Sunday, September 28, 2008

I Hate To Do This Again and Again, and...

...I wish that Kompas had journalists like David Leonhardt, Gretchen Morgenson, or David Warsh in their economics desk, so that some misunderstandings like the following do not come up too often on the paper.
An economic revolution has been started in the late President Ronald Reagan's era. The President believed, in accordance to Chicago Boys (the University of Chicago alumni), that market would work more dynamic and flexible if unregulated. In other words, the role and existence of bureaucracy indeed becomes impediment and prevent market and economic flexibility.
OK, it makes sense, but then the author moves on.
This opinion beats the MIT economist's view, who opts for market regulation. The reason is that there are premises that can not be answered by market (mechanism), that is, the element of greed, that can induce the market players, including the ones in financial sector, to overly exploit their money-grubbing instinct, wanting to make profit by gambling in the speculative (financial) products.
Well, I am afraid that if you open any standard Econ 101 textbook, say from Paul Samuelson's classic, himself an MIT's giant, the reason for market regulation has nothing, I repeat, alas, nothing to do with human's greed. Instead the basic economics itself points out some reasons why market sometimes fails, hence needs some government intervention.

I give you hints: go to discussions on monopoly (or non price-taking behavior), externalities, asymmetric information, and public goods.


  1. Dear Rizal,

    My understanding on the words "market regulation" is not necessarily as "government intervention". Apparently you define market regulation as government intervention. It is mentioned on the 2nd last paragraph in you article.

    Market regulation could be also as "rules of the game". My impression on the article you cited is that the author concerned on "rules of the games in the markets", not "government intervention". I realize he did not cite or mention appropriately relevant people or literature on the issue he addressed. For example: Oliver E. Williamson, Ronald H Coase and Douglas C North.

    Transaction cost economics may be useful to see the financial crises in the US currently. The thing left in neoclassical economics is transaction costs. Any exchange must need contract, which can be either formal or informal contract. In this case exchange (transaction) is more complicated than one without zero transaction costs as neoclassical economists assume.

    I like this citation to show rules of the game in markets absolutely needed:
    "When the butcher comes to me to buy an animal, he knows that I want to cheat him [by giving him a low-quality animal]. But I know that he wants to cheat me [by reneging on payment]. Thus we need Peppe [that is, a third party] to make us agree. And we both pay Peppe a percentage of the deal." (Quoted from Willianson, May 2005, AER).

    Transaction costs economics indeed mentions that opportunism exists; and contract is most likely incomplete since to make it complete very costly. In this state of the world, so we need good and clear rules of the game.

  2. *) "than one without zero transaction costs" on 3rd paragraph should be read as "than one with zero transaction costs".

  3. dendi, I agree on the Coasean/Williamsonian/North approach: when the cost of having market exchange ideal is too high, some non-market arrangement may arise. And that is why we have institutions like firm, hierarchy, law or regulation, which is not necessarily imposed by the government.

    But when our journalist contrasted Chicago and MIT (or more precisely, saltwater vs freshwater tradition), it is about the role of government regulation. He mentioned bureaucracy and market flexibility, didn't he?

    But thanks for bringing in the transaction cost insight, anyway.

  4. Dendi,

    When you said “…The thing left in neoclassical economics is transaction costs…”, well, I think prominent chicago economists
    have done cutting-edge research on this, George Stigler was a few to name.

    I won’t say euphemistically “regulations” as “rules of the game”, which may imply merits on them (like fair play, fairness and etc). I remember Stigler deliberate discussion on regulation: he asked: why do we get public regulation?” Our fellow political scientists perhaps would reply: that is for “public interest”, if so why do we encounter this? It is hard to say regulation is not the government intervention.

    Anw, I found candid words of Stigler which I like :)

    “Am I to admire a man who injures me in an awkward and mistaken attempt to protect me, and to despise a man who to earn a good income performs for me some great and lasting service?” –George Stigler-

  5. Yudo:
    The question is wrongly posed. I would have rephrased Stigler's question and ask you the following. Which one would you prefer: A man who injures you in an awkward and mistaken attempt to protect you OR a man who injures you in his attempt to earn a good income (by taking excessive risks)and gets away with it?

    That's why the need for regulation isn't that clear cut, even for neoclassical economists.

  6. Yudo,

    My words “…The thing left in neoclassical economics is transaction costs…” is cited from Williamson (2005), Page 3, Paragraph 2, or can be see also in Coase (1937)

    I think it is clear that market regulation, as I stated in the first sentence above, is not necessarily as gov. intervention. For example: competition law. Is it gov. intervention? No. It is a rule of the game.

    Moreover, I think we should distinguish between Chicago school approach and Coase-Williamson-North approach (so-called Institutional economics). Chicago school does not like gov intervention or regulation. This school extremely believes that market is superior than any other mechanisms to allocate resources efficiently.

    But for Coase-Williamson-North approach rules of the game (institutions in broad term) is the key issue. This approach believes efficient resource allocation can be achieved not only through exchange in markets but also other mechanisms. It can be allocated either through market which implies transaction cost or hierarchy/organization which implies organizing/bureaucratic cost. Which one is better is just comparing which cost is higher. In some cases transaction cost may be higher than organizing costs. Again, Chicago school never touches transaction cost issue or it is assumed zero. That is why Chicago school economists believe only market is the best one.

    But, I like Coase-Williamson-North approach more since the approach are more down-to-earth in understanding economic problems than Chicago school one.

    Coase (1937). Nature of the firm. Economica.
    Williamson (2000). The New Institutional Economics. JEP
    Williamson (2005), The Economics of Governance. AER.

  7. @ Arya,
    I have no intention to cite Stigler’s words for making case against the Kompas article mentioned by Rizal :). On your question, the answer is clear but such situation in which regulations can be “justified” is not so obvious. If we can agree on several fundamental public goods which should be served by the government, why we cannot agree to place regulations for only serving fundamental public goods? and no more. Surely, we could spend a lot of time for debating what fundamental public goods are…but in many cases we face too many regulations which are not serving their merit purposes.

    On US financial turmoil, general view recently leads us to believe that it happens because of unregulated financial market. It may tell half of story, but using Mankiw words, it seems to distort history. Fannie and Freddie are private companies but at the same time they’re run as the government-sponsored enterprises. They’re exempted from local taxes and they have access to US government credit line( James Surowiecki ). No doubt they can bite their competitors and become so huge. If these two companies are the main reason for current turmoil, then what would counterfactual-path tell us? What would happen if Lyndon Johnson’s government did not privatize the companies? What would happen if the Clinton administration did not pressure the companies to expand mortgage loan? What would happen if the US government did not give signal to back up the companies?

    So, a man tries to injure me in his attempt to get high income by taking excessive risks; it is because he’s not only allowed to do it but in fact there’s strong incentive to do so. Apparently we know that the government fails to regulate its own intervention and it’s even, using Surowiecki words, sponsoring recklessness.


    I think we have a different definition on government intervention. Let me try: any rule imposed upon agents by any coercive action must be government intervention. Would competition law work well without any coercive action? I doubt it. So it is the government intervention though its purpose may serve as “rules of game”. Btw Chicago school economists may don’t like regulations, but they’ve done research on it. When you said “Chicago school never touches transaction cost issue or it is assumed zero” do you think Ronald Coase is not a member of Chicago school? I’m not Chicago school die-harder any way :) and I agree with you about the possibility of non-market institutions in allocating resources efficiently.

  8. Yudo,
    Yes, Coase was in Univ of Chicago. But his approach in my opinion is not a part of Chicago School like Friedman & friends.

  9. Yudo:
    Agree that what to regulate is not always clear in the midst of financial innovations (that's why they are called innovations). This, perhaps, is also why the notion of "fundamental public goods" may be inadequate since innovations will easily expand the definition of public goods.

    On regulations, two points. First, there are possible cases for self-regulations (not necessarily government). It doesn't seem to work in the current crisis.

    Second, you mentioned incentives to take excessive risks. There are incentives for people to do all other things with major externalities (such as crime), and the government doesn't always do the right thing. The question is whether it should stop or whether it should try to do better (I don't really know the answer for the case of the financial market).

  10. Just a short comment.

    In tune with Rizal's post, here's a thought. Maybe the good ones...I mean the really bright econ major graduates just don't find it interesting enough to work as a journalist. They all want to work in the World Bank :D Maybe that's why we've been getting this sort of reporting from Kompas.

    Anyways, with the economic meltdown looming's a great time to be a tenured professor as this one shows:

  11. But Pasha, did you notice that none of those journalists I mentioned is an econ major graduate?

  12. just some notes.

    At Pasha.

    "Any rule imposed upon agents by any coercive action must be government intervention" (Pasha).

    Not necessarily. The fishermen of whale-hunting community in Lamalera, Nusa Tenggara - to name an example - has established (evolving) rules upon (adaptive) agents by the institution (i.e., cooperation) they have crafted themselves. To the extent that coercion is understood as formal law, then you're right: only government can exercise it.


    the segregation (i.e., neoclassic and institutional economists) depends very much on how we see the school of thoughts. Williamson and co are friends of neoclassical economics (sure, they are critical and do acknowledge particular dimension such as bounded rationality.) They differ from the those of classical institutionalist tradition, like Veblen, to whom institution is seen more than simply "rules of the game."

    I share agreement with you, Dendi, as you imply that the world without transaction cost perhaps is non-existent. A change in policy imposes cost on others.

  13. @ Sony
    That's my argument not Pasha's ;). I don't know exactly how the fishermen institution in Lamalera, Nusa Tenggara works. But based on your story, it seems that the cooperative behavior in the fishermen community is similar to what Avner Greif found in the 11-century Maghribi traders. In brief, cooperation takes place because of self-enforcement and a coalition among traders which imposes “social norms” and threat of retaliation (punishment) for any defecting behavior. I think, self-enforcement and threat of retaliation are not coercive actions as the latter may injure your right even when you do nothing bad. I’m not law expert, but a coercive action should not necessarily be drafted in law.

  14. Yudo: Thanks for the correction. The argument's yours not Pasha's.

    As for coercion, I was referring to your sentence

    "Any rule imposed upon agents by any coercive action must be government intervention"

    and had in Mind the (Weberian) way of coercive power exercised by the state. And state here is a arbitrary "proxy" to your "government intervention" ;) Yes, I'm not a legal expert either. So I won't go further on this.

    Your story of Maghribi traders is delicate. Especially because "cooperation takes place because of self-enforcement and a coalition among traders which imposes 'social norms' and threat of retaliation (punishment) for any defecting behavior."

    In the Lamalarean case, or in other so-called small-scale communities, where games of cooperation (such as ultimatum and public goods game) have been played and replicated, the idea that Dendi has brought up turns to be more relevant, in which the way neoclassical economics (i.e, the walrasian, to be precise) seems to be inadequate in explaining the nature of human behavior. In explaining the relationship between "moral sentiment" and "material interest", to quote one of the 2008's article in Journal of Public Economics.

    And this is of relevance to your fine argument on the need to examine closer the "fundamental public goods". We, the economists, have been trained, that the unique single equilibrium always appears (i.e. always defect, not cooperate) in public goods setting.

    Experimental economics and behavioral game theory have a more nuanced story on this. Preferences are heterogeneous (= agents are not always free-riding) and, unlike Becker and Stigler, are context-dependent.

    Against that backdrop, any discussion on institution might take a different path.