An Ecological Perspective on Financial Market Reform

Financial practices such as leverage and maturity transformation have been getting a lot of attention in the aftermath of the recent crisis. Consider, for instance, the following comments by William Dudley from a speech he gave in November:

Turning [to] inherent sources of instability, there are at least two that are worthy of mention. The first instability stems from the fact that most financial firms engage in maturity transformation — the maturity of their assets is longer than the maturity of their liabilities. The need for maturity transformation arises from the fact that the preferred habitat of borrowers tends toward longer-term maturities used to finance long-lived assets such as a house or a manufacturing plant, compared with the preferred habitat of investors, who generally have a preference to be able to access their funds quickly. Financial intermediaries act to span these preferences, earning profits by engaging in maturity transformation — borrowing shorter-term in order to finance longer-term lending.

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

The second inherent source of instability stems from the fact that firms are typically worth much more as going concerns than in liquidation. This loss of value in liquidation helps to explain why liquidity crises can happen so suddenly. Initially, no one is worried about liquidation. The firm is well understood to be solvent... But once counterparties start to worry about liquidation, the probability distribution can shift very quickly toward the insolvency line... because the liquidation value is lower than the firm’s value as a going concern...

These sources of instability create the risk of a cascade... Once the firm’s viability is in question and it is does not have access to an insured deposit funding base, the next stop is often a full-scale liquidity crisis that often cannot be stopped without massive government intervention.

More recently, David Merkel has discussed the issue as follows:

If the money markets get too large relative to the economy on the whole, that means there is possibly an asset/liability mismatch in the economy, where too many are financing long assets short.  It costs more in the short run to finance long-life assets with long debt or equity, but in the short run you make a lot more if you finance short… do you take the risk or not?

GE Capital nearly bought the farm in early 2009 from doing that.  CIT did die.  Mexico in 1994.  When you can’t roll over your short term debts, it gets really ugly, and fast... The phrase, “You can always refinance,” is a lie... Long-dated assets should be financed by non-putable long-dated liabilities or equity.  Don’t cheat and finance shorter than the life of the assets involved.  There is never an assurance that you will be able to get financing on terms that you will like later.

In his report on the Lehman bankruptcy, the court-appointed examiner Anton Valukas observed that "demands for collateral by [its] lenders had direct impact on Lehman’s liquidity" and that the resulting inability to obtain short-term financing "is central to the question of why Lehman failed." As Barry Ritholtz points out, however, this was a proximate rather than ultimate cause of the bankruptcy:

So what actually kills the patient — the disease that ravages the body, destroys its naturally ability to fight off invaders, and leaves it totally vulnerable? Or whichever random infection finally does them in?

In the case of Lehman Brothers, the disease that left them vulnerable was a mad embracing of risk, the excess use of leverage, an extensive exposure to mortgage and real estate, and the enormous usage of derivatives — concurrent with a lack of intelligent risk management.

Citi and JPM were merely the opportunistic infections that came along at when Lehman’s immune system was compromised. That is why you never want to allow yourself to become that vulnerable on Wall Street.

Note that if Lehman were the only firm engaged in such practices, we would probably have had a contained bankruptcy rather than a full-fledged financial crisis:

On Monday September 15, Lehman Brothers... was allowed to go into bankruptcy... It was a game-changing event with catastrophic consequences... the price of credit default swaps... went through the roof as investors took cover. AIG, the insurance giant, was carrying a large short position in CDS and faced imminent default. By the next day Hank Paulson, then US Treasury secretary, had to reverse himself and come to the rescue of AIG.

But worse was to come. Lehman was one of the main market-makers in commercial paper and a large issuer of these short-term obligations to boot. Reserve Primary, an independent money market fund, held Lehman paper and, since it had no deep pocket to turn to, it had to “break the buck” – stop redeeming its shares at par. That caused panic among depositors: by Thursday a run on money market funds was in full swing.

The panic then spread to the stock market. The financial system suffered cardiac arrest and had to be put on artificial life support.

None of this would have been possible without extensive maturity transformation and high levels of leverage across a broad range of financial institutions, making them all simultaneously vulnerable to a liquidity shock. But how did this level of fragility arise in the first place?

As far as I am aware, there are few economists who have attempted to shed light on the process that gives rise to changes over time in systemic financial fragility. An important exception is the late Hyman Minsky, who developed what might be interpreted as an ecological theory of financial practices. I have discussed his ideas at length in a previous post, but they are worth revisiting in light of the Lehman report. 

Central to Minsky's theory is the idea that at any point in time there is a distribution of financial practices in the economy, ranging from prudent debt structures with ample margins of safely to highly aggressive positions involving significant leverage and maturity transformation. In particular, Minsky draws a distinction between hedge financing and speculative financing. The former refers to a debt structure in which expected cash flows in all future periods are large enough to meet contractual debt commitments. Unless revenues are unexpectedly low, therefore, there will be no need for such a firm to roll over its debt. Speculative financing refers to a debt structure in which cash flows are expected to lie below debt commitments in some periods. In this case the firm anticipates that it will need to refinance, and is therefore vulnerable to changes in interest rates and the availability of credit.

Minsky is interested in the manner in which the distribution of financial practices -- the extent of hedge relative to speculative financing in the economy --  changes over time. The proximate determinants of such changes are differential rewards: those practices associated with the highest realized returns will tend to proliferate through reinforcement, imitation, and flows of capital to successful firms. As long as a liquidity crisis is averted, the prevalence of speculative financing will therefore increase. This effect is amplified by the fact that speculative financing results in faster economic expansion and asset appreciation:

The natural starting place for analyzing the relation between debt and income is to take an economy with a cyclical past that is now doing well. The inherited debt reflects the history of the economy, which includes a period in the not too distant past in which the economy did not do well. Acceptable liability structures are based upon some margin of safety, so that expected cash flows, even in periods when the economy is not doing well, will cover contractual debt payments. As the period over which the economy does well lengthens, two things become evident in board rooms. Existing debts are easily validated and units that were heavily in debt prospered; it paid to lever. After the event it becomes apparent that the margins of safety built into debt structures were too great. As a result, over a period in which the economy does well, views about acceptable debt structure change. In the deal making that goes on between banks, investment bankers, and businessmen, the acceptable amount of debt to use in financing various types of activity and positions increases. This increase in the weight of debt financing raises the market price for capital assets and increases investment. As this continues, the economy is transformed into a boom economy." (Minsky, 1982)

The inevitable result of a progressive shift towards increasingly aggressive financial practices is a rise in system fragility. When a liquidity crisis eventually arrives, it is the most highly leveraged firms that face bankruptcy. I summarized this process in a 2002 review as follows:

During stable expansions, profits accrue disproportionately to firms with the most aggressive financial practices, resulting in an erosion of margins of safety. This raises the probability that a major default will trigger a widespread crisis. When a crisis does eventually occur, its most devastating impact is on the highly indebted firms that prospered during the expansion. Balance sheets are purged of debt, margins of safety rise, and the stage is set for the process to begin anew. From this perspective, expectations of financial tranquility are self-falsifying. Stability, as Minsky liked to put it, is itself destabilizing.

Those who recognize that such a process is underway can make a killing when the crisis eventually erupts, but will make steady losses in the interim and must have deep enough pockets to hold on. If they are managing other people's money, they may face major withdrawals of cash precisely when their expected returns are highest (this is the central insight in Shleifer and Vishny's analysis of the limits of arbitrage).

One cannot, therefore, simply rely on self-correcting market mechanisms to keep such crises at bay. What should one do instead? The ecological perspective suggests that static approaches to financial sector reform (such as curtailing the use of certain types of contracts or shifting over-the-counter transactions to exchanges) may not be enough. What is required is a more dynamic policy response that makes aggressive financial practices more costly at precisely those points in time when fragility is greatest. As long as prudence doesn't pay, the injunction that "long-dated assets should be financed by non-putable long-dated liabilities or equity" will surely continue to fall on deaf ears.

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Update (3/18). For anyone interested in reading more about the ecological approach to financial market behavior, Macroeconomic Resilience has a number of posts on the topic; see especially this one on parallels and complementarities between Minsky's ideas and those of the Canadian ecologist Buzz Holling.

On Asymmetry, Reflexivity and Sovereign Default

One of the most rewarding aspects of blogging is that it gives me the opportunity learn from those who read and comment on the ideas expressed here. I have had the good fortune of being visited by a number of informed and thoughtful readers, whose remarks have often been of greater quality than the posts to which they were responding. Among those for whom I have developed the greatest respect is the anonymous author of Macroeconomic Resilience, who left a couple of very helpful comments in response to my recent post on credit default swaps.

MR pointed out that the idea of multiple self-fulfilling default probabilities plays a key role in George Soros' theory of reflexivity, and linked to an article in which Soros interpreted the Lehman bankruptcy in precisely these terms. In fact, it is a combination of reflexivity and a particular kind of risk/reward asymmetry that gives rise to what Soros calls self-validating bear raids:

First, there is an asymmetry in the risk/reward ratio between being long or short in the stock market... Being long has unlimited potential on the upside but limited exposure on the downside. Being short is the reverse. The asymmetry manifests itself in the following way: losing on a long position reduces one’s risk exposure while losing on a short position increases it. As a result, one can be more patient being long and wrong than being short and wrong. The asymmetry serves to discourage the short-selling of stocks.

The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential; by contrast, selling credit default swaps offers limited profits but practically unlimited risks.

The asymmetry encourages speculating on the short side, which in turn exerts a downward pressure on the underlying bonds. When an adverse development is expected, the negative effect can become overwhelming because CDS tend to be priced as warrants, not as options: people buy them not because they expect an eventual default but because they expect the CDS to appreciate during the lifetime of the contract...

The third step is to recognise reflexivity – that is to say, the mispricing of financial instruments can affect the fundamentals that market prices are supposed to reflect. Nowhere is this phenomenon more pronounced than in the case of financial institutions, whose ability to do business is dependent on confidence and trust. That means that “bear raids” to drive down the share prices of these institutions can be self-validating. That is in direct contradiction to the efficient market hypothesis.

Putting these three considerations together leads to the conclusion that Lehman, AIG and other financial institutions were destroyed by bear raids in which the shorting of stocks and buying of CDS amplified and reinforced each other. Unlimited shorting was made possible by the 2007 abolition of the uptick rule (which hindered bear raids by allowing short-selling only when prices were rising). The unlimited selling of bonds was facilitated by the CDS market. Together, the two made a lethal combination.

Soros' point about risk/reward asymmetry directly answers one objection to curtailing purchases of naked credit default swaps, namely that such contracts "provide identical leverage both to the optimistic and the pessimistic side of the transaction." Leverage may be considerable on both sides of the contract but this does not mean that market clearing prices reflect optimistic and pessimistic beliefs in equal measure, because the spreads at which sellers are willing to enter the contract must offer them adequate compensation for the significant downside risk that they face.

MR does not consider reflexivity to be a routine problem in credit markets, arguing that "only when the entity is in a state of low resilience that markets are sufficiently reflexive to push it over the edge." This is also David Merkel's view of the matter:

... if a company or government has a strong balance sheet, and has a lot of cash or borrowing power, there is nothing that speculators can do to harm you.  You have the upper hand.  But, if you have a weak balance sheet, I am sorry, you are subject to the whims of the market, including those that like to prey on weak entities.  Even without derivatives, that is a tough place to be.

But what causes a balance sheet to become weak? In the case of sovereign states, it could be widespread tax avoidance and excessive spending relative to revenues, as has been alleged in the case of Greece. But it could also be a significant decline in economic activity that reduces the tax base and triggers automatic stabilizers. This is how Paul Krugman interprets the experience of Spain, which had a budget surplus three years ago, but "is running huge deficits now [as] a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment."

Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. For this reason, Felix Salmon's claim that countries "have essentially no limit on how much they can tax or cut spending in order to make their debt repayments" cannot possibly be correct as a general principle. A government can change expenditure policies and tax rates, but has no direct control over realized revenues and outlays. As a result, raising tax rates or trimming expenditures (such as unemployment benefits) in the face of severe deficiencies in aggregate demand can worsen rather than improve its balance sheet position.

Under such circumstances, it is terribly important to determine whether the looming threat of default is simply one of several possible equilibrium paths. As Felix acknowledged in his response to my post, it is true in principle that "a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads." Default under these conditions would be terribly wasteful, and I can see no reason why attempts to avoid it should not be pursued vigorously.

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Update (3/11). Paul Krugman also seems to think that it's worth considering the possibility of multiple self-fulfilling default probabilities in the context of sovereign defaults (h/t Mark Thoma):

Markets are getting slightly more bullish on Greek debt — and Peter Boone and Simon Johnson are crying bubble. I’m not so sure, but I think their argument highlights something else: the possibility of multiple equilibria in sovereign solvency...

Suppose that Greece had as much credibility as Germany, and could borrow at a real interest rate of 2 percent. Then stabilizing the real value of its debt, even with a debt ratio of 150 percent, would require a primary surplus of only 3 percent of GDP. That’s certainly possible for some countries, although maybe not for Greece.

Boone and Johnson assume, however, that Greece would have to pay 10 percent nominal, say 8 percent real. Servicing that would require a primary surplus of 12 percent of GDP, probably impossible for almost anyone.

So this suggests that optimism or pessimism about future default can, to at least some degree, be a self-fulfilling prophecy. Not a new insight, I know, but it looks increasingly important for thinking about where we are now.

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Update (3/19). And here's Richard Portes arguing for the importance and empirical relevance of multiple self-fulfilling default probabilities, based on his work with Daniel Cohen (h/t Mark Thoma):

Naked CDS, as a speculative instrument, may be a key link in a vicious chain. Buy CDS low, push down the underlying (e.g., short it), and take a profit from both. Meanwhile, the rise in CDS prices will raise the cost of funding of the reference entity – it normally cannot issue at a rate that won’t cover the cost of insuring the exposure. That will harm its fiscal or cash flow position. Then there will be more bets on default, or at least on a further rise in the CDS price. If market participants believe that others will bet similarly, then we have the equivalent of a ‘run’. And the downward spiral is amplified by the credit rating agencies, which follow rather than lead. There is clearly an incentive for coordinated manipulation, and anyone familiar with the markets can cite examples which look very much like this. The probability of default is not independent of the cost of borrowing – hence there may be multiple equilibria, with self-fulfilling expectations, as Daniel Cohen and I have argued.

Defenders and Demonizers of Credit Default Swaps

The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states.

A cogent case for prohibiting the use of credit default swaps to make directional bets has been made recently by Wolfgang Münchau in the Financial Times:

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer...

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point...

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss...

I do not want to exaggerate the case for a ban. This speculation is neither the underlying cause of the global financial crisis, nor of the eurozone’s underlying economic tensions. But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Felix Salmon objects to this reasoning, arguing that trade in naked credit default swaps adds liquidity to the market, which in turn makes borrowing easier in times of stress:

One of the big problems with debt markets is that, especially during times of stress, they become very illiquid. Many bankers have spent many hours trying to explain to emerging-market finance ministers that just because their bonds are trading at a certain level in the secondary market, that doesn’t mean they can issue new bonds at that level, or even at all.

But it turns out that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. Which is yet another reason to laud the notorious buyers of naked CDS protection, rather than demonizing them.

Sam Jones also rises in defense of naked CDS contracts, though for somewhat different reasons:

Here’s the rub: there is a palpable social and economic benefit to naked CDS positions. And what’s more, that benefit has perhaps never been more strongly borne out than as in the recent case of Greece.

First, some context via a trip back in time: back to 2004, when the Euro was a more lustrous specie than it is today, and when credit default swaps were breaking into the mainstream... some hedge funds in those more moderate times spotted an opportunity for a trade... buy default protection against the eurozone’s weakest member states, the bonds of which had no place trading so close to German bonds. Buy Italy, buy Spain, buy Greece. And do so, naturellement, au naturale...

What they saw happening was an inevitable re-risking of the eurozone. Italy could not possibly be priced so close to Germany indefinitely, and at some point, during the lifetime of their ten year CDS contract, spreads on Italian bonds would widen... The result would be –- if done well — a perfect sovereign basis trade. And because the CDS contracts required so little initial outlay, it could be done on a huge scale, to significant profit...

In 2008 and 2009... the logic of the trade returned with more heft... Last year, big hedge funds were significant buyers of CDS protection on risky EU states: in particular, they bought CDS against Greece in anticipation of a budget blowup that would send the yields on Greek bonds soaring at some point in the next few months...

What, though, to return to the point of this post, of the broader economic and social benefit beyond well-heeled Mayfair and leafy Connecticut? 

Firstly, any naked CDS buying... occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks... Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe...

Secondly... hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

So the argument here is that while hedge funds may have raised the cost of borrowing for Greece in 2008-09, their current actions are making borrowing easier and less costly. 

Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider. 

Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling. 

This is the central insight in Diamond and Dybvig's classic paper on bank runs, and is a key rationale for deposit insurance. William Dudley highlighted the importance of such effects in a speech last November:

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. The main "assets" held by such entities are claims on future tax revenues, which are obviously not marketable. In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.

What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.

Whether or not these considerations are relevant in accounting for the troubles faced by Greece is an empirical question. But it does seem to be within the realm of possibility. At least the Chairman of the Federal Reserve appears to think so: 

Addressing concerns that financial firms have been engaging in trades to bet on a Greek default, Bernanke said that "using these instruments in a way that intentionally destabilizes a company or a country is counterproductive, and I'm sure the SEC will be looking into that."

Felix Salmon hopes that Bernanke "was just being polite to his Congressional overlords, rather than buying in to this theory." I hope, instead, that he is taking the theory seriously.

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Update (3/7). Felix Salmon has another post dismantling a New York Times report on the issue. The Times is an easy target, and it is true that their reporting has been riddled with errors and inconsistencies, including a bizarre failure to distinguish between the systemic effects of selling credit default swaps without adequate capital reserves (as AIG did), and those of large scale naked CDS purchases (as hedge funds are alleged to have made).

But what I would like to see from Salmon is a clearer distinction between the use of CDS contracts for hedging (which even Münchau would probably agree has beneficial effects on the ease and cost of borrowing) and their use for speculation (which need not). The Sam Jones post does this, and makes clear that if current hedge fund activity is holding down CDS spreads, then prior activity must have had the opposite effect. One may then ask whether Greece (and its fellow PIGS) would be in such a precarious position without this prior activity: this is an empirical question that has yet to be convincingly answered.

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Update (3/8). The comment thread following Mark Thoma's post on this is excellent. Leigh Caldwell questions the feasibility of banning naked credit default swaps and links to this post. Robert Waldmann argues that it is trivially easy to do so, and links to his September 2008 post making the case. Paine wonders whether the bank run model is adequate (and seems to be the only one taking the multiple equilibrium problem seriously). Bruce Wilder is concerned that insuring bonds against default destroys incentives for supervision and control. Gump explains the structure and incentive effects of CDS contracts with greater clarity than I've seen anywhere else. And mrrunangun makes an interesting proposal. There's plenty of criticism of my post, but I very much enjoyed reading the entire thread.

Also, I have edited the Münchau quote to remove his quip about banning bank robberies (this was a rhetorical excess, and unhelpful in advancing debate on the topic).

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Update (3/8). Felix responds on empirical grounds, and he may well be right about Greece. But the following claim is clearly incorrect:

Countries have essentially no limit on how much they can tax or cut spending in order to make their debt repayments: just look at Latvia right now. I’m not saying they should always raise taxes and cut spending rather than default, of course — I’m just saying they can. Companies are in a very different boat, and if they can’t find the money to make a payment then they default: it’s as simple as that.

The problem with this is that while governments can change expenditure policies and tax rates, they do not have direct control over revenues or actual expenditures, which depend on the level of economic activity. If attempts to raise revenues are too contractionary, the deficit may increase rather than decrease. As Paul Krugman points out in this post, Spain had a budget surplus just three years ago, but "is running huge deficits now... a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment." Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. There is also political viability to consider: a government has to stay in power if it is to do anything at all.

Public Outrage and Criminal Justice

Today's New York Times reports on the case of Ruchika Girotra, who at the age of 14 was molested by a senior police officer in Haryana, India, and committed suicide three years later after an intense campaign of harassment against her family, including the false arrest and torture in custody of her brother. The family of a witness maintained pressure on the judicial system, backed by considerable attention from the media. The officer was eventually charged in 2000, ten years after the original crime. It took another nine years to win a conviction and a sentence (currently under appeal) of six months in prison and a trivial fine. 

This case is not in the least bit unusual, and illustrates the manner in which a reasonably free press interacts with a sluggish and often corrupt legal system to determine judicial outcomes in India. There have been numerous instances in which serious crimes have been committed by highly placed individuals against whom the evidence is overwhelming. But through extensive witness tampering and intimidation, enough doubt and confusion is sown that no case against the accused can be sustained. The subsequent media attention is then critical in bringing the perpetrators to justice, often after a lag of several years and multiple judicial twists and turns.

Five such cases were discussed in some detail in a paper on "Public Outrage and Criminal Justice: Lessons from the Jessica Lal Case" that I wrote recently with Dan O'Flaherty. (The paper was published last year in a conference volume edited by Bhaskar Dutta, Tridip Ray and E. Somanathan.) These cases all illustrate the importance of public outrage, channeled through a free and competitive press, in securing justice against powerful defendants. And they reveal the importance of what Albert Hirschman called "voice" in his extraordinary book on the variety of mechanisms that can serve to maintain effiiciency in organizations. 

The first of the cases we considered in the paper was that of Jessica Lal:

During the early hours of April 30, 1999, a thirty-four year old model named Jessica Lal was shot and killed at a private party in a South Delhi restaurant, allegedly for refusing to serve liquor to a guest after the bar had closed. The man in question was identified by three eye witnesses as Manu Sharma, the son of a senior Congress Party politician and former Union minister. After several days in hiding, Sharma surrendered to authorities in Chandigarh. In an interview with police that was subsequently broadcast on national television, Sharma confessed to the murder. This confession was later retracted, and a plea of non-guilty entered at trial. During the trial the three critical eye witnesses recanted earlier statements made to the police, and twenty-nine witnesses of lesser importance did the same. One of the eye witnesses, Shyan Munshi, changed his testimony so completely that his revised statement was used as exculpatory evidence by the defence.

Sharma and eight other codefendants were acquitted of all charges in February 2006, resulting in a public outcry against what was perceived to be a gross miscarriage of justice. During the weeks that followed the verdict, petitions were circulated, protest marches organized, and candlelight vigils held. Prime Minister Mammohan Singh publicly expressed concern at the general phenomenon of witnesses changing their testimony, in an oblique reference to the Jessica Lal case. President Abdul Kalam received a petition of 200,000 names collected by journalists at NDTV, and promised action. The decision was appealed to the Delhi High Court by the prosecution in March, and in December the lower court ruling was reversed with respect to three of the defendants. Manu Sharma was convicted of murder and sentenced to life in prison, and two other defendants were convicted for conspiracy and destruction of evidence.

While this case is perhaps the most widely known, there are others that followed a similar course:

Priyadarshini Mattoo was a twenty-five year old law student when she was raped, brutally beaten and strangled to death at her New Delhi residence on January 23, 1996. Although there was no eye witness to the murder, physical and circumstantial evidence pointed immediately to Santosh Kumar Singh, the son of a senior police officer then posted in Pondicherry. Singh had been stalking Mattoo for over a year at the time of the murder, with multiple instances of harassment having been reported to the police. He was seen outside her residence by a neighbor immediately prior to the attack, and blood stained pieces of his motorcycle helmet vizor were found beside the body. DNA tests confirmed the presence of his semen on her clothes and her blood on his helmet.

What seemed like an open and shut case, however, ended in an acquittal in 1999. Defence claims that the physical evidence had been tampered with while in police custody were given enough credence by trial judge to allow for reasonable doubt. Suspicions were raised by the judge regarding deliberate police misconduct, including false depositions, traced to the influence of the father of the accused: by the time of the trial Singh's father was among the most senior police officers in Delhi.

The acquittal triggered massive public outrage, and the case was appealed to the Delhi High Court in 2000. Little action was taken for several years, until the 2006 acquittal of Manu Sharma for the Jessica Lal murder led to renewed scrutiny and a sense of urgency in the part of the Court. The verdict of the lower court was reversed in October 2006, with the High Court finding that the "circumstantial evidence in the case is absolutely inconsistent... with the innocence of the respondent." Justices RS Sodhi and PK Bhasin observed that the acquittal by the trial judge had "shocked the judicial conscience" of their Court. Singh was sentenced a few days later to death by hanging.

The third case we considered was that of Nitish Katara:

While a studying at the Institute of Management Technology in Ghaziabad in 1998, Nitish Katara became romantically involved with a classmate, Bharti Yadav. Bharti was the daughter of D.P. Yadav, a major force in U.P. politics, and the sister of Vikas Yadav, who was subsequently convicted for destruction of evidence in the Jessica Lal case. Her family disapproved of the relationship and Katara received multiple threats over the course of their relationship.

On the night of February 2, 2002, Katara attended a wedding at which several members of Bharti's family were present. Four witnesses observed him leaving in the company of three men, including Vikas Yadav and a cousin, Vishal Yadav. Katara's remains, charred and battered beyond recognition, were found on a roadside the next morning. Vikas Yadav and a cousin, Vishal Yadav, went into hiding but were arrested a few days later. A detailed confession, admitting to the abduction and murder, was recorded by UP police and aired on national television. Vikas admitted to having killed Nistish with a hammer blow to the head and setting his lifeless body on fire. He subsequently led police to the spot where the body had been dumped and the murder weapon concealed.

Once the trail began, however, one witness after another "turned hostile", including all four witnesses who had earlier reported having seen Katara depart with Vikas and Vishal Yadav. In testimony before the court, Bharti Yadav denied a romantic relationship with Katara, admitting only to a vague friendship. There remains a single witness, a passer-by whose scooter broke down on the road taken by the accused, and who has testified to seeing Katara in the vehicle. This witness has reported having received threats against his life, and is currently under police protection. The case remains unresolved, and under intense public scrutiny.

Fourth we looked at what has come to be called the "BMW hit-and-run case":

At around 4am on January 10, 1999, a speeding black BMW crashed through a police checkpoint in Delhi, killing four people on the spot. Two others subsequently succumbed to injuries, leaving just one survivor, Manoj Malik. Three of the dead were police constables. A passer by who witnessed the crash, Sunil Kulkarni, came forward a few days later. According to his initial report to police, three individuals stepped out of the car, briefly inspected the damage, then fled from the scene. The damage was so extreme that the speed of the vehicle upon impact was estimated to be 140 kmph (about 90 mph).

The car was alleged to have been driven by Sanjeev Nanda, son of businessman and arms dealer Suresh Nanda, and grandson of Navy Admiral S.M. Nanda. Also present in the vehicle were his friends Siddharth Gupta and Manik Kapoor. They were returning to Delhi from a party in Gurgaon, and Sanjeev was found to have elevated levels of alcohol in his blood several hours after the incident. The BMW was traced by police following oil leaks from the scene of the crash to the Gupta residence, where it was determined to have been cleaned of blood and human remains. All three were charged with culpable homicide and destruction of evidence.

The trial is still in progress, but there have already been extraordinary changes in witness testimony. Claiming that his initial statement was made under police pressure, Kulkarni testified in October 1999 that it had been a truck rather than a BMW that had ploughed through the police checkpoint. The prosecution dropped him as a witness, considering him to be unreliable, but he was subsequently reinstated. In May 2007, Kulkarni identified Nanda as one of the three occupants of the vehicle, but then retracted this testimony two months later, saying that he had been unable to see any of them clearly.

Nanda now maintains that he was not in the vehicle at the time and had nothing to do with the accident. A sting operation by NDTV turned up evidence of attempted bribery, and it now appears that the witness spent eighteen months residing at a farmhouse owned by the lead lawyer for the defence. Nanda is free on bail while the proceedings continue.

Finally, we examined the so-called Best Bakery case:

The Best Bakery was a Muslim owned and operated business in Vadodara, Gujarat that was set on fire by a Hindu mob during communal riots on March 1, 2002. Fourteen people were killed in the attack, including the owner Habibullah Shaikh and eight other members of his family. Among the witnesses was Zahira Shaikh, the owner's eighteen year old daughter, who identified several individuals in the mob in a March 2 statement to police. The accused were also identified by Zahira in a statement before the National Human Rights Commission (NHRC) of India three weeks later. Twenty-one individuals were charged in the murder.

During the trial in May 2003, Zahira and other surviving members of her family retracted earlier statements made to the police, resulting in the acquittal of all the accused on June 27. Shortly thereafter, on July 11, Zahira claimed in a sworn statement before the NHRC that she and other family members had been threatened and forced to retract their statement. In doing this, she was assisted by Teesta Setalvad, secretary of the NGO Citizens for Justice and Peace. The NHRC petitioned the Supreme Court of India to order a retrial in a state other than Gujarat, and the Court did so on April 12, 2004. The retrial began in October 2004, before a Special Court of Sessions in Mumbai.

At a dramatic November 3 press conference one day before she was due in court, Zahira changed her testimony yet again, claiming that she had been abducted by Setalvad and her organization, threatened and confined for months, and forced to file false statements against the accused. A sting operation by Tehelka magazine in December revealed that a substantial bribe of 1.8 million rupees (about $40,000) was paid to Zahira and her family in order to retract her testimony against the accused. On February 24 2006, nine of the original accused were convicted and eight acquitted by the Court. In separate proceedings, Zahira was convicted of perjury and contempt of court.

In the absence of a vigilant and competitive media, it is unlikely that any of these cases would have resulted in convictions. 

It has been four decades since Albert Hirschman published his classic Exit, Voice and Loyalty. In it, he argued that market competition is just one of several mechanisms through which efficient functioning of organizations can be sustained. Firms in competitive markets are forced to function well for fear of exit: low quality or high prices will induce their customers to look elsewhere. But there are many organizations in which exit is not a realistic option, either because no competitors exist, or because individuals have a sense of loyalty to the group with which they are affiliated. This applies to ethnic groups, nation states, and (most relevant to the examples considered here) judicial systems. In this case, voice remains the only mechanism available for inducing good performance. And without a free and competitive press, the voice of public outrage will often remain muted.

This is how Dan and I conclude our article:

The central message of this paper is that legal institutions alone are not enough to produce justice. In terms of Albert Hirschman’s memorable formulation, effective judicial systems require a balance of exit and voice. Open competition in politics and the media facilitates and amplifies the expression of voice, keeping blatant miscarriages of justice at least occasionally in check.

Albert Hirschman will be 95 years old next month, and is in poor health. He is seldom mentioned as a serious contender for the the Nobel Memorial Prize in Economics. But when I look at the list of those who are considered to be likely recipients, I can't escape the feeling that something is not quite right with our profession.

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Update (3/4). I just came across two wonderful posts on Hirschman by Dani Rodrick. From the first of these:

Reading this work, I am awed once again by a mind which was as much at ease with the technical arcana of irrigation projects as it was with the rarified world of political philosophy. Yet I can also see why he must have been such a source of frustration for his contemporaries.  He was in many ways the ultimate contrarian--always looking for the unique and the exceptional, while not shying from building general theories from those cases.  He was a critic of the reigning development theories of his time (the big push and balanced growth), arguing, quite correctly in my view, that the under-developed societies who had the capacity to implement these comprehensive programs would not have been under-developed in the first place.  He argued instead for a strategic, opportunistic approach, based on making the best of what you have.

And from the second:

Which brings me to the question of the Nobel Prize for Hirschman. I think Hirschman's contributions have been greatly under-appreciated within economics, and that goes a long way to explain why he has not won a Nobel. If the Nobel was given for impact on social sciences more broadly, Hirschman would have clearly won a long time ago. But who knows, there is still some time...   

Rodrick was the first recipient of the Albert O. Hirschman Prize, awarded since 2007 by the Social Science Research Council.

Is Over-the-Air Television Broadcasting Really Obsolete?

Writing in the New York Times today, Richard Thaler had this to say:

Here's a list of national domestic priorities, in no particular order: Stimulate the economy, improve health care, offer fast Internet connections to all of our schools, foster development of advanced technology. Oh, and let’s not forget, we’d better do something about the budget deficit.

Now, suppose that there were a way to deal effectively with all of those things at once, without hurting anyone... I know that this sounds like the second coming of voodoo economics, but bear with me. This proposal involves no magical thinking, just good common sense: By simply reallocating the way we use the radio spectrum now devoted to over-the-air television broadcasting, we can create a bonanza for the government, stimulate the economy and advance all of the other goals listed above. Really.

What Thaler means by "reallocating the way we use the radio spectrum" is to take frequencies currently in use for over-the-air television broadcasting and auction them off for other uses:

Because we can’t create additional spectrum, we must make better use of the existing space. And the target that looks most promising in this regard is the spectrum used for over-the-air television broadcasts... over-the-air broadcasts are becoming a nearly obsolete technology. Already, 91 percent of American households get their television via cable or satellite. So we are using all of this beachfront property to serve a small and shrinking segment of the population.

Alex Tabarrok (linking to the Thaler piece) concurs:

Despite the fact that 91 percent of American households get their television via cable or satellite huge chunks of radio-spectrum are locked up in the dead technology of over-the-air television.

Maybe so. But the transition to digital over-the-air broadcasting has dramatically improved the picture quality that one can obtain with an amplified indoor antenna (even in Manhattan) and has caused many people (myself included) to switch to over-the-air broadcasts for the first time. The first thing I noticed when I did so was a significant improvement in picture quality relative to high-definition cable. Randy Hoffner of TV technology explains why:

Broadcast HDTV delivers by far the best-quality HD pictures, because cable and satellite bit-starve the digital pictures in order to decrease the bandwidth they occupy.

And people are beginning to notice. Here's a Los Angeles Times report from a couple of months ago: 

In Los Angeles, more than 30 over-the-air channels are available in English, including stations featuring movies, dramas and children's programs. Major networks including ABC, CBS and NBC beam out daytime and prime-time shows -- and professional sports -- in resolution with clarity that may shock viewers expecting the hazy broadcast signals they remember from childhood.

"Everyone who does it says the picture quality is actually better than what you're getting through cable," said Patricia McDonough, a senior vice president at Nielsen.

As more viewers tune in to the newly reenergized possibilities of broadcast television, manufacturers say they can't make antennas fast enough.

"Our sales are going through the roof," said Richard Schneider, president of Antennas Direct, a St. Louis manufacturer of the devices.

Schneider said that sales had nearly tripled since the switch-over, and that he had to add a new assembly line in his factory to meet the demand. The company produces nearly 100,000 antennas every month, thousands of which are sold in the Los Angeles area, he said.

Viewers are also finding they can combine broadcast television with the growing array of movie and TV programming available online.

Of course, it may still be the case that the most efficient use of scarce radio frequencies lies elsewhere, as Thaler contends, though it's not obvious to me that installing and maintaining a network of cables is the most cost-effective way to deliver television programming to households. In any case, until there is a change in FCC policy, the "small and shrinking segment of the population" that relies on over-the-air broadcasts is unlikely to continue shrinking for much longer.

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Update (3/2). Robin Hanson and I go back and forth on the issue in the comments section of this post. He makes the point that assigning frequencies to the highest bidders would allow this scarce resource to be put to its highest value uses. This would be true if we had complete markets, but since broadcasters cannot contract with individual recipients of over-the-air television signals, we have a missing market. The absence of a property right in the signal prevents broadcasters from capturing any of the consumers’ surplus, and makes their auction bids uninformative with respect to overall efficiency.

We could just ignore this problem and assign frequencies to those who do have the ability to contract individually with their customers. But it’s not obvious to me that this is a better outcome than trying to complete the missing market – for instance by taxing receivers and allowing broadcasters some use of frequencies at a price that is below the market clearing bid.

The main point of my post was simply that the over-the-air product is now very good -- potentially much better than cable -- and possibly even delivered more cost-effectively. When economists with the professional stature of Richard Thaler make claims about trillion dollar free lunches, it's tempting to jump instantly on the bandwagon. But his basic premise -- that over-the-air broadcasting is "nearly obsolete" -- is not supported by the facts; the technology is alive, improved, and gaining in popularity. That alone doesn't mean it's worth preserving, but the choice is not as obvious as his article would lead one to believe.

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Update (3/7). Cable Television obsolescence watch:

ABC's parent company switched off its signal to Cablevision's 3.1 million customers in New York at midnight Saturday in a dispute over payments that escalated just hours before the start of the Academy Awards.

Further down in the same article:

The signal can still be pulled from the air for free with an antenna and a new TV or digital converter box.

Some of those who do this will notice an improvement in picture quality. They may not give up on cable just yet because the range of over-the-air programming is still quite limited, but they might start to wonder why they are paying so much for an inferior product.

On Intellectual Property and Guard Labor

For several years now Michele Boldrin and David Levine have been making a vigorous case for the outright elimination of most copyright and patent protection. A very accessible (and entertaining) overview of their arguments may be found in Against Intellectual Monopoly, a version of which can (appropriately enough) be downloaded without charge. In it, the authors claim that patent protections stifle rather than stimulate technological innovation, and that copyright has the same chilling effect on artistic creativity. They point to examples of flourishing and innovative industries that thrive without such protections, and others in which the expansion of legal coverage has resulted in stagnation or decline. In doing so, they strike at the heart of the usual argument in favor of intellectual property rights, namely that such rights are necessary for sustaining economic vitality and variety.

Boldrin and Levine's use of the term "monopoly" rather than "property" to characterize patents and copyrights clearly adds rhetorical force to their arguments, but it also has an interesting precedent in English law:

It was the English Parliament that, in 1623, pioneered patent law with the aptly named Statute of Monopolies. At the time the euphemism of intellectual “property” had not yet been adopted – that a monopoly right and not a property right was being granted to innovators no one questioned. Moreover... the Statute did not create a new monopoly. It took the monopoly away from the monarchy (represented at the time by King James I) and lodged it instead with the inventor. It therefore replaced the super-monopolistic power of expropriation the Crown had enjoyed till then, with a milder monopoly by the inventor... The historical facts are worth keeping in mind vis-à-vis the frequent claims that it was the introduction of patent privileges in the seventeenth century England that spurred the subsequent industrial revolution. 

In fact, the authors argue that patent protection delayed the industrial revolution by a generation as James Watt used the "full force of the legal system" to inhibit the spread of superior variants of his invention: 

After the expiration of Watt’s patents, not only was there an explosion in the production and efficiency of engines, but steam power came into its own as the driving force of the industrial revolution. Over a thirty year period steam engines were modified and improved as crucial innovations such as the steam train, the steamboat and the steam jenny came into wide usage. The key innovation was the high-pressure steam engine – development of which had been blocked by Watt’s strategic use of his patent. Many new improvements to the steam engine, such as those of William Bull, Richard Trevithick, and Arthur Woolf, became available by 1804: although developed earlier these innovations were kept idle until the Boulton and Watt patent expired.

Nor was this an isolated case. In 1902, the Wright brothers "managed to obtain a patent covering (in their view) virtually anything resembling an airplane." They subsequently invested little effort in developing and marketing aircraft, but did spent "an enormous amount of effort in legal actions" to prevent other innovators such as Glenn Curtiss from doing so. At around the same time in England, the Baadische Chemical Company used a broad patent covering textile coloring to prevent a competitor, Levinstein, from using a "superior process to deliver the same product." The former company was unable to understand and exploit the new technology, however, and was put out of business when the latter began production in the Netherlands. Other examples of patent holders preventing the spread of innovations that they could not themselves use or profit from are scattered throughout the book.

In contrast, there are numerous cases of rapid innovation in industries with no recognized intellectual property rights. Software could not be patented before 1981, nor could financial securities prior to 1998; yet the pace of innovation was frantic in both sectors. Consider software:

What about the graphical user interfaces, the widgets such as buttons and icons, the compilers, assemblers, linked lists, object oriented programs, databases, search algorithms, font displays, word processing, computer languages – all the vast array of algorithms and methods that go into even the simplest modern program? ... Each and every one of these key innovations occurred prior to 1981 and so occurred without the benefit of patent protection. Not only that, had all these bits and pieces of computer programs been patented, as they certainly would have in the current regime, far from being enhanced, progress in the software industry would never have taken place. According to Bill Gates – hardly your radical communist or utopist – “If people had understood how patents would be granted when most of today's ideas were invented, and had taken out patents, the industry would be at a complete standstill today.”

Even today, the rate of innovation in open-source software remains vigorous without the benefit of protection:

Whatever you are viewing on the web – we hesitate to ask what it might be – is served up by a webserver. Netcraft regularly surveys websites to see what webserver they are using. In December 2004 they polled all of the 58,194,836 web sites they could find on the Internet, and found that the open source webserver Apache had a 68.43% of the market, Microsoft had 20.86% and Sun only 3.14%. Apache’s share is increasing; all other’s market shares are decreasing. So again – if you used the web today, you almost certainly used open source software.

Another industry that remains largely unprotected by intellectual property law is fashion design. Again one finds evidence of creativity and innovation alongside extensive and rapid replication by lower cost imitators:

Even the most casual of observers can scarcely be unaware of the enormous innovation that occurs in the clothing and accessories industry every three-six months, with a few top designers racing to set the standards that will be adopted by the wealthy first, and widely imitated by the mass producers of clothing for the not so wealthy shortly after. And “shortly after”, here, means really shortly after. The now world-wide phenomenon of the Spanish clothing company Zara (and of its many imitators) shows that one can bring to the mass market the designs introduced for the very top clientele with a delay that varies between three and six months. Still, the original innovators keep innovating, and keep becoming richer.

The invention of new techniques in professional sports seems completely unhindered by the fact that the innovators have no power to prevent their creations from being copied:

Innovation is also important in sports, with such innovations as the Fosbury Flop in high jumping, the triangle offense in basketball, and of course the many new American football plays that are introduced every year, serving to improve performance and provide greater consumer satisfaction. Indeed, the position of the sports leagues with respect to innovation in their own sport is not appreciably different from that of the benevolent social planner invoked by economists in assessing alternative economic institutions.

Given that sports leagues are in the position of wishing to encourage all innovations for which the benefits exceed the cost, they are also in the position to implement a private system of intellectual property, should they find it advantageous. That is, there is nothing to prevent, say, the National Football League from awarding exclusive rights to a new football play for a period of time to the coach or inventor of the new play. Strikingly, we know of no sports league that has ever done this. Apparently, in sports the competitive provision of innovation serves the social purpose, and additional incentive in the form of awards of monopoly power do not serve a useful purpose.

There is no doubt that the world would look very different in the absence of patents and copyrights, and this includes the nature of contracts written between creators and distributors of content. To get a glimpse of the kinds of contracts that are likely to become widespread if copyright were to be eliminated, one can look back at the case of publishing in the 19th century, when English authors has no protection with respect to sales in the United States. Yet they often managed to secure lucrative deals with American publishers:

How did it work? Then, as now, there is a great deal of impatience in the demand for books, especially good books. English authors would sell American publishers the manuscripts of their new books before their publication in Britain. The American publisher who bought the manuscript had every incentive to saturate the market for that particular novel as soon as possible, to avoid cheap imitators to come in soon after. This led to mass publication at fairly low prices. The amount of revenues British authors received up front from American publishers often exceeded the amount they were able to collect over a number of years from royalties in the UK.

Now one might argue that with dramatically lower costs of copying and electronic distribution, such a system would not be viable today. Boldrin and Levine provide a truly fascinating rebuttal to this argument:

What would happen to an author today without copyright?

This question is not easy to answer – since today virtually everything written is copyrighted, whether or not intended by the author. There is, however, one important exception – documents produced by the U.S. government. Not, you might think, the stuff of best sellers – and hopefully not fiction. But it does turn out that some government documents have been best sellers. This makes it possible to ask in a straightforward way – how much can be earned in the absence of copyright? The answer may surprise you as much as it surprised us.

The most significant government best seller of recent years has the rather off-putting title of The Final Report of the National Commission on Terrorist Attacks Upon the United States, but it is better known simply as the 9/11 Commission Report. The report was released to the public at noon on Thursday July 22, 2004. At that time, it was freely available for downloading from a government website. A printed version of the report published by W.W. Norton simultaneously went on sale in bookstores...

Because it is a U.S. government document, the moment it was released, other individuals, and more important, publishing houses, had the right to buy or download copies and to make and resell additional copies – electronically or in print, at a price of their choosing, in direct competition with Norton... And the right to compete with Norton was not a purely hypothetical one. Another publisher, St. Martin’s, in collaboration with the New York Times, released their own version of the report in early August, about two weeks after Norton, and this version contained not only the entire government report – but additional articles and analysis by New York Times reporters. Like the Norton version, this version was also a best seller. In addition it is estimated that 6.9 million copies of the report were (legally) downloaded over the Internet. Competition, in short, was pretty fierce.

Despite this fierce competition, the evidence suggests that Norton was able to turn a profit... we know that they sold about 1.1 million copies, and that they charged between a dollar and a dollar fifty more than St. Martin’s did. Other publishers also estimated Norton made on the order of a dollar of profit on each copy. Assuming that St. Martin’s has some idea of how to price a book to avoid losing money, this suggests Norton made at the very least on the order of a million dollars...

What, then, do these facts mean for fiction without copyright? By way of contrast to the 9/11 commission report, which was in paperback and, including free downloads, seems to have about 8 millions copies in circulation, the initial print run for Harry Potter and the Half-Blood Prince was reported to be 10.8 million hardcover copies. So we can realistically conclude that if J.K. Rowling were forced to publish her book without the benefit of copyright, she might reasonably expect to sell the book to a publishing house for several million dollars – or more. This is certainly quite a bit less money than she earns under the current copyright regime. But it seems likely... that it would still give her adequate incentive to produce her great works of literature.

While Boldrin and Levine focus largely on the effects of intellectual property rights on innovation and creativity, they also recognize the enormous waste of resources that arises in order to secure, protect and exploit these rights. There are four types of inefficiencies that can result. The most obvious is the fact that monopoly pricing excludes from the market many who would be willing and able to pay well above the current costs of production for a product; this can be particularly tragic in the case of life-saving pharmaceuticals. Second, there are the productive inefficiencies that tend to arise when firms are sheltered from competition. Third, there are investments in lobbying that serve no productive purpose but are designed to alter the legislative landscape in one's favor. And fourth, there are the costs of legal action and deliberate manipulation of product design to prevent copying and competition.

In fact, the widespread adoption of patents and copyrights has given rise to a peculiarly modern and highly skilled form of what Arjun Jayadev and Sam Bowles refer to as guard labor (see, for instance, Mark Thoma's recent post on their work.)  In the context of intellectual property rights, guard labor includes not just legal teams but also individuals with considerable technical expertise who can alter product characteristics in a manner that prevents resale across segmented markets. As Boldrin and Levine note:

For example, music producers love Digital Rights Management (DRM) because it enables them to price discriminate. The reason that DVDs have country codes, for example, is to prevent cheap DVDs sold in one country from being resold in another country where they have a higher price. Yet the effect of DRM is to reduce the usefulness of the product. One of the reasons the black market in MP3s is not threatened by legal electronic sales is that the unprotected MP3 is a superior product to the DRM protected legal product. Similarly, producers of computer software sell crippled products to consumers in an effort to price discriminate and preserve their more lucrative corporate market. One consequence of price discrimination by monopolists, especially intellectual monopolists, is that they artificially degrade their products in certain markets so as not to compete with other more lucrative markets.

Technically skilled labor is required not only to alter product characteristics, but also to identify products and processes that could be patented for entirely defensive purposes:

The following statement is from Jerry Baker, Senior Vice President of Oracle Corporation

Our engineers and patent counsel have advised me that it may be virtually impossible to develop a complicated software product today without infringing numerous broad existing patents. … As a defensive strategy, Oracle has expended substantial money and effort to protect itself by selectively applying for patents which will present the best opportunities for cross-licensing between Oracle and other companies who may allege patent infringement. If such a claimant is also a software developer and marketer, we would hope to be able to use our pending patent applications to cross-license and leave our business unchanged.

Pundits and lawyers call this “navigating the patent thickets” and a whole literature, not to speak of a lucrative new profession, has sprung up around it in the last fifteen years. The underlying idea is simple, and frightening at the same time. Thanks to the US Patent Office policy of awarding a patent to anyone with a halfway competent lawyer – and, as noted a moment ago, IP lawyers have quadrupled – thousands of individuals and firms hold patents on the most disparate kinds of software writing techniques and lines of code. As a consequence, it has become almost impossible to develop new software without infringing some patent held by someone else. A software innovator must, therefore, be ready to face legal actions by firms or individuals holding patents on some software components. A way of handling such threats is the credible counter-threat of bringing the suitor to court, in turn, for the infringement of some other patent the innovative firm holds.

The idea that certain categories of labor inhibit rather than promote economic growth dates back at least to Adam Smith. The third chapter in  Book II of the Wealth of Nations bears the title: "Of the Accumulation of Capital, or of Productive and Unproductive Labour." In it, Smith states in no uncertain terms that the manner in which labor is divided among productive and unproductive occupations affects the rate of economic growth:

Both productive and unproductive labourers, and those who do not labour at all, are all equally maintained by the annual produce of the land and labour of the country. This produce, how great soever, can never be infinite, but must have certain limits. According, therefore, as a smaller or greater proportion of it is in any one year employed in maintaining unproductive hands, the more in the one case and the less in the other will remain for the productive, and the next year’s produce will be greater or smaller accordingly; the whole annual produce, if we except the spontaneous productions of the earth, being the effect of productive labour.

Smith's argument has even greater force in an economy where some of the most highly skilled individuals are assigned to unproductive tasks. These are precisely the individuals who are best equipped to push against the technological frontier. Their loss in the productive sector therefore lowers the rate of growth for two reasons: they are unavailable to produce goods and services under current technologies, and the rate of technological progress is itself retarded.

There is much more in the book than I have been able to survey here. I have not discussed the theoretical models that provide the analytical foundation for the authors' recommendations. Nor have I mentioned the frivolous patents for methods of putting in golf or swinging a swing, or the submarine patents that seek to anticipate innovations by others. The book expands on all these issues and more, and ends up making as convincing a case for the abolition of intellectual property rights as you are likely to find anywhere. The authors do concede that there may be industries in which the absence of protection may result in suboptimal levels of innovative activity, but argue that even in such cases, direct subsidies rather than monopoly rights would be a superior policy response. Regardless of whether or not you are eventually sold on the main idea, you cannot fail to be impressed by the originality, breadth and detail of the argument. Such books are now a rarity in economics, but Against Intellectual Monoply is proof that they are not yet extinct.

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Update (2/25). Boldrin and Levine provide a concise overview of their arguments (along with a response to some of their critics) in a recent article in the Review of Law and Economics. And this post contains a good discussion of the Jayadev and Bowles paper on guard labor, with applications to intellectual property rights. The author (mtraven) argues that guard labor is in its "purest and most apparently wasteful form when it is guarding digital content," and has this to say about open source software:

In fact, the whole free/open source movement in software and elsewhere may be seen as a response to the unpleasantness of guard labor. Proprietary software requires licensing schemes... that cause new bugs, interfere with legitimate uses, and more generally cause friction. More broadly, locking software behind a pay wall reduces the amount of sharing and requires frequent reinvention of the wheel. It's inefficient, and this drives engineers crazy. Most of the time they don't get to vote, but the FOSS movement arose as a direct response to some of the unpleasantness surrounding proprietary software and has in its way been amazingly successful...

I was around for the birth of the open source movement and efficiency really had nothing to do with it -- it was a moral struggle, based on the anguish of the excluded when a once open resource suddenly being subject to enclosure and guarding. But its ongoing success happened because of efficiency and the self-interest of software producers and companies.

The entire post is worth reading. Lots more on this topic (including occasional posts by Boldrin and Levine) may be found on the blog Against Monopoly.

Some Readings on Liquidity, Leverage and Crisis

In an earlier post I mentioned an interview with Eric Maskin in which he claimed that "most of the pieces for understanding the current financial mess were in place well before the crisis occurred," and identified five contributions that in his view were particularly insightful. 

Along similar lines, Yeon-Koo Che has assembled a weekly reading group consisting of faculty and graduate students in the Columbia community to discuss articles that might be helpful in shedding light on recent events. Included among these is a paper by John Geanakoplos that I have surveyed previously on this blog, and several that I hope to discuss in the future. Ten of the contributions we hope to tackle over the coming weeks are the following:

1. Financial Intermediation, Loanable Funds and the Real Sector by Holmstrom and Tirole
2. The Limits of Arbitrage by Shleifer and Vishny
3. Understanding Financial Crises by Allen and Gale
4. Credit-Worthiness Tests and Interbank Competition by Broeker
5. Credit Cycles by Kiyotaki and Moore
6. The Leverage Cycle by Geanakoplos
7. Collective Moral Hazard, Maturity Mismatch and Systemic Bailouts by Farhi and Tirole
8. Liquidity and Leverage by Adrian and Shin
9. Market Liquidity and Funding Liquidity by Brunnermeir and Pedersen
10. Outside and Inside Liquidity by Bolton, Santos and Scheinkman

I would welcome any comments on these, or suggestions for others that we may have overlooked.