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.

 

It's About Institutions, Not Rulers

 

Evonomics. Need I say more?

With its motto of "the next evolution in economics", Evonomics is proof that evolution need not always lead to improvements.  Each day there seems to be another snarky article on the website attacking one of the fundamental principles of our civilization: Liberty. There does not seem to be a floor to how base the discourse over there can be. This time it's: "Stop crying about the size of government. Start caring about who controls it."

 

The titles says it all. Since Evonomics is David Sloan Wilson's baby, I'm much less willing to believe that the title was slapped on by an editor with no contact with the author, as is so Keeping with the Evonomics' track record, the title is trolling par excellence. It is a glib attempt to sell superiority to Evonomics' readers than to actually try to understand the liberal critique of state-power on its own terms.

Ultimately, Wilson's entire attempt at 'updating' Hayek is, root and stem, an attempt to justify the policies he likes, principally his notion that his arbitrary design principles are the secret sauce for national prosperity. Despite his accomplishments in evolutionary biology, he is a demagogue who poses as a man of science.

 

Here, I can speak from personal experience. I was at the seminar at George Mason that Wilson referred to in the beginning of the article. During the Q&A of that seminar, when Wilson was addressed with the point that basic measures of property rights, à la the Frasier Index, are robustly correlated with a nation's prosperity, Wilson seemed dumbfounded. Yes, he had harped on about the need to get good 'design principles' for states, choosing for his example the curious example of the Nordic petrostate Norway, rather than, say, Sweden next-door (because as you certainly know Sweden is a rather liberal nation). However, that property rights could be that basic design principle was a queer idea to him. The thought seemed to have never crossed his mind!

To think, a man who clearly does not appreciate the clear and vivid link between liberty and prosperity thinks so highly of himself to lecture economists on his website. So much for "the next evolution of economics". 

Daron Acelmogu, who was interviewed in the article, helped to give material for the circus:

It is also the case, and this is something we emphasize a lot throughout Why Nations Fail, that most states throughout history and even today serve the interests of the political elite and are part of their economic problems, not their solution. But this is not because the state is unnecessary or evil, but because of who controls it and what capacities it has invested in and developed.

 

The question that political thinkers should consider is not who should rule but what laws should rule. As understood by David Hume and John Adams, a nation is only as good as its worst ruler. In "That politics may be reduced to a science", Hume wrote: "A constitution is only so far good, as it provides a remedy again mal-administration..." He goes on to assert that: "Is our constitution so excellent? Then a change of ministry can be no such dreadful event; since it is essential to such a constitution, in every ministry, both to preserve itself from violation, and to prevent all enormities in the administration." John Adams stated, and later help enshrine in the Massachusetts Constitution, that principle that a good government was a "government of law, not of man." 

Wilson's shtick is aimed against that sacred principle. The rule of law, after all, would not allow for a government to enact his beloved design principles. And so Wilson seeks to re-orientate the question of constitutional politics around who should rule. But that's a re-orientation that leads straight to tyranny. And that's not just my accusation. It is a microcosm for the salient thesis of Karl Popper's The Open Society and It's Enemies: 

But if we approach political theory from a different angle, then we find that far from solving any political problems, we have merely skipped over them, by assuming that the question 'Who should rule?' is fundamental. For even those who share this assumption of Plato's admit that political rulers are not always sufficiently 'good' or 'wise' (we need not worry about the precise meanings of these terms), and that it is not all easy to get a government on whose goodness and wisdom one can implicitly rely. If that is granted, then we must ask whether political thought should not face from the beginning the possibility of bad government; whether we should not prepare for the worst leaders, and hope for the best. But this leads to a new approach to the problems of politics, for it forces us to replace the question: Who should rule? by the new question: How can we so organize political institutions that bad or incompetent rulers can be prevented from doing too much damage? (Popper 1966: 120-121)

That's an approach to political questions that is embraced to the fullest at George Mason University and makes it one of the best economics department on earth. 

 

All too related to this topic is Tyler Cowen's "The criticism of Trump which few will utter":

It is sad to see so many people, including those on the Left or in the Democratic Party, criticize the idea of a Trump presidency without ever uttering the phrase: “No man or woman should have so much political power over others.”  I agree with many of the moral criticisms of Trump as a leader, but don’t let them distract you from this broader truth.

...

The good news, if that is what one should call it, is that the best criticisms of Trump involve the concept of individual liberty and freedom from arbitrary legal authority and pure presidential discretion.  The bad news is that so few intellectuals have the relevant ideological vocabulary in that regard.

 

Let Greece Go!

 

 

Greece owes  €317 billion, about 175 percent of its GDP. Those numbers are meaningless by themselves. For a vibrant economy, such as that of Germany or the United Kingdom, a similar debt wouldn’t be such a problem. But it’s neither Germany nor the United Kingdom that we’re all thinking about now. Instead, it’s Greece, a dysfunctional nation whose economy has been in recession since 2008. 

It’s looking increasingly likely that Greece will default on that debt this summer. Let’s not kid ourselves, whether Greece would default on its debt has been clear since the Euro Crisis began in late 2009. Since then, Greece has teetered on the brink of default with increasing amounts of cash being given to the Greek government to keep it going—and compliant. The question has been when not if. That time seems to be upon us. Despite technocrats’ efforts to steer Greece to calmer waters, with capital controls on Greek banks being the most recent attempt, Greece is far from them. Rather, the inescapable currents of change, hiding right beneath the surface, continues to drag the Greek ship of state further from coast.

 

Really, the trend of Greek politics over the past half decade or so has been the story of captain after captain fighting against those currents. Greek’s economic and political nature cannot be recast from Brussels or even Athens. Recent concern about Greece failing as a state if it were to default misconstrues the predicament the nation finds itself in. Greece won’t suddenly fail as a state as a result of defaulting on its debts. Rather, Greece has been a failed state all along. Greece has had a long history of political corruption, economic inefficiency, and the systemic failure of its institutions. It was only able to gain admittance to the Euro Zone by cooking its books. Wall-street designed financial instruments could only cover up the mess that was Greece’s fiscal situation for so long. 

The nation has to reform, that much is true. Economic liberalization, and yes austerity, need to occur if Greece is going to prosper. Greece is stuck in an equilibrium of leisurely inefficiency that the Greek people are deluded to think can continue. It cannot, but the teethed reform that can actually change Greece structurally is a point that cannot be pursued as long as Greece holds onto its current debt. Paying back that debt is currently such a drain on the Greek economy that reform simply isn’t politically feasible. Moreover, the point of the troika’s bail-outs have never been to liberalize Greece, but to preserve Greece as a member of the European Union. 

 

Throughout the Euro Crisis, the important decision makers within the European Union have been interested in their own political projects. As self-interested politicians, their interest in Greece has largely been restricted to how Greece fits into a scheme of European unity and they have been more than willing to sacrifice Greece on the cross of European ambition. 

Last May, when giving a speech during the award of the Charlemagne prize for furthering European unity, Chancellor Angela Merkel warned that if the Euro fails, then “then Europe and the idea of European union would die.” Yet, Chancellor Merkel knows to let no crisis go wasted: "We have a common currency, but no common political and economic union. And this is exactly what we must change. To achieve this—therein lies the opportunity of the crisis."  Jean-Claude Juncker has yet to show a whiff of sympathy for Greece and has instead gone out of the way to state that he felt betrayed by Greece in the latest negotiations over Greece’s debt. To European leaders and Eurocrats alike, Greece is just a means towards their end of a centralized Europe, not an end in and of itself.

 

The crisis calls for an empathetic point of view that genuinely wants what is best at Greece. Policy makers should want to best for everybody involved in any political question. Looking at the crisis merely as a moment in the history of the European Unions inextricable march towards unity or as a threat to the world’s financial stability ignores many of the political dimensions that define the crisis.

For instance, merely looking at the financial consequences of Grexit overlooks how the strain of Greek debt has prevented any political progress in Greece. Syriza rose to power by speaking out against the demands put on Greece by the European Union and the troika. The party’s policies may be the last thing that Greece needs, but these are the policies that Greece will inevitably get as long as the troika meddles in their politics. The Greeks understand that the European Union care little for their plight. According to them, Greece needs to stay in the European Union, no matter the Greek costs. 

Greece has borrowed beyond its means, yes, but the banks have been there as enablers. They should have lent money with their eyes wide open. The banks that have lent to Greece made bets that haven’t paid off. The losses of those who haven’t already been bailed out will be certainly extreme, but so have the loses of the Greek people. The interests of the financial sector shouldn’t be made sacrosanct as the expense of the Greek people. Obsessed with the standard of economic efficiency, policy makers have been blind to the concerns of justice and equity involved when the banks get themselves into trouble. Nevertheless, policy choices today can put the developed world back on the right political track. In a world where finance has increasingly made the world fragile, a Greek default could help signal to the world that policy won’t play favorites for the financial sector, as it has done in crises past. 

If Greece is guilty of an irresponsible fiscal policy, the nation’s culpability must be balanced by the irresponsibility of those who lent money at close to near-German rates to a very non-German nation. Creditors and debtors alike are at fault. Greece alone cannot be isolated as the only guilty party who deserves to suffer the costs of the fact that they cannot pay back their loans. Just like almost all the other rich nations, those of Europe need to demonstrate to the financial sector that their interests are no more special than those of ordinary people’s. Letting Greece default on its debt without back-room negotiations to ensure that the banks get paid on their imprudent loans would be a small improvement on that margin.

 

The creation of a euro was an ill-conceived policy, informed more by the fantasies of politicians and eurocrats alike than the fundamentals of their societies. Reality needs to reassert itself. European leaders need to admit that Greece cannot prosper as part of the Euro Zone. The slogan of the hour needs to be: Let Greece go! 

Greece will still be in an unenviable predicament, but it will be in a position to decide on their own policies. If political reform fails, the Greeks would deserve to suffer a catastrophe of their own making. Today, they deserve relief and an opportunity to pursue reform on their own initiative. 

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.

Greece: Putting the 'Political' in 'Political Economy'

 

History suggests that monetary arrangements last only as long as the political economy that supports them.

- The Economist, “The global monetary system: Not floating, but flailing”

 

 

Greece in the headlines is rarely good news, at least for those who care about the stability of the European Union. Yet it is back there. This time, the news is that Greece will soon be holding national elections. The far-left party, Syriza, holds a small, but steady lead in the opinion polls. Although he is now reigning in his rhetoric, Alexis Tsipiras has driven a single message home throughout the campaign: That he will bring to an end the four years of austerity. Although he may have recanted his strong opposition to the Euro, Mr. Tsipiras still represents a threat to the terms the Greek government gave its creditors in exchange for two successive bailouts not so many years ago. 

 

Man is a political animal—Zôion politikòn. It is therefore fitting that one of the most important parts of his society be driven by political concerns, by concerns of identity and fairness, as much as the economic concerns of supply and demand. At the heart of the Euro is a political concern: That Europe needs to be brought under a single political organization, however loose. Whether it is President François Mitterand or Chancellor Angela Merkel, the major decision makers over the course of the Euro’s existence have lived in a world where the horrors of the two world wars were everywhere, whether in the façades of Berlin or the memories of former refuges. 

Yet for as much as I can sympathize with the purpose of the Euro project, it is still a concern born from the tragedy of another era. With or without the European Union, there wouldn’t have been another major European war in the past decades. Neither the United States or the former Soviet Union would have allowed for that to happen. Today, genuine fear of strife between European powers is insensible to the point of being a phobia. If the Greeks decide to leave the Euro, I hope they won’t be held hostage to placate that phobia. 

 

As much as may speak, as The Economist does, of structural reforms in the wake of the Euro Crisis, realistically, nations will continue to do as they always have unless there is a stick telling them to do otherwise. One only need look at France’s own peccadilloes to recognize that the rules of the European Union don’t hold all that much weight under current circumstances. Those circumstances may change, but that would require political centralization, which can in turn only really work if Europe is in any way a policy. Yet it isn’t a polity. The Germans and the French, let alone the Germans and the Greeks, are not going to agree about fundamental matters of policy. Nor are they going to treat the authority of the other over them as legitimate. 

 

Endogenous structural reform is squaring the circle. Exogenous structural reform is, well, empire. And who really wants that?

 

Detroit: Atrophy of an Economy

 

Coleman Young, Mayor of Detroit in 1981

 

Detroit is a monument to the fact that prosperity need not last forever. By assuming that progress is a brute fact of nature and that the opulence shall last forever, one flirts with disaster. Detroit did just that. Whereas Detroit was merely half a century ago one of the entire world's most prosperous cities, today it has a fate much like that of Prypiat. The Daily Mail's article, "The tiny urban island of downtown Detroit, lost in the wide open spaces of a depopulated city", is testament to that. The death of Detroit is all too evident from the air:

 

Laissez-Faire Capitalism Is Not Crony Capitalism

 

The objections which the various schools of Sozialpolitik raise against the market economy are based on very bad economics… They blame the market economy for the consequences of the very anticapitalistic policies which they themselves advocate as necessary and beneficial reforms. They fix on the market economy the responsibility for the inevitable failure and frustration of interventionism.

- Ludwig von Mises, Human Action

In bailing out failing companies, they are confiscating money from productive members of the economy and giving it to failing ones. By sustaining companies with obsolete or unsustainable business models, the government prevents their resources from being liquidated and made available to other companies that can put them to better, more productive use. An essential element of a healthy free market, is that both success and failure must be permitted to happen when they are earned. But instead with a bailout, the rewards are reversed – the proceeds from successful entities are given to failing ones.

- Ron Paul

 

 

In a recent opinion column in The New York Times, “Inequality Is Not Inevitable”, Joseph Stiglitz argues that the vast amount of inequality found in the United States isn’t a product of economic laws which we have no control over, but rather a product of dysfunctional politics. He argues that corruption and a decline in solidarity have ensured that American citizens are no longer able to secure a fairer America - one corresponding more to the Universal Declaration of Human Rights - than we have now.  

Even though he emphasizes the importance of politics and correctly recognizes that America has a crony-capitalism problem, Mr. Stiglitz does very little to actually suggest specific policies to ameliorate the difficulties he writes about. The reason for that is that the fails to identify the very real cause-and-effect relationships which are causing the problems he is dissatisfied with, yet he fails to provide an understanding of them. Namely, that the reason the Federal government is so corrupt is that there are so many opportunities for cronies to manipulate the system and thereby enrich themselves. Although he writes about the problem as one of practical politics rather than technical economics, he fails to adequately address the technical problem of crony capitalism which needs to motivate any viable. 

 

Despite what Mr. Stigliz suggests, laissez-faire capitalism isn’t the cause of the corruption within the Federal government on these matters; in fact, the corruption is possible because it doesn’t follow such policies. If laissez-faire capitalism is anything, it corresponds to the natural system of liberty that Adam Smith describes in The Wealth of Nations, that state of affairs in which the sovereign has no other duties but to defend the nation from outside belligerence, to protect the nation from belligerence within, and to erect those necessary public works. There is wiggle room for certain aspects of policy, but that wiggle room excludes such vast redistributive efforts as bailing out Bear Stearns or General Motors.  

In fitting fashion, Mr. Stiglitz ignores that the very maladies he rallies against aren’t caused by laissez-faire capitalism; instead they are caused by the government creating opportunities for profit from government favor. He fails to consider that human beings are natural entrepreneurs who will sniff out every possible profit opportunity. Just as profit opportunities create vast patterns of specialization and trade within the commercial society so too they create similar patterns with respect to the government and the cronies. 

What separates these patterns, though, is that they aren’t created by providing products people are willing to spend their scarce money to acquire, but they are acquired through political patronage. The market is thereby perverted from a system of profit and loss, in which those firms that supply the market with its most urgently desired products survive and those who don’t disappear, into a system of crony capitalism,  in which those who yield political favor get to cheat profit and loss. Under such a régime of crony capitalism, there is no guarantee that those firms which survive are those firms which are most valued by the consumers. 

 

The problems Mr. Stiglitz associates with capitalism as it is today aren’t problems with the natural system of liberty; rather, they are problems which originate when the government has the power to take from some to give to others on a regular basis. Though legislators may very well intend to help a specific set of people like the poor, their actions create opportunities for those clever enough to exploit the given system for their own benefit. As we all know good intentions don’t guarantee good outcomes. The “rent-seeking society we have gravitated toward, in which the wealthy obtain riches by manipulating the system” is only possible outside of the society of natural liberty, and in a society in which the government has the power to make some rich at the cost of others. 

The Federal government does indeed have a massive corruption problem, but that problem is because of how regulation is put into effect. For example, the Securities and Exchange Commission has the duty to regulate banking, and largely does so by hiring the experts in the field, which just so happen to be the very bankers the SEC is supposed to regulating. Regulators who spend a long time learning the regulatory craft in DC are paid a fortune to then inform Wall Street banks how best to profit from those regulations. Do those bankers help the banks to provide better services to their consumers? Not so much. Instead, they tell the banks how they can make money by manipulating regulations by hiring the very people who once enforced them. At that point, the criteria for succeeding as a bank is no longer about the approval of the customers, but rather the approval of the Federal government and that’s problematic at best. 

Blaming bankers for seeking the SEC’s favor is like blaming a dog for barking. It’s going to do little good. Place the blame where it deserves: that there are channels by which the government can take from some to give to others. Leave the natural system of liberty out of the accusation. 

 

Selfishness may be one of humanity’s great curses, but we cannot blame selfishness for the failure of political systems just as we cannot blame gravity for airplane crashes. There are always going to be vicious people who would impoverish those in need for their own betterment. We cannot expect them to be virtuous. The problem of policy isn’t so much to make people more virtuous as it is to ensure that policy can function despite people being vicious. Policy should be made with a full understanding that there is vice like greed in society, and it should be made so that it isn’t robust to that vice. That isn’t simply a matter of practical politics, but of technical knowledge because one has to know how greed influences political systems to design policies robust (better yet antifragile) to it.  

As much as Mr. Stiglitz emphasizes that alleviating inequality is a problem of practical politics, he gives no solution as to how to ensure that his political vision can withstand the vice of humanity. He rallies against the greed of bankers without actually saying how policies can be better adapted to that fact. Repeating “politics is overrun with money” is a well-rehearsed cliché, not a viable solution to the Federal government’s corruption. The same thing is true for saying that such a system of social democracy works for the Nordic nations. This is America, we’re talking about, not Finland, Sweden, or Norway. What works there may very well not work here, for reasons like different demographics and histories. Overall, though “Inequality is Not Inevitable” identifies problems Mr. Stiglitz has with American society, it fails to provide any means of actually fixing politics, and he fails to account for the human condition when doing so.

  

The problem with American capitalism is that regulations have opened up avenues for profit opportunities which involve entrepreneurs manipulating public policy for their own betterment. Regulators and politicians now have such control over who gets what in the economy that it is now advantageous for people to court the opinions of those within the government. 

If we desire to end the régime in which businesses can enrich themselves by manipulating the system, then we must move towards the natural system of liberty in which businessmen simply have no incentive to buy government favor since the government has no real means of enriching whole classes of people. That, and not the desire for a fairer America, is the best remedy for the corruption within the Federal government, and the overwhelming power cronies have over American politics. 

The Invisible Hand: An Idea Not So Modern

 

For everybody is eager to acquire such things and to obtain property, provided that he will enjoy it when it has been acquired. It ths comes about that, in competition one with the other, men look both to their own advantage and to that of the public; so that it both respects wonderful progress is made. The contrary of this happens in countries which live in servitude; and the harder the servitude the more does the well-being which they are accustomed, dwindle.

Adam Smith? David Hume? Nope, Niccolò Machiavelli. From The Discourses, II.2, translation by Leslie J. Walker, S.J. Like so many ideas, the invisible hand has been understood by more than we moderns. 

The Prisoner's Dilemma: A Matter of External Constraints

 

Men keep their agreements when it is an advantage to both parties not to break them; and I shall so frame my laws that it will be evident to the Athenians that it will be for their interest to observe them.

-Solon, reported in George Shelley Hughs, Ancient Civilizations

 

The prisoner’s dilemma is the textbook example of a coordination failure in which rationality is an insufficient condition for bringing about the best state of affairs. Rather than ensuring the best state of the world, rational forethought actually brings about the worst. Rational forethought - prudence, supposedly a virtue - is the cause of malaise rather than prosperity. The prisoner’s dilemma has thus become a template for all coordination failures to be seen, whether that is the depletion of fishing stocks or the nuclear arms race between the United States and the Soviet Union. 

 

One of the ignored features of the prisoner’s dilemma is that in the orthodox elucidation of the problem, the dilemma is not a dyadic relationship between the two prisoners, but a triadic relationship between the two prisoners as well as the police. Considering that the payoff matrix of a prisoner’s dilemma only provides payoffs for two players, one can easily forget that there are actually three parties at play: two who are interacting within the game and another who is setting up the parameters that the two prisoners are dealing with. In the prisoner’s dilemma, the police are offering the prisoners a deal no rational agent would refuse: “You can either confess your crimes and be a witness against the other guy in the room, get a plea deal, or go on trial for your crime. Oh, and your friend may tattle against you, so make your decision quick.” The two players aren’t prisoners of the dilemma; rather, they’re prisoners of a third party which has created the dilemma they are in. The prisoners have no choice but to play the game put before them.

 

Consequently, the prisoner’s dilemma is not a template for studying cooperation in general. We need to be mindful that game theory is a way of studying particular interactions, and that no game will ever provide a general theory of any phenomena. Whereas the prisoners are stuck in the position that they are within by virtue of being in custody, people across the world are working so as to ensure that cooperation does not take the form of a prisoner’s dilemma. 

People are natural problem solvers. They are able to mold the context of social interaction in ways that violate the assumptions of the prisoner’s dilemma. Human interactions are more than the dyadic choice to cooperate or defect. People aren’t stuck with the choices that they are given by the police, but are instead free to bargain over the gains to cooperation, and to create deals which leave everyone at the table content.  The entrepreneurial facet of human nature ensures that people are alert to opportunities for pure profit and that those opportunities open up the possibilities for better (we could even say Pareto-superior) outcomes. 

 

Interactions can take forms like the invisible-hand game, in which the payoffs guide cooperation to better outcomes for all involved. For centuries, political economists have shown how, with the right rules in place, man’s selfish nature can even benefit social harmony. What enables the maintenance of such cooperation is mutualistic behavior: behavior in which it is in the best interest of both players to do and to see the other player doing.

The threat of defection does not threaten the integrity of the international division of labor nor would it threaten the integrity of a hunting-gathering band because culture structures the payoffs such that they don’t. Cooperation within such societies is mutualistic. Everyone’s best interest is served by cooperation within their respective societies. Cooperation therefore often doesn’t take the form of a prisoner’s dilemma, but rather some game in which cooperation is an evolutionarily stable strategy. 

 

The prisoner’s dilemma does not describe cooperation in general. We would be fools for thinking that. Rather, the prisoner’s dilemma explains a very specific context of social cooperation, and a context which is actually artificially created by a third party, the police which are offering the deal to cooperate with the investigation.

The prisoner’s dilemma is certainly applicable to other circumstances, but when applying it to them, we need to be mindful about what are the circumstances that are preventing players from bargaining with each other to find better outcomes than the one they are initially faced with. Without that explicit constraint, the prisoner’s dilemma will largely fail to apply; after all, the history of human cooperation, from the Paleolithic on, has been a history of human beings adapting their social circumstances to the challenges they face, and that history of adaptation leading to the social conquest of the Earth.  

Institutional Design: The Coevolution of Institutions and Preferences

 

 

From “The Good-Luck Charm That Solved a Public-Health Problem” by Eleanor Smith:

In 2008, Christopher Charles was living in Cambodia and researching anemia… 

Charles, a Canadian epidemiologist, knew that iron-rich foods and supplements were too expensive for most rural Cambodians. Even cast-iron pots, which safely transmit iron to food as it cooks, were out of reach. But he wondered whether a small piece of iron placed in a standard aluminum pot would have a similar iron-releasing effect. To test his hypothesis, Charles distributed blocks of iron to local women, telling them to place the blocks in their cooking pots before making soup or boiling drinking water. The women promptly put them to use as doorstops.

After talking with village elders, Charles learned of a fish known as try kantrop, which the locals ate frequently and considered a symbol of good luck. When he handed out smiling iron replicas of this fish, women started cooking with them. “People associated it with luck, health, and happiness,” he says. Within 12 months, Charles reports, anemia in villages where the fish was distributed virtually disappeared.

The genius of the Lucky Iron Fish is that it does not have to be shaped like a fish. “If we were to go to sub-Saharan Africa,” says Charles, “or a dry area where fish is not an important part of the diet, we could very easily change it to a different symbol of luck.”

 

Preferences matter, and that is displayed in Christopher Charles’ interventions in Cambodian cooking culture, and his design for better ways of cooking. Charles’ actions in Cambodia are certainly a top-down intervention with an epidemiologist using his technical knowledge in order to change the institutions of a society in this case the rules of the game of cooking. His iron bars are institutional design, seeking to enhance human flourishing, but they failed at first because Charles’ failed to take the preferences of those he was trying to help. 

When Charles tried his first intervention, his attempts to change the way that Cambodians cooked their food were unsuccessful because they did not mesh with the Cambodians’ culture and habits, all of which are subsumed under the concept of preferences. The reaction that the women had to the iron, either in block of piscine form, would be categorized as preferences by economists, and those reactions determined whether the women would either use the iron as a doorstop or as a complement to their diet. When Charles’ intervention did not elicit the desired response from the Cambodian women, it was because his intervention did not work along with their preferences, and elicit the right response. However, once Charles’ intervention worked with their preferences, and elicited the desired response, then it worked, and the Cambodian women used the iron supplements in their cooking. 

 

 

For better and for worse, economics identifies all of the reasons for behavior that motivate people in their lives under the category of preferences. For better because preferences enables economics a simple category to think about human action in a teleological manner. What made Jim go to the grocery store? His preferences! They are, after all, his reasons for action. For worse because preferences blind economists to the fact that human beings general act in a program-like, and habitual manner compared to the lighten-rod calculator comprised of preferences. Nevertheless, the concept of preferences does its job well because economics is more concerned with the conscious action than with the psychological intricacies of all of human nature.  

Economists are naturally interested in how institutions form human behaviors. From David Hume wondering about what institutions would form the best outcomes even if all men were knaves to Elinor Ostrom writing about how informal institutions are able to maintain human cooperation despite the lack of formal institutions, the question of what kinds of institutions enable human flourishing has been one of the most important research programs running through the mainline of economic thought. Putting preferences into a black box hurts this research program because it conceals the way that individuals and institutions have evolved through history.

Institutions do not exist within a vacuum; rather, they have evolved through time changed by the different circumstances they have faced, and by the people within them. In addition, endogenous preferences, the replication of preferences across a shared institutional context, are common across the world. In that light, preferences can be looked at like accents. Human beings can consciously try to attain certain preferences, but for the most part - especially if we live an life unreflected on - we are unconscious to the manner we have come to attain our preferences, and so many of them we have simply acquired from our environment. Since the preferences of a population have exerted a crucial influence upon the evolution of their institutions, we need to understand the preferences of a population if we are to understand the success, or failure of its institutions. More tersely, culture matters. 

 

Overall, the failure of Christopher Charles’ first attempt to improve the iron within Cambodians’ diet is an illustration of the importance of preferences to the study of human society, and to the success of institutions. Institutional design is of interest to any student of human institutions because it can shed light onto the functioning of institutions within a complex world. For Charles’ design, it sheds light upon the necessity for institutions to work alongside preferences if they are to lead to desired outcomes.