Market failures vs government failures

In his address to the European Economic Association yesterday in Barcelona, Sir Nicholas Stern, president of the association and author of the world-famous report on climate change that bears his name, traced the development of public economics and economic policy over the last half century. He described how since the 70s, these subjects shifted from James Meade's preocupation with market failures to James Buchanan's emphasis on government failures. In his opinion, the last three decades have witnessed an increasing influence of ideological winds on the profession. The market triumphalism of the 80s gave strength to simplistic applications of some economic theories, like the efficient market hypothesis (that we have address already in this blog), to policy. The teachings on externalities, adverse selection, moral hazard and other market failures pioneered by major economists like Kenneth Arrow or Jean-Jacques Laffont were forgotten because the prevailing political winds blew in the opposite direction. Stern made these winds partially responsible for the current crisis. But also to the Economics profession as a whole, a profession that, in his opinion, with its rapidly increasing balkanization and compartimentalization was not able to resist them.

In the second part of his address, Stern argued that only a broad and encompassing effort by economists would be able to respond to the two main challenges the world faces today: Climate change and the alleviation of poverty, two goals that, he added, must be tackled jointly. Stern argued that we already own some of the necessary tools to do this. We, economists, just simply forgot them. He added that nevertheless these are just starting points (pigouvian taxes on externalities would not be enough to do the trick) and that the new advances on behavioral economics, institutional economics and theories of justice were the lines to follow.

Some of the final points made by Stern were slightly more vague. He argued that discussion and deliberation are necessary to achieve these objectives. These procedures are of paramount importance if we want a complete shift in preferences and views on individual responsability, in the same way in which decades ago society decided through public debate that driving under the influence of alcohol should be sanctioned. In the meantime, the Economics profession should enlighten such debate with new research primarily focused on market failures rather than on government misdeeds.

You can watch the lecture in full here.

Immoral safety?

Many examples of moral hazard refer to people (e.g. bankers) taking excessive risks. They get the upside benefit, such as a high return on a risky loan that turns out OK. If the loan goes bad, they get bailed out, to avoid the domino effect of a series of bank runs, so they don't take the downside cost. Their incentives are askew and inefficient decisions are taken.

But there are some situations where the economy is organised so that too little risk is taken. Suppose you have responsibility in an organisation for health and safety, or avoiding accusations of discrimination. If you are judged just on these criteria, and if you can impose regulations on those in the organisation who produce the final product, then why not impose the tightest regulations possible. This will maximise those indicators on which you are judged (e.g. no accidents, or no lawsuits).

But if you try to get rid of all downside risk, there can be no upside benefit. No risks are taken and the organisation stagnates. You see this in some schools, where teachers avoid activities that may involve some risk to children. But then the children will not get the benefits of those activities.

This is a form of moral hazard, perhaps better called immoral safety.

Credit Crunch reading

Some recommendations from the Economics Department here at the University of Edinburgh:

This youtube video.

At Brown University, there was a "conversation" between Peter Howitt, David Weil and Ross Levine, who discussed the economic situation, the bailout, and the outlook for the future (with paerticular reference to the US). Here's the video, and a short description in the Brown student newspaper.

Robert Skidelsky's recent review in the New York Review of Books of Martin Wolf's book. This is a thoughtful review bringing in nicely the role played by the global imbalances.

Tim Besley was asked by the Queen why nobody had predicted the crisis. His reply to her on behalf of the British Academy can be found here.

Olivier Blanchard (chief economist at the IMF) gave a lecture which gives a good overview of causes and policy responses. The video of the lecture is here.

More on the efficient markets hypothesis and modern macroeconomics

An interesting point by Krugman here (and here) about a comment made by Emanuel Derman:

But the EMH, if you don’t take it too literally and get carried away about axiomatically defining strong, weak and other kinds of efficiency as though you were dealing with axiomatic quantum field theory, does recognize one true thing: that it’s #$&^ing difficult or well-nigh impossible to systematically predict what’s going to happen. You may think you know you’re in a bubble, but you still can’t tell whether things are going up or down the next day. The EMH was a kind of jiu-jitsu response on the part of economists to turn weakness into strength. “I can’t figure out how things work, so I’ll make that a principle.”

(This relates to my previous blog on what Lucas said.) Krugman agrees that the idea you can't predict the future is a rather weak scientific idea to turn into a principle. In fact he quotes an old piece by Jeff Frankel:

It used to be that the goal in econometric work was to get results that were statistically significant, to reject the null hypothesis. In order for an author to stand up in front of a conference proudly, or to expect to publish his paper in a journal, he or she sought to get significant results. This is difficult to do in macroeconomics. The world is a complicated place; it is unlikely that the few key variables that emerge from the particular theory that one has developed will actually go far toward explaining a real-world time series. So what we have done — quite cleverly — is to redefine the rules. Now the goal is to fail to reject the null hypothesis, to get results that are statistically insignificant — in essence, to find nothing. It is far easier to find nothing than to find something. Typically one fails to reject many hypotheses every day, even in the shower or on the way to work.

Lucas defends economics

A follow up in this week's economist, by Nobel winner Robert Lucas, to the articles a couple of weeks ago about the state of economics (see earlier posting). Lucas makes some good points in defense of economics and macroeconomics in particular. He points out that the efficient markets hypothesis merely says that people make the most efficient possible use of the information available to them - this does not per se rule out bubbles (or other inefficiencies at the aggregate level) because no one knows when or if a bubble will burst. He also argues that the rapid and apparently successful response of policy in the US to the crisis was informed by recent macroeconomic research.

Bubbles and Behavioural Economics

Last month's Scientific American had an article entitled "The Science of Economic Bubbles and Busts". Broadly it paints a picture of the economics profession believing in efficient markets and the impossibility ofbubbles, at least until behavioural economics came along to explain to us how bubbles can exist. This ia hardly an accurate depiction. And it paints far too simplistic a picture of what caused the crisis. For example it suggests that basic irrationality was at its core: "A phenomenon like money illusion prevailed: the borrowers of these mortgages failed to calculate what would happen if interest rates rose." There may be an element of truth in this, but equally for many this was close to a one-way bet, borrowing 100% of the cost of a home and walking away when the property market collapsed. It certainly isn't obvious that this was ex ante irrational. And it suggests that a major new approach - better than standard economic modelling - is to use evolutionary simulation models to track rules of thumb trading in financial markets. Well, the truth is, this is nothing new. I can recall models of this type from 25 years ago, or more. It is hardly cutting edge.

Okun's Law - learn some economics

One good thing about the crisis is that one can learn some basic economics from what is going on. Here is a chance to learn what Okun's Law is. In the US there has been some debate about whether unemployment has risen by more than expected in thecurrent recession. Paul Krugman in this article (and see the link to his earlier posting) presents some data and explains that in the last 18 months US growth has fallen roughly 7.7% below trend -- that means that the % change in output (GDP) relative to par is -7.7. Okun's Law tells you how to translate this change in output into a change (opposite sign) in the unemployment rate: traditionally this is roughly a 1 : 0.5 ratio so that -7.7 translates to an increase in the unemployment rate of 3.85%. In fact unemployment rose from 4.8% to 9.3%, a change of 4.5%, slightly higher than Okun's Law predicts, but not massively out of line.

See the earlier posting on the Paradox of Thrift for an opportunity to learn some more...