More on Ostrom

A few years ago I wrote a review of Polycentric Games and Institutions, a wide-ranging collection of papers written by affiliates of the Workshop in Political Theory and Policy Analysis at Indiana University. What unites the various chapters in the book is a shared commitment to the analytical vision of Elinor Ostrom, a co-recipient of this year's Nobel Prize in Economics. I thought I would post a couple of extracts from the review as an addendum to my earlier post in appreciation of Ostrom's work (the complete review is here):

Although several distinguished scholars have been affiliated with the workshop over the years, Ostrom remains its leading light and creative force. It is fitting, therefore, that the book concludes with her 1988 Presidential Address to the American Political Science Association. In this chapter, she identifies serious shortcomings in prevailing theories of collective action. Approaches based on the hypothesis of unbounded rationality and material self-interest often predict a “tragedy of the commons” and prescribe either privatization of common property or its appropriation by the state. Policies based on such theories, in her view, “have been subject to major failure and have exacerbated the very problems they were intended to ameliorate”. What is required, instead, is an approach to collective action that places reciprocity, reputation and trust at its core. Any such theory must take into account our evolved capacity to learn norms of reciprocity, and must incorporate a theory of boundedly rational and moral behavior. It is only in such terms that the effects of communication on behavior can be understood. Communication is effective in fostering cooperation, in Ostrom’s view, because it allows subjects to build trust, form group identities, reinforce reciprocity norms, and establish mutual commitment. The daunting task of building rigorous models of economic and political choice in which reciprocity and trust play a meaningful role is only just beginning.

The review ends with the following paragraph:

The key conclusions drawn by the contributors are nuanced and carefully qualified, but certain policy implications do emerge from the analysis. The most important of these is that local communities can often find autonomous and effective solutions to collective-action problems when markets and states fail to do so. Such institutions of self-governance are fragile: large-scale interventions, even when well-intentioned, can disrupt and damage local governance structures, often resulting in unanticipated welfare losses. When a history of successful community resource management is in evidence, significant interventions should be made with caution. Once destroyed, evolved institutions are every bit as difficult to reconstruct as natural ecosystems, and a strong case can be made for conserving those that achieve acceptable levels of efficiency and equity. By ignoring the possibility of self-governance, one puts too much faith in the benevolence of a national government that is too large for local problems and too small for global ones. Moreover, as Ostrom points out in the concluding chapter, by teaching successive generations that the solution to collective-action problems lie either in the market or in the state, “we may be creating the very conditions that undermine our democratic way of life”. The stakes could not be higher.

Vernon Smith and Paul Romer have also written very nice tributes to Ostrom, which may be found here and here respectively.

Brad DeLong on Modern Macroeconomic Theory

A couple of months ago Brad DeLong wrote a post on the state of modern macroeconomic theory that every graduate student in economics really ought to read. He finds the current situation profoundly disturbing:

There is, after all, no place for economic theory of any flavor to come from than from economic history. Someone observes some instructive case or some anecdotal or empirical regularity, says “this is interesting; let's build a model of this,” and economic theory is off and running. Theory is crystalized history—it can be nothing more. After the initial crystalization it does develop on its own according to its own intellectual imperatives and processes, true, but the seed is still there. What happened to the seed?

This situation is personally and professionally dismaying. I do not say that the macroeconomic model-building of the past generation has been pointless. I don’t think that it has been pointless. But I do think that the assembled modern macroeconomists need to be rounded up, on pain of loss of tenure, and sent to a year-long boot camp with the assembled monetary historians of the world as their drill sergeants. They need to listen to and learn from Dick Sylla about Cornelius Buller’s bank rescue of 1825 and Charlie Calomiris about the Overend, Gurney crisis and Michael Bordo about the first bankruptcy of Baring brothers and Barry Eichengreen and Christy Romer and Ben Bernanke about the Great Depression.

If modern macreconomics does not reconnect—if they do not realize just what their theories are crystallized out of, and what the point of the enterprise is—then they will indeed wither and die.

What else should one be reading to make sense of the recent past? If I had to choose one book, it would be Hyman Minsky's Stabilizing an Unstable Economy, which has recently been republished. It is a work of macroeconomic theory of the highest order. And for a flavor of the arguments contained in it, take a look at The Plankton Theory Meets Minsky by Paul McCully of PIMCO.

On Elinor Ostrom

The choice of Elinor Ostrom as a co-recipient of the 2009 Nobel Prize in Economics has taken many, if not most, economists by surprise.  The annual betting pool at Harvard did not receive a single entry for Ostrom, so half the winnings were shared by those who predicted that there would be no correct guess.  On his widely read blog, Steve Levitt reacted as follows:

If you had done a poll of academic economists yesterday and asked who Elinor Ostrom was, or what she worked on, I doubt that more than one in five economists could have given you an answer. I personally would have failed the test… the economics profession is going to hate the prize going to Ostrom even more than Republicans hated the Peace prize going to Obama.

I, for one, am thrilled at the choice. Ostrom’s extensive research on local governance has shattered the myth of inevitability surrounding the “tragedy of the commons” and curtailed the uncritical application of the free-rider hypothesis to collective action problems. Prior to her work it was widely believed that scarce natural resources such as forests and fisheries would be wastefully used and degraded or exhausted under common ownership, and therefore had to be either state owned or held as private property in order to be efficiently managed. Ostrom demonstrated that self-governance was possible when a group of users had collective rights to the resource, including the right to exclude outsiders, and the capacity to enforce rules and norms through a system of decentralized monitoring and sanctions. This is clearly a finding of considerable practical significance.

As importantly, the award recognized an approach to research that is practically extinct in contemporary economics. Ostrom developed her ideas by reading and generalizing from a vast number of case studies of forests, fisheries, groundwater basins, irrigation systems, and pastures.  Her work is rich in institutional detail and interdisciplinary to the core. She used game theoretic models and laboratory experiments to refine her ideas, but historical and institutional analysis was central to this effort.  She deviated from standard economic assumptions about rationality and self-interest when she felt that such assumptions were at variance with observed behavior, and did so long before behavioral economics was in fashion.

The decision by the Nobel Committee to recognize and reward work that is so methodologically eclectic and interdisciplinary might be viewed as a signal to the profession that it is insufficiently tolerant of heterogeneity and dissent. This is a particularly salient criticism in light of the recent financial crisis and the severity of the accompanying economic contraction. Could it not be argued that economists would have been less surprised by the events of the past couple of years, and better able to contain the damage, had there been more methodological pluralism and less reliance on canonical models in the training of economists at our leading universities?

It may be countered that economics has indeed imported many methods and ideas from other disciplines. Behavioral finance and experimental economics are both areas of intensely active research, and work in these fields is routinely published in top journals.  However, even such interdisciplinary cross-fertilization has something of a faddish character to it, with excessively high expectations of what it can accomplish. Behavioral economics, for instance, has been very successful in identifying the value of commitment devices in household savings decisions, and accounting for certain anomalies in asset price behavior. But regularities identified in controlled laboratory experiments with standard subject pools have limited application to environments in which the distribution of behavioral propensities is both endogenous and psychologically rare. This is the case in financial markets, which are subject to selection at a number of levels. Those who enter the profession are unlikely to be psychologically typical, and market conditions determine which behavioral propensities survive and thrive at any point in historical time.

Hence it could be argued that the recognition of Ostrom’s work this year was not just appropriate but also wise. There is no doubt that her research has dramatically transformed our thinking about the feasibility and efficiency of common property regimes. In addition, it serves as a reminder that her eclectic and interdisciplinary approach to social science can be enormously fruitful. In making this selection at this time, it is conceivable that the Nobel Committee is sending a message that methodological pluralism is something our discipline would do well to restore, preserve and foster.

On Michał Kalecki

Brad DeLong posted the following earlier today, referring to Michal (not Michel) Kalecki:

Back in the 1930s there was a Polish Marxist economist, Michel Kalecki, who argued that recessions were functional for the ruling class and for capitalism because they created excess supply of labor, forced workers to work harder to keep their jobs, and so produced a rise in the rate of relative surplus-value.

For thirty years, ever since I got into this business, I have been mocking Michel Kalecki. I have been pointing out that recessions see a much sharper fall in profits than in wages. I have been saying that the pace of work slows in recessions--that employers are more concerned with keeping valuable employees in their value chains than using a temporary high level of unemployment to squeeze greater work effort out of their workers.

I don't think that I can mock Michel Kalecki any more, ever again.

Few economists have been more unjustly neglected by the profession over the past century than Kalecki, so I was happy to see him mentioned on DeLong's widely read blog. But I feel obliged to point out that Kalecki was well aware that "recessions see a much sharper fall in profits than in wages". His two-sector model predicts precisely this. Kalecki assumes that all wages (and no profits) are spent on consumption goods, which implies that total sales in the consumption good sector are equal to the sum of wages in both (consumption and investment good) sectors. Hence total investment expenditures equal total profits in the economy. Since total investment expenditure is determined by the aggregate (uncoordinated) decisions of firms, Kalecki concluded that while workers spend what they get, capitalists get what they spend. When private investment investment collapses (the hallmark of a recession) then so do profits.

Kalecki's work anticipated significant parts of Keynes' General Theory, and it's a pity he doesn't get more credit for this.

The 2008.DEM.VP.GORE Contract

There have been some very strange price movements in the 2008.DEM.VP.GORE contract on intrade since late May:

This contract pays $10 if Gore is the democratic vice-presidential candidate in 2008. The probability of this event has got to be approximately zero. I can't imagine why someone is sinking thousands of dollars into this contract.

This has to be either a crazy hunch by a very rich individual, or an attempt to profit from some astonishing inside information.

For more on this see:

http://the-ts-maven.blogspot.com/2007/07/demvpgore-knife-fight.html

Information and Prices

How exactly does new information get transmitted into the prices of financial assets once it becomes publicly available? To me this is one of the most interesting questions in the economics of finance. Sometimes the information has rather obvious price implications. For example, once Mark Warner announced that he would not be seeking the Democratic presidential nomination, the price of the contract 2008DEM.NOM.WARNER (which pays $10 if he is the eventual nominee) dropped rapidly from about $1.50 to practically zero, and has remained there since. It's perfectly obvious to everyone that this contract is very unlikely to pay anything at all.

Most of the time, however, new information is much harder to interpret. Today, for example, a new Mason-Dixon poll was released showing Lincoln Chafee up a point in the Rhode Island Senate race, the first time he has led in any poll since August. In fact, the two previous polls in the RCP list had him down by double digits. Clearly, the race there is tightening, and one would expect to see this reflected in the prices of the RI.SENATE06.DEM and RI.SENATE06.GOP contracts. But by how much should the prices change? In other words, to what extent should the new poll cause us to revise our beliefs concerning the likelihood of a Chafee victory?

Well, here's what actually happened to the price of RI.SENATE06.DEM (which pays $10 in the event of a Chafee loss to Whitehouse). The last trade before the new poll became public was at $9.39. Soon after the poll became public on the morning of November 5, the price dropped to $8.73. This was at 8:17 AM. By 9:38 the price was down to $8.00, by 10:08 to $7.50, by 10:22 to $6.70, and by 10:30 to $4.50. By 11:11 it was back up to $7.97, and has remained between $7.00 and $8:00 ever since:

The point is that nobody really knows what the "true" likelihood of a Chafee victory really is, and how exactly to adjust one's beliefs in the face of new information. The market aggregates the opinions of all participants, but does so in a noisy way that can sometimes involve a lot of volatility and overshooting. More interestingly, the process may be path-dependent, since trading alters the distribution of assets and cash holdings among participants, and hence the extent to which their individual beliefs are reflected in the eventual price.

Bayh

Writing recently in Slate, John Dickerson argues:

"The most likely beneficiary of Warner's departure may be Bayh, who was competing for a similar sphere of donors and activists as a representative of the centrist wing of the Democratic Party. As a former governor of Indiana, Bayh can claim executive experience, just as Warner could, and offer the same hope that as a favorite son he could turn a red state into one the Democrats could count on."

As I noted yesterday, the initial market response to the Warner withdrawal was that Edwards would be the main beneficiary. But there's also some support for Dickerson's view. At around the same time as the price of the Warner contract was collapsing, the price of the Bayh contract jumped upwards:



Still, the rise in price here is small compared to the rise in the Edwards contract, and even the Clinton contract has gone up by more. It'll be interesting to see what happens over the next few days.