Stationary Bandit

Generalized Increasing Returns

Pete Boettke asks “Since 1990, what do you consider to be the best economic theory innovations?”  I nominate the research program of Xiaokai Yang.  The late Professor Yang took Adam Smith seriously.  Smith famously declared that “the division of labor is limited by the extent of the market.” The problem with Smith’s theorem, as is well-known, is that it implies a world of increasing returns which are not compatible with competitive markets (by the definition of conventional economics).  Monopolies dominate markets.  Yang formalized and extended Smith’s model to numerous areas of economics but did not come to same conclusions as Smith's modern interpreters.  He developed models to understand economic development and fluctuations, the division of labor, e-commerce, and many others in a world of increasing returns.  The basic idea is simple: sometimes individuals do not make marginal decisions. Inframarginal analysis (i.e. corner solutions) is more appropriate to answer a question about whether to buy on the market or produce at home than marginal analysis.  Furthermore, Yang began from a world where everyone was identical rather than assumed differences.  Specialization and markets emerged over time.  James Buchanan summarized Yang’s contributions.

The contribution of Xiaokai Yang lies in his rigorous development of an explanatory apparatus that commences from and builds upon the presumption that persons, potential traders all, are identical in all relevant respects. Yang spells out and extends the logic to encompass equilibria that involve more behavioral adjustments than those defined in orthodox neoclassical models of general equilibrium.

The inframarginal approach has lots of potential to better understand the modern world than the alternatives.   To date, its inlfuence has been minimal.  But who knows hat the future holds.

 

A Quick Thought on the Powell Endorsement

Colin Powell’s endorsement of Barack Obama has generated a number of explanations (race, hurt feelings resulting from his UN presentation, etc.).  I do not find these reasons satisfactory.  The simplest (and most plausible to me) hypothesis has not yet received much discussion.  Colin Powell is acting in his self-interest.  That is, he is looking for a position of influence and he wants to support the winning candidate.  He waited to Sunday to announce his preference once he has relatively certain who would win the Presidency.  After all, Obama stated after the endorsement that "He (Powell) will have a role as one of my advisers. He has already served in that function, even before he endorsed me." 

A lesson from ten years ago

As the financial mess continues to evolve, I am reminded of the East Asian financial crisis that occurred ten years ago.  Prior to 1998, the presence of the IMF during a crisis stabilized expectations so that investors believed that reforms would take place and the crisis would end soon.  Beginning in 1998, the presence of the IMF signaled to investors the problem was worse than expected.  Is the same change taking place in the US?  Maybe the actions by the Fed and Treasury are making the situation worse because it reveals (rightly or wrongly) that the crisis is deeper than realized.

'Fighting the Last War'

Anna Schwartz's comments onthe current financial mess have received an number of comments.   Her analysis seems right on:

"Lending freezes up when lenders are uncertain that would-be borrowers have the resources to repay them. So to assume that the whole problem is inadequate liquidity bypasses the real issue."

Uncertainty, not liquidity, is the source of the problem.  But what explains the increased uncertainty?  A number of factors including the lack of trading (and therefore no meaningful prices) of toxic securities. But why the focus on liquidity?  Simply put policy-makers are applying the lessons of the Great Depression to today.  Lack of liquidity was one of factors explaining the severity of the downturn in the 1930s.  But today is different: less unemployment, less bank failures, a lot less deflation.  Her solution is simple.

Rather, "firms that made wrong decisions should fail," she says bluntly. "You shouldn't rescue them. And once that's established as a principle, I think the market recognizes that it makes sense. Everything works much better when wrong decisions are punished and good decisions make you rich." The trouble is, "that's not the way the world has been going in recent years."

No one is too big to fail.  If the Fed and the Treasury followed her advice, it seems unlikely we would be in the same situation today.

The continuing transition to capitalism

As the US continues its decades long drift to, shall we say, the left, China continues to become more market oriented.

China's government said it would liberalize the exchange of land among the nation's farmers, in an effort to revitalize the rural economy at a time of increasing strains in food supply and slowing growth.

Farmers will be able to transfer or swap their land; they cannot sell their land as complete private ownership is not allowed.  By using the profit motive to take advantage of scale economies, China hopes it will not face food shortages.  Land will be re-allocated to those who value it most.  It is not complete privatization but it does represent another step in the Chinese transition from communism.  Story here.

A Victory for Adam Smith

Something subtle happened when the Nobel Committee gave Paul Krugman this year’s award: Adam Smith’s vision gained increased credibility relative to David Ricardo’s.  Contrary to popular belief, Adam Smith’s vision has not dominated economics.  Only Smith’s phrases have elicited support; his models have not.  For decades, Ricardo’s approach, with its accompanying Ricardian vice, has influenced public policy and much academic discussion.  Simple abstract models trump more complicated (and in many cases) realistic models.  More importantly, Ricardo’s approach yields inappropriate policy conclusions because of its excessive simplicity. 

Adam Smith developed his system of natural liberty based on the assumption of human homogeneity and the propensity to truck and barter.  Identical people trade because of the gains from specialization.  The pursuit of wealth and approbation lead people to make investments that increased aggregate well-being.  No need to assume differences to generate trade and wealth creation as did Ricardo.

What does this have to do with Krugman?  He took Adam Smith seriously when the Smith claimed that “the division of labor is limited by the extent of the market.” Smith’s theorem implies a world of increasing returns which standard economic models do not assume.  Furthermore, Krugman avoided the Ricardian vice.  Krugman’s simple models did imply simple policy.  When Krugman asked “is free trade passe?” he answered it depends.  The appropriate public policy depends on public choice considerations.  Krugman’s award should be viewed as a victory for those who support Adam Smith.

James Buchanan made a similar case here.

 

In-kind versus cash payments

Sometimes when a government gives out money to those in need, the recipients spend it on goods that the government would prefer they did not.

Malawian civil servants with HIV, who used to receive an extra $35 a month to help them buy more food, are now to get a food handout instead.

"The money may not be spent on what you intended it for," Mary Shawa from the president's office told the BBC.

Are in-kind payments better than cash payments?  Of course not.  Assuming people know what they want, they will spend the cash on the goods they prefer the most.  If they use the money for non-food items, this implies they gain more from these goods than other goods.  Forcing people to consume goods they do not want reduces aggregate welfare.  This is standard economics.  It remains non-standard policy in many places.  Story here.

Hope in South Africa

The resignation of President Thabo Mbeki a few weeks ago has yielded some early benefits.

South Africa's new health minister broke dramatically on Monday from a decade of discredited government policies on AIDS, declaring that the disease was unquestionably caused by HIV and must be treated with conventional medicine.

Health Minister Barbara Hogan's pronouncement marked the official end to 10 years of denying a link between HIV and AIDS by former President Thabo Mbeki and his health minister Manto Tshabalala-Msimang.

Story here. The first step to solving a problem is to identify its source.  Finally, the South African government has done so. 

2008 Nobel in Economics

So Paul Krugman won the Nobel Prize.  I figured he would win but it was a few years away.  But by himself? If Joseph Stiglitz or Kenneth Arrow did not win the award individually, it not clear why Krugman wins by himself.  Their contributions permeated the economic way of thinking (imperfect information and general equilibrium) rather than a few fields in economics.  Krugman’s contribution is primarily for formalizing the increasing returns to scale explanation for trade and, to a lesser extent, economic geography.  As he wrote in 1979: “economies of scale can be shown to give rise to trade and to gains from trade even when there are no international differences in tastes, technology, or factor endowments.”  The big loser, as others have stated, is Avinash Dixit.  Dixit and Stiglitz’s 1977 AER paper set the stage for Krugman, Elhanan Helpman, and others.  Maybe there will be a future Nobel Award to Dixit and William Baumol “for their many contributions in various fields.”

It's Nobel Time Again

Obviously macro and finance awards are not in the running.  That removes Eugene Fama and Kenneth French (add Benoit Mandelbrot as an unlikely trio) and Thomas Sargent and Robert Barro.  Here is my top three (which look similar to my previous lists):

1. Armen Alchian and Harold Demsetz- “for their pioneering contributions to the theory of the firm and the economics of property rights;”

2. Oliver Williamson- “for his application of the transaction cost approach to the theory of economic organization;” or

3. Jagdish Bhagwati, Anne Krueger and Gordon Tullock- “for their development of the theory of rent-seeking.”

 If I had to select only one, it would be for rent-seeking.  It seems appropriate given the financial crisis and response.  My outside choice remains the same as last year- Albert Hirschman.