Markets, states and humans

I was eager to read Paul De Grauwe’s The Limits of the Market because I profoundly agree with its premise that the false dichotomy between ‘the state’ and ‘the market’ has led to bad public policies and lower social welfare. The book is a short overview of the flaws of this dichotomous view of the world. It organises its discussion around two sets of reasons why a ‘free market’ is a meaningless abstraction: externalities and ‘internalities’.

The idea of an externality is familiar of course – that individual choices by a person or business have consequences, good or bad, for others. Once you start thinking about it, you realise externalities are pervasive. Indeed, they include many not acknowledged in standard economic theory which assumes fixed preferences, when of course preferences are socially determined. As De Grauwe points out, it is not easy to address externalities with government policies (not that this means there’s no point in trying): “The market fails in the face of externalities. When this happens, the government must step in. However …. that is also the moment at which the discrepancy between individual and collective interest is widest.”

The word ‘internality’ is new to me – though this is the second time I’ve come across it used by a Francophone author. It refers to the capacity humans have to make decisions that damage their ‘rational’ self-interest. I would think of this as a failure of one of the other assumptions of standard welfare economics, namely individual utility maximisation. The book makes use of Daniel Kahneman’s distinction between System I thinking (emotion, instinct) and System II (reasoned calculation). Market outcomes that satisfy the latter can adversely affect – say – our fairness instinct. “This dissatisfaction creates an opportunity for governments to fill the emotional gap left by the free market and to focus on System I, which steers our emotions. Many emotions find an outlet through government.” Well, most people probably have rather negative feelings about government, but one sees what he means.

The book is an extended reflection on this dual set of market failures, and the inevitable involvement of both (coercive) government actions and individual choices in the economy. I ended up being a bit disappointed, as it does fall between the two stools of accessibility for the general readership and technical rigour for professional economists, so I didn’t feel I got tremendous new insights. It’s also expensive for a very short book (£25 for 160 pages), albeit not in stupid academic book price territory. Still, the framework set out for thinking about the roles of government and market is neat, and I’ll recommend it to students who are particularly interested in the welfare economics but won’t want anything technical.

Humans and financial markets

Well this is exciting: the proof copy of the new book by my brilliant former classmate Andrew Lo (now director of the MIT Laboratory for Financial Engineering) has arrived. It’s Adaptive Markets: Financial Evolution at the Speed of Thought. Paging through, & from conversation with him, the book is a synthesis of modern financial economics and psychology/evolutionary biology, with some AI and neuroscience in the mix. It aims to get away from the stale ‘the efficient markets hypothesis is right/wrong’ dichotomy and looks instead at the interaction between rational calculation and what we know of the structure and non-rational habits of human decision making.

The book starts with a historical perspective; it ends with the financial crisis and recent developments, and discusses what regulatory framework is appropriate. A proposal that seems utterly sensible is to establish a financial market analogue to the National Transportation Safety Board, a standing expert (sorry!) body that investigates transport accidents to determine causes and recommend regulatory adjustments if necessary.

I can’t wait to read it. The book is equation-free and I know from graduate school experience that its author (also co-author of the classic A Non-Random Walk DOwn Wall Street) is so clever he can explain really difficult things ultra-clearly. Looks like one for all interested in financial markets. It will be out in April so I’ll review it properly closer to the date.)

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Urban futures: the ultimate how-to guide

The latest in our Perspectives series is out now: Britain’s Cities, Britain’s Future by Mike Emmerich. Mike, for those who don’t know him, was a key architect of the devolution deal for Manchester, and prior to that had worked in the Treasury and 10 Downing Street. It’s hard to think of anyone who has had such a ringside view – from both sides – of the debate about the role of the UK’s major cities in the economy and society.

The book starts with the historical perspective, looking (from the perspective of agglomeration economics and political economy) at why the big industrial cities like Manchester, Liverpool, Sheffield and Birmingham rose, and declined, and may be on the point of renewal. The following two sections reflect on the role of cultural and social life, and institutions and politicla governance, in explaining the fortunes of a city.

The final chapter has some suggestions for cementing the current phase of renewal – vitally important in the post-Leave vote political landscape. In short, stop thinking small, and stop thinking ‘now’. Success takes a generation or two but we needs to start investing at scale, for a very long time. Specifically:
1.  More and better transport, with political consensus so the projects get delivered.
2. Build more housing and invest in the schools and amenities to make every neighbourhood feel liveable
3. City, business and universities – strong local institutions – must work together
4. Strong local skills institutions involving (& funded by) both employers and the state, and different in different cities, not national templates.
5. Create jobs for the people ‘left behind’ starting with high quality, publicly funded temporary jobs in their community.

This all requires a long-term planning horizon, money, and above all political commitment at the centre and locally. A tall order perhaps, but with a better chance of hapening now than at any time since the 1960s. If you want to know more, Mike’s your man, and the book is available to pre-order now – with you by the weekend.

BTW, this is the 11th Perspective, and we have some cracking new ones in the pipeline. There are a couple of promotional offers available for a while, one for the existing titles, and a discounted subscription to the forthcoming ones.51cT3hSZocL

 

Practical social welfare

I just finished (re-)reading Amartya Sen’s Collective Choice and Social Welfare. The parenthesis isn’t because I can’t remember but because the original 1970 book has been republished with a chunky new section. It isn’t an easy read, even with the corralling of the technical proofs into alternate, starred chapters. Sen addresses the dilemma raised by Arrow’s impossibility theorem and the wider family of impossibility results, which state that a few totally reasonable-seeming assumptions about principles of social choice end up with no decision rule able to satisfy them. The technical language is that between them the assumptions – transitivity, independence of irrelevant alternatives, unrestricted domain, the Pareto (or unanimity) principle, and non-dictatorship – leave a null set. I’ve always thought of it in the shorthand of there being unavoidable conflicts/trade-offs/dilemmas in social choice. Sen shows that for many social choice questions, the assumptions are too restrictive. ‘Unrestricted domain’ means throwing away relevant information; the Pareto condition forbids interpersonal comparisons such as between the rich and the poor. He argues that welfare economics has been impoverished by the Lional Robbins diktat that interpersonal comparisons could not be permitted: it is bizarre that the subject has had so little to say about the distribution of resources and incomes, self-hamstrung for decades.

The additional chapters extend the original and present in a more rigorous manner some of the material in Sen’s The Idea of Justice. There’s a timely chapter on democracy: “Given the mixed bag of results that we can actually get from majoritarian democracy, its defence, important as it is, needs to be seriously supplmented by probing scrutiny of its limits and conditionality.” This written after last November’s US Presidential election.

Not a book for the general reader – The Idea of Justice is a better presentation of Sen’s important work for that audience. But economists should have read Collective Choice and Social Welfare, especially those working on or in public policy. For all its logical abstractions, this is a very practical book.818GkIguxCL

Errant economics

A while ago I checked Thomas Schelling’s essays Choice and Consequence out of the library to read his ‘The Mind as a Consuming Organ’ (which I wrote about in the FT). I just read the other essays in the collection that were new to me. I love his work. Rather like Ronald Coase, he has a way of asking questions that seem obvious with hindsight but not at all so with foresight. There’s a terrific essay (Economics and Criminal Enterprise) on the economics of crime, categorising types of crime according to the underlying economic characteristics of supply and demand. Are there economies of scale (drugs distribution) or the reverse (backstreet abortions, a person-to-person service)? Is the market a legally-created monopoly because of some prohibition which has the effect of substantially raising entry barriers?

The essay also covers ‘organized criminal services’ – bankers, lawyers and accountants linking the underworld and upper-world – and also argues that the interaction between policies and the organization of the criminal enterprise need to be better understood. For example, Schelling writes: “The role of vending machines [in stores paying protection money to a racketeer] appears to be that they provide a tax deductible and ‘respectable’ way of paying tribute.” I love that he bothered to wonder why local laundries so often have a vending machine.

Loads of insights too. The chapter on the relation between state and market points out that businesses often welcome coercion by the state, in situations where neither they nor any competitor could be the first to move. “Barbershops, for example, appreciate mandatory closing on Wednesday in Massachussetts, since it precludes competitors from staying open.” I once tried and failed to convince a UK official that this was a reason for a regulation requiring shops to close their doors rather than heat the high street – none would move first for fear their competitors would entice in all the impulse shoppers. This is a good reason too for outlawing ‘free’ bank current accounts; many banks would like to end this pricing distortion, but none dares act first.

Sadly, Schelling died late last year; we need a new crop of errant economists asking questions about aspects of the economy we take for granted.

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