainly on carbon taxes — would be viable only with the kind of political consensus we clearly aren’t going to get.

What might an effective political strategy look like? … [O]ne way to get past the political impasse on climate might be via “an emphasis on huge infrastructural projects that created jobs” — in other words, a Green New Deal. Such a strategy could give birth to a “large climate-industrial complex,” which would actually be a good thing in terms of political sustainability.

Notice the pattern.

Step 1: Economics textbooks offer a clever-and-appealing policy proposal: Let’s tax carbon emissions to curtail the serious negative externalities of fossil fuels.  It’s cheap, it’s effective, it provides great static and dynamic incentives.  Public choice problems?  Don’t listen to those naysayers.

Step 2: Argh, Pigovian taxes are going nowhere.

Step 3: Let’s have a trendy-but-awful populist infrastructure program to get the masses on board.

So what?  For starters, any smart activist who reaches Step 3 tacitly concedes that public choice problems are dire.  You offer the public a clever-and-appealing remedy for a serious social ill, and democracy yawns.  To get action, you have to forget about cost or cost-effectiveness – and just try to drug the public with demagoguery.

Note: I’m not attacking Krugman for having little faith in democracy.  His underlying lack of faith in democracy is fully justified.  I only wish that Krugman would loudly embrace the public choice framework that intellectually justifies his lack of faith.  (Or better yet, Krugman could loudly embraced my psychologically-enriched public choice expansion pack).

Once you pay proper respect to public choice theory, however, you cannot simply continue on your merry way.  You have to ponder its central normative lesson: Don’t advocate government action merely because a clever-and-appealing policy proposal passes a cost-benefit test.  Instead, look at the trendy-but-awful policies that will actually be adopted – and see if they pass a cost-benefit test.  If they don’t, you should advocate laissez-faire despite all those shiny ideas in the textbook.

Krugman could naturally reply, “I’ve done the math.  Global warming is so terrible that trendy-but-awful policies are our least-bad bet.”  To the best of my knowledge, though, this contradicts mainstream estimates of the costs of warming.  That aside, why back a Green New Deal instead of deregulation of nuclear power or geoengineering?  If recalcitrant public opinion thwarts your clever-and-appealing remedy, maybe you started out on the wrong path in the first place.

Unfair?  Well, this is hardly the first time that Krugman has rationalized destructive populism when he really should have reconsidered.  Krugman knows that immigration is the world’s fastest way to escape absolute poverty.  He knows that standard complaints about immigration are, at best, exaggerated.  But he’s still an immigration skeptic, because:

The New Deal made America a vastly better place, yet it probably wouldn’t have been possible without the immigration restrictions that went into effect after World War I. For one thing, absent those restrictions, there would have been many claims, justified or not, about people flocking to America to take advantage of welfare programs.

Notice the pattern.

Step 1: You start with the textbook case for a welfare state to alleviate domestic poverty.  Public choice problems?  Bah.

Step 2: Next, you decide that you can’t get that welfare state without horrible collateral damage.

Step 3: So you casually embrace the status quo, without seriously engaging obvious questions, like: “Given political constraints, perhaps its actually better not to have the New Deal?” or even “How close can we get to the New Deal without limiting immigration?”

The moral: If the only way you can get your great idea implemented is to mutilate it and/or package it with a pile of expensive junk, you really should wonder, “Is it still worth it?”

Well, is it?

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Tribute to Anna J. Schwartz

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Marginal Revolution University (MRU) has put out an excellent video on the late Anna J. Schwartz, one of the first really successful female economists.

I started to write down some reminiscences, but realized that I did so in 2012 when she died. I’ll mention one thing and then hit some highlights in this 8-minute video.

One of my upsets is hearing people refer to Milton Friedman‘s book A Monetary History of the United States, 1867-1960, rather than the correct way to refer to it: Milton Friedman’s and Anna J. Schwartz’s A Monetary History of the United States, 1867-1960. She wasn’t just some bit player, as the video makes clear.

Now to the highlights: Christina Romer, Claudia Goldin, and Michael Bordo all have nice meaty comments about Anna’s work and its effects on our thinking. All, by the way, have articles in The Concise Encyclopedia of Economics. Christina’s is “Business Cycles,” Claudia’s is “Gender Gap,” and Michael’s is “Gold Standard.”

I have one main criticism. At the 5:36 point, Claudia Goldin says that our learning from Anna’s and Milton’s work on the monetary causes of the Great Depression helped us avoid the financial crisis of 2007-2008 being even more serious. Not quite. In fact, it was Bernanke’s decision to pour liquidity into the economy with one hand and sterilize it with the other that caused there not to be a big increase in the money supply. Michael Bordo pointed this out at the annual Kansas City Fed meeting at Jackson Hole in 2008 and Jeff Hummel elaborated on it in 2011.

Had they really learned the lesson, Americans would have avoided a lot of pain.

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Yes, the system is rigged. But how?

The Atlantic has a recent piece on how the optometrist industry is rigged against consumers:

In every other country in which I’ve lived—Germany and Britain, France and Italy—it is far easier to buy glasses or contact lenses than it is here. In those countries, as in Peru, you can simply walk into an optician’s store and ask an employee to give you an eye test, likely free of charge. If you already know your strength, you can just tell them what you want. You can also buy contact lenses from the closest drugstore without having to talk to a single soul—no doctor’s prescription necessary.

Another Atlantic article finds similar problems in dentistry.  The NYT finds similar problems in health care:

Much of what we accept as legal in medical billing would be regarded as fraud in any other sector.

And NPR provides an example:

# For Her Head Cold, Insurer Coughed Up 25,865

If you think these are isolated incidents, think again.  I personally know of similar examples (one involved an 8,000 bill for a mild cold, paid by taxpayers), so I very much doubt that they are unusual.

It’s not just health care.  Consumers buying cars are ripped off by a car dealer cartel, which prevents direct sales from manufacturers.  The fireman industry is a huge rip-off, with America having roughly twice as many fire stations as needed, as a huge cost to taxpayers.  Young homebuyers are ripped off by older homeowners who prevent new construction in towns like Reston, Virginia.There are similar examples in dozens of other industries, perhaps hundreds of others.

Politicians often complain that middle-class Americans are lagging behind because the system is rigged against them.  They are right.  But the politicians don’t tell the entire story.  Only a modest portion of the rigging is done by big corporations like Facebook, Google, Goldman Sachs and JP Morgan.  The biggest problem is various interest groups comprised of middle class people, who rip off the general public.

If we had free markets in health care, dentistry, optometry, fire protection, home building, car retailing and many other industries, then we could shed enormous numbers of workers from useless activities.  These workers could then produce useful output elsewhere, dramatically boosting real GDP and living standards.  The WSJ reports that our living standards are being depressed by a lack of workers:

# The U.S. Furniture Industry Is Back—but There Aren’t Enough Workers

If a politician promised to crack down on doctors, dentists, teachers, firemen, and older homeowners (like me), they’d certainly get my vote.  Unfortunately, that’s pretty much the only vote they would get.

And yet, we should not despair.  There is a great deal of ruin in a nation.  Despite all of these inefficiencies, living standards continue to rise:

Median family income adjusted for inflation was 29,000 in 1955. Today it’s just over 63,000, an all-time high. . . .

In the 1950s camping was an acceptable vacation. Hand-me-downs were acceptable clothes. A 983 square foot house was anacceptable size. Kids sharing a room was an acceptable arrangement. A tire swing was acceptable entertainment. Few of those things are acceptable baselines for most households today. The average new home now has more bathrooms than occupants.

In 1971, I stayed in a hotel for the first time in my life, at age 16.  I shared a bedroom with my brother, and we had a tire swing in the backyard.  No computer games in those days.  And yet you’ll hear “experts” tell you that living standards haven’t risen since the early 1970s.

We could do much better, but we are still doing pretty well.

HT: Aaron Renn, Tyler Cowen

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Carow Hall Reviews Open Borders

You need a thick skin here at Carow Hall.  If you’re wrong, your colleagues aren’t afraid to tell you.  The upside: When you receive praise, you know it’s the real thing.  So what’s the buzz here for Open Borders: The Science and Ethics of Immigration?

Tyler Cowen:

That is the already-bestselling graphic novel by Bryan Caplan and Zach Weinersmith, and I would just like to say it is a phenomenal achievement.  It is a landmark in economic education, how to present economic ideas, and the integration of economic analysis and graphic visuals.  I picked it up not knowing what to expect, and was blown away by the execution.

Robin Hanson:

In their new book Open Borders: The Science and Ethics of Immigration, Bryan Caplan and Zach Weinersmith do everything you’d think that good policy pundits should do.

They don’t just track trends or scold rivals, they identify and focus on a feasible positive policy change. They don’t just pick any old change, but focus on one of the biggest possible gains they can identify. And it isn’t a complex fragile proposal that most people couldn’t understand, or that would go badly if not implemented exactly as recommended; their proposal is simple and robust. They don’t pick a topic that has little emotional-resonance, regarding which few would act even if they were persuaded; their topic is quite emotionally-engaging. They don’t pick a change so abstract (like futarchy) that few can concretely imagine it; one can create concrete vivid images of what would happen if their proposal were implemented.

They don’t use complex technical prose, they write in simple clear language, and even add engaging pictures; their book is actually a well-done “graphic novel”. They don’t just present one side of an argument, but instead respond to many major counter arguments. They don’t just use one favored framework of analysis, they consider the issue from many possible frameworks. They don’t just focus on their favorite policy choice, they consider many possible ways to compromise with others. They aren’t overly confident in their claims. And while they consider many possible details and complexities, their main argument, regarding the main effect of their proposal, is simplicity itself.

Most important, their arguments seem solid and correct.

Alex Tabarrok:

I expected the ideas to be good. What I didn’t expect was how well the graphic-novel format works to convey those ideas. It’s a joy to read. Bryan’s personality–friendly, welcoming, honest but also analytic, numerate and morally and factually serious–comes through on every page. Every page also contains something interesting. The interplay of graphics and words shows two craftsmen at the top of their game–the pictures offer wry commentary, cameos, and emphases and bear careful viewing. What’s phenomenal is that in addition to being fun to read this is also the most serious book on freedom of movement that has ever been written.

P.S. Garett Jones, who also has an office at Carow Hall, is more critical.  Here are his critiques and my replies.  We also debated the issue back in 2015.

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Monnery on Hong Kong and Cuba

On our sister website, Law and Liberty, I’ve reviewed Neil Monnery’s A Tale of Two Economies.

Monnery was interviewed by Russ Roberts on the occasion of the publication of his previous book, an engaging biography of John Cowperthwaite, whom he sees as the “architect” of Hong Kong’s prosperity.

In this book, he compares Cowperhwaite with Ernesto “Che” Guevara. One was the man behind the key economic choices in Hong Kong, the other the man behind the key economic choices in Cuba. The two countries both “sit at a latitude of around 22 or 23 degree north, just south of the Tropic of Cancer.” In spite of geography, “each came to represent the beacon of a peculiar political theory in the 1960s and after: Hong Kong, what Milton Friedman and many others called an experiment in “free enterprise and free markets”; and Cuba, the last bastion of socialism after the Soviet Union faltered and China reformed.”

Monnery’s book is a fun, engaging read. I highly recommend him, if you are searching for a book to persuade a friend of the benefits of free enterprise.

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Which contentious issues are NOT partisan?

With America’s politics being increasingly polarized, it’s worth giving some thought to the issues are not partisan. What makes an issue cross party lines?  In San Diego, a proposal to limit growth has split the Democratic party:

“The ‘Yes on A’ side was unable to address the racial problem, in a way that clearly made our African-American voting members very uncomfortable,” he said. “Some language in the initiative seemed coded, things like defending neighborhood character and preventing urbanization – those are words long associated with communities of color. The optics of their case just were not good.” . . .

A watershed moment?  As Democrats are ascendant in local politics, we’ve been keeping a close eye for clues that traditionally right-of-center groups are reorienting themselves.

Is this the start of a relationship between the Democratic Party, and the Building Industry Association, which vehemently opposes Measure A?

“The alliance might be shifting, but I’m not sure it’s settled yet and I wouldn’t say this is a beginning of a relationship with the BIA or any other institution,” Rodriguez-Kennedy said. “You might see the BIA endorse Democrats, but I don’t think it’s fundamentally changed the coalition.” . . .

While lots of Democrats had already sided against Measure A, so too had many lined up for it. The Climate Action Campaign, a nonprofit group led by Nicole Capretz that started to push cities into adopting and enforcing aggressive plans to combat climate change and shift to renewable energy, has endorsed the “Yes on A” side.

In Virginia, the housing issue also crosses party lines.  Some Democrats are pushing for more housing development in the DC suburbs, while others are wary:

H.B. 152 is almost certain to face pushback in Virginia, a state where Democrats now control the legislature for the first time since the 1990s. Housing and zoning don’t line up neatly with traditional partisan divides on other issues, though. Conservatives may wind up backing the measure as a market deregulation, while liberals might balk at a measure that could bring density to their doorstep.

School vouchers are another example of an issue that crosses party lines.  Another example is occupational licensure:

Inequality and low productivity growth are two of the biggest problems that vex the U.S. economy. For Jonathan Rothwell, they are of a piece, driven by the power of large and influential groups of professionals in fields like finance, medicine, and law to wall themselves off from competition.

Rothwell, formerly of Brookings Institution and now Gallup’s senior economist, shows that the United States is unique among the advanced nations in the power afforded to these groups. The huge differences in incomes we see in this country are not the result of education or skills, but of political power. Inequality in the United States is also bound up with race and racism, from slavery, to the exclusion of minorities from early professional organizations, to exclusionary zoning that denies minority and low-income people access to suburban schools.

Suppose each party contains a coalition of disparate interest groups.  Then an issue will be non-partisan if it splits the voters in each party.  Thus affluent GOP suburbanites and Democratic public school teachers may both oppose school vouchers, while free market ideologues (GOP) and minority parents may support them.

Home building may be supported by younger and minority voters (Dem) who can’t afford a home, and also by free market ideologues plus building contractors (GOP).  Occupational licensing may be supported by affluent GOP professionals and also by Democratic union members, and opposed by free market ideologues plus minority voters.

When issues are non-partisan, they become invisible to the media.  That creates a distorted perception among voters.  Many of the most important issues facing America don’t even come up in debate, as they are not seen as part of the political war between the parties.  As parties become more tribal, they shy away from these non-partisan issues, in fear of alienating members of their own party.

The GOP tends to demonize “socialism” and hence doesn’t want to highlight the fact that their members often support socialistic policies such as trade barriers, regulatory barriers to entry, farm subsidies, and social insurance for the elderly.  The Democrats like to rail against the evils of unrestrained capitalism, and hence don’t wish to emphasize areas where more capitalism would help the poor.

In my view, the most important problems facing the country are typically issues that neither party wishes to discuss.

PS.  The NYT claims that “non-compete clauses” in labor contracts are also an issue that crosses party lines. What are some others?

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Count Dracula and the Chamber of Wonders

[This post contains spoilers for the final episode of the 2020 Netflix series, Dracula. Proceed with caution.]

The current rendition of Dracula on Netflix, created by Mark Gatiss and Steven Moffat, was providing me with a delightfully gory evening of blood and horror when it stopped me dead. Out of nowhere, Count Dracula himself delivered one of the finest descriptions of the miracle of modern progress since Adam Smith marvelled that the greatest monarch of his time was not as far removed from the peasantry in terms of wealth than the peasant was from the monarch of an undeveloped country.

Adam Smith was able to make progress visible by comparing the rapidly industrializing England and Scotland with countries that had not yet experienced the rapid increase in wealth brought on by the division of labor and the increase of specialization and mechanization. These changes are so widespread and rapid in the 21st century, however, that we are liable to let them go unnoticed. As GK Chesterton noted, “We are perishing for want of wonder, not for want of wonders.” Or, if you prefer, George Will observed more recently in his 2019 book The Conservative Sensibility that “It is astonishing that we do not live in a state of perpetual astonishment.”

Standing in the middle of the modern world, we forget about the wonders that surround us. Gatiss and Moffat’s Dracula notices every single one of them, though. Very early in the third and final episode of the series, he awakens in the somewhat dreary town of Whitby after more than a century of slumber. He invades the completely ordinary home of Kathy and Bob, consumes Bob, and then decides to have a bit of a chat with Kathy. 

“What is wrong with your servants, Kathleen? I’m assuming you have staff; you’re clearly very wealthy.”

“Wealthy?”

“Yes, well, look at all this stuff! All this food. The moving picture box. And that…that thing outside. Bob calls it ummm, a car? Is that yours? And this treasure trove is your house? 

“It’s a dump!”

‘It’s amazing. Kathleen, I’ve been a nobleman for 400 years. I’ve lived in castles and palaces and among the richest people of any age. Never, NEVER have I stood in greater luxury than surrounds me now. This is a chamber of marvels! There isn’t a king, or queen, or emperor that I have ever known or eaten who would step into this room and ever agree to leave it again. I knew the future would bring wonders. I did not know it would make them ordinary.“

(He’s equally fond of Tinder, which he uses as a sort of UberEats.)

It will take more than popular culture to put a stake in the heart of the 21st century’s refusal to see the amazing world humanity has created, but this 90 second scene from Gattis and Moffat’s Dracula is a very good start, and it gives us all a lecture clip to die for.

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Profligacy for Austerity?

Suppose you strongly desire to drastically increase the amount of education that people consume.  What should you do?

The obvious answer: Make education completely free of charge – and have the government pay the the entire cost.

I say this obvious answer is obviously right.  As I explain in The Case Against Education, I favor extreme educational austerity, because I think the education system is a waste of time and money.  Nevertheless, given the goal of drastically increasing educational attainment, completely shifting the cost burden from consumers to taxpayers is highly effective.

Yes, there is some “crowding out” – when the U.S. government spends an extra billion dollars on education, consumption of education probably rises by less than a billion dollars.  Still, total U.S. consumption of education has ultimately increased by trillions of dollars as a result of past government subsidies.

This seems undeniable, but Tyler Cowen now suggests that free college is a way to restrain education spending!

7.  College free for all : Would wreck the relatively high quality of America’s state-run colleges and universities, which cover about 78 percent of all U.S. students and are the envy of other countries worldwide and furthermore a major source of American soft power.  Makes sense only if you are a Caplanian on higher ed., and furthermore like student debt forgiveness this plan isn’t that egalitarian, as many of the neediest don’t finish high school, do not wish to start college, cannot finish college, or already reject near-free local options for higher education, typically involving community colleges.

Tyler graciously acknowledges that I personally oppose free college.  (Come on, my book even has a section called “The Hidden Wonder of High Tuition and Student Debt”!)  Still, Tyler thinks that one viable way to achieve my austerian goal is to make college free.

I could understand Tyler’s claim if Warren were calling for draconian price controls on tuition.  That would be a wonderful way to shrink the sector, though I’m confident that state and local taxpayers would make up much of the shortfall.

I could understand Tyler’s claim if Warren were calling for educational rationing – to deny access to large swaths of would-be students.  That, too, might shrink the education sector.

Warren’s actual proposal, however, imposes neither price controls nor rationing.  Instead, she offers mountains of money to both students and states.  Students will have extra Pell Grants (not loans!) that pay for not only tuition, but housing, transportation, food, and books.  States that agree to eliminate tuition will receive a further bounty:

Warren’s vision calls for the federal government to partner with states that want to invest more in their public universities and match that state investment. While other plans have been dollar-for-dollar, or a 2-to-1 federal match, Warren wants the federal government to kick in two-thirds of the funding, making it a deal states would be hard-pressed to turn down.

Of course, all these plans have a catch; if states don’t want to take the money, their universities are left out of the equation.

Tyler could protest, “The U.S. has the best colleges in the world, thanks to our combination of public and private support.  Warren’s plan starves many of our best schools.”  This would be a fine argument if Warren proposed eliminating private support while keeping public support constant.  What she’s actually proposing, though, is to increase public spending so much that total education spending rises.  Probably by a lot.

Given budget constraints, I’d expect Warren’s plan to be heavily watered-down if it happens at all.  That hardly shows, however, that the watered-down version will work in the opposite of the original plan’s intended direction.  Worse comes to worse, states will turn down her offer and keep tuition where it is.

I know why I oppose Warren’s plan: I love austerity – and so should you.  Yet anyone who remains convinced that even more kids should go to college should be intrigued by her profligate proposal.

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A Simple Argument Against Ex-Im

Ex-Im’s mandate in financing American exports has been reconducted by Congress with the blessing of President Donald Trump, who first appeared to be against but changed his mind because, apparently, exports are important and cannot be left to the market. The law’s instigators won by “tucking it into a large must-pass spending package,” to use the terms of the Wall Street Journal, making sure that it would not be debated by the glorious representatives of the people. Here is a simple case against Ex-Im.

If Ex-Im increases American exports and if that is good, why not boost the agency’s subsidies enough for exports to increase until the whole American GDP is exported? (Whatever Americans needed for subsistence or more would be imported.) If the answer to this question is that subsidizing exports is only good up to a certain point, the question becomes: How are politicians and government bureaucrats as central planners capable of determining that nirvana threshold, as opposed to just laissez-faire the interplay of the decentralized actions of producers and consumers? Can Nancy Pelosi or Mitch McConnell find the nirvana threshold?

The real-world answer comes from what economists call the logic of collective action. Concentrated special interests, represented by the cronies who get the subsidies, win the political competition against the diffuse interests of taxpayers and consumers. Some call that “the swamp.” The government will subsidize cronies’ exports as much as the market will bear, that is, as long as taxpayers will not revolt and the mechanics of politics and bureaucracy will permit.

The opposite approach lies in the Marquis d’Argenson’s interjection: “Laissez faire, morbleu! Laissez faire!” (“Morbleu” is a French swear word, derived from “death of God.”)

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The Dream of Open Borders

Like Martin Luther King, I have a dream: that my four children will one day live in a world where human beings will not be judged by the nation of their birth, but by the content of their character.

My dream, in short, is that my sons and daughter will live to see a world of open borders.  If the arc of the moral universe bends toward justice, our descendants will view the immigration restrictions we continue to casually accept with the same horror that we now reserve for Jim Crow.

I wrote Open Borders hoping to make that arc bend a little sooner – to show everyone ages seven and up that radical liberalization of immigration is not just our moral duty, but an amazing policy opportunity for all humanity.

Happy MLK Day!

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