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An Unusually Worthy Nobel Prize  

We weren’t actually referring to the Nobel Prize in economics, which was awarded to Al Roth and Lloyd Shapley. That’s an excellent award too, and it’s no big surprise. Both men have done foundational work in the theory of matching, markets and market design — work that deepens our understanding of how our society allocates resources, which doesn’t just happen through the miraculous invisible hand of the Walrasian auctioneer. There are often no prices to guide such allocations or prices are severely constrained by institutional, social or informational factors. These issues are paramount in many key “markets” and social allocation problems, including in marriage, kidney and other organ exchange, the allocation of school slots to students, and the allocation of candidates to positions including the matching of medical interns the hospitals, of military cadets to different programs and of students classes. In all of these cases, the allocation of resources has both decentralized elements and design elements, and the work by Al Roth, Lloyd Shapley and their followers and collaborators has enabled us to study these problems systematically and also improve the rules and algorithms that certain centralized institutions can use to achieve and control these allocations according to their objective functions.

Moreover, though no committee can claim not to misfire from time to time, the Nobel Prize in economics has generally been awarded to worthy recipients, with important contributions to the advancement of the science of economics.

The same cannot be said of the peace prize, which has had a decidedly mixed track record. Recently, it’s been awarded, for example, to Barack Obama, exactly for what it’s not clear (we hope it’s not for his tireless work for the cause of world peace through his drone attacks and kill orders). It’s been awarded to Ellen Johnson Sirleaf, the Liberian president previously implicated and indicted for her involvement with Charles Taylor’s rebellion and crimes against humanity by the Liberian Truth and Reconciliation Committee (see our previous posts on this, here, here and here). Of course, there have been some pretty good ones also, including recently the prize for Liu Xiaobo, the jailed Chinese activist for his long and painful struggle for human rights and civil liberties in China, and the one to the International Panel on Climate Change and Al Gore for their work on building and disseminating knowledge — and sounding the alarm bells — on man-made climate change.

But the one to the European Union is a bolder and a more important prize. Here is why.

At the end of World War II, Europe was devastated and economically backward. The Red Army bent on destruction and revenge had occupied parts of Germany and much of Eastern Europe. Hamburg, Cologne, Dusseldorf, Dresden and many other German cities had been flattened by carpet bombing. In the last 14 days of the Battle for Berlin alone, the Red Army fired 40,000 tons of shells, leaving barely a quarter of its buildings inhabitable. Possibly 20 million Germans were homeless and 10% of the pre-war population dead. Over 12 million Germans from Eastern Europe would soon start coming in waves, homeless and often destitute. France, Belgium and the Netherlands were no better after the carnage and pillage caused by German occupation, and Britain would need years to recoil from its huge war effort and the aftershocks of the war and German bombing.

Economically things were similarly dire. Few in Europe had access to technologies that people in the United States took for granted such as refrigerators, central heating and indoor plumbing. In Britain only half the houses had hot water or an inside toilet, slightly more had a fixed bath to wash in and there were only 5,000 televisions sets between 40 million inhabitants. The residential capital stock was destroyed, and the buildup to the war and the war itself meant that there was little equipment capital that would be useful for non-armament industries.

Politically and socially there was little to be optimistic about. Many thought that democracy would not take root in much of continental Europe; some countries would turn conservative authoritarian while others succumbed to communism. Many viewed another war as inevitable and imminent.

In the event, something entirely different happened. Europeans did not fight another war. European democracies flourished and became stronger. None of the Western European countries experienced a coup or brought an authoritarian regime or communists to power. Perhaps most strikingly, all of Western Europe had the most successful three decades of economic growth in its history until the oil price shock of 1973. Though many European nations had a bumpy ride in the late 70s and early 80s, and some of them experienced sky-high unemployment rates, on the whole the last 30 years have been pretty good for Europe.

Our answer to why and how this happened will be no surprise to the readers of this blog: post-war European institutions have been fairly inclusive and democratic, characterized by broad participation in elections and politics both at the national and the local level. They have also been much more robust in handling conflicts and challenges, avoiding the sort of pitfalls that became the undoing of nascent democratic regimes such as the Weimar Republic.

But national institutions are situated in the context created by international ones. It wasn’t just the hostility of traditional elites and the various institutions they controlled that destroyed the Weimar Republic, but also the European context. It was the Nazi regime that arose out of the ashes of the Weimar Republic and its international aggression that decimated the struggling regimes in Belgium, France, the Netherlands, Czechoslovakia and Poland. It was then clear that inclusive political institutions, and consequently inclusive economic institutions, would be impossible in Western Europe without international institutions ensuring peace and stability.

One central institution was transformative for European inclusive institutions: the European Union.

The European Union project worked. Europe didn’t even come close to a war since 1951, and its member countries did not see their democracies threatened. The exceptions here prove the rule. Spain famously averted a military coup in 1981 after Franco’s death but this was before it joined the European Community in 1986. Europe experienced a bloody civil war in Yugoslavia, but this was outside the institutions and the remit of the European Union.

For this, especially at a time when many are turning against the European Union and despairing of the European project, it is an unusually worthy Nobel Prize and unusually astute move by the Norwegian Nobel Prize committee.


The Sad State of Civil Liberties (continued)

Following up on our post on civil liberties in the United States and especially in New York, it is no surprise to see that Mayor Bloomberg and the ever powerful New York security establishment are opposed to a bill proposing to introduce an Inspector General for oversight of the NYPD.

The New York Times draws the parallel to the Mollen Commission investigation. Not to take anything away from the Mollen Commission, which was very much on target and quite transformative for cleaning up the NYPD practices (their excellent report can be found here), the situation is rather different.

The Mollen Commission was largely about cleaning up police practices and corruption. Though unpleasant and difficult for the political elites controlling the city, reducing police crime and corruption is not necessarily inconsistent with their objectives (think of this as a version of political centralization).

The main issues now concern investigating the erosion of civil rights under Mayor Bloomberg and the NYPD leadership in the context of the illegal surveillance and entrapment of Muslim residents by the NYPD’s Intel division, the evermore intrusive stop-and-frisk program targeted at African Americans and Hispanics, and the NYPD’s heavy-handed and illegal suppression of any sort of dissent as witnessed by their intimidation of Occupy Wall Street activists. This makes external investigation by an Inspector General and preferably also by other organizations directly accountable to New Yorkers and human rights organizations such as the ACLU even more important today, and even more likely to be steadfastly opposed by those busy clawing back most of the civil liberties Americans and New Yorkers have enjoyed for the last several decades.


The Sad State of Civil Liberties  

Two excellent articles in the latest issue of The New York Review of Books powerfully underscore the sad state that respect for civil liberties has sunk in the United States in the 11 years since the war on terror was declared (and yes, we know that US record of civil liberties wasn’t always exemplary before then, but still). Perhaps it’s in the nature of declaring war against concepts that takes us down the slippery slope.

Steve Coll in his review of No Easy Day: The First-Hand Account of the Mission That Killed Osama Bin Laden by one of the Navy SEAL team leaders in the Abbottabad raid zeroes in on our very troubling collective acceptance of the de facto order to kill Osama bin Laden — rather than capture and bring him to court. Of course there is no doubt that Osama bin Laden was guilty of planning, financing and masterminding a series of heinous crimes against US targets including the September 11 attacks. And yes, there was no actual order to have him killed. But Coll makes it clear that the mission essentially left no possibility for bin Laden to be captured alive (“The only way bin Laden was going to be taken alive was if he was naked, had his hands in the air, was waving a white flag, and was unambiguously shouting ‘I surrender’” in the words of a Pentagon official is quoted by Coll), and thus intentionally and clearly amounted to a de facto kill order.

There was also no doubt that Hitler was guilty of planning and masterminding atrocities of much greater enormity. But the orders of the allied forces were not to kill him. And it was arguably a turning point for Western civilization that people like Hermann Goering were tried at Nuremberg rather than executed in cold blooded revenge upon capture.

More troubling than the Obama administration’s decision on this is the ensuing public reaction. Almost no mainstream source criticized or questioned the kill order. It seems that we have come to expect much less from our politicians and ourselves.

This, unfortunately, is confirmed by Michael Greenberg’s article on the New York Police Department’s (NYPD) anti-terror tactics, which make even the FBI and the CIA appear soft-touched. The NYPD’s Intel division tasked with tracking and capture of “homegrown terrorists” routinely entraps Muslim young men, and seems to presume that they are guilty unless proven otherwise — both in its intrusive surveillance and in hatching plans to catch them red-handed. Equally disturbing is that Intel seems to particularly favor those with mental instability and IQs far less than 100. In fact, in the two most advertised cases of homegrown terrorism supposedly foiled by Intel, that of Jose Pimentel arrested in November 2010 and of Ahmed Ferhani and Mohamed Mandouh arrested in May 2011, the FBI declined to be involved with Intel on the grounds that these were not serious terrorist threats and federal courts have refused to hear them. Greenberg paints a very troubling picture of the only federal conviction to come out of Intel operations, that of Shahawar Matin Siraj, a likely case of entrapment of a man with an IQ of 78.

Greenberg correctly identifies why this slide of our respect for civil rights and liberties is so dangerous for our cherished institutions (what we would call the US inclusive institutions): the NYPD has now come to add to its highly discriminatory and in all likelihood illegal stop-and-frisk tactics in African-American neighborhoods and its surveillance, abuse and entrapment against the city’s Muslim population the routine deployment of the same heavy-handed tactics against any kind of dissent — especially against members of the Occupy Wall Street movement.

Sure we should worry about inequality, unemployment, money in politics, the fiscal cliff, all the disingenuous rhetoric from both parties on our budget deficit, our failing schools and all that. And we do. But a complete collapse of inclusive institutions can only happen if political institutions turn extractive and repressive. So what’s happening in Zuccotti Park and during the May Day demonstrations in New York City may have as much relevance as a warning sign on how close we have come to destroying our largely inclusive institutions.


Saudi Externalities

Last week, we discussed (see here) the origins of the Saudi extractive institutions which lie in the personal rule of the Saudi royal family and the Wahhabist ideology following on the footsteps of Ibn Abdul Wahhab. The result is a uniquely repressive society where regular citizens have few rights, speech and thoughts is restricted both by the government and the Wahhabist religious establishment, and repression against women, who cannot vote, drive or work in a gamut of occupations, is probably unmatched by any other late 20th century society.

If this was all confined to Saudi Arabia, it would be bad enough, but no different than other flavors of extractive institutions from Uzbekistan (which we discussed here, here and here) to Nepal (here, here and here) or North Korea or Zimbabwe. But it’s worse because Saudi Arabian brand of repression creates significant negative institutional externalities.

Long before Osama bin Laden, a veritable scion of Saudi extremism whose story is masterfully recounted in Steve Coll’s The Bin Ladens: An Arabian Family in the American Century, started attacking US targets, the noxious mixture of Wahhabist state ideology and Saudi petrodollars were creating extremism in the Middle East and beyond. Gilles Kepel in Jihad: The Trail of Political Islam illustrates how Saudi money for schools, mosques and “Islamic development” was pivotal in the rise of Islamic extremism replacing Arab nationalism in Egypt, Algeria and Palestine, and in fomenting and spreading the Jihadist ideology in Deobandi schools in Pakistan and Afghanistan.

In our globalized, integrated world nothing is just national, alas neither is extremism and extraction.


Economic Research vs. the Blogosphere

Our new working paper, co-authored with Thierry Verdier, received an unexpected amount of attention from the blogosphere — unfortunately, most of it negative. The paper can be found here, and some of the more interesting reactions are here, here and here . A fairly balanced and insightful summary of several of the comments can be found here.

We are surprised and intrigued. This is the first time, to the best of our knowledge, that one of our papers, a theoretical one at that, has become such a hot button issue. Upon reflection, we think this says not so much about the paper but about ideology and lack of understanding by many of what economic research is — or should be — about. So this gives us an opportunity to ruminate on these matters.

First a little about the paper: There is an influential and very interesting line of work in political science (with some offshoots in economics), sometimes referred to as the “Varieties of Capitalism” literature, most often associated with the work of Peter Hall and David Soskice. The main idea is that there are many different ways of organizing a capitalist economy, perhaps with two polar cases being a Coordinated Market Economy (CME), which captures certain salient features of Scandinavian countries, and a Liberal Market Economy (LME), proxying for a US style economy. This literature suggests that both of these institutional/organizational arrangements can lead to high incomes and similar growth rates, in particular, because LMEs generate radical innovations, particularly in sectors such as software development, biotechnology and semiconductors, while CMEs are good at incremental innovation in sectors such as machine tools, consumer durables and specialized transport equipment; as part of this institutional arrangements, they also provide more social insurance and generate less inequality. The argument is that different societies have developed these arrangements for historical reasons and once established, they tend to persist (perhaps because of institutional complementarities or because of the usual difficulties of changing institutions). Because their economic outcomes are similar but CMEs provide better social insurance to their citizens, if an LME could turn itself into a CME, this would be associated with a significant gain in welfare.

The main idea of our paper is to observe that international linkages are absent from this picture, and to suggest that the institutional choice of that society is not entirely independent of the choices of others.

For one, countries trade and this induces specialization. If there are some complementarities between specialization decisions and certain institutional arrangements, the world equilibrium might be asymmetric: some countries would choose LME specialize in sectors in which this creates a comparative advantage while others choose CME and specialize in other sectors.

Another international linkage is technological, and this is the one our paper develops formally. We study a simple model in which all countries potentially contribute to advances in the world technology frontier and in turn build on this frontier in their innovation and production. We then introduce a very standard model of incentives: effort in innovative activities is forthcoming as a result of the rewards to this effort. This in particular implies that a greater gap of incomes between successful and unsuccessful entrepreneurs increases entrepreneurial effort and thus also a country’s contribution to the world technology frontier.

The main theoretical result of the paper is to show that under these assumptions and certain plausible parameter restrictions, technological linkages will also lead to an asymmetric world equilibrium in which some countries opt for LME-style institutions (what we call “cutthroat” capitalism) while others adopt CME-style institutions (what we call “cuddly” capitalism). Our model verifies the plausible notion that those under cuddly capitalism will be poorer but happier because of the greater social insurance that these institutions provide. The surprising result — which as we explain below is the main reason for writing models in the first place — is this: in equilibrium those under cutthroat capitalism cannot switch to cuddly capitalisms because of the interdependences in the world economy: when others are doing cuddly, it’s a best response to do cutthroat because the cutthroat country is contributing disproportionately to the world technology frontier and a switch from cutthroat to cuddly would slow down world growth. But given the cutthroat strategy of one (or a subset of countries) pushing the world technology frontier forward, it is a best response for others to cuddly.

So why all the furor?

We cannot help but think that some of it is a little “ideological”. In the same way that we got criticized by the right for arguing that inequality is often created by elites and that colonial exploitation has cast a long shadow on the development of much of the world (see for example this particularly outrageous rightist attack), the moment we raise some potential issues, albeit just theoretical ones, about the Scandinavian model that the left cherishes, all hell breaks loose on the left. Perhaps this is fair game.

But we think this is only part of it. Another aspect is the divide between what the academic research in economics does — or is supposed to do — and the general commentary on economics in newspapers or in the blogosphere. When one writes a blog, a newspaper column or a general commentary on economic and policy matters, this often distills well-understood and broadly-accepted notions in economics and draws its implications for a particular topic. In original academic research (especially theoretical research), the point is not so much to apply already accepted notions in a slightly different context or draw their implications for recent policy debates, but to draw new parallels between apparently disparate topics or propositions, and potentially ask new questions in a way that changes some part of an academic debate. For this reason, simplified models that lead to “counterintuitive” (read unexpected) conclusions are particularly valuable; they sometimes make both the writer and the reader think about the problem in a total of different manner (of course the qualifier “sometimes” is important here; sometimes they just fall flat on their face). And because in this type of research the objective is not to construct a model that is faithful to reality but to develop ideas in the most transparent and simplest fashion; realism is not what we often strive for (this contrasts with other types of exercises, where one builds a model for quantitative exercise in which case capturing certain salient aspects of the problem at hand becomes particularly important). Though this is the bread and butter of academic economics, it is often missed by non-economists.

Now in this light, let us turn to the main criticisms, which came in four flavors.

The first is that the assumptions were not a literal description of the world. For example, this blog picked on the fact that in the model, cuddly capitalism involves no income inequality (if you’re not going to provide strong incentives and effort is binary, then no need to create unnecessary income and consumption variability). It argued that this would be a model of socialism not of social democracy. Well this just totally misses the point of simplifying assumptions. Of course one could generalize the model to have multiple levels of effort (or more elegantly, a continuous effort choice) and then even cuddly capitalism would provide some incentives to entrepreneurs and would involve inequality between successful and unsuccessful entrepreneurs. Why didn’t we do this in the paper? Simple: this is the sort of thing that complicates the exposition and the mathematical analysis but doesn’t add all that much, so the general preference is often towards stripping these features out to distill things to their bare — and clearest — minimum.

The second criticism (for example this) questions the premise of the paper on the basis that the US wasn’t less innovative when it was more equal in the 60s and 70s and several other unequal countries are not very innovative. This is a good point, but it again takes certain aspects of the model more seriously than one should. First of all, in reality of course reward structures are not chosen optimally but result from a variety of economic and political factors. The model simplifies things by assuming that a benevolent social planner at the country level makes these choices (with the explicit caveat that this is a simplifying assumption). In reality then there will be many nations away from the “optimal inequality” beyond what would be necessary to provide incentives to entrepreneurs. As we have argued in several forums (for example here and here), US inequality has at least in part political roots and causes severe challenges to the (already dwindling) inclusivity of American institutions. So current inequality is likely way beyond what would be necessary to provide the right sort of incentives to entrepreneurs. Second and equally importantly, the mechanism in our paper clearly refers to inequality among entrepreneurs, whereas a lot of the inequality in the United States is among workers. It should be obvious that providing a safety net at the bottom of the distribution will not be a major factor in innovation decisions. Perhaps this should have been made clearer in our paper, but then again the paper wasn’t written as a general commentary on inequality but for developing a novel theoretical point.

Cross-country comparisons should be handled with care for the same reasons. But there is an additional problem in this case. As is the main point of Why Nations Fail, some nations are unequal precisely because their politics and economies are dominated — at least in part — by elites, and this type of inequality created by extractive institutions shouldn’t and doesn’t lead to innovation. Our purpose in focusing on Scandinavia and the United States was to zero in on countries that are clear examples of relatively inclusive institutions and develop some new hypotheses on why there are so much apparent differences in the inclusive institutions of Scandinavia and the United States.

The third questions the assumption that greater inequality should really lead to more innovation, for example, because better insurance might encourage entrepreneurial risk-taking. This is a fair point. Clearly, in a world in which there are no financial contracts, inequality can be too high, involving very low consumption for failing entrepreneurs, and can consequently discourage entrepreneurship altogether (or attract the wrong people and entrepreneurship). In such a world either financial contracts or other financial arrangements such as venture capital that enable better risk sharing, or if such private arrangements aren’t possible, government intervention that improves risk sharing, could encourage entrepreneurship and risk-taking. We certainly wouldn’t want to deny this point. However, the main argument here is that still some amount of reward for successful entrepreneurship is necessary for entrepreneurs to try hard and put effort for success. So our argument, again without making any judgment on US inequality being optimal by any metric (clearly it isn’t as we have argued), just agreed with what Alexis de Tocqueville noted more than 200 years ago when he wrote (see here p. 323) :

Thus inequality itself will work to forward the wealth of all, for, everybody hoping to come to share the privileges of the few, there would be a universal effort, an eagerness of all minds directed to the acquisition of well-being and wealth. Make of this nation a huge center of commerce, so that the chances of attaining the wealth with which all the rest can be obtained, multiply infinitely and ever give the poor thousand hopes, and so a thousand reasons for remaining satisfied with their lot.

The fourth (for example Matt Yglesias here as well as again this) question the data we offered in the introduction to illustrate that the United States is more innovative than Scandinavia. Yglesias is right in pointing out that patents only capture some specific types of innovation and many important breakthroughs in productivity will not show up there. But this is not an excuse for ignoring the wealth of data on patents, especially given that the economics literature has shown how patents correlate with growth both at the aggregate and firm level. Of course patenting can vary for a variety of reasons across countries. That’s why, in providing motivating evidence in the introduction of our paper, we did not just start with this next picture, which shows greater patenting activity in the United States than in Scandinavian countries.

Instead, we constructed this picture, which looks at patents by citation. In particular, it plots the numbers of patents granted per one million residents for Denmark, Finland, Norway and Sweden relative to the United States between 1980 and 1999, with each number corresponding to the relevant ratio once we restrict the sample to patents that obtain at least the number of citations (adjusted for year of grant) specified in the horizontal axis. If the difference between Scandinavian countries and the United States is driven by spurious patents or other extraneous factors leading to different patenting propensities, or if Scandinavians were engaged in innovations that were as important for the world technology frontier as US firms, then we should see the gap between Scandinavia and the United States start closing when we look at more and more highly cited patents. In fact the data show the opposite: when we look at more highly cited patents, the gap is greater. Sure this is not everything, but it does suggest that there is less of the breakthrough-type innovations coming out of Scandinavia than the United States (not that everything here is per capita, so the pattern is not driven by the fact that the United States is more populous).