Category Archives: Specialization and Trade Economics Intro

How Bad is Financialization?

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Noah Smith writes,

For a long time, and especially since the financial crisis, many people have suspected that financialization is bad for an economy. There is something unsettling about watching the financial sector become a bigger and bigger part of what people do for a living. After all, finance is all about allocation of resources — pushing asset prices toward their correct value so businesses can know what projects to invest in. But when a huge percent of a country’s effort and capital are put into finance, there are less and less resources to reallocate. We can’t all get rich trading houses and bonds back and forth.

Pointer from Mark Thoma.

1. Economists have no idea how to measure the value created by the financial sector. Ask any economist the following question: how should we define/measure the output of a commercial bank? You will hear the sound of crickets–even among economists who purport to study economies of scale in banking! An even more difficult question is how to measure the output of an investment bank.

2. Mathematical economics, notably the Arrow-Debreu general equilibrium model, implies that the value produced by the financial sector is exactly zero. Note Smith’s phrase “pushing asset prices toward their correct value.” This strikes me as a very truncated view of the role of financial institutions, but even so it is ruled out by Arrow-Debreu, in which prices are determined by a set of equations without any agent in the economy doing any “pushing.”

What should we conclude from (1) and (2)? One possibility is that the value of the financial sector is close to zero. The other possibility is that the cult of mathematical modeling has left economists unable to describe the role of financial institutions in the economy. My money is on this latter possibility.

Economists’ analysis of the financial sector is close to 100 percent mood affiliation. You will find many economists who are convinced that the failure of Lehman Brothers had major economic effects. You will not find a carefully worked-out verbal description of this, much less a mathematical model.

Note that I do not cheer for large banks or for mortgage securitization. My thinking on the financial sector is spelled out more in the Book of Arnold.

Here, the point I am trying to make is that not having a grasp on what financial institutions do should be an indictment of economists, not of the financial sector.

Schumpeter 1, Galbraith 0

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Mark Perry writes,

In other words, only 12.2% of the Fortune 500 companies in 1955 were still on the list 60 years later in 2015, and nearly 88% of the companies from 1955 have either gone bankrupt, merged with (or were acquired by) another firm, or they still exist but have fallen from the top Fortune 500 companies (ranked by total revenues). Most of the companies on the list in 1955 are unrecognizable, forgotten companies today (e.g. Armstrong Rubber, Cone Mills, Hines Lumber, Pacific Vegetable Oil, and Riegel Textile).

Patterns of sustainable specialization and trade are in constant flux.

Specialization and Trade

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Chelsea German writes,

Last week, I wrote about a man who spent 6 months of his life and $1,500 to make a sandwich entirely from scratch, without the benefits of market exchange. The story illustrates how exchange and trade enrich our lives.

After making his incredibly costly sandwich, the same man embarked on an even costlier endeavor: making a suit from scratch. He picked cotton from a field, spun the cotton into thread, wove the thread into cloth, sheared wool from a sheep, harvested hemp, raised silkworms for their silk, killed a deer and tanned its hide to make leather. This process cost him 10 months of work and $4,000.

Pointer from Don Boudreaux.

I just don’t think you capture the phenomenon of specialization and trade with textbook economic models. It is not two-by-two trade. It is far more complex than that. And don’t get my started on representative-agent models of the GDP factory.

The Basic Social Rule

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My latest essay:

I claim here that humans have a fundamental rule of social morality, which is: Reward cooperators; punish defectors. The use of this rule is what enables humans to work effectively with strangers, making possible sophisticated economies and civilizations. However, this rule can cause problems when people mis-classify the social actions of others.

Please read the whole thing and comment. These are ideas that I also plan to include in the Book of Arnold.

Ancient Trade and Trust

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1. From Adam Davidson in the NYT magazine:

At the city gate, Assur-idi ran into a younger acquaintance, Sharrum-Adad, who said he was heading on the same journey. He offered to take the older man’s donkeys with him and ship the profits back. The two struck a hurried agreement and wrote it up, though they forgot to record some details. Later, Sharrum-­Adad claimed he never knew how many textiles he had been given.

Pointer from Tyler Cowen.

This apparently took place in the 19th century, BC. Long-time readers will know that I have taken the view that archaelogists are finding evidence of plunder and calling it evidence of trade. But this example (read the whole story) shows that I am wrong about that.

The main focus of the article is the gravity model of trade, which says that trade between any two entities (cities, countries) is positively related to their size in terms of population and negatively related to the distance between them.

2. Josiah Ober says,

The key to unlocking the puzzling success of the Greek city-state ecology is economic specialization and exchange. Specialization was based on developing and exploiting a local advantage, relative to other producers, in the production of some valued good or service. . .

the costs of transactions were driven down by continuous institutional innovations, notably by the development and rapid spread of silver coinage as a reliable exchange medium; the dissemination of common standards for weights and measures; the creation of market regulations and officials to enforce them; and increasingly sophisticated systems of law and legal mechanisms for dispute resolution.

The whole piece is interesting.

Can Computers Solve the Socialist Calculation Problem?

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Malcolm Harris writes,

What if the problem with the Soviet Union was that it was too early? What if our computer processing power and behavioral data are developed enough now that central planning could outperform the market in the distribution of goods and services?

Pointer from Tyler Cowen.

This is just sad. The socialist calculation problem is not one of processing power. In The Book of Arnold, I try to explain it thusly:

In a command economy, central planners give each family ration coupons for corn flakes and wheat bread. If you were to give a family more ration coupons for corn flakes, then the family would gladly use them. If you were to give a family more ration coupons for wheat bread, then the family would gladly use those. Consumers have no way of signaling to planners that in relative terms they would prefer more corn flakes.

Similarly, workers have no way of signaling to central planners that they have untapped skills. Managers have no way of signaling that there are alternative production methods that might use a lower-cost combination of inputs. Indeed, the central planners do not know the cost of inputs. They only know the shadow prices that they have imputed to those inputs.

The Econometrician and the Entrepreneur

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Don Boudreaux writes,

The market itself is a vast and on-going laboratory of experiments – experiments that are relevant, real, and revealing. These experiments are valuable not least because they are made under real-world circumstances and by people with strong personal incentives to discover and comprehend the ‘truth’ better than their rival experimenters. . .

While I sincerely believe that much useful information can be gathered by academics doing empirical studies (both quantitative and non-quantitative), it is an unwarranted conceit of academics to suppose themselves and their empirical studies to be the only, or even the chief, source of empirical knowledge of social reality.

The notion that markets generate and process information must be very non-intuitive. It strikes me as under-appreciated by many people, including economists. Of course, markets lack perfect information–otherwise there would be no flawed products, no business failures, and no financial crises. But I am not arguing that the market process has generated perfect information. I am simply suggesting that it is hard for someone–even someone armed with a lot of data and a computer–to be more informed than the market.

Markets and Trust

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Liran Einav, Chiara Farronato, and Jonathan Levin write,

Businesses that hope to create successful marketplaces or platforms for matching buyers and sellers have to solve several problems. They need to help buyers and sellers Önd each other, either by developing a centralized assignment mechanism or by allowing for e§ective search. They need to set prices that balance demand and supply, or alternatively ensure that prices are set competitively in a decentralized fashion. And importantly, they have to maintain an adequate level of trust in the market, by developing mechanisms to guard against low quality, misbehavior and outright fraud.

In The Book of Arnold, I write,

In the 21st century, many of us shop on the Internet. How do I know that the biking gloves I order really have the padding that I want? How do I know that the retailer will send me the gloves that I order? How do I know that the gloves will not be stolen before they reach me?

When you consider these sorts of questions, you realize that our modern market economy is built on layers of trust. In order for trade to take place, individual beliefs, cultural norms, and formal institutions must be aligned to reinforce such trust.

The catch is that almost every mechanism for promoting trust has flaws and can be abused.

An Uninspiring Sentence

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With its heavy Scandinavian population, Minneapolis is a key U.S. player in the most avant-garde movement in food today: New Nordic cuisine, based on fish, dairy and cold-weather crops such as rutabagas, mushrooms and radishes.

I’ve missed many a trend in the foodie world, and I can’t wait to miss this one.

From an interesting article on nine cities that supposedly have thriving start-ups in specific industries. My comments:

1. Minneapolis is cited as an exciting place for restaurant start-ups. I call baloney sandwich. If you are an exciting place for a type of business, the business has to produce tradable goods or services. Restaurants do not count. If you want to start a restaurant, do not go to a city where the main growth industry is restaurants. Go to one of the other cities instead.

2. Baltimore and Boston are cited for New Commanding Heights businesses–education and health care, respectively.

3. How does this story affect my claim that cities will be increasingly chosen for their consumption characteristics, not for their production characteristics?