All entries for Tuesday 13 October 2009

October 13, 2009

The 2009 Economics Nobels versus Big Government

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Elinor Ostrom and Oliver Williamson have just shared the 2009 Nobel prize for economics. Unsurprisingly, the first ever award to a woman is attracting much of the media interest. Many journalists are likely to find that an easier topic than the content of their contribution.

Anyway, we'll focus on what Paul Krugman would call the wonkish stuff. What do these two share? According to the prize committee, it is their contribution to "the economic organization of cooperation."

What does that mean? On the BBC news website BBC economics editor Stephanie Flanders is quoted as saying that the judges had rewarded work in areas of economics whose practitioners' "hands were clean" of involvement in the global financial crisis. This is true, sort of. As far as I can see, neither Ostrom nor Williamson have contributed anything to recent asset price bubbles, correlated risk taking by banks, or the psychology of "It's different this time."

But it's more interesting than this. In a year when big government is all the rage, the prize committee has chosen to honour two scholars whose work cautions against big government solutions to economic problems.

I've never read anything by Ostrom; in fact, I'd never heard of her before yesterday. I feel bad about that, but I would feel worse if much more knowledgeable people like Paul Krugman (last year's Nobel laureate) and Steven Levitt (of Freakonomics fame) did not also admit to never having read her work. In order to say anything about it, I am relying partly on the Nobel citation, partly on a short interview she gave to BBC Radio 4 News last night.

Anyway, this is what I have picked up. Ostrom works on the management of common property such as land, water, and fish stocks. Economics 101 tells us that private exploitation will destroy the commons in the absence of government regulation. Ostrom's research is reported to show that there are alternatives in between private exploitation and government regulation. User communities often come up with cooperative management solutions that are less costly or more efficient than either, on their own initiative. It sounds like I should find out more.

In contrast to Ostrom's, I know of Williamson's work. I use it in my research papers, and also in my teaching. In fact, I'll be telling my final year undergraduate students about it next Monday in a lecture on the topic of "Government Failure." (The course is called The Making of Economic Policy, and I give two introductory lectures, one on how markets fail and one on how governments fail.) Williamson comes into the lecture because of his work on what he calls "the impossibility of selective intervention."

The starting point is to imagine the best of all possible worlds. We live in a market economy, and sometimes markets fail. Williamson's work shows, for example, that the very existence of firms is a response to markets not doing everything well. For some purposes it's cheaper to organize exchange within an integrated organization than through markets. Firms are these integrated organizations.

Can an integrated organization fix everything that markets can't fix? The key here is that government intervention is conceptually similar to just having bigger and bigger firms. In fact, twentieth century socialists often thought of the socialist economy as "one big firm." When markets fail, I suppose we'd all like to think the government could step in selectively, just when required and only then, and fix the failure. Then, we could always have the best of everything: market allocation, unless it fails; if the market fails, intervene to correct or replace it. That's selective intervention. Over the last century social democrats and democratic socialists have put forward many different ideas about what exactly needs fixing, but all would have agreed, I think, that selective intervention is the key. Williamson's work suggests, however, that this best of all worlds is out of reach.

Of course, Williamson is a scholar, not an ideologue, so he doesn't reach this conclusion directly. In The Economic Institutions of Capitalism (1985), for example, he asks a related question: what are the true limits on firm size? (Or, why don't we run the economy like one big firm?) He argues that replacing the market with an integrated organization always has unanticipated costs. The market, for example, provides high-powered rewards for success and penalties for failure. Intervention always impairs these incentives. We can define the benefits of intervention in advance, but not the costs. If politicians are allowed to intervention selectively, some interventions will inevitably make things worse.

Why? There are several reasons. One is the cost of good intentions: "Decision makers," Williamson writes, "project a capacity to manage complexity that is repeatedly refuted by events." Another reason is the propensity to micro-manage: Intervention always involves the exercise of power, including the power to divert resources to private goals. A third reason is the effect of "forgiveness" on effort: If a firm is losing out to market competition, there is no appeal against the verdict of customers. Managers and workers know this, so they make inordinate efforts to avoid losses. In a politicized environment, in contrast, sharing and horse-trading are much more important, so loss makers can buy political insurance against failure, or forgiveness. As a result, efforts to avoid failure are less. Finally, loss making activities are more likely to go on making losses. That's because politicization creates scope for lasting alliances based on reciprocity; loss making activities can win subsidies from profits made elsewhere and are not closed down. So, losses persist. 

In short, Ostrom and Williamson point in the same direction. Ostrom is saying that big government may be less necessary than we think. Williamson is saying that, even when necessary, the results of big government will always disappoint.

This is not the same as to say that politicians should never act. If there are always unanticipated costs, there may still be benefits, and the benefits may still outweigh the total costs -- both expected and unexpected. An example is the big-government bail-outs that saved the world economy over the past year. We will be paying the bill for a long time, and the bill will be bigger than anyone thought. The fact is, it had to be done and was worth doing.

The message of the 2009 economics Nobels is not to make a virtue out of what was done from necessity. The return of big government is not a cause for celebration.

I am a professor in the Department of Economics at the University of Warwick. I am also a research associate of Warwick’s Centre on Competitive Advantage in the Global Economy, and of the Centre for Russian, European, and Eurasian Studies at the University of Birmingham. My research is on Russian and international economic history; I am interested in economic aspects of bureaucracy, dictatorship, defence, and warfare. My most recent book is One Day We Will Live Without Fear: Everyday Lives Under the Soviet Police State (Hoover Institution Press, 2016).

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