Economists Behaving Irrationally (or Economists Gone Wild!)

Brad de Long considers it "the greatest improvement in economics in my lifetime."

He is referring to the Journal of Economic Perspectives' recent decision to allow open access to its articles on the web. I tend to agree with him on this and hope that other serious academic journals follow suit.

Anyway, I took the opportunity to scan the contents of its archives to find articles that discuss a relatively new perspective in the economics profession, and that is how individuals or agents do not act rationally most of the time.

I came upon this one by Liran Einav and Leeat Yariv entitled What's in a surname? The effects of surname initials on academic success. It finds that among leading economics departments in the US, the supposed pre-eminent exemplars of rational decision-making,

Faculty with earlier surname initials are significantly more likely to receive tenure (...) are significantly more likely to become fellows of the Econometric Society, and, to a lesser extent, are more likely to receive the Clark Medal and the Nobel Prize. These statistically significant differences remain the same even after we control for country of origin, ethnicity, religion or departmental fixed effects.

There you have it, evidence that economists behave irrationally. The authors go on to state

We suspect the “alphabetical discrimination” reported in this paper is linked to the norm in the economics profession prescribing alphabetical ordering of credits on coauthored publications. As a test, we replicate our analysis for faculty in the top 35 U.S. psychology departments, for which coauthorships are not normatively ordered alphabetically. We find no relationship between alphabetical placement and tenure status in psychology.

Based on this research, not only do economists behave irrationally, their actions are based on others behaving the same way(!) as shown by their careful selection of co-authors and their increasing unwillingness to follow the alphabetical ordering norm. 

I suppose the core principle of economics about people responding to incentives still holds; whether such behaviour is based on rational or irrational norms is quite another thing altogether.

The glorious revolution

In my title, I am of course referring to the event in England in 1688 which unintentionally led to the Bill of Rights, rule of law, and Western capitalism as we know it. As background for those unfamiliar with it, there are two short clips at the end of this piece worth viewing.

The now classic essay by Douglass North and Barry Weingast investigates the institutional innovations that accompanied the resolution of this conflict and relate them to developments in public finance. Their thesis is that without such constitutional and political underpinnings, England would not have achieved global success both militarily and commercially in the following century.

They purposely side-step the religious element that is often cited. Greater importance was placed on the dispute that had been brewing since early in the 17th C between the Crown and Parliament. Many of the same issues in this dispute hound developing and transitional economies today.

At the core of this was the structuring of incentives to control the coercive powers of the state. Previously the divine right of kings was invoked to justify the arbitrary use of such powers resulting in the expropriation of property from the wealthy who were represented in Parliament. Despite objections, the king continued to wield his prerogative by forcing loan contracts on the elite and reneging on the debts.

This unpredictability meant that the Crown was unable to tap private credit markets. Following the revolution, the new monarch acceded to the rights of Parliament over such contractual obligations. As a sweetener, the confidence this engendered opened unprecedented access to capital at more affordable rates. This allowed England to achieve military superiority while maintaining fiscal liquidity and provided the conditions needed for the Industrial Revolution.

It is in keeping with this seminal work that much discussion circles today around the enforcement of property rights and the rule of law in developing and transitional economies. At the heart of the debate is the question whether Western notions of governance particularly legal institutions should be transplanted elsewhere. The differential experiences found in China and East Asia cast doubts on whether a "one size fits all" approach is appropriate.

The Philippines is an example of a developing country that went through a "peaceful revolution" to topple a dictator in 1986, but which is still mired in corruption and political instability. It has enshrined "people power" in its constitution as a vehicle for removing tyrannical rulers. The vibrant NGO and activist business community have proven since then how potent a threat this institution can be.

But the high transactions costs entailed in mobilising popular uprisings has taken its toll. As a result of experiments over the last decade, there is a growing demand for the rule of law in the form of restraint on the part of both the central government and civil society in expropriating public and private wealth from one another. Should a government be formed that addresses this demand, it might pave the way for greater investments in productive sectors, the same way that mutual checks in England between the Crown and Parliament did.

The Romanticism of Elections

As the election season officially commenced in the Philippines this week, it has become quite fashionable among prominent local commentators to romanticise the current Philippine presidential race of 2010 painting it in the epic proportions of a contest between the forces of good and evil. An example of this is a recent column by Mr Manolo Quezon, a former speechwriter for Pres Gloria Arroyo in which he traces the political genealogy of all presidential contenders to the traditions belonging to one of two leading protagonsists in the 1986 people power uprising, former presidents Ferdinand Marcos and Corazon Aquino.

It becomes apparent that Mr Quezon regards only one candidate, Benigno Aquino III, the only son of Corazon, worthy of claiming the mantle of democracy represented by his late great mother. All others it would seem belong to “the wrong side of history” as Pres Marcos had been in 1986. A win by any of these candidates would be “impermissible” from Mr Quezon’s perspective. The dark and ominous undertones of such a statement are evident. Either election officials conclude with an outcome consistent with History (with a capital H), or the forces under the Aquino banner might or should enforce their own will on the situation and produce the right outcome from their perspective.

I don't think it is accurate to paint this race using such a broad brush. It would be an oversimplification of what the candidates, Mr Aquino and everyone else, truly represent. I don't think for instance it is fair to associate any one candidate with the repressive authoritarian regime of Mr Marcos for instance. Not one of them is espousing a return to dictatorial rule, but anyone including Mr Aquino could be capable given the right circumstances of taking the country down a path of greater repression of civil liberties and weakening of property rights as the embattled rule of Mrs Arroyo so aptly demonstrated through her flirtations with emergency powers.

A more balanced approach would produce a nuanced view of the two leading contenders, Messrs Aquino and Manuel Villar, a self-made Fortune 500 tycoon with a rags-to-riches story. It would show the evolution of two previously flawed attempts at addressing the problem of underdevelopment in the Philippines which they, on the face of it, represent and hope to redeem.

One strand, implicitly espoused by Mr Villar, has sought to deal with the rent-seeking nature of a weak state by centralising rule-making with the chief executive and by so doing reduce the potential for petty corruption elsewhere. This is a situation which makes the office he would occupy prone to intensive lobbying, but by the same token, present an improvement on the current situation of chaotic decentralised plunder. With a more disciplined bureaucracy and a coherent strategy, rapid development as illustrated by the East Asian economies becomes possible.

This assumes of course that the chief executive himself is disciplined and capable of resisting intense pressure to collude with powerful interest groups. But even if he succumbs to such pressure, the founder of the Corruption Perception Index (transparency.org) Johann Lambsdorff has found that investors actually prefer grand corruption over petty corruption (!) presumably because of the greater predictability that the former affords.

The problem though with this strand is that in some cases corruption does serve a purpose in enabling productive sectors of society to overcome stifling regulatory hurdles in the pursuit of greater value and output within the economy. By centralising rule-making, the executive also centralises deal-making, which means that only a select group of associates and hangers-on can take advantage of the unique opportunities that abound under a crafty and entrepreneurial president as demonstrated by the past administrations of Messrs Marcos and Joseph Estrada (ousted and convicted for plunder but later pardoned by Mrs Arroyo and now placed third by many pollsters in the race to succeed her).

This lessens the amount of investments made by other players due to fears of expropriation by those closely linked with the administration, a point that is exemplified by a scandal involving Mr Villar’s commercial property ventures and two nearly identical road projects. One was publicly funded, thanks to Mr Villar’s intervention as the head of a powerful Senate finance committee, the other privately financed under a fee for use basis. The private venture eventually backed down due to competition from Mr Villar's free access road that conveniently wound through his commercial neighborhood projects.

The other strand promoted by Mr Aquino seeks to maintain the current system of decentralised rule-making and with it the petty corruption that prevails, but what it seeks to introduce is greater transparency and participation in the system. By all accounts, this is arguably the only legitimate means of prying the state loose from the clutches of special interest groups.

The challenge of course is achieving this goal with the meager resources that a third world nation can ill afford to waste given the multitude of development programs it needs to fund. If even the well resourced governments of advanced economies find it troublesome if not costly to enforce such institutions. (An eminent economist in the field, Douglas North, puts the price tag at 35-40% of GDP. What hope is there then for a cash-strapped government that can only raise a mere 14-7% at best?)

Ironically, pursuing “good government” through a costly enforcement system might in the long-run lead to greater corruption. This is a view endorsed by some leading institutional economists. And in the Philippines, it could be argued, the confiscation and sale of assets acquired illegitimately by public officials that begun under Mrs Aquino has itself become a source of corruption.

So in the end what we are left with are permutations of previously failed or flawed experiments espoused by members of the ruling elite in the hope of vindicating the competing hypotheses adopted by their predecessors in addressing the underdevelopment problem of the country. It is not that one candidate is on the right side of history and the other is not. What each party is seeking at this point is a way to carve out a place in history that would suit their own personal narratives.

Nevermind the BRICs, Here Come the MAVINS

What does being an emerging market mean? The definition seems amorphous. When Jim O'Neill coined the term BRICs back in 2001, he had in mind demographic and financial blocs in developing or transitional economies that were vast and growing. This definition was relaxed to include countries that had "caught up" with advanced economies such as South Korea and Gulf Cooperation Council members.

As the Great Recession turns into the Great Recovery, the converging economies seem to be compensating for the somewhat stagnant growth experienced by most of the developed world. Market analysts at Bloomberg have now coined a new term, MAVINS, referring to Mexico, Australia, Vietnam, Indonesia, Nigeria and South Africa. These six countries are going to be the BRICs of the new decade.

For policy analysts, the question posed by these forecasts is, how durable are these growth narratives? Recently a prominent shortselling market analyst predicted the imminent bursting of the asset bubble in China. It seems that China could repeat the post-dot com folly of the US Federal Reserve in easing monetary policy too long. It was reported this week that China was unwinding much of its stimulus to avoid such a tragedy, but doubts continue to linger.

More fundamental is the question regarding how suitable the institutional frameworks are for some of these emerging economies. China and Vietnam have taken a similar path to development that most of East Asia took from the 1950s to the 70s - a path different from the Anglo-American model built on the institutional building blocs of property rights, rule of law and democratisation.

Some have argued that to take such a quantum leap in such a short span of time (as opposed to centuries which is how long it took in the West) required experimentation using different tools. The impoverished countries of the East could not afford to enforce a system of property rights and the rule of law to foster impersonal contracting, the basis for market-based transactions, so they instead relied on more paternalistic (read: authoritarian) forms of development, i.e. the Development State. Here is a video stating this argument.

This development strategy only takes these countries so far, so the counter argument goes. Unless these emerging economies, China and Vietnam, adopt reforms in their courts and legal system to strengthen contract and property rights, their growth will eventually slow.

So far, it does not seem like the Communist leaders in either country have signalled any intention to go down that path, so I suppose the theory of sustained growth contingent on second stage reforms posited above will be tested soon.

Aquino on Countering the Calculus of Corruption

At the press conference following his announced bid for the presidency in 2010, Benigno "Noynoy" Aquino III revealed what could be a guiding principle in his approach to good governance.

(Right: Senator Benigno "Noynoy" Aquino III announced back in September his intention to seek the presidency of the Philippines in the election of May 2010.)

When asked about his solution to widespread corruption, he said firstly that he would emulate his mother, former President Corazon Aquino, whose reputation for simple living engendered greater honesty among public servants. Secondly, beyond appeals to a concern for the greater good, he would vigorously uphold an enforcement of the rules which would not only entail swift justice in prosecuting those who break the code, but incentives to those who abide by it. He called this his “carrot and stick” approach.

The test of this hypothesis will come no less from his office should he be elected which now seems very likely given his astronomic lead in the polls. In the past, winning and occupying the highest post in the land has been subject to what economists call an “incentive incompatible” problem, namely, a misalignment of incentives that ensured a reneging on the promise to uphold and defend the constitution and the laws of the land.

Given weaknesses in institutions, it has been all too easy to “take” rather than “make” while in office. The so-called checks on the excesses have been ineffective under the structure of rent-seeking incentives at play.

But now Filipinos could be witnessing the birth of public stewardship motivated by a true sense of noblesse oblige. Self-restraint might be the only effective means to check executive greed. In the past every contender and pretender to higher office has feigned a sense of noble intentions. The purifying trials of the Aquino family under the repressive Marcos regime may provide the most authentic case of altruism at work.

Turning their backs on the honest democratic legacy of their parents would prove too costly for the Aquino children because it would mean nullifying the sacrifices made by their parents all throughout their formative years.

The late Senator Benigno Aquino Jr set off a virtuous cycle of willling self-sacrifice that was “gifted” to the Filipino people. They reciprocated first by expressing public grief and outrage over his assassination, and then by endowing the presidency to his wife, Corazon, who in turn renewed the cycle of giving back by restoring democratic freedoms curtailed under the dictatorial regime of her predecessor.

(Right: The assassination of former Senator Benigno "Ninoy" Aquino, Jr on 21 August 1983 shortly after being escorted by airport security off his plane at the Manila International Airport triggered widespread public outrage against the Marcos regime.)

Now it seems the people in honour of her own personal sacrifice following her untimely demise due to colon cancer are about to reciprocate the Aquinos once over by entrusting the presidency to the only son of the family, Benigno III.

This politics of exchange is not the debased form of transactional politics that is common among the ruling elites and their constituents, a practice that has left the Philippines languishing at the bottom of Transparency International's corruption league table for the Asia Pacific.

Rather, the calculus of exchange that seems to have been initiated by the Aquinos follows the pattern of “gift-giving” in close-knit cultures where the commodities exchanged cannot be valued and where renewing ties by re-investing in social capital is the key.

This new and ongoing dynamic that has sparked a sense of altruistic behaviour among those engaged in the "political game” is set to counter the vicious cycle of corruption and rent-seeking that has been entrenched in the governance arrangements of political institutions operating at the moment.