Saving Private Hayek

UPDATE: 3:30pm links to other reviews (all great) of the Fukuyama review at end of this post F.A. Hayek continues to be the most mis-characterized economist of all time.  As if Glenn Beck were not doing enough damage, now even someone I greatly respect -- Frank Fukuyama-- has gotten Hayek wrong yet again. In a review of a new edition of the Constitution of Liberty in the NYT book review, Fukuyama says at the end:


To say Hayek's skepticism about government was based on "great certainty" is not just wrong, it is so much the opposite of  Hayek, it's like accusing Michele Bachmann of excessive belief in the Koran.

Hayek's view of knowledge was that it was partial and dispersed among many. The market gave individuals the incentives to apply this knowledge, and coordinated the uses of this local knowledge in a way that rewards each of us who knows best about any particular narrow area. (Frank notes this insight in an earlier paragraph, which makes the paragraph above even more puzzling.)  Government usually lacks both the incentives and the coordination mechanism. In government we don't know who knows best, so which knowledge wins the argument could often be wrong.

This does NOT imply the caricature that Hayek always opposed government action. As Fukuyama notes:


A government based on individual liberty will have some feedback and reward mechanisms that would produce better government outcomes in such areas than under tyrannical outcomes, and will make possible some kinds of government innovation and discovery that Fukuyama likes. But the political feedback mechanisms even under liberty (like majority voting, protesting, freedom of speech, or lobbying) are much cruder and less likely to align individual and social payoffs than the market feedback mechanisms, so one should be cautious about the scope of activities in which government programs will be effective.  One should be particularly wary of large-scale government plans that require a type of centralized knowledge that Hayek argued forcefully does not exist (down with Robert Moses, up with Jane Jacobs!)

To sum up,  Hayek's skepticism about government was NOT based on his certainty, as Fukuyama would have it,  but on his awareness of his ignorance. (and everyone else's)

Us public intellectuals who are communicating ideas of Hayek to a broader public are NOT fond of ideas that highlight our own ignorance, so one prediction that can be made with a higher degree of certainty than usual is that Hayek will continue to be misunderstood.

UPDATE 3:30pm 5/9/11: Links to other reactions to Fukuyama: Pete Boettke, Don Boudreaux, David Boaz, Don Boudreaux again with more, and, intriguingly, Hayek himself. (HT to Knowledge Problem for bringing them all together.)

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Skeptics and thermostats

UPDATE 12:50PM: Please assume I'm an idiot (see end of post) Many have suffered from being in a building where there was a centralized thermostat for the whole building (or the whole floor), with the predictable result that some rooms are way too hot or way too cold. (Sounds like a metaphor, watch for it...)

Things were even more extreme in the former Soviet Union, where there were centralized heating plants for a whole city, and the hot air would then be pumped out to individual homes and offices. So basically the whole city had one centralized thermostat.

What a nice and simple solution there is: give each room its own thermostat. First, there is automatic adjustment from the thermostat to keep it from being too hot or too cold. Second, the people in the room at any one moment can choose to adjust the thermostat according to their preferences.

A thermostat is a very simple knowledge processing device. So this is a great metaphor for (here it comes!) the advantages of decentralized knowledge over centralized knowledge  (Hat tip to Adam Martin for the Facebook conversation that sparked this idea).

When skeptics (like me) criticize the uselessness of very aggregated centralized knowledge on "how to do development", we get labeled nihilists, like we're saying nobody never knows nothing nowhere nohow. But what we're really saying is that centralized knowledge is an impossible dream for overall economic development, but decentralized knowledge can work very well.

In sum:

1) Skeptics like me are not criticizing ALL knowledge, just saying some types are useful, and others are not. And so the best systems are those that can gather and process decentralized knowledge.

2) Well-functioning markets and democracy give people their own thermostats.

PS {Insert here your own favorite example of the centralized approach to global problems at Davos starting today.}

UPDATE 12:50pm on Please assume an idiot:

In response to commentators:

(1) have I ever heard of any situation where centralized knowledge plays a full or partial role? Yes

(2) does that change the above argument? No

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Complexity, Spontaneous Order, blah, blah, blah...and Wow

UPDATE: Thanks to the commenters who confirmed the "hostile reactions" thesis while disavowing hostility :>)... By the way, I am surprised nobody has yet mentioned that blogs, Twitter, Facebook, etc. are superb examples of Spontaneous Order. I was surprised by hostile reactions to mentioning complexity on the Ivory Coast coup debate. Of course, I dish out hostility like water myself, so it's only fair that I got accused of mindlessly mumbling complexity to sound trendy.

Regardless of exactly what language you use and whom you give credit for what ideas, I think we can all agree that Complex Adaptive Systemic Emergence of Spontaneous Order General Equilibrium in Development (acronym? don't go there) incorporates the following ideas, all of which I think are really exciting.

  1. Nobody designed it.
  2. The old idea that complex phenomena imply a designer (an old argument for the existence of God) doesn't survive. Surprisingly complex phenomena can emerge without design, like Dawkins' "Blind Watchmaker" in evolution. The same in development.

    Corollaries: nobody needs to direct it. nobody needs to even understand it.

  3. Surprisingly simple behaviors and rules can result in complex phenomena.
  4. A lot of the complexity of nature  (to keep using the evolution metaphor) results from the very simple principle of Natural Selection. The analogue in economics is the Invisible Hand, which is also very simple (the latter inspired the former, by the way).

  5. Spontaneous order is not automatically good.
  6. The Mafia is a spontaneous order, case closed. In economics, we get the good "Invisible Hand" outcomes when private returns equal social returns (which, uh, is not true in the Mafia spontaneous order).

  7. Actions can have unintended consequences.
  8. In neoclassical economics, one example is the Theory of The Second Best. If there is one part of the economy where private returns do not equal social returns, then correcting a different part of the economy to make private returns equal social returns could actually make things worse rather than better.

    It should not be too hard to think of Finance examples from the recent Crash.  Could somebody please suggest  something like how going more "free market" in  financial deregulation when the government was implicitly bearing a lot of the risk....made bad things happen?

  9. What do you mean by "actions"?
  10. In development, the trend is to think of more and more things as the undesigned, unplanned outcomes of some spontaneous order...institutions, politics, cultural values, social networks, and so on. So there is nobody left to stand outside the whole system and pull a lever to move everything.

  11. Partial equilibrium analysis still works.
  12. While (1) through (5) apply to the whole system, you can still simplify by isolating a particular part where you can usually link actions to consequences (and then cross your fingers that the general equilibrium effects don't cancel out or reverse the partial equilibrium prediction).

    So I still feel confident saying that price controls will lead to long lines and are a bad idea, that expropriating private property will decrease investment, and that letting you choose for yourself is usually better than having the Central Authorities tell you what to do.

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Substitutability: there is no substitute for learning this wonky concept if you want your project to succeed

The debate we had on the HDI brought up the seemingly drop-dead boring jargon “substitutability.” Surprise! This actually turns out to be a USEFUL concept. Consider two extremes in an everyday example.  For producing the output: “weird music that Bill listens to,” my iPod and my iPhone are perfect substitutes, so one is redundant for this purpose (forget about other purposes for now). For producing this same output, headphones and the iPod are NOT substitutes, they are BOTH required in the proportions: 1 set of headphones for every 1 iPod. So headphones and iPods have zero substitutability.

The exact opposite concept to substitutability is complementarity. Headphones and iPods are perfect complements (you can’t use one unit of either without one unit of the other). At the other extreme, iPods and iPhones have zero complementarity (you CAN use one without the other). This is just a description of technology as it is at the moment, that we might have to take as given (but maybe not, see below).

So why does this matter for, say, aid projects? Aid projects often run into trouble because one of the essential inputs (one of the “complements”) for the desired project output goes missing. So for example, the supply of clean water breaks down because one small part fails on the water pump at the well. None of the other components of the water supply are worth anything as long as the one part of the pump stays broken.

This is a common problem. Indeed, many disasters are caused by the failure of one (sometimes very small) complementary input, like the malfunctioning O-ring that caused the 1986 Challenger Shuttle explosion.{{1}}

Yet the idea of complementary inputs over-predicts the likelihood of disaster – there are so many different parts that could fail, any one of which would be fatal, you would expect MOST Shuttles to fail. Or you would expect a lot more airline disasters than actually happen, since airplanes are subject to the same problem.

So why are more airplanes not falling out of the sky? Airplane designers do not passively accept perfect complements, they add many backup (redundant) systems in case one part fails. In other words, they deal with a complementary (essential) input by creating a perfect substitute for it in case it fails. I follow the same principle when I carry around both my iPod and my iPhone, to avoid the catastrophe in which the battery runs out on one and I can’t listen to my eccentric music.

The lesson for aid projects is to also build in redundancy for the essential complementary inputs. Make sure you have a good backup system of repairmen and spare parts in case the water pump breaks down. This seemingly obvious advice is often not followed–for example in Malawi, between 30 and 40 percent of all waterpoints don’t work.

Oh, and a final word on the HDI debate. Under their old method, UNDP assumed that inputs into the index (like income and life expectancy) were perfect substitutes, so the amount you have of one doesn’t affect the usefulness of the other. This means that even if, say, Zimbabwe has almost no income, it still gets some credit if life expectancy rises.

The new HDI method instead treats these inputs as complements, meaning that a missing input (or an income level very close to zero) would produce the catastrophe of zero overall human development, just as an iPhone with no headphones nets us no music at all.

In our critiques of the HDI, Martin Ravallion, Laura Freschi, and I thought this was way too extreme. People are resourceful enough to “produce” human development even if their income is extremely low, when they will find back-up substitutes for “low material income.”

An important part of development in general is developing systems that provide back-up redundancies for any essential input into production. Development is also the growth of resourcefulness to work around bottlenecks of any one particular scarce input.

And so, class, today’s lesson is: Aid project managers should imitate this resourcefulness. Whenever you get stuck by complements, look for substitutes.

[[1]]In fact, Michael Kremer used this as an analogy for development failures in his classic paper “The O-ring Theory of Economic Development”[[1]]

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Development is Uneven, Get Over It

UPDATE: out of 188 recorded songs on all Beatles albums, how many are now hits on iTunes? See end of post. This a 20 minute extemporaneous talk at UNICEF headquarters in New York on the topic of "Inclusive Growth". After the talk, there is a question, comment, and response session with the audience.  The full video is an hour, if you are really a masochist. (Try this link if the video player above doesn't work.)

To summarize the talk: success is intrinsically uneven, so development and growth is intrinsically uneven, not "inclusive". (See the earlier post about the fractal stubborness of uneven geographic wealth.) In this talk, I also mention how remarkably uneven success shows up in just about every field of endeavor. One way this shows up is in a "power law": there is such a strong negative relationship between the frequency of success and the scale of success that we have to use a logarithmic scale (i.e. a scale where every unit increase means multiplying by 10)  for both to be able to fit the extremes onto the graph, like the one below:

There is no evidence that large-scale redistribution programs can succeed without killing off growth, but targeting things like health and education to the poor has worked and could work even more. Lastly, the best thing of all you can do for "inclusive growth" is asserting the individual human rights of all, including women, gays, and religious, racial, and ethnic minorities. For more detail to fill out these ideas, please watch the video.

UPDATE: Answer to how many Beatles  hits out of 188 recorded songs on their 14 albums are hits today: 15. Even the most successful band in rock history could only produce a lasting hit about 8% of the time (please draw your own profound insights into the intrinsic unevenness of success and non-inclusive growth).

(Sorry about my really excessive Beatle-mania, it's a Baby Boomer thing, you wouldn't understand.)

PS highly imperfect methodology for measuring hits today: the popularity metre on iTunes gets maxed out for hits, all others (most showing zero popularity) are non-hits.

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The US Map of Prices of Pot

UPDATE: just got the question on Twitter: "what does this have to do with development?" Answer: nothing, except that you will never understand development if you are so quick to ask that question. When I first saw this map, I immediately thought legalize pot! what a great teaching tool for my Intro students! So students, please explain using the concepts of supply, demand, and transport costs (including in this case smuggling costs) the pattern of prices you see here.

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Our China who art in heaven, hallowed be thy growth rate

UPDATE 4: thanks to all the critics on this post, too bad I couldnt get Chinese censoring technology to work:) UPDATE 3: 9:30am Sat 10/9: links to Nobel Peace Prize and Charter '08

UPDATE 2: 1:30pm. New Yorker writer Evan Osnos generously replies to my criticisms (see end of post)

SCOREBOAD UPDATE 10 AM 10/8: understanding key to China's future development: Nobel Committee 1, New Yorker 0; Liu Xiaobo 1, Justin Lin, 0.

A writer in the New Yorker has an article fawning all over China’s rulers and Chinese economist Justin Lin (currently the Chief Economist of the World Bank).

I’m saddened to see my favorite magazine publish an article seemingly in search of every possible fallacy about growth, the main one being that if you have a high growth rate, then the current autocrats and their economist advisors must be Gods.

(Sorry to be so harsh.  Can you tell that this time I am really annoyed to see so much gushing over a Party that kills, beats, and imprisons any Chinese citizens who are not quite as enthusiastic about their own government as a New Yorker writer? And recommends this approach to other countries?)

Let’s review the logic and evidence.

  1. See previous post on the myth of the benevolent autocrat. (To be fair to the New Yorker writer,  he mentions briefly at the very end of the article Dani Rodrik’s similar argument. But it comes as across as a CYA after the long hagiography.)
  2. Rapid growth episodes never last indefinitely, so forget all the nonsense about projecting today’s growth rate forward till China overtakes Japan, the US, God, etc.
  3. Especially considering (2), Growth is not a reliable indicator of performance, income levels are what matters:
    1. China’s per capita income is currently 13 percent of the US level.
    2. Remember growth is the CHANGE in income. A change is made up of two elements:
      1. The extent to which things are good now.
      2. The extent to which things were totally f’d up before.
        1. China performs really well on this second part of the CHANGE equation. Not even mentioning previous authoritarian emperors and political chaos, it had from 1949 to 1976 a totalitarian psycho in power responsible for the deaths of millions, the Great Leap Famine Forward, the Cultural Revolution.
    3. So compared to the official “complete wacko destructive” standard set by Mao, today’s citizens are free-er, but still not very free.
    4. Did I mention that I am really annoyed?



UPDATE 1:30PM New Yorker writer Evan Osnos has a generous response to this critique:

Dear Bill, Thanks for the twitter headsup to your post. I agree with your "logic/evidence" on China's growth model. I also agree with you on the myth/fallacy that it's a guaranteed (or democratic) path. I think we'll have to disagree on whether this piece about Lin and his ideas is an endorsement of him - - or an effort to explain the background of an unfamiliar name in an influential job and why he got there. The story also relies on the critiques from Yang Xiaokai, Yawei Liu, Yao Yang, Wu Jinglian, and Dani Rodrik, but only one of those five was referenced in your post. Fair enough: I suspect you found the overall mix to be unpersuasive. As I said, I agree with much of your take on the overall approach to growth. Best, Evan

UPDATE 3: New York Times on Nobel Peace Prize for Liu Xiabo.

The English translation of Charter '08 that Liu Xiabo signed along with 300 other Chinese intellectuals.

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Growing cars in Iowa

[T]here are two technologies for producing automobiles in America. One is to manufacture them in Detroit, and the other is to grow them in Iowa.

Here's the detailed technology by which you grow cars in Iowa:


Who could object to such a nice technological alternative?

Today, I am beginning to teach trade in my Principles of Economics class. This is a classic folk description of international trade first advanced by David (son-of-Milton) Friedman and then quoted by Steven Landsburgh (the source of the quotes here) in his marvelous book The Armchair Economist. David quoted it again in his own book Hidden Order: the Economics of Everyday Life.

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Welcome to economics, all you students (and aid workers)

Today, for the first time in my professional career I taught Principles of Economics. I'll be teaching this all semester long and giving occasional reports from the classroom. The officially required duty of all Principles instructors is to first define economics. Here is the definition from the 18th edition of McConnell, the most popular text on the market and actually the exact same text I used in my own first econ class 35 years ago:

Economics is the social science concerned with how individuals, institutions, and society make optimal choices under conditions of scarcity.

OK, just kill us all from acute boredom right now. [If you are an economist, try introducing yourself to someone: "I am somebody concerned with how individuals, institutions, and society make optimal choices under conditions of scarcity."]Is there some conspiracy to make econ so boring that the number of economists stays low and we get high salaries from our scarcity?

The boredom of economics education also has the unfortunate effect of making economics scarce in aid work, given the number of aid ideas that violate elementary principles that all economists (from all points on the political spectrum) agree upon.

Sorry, I'm not all that concerned with "how individuals, blah, blah, optimal choices, blah, blah, scarcity, blah, blah..."  I'm concerned why some people are so rich and other people are so poor. I want to understand why some economies work and others don't, and why even the ones that work still don't work for everyone. I want to understand how other Americans and I got 64 times richer than our ancestors.

I want to know why Robert Iger, the CEO of Disney, makes $140,000 a day, andwhy some rock-breakers I met in Ghana make $1 a day. I think a differential of 140,000 times is pretty important to understand (obviously includes both domestic and international inequality).

Economics principles are a set of tools that have evolved to transcend scarcity into abundance.  When students use these principles to solve problems in an Econ class, they are recreating the process of historical problem solving in which poor people discovered the principles to become rich people.

I am going to try to convince the students that Principles of Economics gives considerable insight into the slightly different outcomes experienced by us and by our ancestors, and by Disney CEOs and Ghanaian rock-breakers. Stay tuned.

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Manhattan's Non-Market Economy

Tyler Cowen has a great NYT column today about the harmful distortions caused by "free" parking. Manhattan offers plenty more ammunition to his case. Both sides of most crosstown numbered streets (17th, 18th, etc.) are devoted to "free" parking, which adds to traffic gridlock by creating one-lane streets, frequently blocked by delivery vans or by stopped taxis. Those using those "free" slots have to expend a lot of effort to keep moving their cars to comply with various random restrictions, like opposite side restrictions for street cleaning on different weekdays, or weekend vs. weekday, or work hours vs. night.

In short, just about everybody loses except for the readers of Calvin Trillin.

It also adds to my puzzlement about New York -- how can it be the premier world city it is with so many market distortions and/or breakdowns on providing public goods?

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Talking to Mozart about how rapid economic growth is temporary

Update 8/6/2010 3:30pm Response to RT @auerswald People r (Not) Statistical Noise on objection that small bursts of creativity can have very large effects. Um, yes, it's called non rivalry of ideas (and music scores). Many people can simultaneously use the same idea/score. And everyone wants to use the best ones. So the scale effects can be Gigantic. I guess I had noticed I'm not the only one who likes Mozart.

This blog has often pointed out that bursts of rapid growth don’t last. I provoke readers with words like “luck” and “random” to describe the transitory component of growth.

The evidence says High Growth is likely to include a temporary component that will not recur. So High Growth countries in one period will likely experience a decrease in growth in the following period, moving them back DOWN towards the world mean.

The graph below shows a typical regression to the mean graph for a few data-points. The mean of the data is roughly 2 (where the mean reversion line crosses the horizontal axis). Years above 2 are usually followed by a decrease, while years below 2 are usually followed by an increase.

What’s slightly different about this graph is that the numbers here like “2” don’t refer to average annual economic growth, but to the number of masterpieces produced by Mozart every year from 1781 (after he moved to Vienna) until his death in 1791. Mozart produced 18 major classics over this period, or about 2 per year.

However, his economic growth number of masterpieces produced each year fluctuated a lot. For example, in 1788 Mozart produced three of the greatest symphonic breakthroughs of all time (Symphonies 39, 40, and 41), but in 1789 there were no new masterpieces at all.

I decided to discuss this with Mozart to see if we can get any more insight into what drives good and bad years.

Me: I love your symphonies 39, 40, and 41, congrats on having such a great year in 1788.

Mozart: who are you?

Me: Why did you have such a bad year in 1789?

Mozart: Let me get this straight, I revolutionized music with 18 masterpieces in a decade, and your main concern is that I didn’t spread them out more evenly across years?

Me: I just thought we could discover your secret to success by comparing the good years with the bad years.

Mozart: (Whispers to his servant: “Check with Viennese insane asylum whether they are missing a patient…”) I was learning and experimenting all my life, which all contributed to my miraculous final decade. When the masterworks happened to come out during that decade is arbitrary and of no importance whatsoever.

I learned from Herr Mozart that musical creativity, like economic growth, proceeds in fits and starts, and we should not be so obsessed with short term fluctuations.

Also I would not dare apply the words “random” or “lucky” to The Marriage of Figaro. Bursts of creativity, like bursts of rapid growth due to, say, entrepreneurial breakthroughs, may be temporary but they are not “random” in any mechanical sense. They reflect the best of humanity’s purposeful activity, and they stay with us forever even if the original creative moment is fleeting.

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Why African women and girls are still manual porters



A sustainable alternative to women being used as draft animals probably requires something that vastly increases the demand for unskilled labor and makes it more expensive ("sweatshops" look positively attractive by comparison). Of course, there are also these little tiny issues about women's rights and gender equality -- but that too could respond to economic forces that gives women many more viable alternatives.

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Could aid revive business instead of stamping it out?

This post is by Claudia Williamson, a post-doctoral fellow at DRI. This is a central question of The Aid Trap, by Columbia professors R. Glen Hubbard and William Duggan. Instead of supporting development, the authors argue, aid creates additional hurdles. While aid ‘crowds out or corrupts the business sector,’ we remain caught in an aid trap because business doesn’t pull at the heartstrings the way charity does.

The first half of the book documents the historical roots of prosperity and poverty. While people in today’s rich countries rose out of poverty as it became easier to do business, bad institutions and policies in poor countries have created perverse business incentives (for example: it takes 361 days and costs seven times the average per capita income to go through the seventeen procedures required for a firm in Mozambique to get the government licenses it needs to operate).  Not only does aid support bad policies and the government that created them, but by decreasing the reliance on taxes for funding aid removes incentives for reform.  Why become a less corrupt, more business-friendly government when aid makes it unnecessary?

Aid stifles the private sector by hindering local entrepreneurship, decreasing reliance on market transactions and trade.  It is often more profitable to work for an aid agency or a NGO than to start a business. Locals get squeezed out of business when an aid agency shows up, so instead of competing with aid agencies most try and join them. Why buy grain from the local farmer when a NGO is giving it away for free?

The second half of the book describes Hubbard and Duggan’s proposed alternative, a modern “Marshall Plan” that would support business directly without channeling money to governments or through NGOs. An independent agency would loan money to local businesses, and these loans would be repaid not to the agency but to those local governments that have agreed to reform the business sector and spend the money on public infrastructure.

The Aid Trap’s focus on private markets and the need for change in the business environment is a laudatory move in the right direction for helping the world’s poor. But the authors’ new Marshall Plan raises some obvious questions

As the authors acknowledge, post-war Europe is very different than most poor countries today. Reconstruction is completely different than building from scratch. Most European countries had a healthy private sector before the war, implying that many of the barriers to business in today’s poor countries were absent. Removing these barriers is part of the new Marshall Plan, but transforming bad institutions into good ones remains elusive. And if such barriers were removed, wouldn’t private financing find it profitable to provide loans as we see in India or China, possibly making the new Marshall Plan unnecessary?

Despite this, the book as a whole is a great description of the current gridlock in the aid debate, and a creative attempt to get out of it.

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The coming end to China's rapid growth

China's remarkable growth rate is unlikely to last. No country in history has managed to grow nearly so fast for so long. "China is defying the law of gravity at the moment," says New York University economist William Easterly, who has tracked economic development for decades. "But that doesn't mean that gravity is wrong."

From 1900 to 2000, NYU's Mr. Easterly says, per-capita growth of all countries ranged between 1% to 3% a year. Nearly all the nations on the high end so far, he says, are democratic capitalist countries — and the additional growth over long periods of time made them rich.

"When we make too much of growth spurts," he says, "it like making too much of a basketball player who has a hot hand."

From last week’s Wall Street Journal.

And here is some more substance (possibly spurious) to rationalize why China's growth will slow down, for those of you unhappy with impersonal statistical tendencies.

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My original notion was that intentionally breaking the rules to prevent a loss was cheating, and that it was too bad norms prevalent in Football World did not penalize such behavior more fiercely so that it wouldn’t have happened in the first place. (A column in today’s Wall Street Journal agreed with me. Maybe we’re just both fervent Ghana fans.)

But let’s shift now from normative to positive economics. Do the norms in the Football World let you sometimes break the rules intentionally and suffer the official penalty, without any further normsy punishment of everlasting disgrace? From the numerous comments the post received (assuming they weren’t all concealing Uruguayan ancestry), the answer appears to be yes. (Read the comments on the original post; also read Steve Horwitz's great post on the blog Coordination Problem.)  Many commentators pointed out similar intentional rule violations in American sports, which the norms of American sports fans appear to tolerate. Norms in sports (as in economics) evolve spontaneously to fit the needs of participants (fans, players, or businessmen), and so deserve some respect before a rush to judgment. Possible cautionary lesson #1: arrogant people (code word for Americans) should not pass judgment on other societies they don’t understand (like Football World).

Other people pointed out the complexities of rule systems that include penalties for breaking the rules. You don’t want excessively draconian penalties (like the death penalty for contract violations or handballs), or nobody would engage in mutually beneficial activities in the first place, like contracts or football matches. And, with that caveat, no penalty system can be perfectly designed so that it never pays to break the rules in any and all situations. Some egregious case where it paid to break the rule could cause an over-reaction towards excessive penalties or dysfunctional rules (possible examples in financial and economic reforms as well as football).

Norms play a useful role in not only strengthening the incentives to keep the formal rules, but also in complementing the formal rule-formal penalty system. Norms can handle the subtleties of when intentionally breaking the rules and accepting the penalty is OK and when it is not. So for example, social norms might forgive a businessman who chooses to break a contract because of something unforeseen like a fire in his factory, but not so much a businessman who lied about whether there was really a factory fire. In football, I assume fan norms would still be pretty tough on a minor football player on one team who intentionally causes a long-lasting and disabling injury to the best football player on the other team. Possible cautionary lesson #2: Norms are complicated. Norms may evolve in a useful way that no single person can fully understand. Norms can be smarter than I am or you are.

Back to normative economics: I can still express my own opinions – I still think Ghana should have won. Now, that that’s over: Go Spain! (Sorry, Dutch and German fans, but none of your banks’ foundations awarded my research institute 400,000 euros.)

UPDATE July 8, 12:10pm:  just found a great new article on the history of football (in its many varieties) as an example of the spontaneous emergence of rules (HT Facebook friend Gonzalo Schwarz).

UPDATE 2: PS if my memory is correct, neither Netherlands nor Spain were beneficiaries of any of the egregious rule violations and blown calls by refs during this World Cup. Maybe playing by the rules is a winning strategy after all.

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Response to Dani Rodrik on Washington Consensus

Dani gives a response to some “counter-arguments” against his post favoring Import-substituting Industrialization (ISI) over Washington Consensus (WC) that had mysteriously “resuscitated” themselves after they “had long been laid to rest.” I appreciate Dani’s courtesy in not identifying the culprits in this misguided resuscitation of long-dead counterarguments, but it does make it a little difficult to carry on a precise debate. It’s possible that my post about skill vs. luck, and the comments that followed, may have been one of the culprits (fitting the theme of that post, this can only be a probability rather than a certainty). Anyway, assuming that my post and ensuing comments was partly to blame (and thanks to Chris Blattman for a more favorable review), Dani does not have time in his short post to get to the crucial arguments. His original post was too vague about the timing and identification of just who had ISI and who had WC and when, and so what growth experiences to attribute to each, and whether to control for the overall fall in average growth of ALL countries in the world from the ISI to the WC period. And in Dani’s new post, we also have the third category of policy regime “unorthodox but well-targeted reforms” (UBWTR?) for Asian countries. And to test a hypothesis that growth under one regime is higher than under another, you have to calculate standard errors reflecting noise in the growth rate (affectionately called “luck,” which standard errors I and others have shown are large), you cannot dismiss standard errors with a quip about “the check is in the mail.” Most attempts to sort all that out have not been very successful or conclusive, which is why economists started saying things like:

the experience of the last two decades has frustrated the expectations …{that} we had a good fix on the policies that promote growth.

I will acknowledge from whom I think I absorbed this valuable cautionary statement. I am pretty sure it was from a 2005 article by a certain D. Rodrik (ungated version here, official version here).

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How skill beats luck in the World Cup of Development

This blog periodically points out the role of randomness in development, much to the frustration of many readers. This post is how to set things up so that skill triumphs over luck. Today’s official metaphor is, of course, for us sports-obsessed nuts, the World Cup. Early rounds have seen remarkable upsets: Switzerland beats Spain, Japan beats Cameroon, Serbia beats Germany. Yet no super long shot team has ever won the World Cup. In fact, 14 of the 18 previous World Cups were won by only 4 teams: Brazil, Germany, Italy, and Argentina.

The World Cup uses a tournament to make skill beat luck. There’s a preliminary round won by 16 out of 32 teams, and then there’s four rounds of elimination to determine the champion. To simplify for illustration, let’s just discuss a five-round single elimination tournament for 32 teams.

The tournament magnifies the importance of skill versus luck. Based on the above upsets, a weak team still manages to win a single game sometimes, let’s say for illustration 15 percent of the time. So roughly for every 7 games, there will be one huge upset, which explains why the Cup with lots of games has seen a few surprising upsets.  To win a single elimination 5-round tournament, however, this weak team would have to reel off 5 straight upset wins. The probability of this is .15 x .15 x .15 x .15 x .15 = 0.000076, i.e. 13,000 to 1 odds against this weak team winning the tournament.

In contrast, a strong team who wins a single game 85 percent of the time has a .85 x .85 x .85 x .85 x .85 = .44 probability of winning the tournament. Of course, there’s still a slightly worse than even chance that this particular strong team does NOT win, but the probability that SOME strong team will win is very, very high. (We have to make all the probabilities for all 32 teams consistent by making sure they add up to one, but I ignore this since I am only discussing a few teams.)

OK, now it's time for the clumsy transition from the World Cup metaphor to development. As this blog likes to frequently point out, economic growth has a lot of random variation. Over a short period of time (metaphorically equivalent to one game), a country with bad policies and bad institutions still might have a good growth rate. But over a long period of time (equivalent to playing many successive games), the consistent winners are very likely to be countries with good policies and good institutions. So in deciding whether a particular set of policies and institutions are good or bad, you need to look at long periods (tournaments) and not at short ones (single games). How long  the long periods have to be will depend on how important luck is in the short term; the evidence we have on economic growth is that short term luck is very important, and the periods have to be pretty darn long for proper analysis. (Hint: the periods were NOT long enough in this Rodrik analysis as to why the Washington Consensus sucks.)

POSTSCRIPT for those who hate LUCK: we are all intensely uncomfortable with the idea that luck matters at all in something we really care about -- like the World Cup. Not even this luck-reducing therapy is likely to be enough.  The example above still implies which of the strong teams wins is random. But what do the words “random” or “luck” really mean? They could capture temporary and non-replicable fluctuations in human skill as well as pure luck. There are two competing narratives: (1) a strong player on a strong team just happens to be in the right place at the right time to receive the right pass to score a Cup-winning goal. (2) a heroic player consciously exerts extraordinary skill at the most crucial moment to score the Cup-winning goal. Scientifically we can’t really distinguish (1) from (2). Psychologically, we intensely prefer (2). Fine, go with that, just remember it’s not replicable. Same goes for heroic entrepreneurs and political reformers.

POSTSCRIPT 2 for those who hate LUCK: luck matters even as much as it does for the World Cup because there has already been a lot of screening to select the best teams in the world. Saying luck matters does not imply the Balding Middle-Aged Econ Prof All-Stars would have a chance in hell against Brazil. Likewise, in development, luck matters for growth in the sample of societies as much as it does because most of them are already doing their best to achieve growth. If some whack job does a demolition job on their own economy, like Mugabe or Chavez, it’s pretty clear that bad policy will overwhelm good luck pretty quickly.

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Goldman was hedging--how evil!!!!

According to the Washington Post:

Goldman admits it had reduced its exposure to the overheated U.S. property market and had sought to limit possible losses through a strategy that would make money if home prices fell. It says such "hedging" is a routine part of its business and is intended to moderate risk to the firm, an especially vital function when markets shift violently, as they did in 2008.

The Post puts "hedging" in quotes like it is some fatuous excuse by Goldman. Let's see: Goldman is accused of betting against the housing market (that housing prices would fall). It also had other bets that housing prices would rise. It is prudent to not bet the whole firm one way or the other on something so uncertain as housing prices. Having bets on both sides is called "hedging" and is Finance 101.  Goldman Sachs is on the hook for a lot of possible sins, of which it may be indeed guilty. Hedging is not one of them. That the media and politicians can't even understand hedging is not reassuring when the largest financial reform in a generation is underway.

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