I am puzzled by the resurgence of Austrian Business Cycle theory among Sachs, Krugman, Baker and many others who you would not ordinarily associate with the theory.  Sachs, for example, writes:

…the US crisis was actually made by the Fed… the Fed turned on the monetary spigots to try to combat an economic
slowdown. The Fed pumped money into the US economy and slashed its main
interest rate…the Fed held this rate too low for too long.

Monetary expansion generally makes it easier to borrow, and lowers
the costs of doing so, throughout the economy. It also tends to weaken
the currency and increase inflation. All of this began to happen in the
US.

What was distinctive this time was that the new borrowing was concentrated in housing….the Fed, under Greenspan’s leadership, stood by as the credit boom gathered steam, barreling toward a subsequent crash.

What is puzzling about this is two-fold.  First, there is no standard model that I know of (say of the kind normally taught in graduate school) with these kinds of results.  Second and even more puzzling is that the foul-weather Austrians don’t seem to draw the natural conclusion from their own analysis.

If the Federal Reserve is responsible for what may be a trillion dollar crash surely we should think about getting rid of the Fed?  (n.b. I do not take this position.)  The true Austrians, like my colleague Alvaro Vargas Llosa, have long taken exactly this position.  So why aren’t Sachs, Krugman et al. calling for the gold standard, a strict monetary rule, 100% reserve banking, free banking or some other monetary arrangement?  Each of these institutions, of course, has its problems but surely after a trillion dollar loss they are worthy of serious consideration.

Nevertheless, I haven’t heard any ideas, from those blaming the crash on the Fed and Alan Greenspan, about fundamental monetary reform.  (Can Sachs, Krugman et al. really believe that it was Greenspan the man and not the institution that is to blame?  That seems naive.)

Instead, the foul weather Austrians seem at most to call for regulatory reform.  But that too is peculiar.  Put aside the fact that banking is already heavily regulated, have these economists not absorbed the Lucas critique?  In short, suppose that whatever regulation these economist want had been put in place in earlier years.  Would the crash have been avoided or would the Fed have simply pushed harder to lower interest rates?  After all, the Fed lowered rates for a reason and if the regulation reduced the effectiveness of monetary policy in creating a boom well then that just calls for more money.

Chris Blattman, development economist extraordinaire , posts from Liberia.

Today we sat down with an inter-faith network of Liberian religious
leaders to talk about their peace building plans. They are a truly
inspiring organization, building local capacity to resolve conflicts,
and training mediators to resolve disputes in the community. The
countryside is, to some extent, a powder keg, and they are building
local early warning systems and rapid response capability to
potentially serious conflicts.

Moreover, to reduce tensions in
conflict-prone places, these religious leaders–principally Muslims and
Christians–do not just aspire to a new social contract, they sit down
with ethnic and religious leaders in each village and coax them to
actually write one, specifying norms and sanctions.

And they want to know if it’s working.

I
hum and haw about comparison groups, going through my impact evaluation
101 schpiel. I have serious concerns that one would or could develop a
control group, let alone randomize, for such a program. So I dance
delicately around the subject.

"Wait a minute," interrupts the Imam, "Are you talking about a randomized control trial?"

I gape.

"Oh I see!" says one Reverend Minister, "We need a control group! This is a good idea."

It
turns out his holiness was once an agronomist. "This is just like our
control plots for fertilizer. But how are we going to control for
spillover effects?"

An older Methodist leader frowns sitting in the corner glowers. "Please, a moment," he says. "I see a real problem here."

Here
it comes. Here is the doubt and questioning I expected. We’re talking
about a peace building exercise, not fertilizer on a farm plot. Even I
have my reservations. This man, of an older generation, clearly has
other priorities.

"How," he asks "are we going to select a proper sample?"

Hat tip to Dani Rodrik.

Great insights from two legendary entrepreneurs – that’s what Marc Andreessen is offering up in a series of posts on Charlie Munger’s The Psychology of Human Misjudgment.  Munger is Warren Buffet’s long-time partner and vice-Chairman at Berkshire Hathaway.   Andreessen writes:

Mr. Munger’s magnum opus speech, included in the book, is The Psychology of Human Misjudgment
— an exposition of 25 key forms of human behavior that lead to
misjudgment and error, derived from Mr. Munger’s 60 years of business
experience. Think of it as a practitioner’s summary of human psychology
and behavioral economics as observed in the real world.

Here’s a taste of Munger:

…almost everyone
thinks he fully recognizes how important incentives and disincentives
are in changing cognition and behavior. But this is not often so. For
instance, I think I’ve been in the top five percent of my age cohort
almost all my adult life in understanding the power of incentives, and
yet I’ve always underestimated that power. Never a year passes but I
get some surprise that pushes a little further my appreciation of
incentive superpower.

…We [should] heed the general lesson implicit in the injunction of Ben Franklin in Poor Richard’s Almanack:
"If you would persuade, appeal to interest and not to reason." This
maxim is a wise guide to a great and simple precaution in life: Never,
ever, think about something else when you should be thinking about the
power of incentives…

Andreessen is going through the speech and offering comment from his own experiences.  Here’s Andreessen with an important example:

…the result of shifting from stock options to restricted stock should be obvious: current employees will be incented to preserve value instead of creating
value. And new hires will by definition be people who are conservative
and change-averse, as the people who want to swing for the fences and
get rewarded for creating something new will go somewhere else, where
they will receive stock options — in typically greater volume than
anyone will ever grant restricted stock — and have greater upside.

Read the whole thing, it’s the first post in a series I’m very much looking forward to reading.

Earlier this week Tyler wrote:

I was thinking of writing a science fiction story.  In this world human
capital is incredibly valuable.  Even if you lose all your wealth you
can earn back lots very quickly, at least if you are talented and
well-educated….The level of risk-taking is very high and capitalist enterprise starts to collapse…Production resumes only when a) managers precommit to costly drug addictions, so that they again fear pecuniary losses and b) shareholders find altruistic managers and also initiate
charitable contributions to India.  They threaten to cut off those
contributions if managers perform poorly.

Some of you were perhaps wondering what on earth this means.  (Recall my post on Tyler v. Alex.)  Perhaps I can help.  Here is a recent item from the NYTimes.

BlackRock, the publicly traded asset manager, and a hedge fund firm, Highfields Capital Management, are backing a new company seeking to raise $2 billion to buy delinquent residential mortgages.

Private National Mortgage Acceptance will be run by Stanford L. Kurland, former president of Countrywide Financial Corporation, the largest American home-loan provider, the companies said Monday in a statement.

Paul Krugman today bemoans the fact that on the housing crisis and especially on Iraq the people who get the most media attention are those who got it wrong.

It’s even worse, of course, on the matter of Iraq: just about every one of the panels convened to discuss the lessons of five disastrous years consisted solely of men and women who cheered the idiocy on.

(Brad DeLong, Dean Baker and others have made similar complaints.)  I think the fact is correct so what is going on?

The answer is media incentives.  It wasn’t just the experts who were wrong, the majority of the American people got Iraq and housing wrong.  The war was popular in the beginning and people continued to buy houses even as prices rose ever higher.  So what does the American public want to hear now?

The public wants to hear why they weren’t idiots.  And who better to explain to the public why they weren’t idiots than experts who also got it wrong?

Australia has a baby bonus.  The birth rate shot up on the day the bonus first went into effect, July 1, 2004.  As Andrew Leigh and Joshua Gans explained, over 1000 births were delayed from June to July and about 300 births were delayed by more than two weeks.

The bonus is scheduled to rise from $4,187 to $5,000 this July 1 and Leigh and Gans have pleaded with the government to phase it in order to prevent too much birth delay which they think could be unhealthy for the child.  Alas, the government has declined.

All of which leads Andrew to denounce, in delightful Aussie-speak, the bonus as an "unhealthy incentive for women to over-cook their babies."

I couldn’t agree more.  As a libertarian and a humanist I join with Andrew to denounce all government incentives to overcook babies.

Hat tip to Dave Undis.

We have nothing to fear but fear itself, but
fear itself can be pretty scary.

…Fear is ruling the
financial markets. Billions of dollars have been lost in mortgage-related
investments. The Federal Reserve worked madly over the weekend to
engineer a takeover of Bear Stearns and avert a systemic meltdown. But
the big fear remains. How low will house prices go?

If prices continue to fall, mortgage defaults will move well beyond the
subprime sector. Trillions of dollars in losses for investors are not
impossible. But that doesn’t mean they are inevitable.

That’s me in today’s New York Times.  Believe it or not, my piece is one of the more optimistic pieces you are likely to read on the housing crisis.

I think that housing prices went beyond the fundamentals sometime around 2004 (and I said so in 2005, see here and also note my warning that prices could fall dramatically here).   But 2004 levels are still well above long run trend.  Thus my optimism stems from thinking that unlike Japan, our housing prices need not fall back to long run trend (see my piece for graphs).

But the problem is that we can overshoot the fundamentals going down as well as going up and the United States now faces two potentially
self-fulfilling prophecies.

If the financial markets can predict where and when house prices will
stabilize, then credit conditions can quickly return to normal, the
economy can expand and house prices will indeed stabilize.

But if the financial markets remain uncertain about when the decline in
house prices will end, then fear will tighten credit even further, which
would strangle the housing market and generate even more fear.

Unfortunately, I do not know what will push us into the right prophecy (but read my piece, that will help!)  Thus, I am more optimistic than Paul Krugman, who thinks that we may have slipped into the state where no prophecy can bring us back to a good equilibrium, but I’m not that much more optimistic.