Why are stock prices related to company performance?

Like electricity or semiconductors, the stock market remains a mysterious invention of the modern world, something that few of us understand entirely even though we depend upon it everyday.

I hadn't given the stock market much thought myself until I watched Niall Ferguson's excellent documentary The Ascent of Money (available to watch free online here), which shows how some of the most pivotal moments in history (the victory of the North in the Civil War, the coups of Latin America, the defeat of Napoleon) had important financial backstories to them.

This sparked my curiosity to really get a grasp of what the stock market is about. Not just that layman's wisdom of "buy low, sell high," but to really understand why the stock market exists, the value that it contributes to society, and the fundamental forces that drive stock market prices (the first and second points have gotten rather lost lately, so much so that Robert Shiller has had to write a book defending the idea that finance is useful and good).

I found the answer to most of my questions in this really good guide by HowStuffWorks.com, which walks the reader through IPOs, stock exchanges, incorporation, brokers, and the like.

But there was one question I had that I couldn't seem to find an answer for anywhere: why does the stock price have anything to do with company performance?

Often the lay explanation of how the stock market works is trapped in a circular logic. You buy stock, the thinking goes, to sell it to someone else for a higher price. But then that person, thinking the same thing, wants to sell it to someone else for an even higher price. Neither person in this scenario is thinking of profiting from the company per se. But surely it can't be that the only value of a stock is to unload it onto someone else later. So is there any value in holding on to the stock? Does the stock have any value on its own, even when most modern companies do not return profits to its shareholders?

The answer is, of course, yes. I owe (what I think to be) my understanding of the answer to the discussion at this forum, whose contributors seem to be pretty well informed. I haven't seen any discussion of this question hardly anywhere, let alone an answer, so I'm sharing it here, in case others are also curious.

But before we begin this explanation, it's worth taking a step back and establishing the mechanics of the simplist kind of stock, dividend-paying stocks. This detour will be useful to those with less background in the stock market, and will help me cement my new-found knowledge. If you already know this stuff, you can skip down to the next section.

Beginner's Detour

Although the modern stock market is incredibly complex, the earliest system of stocks was rather straightforward. The stock market was invented for two reasons: to raise money for the company, and to spread risk. The Dutch East India Company, widely regarded as the first company to issue public stock, was in great need of both of these benefits. Its voyages to the Orient were not only very expensive, but also very risky and dangerous. Without the stock market, the company would have to borrow at interest, which would have been a bad move given that the outcome of its expeditions was so uncertain. Stocks offered an ingenious way around this problem by spreading risk (and reward) amongs many, many private owners. And people gladly offered up their money, anticipating the massive profits that the company would soon earn.

In the Dutch East India Company, shares entitled their holder to two rights—a portion of the annual profits, and the right to cast a vote in company decisions. Modern stocks are much more complex (by, among other things, dividing stocks into different "classes," which entitle their owners to varying degrees of benefits). But even still, these two rights are the principal benefits that shareholders can expect. 

When shareholders receieve a portion of the profits (called dividends), as in the case of the Dutch East India Company, it is clear why trading is based on company performance. The more profits the company reaps, the larger the dividends will be, and the return will be.

Some people who did not get a chance to buy a stock in the company when they were first being sold wanted to get into the action later; and others who bought the stock wanted to get rid of it. Thus a stock market was born. Note that none of the money trading hands in the stock market went to the Company. It was strictly private agreements who were trading commodities, like people buying baseball cards from each other.

Valuing the stock is a subjective calculation. The stock yields a stream of annual dividends, of an uncertain amount, for the lifetime of the company. As long as the present value of the stream of money is more than purchase price, then it's a good investment.

The idea of present value is of central importance to valuing stocks; stocks, like all investments, return money in the future, money in the future is worth less than money in the present.

This is because of interest rates. Suppose someone offers you $100 today or $100 next year. Suppose also that the generally prevailing interest rate is 5% (say in a savings account, or buying government bonds). Then if you take the $100 today and put it in the savings account you'll have $105 next year. So because you lose that year of not collecting interest, $100 in the future is worth less than $100 today. The present value of a future sum of money is the amount you would need to invest today to collect that sum of money at the future time. To collect $100 next year, one would need to invest $100 / 1.05 = $95.24 today. This is the present value of that money.

Here's a numerical example to show how this works with the Dutch East India Company. Suppose you buy the stock for $30. Suppose the interest rate is 2% and suppose that these are your annual returns for the stock.

Year 1: $20                            Present Value: $19.60
Year 2: $15                            Present Value: $14.42
Year 3: $25                            Present Value: $18.85

Total Present Value over 3 years: $52.87

So the stock pays for itself, even though each year the return is less than the purchase price of the stock.

However, just knowing that you get a return on the stock is not enough. The question you should ask on an investment is not whether you'll get a return at all, but whether you'll get more return here than you would collecting interest on safe investments (i.e. U.S. government bonds, the standard that modern markets use). It only makes sense to take on the additional risk of buying stock if there is potential for making more money. This is why interest rates are so important.

This Dutch East India type stock—the kind that returns dividends—is the simplest kind of stock. But even if we have just a couple dozen companies with this kind of stock, we already have a pretty robust stock market. Some stocks may give small but steady returns; others may be more volatile; a start-up may just be taking off that in the future will return vast sums of money; and the uncertainty around predicting how companies will do at the end of the year will lead to tons of buying and selling. When there are more buyers than sellers of a particular stock, that stock price goes up. When there are more sellers than buyers, the stock price goes down.

Non-dividend paying bonds

Most public companies, as I noted earlier, don't pay dividends to their shareholders. So why do shareholders care about company performance?

The crucial point is that all companies will eventually pay dividends. Paying dividends is the default option. The reason that companies don't pay dividends is because they believe they can generate a larger return for their shareholders by expanding the company than the shareholders could if they took their dividend and invested it themselves. But no company can grow forever (at the very least, scale problems will get in the way). As the company starts to reach its growth limit, it will run out of profitable uses of the money. At this point, the profits will come back to the shareholders, and when this moment comes the profits will be enormous (relative to the company's starting point).

This kind of stock, you'll notice, is different. When you buy this stock, you don't get anything in the short run. But eventually, say after 10 years, when this company does start issuing dividends, it's dividends will be gigantic. So even though you don't get anything for a while, it's worth buying. In the meantime, people buy and sell depending on how much they think the company will eventually be worth.

It's not an automatic process by which the company starts to issue dividends. The company may resist returning profits to its shareholders (e.g. see Apple). But once the shareholders feel that the company doesn't need the money for investment, or can't invest it better than the going interest rates, then they'll start calling for dividends, and vote for such measures at shareholder meetings.

Even if stocks never paid dividends, they would still have some value, because of a stock's ownership power. If someone amasses a controlling stake in a company (usually 51% of stocks), then they can decide how the company will be run. This power, in turn, allows someone to make a lot of money. Take an extreme example: suppose you have a company with $1 billion worth of assets, and 3 stocks, each trading at $1 each. I buy two of the stocks for $2. Then I can go and sell off the company's assets—their buildings and machines and land and other property—and pocket all the cash. This way of making money is called "corporate raiding," and is generally frowned upon. But it's another way the performance of the firm is reflected in its share price.

What I have described is the underlying fundamental forces that move the stock market. Everything else is just people trying to game the system. The layman's understanding of the stock market is based on this gaming of the system—taking advantage of people's expectations, betting on what other people think will happen, or even betting on what other people think other people will think will happen.

But this isn't what the stock market is about. The stock market is about financing companies that will be profitable, and wanting to partake in company profits and ownership. Everything else is, I think, secondary.

Some Confirmation That I'm Not Crazy

In the seventh grade, after learning that I wasn't the first one to figure out that (a + b)² = a² + b² + 2ab, I was convinced that I would never have a novel idea in my life. At the time, this was a sad thought, because I wanted to be original, and make discoveries. But since I began writing this blog, I've enjoyed finding some of my thoughts in other places. Here's a metaphor to explain why:

When I sit down to write my blog, sometimes I feel like the commander of a small space vessel, zooming through vast galaxies of ideas.

Most of my journey passes in solitude—just me (and what appear to be) parsecs and parsecs of uncharted territory. The world of ideas seems so vast. At first, because of the thrill of discovery, I preferred the emptiness. But after a while I started to wonder whether I was just lost. So when I happen to chance upon another traveler, out in the reaches of a distant nebula (where I imagine some of my ideas tend to lie), I find welcome confirmation that really I'm not as lost as I thought.

Regular readers of the blog will know that a little under a year ago I wrote a blog post entitled "Why Profit Doesn't Work in the Media Business," which tried to link the blatant biases in today's journalism with the fundamental economic structure of the business. The idea was that profit, which is supposed to encourage firms to do the socially optimal thing, actually skews their incentives away from it (where in this case the social optimum was a perfectly informed and unbiased electorate).

When I wrote this blog post, I felt I was the only economist arguing that markets may make the news industry more biased. After all, Ronald Coase (1974), Timothy Besley and Robin Burgess (2002), Besley and Prat (2002), Djankov et al. (2003), David Stromberg (2001), and Alexander Dyck and Luigi Zingales (2002) have all advance arguments for why increased competition in the media should result in greater accuracy.

But it turns out I actually wasn't alone. In a working paper called "The Market for News," Harvard economists Sendhil Mullainathan and Andrei Shleifer (M & S) agree that market competition doesn't give us a fair and balanced news media, though their argument is much more detailed.

In my blog post, I developed had two separate explanations for why competition didn't lead to unbiased news, depending on whether consumers of news were either witlessly or willfully misinformed. In the first case, I argued that consumers get biased news because they don't know it's biased. This was more of a power-elite type explanation, which assumed that the owners of the media had certain political reasons for advancing bias, which consumers weren't savvy enough to figure out. Consumers in the media industry today, I said, may be like consumers going to grocery stores before the advent of health standards, not knowing whether the meat was tainted or not.

My argument in the second case was much more straightforward. Basically (if I'm to tease the empirical argument out of the highly normative argument I was making), I said that biased news was a particular kind of product that news media could sell, and that if demand was sufficiently high companies would provide it. This seemed intuitive enough, but I didn't have any model of how that worked.

That's where M & S's paper comes in. M & S propose a simple model of how firms bias their news by essentially constructing a variant of a Hotelling model. In a Hotelling model, customers are distributed over some space, and firms position themselves in the space so as to "catch" as many of them as possible. In this case, the relevant space is ideology. Firms compete by announcing their "slanting strategy" and the price for their product, and customers choose the news source that most aligns with their bias, for the lowest price.

In M & S's framework the way competition leads to bias is that it causes firms to segment the market. To avoid competing for the same customers, firms find it optimal to maximally distance themselves from their competitors. Practically, this means separating themselves ideologically as much as possible—even if that means taking more extreme positions than even their most biased readers. The average reader will find, then, more and more extreme positions (a.k.a. bias) in the news after competition.

This model helps explain the perception that the media has become increasingly biased in recent years. Since the entrance of competitors in the market increases bias, one important contributing factor could be that

changes in media technology have lead to significant entry, especially in television. If these media sources divide the market along ideological lines, we expect them to become more biased than they were in the regime of moderate competition.

Unfortunately, the model also suggests that news bias is very difficult to remove. No firm would find it advantageous to become less biased; but even if one firm credibly committed to ending bias, the other firm would still gain more profits by choosing to bias. This is more or less the conclusion I reached, and why I argued that the only way to reduce bias was for firms to commit do so based on moral or ethical reasons.

Why does no one like free trade?

Most states engage in protectionism, and lots of it. Brazil, for example, just put up a significant tariff against Chinese imports, amidst fears of de-industrialization. And Obama, in his State of the Union, signaled that the U.S. isn't about to let its manufacturing jobs go either. 

The properly schooled free-trading economist is supposed to dismiss all these efforts as "politics" (or so I've been told); and sigh that their advice is once again ignored. But I think it's telling that time and time again, when push comes to shove, most governments are not willing to embrace free trade, even though almost all economic theory shows that the benefits of free trade clearly outweigh the costs in the aggregate and in the long run. Such a consistent pattern begs an explanation.

Whether a country pursues free trade policies or not depends on how it balances the resulting costs and benefits. Clearly, the people who bear the costs and benefits are often different—and this is dilemma that the political economy literature has seized upon to explain opposition to free trade. The way the explanation goes is that because the winners and the losers are different people, and particularly because the benefits are small and dispersed across the population, while the costs are concentrated for small sectors of the economy, politicians find it more expedient to cater to the losers (who put up an effective lobby, since they have much at stake) rather than to the winners (who only stand to gain a little at the margin, and so won't notice if they lose their gain from trade). So free trade is blocked.

This is a powerful explanation, and goes a long way towards explaining a lot of the resistance to free trade. But it makes it seem as if opposition to free trade is inevitable.

Here's an alternative explanation that gives some clear conditions for when individuals will choose to support free trade. It relies on turning the focus away from the distribution of costs and benefits across different individuals, and instead to the costs and benefits over time.

The costs of free trade are most often immediate: lost jobs, industries, careers, and livelihoods. The benefits—economic growth, cheaper and higher quality stuff—come much later. Economists know well that people discount future benefits—that is, people value future costs and benefits less than those in the present. So if the discount factor is large enough, the benefits may come too far in the future to offset present losses.

To illustrate the effect that discounting can have, consider the following numerical example. Suppose a voter is deciding whether to support free trade or not. If she supports it, she'll face a stream of costs and benefits. Denote them by  and . If she doesn't support it, then (in her mind) nothing changes and the net cost/benefit is zero. So it follows that if her valuation of the benefits is greater than her valuation of the costs, then she will support free trade.

Note that this is different than asking whether the benefits are greater than the costs for that individual. This question is given by:

  

whereas the inequality that the voter checks is instead the following:

where    is the discount rate. These sums can produce substantially different values. For example, the following seems to me to be a reasonable graph of the costs and benefits of trade over time.

The costs start very high, but fade quickly. The benefits increase significantly over time. I have set the cost and benefit values so that the sum of the benefits is approximately 3 times the sum of the costs (43 to 16). That, in itself, seems to be a strong argument in favor of free trade. But given a reasonable discount rate of 0.9, the present value of the benefit stream is only 9.5, compared to 15 for the costs! Rationality demands that the voter vote against free trade.

Within this framework, how would we get the individual to support free trade? There are three clear options:

1. Mitigate costs in the present.
   Since the initial impact has such a strong effect, even small reductions in the initial cost can significantly alter the cost-benefit calculus.


2. Accelerate the arrival of the benefits.
   The sooner they arrive, the more they are worth.


3. Allow people the wherewithal be more patient.
   The easier it is for people to wait for future benefits, the more willing they will be to do so

These general principles, in turn, recommend specific policy prescriptions. Mitigating costs in the present often takes the form of a social safety net: unemployment insurance, compensation funds to those who lose their jobs, and the like. Accelerating the arrival of the benefits can mean something like including provisions in free trade agreements to require foreign investment to begin immediately. And a policy that would allow people to be more patient could include setting up a robust and ready job retraining program so that people know they have future benefits to look forward to. [Incidentally, ideology, control, and repression are also ways to make people more patient and more willing to support free trade, and unfortunately this is the way many countries (particularly in Latin America) have gone about it.]

Often I hear economists say that people oppose free trade because they are misguided, or stubborn, or selfish. But my point here is that people may oppose free trade, even if they know full well its implications, simply because the timing of the costs and benefits are unfavorable. The timing of some of those costs and benefits can't be changed—but a lot of them can, and that means there is a lot of scope for policy to shift the politics of free trade. Focusing on concrete policy steps to alter the cost / benefit calculus are likely to go much farther towards increasing trade than the 300 years of sermonizing that economists have been doing.

Competition Inflation

In some places in the U.S., especially on the coasts, the competition in schools is absolutely insane. In Manhattan, for example, moms are enrolling their toddlers in gifted kindergarten test prep classes, in hopes that their child will make it into the "best" kindergartens in the city. In Southern California, it's common that kids will make hour-long commutes every day to attend the gifted magnet school, or will start studying for the SAT their freshman year, or hire private counselors to help them craft the perfect college application. All of this is a far cry from life in Arizona, where, for the most part, pretty much no one bothers with any of that.

All this extra competition, though highly stressful, might be worth it if it produced brighter, more able, students. But in my experience that doesn't happen. Students from the coasts aren't, on average, any smarter than those from other parts of the country. Even the brightest students from the coast are no brighter than the brightest from Arizona, or any other laid-back state. They've just done a lot more work. So ultimately all this extra work seems to amount to a tax on students with ambition in highly competitive environments. Society doesn't gain, and these kids are certainly made worse off.

Why, then, does it continue? And what accounts for the discrepancy in competition between places like Arizona and places like New York, or California?

Asking these questions has led me to a fascinating synthesis between monetary and labor economics. The idea is this: labor markets, like the macro-economy in general, can also suffer from inflation. And some of the insights about inflation that we've learned from monetary economics apply to this labor version of inflation, or what I'll call "competition inflation."

In this analogy, we can think of the jobs, positions, fellowships, etc. (i.e. the total available number of positions to which we can allocate people), multiplied by its prestige factor, as representing the "real output" of the labor market. To illustrate, suppose the labor market wealth is 100. This sum could be achieved either through 100 jobs with a prestige factor of 1, or 5 jobs with a prestige factor of 20. But by this metric, in both cases the labor market has the same level of output.

One's resume is the price one pays for a position. The more prestigious the position, the more it costs, i.e. the better the resume has to be. Like money, resumes have relative, and not absolute, purchasing power; to get a good position, not only does your resume have to be good, but it has to be better than everyone else who applies for the position. This makes resumes like a nominal asset, a kind of currency in the labor economy.

Regular inflation, you'll recall, occurs when the money supply increases faster than the total value of goods and services in the economy. Similarly, competition inflation—or the phenomenon of an escalating resume-price to achieve any given position—occurs when more people have good resumes than there are positions in the labor market to support them (i.e. to draw a more complete analogy, when people's resume holdings outstrip real labor market wealth).

One direct implication of this formulation is that competition inflation isn't inevitable: as long as labor market output increases with the rate of resume improvement, then inflation should stay close to zero. Labor market output is a function of prestige, and job availability. Clearly, if there were an expanding number of prestigious positions to go around, then inflation would be low. But inflation could also be kept low if the number of not-so-prestigious positions expanded at a fast enough rate as well. The reason is that the more plentiful and easily available not-so-prestigious positions become, the less and less motivated people will be to put in the effort for the prestigious positions. That will, in turn, slow the rise of ridiculously lavished resumes.

(We can think of each person as having a tipping point at which they abandon striving for a prestigious position and settle for less, depending on the relative availability of jobs. That tipping point will be radically different for different people. Some people will only work for the prestigious job if there are no other jobs available, and some people will never work in a less-than-prestigious job; most people will fall somewhere in between. Incidentally, this tipping point may be a way of assessing people's subjective prestige valuations.)

Like regular inflation, competition inflation is something that occurs naturally from generation to generation. Baby boom Ivy Leaguers "love to talk about how they would have been turned down by the schools they attended if they were applying today," perhaps in the same way they talk about 25 cent comic books [source]. Since their time, there has in fact been several "devaluations" of the resume. Test scores used to be enough to get into a good college. But when there were too many kids with perfect test scores, admissions officers started looking to extracurriculars, and touting the benefits of the "well-rounded" students. Now they're seeing so many "well-rounded" students that the new fad is "pointy-ness"—being well-rounded plus having some achievement spike in a particular area. No doubt, within ten years the standards will shift again. Each time this shift happens, someone who builds his resume according to the old model will find that their achievements no longer mean as much.

In general, a modest amount of inflation is a good thing, and the same holds true here: as the economy becomes more complex, and as modern jobs require more and more skills, it's a good thing that our institutions push people to become more skilled. The problems come with hyperinflation, as is the case on the coasts. When resume-building ceases to represent any greater skill or talent acquisition, people start to lose faith in the currency. Employers become more skeptical, and students begin to think of the competitive process as arbitrary, or unfair, or meaningless. Having a good resume loses its respect. (Note, for example, the tone of this NYT piece).

In the face of high inflation, people switch to more durable assets. In the labor market, those durable assets are relationships, and networks. When everybody speaks three languages, and has volunteered in orphanages in Peru, employers need some way to make a decision, so professional networks do the work that resumes used to do. In highly competitive environments, then, networking becomes essential, and those people who are highly capable but without contacts lose out the most.

With inflation, there are always winners and losers. The losers are everyone in training, the young and the inexperienced. The winners are the people who already have jobs, i.e. the people who have cashed out their resumes. Someone who starts working may find that twenty years later the average resume required to achieve the same position has increased substantially. In that case, the person has experienced a capital gain; when they leave their job, they will have a job experience more valuable than what they paid for.

With this framework, we can explain some generally puzzling phenomena. For example, we see that competition inflation is most intense at the high school level, but peters out post-college, and is virtually zero for the most demanding positions. (The President's resume has remained about equally impressive on average throughout our country's 200+ years.) The reason for this is that early in our career, the relevant labor market that we face is more closed and restricted. High school students compete only within their city for the prestige positions, which they need in order to get recognized by colleges. But if the city happens to be a hotspot of ambition (because, say, all the kids' parents are investment bankers, or highly successful government officials), then the same ambitious kids will be competing against themselves—and so the resume price will be bid up. After college, however, students compete nationally, and internationally, for jobs. That spreads the ambition around and helps keep competition inflation more stable. Imagine, for example, if Harvard kids were only allowed to get jobs in Boston: competition inflation would be through the roof!

Of course, the major, elephant-in-the-room difference between monetary and competition inflation is that the latter has no central authority that issues currency from the outside: there is no Federal Reserve of Resumes. Instead, resume creation is a highly decentralized process that depends mostly on people's ambitions. However, there are several smaller authorities that set resume standards. For example, ETS, the company that administers the SAT, could increase the value of a perfect score by making the test harder. At an extreme, passing high school (or university) could be made a very difficult, demanding task. These measures would be equivalent to cutting the supply of currency in the labor market, and would curb inflationary pressures. But this solution would be very temporary. Soon enough, there will be enough people mastering the new standard that it will have to be set higher still. (There's also a question of what would happen to the kids who DGAF, and will just stop trying when the standards are raised. It's a question I'll have to explore some other time.)

Is there any resolution to the problem? Ultimately, it seems that controlling resume creation will have no long term effects, since there are enough ambitious kids willing to do whatever it takes. That means the only option is to expand the number of positions available—we need more places for these ambitious high school kids to go. But that won't happen unless there is some miraculous boom in job-creation in this country, or a number of good universities suddenly open up, or ambitious students suddenly gain another route to prestigious position besides college. None of these seems particularly likely.

Update (October 7, 2011):  One important implication of this framework, which I didn't mention earlier, is the presence of an inflation tax. In the normal economy, inflation works like a tax. Suppose the government needs to spend an extra $100 million dollars. Then it can raise that money either by collecting it in taxes, or by just printing it. The latter spares the government the hassle of dealing with angry taxpayers, and makes everyone feel richer, but it still costs them in the end: by printing enough money, the government makes each dollar have less purchasing power, which in effect takes a cut of real wealth away from people proportional to the amount of money they hold.

The labor-resume economy has the same phenomenon. Suppose that the government wants to boost the employment opportunities that people enjoy. It can do so by making it easier to graduate high school and college. In the short run, people will find better jobs. But in the long run, if graduation becomes too easy, the value of the degree will just become worth less, and you end up with situations like this:

“I was in a taxicab a couple days ago, and this is a story that really exemplifies how the economy is changing.  Over the two-way radio, the dispatcher’s voice comes, and he says, ‘Gentlemen, I’m looking for someone to pick up one extra shift on the night shift, a new taxicab driver.  If you know someone, they need to have experience.  And I also need a college education.’  And I thought to myself, ‘If you need a college education to drive a cab in this country, what job don’t you need to have a college education for?’" [from this Freakonomics podcast]

Update (October 13, 2011): Caveat: Thinking of a resume as currency only makes sense when we think of it as a homogeneous product. In actuality, though, what happens is that experience that some employers value applicants experience differently, depending on how it matches with the skills necessary for the job for which they are applying (e.g. as an extreme example, having 10 years of solid experience in engineering will not help you get a Broadway gig).

There are some ways to work around this. For one, we could focus on just (near) universally valued qualifications, like college graduation. Alternatively, we could focus on what happens within specific industries, where all applicants are competing on the same resume, and where it is easier to make apples-to-apples comparisons on qualifications. Either of these would do the trick to preserve the integrity of the analysis.

As one of my professors pointed out, models aren't meant to explain everything at once. So naturally this one can't either.

Update #3 (October 15, 2011): More evidence for my thesis, from this NYT article:

Moulshri Mohan was an excellent student at one of the top private high schools in New Delhi. When she applied to colleges, she received scholarship offers of $20,000 from Dartmouth and $15,000 from Smith. Her pile of acceptance letters would have made any ambitious teenager smile: Cornell, Bryn Mawr, Duke, Wesleyan, Barnard and the University of Virginia.

But because of her 93.5 percent cumulative score on her final high school examinations, which are the sole criteria for admission to most colleges here, Ms. Mohan was rejected by the top colleges at Delhi University, better known as D.U., her family’s first choice and one of India’s top schools.

Ms. Mohan, 18, is now one of a surging number of Indian students attending American colleges and universities, as competition in India has grown formidable, even for the best students. With about half of India’s 1.2 billion people under the age of 25, and with the ranks of the middle class swelling, the country’s handful of highly selective universities are overwhelmed.

This summer, Delhi University issued cutoff scores at its top colleges that reached a near-impossible 100 percent in some cases. The Indian Institutes of Technology, which are spread across the country, have an acceptance rate of less than 2 percent — and that is only from a pool of roughly 500,000 who qualify to take the entrance exam, a feat that requires two years of specialized coaching after school.

The problem is clear,” said Kapil Sibal, the government minister overseeing education in India, who studied law at Harvard. “There is a demand and supply issue. You don’t have enough quality institutions, and there are enough quality young people who want to go to only quality institutions.”

Economics as Medicine

Over the past couple decades, the field of economics has grown enormously. It has invaded its neighboring fields (like political science, and psychology), taken over their journals, and converted their students. However, it's a pity that the transfer of knowledge has been mostly one way. Economics could stand to gain some insights from other disciplines.

I'm particularly struck by the similarity between economics and medicine. At first it seems like an odd connection, but after a minute it seems completely natural. After all, the economy, like individuals, has health. Turn on the TV at any point of the 24 hour news cycle these days and you'll see at least eight different people discussing it. Especially now that the economy is doing poorly, these commentators are like doctors huddled around a patient with a stubborn disease, debating the cause and various prescriptions. In the case of the economy, the names of the diseases are inflation, or high unemployment, and the prescriptions are called tax cuts, stimulus packages, or deficit reduction.

I got the idea to think of economics as medicine from Jeffrey Sachs. As Professor Sachs was making a career out of advising crisis-ridden developing countries, he noticed how many of the skills he needed in his work aligned with those that his wife Sonia needed in her medical practice. Based on these experiences, which he details in his book The End of Poverty, he calls for a new kind of economics, which he calls "clinical economics," that "underscores the similarities between good development economics and good clinical medicine." There are a number of ways, he says, that [development] economics can learn from medicine. Here's his list:

1. The economy is a complex system, and complex systems require differential diagnosis. Doctors don't treat all symptoms the same way; they try to find the underlying cause. Economists, says Sachs, should do the same.
2. All medicine is family medicine. A country's economic situation depends on its history, and its international context. As Sachs puts it, "it's not enough to tell Ghana to get its act together if Ghana faces trade barriers in international markets....if Ghana is burdened by an unpayable mountain of debt....if Ghana requires urgent investments in basic infrastructure as a precondition for attracting new investors...and if Ghana is burdened by refugee movements and disorders emanating from neighboring countries."
3. Monitoring and evaluation are essential. Here takes a stab at the (now outdated) IMF and World Bank practice of judging a country's progress by policy inputs and not outputs. If it's told to cut the deficit, then it's judged by whether it follows through, and not whether this results in any solutions to their problems.
4. Medicine is a profession, and as a profession requires strong norms, ethics, and codes of conduct. Development workers need to take their work as seriously as doctors take theirs.

Excited by the prospects of this idea, I wanted to see how far I could push the analogy. In addition to the parallels that Professor Sachs pointed out, I found these ones as well:

1. Both disciplines have to find a way to make decisions in the face of vast uncertainty and bewildering complexity. In the case of medicine, the root of uncertainty is that the scale of the action is too microscopic for doctors to directly observe; but in the case of economics, it's because the scale is too big. Hence the reason why doctors and economists rely heavily on (statistical) data to figure out what's going on; the sense data (seeing, hearing, etc.) are just not available.
   
2. Both disciplines are fundamentally concerned with the well-being of people. For people to be able to live their lives, they not only need to be physically healthy, but the economy which sustains them also has to be healthy.
   
3. Both disciplines carry high stakes. In medicine, the stakes are life and death. In economics as well, the stakes can be just as severe. Poor economic policy can result in severe depressions, mass poverty, famines (even when food is plenty), and political instability.
   

Sachs' conclusion, and mine as well, is that in all the important ways, the economist's job is essentially the society-level analogue to that of the doctor, or the medical researcher. That is, even though the content of the questions economists and doctors ask are different, and even though the techniques divergely widely, and despite the myriad other differences that mark the two professions as distinct, there's a fundamental common pursuit for well-being that binds them together.

To some extent, the transfer of knowledge from medicine to economics has already begun. Esther Duflo and Abhijit Banerjee have won a lot of fame for their work at using randomized control trials to assess the impact of various development policies. In talking about how they developed these techniques, Duflo and Banerjee cite medicine as their direct source of inspiration. The world of medicine before randomized trials gave us reliable information was dangerous. We hear tales of medieval doctors performing procedures (like leeching) or prescribing drugs without really knowing whether they worked; sometimes the patient's condition would improve, and sometimes not, and recovery seemed to depend more on random chance than anything else. This world seems so long past—but that's pretty much the state where we find modern economics. Economists prescribe policies based on their best guesses, but sometimes they work and sometimes they don't. Randomized field trials finally give us a chance of knowing what works.

But Duflo & Banjerjee's randomized control trials are just the tip of the economics-medicine-interaction iceberg. Just sitting in my chair right now I was able to come up with this intriguing list of research topics:

• The first dictum of medicine is "Do no harm." Should that not be the starting point for economic policy as well? (This seems particularly applicable to the IMF and the World Bank when they advise developing countries.)
• In medicine, a very related concept to randomized control trials is the placebo effect. What if something like that exists in economic policy—which is to say, what if some policies fix recessions, or solve prisoner's dilemmas, or promote cooperation (all classic economic problems) simply because enough people believe they will work. Will Wilkinson, my favorite blogger on the web, gives a scenario of how that's possible.
• Our health, and in particular our weight, depends not just on the amount of food we eat, but also the quality of the food. Two thousand calories of junk food is very different than two thousand calories of a balanced diet. In the same way, we can't measure the performance of the economies just in terms of quantities: it matters not just how much GDP grows, or how much investment increases, or how much consumption increases, but also the kind of GDP, investment, and consumption growth that we see. Knowing that GDP increased 3% tells us very little about whether people are actually better off. (What fraction of the U.S.'s GDP growth in 2002-2008 came from housing and easy credit?). Similarly, as I discussed in an earlier post, not all kinds of consumer confidence (which is generally considered a good thing) are made equal.

Thinking about this connection between economics and medicine is really exciting. Not only do I see society, politics, the other disciplines in the social sciences all in a new light, but I'm also reminded of why I got into economics in the first place.

Economic Logic

Here an upset Michael Moore asks Milton Friedman a question that gets at the very heart of economic logic:

Milton Friedman's point is very subtle, but it's very powerful. Understanding it is fundamental to understanding the nature of human society.

Why Profit Doesn't Work in the Media Business [updated]

In one of my previous posts, I looked at the reasons why the profit incentive doesn't get us the informed, reasonable news coverage that we'd like. Recently, I tightened up the argument. Here's the revised version:

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"No one ever went broke underestimating the intelligence of the American people." -H. L. Mencken

Scholars around the country lament a national media that’s in decline. Neil Henry, Dean of the Berkeley Graduate School of Journalism talks of “erosions in content and traditional journalistic standards.” Kathleen Jamieson, director of the Anneburg Public Policy Center of the University of Pennsylvania, describes a university setting where “students raised on faux news will enter our classrooms cocooned in their own biases and conditioned to mistake ridicule for engaged contention.” And Rick Davis and Peter Stearns of George Mason University agree that “the replacement of serious news by sensationalist nonsense” is undermining legitimate democratic discussion. [link to source]

To add fuel to these critics’ fire, the executives at Fox News unapologetically defend the state of the news, and their networks’ coverage of it. When Roger Ailes, president of Fox News, appeared on a January 31, 2010 edition of ABC’s This Week, he was criticized for certain ethically dubious choices the network made. His response? “I’m not in politics. I’m in ratings. We’re winning” [link]. In the same vein, Bill Sammon, vice president of Fox News, recently admitted to fabricating facts on air: “At that time, I have to admit, that I went on TV on Fox News and publicly engaged in what I guess was some rather mischievous speculation about whether Barack Obama really advocated socialism, a premise that privately I found rather far-fetched” [link].

What’s so upsetting about these quotes is that they reveal a complete disregard for ethics in journalism. Clearly, Fox News executives’ eyes are all on the bottom line. Normally, these two goals—profit and ethics—should align: a company that mistreats its customers should eventually stop receiving business. But there are instances, like this one, where the mechanism clearly doesn’t work.

The basic defense of the profit incentive is that you're almost always likely to getter better results when you incentivize good behavior than when you force it. Profit supposedly sets up an incentive system that induces businesses to serve the public interest as much as possible. Ideally, businesses make profit when they produce goods or services that create a lot of value for people. Customers get what they want, and the business reaps the reward of going through all that effort. Everybody's happy.

But this system isn't foolproof. For it to work, at least a couple key things must happen. First, consumers need to be able to represent an effective check on business. If people generally can't tell when they're getting duped, or swindled, or cheated, or they have no alternatives (i.e. monopoly), then businesses can gain profits at the cost of the public. Second, the consumer’s individual interest can’t be opposed to a broader, collective interest. If individuals demand a good that’s harmful to everyone else, than supplying it can actually be welfare-reducing overall.

The problem with profit in the media business is that neither of these criteria is satisfied. For one, it’s very, very difficult for a well-intentioned layperson to stay informed. As David Foster Wallace puts it, grappling with the “Total Noise” means "dealing with massive, high-entropy amounts of info and ambiguity and conflict and flux… to really try to be informed and literate today is to feel stupid nearly all the time, and to need help" (q.v. "Host" in Consider the Lobster and Other Essays). In this light, news organizations have a moral obligation to help their fellow citizens make informed opinions and cast informed votes. Instead, what happens is that news organizations pose as guides through this media mess while simultaneously producing narratives of their own (Fox News is the best at this, which is why they’re “winning”). Since this strategy is successful, the profit incentive encourages news firms to pursue it; and average consumers of news, who may not realize the spin they’re being fed, also don’t realize that their news only contains half-truths, instead of the Truth that they were expecting. Unwittingly, they receive a defective product, like the Americans who ate tainted meat before health inspections were instituted.

In many cases, though, viewers know exactly what they’re getting out of their news. They like news that caters to their biases and preconceived notions about their world (a.k.a. “infotainment”) and news organizations profit by offering such programming. But is society really better off if everyone just decides which slanted version of the news she is going to watch? Clearly not. Biased news eviscerates reason, dialogue, and compromise—precisely the qualities necessary to have a healthy democracy—and replaces them with polarization, resentment, and suspicion. It’s impossible to come to a reasonable agreement when most people can’t even agree on the facts. So the profit incentive, though encouraging news organizations to satisfy individual preferences, also has the effect of allowing those news organizations to undermine the very democracy they are tasked with upholding.

Thus, the profit incentive is flawed—but it’s unlikely that a patchwork of changes in incentive structures will work either. The difference between legislating about, say, food quality (which has clear, objective measures) and journalism quality (which is hard to define, let alone capture systematically) means that regulation will likely be sidestepped by exploiting loopholes. Likewise, restructuring incentives, such as changing executive compensation packages or making quality reporting more attractive, can only get us so far. As long as most people prefer infotainment to real news, news companies will face a constant temptation to cater to their tastes.

In these kinds of situations, appealing to morality can solve a number of economic problems that external incentives can’t: morality drastically reduces monitoring costs by making people self-policing; and it, unlike most external pressures, tends to be self-reinforcing, since people, once convinced about the morality of certain behavior, generally do not to deviate from it. A sense of morality hasn’t always been absent from journalism. Don Hewitt recalls in his memoir that upon the launch of “60 Minutes” his producer came to him and told him to “make us proud.” “Which,” he says, “may well be the last time anyone ever said ‘make us proud’ to anyone else in television” [link]. We need to bring that sense of morality back.

The Limits to Meritocracy

In the wake of the financial crisis, income inequality has become a sexy topic again among economists. Following a host of notable commentators on the subject (including economists like Raghuram Rajan and Daron Acemoglu and a host of politicians), The Economist has chipped into the discussion with its own article.

The Economist article calls into question the perniciousness of income inequality in itself. It argues that policymakers would do better to focus on eliminating barriers that allow the "most pernicious, unfair sorts of income disparity" instead of focusing on redistribution. Their recommendation? Allow for increased competition and social mobility. "Governments need to keep their focus on pushing up the bottom and middle rather than dragging down the top." That means reducing trade barriers, investing in access to good education for everyone, and, at heart, promoting more competition and meritocracy.

I think they have the right idea in mind. There are definitely more fair and unfair types of inequality. But I have reservations about The Economist's embrace of meritocracy. If we follow the principles of meritocracy all the way to their logical conclusion, then we end up with a grim picture.

Pure meritocracy means, for example, that parents have no way of ensuring that their children will be as well off as they are. To properly judge who deserves to get better positions and opportunities, kids grow up constantly being evaluated and competing with each other. Tensions amongst parents and kids rise to a boiling point when success, or getting ahead, becomes a zero-sum game, where the success of my friend only implies one less opportunity for myself.

Competition is not only a benefit, as The Economist sees it, but also a cost. For some people, competition is a healthy motivator for them to develop their natural abilities. But for most people, it is a form of coercion to work harder than they wouldn't want to, for the sake of positions they otherwise wouldn't aspire to.

High social mobility (in itself a desirable thing) has the cost of intense competition. We already see an example of what that kind of intense competition would like in primary schools in New York City, where some parents are spending thousands of dollars on test prep sessions for their 4 year-olds in order to ensure that they make it into the city's gifted kindergarten program. When I saw an article about this in the New York Times, I was prompted to write a post about the paradoxical nature of a middle class that lives amongst plenty, but which acts as it were fighting for its very survival.

There are limits to how much meritocracy we're willing to tolerate. At some point, the burden of competition weighs down on the benefits of increased/equal opportunity. A world where people are heavily advantaged by their intellectual endowments is not really fairer than a world where people are heavily advantaged by their wealth endowments.

In the end, though, my point against The Economist is pretty weak: I agree with their main thrust, that we should remove people that systematically deny people opportunities. I just want to make sure that we're careful not to rush headstrong into meritocracy either.

Update (March 14, 2011):
John Rawls gives a much stronger argument against meritocracy in A Theory of Justice:

"[In meritocracy] there exists a marked disparity between the upper and lower classes in both means of life and the rights and privileges of organizational authority. The culture of the poorer strata is impoverished while that of the governing technocratic elite is securely based on the service of the national ends of power and wealth. Equality of opportunity means an equal chance to leave the less fortunate behind in the personal quest for influence and social position." (106-107, my emphasis)

So the complaint is not so much that meritocracy makes people work too hard, but that it punishes people for not being bright. This is why the competition that I stressed in the post is a problem: given the severe disparities in life chances that a pure meritocracy produces, one can't afford not to make it.

Understanding the economy from the bottom up

Anthropologists have developed a framework that I think would be instructive to economists. The Livelihoods Framework, as it is known, was developed by scholars of development to compare the development status of two unrelated groups. But I think it offers general insights on how economies work.

For the Livelihoods Framework, the fundamental unit of analysis is the household. Households are socially defined, and include just the nuclear family or a large network of relatives, blood-related or otherwise, depending on the culture.

Households control assets. These are the bundles of goods/abilities/talents/resources that households use in order to survive, and meet their livelihood goals. Because these resources used for the purpose of gaining access to other resources, they are known as varying forms of capital.

Anthropologists have identified around six main forms of capital:

• Natural capital: Resources/access that come from geography. This includes the land that a household owns, or access to river or forests.
• Physical capital: The structures and equipment that a household may own. This includes a house, machinery, and wells, for example.
• Human capital: The skills and abilities of the people in the household. This may be simply having access to labor, from the kids, or also the levels of education, street-smarts, or health that the members of the household may have.
• Social capital: The ability to mobilize social connections to procure resources. For example, a family in tough times may be able to lean on their relatives, or their friends.
• Economic capital: Financial resources. It refers to both the households' income stream, as well as the material assets it can sell in order to raise money.
• Political capital: The ability to procure resources through the political structure. Political capital takes the form of well-connectedness, or access to political institutions.

Households operate within a specific geographical, historical, political, economic and cultural context. This context determines the kinds and levels of assets available to households.

Livelihood strategies are the way in which households mix and match assets to meet their needs and goals. The household's set of available strategies is constrained by the processes and structures which govern the society. These are the rules, norms, and institutions that direct households to act in a certain way.

As a result of employing strategies, households face outcomes. These outcomes refer to the goals that households seek—health, education, financial stability, security, a sense of place. These are the true measures of a household's success.

The following is a standard graphic summarizing the Livelihoods Framework:

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What can economists learn from this model?

1. Economists should think of replacing the individual with the household as the fundamental unit of analysis.

Society is not just a collection of individuals trading and bargaining with each other. Rather, we are parceled into small, socialist blocs, called families, which govern and constrain our actions. Hayek also recognized the divide that exists between family life and social life:

...we must constantly adjust our lives, our thoughts and our emotions, in order to live simultaneously within different kinds of orders according to different rules. If we were to apply the unmodified, uncurbed rules (of caring intervention to do visible ‘good’) of the…small band or troop, or...our families…to the (extended order of cooperation through markets), as our instincts and sentimental yearnings often make us wish to do, we would destroy it. Yet if we were to always apply the (noncooperative) rules of the extended order to our more intimate groupings, we would crush them. (The Fatal Conceit, p 18; qtd. Vernon Smith's Nobel Lecture).

Thus the market isn't reducible down to the individual (nor, as Hayek argues, should it), as classic economic models assume. To be honest, I'm not sure whether this really makes a differences, since we can think of individuals in the market as representing the interests of the whole household, but I think it might, and it's worth exploring. Also, it's useful for us economists to ask ourselves why we are naturally averse to using market principles within families.

2. The assets that households hold are diverse.

I think we often think of money as the only way households can procure resources, but this model makes it clear that there are a number of other ways too. Economists should see the wealth of households in a more holistic light, and see beyond income flows. If, for example, a certain program increases household income, but decrease its natural capital, or its social capital, then we need to be able to recognize a potential net loss in wealth.

3. The importance of consumption is overstated.

This is an old refrain, but the model offers an alternative. Consumption is for the sake of fulfilling outcomes, and these outcomes should be the metrics we use to judge economic success. These other metrics aren't separate from the economy, but an integral part of it.

4. An economy is not only a distribution of resources, but also a distribution of livelihoods.

Economy is the way we live our lives. It's how we decide what careers we pursue, the places we live, the industries we establish, and the way we spend our leisure time. It's what we think our job is, not only in the market, but in life. These concepts are so fundamental to our being that we have a hard time adjusting to change. This is why economic changes are so difficult and, at times, heart-wrenching.

In The End of Poverty, Jeffrey Sachs talks about his role in advising the Russian government during the transformation from communist planning to markets. His description of the challenges that Russia faced really illustrate this point.

The transformation would be the hardest in modern history because the gap between where Russia was and where it needed to be—for domestic peace, stability and economic development--was as vast as imaginable...People were literally in the wrong places. They were in Siberia, living in large secret cities that had been created for military purposes. They were working in heavy industries utterly dependent on the massive use of oil and gas reserves, as if there was no limit to those resources....No economic policy could be massive enough to relocate people, factories, and assets in a matter of days or weeks or even a few years. (pgs. 134-135)

That's why when we craft economic policy, we need to be very careful and judicious. We're pulling the strings of peoples' livelihoods.

A Hypothesis on Poverty

I recently read a paper for class entitled "Destitution and the Poverty of its Politics—With Special Reference to South Asia" by Barbara Harriss-White. Harriss-White analyzes destitition, the state of the poorest of the poor, and finds that it encompasses three aspects: first, "having nothing"—that is, old-fashioned economic poverty, or lack of access and control over assets; second, "being nothing"—having no political rights, being marginalized and outcast; and lastly, "being wrong"—having the law work against you.

As an economist, I was used to thinking of extreme poverty in terms of the first aspect, material deprivation. But these latter two caught my eye. The paper made me realize that true destitution (far beyond ordinary relative poverty) is not just an economic process, but also a social and political one; that is, market processes alone aren't enough to drive people to destitution—it takes people actively excluding others for such a dire situation to exist. As Harriss-White puts it:

Destitution is a process in political economy. It is not simply that the technical requirements for labor processes require some kinds of bodies to be denied access [...] It is not simply that revenue for social sector spending is simultaneously squeezed, and thus eligibility for social protection by the state will need to be restricted (Russell and Malhotra, 2001). It is also that the exclusion of people from exploitation is culturally legitimated; society actively allows oppressive practice and, it is argued here, the state is often complicit in this process.

If she's right, if societies do truly actively allow and legitimate exclusion, then why do they do it? My hypothesis is that it is a culturally evolved way of dealing with overpopulation: societies that have exceeded their carrying capacity exclude groups of people to preserve scarce resources. If the carrying capacity can only support 70% of the population, the social norms evolve to exclude the other 30% from competition.

The people who engage in exclusion obviously do not think in those terms. They think of morality, or personal responsibility, or not having to deal with addicts, or the "unclean." But these tensions only manifest themselves and get worse when people are pressed. I suspect that as societies become wealthier, they become more willing to include formally marginalized peoples, simply because they can afford to; the pretexts formerly used to legitimize the exclusion lose support, lose importance, and slowly drop away.

[The biggest problem with the hypothesis is figuring out what "overpopulation" means. How do we distinguish between "overpopulated" societies and those that are merely very crowded? What standard of living does each person in the society "need"? By whose standards?]

What Makes the Dollar Special?

One of the most jarring things about America after returning from Argentina was seeing so many dollars bills everywhere. I remembered sitting in my Monetary Economics class at my university in Buenos Aires, listening to the professor drive home the point that Americans use the USD as local currency. They don't see anything special about it!, he exclaimed, wide-eyed and emphatic, as if it were an utterly preposterous idea.

And he's right, of course; we Americans look out and see the plurality of currencies and assume ours is just another member of the ranks.

Argentines, however, have an entirely different point of view. Argentina has what they call a "dual currency," which means that dollars are just as standard a medium of exchange as the Argentine peso. For example, most restaurants have a sign on the door that indicates the rate at which they exchange dollars and euros. Apartments are bought and sold in terms of dollars, not pesos, which means Argentines maintain dual accounts of pesos and dollars. I saw wealthy Brazilians vacationing in Patagonia with a stack of crisp $100 USD bills in their wallets, and I even saw Argentines with large sums of USD, even while they were traveling within their own country.

So then, what makes the dollar so special? Why does it hold such a privileged status in other parts of the world?

Most of all, because it is highly stable. Inflation is usually very low, America has never defaulted on a loan, the US Federal Reserve is highly disciplined.

That may sound incredibly boring, but it is enough to get an Argentine who's lived long enough teary-eyed. Just over the past 30-40 years alone, the Argentine monetary authorities have dropped about 13 zeros off the currency; prices were rising so fast during the hyperinflation of the 80s that grocery stores couldn't relabel their items fast enough; and in the 2001 economic crash the dollar exchange rate jumped from 1:1 to 4:1 overnight.

In response to such a high degree of instability, Argentines have sought refuge in the dollar. Highly durable goods, like apartments, are priced in dollars to protect against wild, transient fluctuations. During hyperinflation, even school kids as young as 10 had come to learn that as soon as they obtain extra spending money the first thing they should do is invest in USD.

Even in stable times, like now, holding pesos is still inferior to holding dollars. The exchange rate may say 4 pesos = 1 USD, but in all practicality the two are not equivalent. Having four Argentine pesos is just not as good as having one small dollar. The reason is that although the peso may be stable today, there is no guarantee it will stay stable tomorrow. The fragility of the Argentine market means that holding pesos always carries with it an implicit risk of devaluation.

By the same token, holding dollars carries with it an implicit guarantee from the US government that the currency will preserve its value over time. Because Latin American governments have a history of irresponsibly financing extra spending by printing more money (i.e. inflation), their central banks maintain a reserve of dollars to keep their populations' anxieties at bay. The idea is that if anyone loses faith in the local currency, they can simply swap it out for dollars.

Note how the dollar acts as a monetary guaranteer of the last resort: when people lose faith in all currencies, they turn to the dollar. Thus, what makes the dollar special is that everyone in the entire world trusts in it. It also means that the United States is not only underwriting the monetary stability of its own citizens, but also that of the entire world financial system. Everyone assumes that in a panic at least they'll be able to salvage their savings by converting them to dollars.

The USD is therefore not just another currency, but rather a promise. A promise that in this fiat world of meaningless paper bills, your savings actually mean something.

Such was life

Here's a funny anecdote from the economist Kenneth Rogoff about the intellectual climate of the 80s. If there's anything I love, it's irony:

There are more than a few of us in my generation of international economists who still bear the scars of not being able to publish sticky-price papers during the years of new neoclassical repression. I still remember a mid-1980s breakfast with a talented young macroeconomic theorist from Barcelona, who was of the Chicago-Minnesota school. He was a firm believer in the flexible-price Lucas islands model, and spent much of the meal ranting and raving about the inadequacies of the Dornbusch model: "What garbage! Who still writes down models with sticky prices and wages! There are no microfoundations. Why do international economists think that such a model could have any practical relevance? It's just ridiculous!" Eventually the conversation turns and I ask, "So, how are you doing in recruiting? Your university has made a lot of changes." The theorist responds without hesitation: "Oh, it's very hard for Spanish universities to recruit from the rest of the world right now. With the recent depreciation of the exchange rate, our salaries (which remained fixed in nominal terms) have become totally uncompetitive." Such was life.

The anecdote was presented at an IMF research conference lecture about the influence and brilliance of Dornbusch's overshooting model, which is based precisely on sticky prices. You can read the full lecture here.

Not All Comparative Advantages Are Made Equal

One of the foundations of international trade theory is the old idea of comparative advantage. However, in light of Latin American history, I'd like to make a tweak to it.

Quick overview of comparative advantage
Countries have a certain amount of productive resources (land, labor, capital, etc.) and they use them to produce goods and services. When resources are channeled towards a certain good or service, that means that they can't be used for something else; that is, there's an implicit trade-off every time something is produced. Different countries have different resources and are able to channel them in different ways, which means that different countries give up different amounts of other possible production when they produce the same good. When Country A is able to produce a good without having to give up as much other production as Country B, we say that Country A has a comparative advantage in that good over Country B.

Comparative advantage forms the basis of the argument in favor of trade specialization. Countries should specialize in those things in which they have comparative advantages, and trade for the rest. That way they can have more than what they could have produced individually.

Something's not quite right
After reading about the history of Argentina, and relating it with the history of all the other Latin American countries that tried Import Substitution Industrialization, it's clear that Latin America's experience in specializing in agriculture didn't work out too well for them. Indeed, these countries seem to have been (and, to some extent, still are) rather like leaves tossed about at the mercy of economic winds. At the diplomacy table, they've never had much stature either; rather, it was always the industrial powers that were naming the rules of the game.

Why is it that Latin America found itself in such a weak position? The theory of comparative advantage doesn't give preference to one type of specialization over another. It treats them all as equal. Then why was having a comparative advantage in agriculture such a disadvantage?

Technology and Comparative Advantage
I think the answer to these questions lies in the existence of a technology gap between different types of production.

Some countries are producers of inventions, and some countries are consumers of inventions. For some reason (which I leave to future research) the number of countries that produce inventions has always been small, and the number of countries that rely on those inventions is large. Because the invention-producing countries (currently known as the "developed world," or the "first world") have something that it is rare, and something that the whole world relies on, they gain power. In short, developed countries have a natural monopoly on inventions, and inventions are the most valuable thing humanity has to offer.

To illustrate the point, let's take the case of Argentina and Great Britain in the early 20th century. Great Britain was Argentina's biggest customer of agricultural products, and with the foreign currency that Argentina received in the trade it imported manufactured goods from abroad. Great Britain traded with Argentina because it was convenient; if necessary it could have imported from any other country in the world (because all countries have agriculture), or, at worst, it could have produced its own food. Argentina, however, depended on Great Britain. It needed the foreign currency to buy manufactured goods from Great Britain and the United States, which it wasn't able to produce on its own.

Thus, trading bananas for computers is not an innocent, equal trade; it implicitly signifies a power and dependency relationship.

Conclusion
If economics were only a story about stuff, then the old Ricardian comparative advantage idea would be just fine. But economics is also—and perhaps even more so—a story about power, and that obligates countries to develop the capacity for self-sufficiency.

Why Profit Doesn't Work in the Media Business

Although I'm generally supportive of the profit incentive, I think the following clip shows one example of how it can go entirely wrong:

The Daily Show With Jon Stewart	Mon - Thurs 11p / 10c
Moment of Zen - Roger Ailes Defends Fox News
http://www.thedailyshow.com/
Daily Show Full Episodes Political Humor Health Care Crisis

The basic defense of the profit incentive is that you're almost always likely to getter better results when you incentivize good behavior than when you force it. Profit supposedly sets up an incentive system that induces businesses to serve the public interest as much as possible (of course, no system is perfect). Ideally, if a business makes a product that creates a lot of value for people, then that business makes a lot of profit, and investors come in to supply money to the company so that it can continue to finance its society-benefitting ways. Customers get what they want, and the business reaps the reward of going through all that effort. Everybody's happy.

Of course, this system isn't foolproof; for it to work, a couple key things must happen (at least). First, consumers need to be able to represent an effective check on business. If people in general can't tell that they're getting duped, or swindled, or cheated, or they have no alternatives (i.e. monopoly), then businesses can gain profits without actually benefitting the public. Second, it must be the case that if individual consumers are getting what they want, then society should also be better off. In other words, individual interest can't be opposed to a broader, collective interest.

The problem with profit in the media business is that neither of these criteria are satisfied. First of all, for the average American citizen getting blasted with a veritable fire hose of media all day, it's very hard to tell what's what. As David Foster Wallace puts it, in attempting to grapple with the Total Noise, we find ourselves "dealing with massive, high-entropy amounts of info and ambiguity and conflict and flux; [the alternative to narrow arrogance and pre-formed positions is] continually discovering new areas of personal ignorance and delusion. In sum, to really try to be informed and literate today is to feel stupid nearly all the time, and to need help." Because the facts can be so gray and ambiguous, and because everyone needs help figuring the truth out, news organizations have the opportunity to simultaneously pose as a guide through this media mess and produce a narrative of its own. Fox is especially good at this, which is one of the reasons why, as Mr. Ailes put it, Fox is "winning." Fox News runs such a weasely operation that it holds journalistic credibility with enough people to put the "Fair and Balanced" graphic on air with a straight face.

In a lot of cases, though, Fox News viewers know that they're hearing only what they want to hear. In fact, that's precisely why they watch it. It's called "infotainment." The problem is that in a democracy infotainment poses a serious externality. It results in polarization, passion-driven protests, and, worst of all, a crippling inability to have a serious discussion about hard choices. Our country is worse off—not better off—if millions of Americans decide they'll watch the version of the news they like the best.

Now comes the point where, after critiquing the existing system, I'm supposed to do the responsible thing and supply an alternative. Unfortunately, though, when the execs are so unapologetic about their business strategy there's not much you can do. I can't conceive of a system that would actually incentivize "fair and balanced" reporting, and companies will just find ways around regulation (which is subject to all the terrible terrible pitfalls described in Public Choice Theory). It seems that the only viable solution is to somehow effect a change of heart in the way the media execs see their business. Somehow someone has to convince them to temporarily forgo the large profits they gain from the status quo in order to change for the common good. We need a call for a higher standard, a call to service and stewardship and morality.

Bah, Humbug!

University of Pennsylvania economist Joel Waldfogel has written a book called Scroogenomics: Why You Shouldn't Buy Presents for the Holidays. The book is apparently 186 pages long, and backed by a big name publisher (Princeton University Press), but really all it's about is what everyone knows anyway: gifts are often wasteful because the receiver hardly ever values the gift as much as the giver paid for it.

Though the rest of the world doesn't seem to care about all this waste, Mr. Waldfogel certainly does. As he puts it in his introduction to the book, "If you discovered a government program that was hemorrhaging money—say, spending $100 billion of taxpayer money per year to generate a benefit of only $85 billion—you would be outraged. You might even email your elected representatives to demand an end to the wasteful program." To wit, Mr. Waldfogel even offers a proposal to help us make the holiday season more efficient: instead of traditional gifts, he says, we should have "gift vouchers that are designed to expire after a set period of time, with unused balances going to a charity of the giver’s choice" (The Economist).

As an economics major, books like these dismay me to no end. They're the reason that economists are seen as nothing more than miserable little bean counters (and rightly so, it seems).

Mr. Waldfogel misses the point of gift-giving completely. It's not about the stuff, it's about people. People appreciate gifts not because it saves them the time of going out to buy it themselves, but rather because it shows that the other person values their relationship. This is what is meant by "It's the thought that counts." Thus, Mr. Waldfogel has ended up writing a whole book on the inefficiency of transactions that may not even been inefficient after all. It just requires a change in perspective to realize that although people may not have spent much money on the gift themselves, they can still value it as much as (or even more than) the purchase price simply by virtue of it being a cherished gift.

Books like these make me worry about how materialist we're becoming. If we (like Mr. Waldfogel) care primarily about getting the most bang for our buck out of gifts, then it seems we're forgetting where their true value is supposed to lie.

The Stag Hunt

Last week I was at the local grocery co-op buying some avocadoes and tomatoes. At the checkout line, the cashier, a Jamaican man with dreads, started making some small talk. What do you major in, he asked. Oh, economics? Hey, what do you think of the Fed?

I don't know much about the Fed, really, so I said I didn't wade much in political debates (which I don't) and that I thought they employed decent enough people. I prefer going through life assuming the best in people, assuming that the world isn't rigged against me, I said. The Jamaican man turned serious: But sometimes things are rigged. Sometimes things are rigged, and you have to fix them.

Hm. In my conversation with the Jamaican man, I got the sense that he believed things (the economy, the state of the world, etc.) were messed up only because someone was there to mess it up; that he felt that if only people were cooperative (i.e. "give peace a chance"), the world would be a great place. And this seems a really natural position to take, since, after all, our problems are human-made. But it turns out that our society doesn't work like that. The startling and fascinating conclusion of game theory is that we can end up in sub-optimal outcomes even if everyone would like to cooperate.

How is this possible?

The story behind the game goes back to Rousseau. Imagine, he said, a group of primitive people who had a choice between hunting stag and hunting hare. Hunting stag would, of course, be the best option because it would yield lots of rich meat, but the problem is that it requires everyone to work together to take the stag down. On the other hand, they could hunt hare individually, but the reward wouldn't be as great. In game form the story looks like this:


The numbers in the boxes represent how the players (in this case, an individual vs. the rest of society) value the outcome. Thus everyone hunting stag is the best outcome (3), both hunting hare is second (2), and getting screwed is the worst (1), because you not only waste your time running after the stag, but you don't even get any food.

In other words, these people are as cooperative as you're going to get: They would like to work together and they don't like to take advantage of each other. And yet it's still possible for these primitive people (and us possibly less primitive people) to get stuck in a Hunt Hare/Hunt Hare equilibrium!

The catch here is that it matters not just what players want to do, but what they think others will do. Everyone would like to hunt stag, but only when everyone else hunts stag. So if people think others are inclined to cooperate, they'll cooperate too; but, on the flipside, if everyone is scared of getting screwed over, then they're likely to not cooperate.

Notice that the basic fact that all these people are cooperative hasn't changed. It's just that they don't know that they're all cooperators. And this uncertainty causes all the problems: cooperation is risky, it leaves you vulnerable, and people aren't willing to gamble too much. [Indeed, this game is also called an Assurance Game, because if players were assured that the other was a cooperator, then they would cooperate too.]

This is my long comment to the Jamaican man's remark. Yes, Jamaican man, sometimes things are rigged. But sometimes we can end up in all sorts of social problems even when no one is at fault.

For more information on the Stag Hunt and cooperation and such, see Brian Skyrms' book: The Stag Hunt and the Evolution of Social Structure.