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May 31, 2009

Economist's View - 5 new articles

"Alpha Markets"

Robert Frank says Charles Darwin provides the "true intellectual foundation" for economics, and that his account of "the complex relationship between individual and social interest" is the key to understanding the financial crisis:

Alpha markets, by Robert H. Frank, Commentary, CIF: Though Adam Smith is almost universally regarded as the father of modern economics, most economists will eventually see Charles Darwin's ideas as the true intellectual foundation of our discipline. Smith's modern disciples celebrate his invisible hand theory, which says markets harness individual self-­interest to serve society's interests. Smith himself was more circumspect, claiming only that self-interested actions often lead to socially benign outcomes. But that claim is remarkable enough. Competition among greedy producers often yields innovations that result in cheaper and better products for everyone.

It was Darwin, however, who better grasped the complex relationship between individual and social interest. And we must turn to his account if we are to understand the recent meltdown in financial markets. His deep insight was that natural selection favours traits and behaviours according to their effect on individual organisms, not groups. Sometimes individual and group interests coincide. But interests at the two levels often conflict.

Male body mass is a case in point. Most vertebrate species are polygynous, meaning that males take more than one mate if they can. The qualifier is important, because when some take multiple mates, others get none. The latter don't pass their genes along, making them the ultimate losers in Darwinian terms. So it is no surprise that males often battle furiously for access to mates. Size matters in those battles. And hence the evolutionary arms races that produce larger males.

Bull elephant seals often weigh more than five times as much as females. But their size is a handicap, making them far more vulnerable to sharks and other predators. Given an opportunity to vote on a proposal to reduce their weight by half, bulls would have every reason to favour it. But they have no such opportunity. And any bull that weighed much less than others would never find a mate.

Similar conflicts arise when individual rewards depend on relative performance. This payoff structure, common in financial markets, helps explain why those markets sometimes fail catastrophically. Wealth managers' salaries depend primarily on how well their investments perform in relative terms. Funds offering higher returns immediately attract cash from rival funds. If the invisible hand functioned as Alan Greenspan and other modern disciples of Adam Smith imagined, there would be no problem. Investors would be fully compensated for any additional risk they took in search of higher returns. But human brains forged by natural selection don't work as assumed in economics textbooks.

As our brains were evolving, immediate threats to survival loomed everywhere. Natural selection thus favoured a nervous system keenly sensitive to immediate relative payoffs, much less so to distant ones. Anyone disinclined to seize immediate gains at the risk of having to incur costs in the future would experience low relative rewards in the short run. And when competition was intense and immediate, such individuals often didn't survive to see the long run.

In market settings, a nervous system biased in favour of short-term relative reward is a recipe for disaster. When the price of an asset like housing is rising steadily, unregulated wealth managers can create leveraged investments that generate enormous rates of return. Even in the early years of this decade, many experienced analysts were warning that several mortgage-backed securities were poised to tumble. But investors faced a tough choice: they could earn high returns by continuing to invest in them, or they could move their money elsewhere. Many rejected the latter strategy because it would have required watching friends and neighbours pass them by.

Wealth managers felt compelled to offer the risky investments, since many customers would otherwise desert them. Managers also knew there would be safety in numbers when things soured, since almost everyone had been following the same strategy. The resulting collapse was inevitable.

Adam Smith's invisible hand is a truly extraordinary insight. But when rewards depend on relative performance, it doesn't always deliver.

The financial meltdown that caught Adam Smith's disciples off guard would not have surprised Darwin. One of his central themes was that because much of life is graded on the curve, wasteful arms races create conflict between individual and social interests. The good news is that unlike other animal species, humans can often resolve such conflicts through intelligent regulation.

Also see Paul Krugman's: What Economists Can Learn from Evolutionary Theorists Synopsis.

"Incarceration as a Labor Market Outcome"

John Quiggin makes a good point:

Incarceration as a labor market outcome, by John Quiggin: I wasn't all that surprised that Bryan Caplan didn't like my interpretation of our bet on EU and US unemployment rates, which was that the combined rates of unemployment and incarceration in the US would exceed those in the EU over the next ten years. I was, however, surprised by the vehemence with which libertarian-inclined* commenters here and at Crooked Timber objected to this interpretation.

A string of them echoed Caplan's argument that

From a labor market perspective, though, Quiggin's incarceration adjustment would only make sense if you thought that most or all of the people in jail would be unemployed if they were released.

Caplan has missed my main point. I'm not suggesting that incarceration is disguised unemployment (though obviously it reduces measured unemployment). Rather, I'm saying that, like unemployment, incarceration should be regarded as a (bad) labor market outcome. If you want to evaluate the performance of the labor market, you need to look at both.

There's nothing radical or leftist about this viewpoint: it's one that is at least implicit in all economic models of the labor market of which I'm aware, and is most particularly explicit in that of the Chicago School*. Most of the crimes for which people are imprisoned in the US can be understood as reflecting economic choices which in turn are determined primarily by the labor market in which those choices are made. This is obviously true of property crime and drug dealing, and it's true, directly or indirectly, of lots of violent crime as well. As Gary Becker put it (quoting from memory here) "a burglar is a burglar for the same reasons as I am a professor". ...

There's plenty of statistical evidence from scholars like Glenn Loury to show that criminals ... are drawn disproportionately from groups with bad labor market prospects: poor, disproportionately black, facing low wages and high risk of unemployment. But well-done case studies are often more convincing, so I'll point to the Venkatesh study of Chicago drug dealers reported in Steve Levitt's Freakonomics. Venkatesh found that most street dealers were making less than minimum wages, and were motivated by the very low probability of surviving to attain the only high-paying job realistically available to them, that of the local kingpin. Even more striking was the observation that, when gang members learned Venkatesh was a university professor, they approached him in the hope that he would be able to wangle them jobs as janitors - otherwise an ambitious, and probably unattainable aspiration.

The Chicago theory on which the case for flexible labor markets is based predicts that the lower is the return associated with the "outside options" of employment or reliance on social insurance, the higher will be the incentive to engage in crime as a way of making a living. ... That is, other things equal, low wages and weak or non-existent unemployment benefit systems can be expected to lead to higher crime rates, higher rates of imprisonment or both. ...

So, I would argue, my interpretation of my bet with Bryan Caplan is the more relevant one in terms of policy evaluation. The proportion of bad labor market outcomes is better measured by the sum of unemployment** and incarceration (expressed as a proportion of the labour force) than by unemployment alone.

* Or maybe shmibertarian: as we saw during the Bush era lots of alleged libertarians are quite comfortable with extreme use of state power as long is doesn't touch their bank balances. On the other side of the coin, I should note that the Cato Institute has done some very good work on this subject, including publishing this Glenn Loury piece. ...

Not all prisoners are the result of bad labor market outcomes, and an index of labor market outcomes may weight these two pieces of information differently, so I'm not sure a simple sum of unemployment and incarceration is the optimal measure of labor market performance. But it does seem adequate as a first approximation, or at least better than the unemployment rate alone, and the underlying point is valid.

A Lump of Coal for Obama

More disappointment with the new leader:

Obama walks a fine line over mining, by Tom Hamburger and Peter Wallsten, LA Times: With the election of President Obama, environmentalists had expected to see the end of the "Appalachian apocalypse," their name for exposing coal deposits by blowing the tops off whole mountains.

But in recent weeks, the administration has quietly made a decision to open the way for at least two dozen more mountaintop removals. ... The list included some controversial mountaintop mines. ...

The administration's decision ... sheds on relations between the mining industry and the Obama White House,... environmentalists ... say they feel betrayed...

The issue is politically sensitive because environmentalists were an active force behind Obama's election, and the president's standing is tenuous among Democratic voters in coal states. ... Moreover,... halting mountaintop mining could eliminate jobs and put upward pressure on energy prices in a time of economic hardship.

Coal advocates have solicited help from officials as high up as White House Chief of Staff Rahm Emanuel. And the issue has sparked contentious debates within the administration, including one shouting match...

Although environmentalists had expected the new administration to put the brakes on mountaintop removal, Rahall and other mining advocates have pointed out that Obama did not promise to end the practice and was more open to it than his Republican opponent, Arizona Sen. John McCain.

A review of Obama's campaign statements show that he had expressed concern about the practice without promising to end it. ... And his EPA administrator, Lisa Jackson, has said that the agency ... would "use the best science and follow the letter of the law in ensuring we are protecting our environment." Soon afterward, the agency in effect blocked six major pending mountaintop removal projects...

But this month, after a series of White House meetings with coal companies and advocates..., the EPA released the little-noticed letter giving the green light to at least two dozen projects. ...

Ed Hopkins, a top Sierra Club official, said some of the projects that have now obtained the EPA's blessing "are ... large and potentially destructive..." "It makes us wonder what standards -- if any -- the administration is using," Hopkins said. ...

Environmentalists were stunned to learn from Rahall's office May 15 that the EPA had given its blessing to 42 out of the 48 mine projects it had reviewed so far -- including two dozen mountaintop removals.

The news came in a letter ... from ... the EPA's acting assistant administrator, who wrote, "I understand the importance of coal mining in Appalachia for jobs, the economy, and meeting the nation's energy needs."

Carbon Offsets

Robert Frank argues for carbon offsets as a complement to carbon taxes or cap-and-trade:

Carbon Offsets: A Small Price to Pay for Efficiency, by Robert H. Frank, Commentary, NY Times: Are carbon offsets a good thing? They are intended to reduce the environmental impact of consumption. Traveling by plane, for example, causes carbon dioxide to be emitted into the atmosphere, so travelers can pay a specialist to offset those emissions some other way — perhaps by planting vegetation or installing renewable-energy technologies. It all sounds reasonable.

Yet carbon offsets have drawn sharp criticism, even ridicule. ... But the criticism is misguided. If our goal is to reduce carbon emissions as efficiently as possible, offsets make perfect economic sense.

Consider the decision of whether to buy a hybrid car. ... Many people drive so little that they wouldn't save enough on gasoline to recoup the higher cost. Yet many such people buy hybrids anyway, because they think they are helping the environment. Well and good, but they could help even more by buying a standard car and using the savings to buy carbon offsets. ...

Of course, carbon offsets alone won't eliminate global warming. People also need stronger incentives to take into account the environmental consequences of their actions.

President Obama has proposed attacking the problem with a carbon cap-and-trade system. ... This approach was first used in the United States to address acid rain... Compared with more traditional regulatory measures, the auction method substantially reduced the cost of achieving the law's air-quality target.

As people learn more about such an approach, they seem less likely to oppose it. ... A carbon cap-and-trade system is functionally similar to a carbon tax. ... Carbon offsets are no substitute for the stronger incentives inherent in carbon taxes or cap-and-trade, but they can reinforce their effects. Both carbon taxes and permit auctions would also generate revenue that could be used to buy additional carbon offsets. ... Carbon offsets, though much maligned, are an excellent idea. If you want to help reduce carbon emissions, consider buying some.

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