Right Reason

Comparative Advantage at 200

 

Under a system of perfectly free commerce, each country naturally devotes its capital and labour to such employments as are most beneficial to each. This pursuit of individual advantage is admirably connected with the with the universal good of the whole. By stimulating industry, by rewarding ingenuity, and by using most efficaciously the peculiar powers bestowed by nature, it distributes labour most effectively and most economically: while, by increasing the general mass of productions, it diffuses general benefit, and binds together, by one common tie of interest and intercourse, the universal society of nations throughout the civilized world.

-David Ricardo, Principles of Political Economy, and Taxation

 

April 19th marked the two-hundredth anniversary of the publication of David Ricardo’s Principles of Political Economy, and Taxation, and therefore of also his principle of comparative advantage.

 

In Human Action, Ludwig von Mises rechristened Ricardo’s principle as the ‘Ricardian Law of Association’ and enshrined it as one of the fundamental principles for understanding how material progress is possible through social cooperation: “The law of association makes us comprehend the tendencies which resulted in the progressive intensification of human cooperation” (Mises 1998: 159). In the History of Economic Analysis, Joseph Schumpeter never seemed all that much impressed with Ricardo’s accomplishments; on the topic of comparative advantage, which he never explicitly mentions, Schumpeter notes that Robert Torrens “baptized the theorem, [Ricardo] elaborated it and fought for it victoriously” (Schumpeter 1994: 607). Schumpeter’s unenthusiastic sentiment towards Ricardo is explained elsewhere in his History when he asserts that it was “neither his advocacy of winning policies per se, not his theory per se, that, to this day, makes of [Ricardo], in the eyes of some, the first economist of his time, but a felicitous combination of both” (Ibid: 473). Paul Samuelson was much more enthusiastic towards Ricardo and his exposition of economic theory. He is said (I must confess I cannot find the citation online) to have said that Ricardo’s principle of comparative advantage was an idea in economics that was simultaneously both universally true and not obvious.

However, I do think that a problem can be had with that principle and that, from the side of probability, that problem can be universally true and not obvious to the economic way of thinking, as it manifests in classrooms the world over. Whenever economists teach the lessons of comparative advantage, they do so in realized numbers alone. They write out the context of comparative advantage as if the comparative advantage of each individual element of their system is entirely known and can be pin-pointed to a single number. Although such an elucidation of international trade may be aided by the use of single numbers, the use of those numbers alone suppress the second-order effects of the variability in prices and their nature as random variables in the real-world.

 

The brilliance of the principle of comparative advantage is the way that it disentangles opportunity-costs from nominal costs. The economic way of thinking properly educates us that individuals, as well as nations, should look at the opportunity costs to the patterns of specialization and trade they participate in, not their nominal costs.

In The Principles of Political Economy and Taxation, Ricardo introduces comparative advantage by introducing the celebrated example of exchanging corn and wine:

The quantity of wine which [Portugal] shall give in exchange for the cloth of England, is not determined by the respective quantities of labour devoted to the production of each, as it would be, if both commodities were manufactured in England, or both in Portugal.

England may be so circumstanced, that to produce the cloth may require the labour of 100 men for one year; and if she attempted to make the wine, it might require the labour of 120 men for the same time. England would therefore find it her interest to import wine, and to purchase it by the exportation of cloth.

To produce the wine in Portugal, might require only the labour of 80 men for one year, and to produce the cloth in the same country, might require the labour of 90 men for the same time. It would therefore be advantageous for her to export wine in exchange for cloth. This exchange might even take place, notwithstanding that the commodity imported by Portugal could be produced there with less labour than in England. Though she could make the cloth with the labour of 90 men, she would import it from a country where it required the labour of 100 men to produce it, because it would be advantageous to her rather to employ her capital in the production of wine, for which she would obtain more cloth from England, than she could produce by diverting a portion of her capital from the cultivation of vines to the manufacture of cloth.

Thus England would give the produce of the labour of 100 men, for the produce of the labour of 80. Such an exchange could not take place between the individuals of the same country. The labour of 100 Englishmen cannot be given for that of 80 Englishmen, but the produce of the labour of 100 Englishmen may be given for the produce of the labour of 80 Portuguese, 60 Russians, or 120 East Indians. The difference in this respect, between a single country and many, is easily accounted for, by considering the difficulty with which capital moves from one country to another, to seek a more profitable employment, and the activity with which it invariably passes from one province to another in the same country.

Through free trade, both nations can consume both more corn and wine through nations specializing in their comparative advantage and then obtaining commodities they desire to consumption through exchange. For England, international trade becomes a miraculous technology for transmuting corn into wine. For Portugal, it becomes a miraculous technology for transmuting wine into corn.

 

In his History of Economic Analysis, Joseph Schumpeter provides an exposition of comparative advantage more familiar to students who have sat through an Econ 101 class:

Take two countries, England and Portugal, and two commodities, wine and cloth. Portugal, being the more efficient than England in both lines of production, can produce a certain quantity of wine by the labor of 80 men and a certain quantity of cloth by the labor of 90 men, whereas in England the production of the same quantities of wine and cloth takes, respectively, the labor of 120 and 100 men. Under these circumstances, Portugal will advantageously ‘specialize’ in wine and import cloth, while England will ‘specialize’ in cloth and import wine provided, of course, that wine and cloth exchange on terms between the limits of one unit of English cloth for 9/8 of a unit of Portuguese wine and one unit of English cloth for 5/6 units of Portuguese wine. In the former case, all the advantage goes to England, and Portugal is no better off than she would be without trade; in the latter case all advantage goes to Portugal, and England is no better off than she would be without trade. So far as this goes, any intermediate exchange ratio is possible with advantage to both countries, and if traders in both countries acted as monopolists, the exchange ration would be indeterminate between those limits. (Schumpeter 1994: 607).

A problem with this elucidation of comparative advantage is that it simplifies prices as a single realization, rather than treating them as random-variables. Surely, prices may be a matter of trucking, bartering, and exchanging in this hypothetical case, but Schumpeter still assumes that the prices is going to be fixed, largely relegated to the position of institutional data in the economist’s reasoning.

 

However, prices are variable. That variability is a second-order phenomena that largely gets entirely neglected in the economist’s reasoning. Especially along the time-frame we speak of when speaking of comparative advantage in international trade, prices are probably best treated as being variable and their manifestations at any moment of time as being a realization of a probability-distribution.

When economists’ treat of comparative advantage as simply being matter of, to quote Samuelson, “four magic numbers”, they erase that ubiquitous element of all human action from their narrative: Uncertainty. If the prices of corn and wine are both measured by distributions with fat tails, then there is the chance of a tail-event wreaking havoc on a pattern of specialization and trade, maybe even proving it unsustainable in the long run. To continue with Ricardo’s bucolic theme, nations are very rarely monocultural: When they specialize in only a single crop, let alone a single variation of a crop, then bad harvests and other sun-spot events can be lethal, see the Irish Potato Famine for an example. Some ‘inefficiency’ in the system from the point of view of the realization of prices at any one moment may actually prove to be integral for maintaining a sustainable pattern of specialization and trade.

 

This probabilistic view of comparative advantage does not undercut the significance of comparative advantage per se. This view reminds us that comparative advantage is a phenomenon that emerges from the free interactions of individuals and nations alike. Comparative advantage is generated by people tinkering with different patterns of specialization and exchange and by people being free to fail when their experiments do not work out. Through those free interactions, people gain knowledge about the probability-distributions of the goods and services being exchanges so as to efficiently factors of production to their most urgent uses. Out of each person's pursuit of economy in his own affairs, Ricardo’s law of comparative advantage emerges, not as a product of the human intellect, but out of the actions of a population of producers and consumers alike.

Ultimately, Ricardo’s principle of comparative advantage is a product of human action, not of human design. Yes, for the purposes of black-board economics, it is useful to teach the principle through a mathematical presentation using real numbers for the sake of simplicity. Although Mises is correct in asserting that the wider Ricardian law of association is a fundamental principle of all social philosophy, let alone social science, I do think that Schumpeter is also correct in asserting that we cannot divorce Ricardo’s principle from the free-trading politics he sought to advance.

 

James Buchanan once quipped that order is defined by the process of its emergence. In this fashion, the welfare consequences of Ricardo’s principle of comparative advantage cannot be divorced from the liberal system of natural liberty that Adam Smith advocated in The Wealth of Nations. They are generated by individual-level bricolage, not by national central-planning.

 

 

Sources

Mises, Ludwig von. 1998. Human Action: A Treatise on Economics. Auburn, Alabama: Ludwig von Mises Institute.
Schumpeter, Joseph A. 1994. History of Economic Analysis. New York: Oxford University Press.

 

Justin Wolfers: Better than a Witch-Doctor?

How does one react when one's predictions have been falsified. Well, let's get an example from Justin Wolfers trying to explain why the markets did not crash when Donald Trump was elected: 

 

My own view is that last week’s stock market gyrations reflect a more fundamental market failure.

Call it a failure of imagination. Investors simply failed to imagine how they might feel when they woke up to President-elect Trump.

....

This failure to fully imagine the implications of the new world is not rational, but it’s very human. I know that my thoughts in the days after Mr. Trump’s win are different than those that dominated my election-eve conversations.

 

Mr. Wolfers' explanation assumes that we know what the markets are communicating and that we, being the educated economists that we are, know the possibilities of a Trump administration better than traders do, hence the invocation of market-failure theory. Reading the tea-leaves that are market sentiments is fraught with danger. It is more the purview of warlocks and witch-doctors, whose rituals offer them perception uninhibited by time and ignorance,  than serious economists.

Market agents foresee and adapt. When they fail to foresee and adapt, market agents lose their money and their ideas go extinct. No practicing economist should be invoking market-failure theory to credit himself with greater clairvoyance than the markets. Then again, maybe practicing economists are no better than warlocks and witch-doctors. One may have been better listening to one rather than Mr. Wolfers!

The market process is there to check the errors of market agents. There is no such check on the error of economists, they may read the tea-leaves all they like without reality ever asserting itself.

I think we are better off trusting people with skin in the game than commentators massaging their own egos with incantations of market failure. 

Some Thoughts on Methodological Individualism

 

The wonderful Arnold Kling discusses the issue in a recent blog post, "Methodological Individualism, Libertarianism, and Conservatism":

I believe that there is a weakness in libertarian thought, but I am not sure that methodological individualism is the culprit. Consider an analogy. Chemists want to talk about atoms as being fundamental. But in the spirit of the quote above, one could argue that we do not have a substance until we have many atoms bound together. The relationships binding the atoms are what is really fundamental in chemistry. It is impossible to have a substance with just one atom.

I would say that it is useful for chemists to think in terms of atoms, and by the same token it is useful for social theorists to think in terms of individuals. But it is important for chemists to understand the various bonding mechanisms among atoms, and it is important for social theorists to understand the various bonding mechanisms among humans.

I think that what makes conservative social theory of the Burke/Tocqueville/Yuval-Levin sort distinctive is its emphasis on multiple modes of human interaction and bonding mechanisms, including families, organized religion, civic associations, and business enterprises. Libertarians tend to focus almost entirely on free trade as a mode of interaction, and progressives tend to focus almost entirely on the central government as a bonding mechanism.

 

That the individual is the sole unit of society is a big point made by the Austrian crowd. And they have a point. If one is to suppose that all analysis of social phenomena should be parsed in terms of human action, it does follow, pretty much by definition, that the fundamental unit of society should be the only element of society capable of action, that is the individual. In my estimation, the Homo-agens argument is sound.

However, I do think that we should be suspicious of talk about fundamentals and concerns about parsing social phenomena in terms of human action alone. After all, being a complex system, society emerges out of the interaction of individuals. It is more than the sum of individual action. We can see this in basic institutional analysis. Yes, when analyzing institutions, we should always care about thinking about the costs and benefits that a particular agent weighs in deliberating his future actions, but we will generally have to treat of institutions as transcendent to that deliberation. It will always be the individual plus institutions, with those institutions existing at an emergent level above, so to speak, the level of a single individual's actions. 

 

There are a lot of reasons to be skeptical of those who deny methodological individualism beyond concerns about foundations. Usually when people deny methodological individualism, they're trying to gloss over the differences between people. It's a lot easier to deal with disagreements in politics when one's conversation entirely neglects the level at which disagreement happens. In this fashion, methodological individualism serves as a instrumental prophylactic against error rather than a statement about the foundations of economics 

Economic's Cosmopolitan Scope

 

All too frequently, economics is demonized of as a discipline that legitimates greed and other nefarious aspects of human nature. Not too long ago Evonomics published an article that claimed that the salient feature of studying economists is that it makes its students greedy. One needn't search to hard on the internet to see similar opinions. 

Whatever may be the truth of the claim, there is another salient feature of economics: It takes everybody into consideration. Economics generally doesn't care if one is rich or poor, American or Chinese, gay or straight. The opportunity costs of a policy or action remain constant. Economics therefore teaches its students to think in a cosmopolitan manner, to take into account costs and benefits for all, rather than to a privileged sect.

Currently, political discussions of trade revolve around the benefit of a privileged sect: Americans. The student of economics can utter the defense of trade that no one else will mutter: That trade leads to overwhelming benefits to all, not just within America, but across the globe. Jordan Weissman makes such a case in "Bernie Sanders is the developing world's worst nightmare":

It is one thing to argue that we should not do business with nations that actively manage or manipulate their currencies, as Sanders sometimes does, since exchange rates are supposed to be the market's main mechanism for balancing trade. It's also entirely reasonable to support workers' rights to unionize abroad or push for stricter environmental protections. Indentured servitude and slavery, which are more widespread than many realize, need to be wiped off the face of the earth. Those are all issues that trade pacts should absolutely address.

But a blanket rule against trade with low-wage nations is different. The entire point of trade is that countries have to play to their strengths, which makes the entire global economy more efficient. If you happen to have a highly educated population, thriving capital markets, and lots of high-tech expertise—like the United States or Germany—you're going to export high-end services like banking and advanced manufactured goods like cars and airlines to the rest of the world. On the other hand, if your only advantage is an abundant pool of relatively unskilled labor willing to work 65 cents an hour, then you can probably carve out a niche in textiles and electronics assembly, then gradually build know-how and work up to something more lucrative. But if the United States comes along and says, "Sorry, Vietnam, we're not going to buy another T-shirt unless your people start earning $5 or $7 an hour," factory workers in Hanoi aren't suddenly going to get a raise. Factories are going to close, and businesses will move their operations to a country where employees are productive enough to justify developed-world wages—which typically means the developed world. The U.S. will have just undercut Vietnam's only relative strength.

If Bernie Sanders were to single out, say, American gays and lesbians as a class that could justly be burdened with the costs of a policy, he would be branded as a bigot. But because he claims that dreadfully poor non-American workers can suffer the overwhelming costs of American trade policy, he is a hero of the working class. 

Taking Equilibrium Too Seriously

In “All Systems Will be Gamed,” chapter six of Complexity and the Economy, Brian Arthurs argues that economics lacks a failure mode analysis of how systems work analogous to stress testing in structural engineering. The reason economics doesn’t have such a mode of analysis, Arthur argues, is that economists work with equilibrium assumptions that assume away the exploitive behavior that such stress tests are trying to predict: 

Economic analysis assumes equilibrium of the system in question, and by definition equilibrium is a condition where no agent has any incentive to diverge from its prevent behavior. It follows that for any system being studies no invasive or exploitive behavior cannot happen. If such a system could be invaded, some agents would be initiating new behavior, and the system could not have been in equilibrium. Equilibrium economics then, by its base assumptions, is not primed to look for the exploitation of systems, and as a result systemic studies of how systems might fail or be exploited are not central to how the discipline thinks. (Arthur 2014: 104).

As will be clear to those who read the book, Brian Arthurs really has an issue with equilibrium that becomes a consuming obsession. There is much to be said about the economics profession’s probable abuse of the notion of equilibria. Nevertheless, in attacking the concept, Arthurs does exactly what those who abuse equilibrium do: He takes equilibrium too seriously. As a conceptual tool, equilibrium is a useful way of constructing systems that can improve our understanding of the world. It’s only when we presume that we therefore assume away the unknown unknowns of life, to borrow Donald Rumsfeld’s illuminating phrase, through our systems that we err, yet that is an error Arthur makes himself with his own complexity approach.

 

Such system building isn’t bad per se. Indeed, it is neither good nor bad per se. Building systems, however primitive they may be, is one of the ways that the human mind comes to understand the world surrounding it. The men of system who helped to set up the 2008 Financial Crisis, be they investors who utilized a ridiculous degree of leverage or regulators who pushed value at risk as the way of doing risk management, made the fatal mistake of thinking that their systems were near perfect approximations of the real economy. They were the ones who assumed away tail risks and presumed that they knew enough to end history. The presumption of knowing all of the facts, not the presumption that an economy tends towards equilibrium is what did those men of the system in. (After all, it is very possible for an economy to be heading towards equilibrium and the people within it being wrong about what equilibrium it is tending towards.) 

Brian Arthur has nothing to say about such systems in his article. Instead, he wrongly believes that the sin was in the assumption of equilibrium, rather than in the presumption of knowledge. “Failure-mode studies are not at the center our our discipline for the simple reason that economics’ adherence to equilibrium analysis assumes that the system quickly settles to a place where no agent has an incentive to diverge from its present behavior, and so exploitive behavior cannot happen” (Ibid: 117).  

 

Yes, the assumption of equilibrium does bring much presumption of knowledge if one takes the assumption too seriously. But as a modeling tool, it is more thematic, providing the opportunity for a system builder to provide a coherent narrative, than descriptive. It is only when we assume, as do many equilibrium theorizers do, that Even the use of engineering as the chosen parallel over the course of the article betrays Arthur’s perspective as one who believes that it is possible for economists to reliably foresee how systems are exploited: “Once we have identified where and how exploitation might take place, we can break open the overall economic model of the policy system at this location, and insert a module that ‘injects’ the behavior we have in mind” (Arthur 2014: 111). 

In his very own vision of stress testing economic systems, Arthur still presumes that how the system will be exploited can become a known known, manipulable by analysts, but it’s the unknown unknowns that should be keeping policymakers awake at night. Brian Arthur’s conviction that policy can be improved by using stress-test analysis ignores that policymakers are already trying to figure out how the incentives impel people to take certain courses of action in different policy environments. Contra Arthur, the reason those policymakers make mistakes aren’t that they are working with equilibrium models, or that they aren’t sufficiently scientific. The reason is that no policymaker can’t know everything. 

 

 

Bibliography

Arthur, Brian W. 2014. Complexity and The Economy. Oxford: Oxford University Press. 

Uber's Permissionless Innovation

 

Innovation has been and shall continue to be the principal catalyst for the enrichment of the human race. In the context of the markets markets, innovation enables entrepreneurs to revolutionize the way that economic life is organized, without having to ask permission. The California Labor Commission’s decision that Barbara Ann Berwick is an employee, not an independent contractor, to Uber is a threat to the permissionless innovation that discovers how best to organize society.  

Whereas Uber had been free to experiment in new business models suited to its sharing-economy practices, if it is upheld, the decision would reverse that experiment and force the company to adopt a business model blessed by the regulators. Not surprisingly, the Uber decision is only one example of a larger trend in regulators opposing free-market innovation, whether it is the FDA’s fight against 23andMe’s inexpensive genetic testing or New York City’s fight against Airbnb’s operation in the city.  

Those regulations stand in the way of innovation. They harm the prosperity of society by limiting the scope of innovation. After all, economic progress depends on whether entrepreneurs are able to foresee better ways of organizing economic life than exist today and are able to put their visions into practice. Yet the knowledge of which innovations in particular will help people the most isn’t available to any one person or organization. Instead, that knowledge is dispersed across all of society. 

 

The great advantage of the free markets is that no one needs to know whether an innovation will be successful in its implementation. Profit and loss, coupled with the piecemeal tinkering of entrepreneurs over the space of possible organizations, enables the market process to discover the best ways of organizing economic life. Entrepreneurs create new conjectures about what consumers want and how to provide it to them. Whether those conjectures actually match reality is then tested by profit and loss. Combined monetary calculation, entrepreneurs’ conjectures become more than mere noise. Instead, they become the primary cause of economic progress.

Uber’s business model represents such an experiment. Today, the internet is becoming an ever more important way for people to interact with one another, whether their interacting with family on Skype or with friends on Steam. Uber uses the networking potential of the internet to bring together its drivers and customers alike, both on their own initiative. As Adam Thierer has argued in Permissionless Innovation, the freedom of entrepreneurs to experiment freely with new technologies and business models has to be secured if our era’s new technologies are to be fully exploited. Those technologies, the internet foremost among them, still represent a massive new frontier for organization experiments of all kinds. In a world where people increasingly live more of their lives on the internet, innovations to the way we use the internet will be certainly one of the engines of growth in the decades to come. Regulators’ fight against permissionless innovation threatens that future. More importantly, in doing so, they directly threaten people’s prosperity. 

 

Without organization experimentation, entrepreneurs on the internet won’t be able to discover how best to use the internet to improve the lives of the consumers that they serve and the people they work with. No one person or regulatory agency knows how best to use the internet’s wonderful potential to improve human life. The markets, not the California Labor Commission, should decide whether Uber’s business model benefits people. The voluntary actions of Uber’s independent contractors speak volumes about whether Uber improves their lives. 

Who is the California Labor Commission to judge? Do they have all the knowledge to determine whether drivers are better off being employees than independent contractor?  Indeed, many of Uber’s drivers are seeking a kind of job rewarding independence and personal initiative that would be made illegal by the Commission. Their decision would thereby deny an entire world of economic possibilities to the people of California.  

 

 

Overall, the markets can only be persistently creative if entrepreneurs are allowed to innovation without permission. The success of Uber, now under threat in California, has already demonstrated the power of such innovation. Since there is no one organization that knows how any future innovation will affect the welfare of society, entrepreneurs and consumers alike should be free to tinker with all of the available technologies and to out which ones suit their needs. Those technologies that pass the market test should then be respected by public officials as illustrating the free choices of those involved.  

As long as such permissionless innovation is protected, the markets are endlessly creative. The California Labor Commission’s decisions against Uber is a direct threat to the freedom of entrepreneurs and, in turn, the persistent creativity of the free markets. Moreover, the decision a threat where creativity is needed most: The Internet. If the internet is to be exploited to its full economic potential, regulators need to get out of the way and allow entrepreneurs to create new ways of organizing economic life. 

Leijonhufvud: Coordination and Politics in the Forefront

The shadow of September, 2008 looms large on the economics profession. Whatever we think of the crisis itself, it has been an opportunity for the critics of the economics profession to criticize and to argue for their own approach to the problems of economics. In the Spring/Summer edition of the Cato Journal, the ever-worthwhile Axel Leijonhufvud has done just that, adding to his previous commentary, with “Monetary Muddles.” There are two themes that particularly interest me. I’ll comment on them below. 

 

The first theme is the question of whether the market economy is stable and how we should approach that question. What I like, quite a bit, about Leijonhufvud’s approach is that coordination is in the forefront. In exploring the question of stability, the Swede treats the economy not as a machine existing apart from the action of individuals, but as a network of contracts that emerges from that action:

On any given day, the functioning of a market economy is governed by an intricate web of contracts and less formal promises and understandings. Errors occur. Some promises are broken. For the system as a whole to work reliably, it must isolate those cases and deal with them in more or less short order. But in some circumstances, one default will trigger another. Under normal conditions, such chains of default will be short. (Ibid: 186)

Whether the market is stable is a matter of coordination. If the intricate web that Leijonhufvud writes of is perfectly coordinated with the future intentions of its entities and with the future circumstances of the world they are surrounded by, then the market economy will remain stable. As long as it is perfectly coordinated, then there is nothing that can upset that coordination. As long as the entrepreneurs involved can perfectly foresee the future state of the world, whether its whether a creditor of theirs will go bankrupt or whether there will be a bad harvest in three years, error is impossible. The ex post has been collapsed into the ex ante, equilibrium is established and so there isn’t any logical space for an event that can disrupt the coordination between entrepreneurs constituting the economy.

When thinking about the stability of the market economy, I cannot help but to think about ecological collapse as a theoretical parallel. When an ecosystem collapses, an ecosystem suffers a dramatic reduction in the population of animal species it can support. That cataclysm generally reveals itself as a discontinuity when we chart out the population level over time. A paradigmatic example of ecological collapse is the collapse of the Atlantic cod population off the coast of Newfoundland in 1992. After decades of intense fishing, the population suddenly collapsed. The decline wasn’t gradual or expected, but sudden, taking the entire fishing industry by surprise. 

In the article, Leijonhufvud finds a beautiful way of describing this temporal asymmetry by quoting The Sun Also Rises:  “In Hemingway’s The Sun Also Rises, one of the protagonists asks his friend: ‘How did you go bankrupt?’ ‘Two ways,’ went the answer, ‘gradually, then suddenly’” (Ibid: 181). Although the causes leading up to the event were decades in the making, the collapse of the Atlantic cod population, much like the value of sub-prime loans, was sudden. Per Bak’s phenomenon of self-organized criticality is also quite interesting here, but I lack the time to provide the lengthy description Bak’s theory deserves.

 

In discussing the recent crisis, Leijonhufvud’s argument is a curious synthesis of an Austrian view that the crisis was a product of an over investment boom with the view that the financial regulation was made possible by deregulation. It isn’t all that surprising that Leijonhufvud would argue such a position. Both of those views share his concern with coordination and the interconnectedness of the market economy. He champions the Austrian business cycle approach: “The period leading gradually to the recent sudden crisis has the hallmarks of an ‘Austrian’ boom”(Ibid: 181). In discussing the recovery from the crisis, much like Austrian theorists, he using the metaphor of recalculation: “A financial crisis reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again” (Ibid: 187).  

Once the boom has taken its course and interfered with the calculation of value so as to create error in the ways that entrepreneurs coordinate with one another, crisis is unavoidable. To suppress the crisis would be to prevent the process of the correction of those wrong values interfering the correct coordination of entrepreneurs within the economy. Yet before we take Leijonhufvud to be arguing for laissez-faire, let’s not forget that he wrote of the critical role of government right after: “Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. If we had done so this time, it would have led us into another Great Depression” (Ibid). For Leijonhufvud, economic crises are political, requiring governments to do something about them—the second theme of note in “Monetary Muddles.” 

In the course of an economic crisis, there will always be winners and losers. Politics can’t be avoided in that determination. Leijonhufvud criticizes current governments’ reliance on monetary policy in making decisions about who wins and who loses. Indeed, he even goes as far as to argue that the independence of central banks is incompatible with a democratic society: “Once it is realized that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society” (Ibid: 192). Here, I am very pessimistic since the power to make monetary policy through legislation would attract a whole lot of lobbying and would probably still be skewed to the advantage of those with the access to the halls of power. Nevertheless, Leijonhufvud is spot on in asserting that the economics profession has skirted the political questions that must accompany an economic crisis.  

 

Overall, “Monetary Muddles,” much like the vast majority of Leijonhufvud’s corpus, is very much worth reading carefully. Coordination is always on the forefront in the way that he tackles the questions of economics. Moreover, he is always willing to grab political questions with both hands. Both are qualities that make Axel Leijonhufvud a theorist to admire.

Kling on Coordinated Specialization

In "Co-ordinated Specialization," Arnold Kling meditates on the problems of teaching economics from an emergent perspective. He departs from a quote taken from the textbook, The Economic Way of Thinking, that he lauds as progress from Samuelson's seeing-like-a-state textbook. In the quote, the authors, Paul Heyne, Peter Boettke and David Prychitko, argue that economics is a theory of choice that studies the unintended outcome of purposive action within the market order:

I prefer something more Smithian and less Misesian. I would be inclined to start with something like this:

The most striking economic feature of modern society is that we can consume the products and services requiring millions of tasks while performing only a few tasks ourselves. Obviously, this requires some form of coordinated specialization. How can this coordination take place? Consider three possible extremes.

1. Decentralized decisions, but with no prices and profits. People just spontaneously decide on their own what would be most useful to society.

2. Centralized decisions, made by an expert planning bureau.

3. Decentralized decisions, guided by prices and profits, and regulated by competition.

The problem with (1) is that you will get imbalances. Suppose that getting milk to urban consumers requires both dairy farmers and truck drivers. If too many people would rather be truck drivers than dairy farmers, then there won’t be enough milk to transport. If too many people would rather be dairy farmers, then the milk will spoil on the farms. More generally, the jobs that no one wants to do will tend to go undone. Computer programmers will all work on video game hacks, not on inventory control systems. Basically, (1) only works when there are very few tasks to be divided among a small number of people who all get along.

...

Returning to Heyne-Boettke-Pryhitko, I would prefer not to put as much emphasis on the methodological dogma that people choose in response to expected benefits and costs. Instead, I prefer to emphasize the question of how a society can operate with each individual performing a few tasks while consuming the products of vast multitude of tasks.

I lean towards Mr. Kling's sentiments on this matter. Unlike orthodox Austrians, such as Boettke, I don't see economics first and foremost as the study of human choice. Rather, I think that the scope of economics is the study of economic order first and foremost.

Economics is about the study of human choice insofar as that choice is a cause of economic order, but we shouldn't let the focus on the emergent order, which cannot be expressed from the point of view of any single maximizing agent, drift from view. The ecological features of economics are most pronounced in this study of coordinated specialization. Just as species adapt to the different niches that other species have taken in an ecosystem, so do people adapt to the different specializations that people have taken in a commercial society. Here, the effects of variation and selection, be it market or natural, are to be emphasized above individual choice. 

The Smithian emphasis on the concatenation of activities within the market order, as illustrated by his parable of the workman's coat in The Wealth of Nations, must come before the Misesian emphasis on the logic of human action, as illustrated by the first hundred pages of Human Action. 

Immigration in a Hive-Mind World

Nathan Smith, an economist who has done work estimating the potential impact of open borders, has recently provided his thoughts about the impact of the hive-mind hypothesis, best argued for by Garett Jones, on immigration in "Open Immigration and the Hive Mind Hypothesis." 

For those unacquainted with Mr. Jone's hive-mind hypothesis, the main paper that explicates the idea, "National IQ and National Productivity" is available at SSRN. I've always taken the hive-mind hypothesis, at least as far as it matters for Mr. Smith's post, to be the hypothesis that if we took the causes of an person's productivity and expressed them in terms of a Price equation, the covariance term would dominate. The domination of the covariance term reflects the spillover effects of human capital from one person to another. 

The hive-mind hypothesis could have a staunch advocate of open borders thinking twice. After all, if the hypothesis holds water, then the productivity gains that economists expect due to the rearrangement of factors of production across the world. As Mr. Smith writes:

First, if the hive mind hypothesis is true, the impact of open borders on world GDP would probably be far less favorable than most of the existing estimates suggest. In one of the two model extensions that make TFP a function of human capital externalities, I find that world GDP falls by nearly one-quarter under open borders. One critique of open borders is that it would kill the goose that lays the golden eggs. The hive mind hypothesis is probably the form of “killing the goose” argument that has the best support in the literature at the moment.

Mr. Smith ends up concluding that open borders would probably not kill the golden goose even in a hive-mind world because there is no reason to think that the allocation of human capital across the world is anywhere near optimal. Open immigration, and the right institutions, could therefore move around people to make for even better hive minds. 

The entire post is worth reading at length, for no other reason than the hive-mind hypothesis helps to introduce concerns of scale and increasing returns that I think can be neglected in discussions about immigration. Although Mr. Jones' exact hypothesis may not be right, though I certainly lean more in the affirmative direction, increasing returns exist elsewhere in human society as a product of scaling—the Santa Fe Institute has made possible a lot of research in increasing returns in cities as a result of scale—so the problem is a general one that advocates of open immigration must grapple with. 

The Market Process is Generative

 

None, because "markets" are about recognizing that information is dispersed in all social systems, and that the problem of society is to find, devise and discover institutions that incentivize and enable people to make the right decisions without anyone having to tell them what to do. The idea that market forces should be limited stems from a fundamental error in beliefs about markets. This is the wrong question.

-Vernon Smith

 

 

The market process is needed to generate the data of the market. The market process is generative. Guided by price signals, entrepreneurs are actively trying to figure out the nature of the demand on the market. When we speak of the ‘market data’ we aren’t speaking of facts that exist independently of the market. Instead, we are speaking of facts that only become known once the market has created them. The market data are therefore a raison d’être for the market process and the competition between entrepreneurs that constitutes it. If we could secure that data sans the markets, then the human mind would be able to supersede the market process. 

Nevertheless, economists have often erred in treating of the market data as existing apart from the competition that exist between entrepreneurs and have therefore criticized competition as inefficient because it leads to outcomes the economist deems undesirable. Yet, in making such a judgment, the economist is assuming that he knows the market data before the markets generate them.

 

 Dennis H. Robertson fell into that error in his classic Banking Policy and the Price Level when he argued that inappropriate fluctuations in industrial output were caused by competition: 

The main reason for which the actual expansions of industrial output which occur are greater than the relatively most appropriate expansions, seems to be the stress of competition, aggravated by the length of time which is required to adjust production to a changed demand. If conditions are such that our hypothetical producing-group would be furnished with a rational inducement to a 10 per cent. Increase of output, but if, in fact, the trade is organized into fifty independent and competing firms, it is quite likely that each firm, regarding itself as the special protégé of Providence, and ignorant of the preparations that are being made by its neighbours, will prepare to provide, say, one-twentieth instead of the appropriate one-fiftieth of the appropriate total increase in output, so that total production is increased by 25 per cent. instead of by 10 per cent. (Robertson 1949: 37-38). 

Here, Robertson assumes that producers are simply reacting to a well known shock, and that all that remains is for producers to adapt to that shock. He distills entrepreneurship to solving a technical economic problem, and in doing so ignores that it isn’t clear to anyone that production should increase by ten percent. 

Maybe God knows, but He isn’t giving out consulting advice. Instead, the process of competition, the very same process which Robertson blames for creating irrational adjustments in production, is the manner by which producers discover the demands of the market and how much output is desired by consumers. 

 

The minute that one draws a neat supply and demand diagram, as one would have to figure out that the ‘appropriate’ shift in supply is by ten percent, one assumes away, at least in its allocative sense, the economic problem that the market solves: What people want and how best to supply that. 

Producers aren’t simply passive mechanisms that turn market data into market output; instead, they are forward-looking entrepreneurs who have to speculate about the future constellation of supply and demand. The market then selects those entrepreneurs who supplied the consumers with their most urgent wants. So, rather than simply reacting to the data of the markets, producers are generating its data by making conjectures about what are the consumers’ most urgent wants and then the survival of the producers who successfully speculate about those needs. Market selection and entrepreneurship thus interact to generate the data of the market. 

 

The market process is ergo generative. We cannot speak about the outcome of the market process without having studied its history. And here we reach our ultimate conclusion: As an evolutionary science, economics is by definition a historical one. If order is to be defined in the process of its emergence, then we have to have knowledge of the unique process behind the generation of each unique order. That requires knowledge that goes beyond the merely formal into the material.