Some Sensible Economic Insights to help understand the documents

Rigged Rules of the Game
  • Excerpted from Peter A. Coclanis review of Why Nations Fail: The Origins of Power, Prosperity, and Poverty, by Daron Acemoglu & James A. Robinson (2012).
  • Economists and political theorists have focused on geographic factors, natural resources, culture or the influence of good or bad ideas about economics to explain differential economic outcomes. Acemoglu and Robinson are dubious about the explanatory power of such variables. For them, none of these approaches will do.

  • To what, then, are prosperity and poverty due?In the authors’ view, they arise from the constitution of a country’s or region’s political and economic institutions, which is to say, to the structures and mechanisms – formal or informal – that set the “rules of the game” governing individual and group behavior. Why? Because institutions, starting with those in the political realm, shape the incentive structure in any society. When the institutional framework established is “embracive” – characterized by limited, but active government and broadly distributed political power, and by open, competitive markets, the rule of law and protections to property – prosperity generally ensues.

    On the other hand, when small groups of insiders [such as we have in Latin America and increasingly in the US] create an “extractive” institutional frame, based upon arbitrary power, a narrow political base, rigged markets and a capricious legal system, poverty and underdevelopment typically result, with economic progress for the masses impeded, and power and resources concentrated in the hands of a few.
    Excerpted from The Darwin Economy: Liberty, Competition, and the Common Good by Robert H. Frank (Princeton Univ. Press, 2011). Here are some economic concepts to help make sense of the documents and debates over globalization and economic policies.

    Charles Darwin trumps Adam Smith

    (p. 17) I base my prediction on a subtle but extremely important distinction between Darwin's view of the competitive process and Smith's. Today Smith best remembered for his invisible-hand theory, which, according to some of his modern disciples, holds that impersonal market forces channel the behavior of greedy individuals to produce the greatest good for all. This characterization is an oversimplification. But it captures an important dimension of Smith's understanding of the competitive process. In any event, it's fair to say that the invisible-hand theory's optimistic portrayal of unregulated market outcomes has become the bedrock of the antigovernment activists' worldview. They believe regulation is unnecessary because they believe unbridled market forces can take care of things quite nicely on their own.

    Darwin's view of the competitive process was fundamentally different. His observations persuaded him that the interests of individual animals were often profoundly in conflict with the broader interests of their own species. In time, I predict, the invisible hand will come to be seen as a special case of Darwin's more general theory. Many of the libertarians' most cherished beliefs, which are perfectly plausible within Smith's framework, don't survive at all in Darwin's.

    Progressive consumption tax rather than an income tax

    (p. 83) An added attraction of economist Lawrence Seidman's proposal [for a progressive consumption tax] is that it would create a temporary spending boom for a sluggish economy that could really use it. The key step would be to pass the surtax right away, but delay its implementation until the economy was once again operating near full employment. Mere announcement that the tax was coming would spur a flood of additional high-end spending as wealthy families rushed to build mansion additions and stage lavish parties before the tax took effect. Granted, that might not be the best way to stimulate additional spending. But it would clearly be better than standing idly by while total spending remains far too low to support full employment.

    In the long run, a progressive consumption tax would gradually shift the composition of final spending away from consumption toward investment, causing productivity to grow more rapidly. In the event of an economic downturn, a temporary suspension or reduction of the tax would be a powerful stimulus tool, since consumers would benefit only if they increased their spending right away. In contrast, temporary income tax cuts tend to be a weak stimulus tool, because fearful consumers often save them.

    Movement libertarians can of course be expected to denounce the progressive consumption tax in the same harsh terms they reserve for other taxes. Theft! Social engineering! Frank thinks the bureaucrats in Washington know how to spend our money more wisely than we do! Class warfare! But mature adults understand that we must tax something. Right now we tax savings, which discourages productive investment. We tax payrolls, which discourages job creation. Instead, why not tax things that we would otherwise have too much of?

    Fallacy of Trickle-Down Economics

    (p. 159) Others might react differently to a tax increase. Because a higher marginal tax rate reduces the opportunity cost of taking additional time off (in terms of forgone after-tax income), it might lead some to work fewer hours than before. Economic theory tells us nothing--absolutely nothing--about of which of these opposing effects might prevail.

    If economic theory provides no justification for the trickle-down doctrine, what do the numbers say? Here as well, the doctrine finds little support. One test is suggested by the observation that if lower real wages induce people to work shorter hours, then the opposite should be true when real wages increase. Since 1900, average hourly wages in the United States have risen more than fivefold in inflation-adjusted terms. According to trickle-down theory, then, Americans should be working significantly longer hours now. Yet the current American workweek is only about half what it was in 1900

    Trickle-down theory also predicts shorter workweeks in countries with lower real after--tax pay rates. Yet here, too, the numbers tell a different story. For example, even though CEOs in Japan earn less than one--fifth as much as American CEOs and face substantially higher marginal tax rates, they actually work longer hours than their American counterparts.

    Trickle--down theory's emphasis on incentives has led many to predict that greater income inequality should be positively correlated with economic growth rates. The idea here is that greater income disparities should cause people to feel greater pressure to catch up with those ahead of them. As discussed in chapter 4, inequality does indeed affect spending patterns. Yet when researchers examine the data within individual countries over time, they find a negative correlation between growth rates and inequality. During the three decades immediately following World War II, for example, income inequality was low by historical standards, yet growth rates in most industrial countries were extremely high. In contrast, growth rates have been only about half as large during the years since 1973, a period in which income and wealth inequality have been steadily rising in most countries.

    Tragedy of the Commons & the effect of unbridled freedom

    (p. 164) The cod, once abundant in the North Atlantic, saw its population decline by more than 95% from overharvesting. The incentives that led to this decline were similar to those that produce excessive entry into many winner-take-all markets. (p. 165) But with only limited supplies of cod it the fishery, the average would steadily decline as the number of fishermen rose. Economic theory predicts that entry into the fishing industry would cease once the annual earnings from fishing had declined to $50,000, at which point people would be indifferent between fishing and factory work. Arbitrarily, let's say that happens when there are forty fishermen (the qualitative point of the example is independent of that number).

    With annual earnings of $50,000 apiece, those forty fishermen would earn a total of $2 million a year, and the remaining sixty who chose factory work would earn a total of $3 million. Collectively, then, our one hundred workers would earn $5 million a year. But that's the very same total they'd have earned if all one hundred had chosen factory work! The fishery, potentially an extremely valuable resource, ended up being of no economic value at all. The problem was that individual incentives led too many people to become fishermen, in the process completely dissipating the potential economic surplus from fishing. (That it would have been possible to do better is clear by noting that if only one person had chosen fishing, the collective earnings of the one hundred would have been larger by $50,000, since the lone fisherman would have earned $100,000 while the other ninety--nine would have earned $50,000 as factory workers.)

    The tragedy of the commons occurs because of a simple externality. Each potential fisherman cares only about the earnings from the fish he expects to catch. He has no reason to consider the fact that his entry would reduce the number of fish caught by existing fishermen. When the market reaches equilibrium, the last entrant's $50,000 in earnings from fishing is just enough to compensate him for the $50,000 he gave up by not working in the factory. But because his entry also reduced the size of each existing fisherman's catch, the system--wide effect of his entry was actually negative. Individual incentives to enter fishing are thus far too large, and overfishing is the expected result.

    The incentives confronting aspiring portfolio managers are exactly analogous. Just as there are only so many fish in the sea, at any given moment there are only so many deals to be struck. Beyond some point, increasing the number of money managers produces much less than proportional increases in total commissions on managed investments.. . . . So here, too, private incentives result in wasteful overcrowding.

    Conclusion: A mix of markets and regulation

    (p. 213) As John Stuart Mill maintained, the government may legitimately restrict individual behavior to prevent undue harm to others. (p. 214) Anti-tax, anti-government rhetoric has prevented us from taking greater advantage of that simple insight. Some countries have reasonably honest governments that reliably deliver valued public goods and services [think Scandinavia]. Every rational person would want to live under such a government. But good government doesn't just happen. It must be nurtured carefully. “Starve the beast” rhetoric surely hasn't helped us forge the kind of society most of us want to live in.

    We need good government because individual and societal goals are often squarely in conflict. When they are, it's naïve to expect an invisible hand to         produce good outcomes. The good news is that intelligent tax policy can often guide us to better outcomes unobtrusively. Simply by taxing behaviors that cause harm to others, we could easily afford to maintain our roads and bridges without having to make any painful sacrifices in private consumption.

    Although the traditional libertarian position does not withstand careful scrutiny, I was never under any illusion that theories or evidence would compel committed ideologues to change their minds. But in writing this book, my hope was that it might persuade at least some anti-government activists to rethink their uncritical opposition to collective action. There remains a pivotal role in public debate for those who care most passionately about personal autonomy. Almost no one wants a government that tries to regulate every behavior that somebody, somewhere, might find annoying. A truly effective government would focus only on behaviors that cause real harm that others cannot easily avoid on their own. It would try to discourage those behaviors with the lightest touch possible.

    To have a government like that would be to have a successful libertarian welfare state. To get there, we'll need a new generation of libertarians who are willing to accept legitimate restraints on their own behavior, while continuing to battle ferociously to prevent government from intruding any more than necessary.

    Every generation has had its doomsayers. But unlike those of previous generations, who were mostly religious fanatics, ours are the planet's most distinguished scientists. They tell us there's a good chance we'll burn up if we don't act forcefully and quickly to reverse global warming. The policy instrument that would accomplish that goal is simple and well understood – essentially some variant of a stiff carbon tax. The costs we'd have to bear would be modest. Yet it appears we'll take no action.

    What stands in our way are anti-tax, anti-government zealots driven by a philosophy that, on close examination, collapses under its own weight. They're in control of the conversation at the moment, but they're not invincible. Win or lose, we should fight them. Looking back on it all, would you feel comfortable if you hadn't? Cynical friends caution that I'm naïve to believe we can do better. I'm just tilting at windmills, they say. Perhaps. But as Cervantes reminds us in the words of Don Quixote, "Too much sanity may be madness--and the maddest of all--to see life as it is, and not as it ought to be."