Category: Books

Why did the U.S. financial sector grow so large?

by  Tyler Cowen in

Edward Conard, author of Unintended Consequences: Why Everything You’ve Been Told About the Economy is Wrong, offers a hypothesis.  He suggests the underlying cause is the (relatively recent) prevalence of risk-averse foreign capital:

With an abundance of risk-averse offshore capital, the constraint to increase investment and risk taking has been the capacity of risk underwriters, not capital providers.  Today, Wall Street uses financial innovation to decouple risk from investment capital and predominantly sells risk to risk underwriters, which is no different from an insurance broker or insurance company.  Wall Street deconstructs, prices, underwrites, syndicates, trades, and makes markets for risk.  Because Wall Street now performs the more abstract function of syndicating risk rather than merely raising capital, people — even people as well informed as former president Bill Clinton — have naively concluded that these transactions serve “no economic purpose.”  Risk underwriting is every bit as important as funding investment, perhaps even more so in today’s economy where the trade deficit leaves us awash in risk-averse short-term debt to fund investment provided someone else underwrites the risk.

So far I find parts of this book brilliant and other parts dead wrong.  In any case it is full of substance, it is one of the must-read books of the year, and once I finish it I will be giving it a second read through right away.

Jared Diamond reviews *Why Nations Fail*

by  Tyler Cowen in

There is much in the review, excerpt:

In their narrow focus on inclusive institutions, however, the authors ignore or dismiss other factors. I mentioned earlier the effects of an area’s being landlocked or of environmental damage, factors that they don’t discuss. Even within the focus on institutions, the concentration specifically on inclusive institutions causes the authors to give inadequate accounts of the ways that natural resources can be a curse. True, the book provides anecdotes of the resource curse (Sierra Leone cursed by diamonds), and of how the curse was successfully avoided (in Botswana). But the book doesn’t explain which resources especially lend themselves to the curse (diamonds yes, iron no) and why. Nor does the book show how some big resource producers like the US and Australia avoid the curse (they are democracies whose economies depend on much else besides resource exports), nor which other resource-dependent countries besides Sierra Leone and Botswana respectively succumbed to or overcame the curse. The chapter on reversal of fortune surprisingly doesn’t mention the authors’ own interesting findings about how the degree of reversal depends on prior wealth and on health threats to Europeans.

Do read the whole review (that is not just the usual cliched command to do so), and I will gladly link to any response by Acemoglu and Robinson.  Here is Diamond’s bottom line:

My overall assessment of the authors’ argument is that inclusive institutions, while not the overwhelming determinant of prosperity that they claim, are an important factor. Perhaps they provide 50 percent of the explanation for national differences in prosperity. That’s enough to establish such institutions as one of the major forces in the modern world. Why Nations Fail offers an excellent way for any interested reader to learn about them and their consequences. Whereas most writing by academic economists is incomprehensible to the lay public, Acemoglu and Robinson have written this book so that it can be understood and enjoyed by all of us who aren’t economists.

What I’ve been reading

by  Tyler Cowen in

1. Héctor Abad, Oblivion: A Memoir.  A charming and intense memoir of a boy and his relationship to his father.  It seems to be true, but it can be read profitably as either non-fiction or the equivalent of fiction.  Recommended.  Abad is still an underrated author in the United States.

2. Steve Coll, Private Empire: ExxonMobil and American Power.  It’s OK enough, and certainly informative, but I found it a little boring.  Somehow the organizing principles behind the material needed to be stronger.

3. Michael Dirda, On Conan Doyle: Or, the Whole Art of Storytelling.  Short meditation on both the merits of Doyle beyond Sherlock Holmes and why fiction, and our responses to it, are and should be deeply strange.  I very much liked it.

4. Nell Freudenberger, The Newlyweds.  For modern fiction this is not too trendy, and it ends up being deeper than one expects.  It is the story of an American man who meets his Bangladeshi bride over the internet and flies to Bangladesh to woo her and bring her back.

5. Arthur Herman, Freedom’s Forge: How American Business Produced Victory During World War II.  I wish the book had more explicit economic content, but it is nonetheless an interesting look at the supply-side improvements which helped the American economy during World War II.

Solomon’s Knot and Gray Markets

by  Alex Tabarrok in

Solomon’s Knot: How Law Can End the Poverty of Nations has received less attention than some of other recent big books on development but I found it to be rich in institutional detail, wisdom and practical advice. The authors, Robert
Cooter and Hans-Bernd Schafer, are law professors and as befits their expertise they spend less time on why institutions differ and more on the details of how institutions differ–there is more in Solomon’s Knot, for example, on issues like relational finance, venture capital, joint-stock companies, contract law and bankruptcy law than in other books with a similar theme.

Here is one idea that I had not previously considered, should judges enforce contracts in the gray market?

…businessmen and workers must violate many regulations in order to get things done, especially in poor countries. Thus a builder in Cairo violates building restrictions, a worker and employer in Brazil evade employment taxes, and a manufacturer in Russia runs a factory without a permit to do business.

Throughout the world, much of the economy operates in the “grey market”…a survey of 145 countries estimated that gray
markets activities produce between 30% and 40% of GNP (gross domestic
product). The gray market’s share of total employment is even higher than its
share of GNP.

Judges in many countries will not enforce contracts in the gray market considering them null and void due to the extra-legality. Even when the contracts might be enforced, participants fear that they will be otherwise punished if they make use of the legal system. Cooter and and Schafer argue, however, that such contracts should be enforced and a strict separation be kept between law and regulation. They point to Germany as an example:

…Unlike many developing countries, German legal doctrine and practice avoid this
result. German regulatory violations seldom void contracts, and German
prosecutors seldom act on regulatory violations revealed in a civil trial. Thus a
gardener in the German gray market who does not pay taxes can sue an
employer for unpaid wages without fear of triggering regulatory prosecution.
And a customer who buys a restaurant meal at an hour when law requires the
closing of restaurants still has to pay his credit card bill. The same applies for a
construction contract that violates zoning regulations, or a credit contract that
violates banking regulations. Although seldom discussed in constitutional law,
separating the civil courts from the regulators and police is an important part of
the separation of powers, especially in countries with a large gray market.

The case for separation is strongest for gray markets because the underlying acts are not per se illegal but could the argument be extended even to black markets? Jeff Miron and Miron and Zweibel (JSTOR) argue that one reason that drug prohibition increases violence is that when courts are unavailable, violence becomes the least costly method of dispute resolution. What Cooter and Schafer suggest, however, is that it is at least conceivable to have a situation where the act remains illegal but the actors can resolve disputes in court. Imagine, for example, a drug user taking a dealer to court for cutting the product or a prostitute suing a john for not paying.

It seems naive to expect that we would enforce a rule not to use information from civil court to prosecute illegal behavior. Yet there is a precedent; if a police officer obtains evidence illegally, even without intent, then we throw such evidence out of court. A very strange incentive system. Nevertheless, if we can let murderers go free because the evidence against them was obtained illegally then perhaps we could also let drug dealers bring their contract disputes to court without on that basis prosecuting them for drug dealing.

Addendum: Here is a good interview of Cooter by Nick Schulz and an excerpt from the book.

Scaling the Great Wall

by  Tyler Cowen in

Here is my essay from Washingtonian magazine, adapted from An Economist Gets Lunch, about what it is like to shop at a Chinese supermarket for a month.  Here is one bit about search theory:

Then there’s getting your cart down the aisle. The main aisles fit two carts side by side, barely. It’s hard to get down the aisles, and that discourages browsing. My initial tendency was to search the empty aisles, if only because I knew I could get down them without much delay. This obviously isn’t the best strategy, and it led me to spend too much time looking at the highly durable items, which are purchased less frequently by other customers. Overall, I felt far less mobile than in an American supermarket. I started going later at night and avoiding the weekends to circumvent these problems.

It’s common to see a Great Wall customer spending a solid minute or two inspecting the quality of a pineapple, thereby blocking that portion of the aisle. The customers who seek green peas go through the bin pea by pea. One woman became entranced picking out the best garlic chives, and a man asked for sales help in selecting the best clams–by what standard he judged them I’m not sure. No one was much enamored of the scooping technique for filling a plastic bag.

How much structural unemployment was there during the Great Depression?

by  Tyler Cowen in

A few times recently Paul Krugman has raised the issue of structural unemployment in the Great Depression, so I thought I would offer a look at what has been written on the topic.  Here is Richard J. Jensen, from a survey article:

Economists agree that Keynesian stimuli would not have helped structural or hard-core unemployment, only cyclical unemployment. As Table 1 suggests, about half of the unemployment was cyclical from 1931 through 1933; it was then that stimulus was needed and might have worked. By 1933, the appearance of a large, new, structural/hard-core element raised the natural level of unemployment from the 5 to 6 percent range to 12 to 15 percent. If a Keynesian stimulus had been tried and it had eliminated cyclical unemployment, the remaining unemployment still would have been io to 15 percent. Further fiscal or monetary stimuli would have resulted in inflation.

Later he moves directly to the key question:

…we need to discover how the war cured hard-core unemployment permanently. On the supply side, the growth of high schools and colleges, the postwar draft, and Social Security retirements removed young and old from the labor force. Wartime training and experience, in industry and in the military, made workers more productive, and upgraded skills so that the supply of unskilled labor was much smaller. In terms of efficiency wages, employers reshaped jobs to suit the skills and increase the productivity of available workers. They had to use men (and women) whom they would not have dreamed of hiring a few years before.

Personnel management became even more important. The number of industrial-relations staff rose from 2.5 per 1ooo employees in 1937 to 8.o in 1948. They were charged with improving productivity despite the extraordinary shortage of manpower, the high quit rates, the government-imposed wage freeze, and the new strength of labor unions. They dropped categorical restrictions against the poorly educated, the unemployed, women, the old, the handicapped, and sometimes, in spite of intense resistance, blacks. Recruitment of new workers became an art form, with sound trucks blaring in the streets beseeching people to come to work and earn big money. Jobs were restructured so that fewer skills were needed. Intensive in-shop and in-school training programs reached millions. Anyone with a modicum of skill was rapidly promoted, even to the status of foreman or instructor. The results further justified the use of efficiency-wage procedures, but this time efforts were made to find the right niches for workers who had been “hopelessly unemployable” in the 1930s.

In other words, the path out of high unemployment involved much more than a mere reflation of nominal values.  (By the way, when it comes to terminology I might not use the phrase “structural unemployment,” but it also is not “simple cyclical unemployment.”  I would say that in some circumstances the traditional distinction between cyclical and structural unemployment breaks down, but note that in terms of its parent literature this piece is using the terms properly, even if they sound somewhat off in a 2012 blogosphere context.)

In any case, history suggests that stimulus policy has to take some very specific forms to reach those “called cyclically unemployed by some, structurally unemployed by others” unemployed workers and that is the practical upshot.

Another practical upshot is that you still can believe in labor market hysteresis, as presented by DeLong and Summers.  Without some analysis like the above, the DeLong/Summers claims are otherwise contradicted by American post-Depression productivity once joblessness lifted.  Where were the long-term scars?  Well, they were fixed but it wasn’t easy.  So the relevance of hysteresis can be saved, but we still are left with proper stimulus being very difficult to do, unemployment being quite sticky, and proper policy requiring lots of structural attention.  The Great Depression is evidence for all of those views, not against them.

Here is one more bit, with a sad sting at the end:

The war, by removing millions of prime men from the labor market, by restructuring the work process, by subsidizing wages, and by massive retraining, finally gave the private sector the methods and the incentives to rehire the hard-core. Never since has hardcore unemployment affected more than one worker in a hundred.

Michael A. Bernstein’s book, The Great Depression: Delayed Recovery and Economic Change in America, 1929-1939, also considers the significant role of structural unemployment (don’t forget my taxonomic caveat) in the Great Depression.

It is important to learn from this literature rather than dismiss it.

The Independent on *An Economist Gets Lunch*

by  Tyler Cowen in

The review is here, by Will Dean, the summary is here:

If you’re interested in how the food and restaurant industries work – and how to exploit those factors for your own good – then Cowen’s work is indispensable.

And:

All good advice. It has no recipes, few restaurant recommendations and no famous chef names, but An Economist Gets Lunch might be the most interesting book about food you read all year.

Jim Manzi’s *Uncontrolled*

by  Tyler Cowen in

The subtitle is The Surprising Payoff of Trial-and-Error for Business, Politics, and Society, with an emphasis on RCT.

This is a truly stimulating book, about how methods of controlled experimentation will bring a new wave of business and social innovation.  Here is an Eric Posner review.  Here is a Kirkus review.  There will be more.  Kevin Drum offers good remarks.

The Armchair Economist-Revised Edition

by  Alex Tabarrok in

The Armchair Economist includes my favorite line in all of popular economics:

Economic theory predicts that you are not enjoying this book as much you thought you would.

I laugh every time I read that line and I think what a brilliant opening to an essay on auction theory and the winner’s curse!  And then I think, but in fact I am enjoying this book more than I thought!

I first read Landsburg’s book some twenty years ago and dipping into the revised edition over the weekend I can see how influential The Armchair Economist has been on my own teaching and writing, particularly Landsburg’s wonderful and deep essay, Why Prices are Good: Smith v. Darwin. Around 1997, the Armchair Economist also inspired my (now) colleague Bryan Caplan to create a listserv to discuss economics with a small cadre of like minded readers. Many of the people on that listserv would later become well-known econ bloggers. My history makes me assume that everyone has read The Armchair Economist, after all, all my friends have read The Armchair Economist! More rational reflection tells me that time and the flowering of popular economics means that there is a whole new generation of readers ready to be delighted and inspired.

*The Washington Post* covers *An Economist Gets Lunch*

by  Tyler Cowen in

Cowen fears the effects of gentrification, which tends to drive up real estate rates and drive out ethnic restaurants. It can also lead to blander food. But if defense funding is cut, and the impact is felt locally, that would be a good thing for ethnic restaurants, if not for the populace in general, Cowen said.

And finally, some more helpful tips for ethnic restaurant exploration: ”It’s all about the ordering,” Cowen said. The best places have smaller menus, so they aren’t trying to please everyone, and likely do several things very well. Don’t ask the waiter what’s good, “that will only confuse them.” Instead, ask, “What dish do you have here which is special?” or “What are your regional specialties.”

That is from Tom Jackman, here is more.  Also from the Post today, Tim Carman adds further discussion.

*The Great Inversion and the Future of the American City*

by  Tyler Cowen in

The author is the excellent Alan Ehrenhalt, here is one bit:

Walking the streets of the Financial District today, one can’t help but think that it is, indeed, a throwback to an earlier version of the city’s life.  But not to the Wall Street of a century ago: That was an economically segregated one-use neighborhood, with offices and virtually nothing else, no residents, hardly a place to shop, only a handful of restaurants to cater to the financial workforce.

But look back farther than that, and you begin to see a resemblance.  In some ways, lower Manhattan in the early twenty-first century has come to resemble lower Manhattan in the late eighteenth and early nineteenth: brokers, investors, and insurance agents who live in the neighborhood and walk to work; a social life that does not disappear at quitting time, the way it did twenty years ago; a modest but growing number of families with young children.  Ron Chernow offers a picture of this early lower Manhattan in his biography of Alexander Hamilton, who lived there both as a college student and as a young lawyer.

Recommended, you can buy it here.