The Economics Book

POST-WAR ECONOMICS 249 See also: Economic man 52–53 ■ Economic bubbles 98–99 ■ Risk and uncertainty 162–63 ■ Irrational decision making 194–95 ■ Behavioral economics 266–69 A probability experiment offered a choice of bets. A further choice offered $100 if a red or yellow ball was Players were told there were 30 red balls in an urn, together drawn, or $100 if a black or yellow was drawn. This time, with 60 balls that were an unspecified mixture of black and most players opted for black or yellow. In each case, yellow. Drawing a red ball would win $100; a black would players showed a preference for known odds over win $100. Most players opted for a bet on the red. unknown odds. drawing on an idea originally experiments since Ellsberg Daniel Ellsberg described by John Maynard Keynes published his paper. It (p.161) in the 1930s. has become known as “ambiguity Born in 1931, Daniel Ellsberg aversion,” and sometimes studied economics at Harvard Aversion to ambiguity “Knightian uncertainty” after the University, and joined the US Ellsberg described a thought US economist Frank Knight (p.163). Marine Corps in 1954. In 1959, experiment in which a cash prize In seeking to know more about he became an analyst for the was offered if a ball of a particular “unknown unknowns,” people may White House. He received his color was drawn from an imaginary act inconsistently with previous, PhD in 1962, in which he first urn (see above). The bets made by more logical choices, and put presented his paradox. the experiment’s participants questions of probability aside Ellsberg, then working with demonstrated that people tend to when making their choice. top security clearance, became make a reasoned choice when disillusioned with the Vietnam given some information from which Know the unknowns War. In 1971, he leaked top the degree of probability, and Ellsberg’s paradox has proved secret reports detailing the therefore risk, can be assessed. controversial. Some economists Pentagon’s belief that the war However, their behavior changes if claim that it can safely be could not be won, before a future outcome seems contained within conventional handing himself over to the ambiguous, and this is the paradox theory, and that experimental authorities. His trial collapsed that departs from expected utility conditions do not properly when it was revealed that theory. People prefer to know more reproduce people’s behavior White House agents had used about the uncertainties they face, when faced with real-life illegal wiretaps of his house. rather than less. In the words of ambiguity. However, the financial former US Defense Secretary crisis of 2008 has provoked Key works Donald Rumsfeld (1932– ), people fresh interest in the problem prefer the “known unknowns” to of ambiguity. People want to 1961 Risk, Ambiguity, and the “unknown unknowns.” The know more about the unknown, the Savage Axioms outcome of the experiment has unquantifiable risks that expected 2001 Risk, Ambiguity, and been reproduced in several real utility theory cannot account for. ■ Decision

SIMILAR ECONOMIES CAN BENEFIT FROM A SINGLE CURRENCY EXCHANGE RATES AND CURRENCIES



252 EXCHANGE RATES AND CURRENCIES IN CONTEXT B y the early 1960s the imports by using the proceeds institutions of the post-war of their exports. Alongside this, FOCUS economies were well a series of moves toward the Global economy established. Toward the end of integration of European economies World War II the Bretton Woods began to float the possibility of a KEY THINKER system (pp.186–87) was set up to currency union between European Robert Mundell (1932– ) regulate the financial relations countries. This started with the between the big industrial states, Treaty of Paris in 1951, which BEFORE basing Western capitalism on a established common trading 1953 Milton Friedman argues system of fixed exchange rates that areas for coal and steel. In 1961, that freely floating exchange controlled the flows of capital and Canadian economist Robert rates would enable market money worldwide. International Mundell was the first to attempt forces to resolve problems trade had recovered after the slump an analysis of what he called an with balance of payments (the of the interwar years, and economic “optimal currency area.” difference between the value growth was rapid. of exports and imports). Currency areas However, there were glitches in Mundell sought to answer what AFTER this system. First there were might at first seem an odd 1963 US economist Ronald problems with balance of payments question: over what geographical McKinnon shows that small —the difference between what a area should one type of currency be economies would benefit from country pays for imports and what used? At the time this issue had a currency union since they it earns from exports. Balance of barely been posed. It had simply can mitigate shocks better payments crises occurred because been taken for granted that national than large economies. countries could not easily adjust economies used their own national their exchange rates within the currencies. The idea that this might 1996 US economists Jeffrey international system. Coupled with not be the best arrangement had Frankel and Andrew Rose tight labor markets and inflexible not really occurred to anyone. argue that the criteria for domestic prices, the previously Mundell realized that while history a currency area are automatic, market-led mechanisms had provided nations with their themselves affected by prior that allowed countries to adjust to own currencies, this did not mean economic development. external economic shocks did not it had provided them with the best function very well. The result was possible currency arrangements. a series of crises that arose when There were clearly costs involved in countries were unable to pay for Different regions Specialization leads to But trading in multiple specialize in producing trade between regions. currencies creates additional costs. different goods. Similar economies … there is no need for These costs can be can benefit from a exchange rates tailored eliminated if the regions are in similar phases of growth single currency. to local conditions. and slump because…

POST-WAR ECONOMICS 253 See also: Boom and bust 78–79 ■ Comparative advantage 80–85 ■ International trade and Bretton Woods 186–87 ■ Market integration 226–31 ■ Speculation and currency devaluation 288–93 A small region that crosses national borders may benefit from a single currency. An area may import electricity from a power station across the border without the costs of exchange rates. using many different currencies, to offset trade imbalances. Suppose manfacturing economy—is in fact since these had to be exchanged if a country specializing in made up of several nation-states. It trade was to take place. At one agriculture is trading with a would therefore be efficient for extreme, having a different manufacturing economy. A sudden them to share a currency. currency for every zip code in a city increase in productivity in the would be very inefficient. On the manufacturing economy might Business cycles other hand one currency for the cause an excess demand for Later thinking on the subject entire world would be an agricultural products and an excess helped clarify the conditions under undesirable straitjacket on so many supply of manufactured goods. The which a currency area would be diverse economies. Mundell asked manufacturing economy slips into most economically viable. For a what was the most efficient point a balance of payments deficit, region to be best suited to a single between these two extremes. importing more (by value) than it currency, it would need flexible exports. The deficit causes the markets for capital and labor, First of all it is important to manufacturing country’s currency allowing both to move freely in understand why countries need to depreciate, making its exports response to market demands. different currencies. A country cheaper, and therefore boosting Prices and wages would, as a with its own currency can make them and restoring equilibrium. result, need to be flexible, adjusting decisions about its money supply to demand and supply changes and and interest rates, and can But suppose instead that the signaling to mobile capital and therefore set its monetary policy manufacturing economy and labor where they should move. tailored to its own domestic the agricultural economy shared a The different parts of the region economic conditions. Also, when currency. In this case the type of would also need to share broadly the exchange rates of its currency adjustment described above would similar business cycles, allowing are not fixed, the exchange rate not be possible, and it might be the shared central bank for the with its trading partners can adjust that separate currencies would be single currency to act appropriately more beneficial. It might also be the for the whole region. There would It hardly appears case that a single economic area— also need to be mechanisms for ❯❯ within the realm of such as that constituted by the political feasibility that national currencies would ever be abandoned in favor of any other arrangement… Robert Mundell

254 EXCHANGE RATES AND CURRENCIES Crowds gather in Frankfurt, Germany, for the launch of the euro, the single currency of the eurozone, on January 1, 1999. For a while the euro traded alongside national currencies. dealing with situations when business cycles weren’t completely synchronized across the region. The most obvious of these would be fiscal transfers—taking taxes from one area enjoying growth and redistributing to another in recession. This last condition, and the failure to implement it, was to have grave consequences for Europe. Introducing the euro implement further constraints on attempted to fix national currencies The idea of a single currency for euro membership to ensure that the against each other within the EU. Europe began taking shape in 1979, currency could function effectively. The euro went a step further, when the European monetary removing all national currencies system (EMS) was formed to The “convergence criteria,” and, in effect, permanently fixing stabilize exchange rates. Finally, in enshrined in the 1992 Maastricht exchange rates. Important new 1999, the eurozone (the area of the Treaty, were drawn up to make sure rules on government debt were single currency) was established that all those countries wishing to introduced. Under the stability and with 11 member states of the join the euro would share similar growth pact of 1997, no country European Union (EU). While EU economies and be at similar stages was to have a national debt of states traded heavily with each in their business cycles (growth or more than 60 percent of its gross other and their institutions had recession). The previous exchange domestic product (GDP) and the removed restrictions on the rate mechanism (ERM) had already movement of labor, capital, and goods, it was deemed necessary to Robert Mundell Born in Kingston, Canada, in 1932, the International Monetary Robert Mundell studied at the Fund. Alongside his work University of British Columbia in on optimal currency areas, Vancouver before moving to the Mundell developed one of the University of Washington in first models to show how Seattle. He earned his PhD at the macroeconomic (whole economy) Massachusetts Institute of policy interacts with foreign Technology in 1956. He was trade and exchange rates. He professor of economics at the was awarded the Nobel Prize in University of Chicago from 1966– economics in 1999 in recognition 74, when he moved to Columbia of his work on macroeconomics. University in New York. Key works Apart from his academic work, Mundell has acted as adviser to 1968 International Economics the governments of Canada and 1968 Man and Economics the US, and to organizations 1971 Monetary Theory including the United Nations and

POST-WAR ECONOMICS 255 … countries with tight regions and redistribute to those in growing trade surpluses that were international trade deficit—for example, to tax matched by rising deficits in the ties and positively Germany and spend in Greece. But south. Without the mechanisms to correlated business the political will to perform this provide for fiscal transfers between was lacking. Instead, Europe’s surplus and deficit countries, these cycles are more likely to join, leaders hoped that the stability and deficits were (in effect) funded by and gain from [European growth pact would provide enough the creation of rising debts in the Monetary Union]… of a bind on government activities south. When the financial crisis Jeffrey Frankel that an explicit fiscal transfer broke in 2008, the unbalanced Andrew Rose mechanism would not be needed. system was pushed over the edge. annual deficit was not to exceed Eurozone crisis The euro crisis has raised 3 percent of GDP. A new European For nearly a decade after its launch questions about whether Europe Central Bank would act for the euro the euro functioned well. European is an optimal currency area. Some area, replacing the national central trade increased by up to 15 percent countries have seemed ill-matched banks and setting monetary policy by some estimates. Capital and in trading terms, and the absence across all the member states. labor markets became more of a fiscal transfer mechanism has flexible. Growth, particularly in the meant that these imbalances could Fatal flaw poorer countries of Ireland and not be overcome. The stability and However, the provisions for the euro southern Europe was impressive. growth pact was not robust enough did not contain a mechanism for But underneath this picture were to force distinct national economies risk-sharing—crucially, they did profound problems. Differences in to converge. not include a means for fiscal (tax labor costs helped exacerbate trade revenue) transfers across European imbalances between different Euro member countries face countries. The reason for this was countries. The euro area as a whole difficult choices. If a mechanism simple, and political. Despite the was broadly in balance with the to undertake fiscal transfers can long establishment of some transfer rest of the world, exporting roughly be constructed, euro countries mechanisms, such as the Common as much as it imported. But within may be able to overcome their Agricultural Policy, there was no the euro area, huge differences own unevenness. If the political desire in any EU country to lose appeared. Northern Europe had consensus for such a mechanism its ability to set its own taxes and can’t be reached, the existence of spending levels. Fiscal transfers the euro may be threatened. ■ across the continent would have required a strong, central authority, able to take taxes from surplus The eurozone was established in 1999 as the monetary union of the 11 European Union states shown here. By 2012, there were 17 eurozone members, with eight more scheduled to join.

256 FAMINE CAN HAPPEN IN GOOD HARVESTS ENTITLEMENT THEORY IN CONTEXT Families exchange their I ndian economist Amartya Sen labor for money, with which grew up during the Great FOCUS Bengal famine of 1943. He was Growth and development they buy food to survive. only nine years old when a man arrived in his school who hadn’t KEY THINKER If there is a change in the eaten in 40 days. Prior to this Amartya Sen (1933– ) price of their labor or food… meeting, Sen had been unaware of the suffering that was taking place BEFORE … and wages become too low in his region. None of his family, nor 1798 Thomas Malthus to buy the minimum amount his friends’ families, were affected. concludes that an increasing Even at this young age, Sen was population will lead to famine of food a family needs… shocked at the class-based nature and death in An Essay on the of the suffering. Almost 40 years Principle of Population. … the family will starve, later, the memory of the Bengal even if plenty of food famine drove Sen to research and 1960s The commonly held is being produced. write about the subject in Poverty view is that famine is due to and Famines: An Essay on a decline in food availability. Famine can happen Entitlement and Deprivation in in good harvests. 1981. Sen concluded that, contrary AFTER to popular belief, famine is not 2001 British economist caused primarily by a shortage of Stephen Devereux argues that food. Bad harvests, droughts, or entitlement theory misses the reductions of food imports are political causes of famine. often contributing factors, but a more important factor is the way 2009 Norwegian academic the food is distributed. Dan Banik publishes Starvation and India’s Entitlement Democracy, showing how An absolute scarcity of food is very starvation and undernutrition rare; it is far more common for food can still occur despite a supplies to be unavailable to those functioning democracy. who need them the most. Sen termed the bundles of goods and services that individuals have

POST-WAR ECONOMICS 257 See also: Markets and morality 22–23 ■ Demographics and economics 68–69 ■ Supply and demand 108–13 ■ The poverty problem 140–41 ■ Development economics 188–93 Famines such as the Congo famine of 2008 were caused by economic failure, according to Amartya Sen. He claimed that famine has never been known to occur in a functioning democracy. access to as their “entitlements.” evidence to support his theory. In rule, was going through a boom Famines are an example of an Bengal he discovered that the total as the British government pumped entitlement failure, and entitlements food production, although lower in money as part of its war effort. depend on more than just the than the year before the famine This resulted in laborers suffering amount of food produced. In a began, was still higher than in a reduction in their ability to buy modern, exchange-based economy previous, famine-free years. He food, and so they starved. most people do not produce their concluded that the principal cause own food; they exchange a of the famine was the inability of Sen argued that democratic commodity (their labor) in return for farm laborers’ wages to keep pace countries in particular should be another commodity (money), which with the inflation-fueled rising able to prevent the worst famines. is then exchanged again for food. price of food in Calcutta (now His groundbreaking approach led Whether a family has enough food Kolkata). India, then under British to an overturning of beliefs and to live on depends on what it can approaches to famine. ■ sell or exchange in comparison to the price of food. A famine occurs when families’ entitlements (the goods they have access to, not the amount generally available) fall below the minimum amount needed to survive. This may happen if the price of food rises or wages fall. Sen analyzed the Bengal famine of 1943 and more recent famines in Africa and Asia to collect empirical Amartya Sen Amartya Sen was born in in the US; and Oxford and Santiniketan, West Bengal, India, Cambridge in the UK. In 1988, in 1933. His father was a professor he received the Nobel Prize for of chemistry, but Sen chose economics. He moved to Harvard economics, graduating from the University in 2004, where he is University of Calcutta (now Kolkata) professor of economics and in 1953. In the same year he philosophy. Sen has married attained a second degree from twice and has four children. Cambridge University, UK. At 23, Sen became the youngest ever Key works Head of Economics at Jadavpur University, Calcutta. A prize 1970 Collective Choice and fellowship enabled him to diversify Social Welfare his studies into philosophy. Sen 1981 Poverty and Famines: has taught at universities in An Essay on Entitlement Kolkata and Delhi in India; MIT, and Deprivation Stanford, Berkeley, and Cornell 1999 Development as Freedom

CONTEM ECONOM 1970–PRESENT

PORARY ICS

260 INTRODUCTION George Akerlof OPEC, a group of Arthur Laffer explains Edward Prescott and describes markets where oil-producing countries, the Laffer curve, which Finn Kydland begin an oil embargo, argue for one buyer has better plunging the world into shows how increased independent information than taxes can lead to economic crisis. central banks. another, and opens up decreased revenue. a new field of information economics. 1970 1973 1974 1977 1971 1973 1974 1979 President Richard Nixon Augusto Pinochet seizes Hyman Minsky Psychologists Amos breaks the link power in a coup in Chile, outlines his Tversky and Daniel Kahneman publish between the US dollar which becomes financial instability and the price of gold the first country to hypothesis, showing Prospect Theory, implement monetarist how stability leads the foundation of on the advice of economic policies. behavioral economics. Milton Friedman. to instability. I n the 25 years following rather than tackling unemployment, born economist Friedrich Hayek World War II Keynesian inflation should be the focus of (p.177), who put the individual, not policies, which advocated an economic policy, and the only role the state, at the heart of economic active state intervention in the of the state should be in controlling thinking, and by economists economy, made the Western world the money supply and allowing who saw tax cuts as a means prosperous. In the words of British markets to work—a doctrine of increasing tax revenue. Prime Minister Harold Macmillan, known as monetarism. people had “never had it so good.” Liberalization became the However, in the early 1970s an Rise of the Right new watchword. Deregulation of oil crisis triggered an economic As faith in Keynesian policies financial institutions not only made downturn. Unemployment and waned, the right-wing parties it easier for firms to borrow, but also inflation both rose rapidly. The of Ronald Reagan and Margaret allowed lenders to indulge in the Keynesian model no longer Thatcher, both staunch believers in new forms of financial engineering seemed to be working. Friedman’s monetarist economics, that promised high returns with took power in the US and Britain. zero risk. Throughout the 1980s For some years conservative The policies they introduced in the the economic mood was changing economists had been arguing for a 1980s marked a return to the old worldwide. Reforms in the Soviet return to more free market policies, beliefs in the stability, efficiency, Union were to lead to the eventual and now their arguments were and growth of markets if left breakup of the Soviet bloc, being taken more seriously. US to their own devices. reinforcing conservative economist Milton Friedman (p.199), economists’ views that socialist was now the foremost economist of The social policies of so-called policies did not work. Mainland the Chicago School, which opposed Reaganomics and Thatcherism Europe, however, resisted the Keynesian ideas. He suggested that were influenced by the Austrian- American swing from Keynes

CONTEMPORARY ECONOMICS 261 Mikhail Gorbachev Alice Amsden Alberto Alesina Nicholas Stern begins a process of describes the rise and Dani Rodrik work describes global economic reform in warming as the the Soviet Union of East Asian on the relationship “biggest collective Tiger economies. between economic action problem” known as perestroika. facing human society. growth and inequality. 1985 1989 2000S 2006 1988 1994 2005 2008 Marilyn Waring’s Robert Flood and In The End of Poverty, A banking crisis causes If Women Counted Peter Garber create Jeffrey Sachs suggests worldwide recession gives a gender- the first of a number as credit is withdrawn based perspective that debt relief of currency can kick-start economies and housing on economics. crisis models. bubbles burst. in the Third World. to Friedman and only gradually that the “scientific” models of the political instability. At the same adopted more free market economy were based on the wrong time the technology that had economic policies. sciences: new ideas in mathematics brought economic prosperity now and physics, such as complexity posed an economic threat in the Rethinking free markets theory and chaos theory, were form of global warming and climate Although monetarism and the perhaps better analogies, and change, which needed to be dealt liberalization of markets may have behavioral psychology could with at an international level. helped to make markets more better explain the actions of efficient through the 1980s and 90s, “economic man” than economists’ In the first decade of the 21st some economists were uneasy standard notion of rationality. century a succession of financial about the sustainability of these crises rocked the Western policies. As early as 1974, US Meanwhile, younger economies economies, and it seemed that economist Hyman Minsky (p.301) were developing, especially in Asia, free market policies had failed. had warned of the inherent where reforms were transforming Once again, economics became instability of financial institutions. the Chinese and Indian economies. concerned with the inequalities An acceleration of the “boom and A new economic bloc emerged to and social consequences of free bust” cycles seemed to confirm rival the West, in the form of the markets. A few economists even his hypothesis. Deregulation BRIC nations (Brazil, Russia, India, wondered whether the failure of encouraged risky borrowing, and China). The prosperity of these free markets was heralding the which led to the collapse of firms new economic powers stimulated collapse of capitalism that Karl and banks. Other economists a renewed interest in so-called Marx (p.105) had predicted. Not challenged the efficiency and development economics since other for the first time, the world seemed rationality of the market, arguing countries remained locked in to be on the verge of profound poverty by crippling debt and economic change. ■

262 IN CONTEXT IT IS POSSIBLE FOCUS TO INVEST Banking and finance WITHOUT RISK KEY THINKERS FINANCIAL ENGINEERING Fischer Black (1938–95) Myron Scholes (1941– ) BEFORE 1900 French mathematician Louis Bachelier demonstrates that stock prices follow a consistent but random process. 1952 US economist Harry Markowitz proposes a method to build optimal portfolios based on diversifying risk. 1960s Capital Asset Pricing Model (CAPM) is developed to determine the correct rate of return for a financial asset. AFTER 1990s Value-at-Risk (VaR) is developed to measure the risk of loss on a portfolio. Late 2000s Global financial markets collapse. D uring the 1960s the institutional foundations of the post-war world were steadily eroded. The Bretton Woods system (pp.186–87) of fixed exchange rates, pegged against a US dollar that was in turn locked into a fixed price against gold, was starting to buckle. The US was running persistent trade deficits (where imports outstrip exports), while recurrent balance-of-payments crises elsewhere provoked calls for the introduction of freely floating exchange rates. In 1971, President Richard Nixon took definitive action: he unilaterally canceled the dollar to gold relationship, ending the whole Bretton Woods system.

CONTEMPORARY ECONOMICS 263 See also: Financial services 26–29 ■ Public companies 38 ■ Risk and uncertainty 162–63 ■ Behavioral economics 266–69 ■ Efficient markets 272 ■ Financial crises 296–301 If we assume that financial … the probabilities of reduce risk and insure against the markets are efficient, future price variations future. This is known as a “hedge.” However, the derivative contract and prices will rarely can be calculated. can work the other way around. differ widely from Instead of providing insurance an average value… This means a contract against the future, it can be used to buy goods at a future to gamble on the future. A forward It is possible to contract locks in the delivery of invest without risk. price can be valued goods for a certain price on a certain accurately and used date. But if the immediate market At the same time domestic to insure against risk. price (the “spot price”) on that date economies were experiencing is less than the price in the forward steadily rising rates of inflation. derivative contract is a “forward,” contract, an easy profit could be Keynesianism (pp.154–61), the which specifies the price and future made. Of course if the market price economic thinking that had date for delivery of a commodity, is more than the one specified, it dominated the post-war years, such as coffee. The advantage of results in a loss. Furthermore, as came under sustained intellectual this arrangement is that it allows derivative contracts do not involve attack. The financial markets, producers to lock their customers payment for actual assets or which had been tightly regulated into a price in the future, regardless commodities, but only for the right since the 1930s, pushed for a of how—in agricultural commodities to buy those products in the future, removal of restrictions on their —harvests and production actually they allow people to deal in huge activities. These restrictions were turn out. The derivative aimed to quantities. Derivatives give traders finally lifted in 1972, when the leverage—more “bang for their buck.” Chicago Mercantile Exchange was allowed to write the first derivative Letting go of the asset contract on exchange rates. Derivative contracts became standardized and could then be bought and sold on a market like any other commodity. The first ❯❯ Futures contracts Derivatives have existed for centuries. A derivative is a contract written not directly for a commodity itself, but for some attribute associated with it. For instance, a typical early The price of rice may vary with changes in weather. A forward contract, where one party agrees to buy the rice at a certain price on a certain day, allows the grower to manage risk.

264 FINANCIAL ENGINEERING exchange to offer tradeable Option contracts are a type of incorporate all the information derivatives in agricultural products derivative that give someone the option you are basing your hedge on. was the Chicago Board of Trade, in to buy or sell something, such as coffee, The second assumption was that it 1864. However, the possibility for at a certain price on a certain date. is always possible to put together speculation that all derivative The option need not be exercised. an option contract that mirrors a contracts contain led to repeated portfolio of assets. In other words bans on their use. “Cash-settled” controlled. Exchanges were not every possible portfolio of assets contracts provoked particular allowed to trade them. But with that can be assembled can be concern. These were derivative the collapse of the fixed exchange- perfectly hedged by options. All contracts in which the delivery of rate system in 1971, a need rapidly risk vanishes with this insurance. the underlying asset did not have emerged for hedging against to take place on the specified day. potentially volatile floating Third, they assumed that Cash could be exchanged in its place. exchange rates. Restrictions were although asset prices fluctuate At this point all real connection lifted, and the market for derivatives randomly over time, they vary between the underlying product and quickly expanded. in a regular way, known as the the derivative had been lost, and the “normal distribution.” This possibilities for purely speculative This provided the background implies that, in general, prices behavior were immense. to a critical problem. There was no will not move very far over a reliable means to accurately price short time period. Deregulation derivatives since they were, by Recognition of this speculative nature, highly complex contracts. By using these assumptions, potential motivated governments Even a simple “option” (providing Black, Scholes, and Merton were to introduce strict regulations. the right but not the commitment able to provide a mathematically From the 1930s onward, cash- to trade an underlying asset at a robust model for pricing a standard settled derivatives in the US were certain point in the future) had option contract on the basis of classified as a form of gambling, a price that was determined by the underlying asset’s price rather than investment, and strictly several variables, such as the movements. Derivative contracts, current price of the underlying once seen as unreliable instruments, asset, the time to the option’s could now be processed on a huge deadline, and the expected price scale using computer technology. variation. The problem of providing The path was cleared for a vast a mathematical formula for this expansion of derivatives trading. problem was finally solved in 1973 by US economists Myron Scholes The option pricing model Black, and Fischer Black, and expanded Scholes, and Merton devised upon by fellow American Robert provided a whole new way to think C. Merton the same year. about financial markets. It could even run in reverse. Existing option These economists built on prices could be fed backward certain assumptions and insights about financial markets to simplify Don’t cross a river the problem. First, they made use if it is four feet deep of the “no arbitrage” rule. This means that prices in a properly on average. functioning financial market reflect Nicholas Taleb all the information available. An individual share price would tell you both the value of the company today, and what market traders expect of it in the future. It should be impossible to earn guaranteed profits by hedging against future risk because prices already

CONTEMPORARY ECONOMICS 265 In the years leading to the 2008 crash, banks assumed that investment risk Low risk, high rewards followed a “normal distribution” pattern (the blue line), where there is a high probability of making a small gain, and a very low probability of making an US-Lebanese economist extreme gain or loss. However, investment risk actually follows a different Nicholas Taleb claims that by pattern (the dotted line), in which extreme events are far more common. underestimating the risk of extreme price movements, High the apparently sophisticated probability, financial models overexposed small gain investors to the real risk. FREQUENCY OF EVENTS Collateralized debt obligations Low Low (CDOs) are a prime example. probability, probability, These are financial instruments big loss big gain that raise money by issuing their own bonds before LOSS 0 GAIN investing that money in a mixture of assets such as into the pricing model to generate secure, profitable new ways to loans. CDOs took on the risks “implied volatilities.” This created manage the risks associated of very low-quality (subprime) a new way to manage risk: instead with lending. housing debts that had a high of trading on the basis of prices chance of defaulting, and or expected prices, portfolios of By September 2008, when the mixed them with high-quality assets could be put together US investment bank Lehman debt, such as US Treasury directly on the basis of their Brothers filed for bankruptcy, it had bills. They apparently offered riskiness as implied by the market become clear that this expansion low risk and high rewards. But price. Risk itself, as described by had fatal weaknesses. Critical this relied on an assumption the mathematical models, could among these was the dependence that the combined risk of be traded and managed. on the assumption of a normal default followed a normal distribution: the idea that most distribution pattern and The 2008 crash prices cluster around an average, was stable. As US subprime The explosion in financial innovation, and extreme price movements mortgages defaulted in aided by sophisticated mathematics are very rare. But this had been increasing numbers, it became and ever-increasing computing disputed as early as 1963, when clear that this assumption did power, helped drive the French mathematician Benoît not hold, and the enormous extraordinary expansion of the Mandelbrot suggested that extreme CDO market imploded. financial system over several price movements were much more decades. From negligible amounts common than expected. Black swans are rarely sighted in the 1970s the global market for but do exist. Nicholas Taleb refers derivatives grew on average by 24 Post-crash, these models are to the highly unexpected, extreme percent a year, reaching a total of being reexamined. Behavioral movements of the market as $596 trillion by 2008—about 20 economists (pp.266–69) and “black swan events.” times global GDP. Applications econophysicists use models and multiplied as firms found apparently statistical techniques drawn from physics to better understand financial markets and risk. ■

266 IN CONTEXT PEOPLE FOCUS ARE NOT Decision making 100 PERCENT RATIONAL KEY THINKERS Amos Tversky (1937–96) BEHAVIORAL ECONOMICS Daniel Kahneman (1934– ) BEFORE 1940s US economist Herbert Simon argues that rational decision alone does not explain human decision making. 1953 French economist Maurice Allais criticizes expected utility theory, saying that real-life decisions are not always taken rationally. AFTER 1990 Economists Andrei Shleifer and Lawrence Summers show that irrational decisions can affect prices. 2008 US psychologist and economist Dan Ariely publishes Predictably Irrational, showing irrationality has a pattern. U ntil the 1980s standard economic theory was dominated by the idea of “rational economic man” (pp.52–53). Individuals were understood to be agents who look at all decisions rationally, weighing the costs and benefits to themselves and making a decision that will give them the best outcome. Economists thought that this was how people behaved in situations of both certainty and uncertainty, and they formalized the idea of rational decision making in expected utility theory (pp.162– 63). In reality, however, people often make irrational decisions that don’t give them the highest payoffs and may even hurt their own prospects.

CONTEMPORARY ECONOMICS 267 See also: Economic man 52–53 ■ Free market economics 54–61 ■ Economic bubbles 98–99 ■ Risk and uncertainty 162–63 ■ Irrational decision making 194–95 ■ Paradoxes in decision making 248–49 When faced with making a … people do not calculate apply whether the individual was decision where outcomes gains and losses through facing risks that involved gains mathematical probability. or losses. However, Tversky and are uncertain… Kahneman found that individuals They are affected more are risk-averse when facing gains People are not by whether they stand to but risk-loving when facing losses: 100 percent rational. gain or lose, and how the the nature of individual preference seems to change. Their work Early studies of these quirks of question is framed. showed that people are “loss behavior were made in 1979 by two averse,” and so are willing to take Israeli-American psychologists, Economists had long understood risks to avoid losses, where they Amos Tversky and Daniel that people are often “risk-averse.” would not be willing to take risks Kahneman. They looked at the For example, if given a choice to gain something. For example, psychology involved in decision between definitely receiving $1,000 the loss in utility from losing $10 making and backed up their or having a 50 percent chance of appears to be greater than the gain hypotheses with empirical receiving $2,500, people are more in utility from gaining $10. examples. Their key paper, likely to choose the guaranteed Prospect Theory: An Analysis $1,000—despite the fact that the These quirks in behavior of Decision under Risk, outlined a average expectation of the second, show that the way that choices theory that marked the start of uncertain, option is higher, at are presented influences people’s a new branch of study known $1,250. The psychologists decisions, even if the ultimate as behavioral economics. This constructed the opposite situation, outcomes are the same. For aimed to make economists’ giving the same people the choice example, consider a situation theories about decision making of either definitely losing $1,000, or where a disease is projected more psychologically realistic. having a 50 percent chance of no to kill 600 people. Two programs loss and a 50 percent chance of exist to counter the disease: A, Dealing with risk losing $2,500. In this situation, which saves 200; and B, which Tversky and Kahneman found people who chose the safe option offers a one-third chance that that people commonly violate in the previous example now 600 people will be saved versus a economists’ standard assumptions chose the riskier alternative of two-thirds chance that no one will about behavior, particularly when the gamble between no loss and be saved. When the problem is consequences are uncertain. Far a large loss. This is known as explained to them in this way, the from acting with rational self- risk-seeking behavior. majority of people show themselves interest, people were found to be to be risk-averse—they opt for the ❯❯ affected by the way a decision is The standard economic presented and responded in ways approach to decision making A government wishing to persuade that violate standard theory. under uncertainty assumed that people to be vaccinated should stress any one individual was risk-averse, the increased probability of death if risk-loving, or didn’t mind either they are not vaccinated. People hate way. These risk preferences would losing more than they love winning.

268 BEHAVIORAL ECONOMICS Q: This is a two-stage People’s choices in multistage certainty of saving 200 people. game. There is no choice at games vary according to how If the question is restated, stage 1, just a 25 percent chance questions are framed. If they are however, with the choice being directed to ignore factors that both between program C, which of moving on to stage 2. choices have in common, such as guarantees the death of 400 people, Do you want to play? Stage 1 in this example, they may or program D which offers a one- make inconsistent choices. third chance that nobody will die Q: At stage 2 versus a two-thirds chance that you have two choices: A: Yes. 600 people will die, most people either A—a guaranteed $3,000, will pick the risky program D. or B—an 80 percent chance A: I’ll take A, of $4,000. But you have to decide please—the The ultimate outcomes of the before you start stage 1 which guaranteed $3,000. pairs of choices are the same: in of these two options you want both A and C we definitely end up to take at stage 2—if Really?… with 400 dead, while with B and D, you make it that far. In that case there is an expected outcome of I’ll take B! 400 dead. Yet now people prefer Q: Final answer? the option that is more of a gamble. Do you realize that People are more willing to take Option A actually gives you risks to prevent lives being lost a 25 percent chance of winning (a loss) than they are to save lives $3,000, while Option B gives (a gain). We place more subjective you a 20 percent chance of value on losing something than winning $4,000? gaining something—losing $10 feels worse, apparently, than gaining $10 feels good. This tendency toward loss aversion means that, when choices for change are framed in such a way that the consequences are seen as negative, people are more likely to perceive the change as a problem. Knowing this can be used to influence people. For instance, if a government wants to encourage Behavioral economics in action The new field of behavioral might be most profitable for the interest rate. The economics has provided firms the bank. They sent out 50,000 experiment discovered that with new ways to drive their letters offering different interest the interest rate was only the businesses. In 2006, a group rates—some high, some low. third most important factor of economists devised an The letters also featured photos in stimulating demand, and experiment for a bank in South of employees, and a simple or including a photo of a female Africa that wanted to grant complicated table showing the employee in its marketing had more loans. Traditional different chances of winning a an effect equal to dropping economists would have advised prize if the letter was replied to. the interest rate by five points. the bank to lower its interest This is a groundbreaking result: rate to stimulate demand. By tracking which customers identifying psychological Instead, the bank allowed the responded, it was possible factors to stimulate demand economists to experiment with to quantify the effect of can be a lot cheaper than various options to find out which psychological factors against lowering the interest rate. the purely economic factor of

CONTEMPORARY ECONOMICS 269 people to adopt something, it is more likely to be successful if it emphasizes the positive gains involved in making that decision. If, on the other hand, it wants people to reject something, it should focus on what they stand to lose. Processes and outcomes the idea of “rational economic man.” A scalper sells a sports ticket for Kahneman and Tversky also The theory is a founding pillar of cash. The amount that seller and buyer showed that the process by which behavioral economics, and has also value the ticket depends not just on its decisions are made can affect had wide-ranging influence perceived utility, but also on factors choices even when the process on marketing and advertising. By such as the way the seller obtained it. doesn’t affect the final payoffs. understanding the way we make decisions, marketers are able to For example, the theory explains For example, imagine a game market their products much more why people may travel to a different of two stages in which a player is effectively. A good example of part of town in order to save $5 off given a choice of two options at the this is in-store promotions, a $15 DVD, but they are unlikely to second stage if they make it that which offer “huge discounts” on make the same trip in order to save far. However, they must make their items with initially inflated prices. $5 off a $400 TV, even though their choice before the first stage. An net wealth is impacted by the same example of such a game is laid Prospect theory has amount in each case. Loss aversion out on the opposite page. implications for many kinds of also explains what is known as the common economic decisions. endowment effect: people tend to In this two-stage game, most place a higher value on an object people choose the guaranteed One may discover that when they own it—and do not want $3,000 option. However, when the the relative attractiveness of to lose it—than before they own it, decision is shown as a straight options varies when the same when it is only a “potential gain.” choice between a lower chance of decision problem is framed winning $4,000 or a higher chance Behavioral economics is of $3,000, most people choose the in different ways. vital to our understanding of the lower chance of winning more Amos Tversky economy and has introduced money. Why the change? Daniel Kahneman psychological realism into modern economics. Prospect theory was the In the two-stage process first to suggest that people are not people ignore the first stage simply 100 percent rational because it is common to both machines. The implications of this outcomes. They see the options as realization—for economic theories a choice between a guaranteed and government policies—are wide- win and merely the chance of a win, ranging. For example, giving people even though the probabilities are a sense of ownership may affect how altered by the first stage. This well they look after something. ■ contradicts standard economic rationality in which decisions are only influenced by final outcomes. The end of rational man? The key insights to this work—that we hate to lose more than we like to gain, and that we interpret losses and gains in terms of context—have helped illuminate why people make decisions that are not consistent with utility theory or

270 TAX CUTS CAN INCREASE THE TAX TAKE TAXATION AND ECONOMIC INCENTIVES IN CONTEXT C ommon sense tells us that the case, and that cutting if a government wants to taxes can result in governments FOCUS raise more money to spend collecting more, not less, money. Economic policy on public services, it must raise taxes, however unpopular that may This is a key idea of 1980s KEY THINKERS be. Likewise, cutting taxes seems to “supply-side” economists. The Robert Mundell (1932– ) imply cutting public services. supply side is the part of an Arthur Laffer (1940– ) However, some economists have economy that makes and sells suggested that this is not always things, as opposed to the demand BEFORE side, which is the buying of goods. 1776 Adam Smith suggests that moderate taxes might If the government If the tax rate is 100 percent, bring in more revenue than takes no tax, it the government receives high ones. receives no revenue. no revenue because no one will bother to work. 1803 French economist Jean-Baptiste Say argues If taxes are set too high, Somewhere between that supply creates its workers are encouraged to 0 and 100 percent lies the own demand. work less and so pay less tax point where tax revenues overall, so revenues decline. AFTER are at a maximum. 1981 US President Ronald Reagan cuts top-rate tax and But if taxes are lowered, it Tax cuts can increase capital gains tax. encourages workers to work the tax take. more and revenues increase. 2003 US President George W. Bush ignores criticism from leading economists and pursues a policy of tax cuts. 2012 In January the US government deficit hits an unprecedented $15 trillion.

CONTEMPORARY ECONOMICS 271 See also: The tax burden 64–65 ■ Gluts in markets 74–75 ■ Borrowing and debt 76–77 ■ The Keynesian multiplier 164–65 ■ Corporate governance 168–69 ■ Monetarist policy 196–201 GOVERNMENT REVENUE maximum no revenue. If it takes 100 percent revenue tax, it will get no revenue either, since no one will work. But even Many tax havens formed in the ideal tax below 100 percent, very high 1970s, when small islands and point income tax rates discourage people countries such as Monaco chose to from working. This reduction in impose low taxes—or none at all 0 100 hours worked outweighs the high —in order to attract investment. TAX RATE (PERCENT) tax rate, and the result is a fall in tax revenue. When top-rate taxes curve lies. Those on the political The Laffer curve displays the are very high, revenue can also be Right argued that the economy was relationship between tax rates and lost by the highest income earners at a point to the right of the peak of government revenue. It shows that leaving the country or putting their the curve, meaning that tax cuts higher taxes do not always result in money in tax havens—countries would increase revenue. Those on increased revenues. charging little or no tax. Laffer the Left disagreed. drew a bell-shaped curve (left) to Supply-side economists argue that show that somewhere between the A win–win situation the best way to make the economy extremes of no tax and 100 percent For politicians on the Right, Laffer’s grow is to improve conditions for tax, there is a point at which a theory was attractive. It meant that the supply side, freeing companies government will maximize revenue. they could make themselves from regulations, and cutting popular by cutting taxes, yet subsidies and high-rate taxes. The argument then is that from pledge to maintain public services, a starting point of high tax rates, too. In 1981, President Ronald From tax to tax havens tax cuts, along with other policies Reagan was able to cut top-rate The revenue argument for cutting to strengthen the supply side, can taxes and still be a hero to many of taxes came from US economist enhance economic efficiency and the poorest US citizens. However, Arthur Laffer. He said that if a generate more tax revenues. In the there is little evidence that the idea government takes no tax, it will get 1970s, when Laffer developed his actually works. In the US and other theories, some countries taxed countries tax rates are far below Supply-side economics some people at 70 percent, and a the level of the 1970s. However, the few taxed the highest earners at supposed tax revenue bonanza has The theory of supply-side 90 percent. Economists disagreed not arrived. Instead, tax cuts have economics generated a about where the peak on the Laffer been funded largely by rising considerable amount of borrowing deficits. ■ controversy when it was but it was US economist Arthur developed in the 1970s. It Laffer’s tax curve that caught emerged in response to the economists’ attention. The apparent failure of Keynesian Laffer curve was developed policies of government under the guidance of Canadian intervention (pp.154–61) to deal economist Robert Mundell with a flat economy combined (p.254), who argued that if tax with high inflation—a condition rates were cut, national output known as stagflation. The would increase, and tax term was popularized by revenues would rise. After a US journalist Jude Wanniski, quick dip revenues did actually rise, but there has been huge debate ever since over whether he was proved right.

272 PRICES TELL YOU EVERYTHING EFFICIENT MARKETS IN CONTEXT A commonly held belief In an efficient market among investors is that at any point in time the FOCUS they can “beat,” or actual price of a security Markets and firms outperform, the stock market. will be a good estimate The US economist Eugene Fama KEY THINKER disagreed. His study, Efficient of its intrinsic value. Eugene Fama (1939– ) Capital Markets (1970), concluded Eugene Fama that it is impossible to beat the BEFORE market consistently. His theory the Dotcom bubble of the 1990s, 1863 French broker Jules is now known as the efficient where “irrational exuberance” was Regnault publishes Playing the market hypothesis. blamed for artificially inflating Odds and the Philosophy of the technology stock, and the more Stock Exchange, which states Fama claimed that all investors recent financial crisis of 2007–08. that fluctuations in the stock have access to the same publicly market cannot be predicted. available information as their rivals, After these crises many so the prices of stocks fully reflect observers have declared the theory 1964 US economist Paul all the knowledge available. This is redundant; some have even blamed Cootner develops Regnault’s the “efficient market.” No one can it for the crashes. Eugene Fama ideas on fluctuating markets in know what new information will be himself has conceded that his The Random Character of released, so it should be almost uninformed investors can lead the Stock Market Prices. impossible for investors to make a market astray and result in prices profit without using information becoming “somewhat irrational.” ■ AFTER unavailable to the competition, or 1980 US economist Richard “insider trading,” which is illegal. Thaler publishes the first study of behavioral economics. However, problems with the hypothesis have been highlighted 2011 Paul Volcker, former by behavioral economists. They chairman of the US Federal point to the theory’s failure to Reserve, blames an account for investor overconfidence “unjustified faith in rational and the “herd” instinct. These expectations and market problems manifested themselves in efficiencies” for the 2008 financial crash. See also: Economic bubbles 98–99 ■ Testing economic theories 170 ■ Financial engineering 262–65 ■ Behavioral economics 266–69

CONTEMPORARY ECONOMICS 273 OVER TIME, EVEN THE SELFISH COOPERATE WITH OTHERS COMPETITION AND COOPERATION IN CONTEXT I n 1984, US economist Robert found to produce mutually Axelrod wrote The Evolution beneficial outcomes. But one must FOCUS of Cooperation. It was based not be too nice—if someone is Decision making on the results of a series of games, betrayed, it is essential to hit back in which the strategies of game in the next move. To maintain KEY THINKER theory specialists were pitted credibility, players must retaliate Robert Axelrod (1953– ) against each other via computer immediately if they are “sold out.” programs to see which was most This approach to the analysis of BEFORE successful. The game they played competition and cooperation has 1859 British biologist Charles was the prisoner’s dilemma developed into a rich field that Darwin publishes On the (p.238), a game involving two examines how social and even Origin of Species, arguing that thieves captured by the police. moral rules emerge. ■ the best-adapted species are Should each thief choose to those most likely to survive. confess, stay silent, or “sell out” the other thief? The game explores 1971 US biologist Robert whether it is wiser to cooperate for Trivers publishes The mutual benefit or to act selfishly. Evolution of Reciprocal Altruism, which shows how The best strategy When President Bush and Russian altruism and cooperation Axelrod discovered that cooperation President Putin signed the Treaty of can benefit individuals. can arise through self-interested Moscow in 2002, they cooperated to actions. His series of games tested greatly reduce their nuclear arsenals, AFTER many strategies. The most despite mutual distrust. 1986 US economists Drew successful strategy was simple Fudenberg and Eric Maskin tit-for-tat, where a player cooperates explore cooperation strategies on the first move and then mirrors for repeated games. his or her opponent, so is never the first to “sell out.” The most 1994 British economist successful approaches were those Kenneth Binmore publishes that were “nice.” Cooperation was Playing Fair, using game theory to explore the See also: Economic man 52–53 ■ Effects of limited competition 90–91 ■ development of morality. Economics and tradition 166–67 ■ Game theory 234–41

274 MOST CARS TRADED WILL BE LEMONS MARKET UNCERTAINTY IN CONTEXT The buyer of a This inequality second-hand car has of information FOCUS less information about its creates uncertainty Markets and firms quality than the seller. for the buyer… KEY THINKER Sellers with good cars … who becomes reluctant George Akerlof (1940– ) therefore withdraw their to pay a high price for any car on the market. BEFORE cars from the market. 1558 English financier Sir Thomas Gresham advises that The market begins … most cars traded “bad money drives out good.” to collapse because… will be inferior— lemons. 1944 John von Neumann and Oskar Morgenstern publish U ntil US economist George His key work, The Market for the first attempt to analyze Akerlof started studying Lemons (1970), explains how strategic behavior in prices and markets in the uncertainty caused by limited economic situations. 1960s, most economists believed information can cause markets to that markets would allow everyone fail. Akerlof stated that buyers and AFTER willing to sell goods at a certain sellers have different amounts of 1973 US economist Michael price to make deals with anyone information, and these differences, Spence explains how who wanted to buy goods at that or asymmetries, can have people signal their skills price. Akerlof demonstrated that disastrous consequences for the to potential employers. in many cases this is not true. workings of markets. 1976 US economists Michael Rothschild and Joseph Stiglitz publish Equilibrium in Competitive Insurance Markets, a study of the problem of “cherry picking” when insurance companies compete for customers.

CONTEMPORARY ECONOMICS 275 See also: Free market economics 54–61 ■ Market information and incentives 208–09 ■ Markets and social outcomes 210–13 ■ Signaling and screening 281 Asymmetric information that “bad money drives good A car dealer can reduce a buyer’s The buyer of a second-hand car money out of circulation.” In the risk when selling a car by offering has less information about its same way sellers with better- guarantees. In many cases quality than the seller who already than-average cars to sell will markets adjust to account for owns the car. The seller will have withdraw them from the market, asymmetric information. been able to assess whether the because it is impossible for them car is worse than an average to get a fair price from a buyer policies, but firms are still similar car—whether, it is a who is unable to tell whether that unable to identify them accurately. “lemon”—an item with defects. car is a lemon or not. This means This is known as “adverse Any buyer that ends up with a that “most cars traded will be selection,” and the potential for lemon feels cheated. The lemons.” In theory this could lead adverse selection means that existence of undetectable lemons to such low prices that the market insurance companies end up in the market creates uncertainty would collapse, and trade would with, on average, much greater in the mind of the buyer, which not occur at any price, even if risks than are covered by the extends to concerns about the there are traders willing to premiums. This has resulted quality of all the second-hand buy and sell. in the withdrawal of medical cars on sale. This uncertainty insurance policies for people causes the buyer to drop the price Adverse selection over a certain age in some areas. ■ he is willing to offer for any car, Another market in which lemons and as a consequence prices drop affect trade is the insurance across the market. market. In medical insurance, for instance, the buyers of policies Akerlof’s theory is a modern know more about the state of their version of an idea first suggested health than the sellers. So insurers by English financier Sir Thomas often find themselves doing Gresham (1519–79). Gresham business with people they would observed that when coins of rather avoid: the least healthy higher and lower silver content people. As insurance premiums were both in circulation, people rise for older age groups, a greater would try to hold on to those of a proportion of “lemons” buy higher silver content, meaning George Akerlof Born in Connecticut in 1940, 1978, he taught at the London George Akerlof grew up in an School of Economics before academic family. At school he returning to Berkeley as became interested in the social professor. He was awarded the sciences, including history and Nobel Prize for Economics in economics. His father’s irregular 2001, alongside Michael Spence employment patterns fostered his and Joseph Stiglitz. interest in Keynesian economics. Akerlof went on to study for an Key works economics degree at Yale, then gained a PhD from MIT 1970 The Market for Lemons (Massachusetts Institute of 1988 Fairness and Technology) in 1966. Shortly after Unemployment (with Janet joining Berkeley as an associate Yellen) professor, Akerlof spent a year in 2009 Animal Spirits: How India, where he explored the Human Psychology Drives the problems of unemployment. In Economy (with Robert J. Shiller)

276 THE GOVERNMENT’S PROMISES ARE INCREDIBLE INDEPENDENT CENTRAL BANKS IN CONTEXT If governments can act at their F ollowing World War II, discretion, they can break economics was dominated FOCUS their promises, therefore… by Keynesian thinking Economic policy (pp.154–61). This claimed that … the government’s governments could maintain high KEY THINKERS promises are employment through two types of Edward Prescott (1940– ) not credible. discretionary policies, which are Finn Kydland (1943–) introduced to achieve specific goals Rational individuals forecast through a particular set of actions. BEFORE this breaking of promises, The two types of policy used for 1961 John Muth publishes and change their own controlling employment were fiscal Rational Expectations and the behavior to suit. policy (government spending and Theory of Price Movements. taxation) and monetary policy This prevents discretionary (interest rates and the money supply). 1976 US economist Robert government policy Lucas argues that it is naive to from working. In 1977, two economists—Finn model government policy on Kydland of Norway and Edward solutions that have worked in Governments should credibly Prescott of the US—published a the past. commit to following paper entitled Rules Rather than Discretion, which argued that AFTER simple rules, not use discretionary policy was in fact 1983 US economists Robert discretionary policy. self-defeating. Their argument was Barro and David Gordon based on the concept of rational suggest that high inflation expectations, which was developed arises from discretionary by the US economist John Muth government policy and (p.247). Muth argued that since propose central bank having incorrect beliefs about independence. prices is costly, rational individuals seek to minimize their errors by From 1980s Independent planning ahead to avoid this. central banks are established in many countries worldwide Before this, macroeconomic and commit to simple models had operated on the policy rules. assumption that individuals only look backward, naively expecting the future to look like the past. The

CONTEMPORARY ECONOMICS 277 See also: Economic man 52–53 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Inflation and unemployment 202–03 ■ Rational expectations 244–47 A government may try to deter the To see how this works, imagine a that higher wages will be offset building of homes in a flood-prone area lenient teacher who is trying to by higher prices. Accounting for by not subsidizing flood insurance. But make a lazy pupil do his homework. rational expectations, the effect of if it has bailed people out after a flood The teacher tells the student that if the boost is simply higher inflation. in the past, they will not be deterred. he doesn’t hand his homework in, he will be punished. But the pupil An uncompromising rule new model predicted that if people knows that the teacher is lenient The solution for our teacher would collect information and are rational, and does not like to punish. The be a compulsory school rule for they can—and will—anticipate pupil anticipates that if he doesn’t punishing late homework so he government interventions. They hand in the work, he won’t be would have to comply. In a similar then adapt their actions to the punished. Knowing this, he does way Kydland and Prescott government policy they expect, and not do the homework. The teacher’s proposed that instead of having a that policy is in turn rendered less aim of getting the pupil to hand in free reign to set economic policy, potent. Discretionary policy can his homework is undermined by governments should commit to only work when individuals are the pupil’s rational behavior. following clear rules. A more radical taken by surprise, and it is hard solution of the teacher’s dilemma to surprise rational individuals. Kydland and Prescott said would be to delegate punishment- that government promises of low giving to a strict principal. In inflation face the same problem. macroeconomic policy this kind of The government does not like high role can be taken by independent unemployment. So it will boost the central banks, which place less economy to keep unemployment weight on employment and more low, but this will push up inflation. weight on low inflation than the Like the teacher who threatens a government does. Their control punishment he will not inflict, the of monetary policy allows the government has conflicting aims. government to credibly commit Individuals know this and so do not to low inflation. The period of low believe the government’s promise of inflation that arose in the 2000s low inflation. This undoes the aim of is often attributed to the rise of increasing demand to lead to higher independent central banks. ■ employment, because people know Finn Kydland Born on a farm in Gjesdal, Norway, taking Kydland with him. in 1943, Finn Kydland was the Returning to NHH in 1973, oldest of six children. After high Kydland published his key paper school he taught in a junior school with Edward Prescott. In 1976, for several years, where a fellow Kydland returned to the US, teacher suggested he study where he has taught ever since. accountancy, which awakened In 2004, he was awarded the his interest in business. He Nobel Prize for Economics. started an economics degree at the Norwegian School of Economic Key works and Business Administration (NHH) in 1965. Kydland intended 1977 Rules Rather than to become a business manager, Discretion (with E. Prescott) but after graduation he became an 1982 Time to Build and assistant to economics professor Aggregate Fluctuations Sten Thore, who moved to 2002 Argentina’s Lost Decade Carnegie Mellon University, (with Carlos E. J. M. Zarazaga)

278 THE ECONOMY IS CHAOTIC EVEN WHEN INDIVIDUALS ARE NOT COMPLEXITY AND CHAOS IN CONTEXT N o system yet discovered Looking for complexity guarantees a good return If the real world does indeed FOCUS in the stock market. One behave like this, why do we find it The macroeconomy might have hoped that economics, so hard to predict stock market with its theoretical models in which crashes? Some economists feel KEY THINKERS the economy always reverts to an the entire linear approach is René Thom (1923–2002) equilibrium, would give us such a obsolete. Austrian economist Jean-Michel Grandmont tool. Most economic theory is Friedrich Hayek (p.177) believed (1939– ) modeled on the laws of motion that economics is far too complex Alan Kirman (1939– ) developed in the 1680s: every to model in the same way as action leads to an outcome, and physics. One response to such BEFORE every event is linked in a causal doubts is complexity theory, 1887 French mathematician chain backward and forward in which emerged from the work Henri Poincaré’s analysis time in what is called a “linear” on thermodynamics of Russian- of the interaction between process. Standard economics Belgian chemist Ilya Prigogine three bodies orbiting each builds its large-scale predictions— (1917–2003). Unlike standard other lays the foundation the equilibrium that an economy economics, this approach for chaos theory. will arrive at—from the combined recognizes that predictable, effect of the behavior of rational regular actions by individuals 1950s French mathematician individuals reacting to prices. do not necessarily lead to a Benoît Mandelbrot finds stable, predictable economy. recurring patterns in the variation of cotton prices. In 1975, French economists Jean-Michel Grandmont and Alan 1960 US mathematician and Kirman argued that economies are meteorologist Edward Lorenz “complex systems.” In standard discovers the butterfly effect economic models of perfect in meteorology. competition individuals do not AFTER Tiny changes in initial conditions can 1980s Northern Irish cause large changes in outcomes. This economist Brian Arthur is known as the “butterfly effect:” develops complexity theory. Edward Lorenz’s suggestion that a butterfly flapping its wings in Brazil could lead to a cyclone in Texas.

CONTEMPORARY ECONOMICS 279 See also: Economic man 52–53 ■ Economic bubbles 98–99 ■ Wild randomness Testing economic theories 170 ■ Behavioral economics 266–69 In the 1960s and 70s French- Economists assume that This means that the economy American mathematician individuals act rationally should be predictable. Benoît Mandelbrot argued that economists are wrong and that all events are to try to smooth out determined by cause economic figures by looking for averages and ignoring and effect. extremes. He argued that it is the extremes that give These small differences But economies are the true picture. can lead to a myriad of complex systems, and different outcomes. individuals may each act Mandelbrot’s criticism slightly differently to was aimed at those who model prices for shares any given event. and commodities on the assumption that one price The economy is leads directly to another and chaotic even when things average out in the long individuals are not. run. He believed that the mild elements of randomness directly interact with each Lorenz was trying to discover built into these models are other; they just respond to prices, why the weather could not be misleading. Models should constantly changing their predicted far into the future. His be based on the assumption behavior and prices to achieve computer analyses revealed that of “wild randomness”—the the best outcome. In a complex minute changes in the atmosphere idea that individual freak system such as an economy, might multiply to produce dramatic occurrences matter as a individuals interact directly with changes in the weather. change takes place. For each other using simple “rules of Mandelbrot markets are far thumb” rather than rational To analyze chaotic movements, more volatile than economists calculations, a little like bees in theorists have developed a form suggest, and the mistake they a hive. This can lead to complex of “non-linear” mathematics. continually make is to try to patterns of behavior in the economy Much like the weather, they argue come up with laws that work as a whole. that a minute change in starting in the same way as the laws conditions can produce such a of classical physics. Chaotic economies different outcome that the process Ideas related to Grandmont and appears chaotic, whether for stock Small variations in velocity will Kirman’s arguments are found in market movements or economic shoot a pinball in totally different chaos theory, first developed in the growth. If they are right, then the directions. Like a pinball player, 1950s by US mathematician and predictable equilibriums that are economists cannot always predict meteorologist Edward Lorenz. the bedrock of most economic which way stocks will go. theories are very far off the mark. ■

280 SOCIAL NETWORKS ARE A KIND OF CAPITAL SOCIAL CAPITAL IN CONTEXT T he word “capital” is most networks are also important to commonly used to refer economic performance. Just as FOCUS to the machinery used a screwdriver (physical capital) Society and the economy in production: physical capital. or a university education (human A broader definition includes the capital) can increase productivity, KEY THINKER skills of the labor force: human so do social contacts, because Robert Putnam (1941– ) capital. The efficient use of they affect the productivity of physical and human capital has individuals and groups. The BEFORE long been recognized as key to interactions between people at 1916 The term “social capital” an economy, but in the 1990s US work, in their community, and in appears in an article by US political scientist Robert Putnam their leisure time, can be educator Lyda J. Hanifan. suggested a less tangible form of considered “social capital.” capital, made up of social 1988 US sociologist connections. He argued that social Social networks help individuals James Coleman describes improve their skills, advance their social capital, applying it A society of many virtuous careers, and increase overall to the phenomenon of but isolated individuals productivity by encouraging high school dropouts. is not necessarily rich cooperation and information in social capital. sharing. Conversely, when these AFTER Robert Putnam connections dwindle, economic 1999 US political scientist performance suffers. Putnam Francis Fukuyama argues that pointed out that since the 1960s social capital has not declined people in developed countries have in developed countries such become more isolated, living in as the US. urban areas with little sense of community. He argues that this has 2001 British Marxist contributed to economic decline. economist Ben Fine criticizes While not all economists agree with the concept of social capital. his analysis, social capital is now generally accepted as a significant 2003 British sociologist John element of economic performance. ■ Field says social capital theory means “relationships matter.” See also: Protectionism and trade 34–35 ■ Comparative advantage 80–85 ■ Economies of scale 132 ■ Market integration 226–31

CONTEMPORARY ECONOMICS 281 EDUCATION IS ONLY A SIGNAL OF ABILITY SIGNALING AND SCREENING IN CONTEXT A new field of economics The subject area of a student’s was developed in the degree and their knowledge of it are of FOCUS 1970s, when US economist secondary importance when applying Decision making George Akerlof published his for many jobs. Rather, their degree insights on how disparities of signals ability and a capacity for work. KEY THINKERS access to information might be Michael Spence (1943– ) overcome (pp.274–75). The opposite of this process, for Joseph Stiglitz (1943– ) example where an employer uses US economist Michael Spence the interview to elicit information, BEFORE said that, in practice, if Person 1 is known as screening. Someone 1963 Kenneth Arrow has more information than Person 2 buying a used car, or considering addresses the problems in a transaction, Person 1 is likely granting a loan, will use screening of information economics, to send a signal to allow Person 2 to questions to glean information such as when one party make a more informed decision. before deciding. Signaling and to a transaction has better screening are used in all forms of information than another. The example Spence gave was business transactions. ■ that of the job interview, where an 1970 George Akerlof describes employer has less information than markets with information the applicant about his or her disparities in The Market potential productivity. The for Lemons. applicant provides a resume detailing educational AFTER achievements, which may have no 1976 Michael Rothschild relevance to the post applied for but and Joseph Stiglitz pioneer do signal a willingness for hard “screening,” by which an work and application. In Spence’s uninformed party can induce view higher education, unlike another to impart information. vocational training, mostly has a signaling function, and prospective 2001 Michael Spence, George “good” employees will invest in Akerlof, and Joseph Stiglitz more education to signal their win a Nobel Prize for their work higher potential productivity. in information economics. See also: Behavioral economics 266–69 ■ Market uncertainty 274–75 ■ Sticky wages 303 ■ Searching and matching 304–05

THE EAST ASIAN STATE GOVERNS THE MARKET ASIAN TIGER ECONOMIES



284 ASIAN TIGER ECONOMIES IN CONTEXT East Asian This required a countries aimed to build range of investments FOCUS competitive advantage that private firms could Growth and development in new industries. not provide. KEY EVENT Japanese investment This allowed the state The state made the begins flowing into South to promote industrial investments and then Korea’s economy in 1965. enforced performance development in criteria on those firms, BEFORE certain directions. 1841 German economist helping efficiency. Friedrich List argues that In this way the state protecting industry would led the market, rather The East Asian help economies to diversify. state governed than just following it. 1943 Polish economist Paul the market. Rosenstein-Rodan argues that poor countries need a “big push” to develop through state investment. AFTER 1992 US economist Alice Amsden claims South Korea’s use of performance criteria fostered industrial growth. 1994 US economist Paul Krugman argues that the East Asian takeoff was a result of increases in physical capital rather than true innovation. A fter World War II the domestic product, or total national The environment from which the economies of a cluster of income from goods and services) is Asian Tigers emerged was shaped East Asian nations grew often used to measure a nation’s by government intervention and dramatically. Led by a new set of wealth. In 1950, South Korea’s GDP- dense links between the state and actively interventionist governments, per-person (GDP divided by the size the economy, an economic model these countries were transformed of the population) was half that of that came to be known as the from economic backwaters into Brazil’s; by 1990, it was double; by “developmental state.” After World dynamic industrial powers in just 2005, three times as high. This kind War II there had been huge a few decades. The so-called Asian of growth resulted in a remarkable expectations of development in Tigers—South Korea, Hong Kong, decline in poverty. By the late 20th poorer nations, and the goal of rapid Singapore, and Taiwan—were century the original four Asian economic advancement became the followed by Malaysia, Thailand, and Tigers had living standards that driving force behind government Indonesia, and then by China. These rivaled those of Western Europe, a economic policy. Powerful countries achieved sustained historically unprecedented change bureaucracies were involved in growth in income per head faster in fortunes that has been dubbed directing the economic activities than in any other region. GDP (gross the “East Asian miracle.” of the private sector in ways that

CONTEMPORARY ECONOMICS 285 See also: The emergence of modern economies 178–79 ■ Development economics 188–93 ■ Economic growth theories 224–25 ■ Market integration 226–31 ■ Trade and geography 312 South Korea’s rapid development was sees the state’s job as correcting macroeconomic stability, vital initiated by Park Chung-hee, an army market failures—governments for giving certainty to investors. general, in 1961. He restored relations provide public goods, such as They intervened to correct market with Japan, Korea’s former occupier, defense and street lighting, which failures through the provision of and attracted Japanese investment. private markets alone tend not to defense and schooling. They also deliver. They ensure that institutions built infrastructure such as ports seemed to go far beyond anything such as courts function properly so and railways, whose high set-up attempted in Western Europe. that contracts can be enforced and costs deterred private firms. The However, their governments property rights protected, but East Asian developmental states preserved private enterprise, and beyond that their role is minimal. were held to be successful because their new model had little in Once the basic prerequisites for they followed the market. common with the state planning market activity are in place, classical of the communist bloc. Asian Tiger economics suggests that the state Leading the market states shaped development by should withdraw and let the price The New Zealand economist steering investment toward mechanism do its work. It is Robert Wade argues that the East strategic industries and promoting thought that market-friendly Asian development states both the technological upgrading of institutions and a limited state led and followed markets. They producers. This induced a shift were key to Britain’s economic drove the expansion of favored of workers from agriculture to the success during industrialization. industries by providing cheap expanding industrial sector. Large credit and subsidies. By leading investments in education gave Some economists contend that markets their chosen allocation of workers the skills needed for new this also occurred in successful resources was markedly different industries, and industrial enterprises East Asian economies: when these from what it would have been, had soon began to export their products, states fostered development, they it been dictated by markets alone. becoming the motors for sustained, did so by supporting markets, not trade-driven growth. by interfering with them. Their US economist Alice Amsden interventions helped to allocate has characterized this as the state resources and investment in ways deliberately “getting prices wrong” that were in line with markets: in a in order to build new types of sense the state “got prices right.” competitive advantage. A crucial To do this, governments cultivated part of this was that the new ❯❯ A new kind of state This type of state had never been seen before. It challenged orthodox views about government’s role in the economy. Standard economics Now a major center of international finance, Hong Kong plays an important role in China’s ongoing economic success while preserving its own system of government.

286 ASIAN TIGER ECONOMIES The rapid rise of the Asian Tigers was based on exports. Large facilities to handle container ships, such as these in Singapore, were built by the state to promote growth. “infant industries,” pumped up Korea’s steel industry. In the 1960s generating resources. “Getting with subsidies and trade protection, the Korean government was prices wrong” did not help to were eventually made to grow up. advised by the World Bank not to build comparative advantages The state could enforce enter the steel sector because it in new industries. It led instead performance criteria on firms had no comparative advantage to inefficient production and because it was able to withdraw there—others could easily beat its economic stagnation. preferential treatment as needed. prices. By the 1980s Posco, a large Korean firm, had become one of the In East Asia successful states Robert Wade argues that the world’s most efficient steel producers. seemed better able to resist way these states chose to lead pressures from private interests. the markets explains the creation Political interference After setting up its new steel firm of comparative advantages in Attempts at interventionist policies in the 1960s, the South Korean industries where none previously in regions outside East Asia were government ensured that the firm existed. Initially, the prices of unsuccessful, which tarnished the was meeting efficiency targets. goods from a new industry would reputation of the developmental If political interests had emerged normally be internationally state. In Latin America and Africa that had prevented the state from uncompetitive. In addition, the the preferential treatment of firms disciplining the firm, the state production of a new product often and sectors generated poor would have become the servant requires the simultaneous setting incentives: firms were shielded of narrow interests, not of the up of other industries and from competition, but the state did overall economic efficiency of the infrastructure. The coordination of not enforce performance criteria. economy. The state had to remain this process is difficult if left to Infant industries never grew into autonomous and resist pressures private firms rather than the state. successful exporters. for favoritism from particular groups. At the same time the state Moreover, these protected, infant In Latin America especially, provided firms with credit and industries became competitive preferential treatment became linked technical assistance—to do this when they were given classical to politics with little economic and to monitor firms’ performance, incentives to learn how to become payoff: some firms received it was necessary for the tentacles of more efficient. In order to achieve subsidies and tariff protection but the state to reach into the smallest the economic education of new did not become more productive. cogs of the economy. The economic firms and the coordination of initial Over time these firms became production, governments needed to a drain on their governments’ The state… has set relative act in violation of narrow market budgets, absorbing rather than prices deliberately ‘wrong’ prices. This occurred in South in order to create profitable investment opportunities. Alice Amsden

CONTEMPORARY ECONOMICS 287 bureaucracy needed to hold China began a series of reforms Industrial policy detailed information about all of its communist system in the and incentives potential investments, and to late 1970s. It created its own brand maintain effective relationships of developmental state, which The East Asian developmental with industrial managers. resembled the Asian Tigers, and states gave preferential had an authoritarian government treatment to firms in favored US economist Peter Evans has that was responsible for promoting sectors while creating called these markers of successful the private sector and exports. incentives for performance. developmental states “embedded Agriculture was de-collectivized, They did this by requiring autonomy.” Only when this is in and state-owned industries enterprises to meet place is there a chance for a state were given more autonomy and performance criteria, partly to “get prices wrong” without subjected to greater competition. through contests in which being co-opted by vested interests. These reforms helped unleash firms competed for prizes. Embedded autonomy is not easy a vast expansion of private to create, and its absence may be economic activity, without the Typically, the criterion a factor behind the poor outcomes introduction of Western-style for winning was successful of state intervention in other property rights. exports. The prize was credit developing regions. lines or access to foreign Alternative incentives emerged exchange. In South Korea and The rise of China from China’s unique institutions: Taiwan, for instance, firms With the East Asian financial crisis for example, from the “Household had to show proof that they of the 1990s the developmental Responsibility System,” whereby had won an export order. Only state model was again called into local managers are held responsible then did they receive their question. Many sensed that the for an enterprise’s profits and prize. South Korea launched institutions that had fostered rapid losses, without the need for private competitions in which private industrial growth after World War property ownership. The results firms bid for large projects II had lost their potency by the late have been dramatic. While China in new industries such as 20th century. On the other hand remains poor relative to Western shipbuilding. Successful firms the spectacular rise of China Europe, its rapid growth took 170 received protection from the has resurrected the idea of the million people out of poverty during international market for a developmental state, or at the very the 1990s, accounting for three- time. Performance criteria least of policies and institutions quarters of the poverty reduction involved firms becoming that produce rapid economic in developing regions. internationally competitive transformation while deviating by a certain deadline. Failing from the prescriptions of standard, The histories of China and firms were punished. classical economics. the Asian Tigers show that there is no unique path to development. The South Korean steel Like most Chinese cities, the eastern The way that their states industry was a big success of city of Hangzhou has seen rapid intervened in the economy was the developmental state. By 2011, growth and a spreading urbanization very different from anything that South Korea was the sixth largest as China has industrialized. took place in Europe when it was steel producer in the world. developing. However, it seems that all development models, even successful ones, eventually run into constraints. The benefits of the development state petered out in the Asian Tigers in the 1990s— institutions that had worked in one decade began to fail in the next. One day the Chinese state, too, may lose its potency. It may have to reinvent itself if its spectacular rise is to continue. ■

BELIEFS CAN TRIGGER CURRENCY CRISES SPECULATION AND CURRENCY DEVALUATION



290 SPECULATION AND CURRENCY DEVALUATION IN CONTEXT A currency crisis is a large when money was based on and sudden collapse in precious metals, a currency usually FOCUS the value of one nation’s lost its value through currency Global economy currency relative to other currencies. debasement, which occurred when For about 30 years after World a ruler reduced the precious metal KEY THINKER War II the world’s main currencies content of the coinage. After money Paul Krugman (1953–) were governed by the Bretton began to be printed on paper by Woods system (pp.186–87), central banks, high inflation would BEFORE which was based on fixed, but cause a country’s currency to 1944 Greece experiences adjustable, exchange rates. collapse. This happened in the largest currency crash Germany in 1923, where at one in history. When this system ended in point prices were doubling every 1971, currency crises became more two days. However, a country does 1978 US economic historian common. In general a currency not need hyperinflation to have a Charles Kindleberger stresses crisis is triggered by people selling currency crisis. For example during the role of irrational behavior a country’s currency in large the Great Depression of 1929–33, in crises. amounts. This behavior seems prices of commodities such as to stem from the interaction of minerals and food collapsed, and AFTER people’s expectations and certain the currencies of Latin American 2009 US economists Carmen underlying economic weaknesses countries, which were reliant on Reinhart and Kenneth Rogoff (known as “fundamentals”)—in this export trade, fell with them. publish This Time is Different: other words people’s reactions to Eight Centuries of Financial perceived problems. Economists Inconsistent policies Folly, in which they draw have tried to model this interaction Writing in 1979, US economist similarities between crises mathematically, but every time they Paul Krugman showed that for a over the centuries. think they have found a model that currency crisis to happen, all that is fits the data, a new type of crisis needed is for a government to carry 2010–12 Divergent national seems to emerge. out policies that are inconsistent priorities, serious policy with the exchange rate. errors, and huge speculative Currency crises in context pressures threaten the Like hurricanes, financial crises Krugman’s argument is the breakup of the euro. happen surprisingly often but are foundation for a first generation of hard to predict. Centuries ago, currency crisis models. These models start by assuming that EXCHANGE RATE (PESOS PER $) Currency is In “first generation” there is a fixed exchange rate attacked when crisis models, when between the home currency and an the shadow rate one currency is fixed to external currency, and that the rises above the another, its “real” value, home government is running a fixed rate or shadow rate, may fall budget deficit (it is spending more below the value at which than it is collecting in tax), which it is financing by printing money. Fixed rate is it is fixed. In this case By increasing the supply of the currency, this policy creates an 2 pesos/$1 this is the point at inconsistency with the value of the currency set by the fixed exchange which the shadow rate. Other things being equal, the policy will cause the “real” value Fixed rate exchange rate rises of the home currency to fall. above 2 pesos/$1. Next, the models assume When this happens, the that the central bank sells its own reserves of foreign currency in order Shadow rate currency is vulnerable to support the currency. However, starts at 1.5 to attack as speculators pesos/$1 but buy the country’s rises over time foreign currency reserves in anticipation of a devaluation. 0 TIME

CONTEMPORARY ECONOMICS 291 See also: Economic bubbles 98–99 ■ Rational expectations 244–47 ■ Exchange rates and currencies 250–55 ■ Financial crises 296–301 ■ Bank runs 316–21 ■ Global savings imbalances 322–25 it is assumed that people can see at the fixed exchange rate than at Women examine a new Zimbabwean that eventually the foreign currency the shadow exchange rate, they dollar bank note in 2009. After a period reserves of the central bank will be will launch a speculative attack of hyperinflation, the government exhausted. The exchange rate will and buy all the foreign currency revalued the currency by removing then have to “float” (be traded reserves at the central bank. The 12 zeroes from the old notes. freely) and decline. The model home currency will then be forced proposes that there is a “shadow to float, and the depreciating exchange rate,” which is what shadow exchange rate will become the exchange rate would be if the the actual exchange rate. The central bank were not defending speculative attack occurs at the fixed exchange rate. People the point where the steadily know what this shadow exchange depreciating shadow exchange rate is (and will be) at any given rate equals the fixed exchange rate. time by looking at the government deficit. The moment they see that it This model seemed relevant is better to sell the home currency to the currency crises in Latin America in the 1970s and 1980s, ❯❯ If people believe that… … government policies … government’s … an exchange rate are inconsistent with commitment to an is vulnerable due a fixed exchange rate exchange rate is constrained by conflicting to weak banks, a financial and there is an opportunity domestic priorities… bubble, misinformation, to make a profit… or the actions of other speculators… … a speculative attack on the currency may be launched. Beliefs can trigger currency crises.

292 SPECULATION AND CURRENCY DEVALUATION Internal and external economic factors put downward pressure on the currency’s value. The value of the currency to which currency “X” is fixed remains the same. Currency “X” is When one country's currency is pegged forced to devalue. to another, pressures from outside or inside the country can force the link to be broken. At that point the currency's value may collapse. such as the crisis in Mexico in models allowed the government to one outcome is possible, 1982. However, in 1992–93, a have a choice. It may be committed what economists call “multiple currency crisis erupted in the to a fixed exchange rate, but this equilibriums.” A speculative attack European Monetary System (EMS), “rule” has an escape clause. If might occur if enough people which appeared to contradict this unemployment becomes very high, believe that other people are going model. Under this system’s the government may abandon its to attack the currency. They Exchange Rate Mechanism (ERM), commitment to the fixed exchange will then attack it, and a crisis will European countries effectively rate because the social costs of unfold. But if people don’t hold fixed, or pegged, their currencies defending the currency (for these beliefs, the crisis may not to the German Deutsche Mark instance through high interest happen. In these models crises are (DM). Several currencies came rates) are too great. We can see “self-fulfilling.” At an extreme they under pressure from speculators, these hard choices in the plight suggest that a crisis could happen notably the financier George Soros. of Greece in 2012. However, irrespective of the economic It would be difficult to argue that without a speculative attack these fundamentals of a country. These countries such as the UK were extra social costs would not arise. new models, based on the work of running policies inconsistent with These models imply that more than economists such as the American the targeted exchange rate. The Maurice Obstfeld, seemed more UK had a very small budget deficit The only absolutely sure- realistic than the earlier ones since and had previously been running at fire way not to have they allowed for governments’ use a surplus, yet in 1992, the country of instruments, such as interest was forced to withdraw from one’s currency speculated rates, to defend the currency, the ERM, to the great political against… is not to have an raising interest rates to prevent embarrassment of Chancellor of devaluation. They also seemed to the Exchequer (finance minister) independent currency. dovetail with the experience of the Norman Lamont. A new model was Paul Krugman ERM crisis, where government needed to explain these events. policies were constrained by high levels of unemployment. Self-fulfilling crises In the first generation models, the Financial fragility government’s policy is “fixed:” The East Asian crisis of 1997 (see the authorities mechanically use up opposite) seemed not to fit the first their foreign reserves to defend the two types of model. Unemployment currency. A second generation of was not a concern, yet East Asian

CONTEMPORARY ECONOMICS 293 currencies came under sudden, foreign markets. Economists argue The East Asian massive speculative attack. In the that by monitoring such warning financial crisis second generation models the signs, crises may be predictable up escape clause of devaluation was to one or two years in advance. The 1997 East Asian supposed to relieve the economy crisis seemed to come from from social costs, but the sharp Avoiding crises nowhere, overwhelming collapse of their currencies was Studies suggest that between countries with strong growth followed by a severe—though short- 5 and 25 percent of recent history records and government lived—downturn. Financial has been spent in one crisis or surpluses. Before the crisis fragility, caused by a banking boom another. New crises will continue most countries in the region and bust, played an important role. to surprise us, but there are signals had pegged their exchange In light of this economists began —such as the real exchange rate, rates to the US dollar. The to focus on the interaction of exports and the current account, first signs of trouble were weaknesses in the economy and the amount of money in the businesses failing in Thailand and speculators’ self-fulfilling economy relative to the central and South Korea. On July 2, expectations. This third generation bank’s international reserves— 1997, after months of battle model now took into account new that may help to warn us to save its pegged rate, kinds of financial fragilities, such when currency hurricanes are Thailand devalued. The as those that arise when firms and approaching. The experiences Philippines was then forced banks borrow in foreign currency of the last few decades have to float on July 11, Malaysia and lend in local currency. Banks exposed the financial roots on July 14, Indonesia on would be unable to pay their of crises. Economists now talk of August 14. In less than a year debts in the event of currency “twin crises”—vicious spirals the currencies of Indonesia, devaluation. These kinds of currency and banking crises. Thailand, South Korea, of weaknesses could spark Rapid financial deregulation and Malaysia, and the Philippines speculative attacks and crises. liberalization of international fell by between 40 and 85 capital markets are thought to percent. Only Hong Kong held As well as developing theories, have led to crises in countries with out against the speculators. economists have looked at the weak financial and regulatory evidence for possible warning signs institutions. As well as paying The crisis has been blamed of currency crises. In a 1996 article attention to the macroeconomic on a severe banking crisis. Jeffrey Frankel and Andrew Rose signs of future crises, governments Borrowing was often short- reviewed currency crashes in 105 also need to attend to these term, and when foreign developing countries from 1971 to institutional vulnerabilities. ■ lenders withdrew their 1992. They found that devaluations capital, contagion ensued, occur when foreign capital inflows and currencies collapsed. dry up, when the central bank’s foreign currency reserves are low, when domestic credit growth is high, when major external (especially US dollar) interest rates rise, and when the real exchange rate (prices of traded goods from home relative to those abroad) is high, which means that a country’s goods become uncompetitive in Icelanders take to the streets of Reykjavik to denounce the state's handling of the currency crisis in 2008, which saw the krona lose more than one third of its official value.

294 AUCTION WINNERS PAY OVER THE ODDS THE WINNER’S CURSE IN CONTEXT In an auction where the value A uctions have been of the sale item is uncertain, around for a long time, FOCUS every bidder makes his own but economists have only Decision making recently come to realize that they decision on its value. are an ideal proving ground for the KEY THINKERS competitive strategies of game William Vickrey (1914–96) If they decide their theory. Game theory came to Paul Milgrom (1948– ) valuations privately, prominence in the 1950s when Roger Myerson (1951– ) there will be a range of mathematicians saw that simple different valuations. games could illuminate situations BEFORE in which people compete directly. 1951 US mathematician The true value of the item This idea proved hard to apply to John Nash develops a concept will tend to be around the the real world. However, the strict of equilibrium in games, midrange of the different rules of an auction, with limited which becomes a tenet of participants and pokerlike buying auction theory. bidders’ valuations. strategies, seemed much closer to the theory. 1961 Canadian economist The sale will go to the William Vickrey uses game bidder who overestimates Types of auction theory to analyze auctions. The first person to apply game its value the most. theory to auctions was Canadian AFTER economist William Vickrey in the 1971 It is shown that oil Auction winners pay 1960s. He compared the three most companies bidding for drilling over the odds. common types of auctions. An leases may not be aware of the “English auction” is the method “winner’s curse.” used in British art houses, where bidding goes up until only one 1982 US economists Paul bidder is left. In a “Dutch auction,” Milgrom and Robert J. Weber used in Dutch flower markets for show that when bidders know example, the price drops until it their competitors’ valuations, reaches a price someone will pay. an “English auction” gives the In a “first-price auction” bidders best price for the seller. submit sealed bids, and the highest bidder wins. Vickrey proposed a

CONTEMPORARY ECONOMICS 295 See also: The competitive market 126–29 ■ Risk and uncertainty 162–63 ■ Selling the spectrum Social choice theory 214–15 ■ Game theory 234–41 Auction theory came into $90 phenomenon of the “winner’s its own with a dramatic spate $100 curse:” an item goes to the of government auctions in the $98 bidder who overvalues it the US in the 1990s as industries most. Imagine that you submit a were privatized. The biggest In an auction there is a danger that successful bid of $100 for a picture. sell-off came when mobile the winning bid will come from a You win because your bid is higher phone companies prepared bidder who has overvalued the item, than all the others. Suppose the to pay huge sums for a share a misfortune known as winner’s curse. next highest bid had been $98. You of the electromagnetic could have bid lower—$98.01—and spectrum (the airwaves) on fourth type of auction, similar to still been successful. In general the which to transmit. The US the first-price auction, but in which winning bidder pays “too much,” government wanted to the winner pays as much as the in this case to the tune of $1.99. maximize its return, but it second-highest bid. also wanted to ensure that Auction theory can be used the sale went to the bidder Using mathematics, Vickrey to design auctions that maximize who valued it most. proved that when bidders value the seller’s revenue and ensure that items independently, all four types the good goes to the buyer who In 1993, the Federal of auction yield the same revenue values it most. The success of Communications Commission for the seller, a discovery known the US government’s spectrum (FCC) brought in auction as “revenue equivalence theory.” auctions in the 1990s (see box, theorists to design the right) created a buzz about this new auctions for the 2,500 so- Shaded bids area of economics. For many it was called spectrum licenses. Vickrey showed that it is better proof that game theory was not just The telecom companies, for bidders to bid less than their theory but really did apply in actual meanwhile, hired auction valuations, a strategy auction markets. Others insist that auctions theorists to design their bid theorists call “shading,” otherwise are a special type of market, and strategies. The FCC decided they may end up paying over the that even they might not be fully on an English-style auction odds. Shading gained special explainable using game theory. but with a twist: the identity significance in the 1970s, when it What does seem true is that of the bidders was kept secret seemed that oil companies bidding auctions have now expanded well to avoid retaliatory bidding or for offshore drilling rights often beyond their traditional domains collusion to keep prices down. ended up paying far too much. of government procurements and The auctions broke all records, Auction theorists discovered the public bond sales. ■ and the approach has been widely copied. In Dutch auctions, as used in Holland’s Aalsmeer flower market, the price starts high and then begins to drop. The first bidder to stop the price as it drops takes the flowers.

STABLE ECONOMIES CONTAIN THE SEEDS OF INSTABILITY FINANCIAL CRISES



298 FINANCIAL CRISES IN CONTEXT T he instability of economic Pictured here after his arrest in 1910, systems has been debated Charles Ponzi ran investment scams in FOCUS throughout the history of the US promising unrealistic returns. Banking and finance economic thought. The view of Minsky compared capitalist booms to classical economists, following in Ponzi schemes, doomed to collapse. KEY THINKER the tradition started by Adam Smith, Hyman Minsky (1919–96) is that an economy is always driven Financial Instability Hypothesis.” toward a stable equilibrium. There The paper suggested that the BEFORE will always be disturbances that modern capitalist economy contains 1933 American economist create booms and slumps—a the seeds of its own destruction. Irving Fisher shows how pattern that is sometimes called debt can cause depression. the business cycle—but ultimately In Keynes’s view the modern the tendency is toward stability capitalist economy was different 1936 British economist with a fully employed economy. from the economy that had existed John Maynard Keynes claims in the 18th century. The major the financial markets have a The Great Depression of 1929 difference was the role played by larger role in the functioning led some economists to examine money and financial institutions. of the economy than was business cycles in more detail. In In 1803, the French economist previously thought. 1933, US economist Irving Fisher Jean-Baptiste Say (p.75) gave a described how a boom can turn to classical interpretation of the AFTER bust through instabilities caused economy as essentially a refined 2007 Lebanese-American by excessive debts and falling prices. barter system, in which people risk theorist Nassim Nicholas Three years later John Maynard produce goods that they exchange Taleb publishes The Black Keynes (p.161) questioned the idea for money, which is used to Swan, which criticizes the that the economy is self-righting. In exchange for the goods they want. risk-management procedures his General Theory, he developed The real exchange is good for good: of financial markets. the idea that an economy could money is just a lubricant. Keynes settle into a depression from which argued that money does more than 2009 Paul McCulley, former it had little hope of escaping. this: it allows transactions to occur managing director of a large over time. A firm could borrow US investment fund, coins the These works were the genesis of money today to build a factory, term “Minsky moment” for understanding the unstable nature which it hopes will generate profit the point at which booms bust. of modern economies. In 1992, that can be used to pay back the Hyman Minsky looked at the loan and the interest in the future. problem again in his paper “The Minsky pointed out that it is not PRICE (IN THOUSANDS) $300 House prices in the $275 US climbed steeply $250 from the late 1990s $225 Inflation-adjusted until 2007 as banks $200 house prices increasingly granted $175 mortgages to people $150 without the income to $125 pay the money back. $100 $75 $50 Actual house $25 prices at the time $0 1975 1979 1983 1987 1991 1995 1999 2003 2007 YEAR