Why a top monetary economist is wrong

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Yesterday I had lunch with an old friend who is a top monetary economist. We were discussing a conference on the state of macroeconomics that I attended recently. The conference seemed to me to reveal quite a deep division between those macroeconomists who thought their pre-crisis New Keynesian DSGE models were basically fine, although obviously in need of having a financial sector added to them, and other economists taking a wide range of approaches but pretty sure the pre-crisis mainstream approach is defunct. I’m in the latter category, with the caveat that it’s nearly 25 years since I’ve done any proper macroeconomics.

Alas, my dear friend is in the amended status quo camp. He said the tools a monetary economist needs can be found in the Michael Woodford tome [amazon_link id=”0691010498″ target=”_blank” ]Interest and Prices: Foundations of a Theory of Monetary Policy[/amazon_link]. His argument went like this. Any macro model makes simplifying assumptions. We macroeconomists could have assumed that prices and wages are perfectly flexible, which would make the models easier, but we didn’t. That was a correct call. We did make the simplifying assumption that the financial sector was a veil and we could ignore the incentives on bankers’ behaviour, and that was a misjudgment. But economists understand incentives, it’s straightforward to fix, and we’re putting the financial sector into the models now.

[amazon_image id=”0691010498″ link=”true” target=”_blank” size=”medium” ]Interest and Prices: Foundations of a Theory of Monetary Policy[/amazon_image]

This argument is on the face of it perfectly reasonable, but it reminds me of a conversation I had with another tleading economist in the mid-1990s, when I was working as a journalist reporting on technology and becoming enthused about the likely implications of the internet and World Wide Web for the economy. This economist argued that all the internet did was reduce transactions costs, and economists understand how to model transactions costs, so the new technologies would turn out not to be very interesting analytically. This was also true in a small way, and false in a much bigger way.

The moral is that the judgments reflected in simplifying assumptions are not a small technical matter. Transactions costs are not a side-show in economic analysis, they are the main attraction, driving the fundamental structures and institutions of the economy. So it is with the assumptions behind conventional macro models, which encapsulate a world-view about the nature of economic and political institutions  – the failure of pre-crisis DSGE models is not a question of small and easily corrected misjudgements but rather missing the main point.

(Strategic) thinking is hard to do

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I’m taking a break from economics by reading [amazon_link id=”0099551861″ target=”_blank” ]Revolutionaries: Inventing an American Nation[/amazon_link] by Jack Rakove, a history of the American revolution told through the debates among its leaders. The gaps in my knowledge on this subject are large, and it’s a beautifully written book, so I’m enjoying it. It has made me realise, once again, how few people think strategically at all – that is, think about how their interlocutor is going to react in his (or her) next move – never mind what their end-game might be. The American victory over Britain could almost be summed up as the result of having a few more strategists.

[amazon_image id=”0099551861″ link=”true” target=”_blank” size=”medium” ]Revolutionaries: Inventing an American Nation[/amazon_image]

This is just as true in modern life. The best business book on strategy is, at least in my reading, Nalebuff and Dixit, [amazon_link id=”0393310353″ target=”_blank” ]Thinking Strategically[/amazon_link]. It uses game theory but isn’t all that difficult. Still, just as Daniel Kahneman points out in [amazon_link id=”0141033576″ target=”_blank” ]Thinking, Fast and Slow[/amazon_link], how hard it is to calculate anything, I’m sure it must also be hard to strategise.

[amazon_image id=”0393310353″ link=”true” target=”_blank” size=”medium” ]Thinking Strategically: Competitive Edge in Business, Politics and Everyday Life[/amazon_image]

e-mergers

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There’s obviously much excitement in the publishing world about the Random House-Penguin merger. It’s the kind of merger that makes me wish I was still on the Competition Commission, as the issues are fascinating. The justification given by the parties is that they will be able to invest on a larger scale in e-books. Clearly, all publishers are anxious about Amazon’s market power – 40% of all retail book sales in the UK according to one figure I saw. But this is complicated territory, competition-wise.

I was a member of the Competition Commission group that gave the 2006 go-ahead for Waterstones and Ottakar’s (remember them?) to merge on the grounds that online book sales offered vigorous competition to high street booksellers. Since then, Borders/Books Etc has also gone from British high streets, although Daunts and Blackwells seem to be more than holding their own. Ironically, the publishers – including Penguin – were vociferously opposed to the Waterstone’s merger, saying online sales would not pose an effective competitive threat to a single big high street chain.

What a lot of today’s commentary is not discussing in detail is the question of which markets along the whole value chain need to be assessed. There’s a transaction between author and publisher – mega-publishers look bad for most authors but on the other hand there seem to be quite a few reasonably successful small publishers springing up. Then the wholesale transaction between publishers and retailers – and here there is growing concentration on both sides, with the intriguing wrinkle that Amazon can act as a platform for smaller publishers to reach readers.

Finally, there is the retail market, both in its physical and e-book manifestations. Amazon is clearly dominant, and seems to be pricing Kindle devices at cost to hook customers in, but is not blatantly using its market power to raise prices to consumers, as opposed to squeezing the publishers’ margins – although given that the price of an e-book is a rental rather than a purchase price, that is a hypothesis to be tested. Anyway, one would need a two-sided market model to assess the competitive impact of changes in the two separate margins, as there is no reason these would be the same under perfect competition. Besides, any competition regulator would want to see a standardised e-book format emerge.

All in all, it would be a terrific case to be on! I’m not sure it will be referred – Penguin seems confident it can avert that with sufficient undertakings and disposals – but if there is an inquiry, the report will make a cracking good read.

The economics of poverty

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I’ve been looking through the new [amazon_link id=”0195393783″ target=”_blank” ]Oxford Handbook of the Economics of Poverty[/amazon_link], edited by Philip Jefferson. It isn’t a book to read from cover to cover and review, as a handbook, and I’ve only read two of the chapters. Still, this looks like a useful resource for economists interested in two fields, development economics and income dynamics. In fact, this is something I particularly like about the book, that it includes some research on developing countries alongside the US (although a shortcoming is that its developed world focus is very US-centric). Surely, to the extent that we think economics should aspire to any universality, the economics of poverty must have some application to poverty in any country? So there are chapters by Martin Ravallion (about global patterns) and by Gary Fields (about low earnings in the developing world – he wrote the excellent [amazon_link id=”0199794642″ target=”_blank” ]Working Hard, Working Poor[/amazon_link], which I reviewed here) and by Juliet Elu & Gregory Price about gender inequality in sub-Saharan Africa.

The overlap between development economics and the economics of poverty in western societies is surely fruitful territory. One of my favourite books is [amazon_link id=”0691148198″ target=”_blank” ]Portfolios of the Poor[/amazon_link], a sort of ethnographic, diary-based study of how poor people in India and South Africa actually handle money. A study of this kind would be most helpful in assessing concerns about payday lending in the UK; these short-term lenders are clearly satisfying an otherwise unmet demand. What financial needs of people on low incomes, exactly, are conventional financial services unable to address and is there really a policy or regulatory gap, or is payday lending actually a market solution?

The Handbook also has some cross-cutting chapters that look interesting, on subjects like obesity, healthcare, housing and place-based policies. I read and liked the chapter on the need to get the best from both economics (analytical & empirical rigour) and sociology (illuminating detail and understanding of social networks/capital) in studying poverty.

[amazon_image id=”0195393783″ link=”true” target=”_blank” size=”medium” ]The Oxford Handbook of the Economics of Poverty (Oxford Handbooks in Economics)[/amazon_image]

Best business books and the nature of ‘business’

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Andrew Hill has a nice feature in the weekend FT about the secret of writing a successful business book. It’s a trailer for what must be the upcoming decision on the FT’s Business Book of the Year. The shortlisted titles are:

[amazon_link id=”0007413513″ target=”_blank” ]The Hour Between Dog and Wolf[/amazon_link] by John Coates

[amazon_link id=”1846146593″ target=”_blank” ]Private Empire[/amazon_link] by Steve Coll

[amazon_link id=”1408703742″ target=”_blank” ]Steve Jobs[/amazon_link] by Walter Isaacson

[amazon_link id=”1608190706″ target=”_blank” ]Volcker[/amazon_link] by William Silber

[amazon_link id=”184614471X” target=”_blank” ]What Money Can’t Buy[/amazon_link] by Michael Sandel. (I reviewed it here.)

[amazon_link id=”1846684293″ target=”_blank” ]Why Nations Fail[/amazon_link] by Daron Acemoglu and James Robinson. (And I reviewed this one here.)

The shortlist makes it plain that the definition of business book is capacious as there are economics books and biographies here. I suspect the ranks of ‘self help’ business books that fill the relevant bookshop sections will rarely if ever make it onto the FT’s shortlist. The correct definition for eligible books is probably ‘thoughtful books about business in its broadest sense – history, philosophy, psychology, society – but not about how to run a business’.

That’s fine – the aim of contests like these is to get people reading serious books, which must be a good thing. The shortlist gives me an appealing reading list. Of the two of the above list I have read already, I think Sandel should not win it, as my review will explain.

Of course, the Enlightened Economist book of the year winner has already been announced – it was Ariel Rubinstein’s [amazon_link id=”1906924775″ target=”_blank” ]Economic Fables[/amazon_link].

[amazon_image id=”1906924775″ link=”true” target=”_blank” size=”medium” ]Economic Fables[/amazon_image]

Here is my review of the book. And here was my shortlist.