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...

UK output falling fast

UK output fell over the last year (12 months to June) at a rate of 5.6% (see this BBC page for details). This is almost the same as the negative growth experienced in the worst 12 months in the Great Depression (-5.8%), although current records began in 1955 so it may not be strictly comparable. The last quarter's decline, while much smaller than the previous one (see graphic from the BBC), was worst than expected. These figures tend to get revised after a bit---see Stephanie Flanders' blog for a guess about which way the current figures might be revised.

The state of economics

This week's Economist has some articles on the credit crunch and the science of economics. It is fairly critical of both macroeconomics and financial economics. My feeling is that it is a bit harsh to half-blame economics, particularly financial economics, for causing the crisis. There are a number of reflections on the Economist articles in the blogosphere by Stephanie Flanders here, Paul Krugman and Brad DeLong. Krugman is partly defensive, but DeLong isn't:

In my view, when you have Nobel Memorial Prize-caliber economists like Arizona State's Edward Prescott, Chicago's Robert Lucas and Eugene Fama, and Harvard's Robert Barro claiming that there are valid theoretical arguments proving that fiscal stimulus simply cannot work, not even in a deep depression--even though they cannot enunciate such theoretical arguments coherently--it is entirely fair for outsiders to conclude that academic economics as a profession is useless.

China bounces back

China's economy grew at an annual rate of 7.9% between April and June, up from 6.1% in the first quarter, thanks to the government's big stimulus package. The country's quickening economic expansion comes as most nations in the West continue to experience recession. Beijing now expects China to achieve 8% growth for 2009 as a whole, which compares with a predicted contraction of between 1% and 1.5% in the US. (BBC News; click figure to enlarge.)

Everyone seems surprised that the Chinese economy has recovered so quickly. This is being ascribed to the stimulus package announced in last November, but it is surprising that it could come through so quickly.

July 2009 Graduations

Congratulations to everyone who graduated earlier this month.

Unemployment rising rapidly

UK unemployment rose by a record 281,000 to 2.38 million in the three months to May, the Office for National Statistics has said. (See BBC report here.) This is according to the ILO (survey) approach to measuring unemployment. In fact those claiming jobseekers' allowance did not increase in number last month very much, so there seems to be a discrepancy. It may simply be that many of the new unemployed are not bothering to apply for the allowance, which isn't very much (around £65 a week). Everyone expects unemployment to carry on rising until at least early next year as changes in unemployment usually lag output changes.

The paradox of thrift — for real

If you don't understand the paradox of thrift - and every self-respecting first-year economics student upwards really should (I know we don't teach this stuff any more!) read this recent post by Krugman.

UK Inflation falls (a little)

UK annual inflation fell in June as the Consumer Prices Index (CPI) dropped to 1.8% from 2.2% in May, the Office for National Statistics (ONS) said. This is below the Bank of England's target of 2%, but it is surprising perhaps that it is only now below target given general defaltion fears. This is the year on year rate, so measures price changes over the last 12 months, rather than how prices have changed just over the last month or so.

The Retail Prices Index (RPI), a key inflation figure which includes mortgage interest payments and housing costs, became even more negative, falling to -1.6% from -1.1%, the lowest figure since the statistic has been collected in 1948! However given that monetary policy has pushed interest rates down so much, this is perhaps not such a good measure of inflation.

See this page from the BBC for an explanation of inflation and how the statistics are calculated.

Markets and Morals

This year's Reith Lectures were given by Michael Sandler of Havard (rumoured to be the person on whom Montgomery Burns of the Simpsons was modelled!). I liked the first lecture which was on the morality of markets and can be listened to here (or click for transcript). Should we have markets in immigrants, body parts? Should we pay children who do well in tests? Market triumphalism has given way to a new market scepticism. Almost everybody agrees that we need to improve regulation, but this moment is about more than devising new regulations. It’s also a time, or so it seems to me, to rethink the role of markets in achieving the public good. There’s now a widespread sense that markets have become detached from fundamental values, that we need to reconnect markets and values. But how? Well it depends on what you think has gone wrong. Some say the problem is greed, which led to irresponsible risk taking. If this is right, the challenge is to rein in greed, to shore up values of responsibility and trust, integrity and fair dealing; to appeal, in short, to personal virtues as a remedy to market values run amuck...ll in test scores? What about carbon trading?

Inspiring Green Innovation

There was an excellent programme this week in the BBC's Analysis series by Tim Harford, The Undercover Economist, who examines the economics of different ways to inspire the creators and inventors who may come up with solutions to global warming. Is innovation best left up to the market (with price incentives supplied by the state) or is this issue too big to leave the private sector to its own devices? This can be listened to by going here or play directly (not sure how long the BBC keeps this available).

Don't tighten policy yet!

There is an interesting article in this week's Economist by Christina Romer (chair of the Council of Economic Advisors in the US) in which she explains that errors were made late on during the Great Depression when policy was inadvertently tightened (by cutting back various items of government spending and the ending of some tax reductions) and unemployment shot up again (from 15% to 19%). Her point is: We shouldn't repeat the same mistake now.

1931 and all that

(Click to enlarge.) As Stephanie Flanders points out, so far output is tracking fairly closely the fall in the great depression in the UK. That's the bad news. The good news perhaps is that the depression between 1929 and 1934 actually wasn't that bad in the UK. Output only fell by 4.6% in the worst year (compare that with 10% in the US). The graphic shows that the Thatcher period (1979-83) was quite similar to the Great Depression period.

Miscellany from Krugman

A couple of quite interesting columns by Paul Krugman in the New York Times this week. In "Reagan did it" he argues that it is all Reagan's fault: the financial deregulation during the Reagan era set the stage for people in the States to run up very high levels of debt (with the savings ratio--the fraction people save out of their disposable income--falling from around 10% to around zero) and financial institutions to likewise have high borrowing relative to capital. In "The big inflation scare" he argues that fears of inflation are grossly exaggerated - there is no reason to believe that the monetary policy being pursued (including quantitative easing), which is pumping large amounts of money into the economy, will lead to rising prices. The time to be careful, he argues, is once we are coming out of recession.

Lord Stern on Climate Change

Anthropogenic climate change is one of the major problems facing the planet. It also raises a host of interesting and challenging economic issues, from the selection of policy instruments (command and control regulation, carbon taxes, cap-and-trade, and hybrid schemes), through the analysis of risk, uncertainty and irreversabilities, to the global political economy of reaching an effective international environmental agreement which adequately addresses equity and development issues. The scale and potential impact of climate change on global well-being puts the current, but temporary in nature, financial crisis in perspective. Lord Nick Stern, whose 2007 Review of the Economics of Climate Change (link) did much to raise awareness of the urgency of the problem, has recently published a new book updating his views - A Blueprint for a Safer Planet. An audio file of the informative and very accessible LSE lecture by Nick Stern, to launch his book, can be downloaded at: link). It is well worth listening to both as an economist and as a responsible citizen.

Irrationality, salad and chips - failure of the independence axiom

One of the basic tenets of our approach in economics is that the mere presence of an extra possible choice in the options available to a rational consumer should not affect the decision taken, as long as the consumer does not choose the extra choice itself. This is a version of the "independence of irrelevant alternatives" assumption that crops up in pretty much all rationalchoice theories. However, it seems that the mere presence of a salad on a menu, even if not chosen, makes diners more likely to opt for chips. See this article.

"Investigators asked college students to choose foods from menus that differed in only one feature; one menu offered a salad and the other did not. The point? To find out whether the presence of a salad on the menu influenced what else the students ate. It did. The students choose French fries more often from the menu with the salad."

Why do people like trams so much?

Tyler Cowan in Marginal Revolution asks "why do people like streetcars so much?" Actually I have yet to meet anyone who is enthusiastic about the Edinburgh tram project (other than TIE's supremo), although admittedly many of my conversations on this topic were with taxi drivers, who may have vested interests in the matter. One of my colleagues argues that buses simply dominate trams - they are much cheaper and more maneuverable. But it is a mystery why they apparently remain so popular with many people.

According to Eichengreen and O'Rourke: "globally we are tracking or doing even worse than the Great Depression, whether the metric is industrial production, exports or equity valuations." Krugman calls this "half a Great Depression" becuase the fall in manufacturing output in the US is not as bad as it was in 1929. But they point out that looking at global data, things don't look so good. On the bright side, the policy response (monetary and fiscal) looks a lot better now, so there is still hope...

Inflation not falling as fast as expected

The latest (February 2009) inflation figures were a bit of a surprise in that the CPI rate actually increased from 3.0 to 3.2% while the RPI rate which includes mortgage interest didn't go below zero--it fell from 0.1 to 0.0%. The CPI means the Governor of the Bank of England may have a write another letter explaining why inflation is too high. A bit ironic given that everyone is terrified about deflation. The graphic from the BBC shows what's going up and what's going down (click to enlarge).

More on the American bank plan to get rid of toxic assets

For anyone interested, the debate still rumbles on. Here is a summary of the different sides, and here is Krugman's response. The gist of what he says is that the plan, to allow the toxic assets to be bought up with most funding coming from the government, by driving prices of these assets up, will benefit not only those banks who are in trouble, but also many others, so it is basically a waste of a lot of money. He favours a much more targeted approach. This is a well argued counter view by a fund manager.

Gentlemen Prefer Blands; or it all depends on the elasticities.

Simon Clark comments on the posting below by Santi Sanchez-Pages (Gentlemen Prefer Dumbs)

My colleague Santi sets out a very interesting analysis. As any good economist will tell you, it all depends on the elasticities. If v (value of match) = pq, and p depends on q, then write p = p(q) (with p' < 0) so v = p(q)q. Then dv/dq = qp' + p is positive if p'q/p, the elasticity of breeding probability with respect to female quality, which we label as e, is greater than -1 (recall that p' < 0).

If e > -1 (e.g. if p is constant) then the higher quality is not offset by the reduction in probability, so we would still have positive assortative matching (PAM). If e < -1, we get negative matching (NAM); high quality men will want to avoid high quality women as they are too unlikely to have children.

But e may be variable. Suppose q lies between 0 and 1 and p = 1 - q. Then v = q-qq (I can't do squares in Html!); simple calculus, or graphing v against q, shows that the highest value women have q = 0.5 and the worst 0 or 1. Women can be ranked by the absolute value of (q-0.5), so q = 0.25 is as good as q = 0.75. Then we would see NAM between the highest quality women and a representative half of the men (of all types) and PAM between the lowest quality women and the other half of the men. More like 'Gentlemen prefer blands'.

With equal numbers of men and women, whether some agents remain unmatched depends on whether they have a 'reservation quality' (as in 'I'm not that desperate!'). In the set-up above, if men will not accept v less than v*, single men will be low quality, and single women will have q outside the interval bounded by the two solutions to q - qq = v*. So we would observe spinsters who are either successful professional women too busy to breed or women ready to breed but too uneducated; an interesting area for empirical research.

As Santi says, it is true that we have a lot to learn from other disciplines, but the concept of elasticity can also be useful outside economics. Note the resemblance between v = pq ,and revenue = pq = price x quantity. If a man has a cost per unit of quality of c of providing 'satisfaction' to a high quality woman then v = (p - c)q, which can be thought of as total revenue less total cost. So maybe there are further parallels to be explored.

Gentlemen Prefer Dumbs

A few days ago, during a nice dinner at The Vaults, two friends of mine, let's call them K and M, an economist and an anthropologist respectively, and myself, we were talking about the possible effects of the economic crisis on the marriage market. At some point we discussed whether the crisis was going to alter in any way the assortative matching that typically arises in that market. From your own experience, you should have noticed that people tend to match with people of roughly their same socioeconomic status and/or physical attractiveness. The explanation is simple. Suppose that the value of a person can be measured in a universal scale, like the genetic fitness of their potential offspring or the resources they can provide to that offspring. Suppose also, for the sake of the argument, that there is the same number of people in each side of the marriage market. Therefore, everybody in one side of the market (let's say the males) share exactly the same preferences over potential partners, and the same happens in the other side (i.e., the female side). If that is the case, the only pairwise stable matching is assortative: the best male matches with the best female, the second best male with the second best female, and so on. Suppose that that were not the case. It would imply that at least one person in each side of the market is matched with someone with a lower ranking that him/herself. These two "unhappy" people could improve their situation by breaking their previous match and being together.

Then my anthropologist friend M raised a question: We observe that males tend to go for females that are not more intelligent or successful than themselves. Why? After acknowledging that there was a certain truth in that, K and I looked for an answer. The simplistic model of matching that I proposed above assumes that females will have offspring for sure. But that may not be the case in reality. More successful and intelligent women will typically have better outside options to childbearing so they are less likely to agree to reproduce. So if that probability is Pi and the value of female's i offspring is Qi, the value of matching with that female is just PiQi. Hence when going for more intelligent females, men may be trading off higher quality offspring with a lower probability of reproduction. Notice that the same argument applies if Pi represents the men bargaining power within the household against female i and Qi is the quality of the relationship or a measure of some other type of investment made by the female. This assumption can be enough to generate a non-assortative matching in which men have a positive optimal level of female “dumbness." And implies, if we maintain the assumption of equal number of males and females, that that some very intelligent and successful females may remain unmatched.

The moral of the story for you should be that we can try to apply that economic thinking to shed light on any question, phenomenon or puzzle you may encounter. And also that we have lot to learn from listening to other disciplines. That is, unless you are too busy chasing a dumb enough partner out there.

US Banks

There is a heated debate in the US blogosphere about whether Treasury Secretary Geithner's plan to, essentially, buy up toxic assets, is the best way forward to stabilise the banks (the alternative is roughly to guarantee bank debts). If you are to read one thing on this, it should be this article by Krugman which puts the issues over in a beautifully clear way. What he doesn't say in that post, but elsewhere in an earlier post however, is that the reason why he is so against the current plan to buy up the assets is that:

This plan will produce big gains for banks that didn’t actually need any help; it will, however, do little to reassure the public about banks that are seriously undercapitalized.

Football: economists excel at games (in theory)

The staff have started training for the this year's Academics v Senior Honours football match so I thought I would re-post the photos and video of the March 2009 match.




Everyone enjoyed themselves and the staff upheld the reputation of the School by winning 2-0. Santi and Ahmed were the goal-scorers.

Here's a short video of the game:

This year, we're going to draw the SH team members' names out of a hat during the coming SH party (Thursday 4th March - in the coffee room, 1st floor, 31 BP, 4pm) and the game itself will be towards the end of March. If you want to put your name forward for the team, just email Karen or Christina on Economics.SSO@ed.ac.uk and we'll put you on the list.

Feedback from the Credit Crunch Seminar 2

Simon Clark reports back from the Credit Crunch Seminar on March 12.


Take 60 ordinary people, roughly a cross-section of Edinburgh society, and invite them to give their views on the credit crunch and the economic crisis. Or rather, light the blue touch-paper and stand back, well back.

The meeting was permeated by a deep sense of injustice. How can people just walk away from the mess they have created, often with a big pension, when others lose their jobs and pensions though no fault of their own? You may think economics deals with efficiency and hard-headed analysis, and that concerns of equity and justice are the domain of the soft-headed disciplines (usually ending in 'ology'). Wrong for two reasons! Firstly, if people care about fairness then it will affect their behaviour. For example, they may avoid buying from businesses they see as treating their workers and suppliers badly, or not doing their bit for the environment. Or if people at work are treated fairly, they may be more productive. Secondly, think of the raw politics of the situation. You may disagree with knee-jerk reactions to punish greedy bankers, but if a political party can get support for measures to redress injustices, real or perceived, then - purely as a matter of economic forecasting - you need to take that on board in forming your expectations of future policy.