Funny Money

I’ve been enjoying what author Dave Birch of Consult Hyperion calls a blook – this year’s reader of his tomorrow’s transactions blog posts. Any regular reader of the blog, or indeed Dave’s book Identity is the New Money, will know how astoundingly entertaining retail payments and electronic ticketing can be. His historical knowledge is extensive, as is his range of cultural references.

The blook also gathers in one place so many examples of the dimness of the financial services industry, explaining why there is so much fraud around. Why do chip and pin cards still get issued with magnetic stripes on the back – “trivially counterfeitable”? Why do we still need to sign the back? (Dave never signs with his real name – “I don’t want theives who steal my card to have a copy of my real signature to practice with.” It’s also from him that I learned never to sign up for free wifi with my real email address because that just results in more spam. They don’t know my name isn’t Doris Day.)

But above all, it’s very funny. I can’t see the 2015 reader on Amazon yet, only the 2014 one, but no doubt it will be there soon. Or there’s always the tomorrow’s transactions blog.

 

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Whose choice?

I’m improving my Public Policy Economics course ready for the next academic year at Manchester (hello, prospective ECON20431 students, if you’re reading this blog!) One of the areas that troubled me last year was how economics treats questions of social welfare in public policy analysis. I thought it was just me, as it had been many years since I thought about it. Having just finished Daniel Hausman’s Preference, Value, Choice and Welfare, I’m reassured that it is just difficult territory.

The book has two big points. One is to argue that ‘preferences’ in economics is used, and ought to be used, to mean subjective comparative evaluations that include all relevant considerations – including moral imperatives, social norms, passions, whims. This obviously does not mean the same as everyday usage of ‘preference'; in everyday language we consider moral duties can conflict with preferences, for example. It also means self-interest can’t be built in to preferences. “Preferences are the outcome of demanding and poorly understood processes of comparative evaluation.” People might often take short cuts (as per Gerd Gigerenzer) or be vulnerable to certain biases (per R Thaler et al).

Preferences are then combined with beliefs to determine choices. Hausman argues that economists often ignore the role of beliefs or judgements about the choice environment because they tend to assume people’s beliefs are correct.

His second big point is that economists should not and cannot then say that what determines preferences is a matter only for psychologists or other social scientists; economics itself has to engage with the question of preference-formation.

I agree with Hausman so far. I am less clear about the part of the book that is about preferences and welfare. He argues that the satisfaction of people’s preferences is evidence that their welfare is being improved, but that welfare cannot be defined as the satisfaction of preferences, as economists assume. I don’t understand the second part of this: he says it is because preferences are not defined by self-interest, but I don’t follow why welfare has to be defined by self-interest rather than being defined by preferences (including moral imperatives, emotions etc). Hausman then goes on to assume policies should aim to improve social welfare, which is fine if you agree with the definition of welfare. But he asks why policy should be sensitive to people’s preferences beyond the promotion of their welfare, and goes on to discusss the behavioural economics findings that people might often not be good judges of their own interest. He challenges methods such as contingent valuation, because they reflect people’s sense of moral obligation, for example. That doesn’t seem to me to be a problem at all.

I think my difficulty with this is that as soon as you posit an ‘objective’ concept of welfare as what is in people’s best interests, and allow this to diverge from their preferences – especially in this wide sense which can include concern for others or for absolute moral imperatives – you are in the territory of social scientists determining what is best. Indeed, Hausman agrees that if people do include the seeking of their own benefit and are good judges of circumstances, preference satisfaction is a good indicator of welfare; and even if not, it might be better than a third party deciding.

Anyway, an interesting book (& there’s much more than I’ve summarized here including a discussion of Sen‘s approach), even if it hasn’t saved me from having to continue puzzling over this territory.

Europe’s former glories

Why Did Europe Conquer the World? That’s the title of a new book by Philip Hoffman of CalTech. His answer is a very neat development of part of Jared Diamond’s famous Guns, Germs and Steel and Paul Kennedy’s equally famous The Rise and Fall of the Great Powers.

 

Hoffman is not impressed by the germs part of the story, but does believe a combination of technological advances in weaponry, the ability to turn resources into tax revenues to fight wars, and competition between European states constitute a good explanation for the literal and cultural conquest of so much of the world by Europeans.

However, historical contingency also played a huge part in his telling of the story, the contingency of the long Dark Ages that kept European states of a similar size to each other, without a single hegemon becoming much larger than its rivals. This turned the competition described by Kennedy into a tournament – and an appendix models this formally. Rulers were in a contest for a big enough prize – glory or land – and incentivised to use resources – revenues that they could raise at low political cost especially as financial innovations came along in the modern era – to pour into new military technologies based on gunpowder to get an edge over each other. War was frequent, and there were few obstacles to adopting the new technologies.

Having set out the model, the book shows quite persuasively why only the European states met these tournament conditions. For example, China was much larger than neighbouring states and used its resources on old technologies to fight the horsemen of the steppes. India had plenty of rivalrous states but was unable to raise revenues at a low enough political cost because the raising of tax revenues was decentralised to local rulers.

Hoffman’s argument makes sense to me, although I’m sure historians could find some of the generalisations too sweeping. This book is a very interesting addition to the flourishing history of the world genre, including Ian Morris’s enjoyable Why the West Rules for Now as well as Diamond and Kennedy. The tournament model is not a complete explanation. For instance, it does not fully explain things like the origins and role of financial innovations or scientific discovery. However, this is a terrific example of the insight you can get from a simple model.

Government by gang

America has more prisoners, some 2,240,000, than any other nation on earth – only China gets anywhere close; of the total, there are about three African Americans or Hispanics for every white. All round, the American criminal justice system is an ugly scar on the nation. President Obama said as much when he visited a prison last week, the first sitting US President to make such a visit.

David Skarbek’s The Social Order of the Underworld: How Prison Gangs Govern the American Penal System, is a fascinating account of what happens inside the country’s huge and violent prisons. It uses the analytical tools of institutional economics – notably Douglass North’s and Elinor Ostrom’s explanations of how groups collectively organise themselves – to probe the internal gang-run pecking order in prisons, their drugs-based economies, and their links to external gang activity.

The bottom line of Skarbek’s analysis is that “gangs thrive because of a demand for governance.” He traces the change from a prison social order based on conformity to social norms (the ‘convict code’), before the 1970s, to one run wholly by the gangs, with clear hierarchies and detailed rule books. Loyalty to the gang – all race-based – has to be total, on pain of death, and life-long. The gang structures connect those in prison to the outside drugs economy as well. The trigger for this shift in social order was the big increase in the prison population from the mid-1970s: “Norms will be effective at providing governance when the inmate population is relatively small, but as it grows norms will break down.” In addition to the size factor, the growth in the prison population meant a big increase in the proportion of new, inexperienced prisoners who did not know the norms, and many of them younger men who did not care, and were often more violent. Inmate violence rose dramatically in the early 1970s.

Prison officials were unable – in the large new facilities being built or in the old and increasingly over-crowded ones – even to observe what was happening, never mind control it. The gangs filled the governance vacuum. “Gangs are quasi-governments.” (Skarbek also quotes Will Baumol’s reversal of the point – governments are quasi-gangs.) What’s more, the gangs play the community assurance role in the contraband trade that has been documented among other trading communities – by Avner Greif for example. “All members of a gang are responsible for each member’s actions.” Somebody who cheats on a deal will be punished by his fellows.

Interestingly, there are no gangs in female prisons, and women’s prisons are not racially (self-)segregated either. Skarbek allows the absence of testosterone to play a role, but argues that the main explanation is that women’s prisons are much smaller and with far fewer women incarcerated. The social order that emerges there is sorting into small ‘families’.

The book ends with some wider reflections on the importance of understanding informal economic and social institutions. I couldn’t agree more. A third of the world’s population live in countries with collapsing states. Governments are often ineffective when they exist. The world’s shadow economy is huge. Even in well-governed, stable states, there are swathes of economic life that do not touch government. “To understand aggregate economic and social outcomes, we must understand the extent to which people rely on extra-legal governance.” Inside America’s prisons, there is a formal governance vacuum but economic exchange thrives and the violence is strictly controlled by the gang leaders.

From institutional economics, the conditions for informal governance to be effective are known: enough social or cultural homogeneity; small enough for reputation to leverage good behaviour; simple, easy-to-monitor economic exchanges, with stakes that are not too high; high self control, patience; and repeated exchanges. Yet as Skarbek shows even in the unpromising conditions of the prison world, effective governance can emerge.

How could America reform its prisons and reduce the power of the criminal gangs? Skarbek suggests making prisons smaller and safer, and incarcerating far fewer people. The unwinnable “war on drugs” and tough mandatory sentencing fuelled the increase in prisoner numbers, which created the power of the gangs.

This is a terrific book. Along with Diego Gambetta’s Codes of the Underworld (& his earlier The Sicialian Mafia), it is a model example of how to use economic analysis to highlight the illegal world, without falling into the trap of economic imperialism. The Social Order of the Underworld would be a great case study for a course on institutional economics. It is also a must-read for anyone concerned about America’s absolutely shameful record on criminalising and imprisoning young, non-white men.

Not all economists are neoliberal, honest

It was because of a tweet linking to her LSE lectures that I decided to read Wendy Brown’s Undoing the Demos: Neoliberalism’s Stealth Revolution. My relationship with the concept of neoliberalism is an uneasy one, in that I don’t really know what it means. Often, radical writers use it to mean ‘most of economics’ – Philip Mirowski’s Never Let A Serious Crisis Go to Waste is a good example of this –  making an exception only for certain Marxist or otherwise unimpeachably heterodox economists. I understand the idea well enough to know Yanis Varoufakis is not neoliberal. However, writing off all the rest of economics makes it an unhelpful concept in my book. Of course there are ideologically right wing economists but there is a wide range of views about both politics and economics within the profession.

I thought Brown’s book was going to be subtler. Here is her definition: “neoliberalism is not about the state leaving the economy alone. Rather, neoliberalism activates the state on behalf of the economy, not to undertake economic functions or intervene in economic effects, but rather to facilitate economic competition and growth, and to economize the social, or as Foucault puts it, to ‘regulate society by the market’.” She adds that neoliberalism entails “the dramatic curtailment of public values, public goods and popular participation in political life.” This definition makes sense to me – and makes neoliberalism a political ideology, one that uses its claim about the primacy of markets to extend a certain political order into more and more areas of life. It is similar to Michael Sandel’s argument in What Money Can’t Buy.

However, Brown goes on to list all the neoliberal economists who include Milton Friedman, Friedrich Hayek, Gary Becker – but also Joseph Stiglitz. Wait – Joe Stiglitz in the same camp as Becker?! Barack Obama also gets labelled as neoliberal, along with Reagan and Bush. So this is back to vacuous.

It’s a shame because the argument that the primacy of the market has been extended into inappropriate domains needs to be taken seriously. People regard ticket scalping as unfair – this includes many economists – so those of us who do economics have to respect the fact that some values other than economic efficiency might have to win out. Freedom, civic cohesion, fairness are all important values. Where it is appropriate to prioritise efficiency, or to use market processes to achieve either efficiency or other outcomes, should always be a matter of public and political debate. Most of the economists I hang out with – applied micro people – think it will depend on both people’s political choices and on the exact circumstances: the US trade in SO2 emissions works well, the EU market in carbon emissions does not; Alvin Roth‘s matching markets for kidneys or medical jobs are magical (and no money changes hands). My kind of economists tend to be pragmatists, unlike those in politics who argue the market is always best.

There are some real dilemmas. Later in the book, Brown gives short shrift to the idea that ‘governance’ is ever more important than politics, and argues that independent, technocratic bodies such as central banks should not take decisions with political consequences – and no doubt the many critics of the ECB and the right-wing critics of the Fed would warmly agree. It does not seem so obvious to me. Central banks take ‘better’ decisions when they are independent in the specific sense that growth is less volatile and inflation lower. Yet of course they need legitimacy – answering to parliament, fulfilling a remit set by the government. And the Greek crisis has indeed demonstrated that central banking is political at times of great stress. Perhaps Brown is right but I don’t think she argues the case well, when there are areas of policy in which expert advice or decisions made by technocrats delivers good outcomes. Surely this is debatable.

Anyway, Undoing the Demos is an interesting book even though I ended up disagreeing with much of it. I will say that whenever anybody next tells me economics is an abstract, wholly theoretical subject, I will make them read this. But it still helped me understand Michel Foucault’s almost totally incomprehensible The Birth of in Biopolitics, which I read recently. And I do think it’s important to push back against the political stance that disguises ideological projects with the claim that market are always right.