Saturday, November 28, 2009

There are two college economics courses

College catalogs list many economics courses, but there are really only two: a theory course and an applied (?) course. (I’ll explain the question mark later.) The former, by which the student is introduced to economics, explains the free choices by intelligent and informed individuals (consumers or entrepreneurs) of their preferred consumption and production paths subject to the limitations set by market prices, incomes, and production possibilities. The model abstracts from uncertainty (except within well-defined limits) and the costs of information and transactions. Its simplicity is revealed by the fixed availability of well-defined goods and technology (there is no innovation) and the uniqueness of prices. There is one price per good/market, that is, no spread between what the buyer pays and the seller receives.

It is taught that these conditions produce efficient outcomes such that trade-offs between the utilities and costs of goods are equal. Selfish interests are led as if by an invisible hand to promote the general welfare. This theoretical construct defines economics, and students of its finer details, such as the existence and stability of equilibria, are the most prestigious of their profession and are rewarded by Nobel prizes.

Notwithstanding these simplifications, advocates of free markets point to their practical successes. The societies in which the behavior described above is given freest rein are the world’s richest, healthiest, and most egalitarian.

Having learned economic theory, students look forward to its application to real world problems. They look in vain, for the lessons of the first course are rejected or ignored. They find that transactions costs are large, information is lacking or perverse, uncertainty is insuperable, individual actions have external effects whose costs and benefits are not fully captured by prices, and most of all, preventing solutions to these problems, individuals are dull and passive. Students learn that these disabilities result in market failures which requiring the government’s correction.

We saw in earlier blogs how these views have resulted in financial regulations, and will come back to financial markets next time. In preparation, it will be useful to learn more about the strategies of those opposed to free markets. A good place to begin is medicine, where arguments for market failures are carried furthest. Regulated utility monopolies are justified by economies of scale (because unregulated cost minimization is presumed to be inconsistent with profits) and the regulation of financial firms is justified by externalities (a firm’s failure has wider effects) and imperfect information (leading to bank runs), but it seems that no part of economic theory is satisfied in medical markets.

The seminal article on the economics of medical care was Kenneth Arrow’s “Uncertainty and the welfare economics of medical care” (1963). He contended that the market for medical services differed from ideal markets in (1) the irregularity and unpredictability of demand, (2) supply restricted by the high cost of training and doctor licensing, (3) patient (demanders) relations with their doctors (suppliers), who have superior information and emphasize patients’ welfare relative to profits, (4) uncertainty as to the quality of the product, and (5) price discrimination (bills depend on ability to pay). Leading textbooks cite these differences as sufficient reasons for the allocation of medical services according to official cost-benefit analysis (Phelps 2003).

We have not yet determined the best system of medical care, nor will we. We can say, however, that it does not follow that because the assumptions of the ideal model are incompletely satisfied, government intervention is an improvement. Arrow also made this leap of logic in other places (1971). General equilibrium theorists have developed sufficient conditions (summarized above) for the existence of an unregulated ideal system, and then concluded that because these conditions are incomplete, regulation is necessary. But sufficiency does not imply necessity. The markets seen by Arrow might work as well, or better, if left alone than when regulated. He is a devotee of the nirvana approach that chooses between “an ideal norm and an existing ‘imperfect’ institutional arrangement,” which must therefore be rearranged (Demsetz 1969).

It is often not clear that the resulting rearrangement is an improvement, and in the case of medical care it sometimes looks quite the opposite. Many actual and proposed interventions worsen the problems seen by Arrow. Consider his primary theme of uncertainty, where Arrow neglects the most important theoretical and practical approach to its resolution, which is reputation based on experience. We know nothing about anything until we’ve tried it. Arrow’s argument is like those simple textbook introductions that consist of one-period cases with no learning, or indeed any chance of learning. George Akerlof received a Nobel Prize for his “market for lemons” paper that proved the impossibility of a used-car market. This market does exist, of course, because people invest in information. The practical point of that article, and others on insurance and other contracts affected by uncertainty, is that information has value. Arrow’s implied suggestion that people will not invest in information about the performances of doctors and hospitals, as they do in other markets, is not to be believed. Nor are the other problems raised by Arrow beyond remedies by consumers and suppliers.

In addition to discouraging investment in the reduction of uncertainty, another unfortunate effect of some health-care proposals is the rejection of information through bureaucratic cost-benefit analyses. Only patients can know the value of their medical services (as with other services, however uncertain the outcomes), which is not realized unless their choices are based on the costs they bear. The high cost (to society) of medical care is due to a related problem: subsidies that cause excess demands which are paid for by third parties (taxpayers).

Markets are never ideal, but we should ask why the advocates of change prefer further departures from free-markets to the opposite. The case that medical care is less amenable than other markets to deregulations bringing it closer to the conditions of economic theory has not been made.

Economic analysis is rejected in the market for medical care, as in other markets, in favor of politically powerful interests who hope to benefit from regulations and subsidies. They should be grateful to Arrow and other economists of the second sort.


Akerlof, George. 1970. “The market for lemons: quality uncertainty and the market mechanism," Quarterly J. Economics.

Arrow, Kenneth. 1963. “Uncertainty and the welfare economics of medical care,” American Economic Rev.

_____ and Frank Hahn. 1971. General Competitive Analysis. Holden-Day.

Demsetz, Harold. 1969. “Information and efficiency: another viewpoint,” J. Law and Economics.

Phelps, Charles. 2003. Health Economics, 3rd ed. Addison-Wesley.


Thursday, November 12, 2009

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

8. Monetary Policy as Credit Control

Let me end my talk [in honor of Milton Friedman’s 90th birthday] by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna [Schwartz]: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Ben Bernanke, University of Chicago, Nov. 8, 1992.

In fact the Federal Reserve has learned nothing, and is doing it again, it being the substitution of controls for monetary policy.

Friedman and Schwartz argued that the Federal Reserve caused the Great Depression by allowing the money stock to fall 38% between 1929 and 1933, while the Hoover administration focused on bank reform (deposit insurance and banking structure in the Glass-Steagall Act, which separated commercial and investment banking) and the injection of capital into banks by means of the Reconstruction Finance Corporation. RFC officials used their authority as shareholders to reduce salaries of senior bank officials and force changes in bank management (Butkiewicz 2002). Friedman and Schwartz (1963, pp. 325-30) contended that these measures were ineffective, or worse, probably delaying recovery, which came only with the growth of the money supply (Romer 1992).

The following contemporary account of the RFC, which was expanded by the New Deal, is interesting:

The best banking walls of Wall Street did not fall down last week before the long trumpet-blasts of Jesse Jones [head of the RFC]. But most of them opened their postern gates and let Mr. Jones come in with the money he was determined to inject into them.

The National City was the only big bank last week to surrender completely. It the stockholders approve, it will let the RFC buy $50,000,000 of its preferred stock. Mr. Jones radiated assurance that the government would not make itself a nuisance at stockholders’ meetings. But the fact remained that the U.S. will become National City’s biggest stockholder – and if ever two preferred stock dividends should be omitted, the Government will have complete control.

Eight other New York banks were able to resist the RFC’s passion to become a stockholder because they were state institutions. They compromised by selling the RFC “capital notes.” Thus supersolvent Guaranty Trust, already vexed by having more money than it can profitably use, planned to let the Government lend it $20,000,000.

Having removed the curse of taking government aid, Mr. Jones could now proceed to make the Government a large, if not the largest stockholder … in perhaps one-quartet of all the country’s banks ….

National City planned to use its huge piece of government money to write down its common stock [and] surplus. “With the adoption of the plan,” Chairman Perkins informed his stockholders, “the assets of the bank will be carried at conservative values ….”

“Without disgrace,” Time, Dec. 18, 1933.

We might think that, given the opening quotation, Bernanke would have eschewed direct controls and the subsidization of specific institutions in favor of control of the aggregate money stock. But we would be wrong. He and his colleagues have done the opposite. The failed official strategy of the Great Depression has been repeated in the Fed’s lending to specific institutions, its focus on the risk and liquidity of particular markets, the Troubled Asset Relief Program, Asset Backed Commercial Paper, swap agreements, and other market interventions, as well as lobbying for more regulations of financial institutions of which it would be the principal administrator.

What about monetary policy? The easy money (negative real rates) of 2002-2005, followed by the tightening of 2006-2007, is reminiscent of the run-up to the Great Depression. In 1928-29, the Fed focused on credit control and the behavior of particular institutions, being slow both to raise interest rates in the face of rising demands, and lower rates in recession – just as in mid-2008, when the Fed suddenly became hawkish about inflation. The intensification of the recession began before the financial turmoil of September 2008. “In this recession, unlike the other recessions that followed the Depression [but like the Depression], commentators [like the Fed] have assigned causality to dysfunction in credit markets (Hetzel 2009).

A key to this similarity may be found in Bernanke’s view of the financial markets (in which he, like the Fed of 1929-33, has found plenty of support in official circles). His fame as an economist rests on his 1983 paper that stressed capital flows and the banking structure as contributors to the severity of the Great Depression. In particular, bank failures and the fall in bank loans joined the money stock as significant causes of the downturn. The recovery came with the turn-around in money (while bank loans remained weak), but Bernanke has never, despite his protestations, been shared the Friedman- Schwartz view of money’s importance, or of the economy in general. A key element of Friedman’s monetarist philosophy, as important as money, is its reliance on free market institutions. The government should (1) let them alone while (2) pursuing a stable monetary policy. Bernanke and the present Fed have done neither.


Ben Bernanke. “Nonmonetary effects of the financial crisis in the propagation of the Great Depression,” American Economic Rev., June 1983.

James Butkiewicz. “Reconstruction Finance Corporation,” EH.Net Encyclopedia, ed. Robert Whaples, July 19, 2002

Milton Friedman and Anna Schwartz. A Monetary History of the U.S., 1867-1960. Princeton Univ. Press, 1963.

Robert Hetzel. “Monetary policy in the 2008-2009 recession,” Federal Reserve Bank of Richmond Economic Quarterly, Spring 2009.

Christina Romer. “What ended the Great Depression?” J. Economic History, Dec. 1992.


Thursday, November 5, 2009

Henny-Penny and friends, whose careers were ended abruptly.

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

7. We’ve got to do something

We need to compare the cost of this package against the cost of doing nothing. The cost of doing nothing would be catastrophic!

Wisconsin Congressman David Obey.

We can’t afford to wait. We have to act. Presidential spokesman Robert Gibbs.

“I do try to put a lot of weight on what people are saying,” Watt said, referring to the overwhelming opposition of his constituents. “But in this case, I think a lot of people don’t know exactly why a bailout is necessary… On this issue, we have heard the top two economic authorities in the world tell us we’re on the verge of a calamitous event.”

North Carolina Congressman Mel Watt.

Were the massive government responses to the economic downturn in the interests of the public, i.e., for recovery, or simply political, i.e., to assure voters that government was not unresponsive; there would not be a repeat of the do-nothing Hoover administration, as it has erroneously come down in history.

We know the futility of the former. A small part of the so-called stimulus packages was directed to the short term, and that part (such as temporary tax breaks) was known to be ineffective (see this blob for September 23 and 29). The best we can hope for is that they will do little harm, that they will, as George Selgin suggests, be like Granny’s cure for the common cold: work in a week to ten days (The Beverly Hillbillies). (It now looks like we’re out of the recession after 6 quarters – IV/2007 to II/2009 – with a fall in real GDP of 2.8%; compared with the most similar post-WWII recession of 3.2% in 5 quarters, IV/1973 to I/1975. Government either shortened or lengthened the recession, depending on your point of view.)

History suggests that the political motive is also futile. Polls, letters to Congress, and the Tea Parties on tax day (April 15) indicated that many, probably most, Americans opposed the government’s actions. More important to those who will run for reelection, votes have depended not on good intentions but on actual economic conditions (Fair 2009). As the lawyer played by James Mason in The Verdict said to his young assistant: “You’re not paid to do your best. You’re paid to win.” Government actions during recessions have varied from highly (e.g., Hoover) to not very (e.g., Carter and G.H.W. Bush) active (see Hoover 1940, 97-119; Wood 2005, 204-11; Carter 1995, 541; Keech 1995, 69-70). Much more constant, at least since Martin Van Buren, has been the failure of reelection attempts during recessions, whatever the efforts to forestall them, notably in the 20th century, Hoover, Carter, and G.H.W. Bush. The 1990-91 recession had officially ended, but unemployment continued. “It’s the economy, stupid,” was Clinton’s successful slogan in 1992.

The lesson is that mindless action is politically futile – at best: spending loses votes (Peltzman 1992).


Ray Fair. “Presidential and congressional vote-share equations, "American J. Political Science, Jan 2009.

Jimmy Carter. Keeping Faith. Memoirs of a President. Univ. of Arkansas Press, 1995.

Herbert Hoover. Memoirs: The Great Depression, 1929-41. Macmillan, 1952.

William Keech. Economic Politics. The Costs of Democracy. Cambridge Univ. Press, 1995.

Sam Peltzman. “Voters as fiscal conservatives,” Quarterly J. Economics, May 1992.

George Selgin. “Did Bernanke save us from another Great Depression?” Christian Science Monitor, Sept. 17, 2009.

John Wood. A History of Central Banking in Great Britain and the United States. Cambridge Univ. Press, 2005.