Stone’s Fall

I have been reading a bit more fiction this summer and recently finished Iain Pear’s new novel Stone’s Fall. The reason that I reference the book here is because, in addition to being a good novel, it is replete with references and lessons in economics. The book is centered around the story of John Stone (Lord Ravenscliff), a wealthy English businessman who dies after falling out a window. His will leaves a substantial sum to a child that his (much younger) wife knows nothing about. This leads her to hire a newspaper reporter with a knack for getting to the bottom of a story to find this child. The story is told in three parts by three separate narrators in three separate time periods in three different locations (London, Paris, and Venice).

While the book is quite good in and of itself, I think that I enjoyed it much more because of the references to economics. The book takes place during the end of the 19th- and the dawn of the 20th-century and is filled will a discussion of the changing economic landscape as a result of the Industrial Revolution. The first narrator is the reporter, Matthew Braddock, who initially is quite skeptical of capitalism. However, there is a great Hayekian moment in which the reporter visits a vertically integrated shipyard (p. 174 – 5):

“I stared in utter amazement, and with emotions verging on awe. The yard was gigantic, so big you could not see the end of it, whichever way you turned, it was simply swallowed up in the haze of sunlight through smoke. A vast mass of machinery, cranes, yards, buildings, storage areas, assembly sheds, offices, stretching out before my eyes in every direction. Plumes of thick black smoke rose from a dozen chimney, the clanking, thudding, scraping and screeching of machinery came from different parts of the scene. It seemed chaotic, even diabolical, the way the landscape had disappeared under the hand of man, but there was also something extraordinarily beautiful in the intricacy…”

[…]

“And you run it all?” I asked, genuinely impressed.

“I run this plant.”

“How? I mean, how can one person have the slightest idea what is going on in that — chaos?”

He smiled. “That is where Ravenscliff was a genius. He developed a way of controlling all this, and not just this, but all of his factories, so that any moment you can find out what is going on, where it is happening. So that chaos, as you call it can be tamed and the hidden patterns and movements of men, and machinery and capital and raw material, can be forced to act in a way which is efficient and effective.”

“Elegant?” I suggested.

“That is not a word a businessman often uses, but yes, it is elegant, if you wish…”

Later the plant manager even explains the insights of Adam Smith’s “invisible hand”, telling the reporter that, “[t]he job of any company is to make as much profit as possible. As long as that is the main aim of the managers, then there is no need to direct them. They will, collectively, take the right decisions.”

The second part of the book was likely my favorite as it is narrated by Henry Cort, a British spy. Without giving away too much of the plot, Cort discovers a plan orchestrated by the French and the Russians to weaken (and perhaps ruin) the Bank of England by draining its gold reserves. This story line is excellent, with a discussion of banking and the role of the international gold standard.

The third section is told from the perspective of John Stone and succeeds in filling in the gaps of the mysterious businessman as well as the main story arch. It is in this section that we get my favorite quote from the entire book (p. 427):

“A few months ago I read a book by Karl Marx on capital. Elizabeth gave it to me, with a smile on her face. A strange experience, as the author’s awe exceeds even my own. He is the first to understand the complexity of capital and it subtlety. His account is that of a lover describing his beloved, but after describing her beauty and the sensuality of her power, he turns away from her embrace and insists that his love should be destroyed. He could gaze clearly into the nature of capital, but not into his own character. Desire is written in every line and paragraph of his book, but he does not see it.”

In short, Pears has written an excellent novel. While the main plot, as described above, seems rather simple, the book is anything but. The subplots, the richness of the characters, and, of course, the economic references make this a great text for the average reader and econ nerd alike.

Best. Title. Ever.

A new NBER working paper by Gary Gorton and Andrew Metrick is entitled “Haircuts.” It’s a great title and an interesting paper. Here is the abstract:

When “confidence” is lost, “liquidity dries up.” We investigate the meaning of “confidence” and “liquidity” in the context of the current financial crisis. The financial crisis is a manifestation of an age-old problem with private money creation, banking panics. We explain this and provide some evidence with respect to the current crisis.

Here is the link (sorry, it is gated).

Quote of the Day

“I have been reading [John] Taylor’s various arguments very closely since last fall. I also read a lot about the failure of modern economics, and how modern macroeconomists in particular have been proven completely worthless. But reading Taylor has made me really think twice about those statements.”

— Pete Boettke

Yet More Unseen Effects from Cash for Clunkers

Courtesy of Division of Labour:

Mechanics don’t seem to like the program….

…nor do charities.

A Mass Breakout of Laziness

It seems to have become the purpose of this blog for me to defend ideas that I don’t particularly believe in. First, I had to defend claims about the stimulus package despite my opposition to it. Now, I must defend real business cycles.

First, our friend Arnold Kling offers an alternative to what he refers to as “hydraulic macro”:

I wish to reject this whole concept of macroeconomics. Instead, I want to get economists to think about unemployment in terms of the economic calculation problem.

[…]

I think that in the last 18 months, an unusually high number of people have had their plans go awry. They wish they had made different choices in terms of their education and occupations. Digging out from these mistakes is going to take a long time. A lot of recalculation needs to get done, and the problem is really daunting.

I don’t think that fiscal and monetary policy solve this calculation problem. At best, they substitute the errors of fumbling central planner for the errors of fumbling individuals.

(In a follow-up post, Kling refers to this as “not your father’s real business cycle theory.”) In response to this post Karl Smith asks:

I am sensitive to this perspective. Its elegant and compelling to see real micro problems at the heart of macro fluctuations. There are several problems, however:

— How do you get to unemployment from here. If people are retooling I see a huge demand for retraining. Or them accepting very low wages in a new industry but why persistent unemployment. Why doesn’t the labor market clear.

— How you get from here to monetary induced contractions. Maybe there is still debate over whether the Fed can stop a recession or at what costs. However, how do you get from here to the Fed being able to start a recession. The experience of the early eighties seems to clearly show us that the Fed can.

— How do we get the Great Depression from here?

Ultimately these are the challenges that I think sink most attempts at a real macro theory. [Emphasis added.]

[SIGH.]

Before proceeding, I would like to remind folks that the original real business cycle models were not used to claim that the entirety of all business cycles were independent of money, sticky wages and prices, etc. Rather, they were used to demonstrate that a significant portion of the business cycle could be explained without these frictions.

In any event, the quote in bold has long been one of the fundamental complaints leveled against real business cycle models. Kling himself references Modigliani calling real business cycles “a sudden breakout of laziness.” Others question the existence of negative productivity shocks. Et cetera, et cetera. However, real business cycle theorists have spent a great deal of time attempting to address these concerns. Kehoe and Prescott recently edited an entire book dedicated to understanding depressions using real business cycle theory.

What’s more, it is not acceptable to pose this question regarding the depression in 2009 as Cole and Ohanian wrote a highly cited paper on the Great Depression using a real business cycle model 10 years ago. Here is the abstract:

Can neoclassical theory account for the Great Depression in the United States — both the downturn in output between 1929 and 1933 and the recovery between 1934 and 1939? Yes and no. Given the large real and monetary shocks to the U.S. economy during 1929–33, neoclassical theory does predict a long, deep downturn. However, theory predicts a much different recovery from this downturn than actually occurred. Given the period’s sharp increases in total factor productivity and the money supply and the elimination of deflation and bank failures, theory predicts an extremely rapid recovery that returns output to trend around 1936. In sharp contrast, real output remained between 25 and 30 percent below trend through the late 1930s. We conclude that a new shock is needed to account for the Depression’s weak recovery. A likely culprit is New Deal policies toward monopoly and the distribution of income.

(Non-gated link.)

Now, of course, one does not have to agree with Cole and Ohanian or other real business cycle theorists. (See, for example, this paper by Gauti Eggertson entitled, “Was the New Deal Contractionary?”) However, there are explanations out there that address the questions that Smith is asking.

UPDATE: It seems that Will Ambrosini beat me to this.

A Tale of Marginal Analysis

Casey Mulligan has written a post entitled, “The Laws of Economics Have Been Suspended”. Here is the gist:

Professor Krugman is also saying this week that this recession has nothing to do with bad incentives to earn labor income. (Bless him for citing me! When this is all over, I would love to have a monopoly on teaching the “old fashioned” laws of economics.)

I don’t quite understand this obsession with UI-apologetics, because UI (unemployment insurance) is just one of many policies that collectively (and some by themselves) create terrible incentives:

• mandating the employers with large payrolls provide health insurance, but that employers with small payrolls do not
• minimum wage hike
• means-tested mortgage modification (presenting millions of workers with implicit tax rates in excess of 100% (sic))
• mean-tested student loan modification
• unemployment insurance extensions
• state income tax hikes,
• IRS means-tested enforcement of prior tax debts
• marginal federal tax rate hikes on the “rich”!

According to Professor Krugman, I am the only one crazy enough to suggest that a list of bad incentives like this might actually show up in the aggregate data!

Not content to let Krugman take all of the credit, one of the anonymous bloggers over at The Economist has written a post entitled, “Lazy workers, enjoying the dole”, in which they argue:

Mr Mulligan seems to be to be using one point, on which he is correct, to make another, on which he is very wrong. Unemployment benefits clearly do provide an incentive to stay out of work longer. Holding other things constant, we would expect an increase in the generosity of unemployment benefits to lead to more joblessness.

But that does not mean that in the absence of unemployment benefits the unemployment rate would be lower, because one cannot hold other things constant while changing benefits.

Of course, this prompted a response from Will Ambrosini: “The Economist doesn’t understand marginal analysis.” Ouch!

Perhaps this is an example why economists have been much maligned recently.

More on Cash for Clunkers

Russ Roberts:

Imagine you’re a member of Congress. You’re a fan of the Cash for Clunkers program. You discover that the $1 billion that Congress budgeted for the program has been spent in FOUR DAYS. The program is now out of money. What do you do?

A. Realize that $4500 per clunker was too big a subsidy and that you can achieve the same effects with a much smaller amount.

B. Worry that maybe there is some fraud in the program and that some of the cash isn’t going to clunkers

C. Increase the budget by $2 billion

HT: Three Sources

Cash For Clunkers

Randall Forsyth on “Cash for Clunkers”:

What’s especially dispiriting is that this lesson was taught more than a century and a half ago by French economist Frederic Bastiat.

A shopkeeper’s window was broken by a little boy, which made for extra business for the glazier who fixed it. Extended to the ultimate, breaking every window in town would be the ultimate windfall for the glazier. The town’s income statistics and tax revenues would record a gain.

But the town would be worse off. Their old windows would be replaced with new ones, perhaps more energy-efficient, but the shopkeepers and homeowners would be out the cost of the new windows.

Steroids, Baseball, and Economics

Steve Buffum writes:

I was thinking of this when I read Buster Olney’s description of the behavior of baseball players in 2003 in the face of steroid testing. Olney seemed to believe that this was a spectacular case of outrageous “selfishness” on the part of those players who chose to use PEDs. If you draw this as a game-theoretical matrix, though, you find that the Nash Equilibrium is, in fact, exactly where the real-life system ended up. For the purposes of this analysis, it does not matter exactly what the effects of PEDs are on performance, only that the individual player perceives a significant value to using them. The players’ actions are based on their beliefs, not necessarily on any grand longitudinal study of physical results.

[…]

In a sense, having players testing positive for PEDs in this circumstance doesn’t represent anything extraordinary. It’s pretty much the result predicted from a combination of Game Theory and Human Behavior. Somewhere, John Nash is nodding patiently.

HT: Gbenga Ajilore