Bengt Holmstrom Re-discovers a Theory of Debt Contracts

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He writes,

The purpose of money markets is to provide liquidity for individuals and firms. The cheapest way to do so is by using over-collateralised debt that obviates the need for price discovery. Without the need for price discovery the need for public transparency is much less. Opacity is a natural feature of money markets and can in some instances enhance liquidity, as I will argue later.

Pointer from Timothy Taylor. The theory that debt is used when the underlying assets are opaque is not quite new. My articulation of it owes a bit to the delegated monitoring idea of Doug Diamond.

The natural error for economists to make is to assume that bank creditors “see through” the bank to the underlying assets. What Diamond got me thinking is that the whole point of a debt contract is to ensure that the creditor does not have to see through the bank unless the bank gets into trouble. That is the insight that Holmstrom is re-discovering.

Specialization, Bilateral Monopoly, and Firms

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A bilateral monopoly is when there is one buyer and one seller.

When the first IBM PC was introduced, there was one buyer for Microsoft’s operating system (DOS) and one seller. However, IBM allowed other companies to make “clones,” with the result that the hardware became a commodity and the software became worth a fortune.

We rarely observe bilateral monopolies between two firms, because each firm has such a strong incentive to try to create competition on the other side of the bilateral monopoly. Thus, I would argue that bilateral monopoly is more likely to wind up within a firm than across two firms.

Specific human capital, meaning skills that are valuable only in the context of a particular industry or a particular organization, gives rise to bilateral monopoly. An employee who is familiar with the procedures, culture, and systems that are peculiar to one firm is more valuable to the firm than another employee. For the employee, the firm is now a better fit than some other firm.

In the economy as a whole, specialization tends to produce a lot of specific human capital. Thus, many economic relationships have to take bilateral monopoly into account. You can think of these sorts of bilateral monopolies as repeated games, in which cooperating means sharing the rents from specific human capital, and defecting means either trying to appropriate all of the rents or ending the relationship.

Typical contract features that try to deal with these repeated games include increases in pay and benefits tied to length of service, including pension vesting or additional weeks of vacation. Some firms offer training or tuition reimbursement with a requirement that the worker continue with the firm for a period of time afterward.

I think that most of these sorts of contractual features could be reproduced across the boundaries of firms. That is, if I want you to invest in human capital specific to my firm, I can design a contract that induces you to remain in a long-term relationship.

However, there is another type of inducement that is almost inherently within the firm. That is the inducement provided by promotion from within. If you know that internal candidates have an advantage when a high-level position opens up, that gives you an incentive to invest in specific human capital within that firm.

In fact, I believe it is the case that organizations that promote almost entirely from within have very loyal middle managers. The cost is that such organizations can be culturally rigid and stagnant. Conversely, firms that frequently fill high-level positions from outside and/or engage in mergers and acquisitions can be more flexible and dynamic, but at a cost of low morale and high turnover at lower levels of management.

Specialization, Externality, and Firms

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Suppose that a production process is divided into tasks. Think of Adam Smith’s example of a pin factory, or think of a software application developed by many people.

It is unlikely that this process will be coordinated by decentralized market prices. Separately, each worker’s contribution to the process is not marketable. It is the final product that can be sold. In a sense, there is a “production externality,” in that the finished product is worth something, even though the individual worker’s output is worth nothing by itself. The task of Coasian bargaining among the workers to come up with a way to allocate this externality is onerous, so it is handled by a manager in the context of a firm.

Adam Gurri on Persuasion and Economics

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A long post, difficult to excerpt. A few snippets:

One of the things that I found jarring about The Rhetoric of Economics is that McCloskey argues, among other things, that appeals to authority are natural and necessary. That pointing out that an argument involves an appeal to authority does not invalidate that argument.

What I would say is that what people think of as scientific discourse does not rely so heavily on appeals to authority. At some point, you can say, “If you don’t believe in gravity, try an experiment yourself. Jump out of a 10-story window and see what happens.”

But when Olivier Blanchard tells you that every macro model includes an aggregate demand relation, a Phillips relation, and a monetary policy relation, he cannot issue an equivalent challenge. Instead, the literature emerged that way mostly because scholars published papers that borrowed from other published papers.

I would not argue that there is a scientific method that is so pure that it can be operated without any bias or other human characteristics. But clearly there are arguments that are more persuasive than others, and arguments that apply the scientific method can be more persuasive than arguments that rely primarily on authority.

For Smith, trade was never a mechanistic process. The act of offering payment is itself an act of persuasion.

I think this notion of the centrality of persuasion in human affairs, and in markets in particular, is what economics should strive to rebuild itself around. This does not mean that the insights from economists’ contributions up to this point should be discarded, just that we should seek to find their appropriate context.

Engineered Babies

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Frank K. Salter writes,

So when significant numbers of fertile women begin using IVF, we will know that market-based eugenics has left the launch pad. This could easily expand into positive eugenics where parents choose the best among healthy embryos in an attempt to give their children a better start in life. Most parents want their children to be not only healthy, but happy and successful. The surmise by James D. Watson, co-discoverer of the structure of DNA, is plausible: “Once you have a way in which you can improve our children, no one can stop it.” Watson wants parents to have access to genetic screening. That would aid negative eugenics but it would make the slope to positive eugenics more slippery.

The long article is interesting throughout. Pointer from Jason Collins. I should note that a recent issue of Technology Review carried the cover story “We Can Now Engineer the Human Race.”

Pinker, Hobbes, and Baltimore

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I am still re-reading The Blank Slate. In his chapter on violence, he endorses Hobbes. On p. 330, he writes,

Adjudication by an armed authority appears to be the most effective general violence-reduction technique ever invented. . .there can be no debate on the massive effects of having a criminal justice system as opposed to anarchy. The shockingly high homicide rates of pre-state societies, with 10 to 60 percent of the men dying at the hands of other men, provide one kind of evidence. Another is the emergence of a violent culture of honor in just about any corner of the world that is beyond the reach of the law. Many historians argue that people acquiesced to centralized authorities during the Middle Ages and other periods to relieve themselves of the bureden of having to retaliate against those who would harm them and their kin. And the growth of those authorities may explain the hundredfold decline in homicide rates in European societies since the Middle Ages.

See also Mark Weiner, The Rule of the Clan. A few remarks.

1. This chapter challenges the more anarchist-leaning libertarian views. Instead, Pinker argues that it is natural for humans to form coalition, to fear others’ coalitions, and to launch pre-emptive strikes on relatively small pretenses. (Of course, governments do this as well. Pinker would not argue that nation-states are inherently peaceful with one another. Quite the contrary.) Another excerpt, from p. 331:

When law enforcement vanishes, all manner of violence breaks out: looting, settling old scores, ethnic cleansin, and petty warfare among gangs, warlords and mafias.

2. Reading this chapter, I could not help thinking of Baltimore. Another excerpt, also from p. 331:

The generalization that anarchy in the sense of a lack of government leads to anarchy in the sense of violent chaos may seem banal, but it is often overlooked in today’s still-romantic climate. Government in general is anathema to many conservatives, and the police and prison system are anathema to many liberals. Many people on the left, citing uncertainty about the deterrent value of capital punishment compared to life imprisonment, maintain that deterrence is not effective in general. And many oppose more effective policing of inner-city neighborhoods, even though it may be the most effective way for their decent inhabitants to abjure the code of the streets. Certainly we must combat the racial inequities that put too many African American men in prison, but. . .we must also combat the racial inequities that leave too many African Americans exposed to criminals.

He does proceed to point out that drug laws, by creating an underground economy in which participants cannot call in police to contain disputes, help to promote a climate of violence.

My Essay on MIT Economics

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It covers a number of themes recently discussed on this blog.

My sense is that the MIT-dominated profession has experienced a decline in critical thinking. Instead, once a modeling assumption has appeared often enough in the literature, it no longer is questioned. This creates an element of arbitrariness and path dependence to the professional consensus about the equations used to characterize the economy.

The Art of Statistical Scamming in Experiments

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John Bohannon writes,

Here’s a dirty little science secret: If you measure a large number of things about a small number of people, you are almost guaranteed to get a “statistically significant” result. Our study included 18 different measurements—weight, cholesterol, sodium, blood protein levels, sleep quality, well-being, etc.—from 15 people. (One subject was dropped.) That study design is a recipe for false positives.

Usually, I think of health studies as bad because they are non-experimental. But this is a way to scam experimental studies.

John Cochrane vs. Financial Intermediation

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He writes,

just why is it so vital to save a financial system soaked in run-prone overnight debt? Even if borrowers might have to pay 50 basis points more (which I doubt), is that worth a continual series of crises, 10% or more downsteps in GDP, 10 million losing their jobs in the US alone, a 40% rise in debt to GDP, and the strangling cost of our financial regulations?

My take:

1. As I have said before (scroll down to lecture 9), the nonfinancial sector likes to hold riskless, short-term assets and issue risky, long-term liabilities. Financial intermediaries emerge to take the other side.

2. When governments run deficits, they need help from banks, which hold government debt. It used to be that governments ran deficits to finance wars. Now they run deficits routinely.

3. Banks have an easier time convincing customers that bank liabilities (i.e., the funds customers hold on deposit) are riskless if government will provide implicit or explicit guarantees.

From (2) and (3), we see that banks and government are co-dependent. This co-dependency makes it unlikely that we will find a free-market banking system.

We can expect government policy to be ambivalent with respect to the financial sector. On the one hand, it wants the financial sector to thrive, so that deficits can be financed and the economy has plenty of credit available. That argues for lots of guarantees with limited regulation. On the other hand, it wants to restrain the moral hazard that leads banks to take on too much risk and make the system prone to crises. That argues for limited guarantees and lots of regulation.

Policy makers do not deal rationally with this ambivalence. Instead, over time both guarantees and regulation tend to increase. For instance, in the wake of the financial crisis the government has extended both its guarantees (money market funds) and its regulation (non-banks that are “systemically important”). It is true that some types of financial regulation, such as restrictions on interstate banking, interest-rate ceilings, or other anti-competitive rules, have declined over time. But in the area of safety and soundness regulation, over the years the effort has been to make regulation more sophisticated and effective. That this has not been successful is due in part to the greater prevalence of guarantees and also to what I call the regulator’s calculation problem.

The New Matchmaking

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A reader suggests, probably correctly, that this story belongs under Four Forces Watch.

The company has come up with a secret algorithm that invites select users to access the app based primarily on LinkedIn résumés and friend networks. Ambition, Bradford says, is the biggest trait The League looks for within its community.

It is a dating application with a very limited, exclusive clientele.

I remember when some discos/nightclubs used a similar sort of business model.