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.

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

Economy and society

It’s fair to say the average economist doesn’t pay much attention to sociologists, but to the extent that (s)he does, Mark Granovetter will be a familiar name. His concept of the distinct roles of ‘strong’ and ‘weak’ ties has become widely-cited in the economics literature. Now Granovetter, a Professor of Sociology at Stanford, has published a new book – intended as the first of two volumes – aiming at a synthesis of his views on how the economy and society are enmeshed with each other (it’s out in 2 weeks, can be pre-ordered now)

. Society and Economy: Framework and Principles, sets out at a high level of abstraction definitions and relationships between concepts such as trust, power, norms, values, as they relate to economic decisions and actions.

The book starts out by quite fairly skewering the ‘Just So’ character of some economists’ uses of sociological concepts to explain how economic norms or institutions have come about. The book suggests that if economics wants to use a concept such as ‘social norm’, then it must engage with questions of how norms come about, which will involve cognition and emotion and social relations. Economics has of course started to dabble in psychology with the ‘behavioural’ revolution, but in the limited sense of simply noting behavioural regularities. Here Granovetter echoes Daniel Hausman (Preference, Value, Choice and Welfare) in arguing that it “does not seem a good recipe for scientific progress” to claim that how people reach economic decisions, or how groups settle on social norms, is simply outside the domain of economics.

If this seems a bit high-fallutin, just consider how much influence social norms have on outcomes. In the 1970s, for corporate executives to pay themselves many hundreds of times what they paid their average employee lay outside the ‘moral economy’ of the times; within a generation that norm had shifted entirely. Surely it is important for economists to understand how that came about?

The book has a particularly interesting chapter on trust, which notes that the outcome of trusting behaviour can arise for different reasons. Granovetter argues that many researchers define trust narrowly to be trust due to their favourite reason, whether that’s an internal psychological state, or an expectation of reciprocal behaviour, or risk-taking with regard to others’ behaviour for some expected benefit.

The promised second volume will apply the concepts defined and analysed in this first volume to specific topics such as corporate governance, organisational forms, and corruption. That’s something to look forward to – this first volume is pretty abstract as it concerns definitions and methodological debates in the literature. Still, the challenge to economists is a fair one, I think. We don’t all have to become competent psychologists or sociologists, but I agree that somehow economics does have to take up the methodological challenge of making sure our borrowing of concepts such as trust or norms is meaningful.

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Global (Dis)order

I’ve been on a run of reading history books, and am about to finish Adam Tooze’s The Deluge: The Great War, America, and the Remaking of the Global Order 1916-1931. It’s beyond my professional competence to review properly, in the sense that the book clearly has a distinctive perspective on the way Woodrow Wilson used America’s financial lifeline during and after the war, and the Treaty of Versailles negotiations, to shape the impending American Century. My guess is some historians would disagree about how purposeful this exercise of financial power was. Nevertheless, to the non-expert reader, this is a brilliant and compelling book – above all for taking a global perspective. I particularly liked the inclusion of substantial sections on Japan and China, and on India and the seeds of collapse of the British Empire. It is easy for a west European to forget for example the role of Japan in Siberia, and to concentrate on Russia’s western borders.

91HjfjpIRfLThere are also illuminating perspectives on the impact of the war on America itself, including the deployment of the new Federal Reserve Board and the governance of the US economy. Tooze points out that before Wilson committed to support the Entente, substantial private finance had been directed to the war effort: “Through the private business contacts of JP Morgan, supported by the business and political elite of the American Northeast, the Entente was carrying out the mobilization of a large part of the US economy, entirely without the say-so of the Wilson Administration.” When the US officially entered the war, the state’s role in the management of capitalism expanded greatly, only to be firmly contained again in the post-war era. It is often forgotten how severe the post WW1 recession was, even in the US – Tooze underlines its impact on the inter-war order. (Another book that focuses on this event, in a fascinating albeit maverick interpretation, is James Grant’s The Forgotten Depression)

Another very interesting thread running through The Deluge, at least for economists whose only perspective to date comes from Keynes’s famous The Economic Consequences of the Peace, is Tooze’s argument that Keynes’s polemic was a distortion of the truth. Tooze argues, contra Keynes, that the Germans tricked the Entente into the armistice, rather than the other way round. He agrees that the book reflected widespread disillusion with the Treaty, but also contributed to its loss of legitimacy and “helped to further poison the atmosphere between London and Paris.” It might not even have helped Germany, Tooze suggests: “A good faith effort to honour the Treaty, even if it had fallen short, might well have steered the Weimar Republic away from the ruinous crisis of 1923.” Furthermore, Keynes painted the alternative financial settlement he suggested as “an entirely novel idea, a great opportunity that had been missed at Versailles,” knowing well (as he had been there) that it was discussed at Versailles and rejected by Wilson (not Clemenceau). For if there had been greater generosity toward the Germans, the British and French would have had to seek debt write-offs from the US. “The result was grossly to misrepresent the politics of the peace making process,” Tooze concludes.

As it happens, I was (nearly) finishing the book at the Trianon Palace hotel in Versailles where the treaty was signed. Another fine historian, Margaret McMillan (The War That Ended Peace and Peacemakers) was attending the same conference. Here she is in front of the commemorative plaque.IMG_3905

 

When Michael Lewis came to dinner

That Michael Lewis came to dinner at our house once. This was about 30 years ago, when he was dating a friend of mine for a while, and before Liar’s Poker made him famous. He was charming – working in finance – but if only I’d known who he’d turn into, I’d have quizzed him closely about his stellar writing technique.

I’ve just devoured The Undoing Project, his much-trailed book about Daniel Kahneman and Amos Tversky, and their launching of the behavioural revolution in economics, over two evenings. It’s a wonderful book. I heartily recommend it as a Christmas gift for the economists in your life, or a treat for yourself over the holiday.

The book weaves together the personal and intellectual biographies of its protagonists. It explains the ideas, including the paradoxes requiring one to think about probabilities, beautifully clearly. It’s also just a terrific human story about an intense creative friendship as it flowed, and ebbed, over the decades and continents. If they’re not always totally likeable, the two characters are always immensely sympathetic.

It will surely send many readers on to Kahneman’s Thinking Fast and Slow, which requires some mental effort but everybody who fancies themselves an intelligent, educated person ought to have read. Although I’ve read loads of behavioural economics books and papers, and so think I know about a lot of the insights the literature has given us about how our decision-making processes function, there were still some new (to me) ones in The Undoing Project. These are two I found. Tversky had a rule that you must wait a day before replying to any invitation, even one you wanted to accept. It becoms much easier to decline the ones you don’t want. This is advice I definitely need to follow.

The other comes from thinking about reversion to the mean. An exceptionally (beyond average) good or bad performance is usually followed by one that is less good or less bad (closer to average).  Yet coaches and teachers and bosses often hold that if you praise someone for doing well, they do less well next time, and if you shout at someone for doing badly, they do better next time.  “Because we tend to reward others when they do well and punish them when they do badly, and because there is regression to the mean, it is part of the human condition that we are statistically punished for rewarding others and rewarded for punishing them,” wrote Kahneman. This strikes me as profound and something one ought to act on.

It was surprising to learn that at the height of his fame, in the years before his death, Tversky was bugged by the criticism of their work by Gerd Gigerenzer. I’ve never seen Gigernenzer’s argument that heuristic rules of thumb were rational because they economized on brain energy as a fundamental attack on Kahneman and Tversky, more an extension. There’s surely loads still to be discovered about decision making (especially under uncertainty), not least when decisions are conventionally ‘rational’ versus when ‘behavioural’ behaviour kicks in.

As economics is all about decision-making in the domain of resource use and allocation, this overlap with psychology and cognitive science is an exciting area – even though I’m deeply uneasy about the eagerness with which some economists and policy makers are leaping to adopt ‘nudges’ as another handy tool for social engineers to get the people to behave as they ought. We certainly ought to be teaching this at A level and in universities. The Undoing Project is a great book to introduce behavioural economics – and a cracking good story, told by a master.

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