A Nobel Prize for real world economics

The news that this year’s Nobel memorial prize in economics has gone to Jean Tirole is absolutely excellent, a really well-deserved award. I’m not going to compete with the swift and thorough summary already put out by Tyler Cowen. But I do want to add one comment just in case there are people out there thinking, why on earth has the prize gone to an economist who does theoretical, highly mathematical work – isn’t that yet another sign of how remote from the real world the whole discipline of economics has become? No economist who knows Tirole’s work will think so, and I’m sure there will be general delight about his selection, but maybe there are others who might make this mistake.

This is of course a common complaint about economics. It’s only partly true, and therefore partly false. There are for sure some economists who rely too much on basically very simple mathematics to gussy up economic analysis that doesn’t really need any equations. However, often economic thinking about the messy, complicated real world gets to a point at which the inter-relationships between variables are so knotty that mathematics is better able than words to keep track of them. The results are sometimes surprising.

Jean Tirole’s mathematics is of this kind. For example, in the work I know on two-sided markets (those where a platform stands between buyers and sellers), competition and market power look very different than they do in conventional markets like those for clothes or haircuts – so the conclusions competition authorities should draw from pricing on one side of the market might be very different from the usual ones. As the Scientific Background paper says:

“Tirole’s models have sharpened policy analysis. Focusing on the fundamental
features that generate a divergence between private and public interests, Tirole has
managed to characterize the optimal regulation of specific industries. Often, his rigorous
thinking has overturned previous conventional wisdom. For example, he successfully challenged the once prevalent view that monopoly power in one market cannot be profitably leveraged into another market by vertical integration. As a result, competition authorities have become more alert to the potential dangers posed by vertical integration and restraints. More generally, Tirole has shown how the justifications for public intervention frequently boil down to problems of information asymmetries and credible commitments. These general lessons — together with a catalogue of specific applications — form a robust foundation for policy analysis.”

His research has built the fundamental methods for the applied study of actual markets characterised by information asymmetries, moral hazard, lock-in, the exercise of power – features that are all too prevalent in the real world of business. It has huge practical relevance to regulators, including in the financial sector, and competition authorities. As Tyler points out, Tirole has also written on intrinsic motivation versus financial incentives.

The example of his work emphasises a broader point, which is that appropriate mathematics is essential in economics. And as Tony Yates recently pointed out, the maths needed as economics – thank goodness – gets ever closer to the real world is likely to get harder and harder. Say, if the subject takes more seriously non-linear dynamic systems, or strategic interactions between firms with different degrees of market power in a network market. Having said that, I always like F.Y.Edgeworth’s advice to regard mathematics as a kind of intellectual scaffolding, essential for the construction process, but preferably to be removed at the end.

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Money as a process, not a thing

Nigel Dodd’s The Social Life of Money is fascinating. I’ve never understood money and don’t think I do yet. One of the signs of its abstraction as a concept is the way people bring their own interpretations to it, perfectly plausibly.

In my first ever job, in the Treasury in the mid-1980s, I had the task of looking at the properties of different linear combinations of deposits, all corresponding to different definitions of money – not that I over-thought it at the time. Economics textbooks over the years have blithely carried a completely fictional, institution-free account of the money multiplier, and give us probably the least plausible explanation, typically – and unhistorically – claiming money emerged from barter trade.

Information scientist Jaron Lanier’s book Who Owns The Future, which I’m currently reading, says, “Money is simply another information system.” Digital identity and currency guru Dave Birch tells us Identity is the New Money. This echoes Keith Hart in his classic The Memory Bank: “The two great memory banks are language and money. Exchange of meanings through language and of objects through money are now converging in a single network of communication, the internet.” Another anthropologist David Graeber in his tome Debt: The First 5000 Years rooted money in group cultures. Nigel Dodd is a sociologist so he gives us the sociological perspective.

     

Dodd’s book starts by looking at the various origin myths and links each to current (sociological) monetary theories. It then takes money by theme: capital, debt, guilt, waste, territory, culture and utopia. The chapter covering the terrain most familiar to economists is that on debt, but it takes an entirely different perspective, with Keynes and Minsky the principal economists named here. The chapter’s conclusion gives its flavour: “A monetary system that i defined by an over-arching orientation toward the interest of creditors is inimical to democracy. …. Democracy, or society, now appears to be in open conflict with the needs of finance. Debt is no longer facilitating capitalism, it is driving it.”

In a way, I found this book very heavy going because it is written in the language of sociology, and with lots of references unfamiliar to me. But it’s good for any of us to look through the lens of a different discipline. I find Dodd’s conclusion persuasive – that money is not a thing but a social process. This tallies with Dave Birch’s argument that the combination of ubiquitous mobiles and their record of a dense social graph means digital identity is fast becoming the latest manifestation of money.

Dodd also presents the paradox that money is both outside the realm of values it describes, as the means of measurement, and inside it as a particular commodity with a value – he quotes Georg Simmel as saying money is both the measure and measured. And he links this self-referential character to the capacity for financial bubbles and crises to inflate themselves. True value lies in the social life of money, in the activities of human societies.

What this means for monetary policy is another matter entirely, and Nigel Dodd’s forays into economics are far less persuasive – not that there seems to be a more compelling approach to money on offer from the macroeconomists either at the moment. Sticking a bit of ‘institutional’ friction into DSGE models to represent the banking and shadow banking sectors can only be a sticking plaster until monetary economists start to take seriously the insights to be drawn from sociologists and others.

UK bank profits are back to their pre-crisis peak

Earlier this week I attended the ONS’s regular Economic Forum, and the recent changes to the National Accounts provided one of the main subjects discussed. The slides included this one showing the old and revised profits of the financial sector in the UK:

Financial sector profits, ONS

The revision incorporates a change to the reference interest rate used in the ‘FISIM’ methodology for the finance sector (see my GDP: A Brief But Affectionate History for more on this, and also Banking Across Boundaries by Brett Christophers). Although this does not remove the absurdity that the sector’s biggest contribution to GDP growth came at the end of 2008, as the financial crisis burst upon us, it has led to sensible revisions – including the downward revision in financial sector profitability shown in the chart here, with the new red line below the old blue line.

However. it is equally striking that recent profitability has been revised up significantly, and in the most recent quarter has matched the earlier peak.

This confirms anecdotal evidence (i.e. bankers and business people I chat to) that banks have been taking advantage of low headline interest rates to increase their interest and profit margins. While they moan about the regulatory burden, this doesn’t seem to have affected their profits or bonuses at all. I hope the Competition and Markets Authority will be looking at the new ONS profitability data in its decision about whether to launch a market inquiry into the banking sector – it is due to publish its decision any time. And good luck to Colette Bowe, announced today as the new chair of the Banking Standards Review Body, set up by the banks to make them all behave better – a very impressive woman but a massive task. My firm belief is that the market structure will need to change if the ethics of people working in the sector are to improve; they aren’t all bad people, but they face terrible (from society’s perspective) incentives.

The ONS Economic Forum was full of other interesting information – including news that it will start to publish wider well-being indicators alongside the quarterly national accounts data (the third release) from December. Sarah Connor of the FT has written this up.

  

Trains, planes and no automobiles

On my planes and trains just recently I read Charlie LeDuff’s Detroit: An American Autopsy. No automobiles in my travels, and, as it happens, not much about the automobile left in Motor City either.

It’s a gripping read, in the same post-crisis-America genre as The Unwinding by George – another superb read that paints a depressingly realistic picture of life for so many people in the post-industrial US. Detroit is a rather gonzo journalism version – LeDuff used to report from war zones. As it turns out, that perspective seems all to appropriate when he returns to his home city.

One of the most depressing aspects is how quickly and comprehensively the polity and economy crumble when trust or social capital falls below some threshold. Everybody is afraid. Normal contact and transactions become impossible. There are, for example, no high street names left in the city of Detroit, none – the chain stores have all left. Politics had become – this was written before the official bankruptcy – absolutely venal with all the usual manifestations of corruption and incompetence that characterise poor countries with failed institutions.When LeDuff writes: “The entire country was being run into the ground by a generation infected with incompetence and greed,” he surely speaks for many of his fellow citizens. Among the most incompetent, as portrayed here, are the managers of the big auto companies, whose bailout by the Federal Government in 2009 did nothing to stem the tidal wave of job losses.

The book is interesting about the loss of this factory work. It doesn’t romanticise it at all, recognising how dull, dispiriting and disempowering it is. At the same time, LeDuff argues that it taught workers an important perspective on the world and – at least in the past – an understanding of the nobility of the hard grind. “Turning away from our birthright – our grandfather in the white socks – is the thing that ruined us,” he writes of his generations aversion to the discipline of hard graft that – at least – factory work gave earlier generations.

The collapse theme harks back to my last post here, about how essential trust is to a modern (any) economy. Detroit offers an example of the post-trust economy. Read this book and be afraid.

The paradox of trust

John Plender reviews favourably Trust: A History by Geoffrey Hosking. The review says: “He argues, convincingly, that there is a tendency to give too much attention to power and the law relative to trust. The workings of trust are nonetheless complex….In the complex modern world, what increases trust in one group can intensify distrust in another.”

This seems to me one of the most difficult questions in the trust/social capital literature: what is the scope of the relevant group for trust to be a positive rather than a negative influence on the economy? Criminal gangs can be high trust organisations yet decrease trust in the society of which they form a part, and so on. Divisions into inside and outsider groups rarely end well.

Last year I wrote a short essay for the OECD Forum on the economic cost of diminishing trust in many of the institutions in OECD societies, including trust in big business. It highlights the paradox that the complicated, interlinked modern economy could not work without high levels of trust and yet so many indicators show that trust in established institutions is declining. More questions than answers here too, I’m afraid. But one can’t help but feel that we’re in a very corrosive downward spiral in trust at present.