Coordination Problem

The Challenge Ahead for the MCC

A few weeks ago, in an entry on the Millennium Challenge Corporation (MCC), I mentioned that the only reason why the MCC will ever succeed at changing the face of foreign aid is if it comes to be seen as a reward scheme for good institutional change – not because it provides aid under “good conditions”. While the MCC is in a position where it could achieve this feat, the usual political game is threatening to spoil the idea. [Just to make sure: aid will never achieve anything. The reason why I have some interest in the MCC is because it is the only agency which could tackle the problem of development using institutional incentives, not hand outs.]

The Mercatus Center just published a new issue in its great Policy Series entitled The Challenge Ahead: Maintaining a Focus on Incentives to Enable Development. It is co-authored by Brian Hooks, Daniel Rothschild and myself. We argue that the continued success of the MCC will depend on the ability of the leadership to allow the mission to guide its decisions. The MCC’s mission is to reduce poverty through growth, not through any other means (because other means won't work). The only way to obtain growth is through institutional (and cultural) change enabling entrepreneurs to bet on their ideas, and to guarantee them the rewards of their ventures (this is what the leadership must focus on).

So far, this institutional (and cultural) change has remained elusive for development agencies – either because they had the wrong idea or, even when they had the right one, because they couldn’t find the mechanisms fostering such a change. The MCC is now in a position where it could succeed where other agencies have failed because it is using the institutional incentive lever. I am probably too optimistic on this one, but for now, we can hope for the best.

The Mystery of the Mundane

I've been teaching principles of economics to students since 1985 and using The Economic Way of Thinking by Paul Heyne the entire time.  I am now an author on that text (along with my good friend Dave Prychitko), but my bias toward that text for introducing economics to college students was well established before I signed on to keep the book up to date after Paul's unfortunate passing.

Heyne has two meta messages in that book --- one for professors and one for students. For the professors, the basic idea is that we overteach economics to students and thus don't get the basic principles across to them during their one introduction to the subject.  There is a logic to this, many principles teachers are either brand new PhDs or graduate students and the incentives they face is to publish not be an effective teacher. As a result they want to teach what they most recently learned and just boil it down to an undergraduate level. So you get a fresh PhD teaching PhD level microeconomics without the proofs.  And 1 out of 100 students get it.  The other 99 walk away either thinking economics is worthless or boring, and perhaps both.  Heyne says to us, guys focus on first principles (opportunity costs and spontaneous order) and the interpretation of a wide variety of human relationships that can best be explained with the use of these principles and you will make the subject matter of economics come alive and be exciting to students and leave them wanting more.  This strategy has worked for me as in every school I have taught in (GMU, Oakland, NYU and Manhattan College) I have been able to get students to become economics majors and eventually pursue graduate study in economics after hooking them with the principles course.  I am sure that there are some students who leave my class believing economics is worthless and boring, but I think my percentage is better than 1 in 100.

As for the students, Heyne's message is simple as well.  Allow yourself to be curious about the world, and to find the mystery in the mundane.  Buying a cucumber at the local grocery shop, the shirt on your back, and the shoes on your feet are all fascinating subjects to explore using the economic way of thinking.  Finding the hidden pattern in the buzz of daily life is what we will do in the first 6 weeks of class.  If you allow yourself to be amazed by the world around you, then you will do well in studying economics.  Adam Smith explained the mystery by reference to the common-woolen coat on the back of the day laborer; F. A. Hayek found it in the movements of the price of tin; Milton Friedman borrowing from Leonard Read used the pencil.  James Buchanan used to tell us in class that the number one educational role of the economists is to teach the principles of spontaneous order, and I believe that on this issue, as on so many others, Buchanan is 100% correct.

Tim Harford's The Undercover Economist has just been published.  It is not a principles of economics text, but it is perhaps the best book currently available in its genre.  In my opinion there is more economic intuition behind this book than Freakonomics -- a judgment which might shock some readers.  But the persistent and consistent applications of opportunity cost reasoning and explaining how order emerges out of the behavior of individuals even though it is not anyone's intention to promote the overall order is revealed throughout The Undercover Economists in a vareity of illustrative stories from throughout the developed and developing world.  We get stories of wonderful unintended desirable consequences within some regimes, and the horror of unintended undesirable conseuqences in others.  Harford's work is one which champions "looking out the window" and making sense of what is seen through the economic way of thinking.  In many ways this is what it is all about, and once you "get it" it is wonderfully addictive and transformative.  Economics is the mind-quake everyone needs to make sense of the world around us, and on the basis of that understanding arrange our political, legal social and economic affairs so we can simultaneously achieve liberty, peace and prosperity.

I would like to learn what others consider the best way to excite young minds about the discipline of economics and the most effective books they have found in doing so, so comments are open.

Dogmatists, Ideologues, and Pragmatists

In a recent blog on the nomination of Ben Bernanke as the Fed Chairman, Tyler Cowen explains that to be at the head of the Fed, the chairman “should have a mastery of data and an understanding of the macroeconomy. He must not be a dogmatist.” The good news is that Bernanke is not a dogmatist, as he understands what it means to crunch data and what the macroeconomy is all about.

The term “dogmatic” is often used in a negative way. Those who are dogmatic don’t really know what they are talking about because they don’t pay attention to what reality says. They blindly follow a certain direction – a dogma – without trying to develop alternative explanations.

The word “dogma” is of Greek origin (dokein) and has been used by the Roman Catholic Church (RCC) for instance. The RCC distinguishes the “deposit” (original information given to the Apostles) from the “dogma” (body of truth that has been affirmed by the councils of the Church and the Magisterium over centuries) from the “doctrine” (the development of RCC thinking on the basis of deposit and dogma).

So being dogmatic is to follow the dogma and in the case of the RCC, it is to follow what the Church considers to be the truth. The dogma of the Church is in fact very important, as it is the way for her to keep the deposit, that is, to protect the message from being corrupted.

All this is good for the RCC, but outside of the context of the Church, dogmatism cannot exist we are told, as we have no message to protect from corruption. Au contraire, science progresses precisely by corrupting old thinking, thereby renewing itself all the time. Dogmatism hinders this process and thus must be rejected.

So must be ideology, which is another version of dogmatism. According to Joseph Schumpeter in his famous paper Science and Ideology, ideologues are those who hold on to ideas that should have been removed through scientific inquiry. Their thinking of the world doesn’t evolve even in the face of evidence.

In contrast, many say that pragmatists have a good sense of what reality is about. They have no privileged idea (except precisely that they have no privileged idea) and they are willing to change their thinking, to adapt to circumstances.

In the world of policy for instance, pragmatists are taken seriously (for more on this see NZ Business Roundtable Roger Kerr, who has a good speech on Ideology and Pragamatism in Public Policy). In a debate at the New Zealand Treasury on Economic Transformation, David Skilling, one of the protagonists favoring a rupture with the past and its reforms, said to me that he saw himself as a pragmatist. Defending free market ideas, as I was doing, was too ideological. I had to understand that the circumstances of NZ had changed and thus the free market approach was not valid anymore.

Pragmatists, in their search of a “dogma-free economics”, are confused. The trouble with the dichotomy between dogmatism and ideology on the one hand, and pragmatism on the other is that it has no real raison d’être in economics. After all, Austrians are dogmatic ideologues: they believe that the corpus of economic laws is logically true (dogma) and cannot be subject to empirical testing (ideology). Moreover, historical work is necessary to understand the context in which economic laws operate. One could call the latter pragmatism if pragmatism is about understanding existing circumstances. So Austrians are pragmatists as well – and in the true sense of the word perhaps. Being “dogmatic ideologues” is precisely what makes Austrians correct!

It is interesting to note that someone like Gunnar Myrdal singled out the Austrian school for not being linked to a political or ideological agenda. Moreover, after the collapse of the Soviet Revolution in 1920, Nikolai Bukharin was the only soviet to admit that the criticisms of the communist system provided by Austrian economists were the most powerful ones because of their scientific merit (see Peter Boettke's work on this). And this is in spite of the fact that the Austrian school was seen by many (especially the soviets) as the most dogmatic school!

Many will rejoice in the fact that Bernanke is not dogmatic. However, they may be surprised if he introduces through the back door certain principles (should I say ideology?), such as his dislike for deflation, that he sees as vital to the good conduct of monetary policy. Then and only then, they may regret his lack of (Austrian) dogmatism (for an example of that, see, as Pete explained in his previous post, George Selgin’s work on free banking in general and the meaning of deflation in particular).

Bernanke, the Fed and the Monetary Theory of the Trade Cycle

Ben Bernanke is a super-star among economists.  As Tyler Cowen points out at Marginal Revolution Bernanke is credited with several major contributions to economics and monetary theory.  He also is a genuinely nice guy.  He taught monetary history one semester at NYU when I was teaching there and several of the students in our Austrian program took his class and the consensus was: (a) he was technically the best teacher they had, and (b) he listened and carefully considered all arguments from opposing points of view, including those from the Austrian camp.  I spoke with him on a few occasions in the hallways or in the elevator and had the same impression.  In short, despite his super-star status he did not have any sort of pompousness. (I actually have an empirical generalization on this which is that there is an inverse relationship between true stature as an economist and pompousness; only those ultimately insecure in their position have to behave in a way that insulates them ---- and this applies for subcultures in economics as well, including Austrianism.)

However, I am unwilling to join the bandwagon of full endorsement.  Not because Bernanke isn't a smart economists --- he is among the smartest of his generation as his model on irreversible investment demonstrate (and I recommend readers of this blog to look at his papers on this, and also those of Dixit --- but you might also want to read the paper by Pete Leeson, Chris Coyne and myself that is due out this year in the Review of Political Economy on the subject as well).  Moreover, as I just pointed out and all accounts seem to confirm he is a nice guy and works hard at his job.  But as Deirdre McCloskey has often warned, we shouldn't confuse being smart with being good, and we shouldn't always attribute being nice with behaving correctly.  Smart and a nice guy is not the same as being a good economist who acts boldly to stem the rising tide of bad ideas.

What are the sources of my doubts?  Well, first, it is the idea evident in the entire discourse that the Fed Chairman can "control" the economy.  Take credit for successes as well as blame for failures of the economic system.  The Fed is viewed in this regard as a tool for fine-tuning the economy.  The belief is often promulgated that Greenspan has been a superb central banker --- e.g., the narrative that is told about him building an alliance with the Clinton administration to generate an economy capable of generating budget surpluses during the 1990s.  But can we really credit Greenspan with the (a) technology boom of the 1990s, and (b) the log jam in government that prevented bad policy from being enacted?  On the other hand, can we reasonably argue that Greenspan presided over inflationary policies that have continued in the 2000s and that are captured in asset inflation and the real estate boom rather than in measured price inflation data?  If so, then the bust to follow may reveal Greenspan's reign as another example of the inability of the Fed to manage monetary policy effectively. (Remember Friedman's long and variable lag and the distortionary consequences?!  I don't think we can say that Greenspan has followed a monetary rule, but instead has been a discretionary central banker.  Is the argument now-a-days that wise discretion can now outperform rules?! ... is so perhaps we should give socialism another try, but just make sure we have wise (smart and nice) rulers.)

But, second, my real cause for doubt is that Bernanke has to cope with the legacy of Greenspan, not just the myth, but the reality of an economy teetering on the edge.  How will he react?  His intellectual framework tells him that his number 1 responsibility is to fight deflation.  To me, this translates into a willingness to inflate rather than let prices fall in adjustment.  But as George Selgin has persuasively argued, falling prices during a period of real economic growth need not be destabilizing at all.

Fed mismanagement of the money supply has real consequences on the patterns of exchange and production throughout the economy. The economic forces at work will reveal the unsustainable pattern and compel a reshuffling of resources.  But government policies that tend to generate an unsustainable boom, also rarely allow the necessary readjustment to go on unimpeded.

The discussion that will emerge during the confirmation of Ben Bernanke should provide an opportunity for Austrian school economists to push for a renewed interest in research on the monetary theory of the trade cycle.  The RAE has published some important papers on the subject which can be found in our issue archives, and the books published by Tyler Cowen, Roger Garrison, and Steve Horwitz also form a good starting point for a re-evaluation of the theory and its importance for our current situation.

One conclusion we may reach after careful study is that we should not expect the Fed to be able to manage the money supply effectively to eradicate booms and busts, and that instead we should be looking at alternative institutional arrangements such as free-banking, rather than trusting smart and nice guys (no matter how smart and nice) to do the right thing.

Happiness and Economics II

In an earlier post I mentioned that Pete Boettke and I are writing a paper focusing on Austrian/Public Choice insights on the expanding happiness and economics research.  We have completed a first draft of the chapter.

To put the chapter in context, we were invited to contribute to a book project titled, "Happiness and Public Policy: Theory, Case Studies and Implications."  The editor had read my earlier review of Gregg Easterbrook's, The Progress Paradox, and asked us to expand on the themes that I had addressed in the review.  The intended audience is scholars from across the social sciences so we were asked to assume no prior knowledge of Austrian or Public Choice economics on the part of the reader.

Comments are open and we would appreciate your constructive suggestions.

More on MMP in New Zealand

The Economist this week has an article on Helen Clark’s new government. It explains well the dance of New Zealand political parties since the election’s results. Clark has become Prime Minister for the third time, and by now she displays remarkable skills and creativity in government-making under a proportional-representation system (MMP).

The new government arrangement allows Clark to retain a good control over the Labour agenda while avoiding squabbling with her coalition partners. As The Economist put it, Labour and its coalition partners “agree to disagree”.

Consequently, the small parties in the coalition will “vote with the government on matters related to their portfolios, and on motions of confidence, but will be free to rubbish it otherwise.” While it may enable Clark to avoid instability, it will probably foster more backsliding than there would have otherwise been with a pure Labour majority.

FPP vs. MMP

In a comment to my post (Does Social Change Depend on the Electoral System?), Ilya Somin (of George Mason University) pointed that while FPP has clear advantages, such as that it produces clear winners, it also has serious drawbacks:

True, in a PR system you have to pay off small parties to join a coalition. But in an FPP system, you have to pay off interest groups within the major parties. It's not clear to me which [one of the two systems] is more of an obstacle to reform.

The flip side, of course, is that under [FPP] the opposition can more easily return to power and undo your reforms. So just as Thatcher was able to sweep her reforms into place with a relatively narrow coalition, so too did the post-WWII Labor Party when it created the quasi-socialist system Thatcher was trying to get rid of.

It is true that the reforms in New Zealand could have been undermined even in the absence of MMP. When the Labour Party returned to power in 1999, it could probably have won a majority under the old FPP system.

In my post I argued that one should choose between electoral systems based on their ability to foster social change, as opposed to the status quo. The status-quo is however desirable in some circumstances. The conundrum of constitutional law is to create institutions that make change difficult (for instance by having three elections: two legislative and one presidency as in the US) and yet can lead to a turn-around if needed (which you can generally obtain under FPP and a unicameral Parliamentary system).

Thatcher won in 1983 and was able to continue her reforms not only because of FPP but also because the opposition was deeply divided (as Ilya put it: “the Thatcher Revolution happened at least in part because the British left failed to follow Duverger's Law”). This shows that positive social change requires a set of conditions that are rarely met in the real world – which is why we rarely experience it.

Is Growth Good for the Soul?

Joseph Stiglitz reviews Benjamin Friedman's The Moral Consequences of Economic Growth.  Stiglitz summarizes the book as follows:

There is a well-developed populist antigrowth literature concerned with, among other things, the impact of growth on the environment and on poverty. In this major work, The Moral Consequences of Economic Growth, Benjamin Friedman takes on such critics, positing that growth has not only obvious economic benefits, but moral benefits as well. He argues that it has the potential to improve the environment, reduce poverty, promote democracy, and make for a more open and tolerant society.

Stiglitz then states that Friedman presents the nuanced argument (though not as nuanced as Stiglitz would like) that markets cannot be expected to generate these outcomes by themselves, but require for their operation the important role of government.  Without "good" government, Stiglitz contends, growth, social justice and even economic efficiency will prove to be ellusive.  This review essay is worth reading in full, especially Stiglitz's section entitled "The Myth of the Invisible Hand." 

My own take is that Stiglitz is the most powerful theorist in economics of his generation, and as such he is on the list of economic thinkers which Austrian economists must continually engage --- though his recent turn toward popular writing and policy wonkism tarnishes rather than enhances his importance as an economic theorist today.

Communism and Preferences

In response to my post on Fly in a Bottle, Scott Cunningham (of the University of Georgia) pointed me to this new NBER paper by Alberta Alesina and Nichola Fuchs Schuendeln entitled "Good Bye Lenin (or not?): The Effects of Communism on Peoples Preferences."  Here is the abstract from their paper:

Preferences for redistribution, as well as the generosities of welfare states, differ significantly across countries. In this paper, we test whether there exists a feedback process of the economic regime on individual preferences. We exploit the "experiment" of German separation and reunification to establish exogeneity of the economic system. From 1945 to 1990, East Germans lived under a Communist regime with heavy state intervention and extensive redistribution. We find that, after German reunification, East Germans are more in favor of redistribution and state intervention than West Germans, even after controlling for economic incentives. This effect is especially strong for older cohorts, who lived under Communism for a longer time period. We further find that East Germans' preferences converge towards those of West Germans. We calculate that it will take one to two generations for preferences to converge completely.

You can download the paper here.

Thanks to Scott for the pointer, and also Scott himself has a fascinating paper on sex ratios and risky sexual behavior.

Does Social Change depend on the Electoral System?

Two recent elections in Germany and New Zealand have reminded us in what way some electoral systems can create difficulties and can accentuate the well-studied problems associated with voting. That the choice of electoral systems has an impact on the final outcome is hardly news. Condorcet in the 18th century showed how different electoral systems could lead to different results with the same voters’ preferences. What is interesting in these current cases is that both Germany and New Zealand use the same electoral system of proportional representation.

The September election in Germany ended in an impasse for more than three weeks. Gerhard Shröder and the SPD had to admit defeat for Angela Merkel to become Chancellor and form a coalition government. Shröder and the SPD have already denounced the new government as “Anglo-Saxon” and argued that it will not work (see The Economist).

At the same time in New Zealand, an election held on September 17th also led to an impasse for almost four weeks. While Germany got the spotlight, hardly anyone paid attention to NZ. The incumbent NZ Prime Minister, Helen Clark, and the Labour Party obtained 50 seats in Parliament (more than 60 would have been needed to have the majority) and the main opposition party – the National Party led by Don Brash – obtained 48 seats (see results). There were 19 parties standing for the election and eight of them obtained seats in Parliament (there is a 5 percent threshold).

Clark announced her new government earlier this week. While the Green Party was left out (thank God), three minor parties are involved: New Zealand First, United Future, and Jim Anderton’s Progressive. In other words, Clark’s third term is more than ever dependent on the goodwill of other parties, especially New Zealand First and its leader, Winston Peters, who is now foreign minister.

The Electoral Act 1993 introduced proportionality (called mixed member proportional – MMP) in the New Zealand electoral system. The first election under MMP was held in October 1996. It has now been more than 10 years since the change and four elections (including September ‘05) have taken place.

For many observers in New Zealand, there is enough evidence to step back and take a good look at the effects of MMP. Roger Kerr has called the MMP system: Much More Paralysis. He argues that government spending tends to be higher under MMP because of the need to buy smaller parties into coalition governments (as the presence of Winston Peters in a previous government showed).

Moreover, there has been a clear change in the pace of the reform process after MMP was first used in 1996. In fact, as I argue in a forthcoming paper in The Independent Review, backsliding has taken place in NZ over the last ten years – a period during which coalition governments have become common. This was a concern expressed by Evans, Grimes and Wilkinson in their excellent JEL paper in 1996 (Economic Reform in New Zealand 1984-95: The Pursuit of Efficiency). As they put it:

The political sustainability of the reforms awaits the test of the first general election to be held under the new mixed-member proportional voting system. The process of balancing demands for economic efficiency versus rent-seeking and redistribution will be complicated by the advent of the new electoral system. Individual political parties seem likely to focus on narrower constituencies than in the past. (Evans et al. p. 1893)

The reforms in New Zealand during the 1984-95 period were made possible because of the first-past-the-post (FPP) system. Under FPP, each Member of Parliament is elected because he/she gained more votes than any other single candidate in his/her particular electorate. FPP was replaced because it tends to foster a two-party system and delivers majority governments (and thus ignores third parties even when they achieve a significant level of support).

MMP gave birth to a host of new and interesting parties in New Zealand, such as ACT, Libertarianz, and Atearoa Legalise Cannabis (close to the Green Party), although it gave birth to a lot of bad ones as well. ACT has played a very important role in the last ten years in proposing economically sound and rational policies and denouncing bad political behavior. However, it is not clear to me that the price to pay to have more representation is worth it.

True, countries with FPP can be stuck in sub-optimal equilibria for a long-time. However, it is also clear that deep policy reforms have taken place under FPP systems in a way that is perhaps impossible with MMP. Germany and New Zealand are in difficult situations: they both have similar electoral systems and they both have coalition governments. Whether Merkel will be able to implement social change à la Ludwig Erhard is difficult to say. While this is what Germany badly needs, my guess is that it won’t happen. As for Clark, she will be in the hands of her coalition partners and more backsliding is to be expected for the next three years in New Zealand.

As Condorcet showed, all electoral systems have problems. I believe the criterion to use for selecting a voting system is whether it allows for social change to take place as opposed to giving representation to small parties, which at best ends up reinforcing the status-quo and at worst leads to backsliding.

I don’t know whether much research has been done on the subject, but my casual observation, as continental Europe demonstrates, is that proportionality is generally bad for positive social change. Canada, Britain and the US all have FPP systems, which produce clear winners and in which the balance of power cannot be held by small parties. This perhaps explains in part the superiority of Anglo-Saxon jurisdictions over others.