Facebook Solution

On a recent visit to my favorite secondhand bookstore here, I bought a small book with nice cover titled On Rumors, by Cass Sunstein. I like this short book while discussing its first two subtitles -- how falsehood spread and why we believe them-- (answer: informational and confirmatory cascade and group polarization) ; but not so much on the third -- what can be done.

It's a small wonder nonetheless, knowing that Sunstein, along with Thaler, is the leading figure in paternalistic libertarianism. He goes that to prevent falsehood to spread, we need to create a "chilling effect" against rumors through law.

But actually I like what he describes as (overly) optimistic market-for-ideas solution when he write:

"Perhaps the Facebook generation and its successors will treat a wide range of rumors, including negative and vicious ones, with bemusement or a yawn."

This is spot-on.

Econometrics Agony

Agony is when ManU/Liverpool/Chelsea/Arsenal lose to one and another --depends on what team you root for.

But for ones who ever do econometrics exercise for their paper, few beat the definition of agony in a short haiku by Keisuke Hirano that appeared in the highly recommended Angrist and Pischke's Mostly Harmless Econometrics.

T-stat looks too good
Try clustered standard errors --
Significance gone

OK, it's not as depressing as infamous Hemingway's six-word story ("For sale: baby shoes, never worn."); but trust me, if you ever work with regression and robustness test, you would share the pain.

Dr. Doom* says

"Indonesia, moreover, has shown resilience not only economically, but also as a nation. In spite of its diverse ethnic makeup and far-flung island territory, the country has made a quick transition from military dictatorship and has recovered from myriad challenges and setbacks, including the 1997 Asian financial crisis, the tsunami in 2004, the emergence of radical Islam, and domestic unrest. While Indonesia’s per capita GDP remains low, it is a country’s potential that matters in economic affairs, and here Indonesia shines."

" *Nouriel Roubini of NYU, in this commentary

On Banking Crisis

So if you like Kindleberger's Manias, Panics, and Crashes, chance is that you'll like this Reinhart and Rogoff's This Time Is Different.

One of the reasons is that the latter gives not only narrative, but also some simple numbers to ponder. My favorite chapters are on banking crisis, inflation, and currency crisis. The discussion on the Second Great Contraction (a.k.a current US financial crisis) is also worth for perusal.

Chapter 10 starts with these sentences:

"Although many now-advanced economies have graduated from a history of serial default on sovereign debt or very high inflation, so far graduation from banking crises has proven elusive. In effect, for the advanced economies during 1800-2008, the picture is one of serial banking crisis."

also,

"...there is indeed significant theoretical and empirical support for the view that a collapse in a country's banking system can have huge implication for its growth trajectory."

Moral of the story: dealing with potential banking crisis is bloody difficult and easier said than done.

On the role and limit of community

If I were a newspaper journalist, writing a story on the Nobel Prize winners should not be a difficult job. Just translate and rephrase the 5-page public information prepared by the committee, which has neatly summarized the contribution of the Laureates. Unless if you had a prior ‘agenda’ in your mind; e.g. attacking mainstream economics cum economists cum global capitalism. Then you risk writing something that has no connection between the report and your conclusion.

My favorite newspaper provided a good example on how a single paragraph had successfully driven the article way out of context:

The economic collapse caused by the crisis was a blow to the Nobel Committee’s credibility. The public has seen how economic theories, which have been developed by economists and brought them previous Nobel awards, were proven ineffective, leading to the global economic catastrophe.

Surely, if the ‘reporter’ has spent some time in researching previous awards, he or she may have understood that a significant portion of the awards were given to economists who have devoted their career to show how market can fail. Moreover, although Ostrom and Williamson’s work was about non-market transaction, it is misleading to conclude that non-market transaction is a solution to the market at anytime and any place.

Remember, also, that the Nobel Prize in Economics is awarded to studies that have made significant contributions over the past two or three decades. That means, there is a 2-3 decades lag between the time the theories were developed and the Prize. During the period, many studies have followed the original works. So it doesn’t mean that this year’s Nobel marks a significant U-turn in the economic discipline.

One particular area is how communities can solve the coordination and allocation problem in the absence of working market – Ostrom’s contribution. In the past two decades, there have been a significant number of economic papers that studied this issue. I summarized some of them in this note.

In addition to that, I’d also want to point out some interesting papers written by MIT’s Ben Olken. Here he showed that higher level of ‘civic participation’ in the village is not associated with lower village corruption, contrary to the standard theory of social capital. In another paper he argued that, external monitoring (for example, audit by a government agency), is still more effective in minimizing corruption of local public expenditure compared to monitoring by community.

In this work in progress (co-authored with others), he showed that in identifying who are the poor in a community, full community-based targeting is no more dominant than the top-down approach. However, a combination of the two provides the best result. Then, in another paper, he concluded that higher level of civic participation in local political decision making has little effect on actual decisions. However, the inclusive process in itself can substantially increase satisfaction and legitimacy.

The bottom line is, while the role of community should be appreciated more and paid greater attention in economic works, we also need to understand the limit of community in solving the problem of allocation and coordination. No need to say, we should be very careful before making inferences on the relations of Ostrom’s works and the solution to the economic crisis.

Note: all Ben’s works above are using Indonesian cases.

On market, behavioral economics and poverty

In my Facebook note, which have somewhat become the substitute for blogging, we have a productive exchange on, again, market. Specifically, on why most economists believe in the market, what are the limits of the market, and how the economics as a discipline has evolved and integrated the so-called 'non-mainstream' approaches. One of the 'non-mainstream' approaches is the field of behavioral and experimental economics. Basically, they show how the rationality assumption is often violated due to cognitive, emotional, bounded rationality etc.

I just recalled some readings by Harvard's Sendhil Mulianathan that addressed how psychology and behavioral perspectives can help us understand more why rationality assumption often fails, particularly in the context of poverty: this one, this one (with Richard Thaler), and this one (with Marianne Bertand and Eldar Shafir). Those three are basically emphasizing each other. He discussed some cases in which the rational maximization model may not be a very good approximation of human behavior, especially when we talk about poverty: underinvestment in education, undersaving, loss aversion in property rights assignment, misaligned teacher's motivation or low take-out rate of social programs.

I admit that, yes, we have to keep rethinking our epistemological position on rationality and how the market works and doesn't. On the other hand, we as economists do know that market often fails, hence it results in suboptimal outcome. But what we doesn't always know why it fails, let alone what solution should we prescribe. The reason is because "all working markets are alike, every failed markets fails in their own way." Meaning, we need to see things case by case and come up with specific - take a deep breath - policy implication, if any.

So why do we still stick to our mainstream or traditional economic tools? Because it is still a good tool. It enables us to: 1) compare the outcomes when the market works (called the benchmark condition) with the one under market failure, 2) analyze which assumptions are violated, 3) think about what - take a deep breath - policy implication, if any.

And The Nobel was (not) given to…

Update: a typo in the 7th paragraph has been corrected. Thanks, Roby. Also, take a look of Haryo Aswicahyono's nice analogy of Williamson's work here (Facebook member only).

If you are betting on Oliver Williamson winning this year’s Nobel Prize, congratulations! According to Ladbrokes, his odd was 50/1. Elinor Ostrom was not even on the market as she is a political scientist by profession. (Don't forget also that Ostrom is the first female Laureate!).

But this is what makes the Nobel Prize in Economics interesting: there is no good predictor whatsoever on who’s going to win in a given year. You may tip someone to win it within, say x years, or win it someday. But I guess no one have ever made a good fortune in betting on the winner. Kaushik Basu once said, he was tipping his mentor Amartya Sen to win the Prize for five years in a row before he gave up. When Sen did win it in 1998, Basu did’t bet. In the 1990s, almost everyone predicted Paul Krugman will win the Prize. But just when everybody stopped thinking Krugman will win it at all, the Committee awarded him in 2008.

To be honest, I am not a follower of both works, so I won’t be a good reviewer of the decision. But the official Nobel Prize website has written a nice summary of their works (as well as a more elaborated one). What I am interested is what is the message, if any, sent by this year’s award? It’s not that the Nobel Committee has ever taken into account the recent economic situation or discourse in making their decision. However, it’s hard to disagree that the current global crisis has put economic science and profession under the spotlight more than ever. In that case, I am more interested in taking a closer look on who don’t win it.

Prior to the announcement, several names were being tipped as the strongest candidates. One name that has been constantly in the circulation for some years is Chicago’s Eugene Fama. He was referred to as the father of the ‘Efficient Market Hypothesis.’ I do think he deserves the Prize (most likely shared with Kenneth French), based on how influential his work is. But for many reasons, I can see that if he wins it this year, it will spark controversies, even bitter and harsh debates, however unfair it will be.

Another strong candidate was Ernst Fehr. He was well-known for his contributions in behavioral finance, experimental economics, even neuroeconomics – where people see how human makes economic decisions from neuroscience perspective. Fehr, and some other people that may share the Prize like Matthew Rabin, Richard Thaler or Armin Falk, has worked in a field that can somehow be a counter-argument to the efficient market argument. Bounded rationality, cognitive and emotional factors and other things make rationality assumptions are often violated. No one will doubt their significant contributions to economics. However, if the Prize goes to Fehr et al, I can see a wave of ‘I told you so’ attitudes, or even disproportionate attack against the rational agent vis-à-vis efficient market camp.

Well, I may be wrong. Those controversies may not happen at all.

Back to this year’s Prize. If there is any message from the decision, then it would be “Let’s pay more attention to other things apart from the market.” Ostrom and Williamson’s work show that many transactions happen outside of the market: within society or ‘commons’ (Ostrom’s), or firm (Williamson's). True, in many cases market fails to exist or work properly. But even in the absence of the market that is working properly, agents can still coordinate actions that is optimal, and that the government intervention is not always the answer. A closer look on what happens within the mezzo-institution will help us understand ‘what-to-do’ better.

That’s the best I can summarize. Better comments include:

The common theme underlying the prize this year is that markets do not solve all problems of resource allocation and incentives well or even at all. That is not a new idea. What is important is that people and societies find ways through organizational structures and arrangements, political and other institutions, values, incentives and recognition, and the careful management of information, to solve these problems. (Michael Spence).

Issuing the award to these two economists is a welcome trend because it once again leads us to focus on the microeconomic issues that have, when aggregated, macroeconomic consequences. … The joint award to Ostrom and Williamson could be read as a needed corrective on this macroeconomic approach. The common thread that links these two authors together is their concern with mid-size institutions that face serious questions of coordination and control. (Richard Epstein).

… the Nobel selection committee … is expanding the scope of "economic sciences" into the social sciences. That is probably a good thing for several reasons. … I think the point to emphasize is that Elinor Ostrom does great economics at the same time as she does great political science. So does Dan Kahneman. The overlap between the two disciplines is great. (Thomas Schelling).

They show how firms, communities and organizations come to solve these problems absent government regulation and how the choices they make can be disrupted or worsened by bad state policy or sustained by good rules that promote stable property rights and reliable contracts. (John Nye).