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Remembering Adam Smith Efficiently

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Adam Smith is usually remembered as the father of economics and laissez-faire, for the metaphor of the invisible hand, and for its meaning that people acting in their self-interest promote the public good.  A vocal minority likes to point out that Adam Smith was much more complex than this, and in particular that his thoughts on businessmen and the role of government are very different from those of many people who claim to love Smith.  However, I believe that the naive picture of Smith that most people have is in fact efficient, in the same way that peoples’ ignorance of politics is efficient.

Smith was in fact quite complex.  He is thought of as a champion of capitalists and businessmen, but he said they are “an order of men, whose interest is never exactly the same with that of the public, who have generally an interest to deceive and even to oppress the public, and who accordingly have, upon many occasions, both deceived and oppressed it” and that “People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

He is thought to have said that people are only motivated by rational self-interest, but he was no Gary Becker.  He recognized that people want to do good, saying: “We are pleased, not only with praise, but with having done what is praise-worthy” and ” To prevent, therefore, this paltry misfortune to himself, would a man of humanity be willing to sacrifice the lives of a hundred millions of his brethren, provided he had never seen them? Human nature startles with horror at the thought, and the world, in its greatest depravity and corruption, never produced such a villain as could be capable of entertaining it”.  He also recognized that people are far from rational, saying “self-deceit, this fatal weakness of mankind, is the source of half the disorders of human life” and “The chance of gain is by every man more or less over-valued”.

Smith is thought to have called for laissez-faire small government, but in fact he suggested several large roles for government, such as putting a ceiling on interest rates to curtail risky investments, progressive taxation, and public education to counter the bad effect of the division of labor: “He naturally loses, therefore, the habit of such exertion, and generally becomes as stupid and ignorant as it is possible for a human creature to become…. in every improved and civilized society this is the state into which the labouring poor, that is, the great body of the people, must necessarily fall, unless government takes some pains to prevent it.”

For a supposed apologist for propertied classes, he sometimes sounds a lot like an anarcho-communist, saying: “As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed” (of course, all the classical economists hated landlords, even if they loved capitalists), and “The affluence of the rich excites the indignation of the poor, who are often both driven by want, and prompted by envy, to invade his possessions. It is only under the shelter of the civil magistrate that the owner of that valuable property, which is acquired by the labour of many years, or perhaps of many successive generations, can sleep a single night in security.”

Smith takes his message to the streets

Given all this, how can I say that Smith is remembered efficiently as promoting self-interest, capitalism, and small government?  There are two main reasons.  One is simply that Smith said a lot of things, and it is easy to distort his main message with selective quotes.  As Jacob Viner said, “Traces of every conceivable sort of doctrine are to be found in that most catholic book, and an economist must have peculiar theories indeed who cannot quote from the Wealth of Nations to support his special purposes”.    Smith made no strong effort at self-consistency; again as Viner said, “The one personal characteristic which all of his biographers agree in attributing to him is absent-mindedness, and his general principle of natural liberty seems to have been one of the things he was most absent-minded about.”

In the main, Adam Smith’s message was that markets worked well and that mercantilist calls for government to restrict trade should be opposed.  The usual quotes used to show Smith’s support of self-interest and laissez-faire are in fact more representative of his work as a whole than the quotes I used above to show his nuance.  The most popular such quotes are probably: “it is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest” and “he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention…. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it.”  He can’t have believed much in the power of altruism as he said “The late resolution of the Quakers in Pennsylvania to set at liberty all their negro slaves,  may satisfy us that their number cannot be very great. Had they made any considerable part of their property, such a resolution could never have been agreed to.”  The list of government policies supported by Smith is very small compared to what modern governments do, though it would not make all libertarians happy.

The main reason I say Adam Smith has been remembered efficiently is that his ideas about self-interest and the invisible hand were what set him apart at the time and what inspired later economists.  People like me who are interested in history and Adam Smith for their own sake should know about the complexities.  But many people before Smith had criticized the conspiracies of business, advocated for government regulations, and recognized that people have many motivations.  What made Smith different, and what later economists built on, was his focus on self-interest and how to maximize happiness.  Adam Smith was not Gary Becker, but his works had the seeds of modern economics in a way that previous thinkers did not, and it makes sense to focus on the parts of his work that would later bear so much fruit.


Written by James Bailey

June 15, 2011 at 6:07 pm

Malthus was right, but he would want you to have kids

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Mr. Malthus- central Propositions correct, indeed obviously so- Misinterpretations by modern critics and supporters- The importance of certain technological developments

Thomas Malthus is famous for his 1798 Essay on the Principle of Population, which argued that population will always quickly rise to the limit that the food supply allows, meaning many people will always live in poverty and near-starvation.  Ever since its publication, people of all kinds have been eager to attack the ideas and their author.  I have to admit I always found it hard to take Malthus seriously- mostly because the last 200 years of increasing population without world famine seem to prove him wrong; also because of the silliness of the “arithmetic vs. geometric growth” thing.  However, when you look closely at what Malthus said, he was mostly correct, and when wrong it was not for the reasons most people came up with.

Malthus’ main ideas can be summarized: 1) people need food to live  2) there is only so much land to grow food on 3) Given that the “passion between the sexes” is a part of human nature, people just keep having kids 4) given 1-3, population will increase until it hits the food-limit imposed by nature and is kept in check by starvation

He notes that when people encounter “new” land, as in America, their population will double as quickly as every 25 years and quickly fill it up; people everywhere would like to have enough kids that population increases in this way.  It is hard to imagine agricultural productivity doubling every 25 years to enable the same population growth on a set amount of land.  Certainly adding more workers to a given farm quickly hits diminishing returns.  Further, it is hard to imagine even now- and must have been very hard in 1798- to imagine that new techniques, crops and machines could double output every 25 years.

Malthus describes many ways in which population is kept in check short of famine.  There are other ways the death rate is increased- war, disease, infanticide- and he argues these become more common when food is short.  There are ways the birth rate is decreased- abstinence and late marriage.  His economic analysis is excellent for its time.  He describes how price signals enable individuals to make decisions that avoid famine.  As population gets close to the food limit, food prices increase, so kids become more expensive to feed, and people try to have fewer of them.  When many people are nearing the subsistence level, the price of labor will be low.  When labor is cheap and food expensive, farmers will have a bigger incentive to produce more food.  Prices enable population to fluctuate less violently around the equilibrium level.

Malthus’ main descriptive proposition, that population will quickly catch up to any increase in potential food production, was true for essentially all human history until about 1880, when the demographic transition began in earnest and children per woman began its long decline while agricultural productivity expanded rapidly.  But what policy conclusions did Malthus draw from his idea?  This is where things get weird.

Malthus’ idea has been adopted by leftist environmentalists to argue that people in general should have fewer kids.  This is probably why I thought Malthus must be wrong when I heard about him as a college freshman.  But Malthus himself didn’t argue this at all.  In fact, Malthus thinks that having kids is great as long as you can afford to feed them with your own money.  He likes kids; he doesn’t like it when they starve; he doesn’t like it when people have to turn to welfare or adoption to get their kids fed.  He really didn’t like welfare:

“The poor-laws of England tend to depress the general condition of the poor…. increase the population without increasing the food for its support…. create the poor which they maintain…. diminishes the shares that would otherwise belong to more industrious and worthy members… dependent poverty ought to be held disgraceful.” p 38-9 Norton 2nd ed

Malthus’ main policy conclusion is that the poor laws (the welfare of his day) should be abolished.  His secondary conclusion is to support agricultural productivity, by encouraging “tillage above grazing” (thus producing more calories per acre), opening new farmland, and encouraging agriculture above manufacturing and cities.  This will increase the number of people the land of England can support.

His main advice to individuals is not to have kids if they are likely to starve or have to go on the public dole.  If welfare is abolished as he would like, this is simplified to: don’t have kids if they are likely to starve.  This is why I feel confident that Malthus wouldn’t mind if you (I assume those likely to read this could afford to feed kids) have kids.

So what did Malthus get wrong?  He didn’t foresee effective birth control or the explosive, endogenous growth of agricultural technology.  He assumed that having fewer kids would always mean misery (abstinence) or vice (infanticide), both of which are hard to do.  If he had known about condoms or the pill, he may have called them “vice”, but he would recognize them to be easier than abstinence and more moral than infanticide.  Birth control, when people are rich and educated enough to use it, is itself enough to evade the Malthusian trap, as below-replacement birthrates in many countries now attest.  Malthus saw technology as something that developed slowly and randomly, so he didn’t consider that it could avoid the trap, and didn’t include research as a way to encourage agriculture.  In fact, agricultural technology has grown “geometrically” (exponentially).  It has not done so randomly, but instead is largely due to factors Malthus ignored- like government-sponsored research- or spurned as pulling workers away from agriculture, such as cities (where most inventions and discoveries take place, even in agriculture) and manufacturing (which makes tractors, et c).

On the whole, though, I was surprised by how rational Malthus’ writing is and how much modern economics he knew in 1798.  His work has not been rendered completely irrelevant by technology and birth control; much of the world does still live on or near the Malthusian frontier.  It is unclear to me whether it is helpful to give food aid to such regions, either through private charity or government food subsidies as with Indian rice.  Personally I think giving to education in poor countries is a better bet, and the fact that it does not aggravate a potential Malthusian trap is one reason why.

To get back to kids though, there are lots of good reasons you may not want them, but one reason you shouldn’t have is that “the world is overpopulated and Thomas Malthus would be sad”.

Written by James Bailey

June 2, 2011 at 5:23 pm

The Strategy of Conflict

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The Strategy of Conflict"" is a book by econ Nobelist and game theorist Thomas Schelling.  The book reminds me of Milton Friedman’s book Capitalism and Freedom (which I reviewed here), since both are books from the early 1960’s that have been popular and influential and yet still seem ahead of their time in many ways.  Schelling explains the basics of game theory in a way that is accessible to those with no background in math or economics.  There are many tables, and parts 3 and 4 have some equations, but I plan to recommend parts 1 and 2 to ambitious Principles of Economics students who express interest in game theory.  The book is so easy to understand because it is full of short, down-to-earth examples, many applied to everyday life and many others to the US-Soviet conflict.

One key idea of the book is that in bargaining, “weakness” is often a strength.  One side can benefit by reducing their own ability to communicate, or make choices, or benefit from certain choices.  Another key idea is what would later be called the “Schelling point”, the focal point of players’ expectations that may have more to do with idiosyncrasies of the players or superficial aspects of the game than with the usual abstract, mathematical, rational method of solving games.  This explains the importance in practice of ideas and slogans like “a slippery slope”, “a line in the sand”, or “Fifty-four Forty or Fight!“.

The major reason I say the book is ahead of its time is Schelling’s insistence on applying game theory to real life, and changing game theory so that it can be more usefully applied to real life.  He reviews some experimental tests of game theory and proposes many more; I don’t know the literature well but I believe many of these proposals have yet to be carried out.  He demonstrates the importance of the details of games that most game theorists would still ignore, for instance asking:

Another set of questions, also pertinent to problems of limited war, international or other, would be whether a stable, efficient outcome is more likely when the connotations of the game -the names and interpretations that are overtly attached to the moves and pieces and objects on the board — are familiar and recognizable or when they are quite novel, unfamiliar, and unlikely to inspire similar notions in the two players. Is it — to speak of the game in a particular extensive form — more likely that rational players can keep a war limited in Southeast Asia, using conventional and atomic weapons, or in a battle against an unknown adversary on the surface of the moon, using strange bacterial weapons? These are important questions; they are at the very center of game theory; and they are questions that cannot possibly be given a confident answer without empirical evidence. And there is no arguing that rational players have the intellectual capacity to rise above these details of the game and ignore them; the importance of the details is that they can be supremely helpful to both players and that rational players know that they may be dependent on using these details as props in the course of their mutual accommodation.

I recommend the book to anyone interested in game theory, foreign policy, bargaining, economics, cooperation… life.


Written by James Bailey

May 19, 2011 at 2:52 pm

The Big Short

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Michael Lewis’ book The Big Short: Inside the Doomsday Machine has been a popular bestseller even as it received unanimously good reviews from economists- the harshest review I saw was Eric Falkenstein’s “entertaining but doesn’t get to the heart of the issues” take.  So of course a part of me was secretly hoping the book’s arguments would be wrong or oversimplified, and I could explain why and feel superior to everyone else.  But I am afraid it was simply an excellent book.  It is very entertaining, gives a good explanaiton of the crisis (though not mutually exlusive of other potential explainations), and explains complicated financial ideas in a way that most people should be able to grasp.

One of the big themes of the book (though it is not explicitly stated this way) is that the Efficient Markets Hypothesis often fails to apply to U.S. financial markets.  This is often because its assumptions are not met, particularly in bond markets where there are few buyers and sellers and little information is publicly available.  But sometimes large, liquid markets seem to take a surprisingly long time to incorporate publicly available information.  For instance, one small hedge fund claimed that they were the only people really examining the financial statements released by subprime mortgage companies in early 1997, and that it took the market months to look at the same data and realize the firms would soon be bankrupt; the fund’s accountant said “it made me feel good that there was such inefficiency to this market… if the market catches on to everything, I probably have the wrong job.”

Another small hedge fund, Scion Capital, made huge returns when their “decision-making apparatus consisted of one guy [Mike Burry] in a room… poring over publicly available information”.  Lewis tells the entertaining and inspiring stories of how three small, wildly successful hedge funds got started.  My favorite was Cornwall Capital, “two guys in a garage in Berkeley with $110,000 in a checking account”.

One small part of the book gave me an idea for a great economics paper (which has probably been written already).  There is now a great debate about whether “bubbles” can be meaningfully defined, discovered in advance and deflated.  Many argue that once you have a definition of a “bubble” that is meaningful and testable, you will not be able to find any.  But in the book, Mike Burry puts forward the thesis that

“It is ludicrous to believe that asset bubbles can only be recognized in hindsight.  There are specific identifiers that are entirely recognizable during the bubble’s inflation.  One hallmark of mania is the rapid increase in the incidence and complexity of fraud… the FBI reports mortgage-related fraud is up fivefold since 2000.”

I would love to get fraud and financial data by sector and look for relationships.  I am sure others have done this already, but if not it would be cool to test the theory, and if it holds up start making money on it.  (of course, making money by killing the Efficient Markets Hypothesis only serves to make it stronger going forward… it is like Obi-Wan Kenobi.)  Another potential way to make money described in the book is to buy options (which at least as of 2007 were usually priced by assuming a normal distribution of potential prices) on stocks which should have a bi-modal distribution of future prices; it made me wonder if this still works.

As far as an explanation of the financial crisis, the book has two main explanations.  One is that the bond market is opaque and oligopolistic.  “The presence of millions of small investors had politicized the stock market.  It had been legislated and regulated to at least seem fair.  The bond market, because it consisted mainly of big institutional investors, experienced no similarly populist political pressure… bond traders could exploit inside information without worrying that the would be caught… in the bond market it was still possible to make huge sums of money from the fear, and the ignorance, of customers.”

The second, and related explanation is that the bond-rating agencies were very bad at their jobs, and only some people realized that.  The Wall Street banks making securities could exploit the flaws in the rating agencies models to get their product rated too highly.  Meanwhile, some investors stupidly trust the rating agencies and buy bonds at high prices assuming their ratings to be correct.  There were many flaws in the rating agency model, perhaps the most surprising to me is that “both Moody’s and S&P favored floating-rate mortgages with low teaser rates over fixed-rate ones”.  Many people focus on the potential corruprtion at the rating agencies and Lewis does bring that up, but his main focus is on stupidity.  “You know how when you walk into a post office you realize there is such a difference between a government employee and other people.  The ratings agency people were all like government employees.  They’re underpaid.  The smartest ones leave for Wall Street firms so they can help manipulate the companies they used to work for.”

In the epilogue Lewis turns to a third explanation for the crisis: a faulty incentive structure for employees in financial firms.  “What are the odds people will make smart decisions about money if they don’t need to make smart decisions about money- if they can get rich making dumb decisions?”

Before this post gets any longer, I’ll just say: read the book, it tells some great stories.  Also, check out Lewis’ article on the Greek debt crisis.  He manages to interview a lot of important Greeks.  The article is fascinating but somewhat depressing as it makes me wonder how Greece can possibly fix its government and social order; I can understand why Paul Romer proposes giving the EU a bigger role in governing Greece.


Written by James Bailey

September 20, 2010 at 11:34 pm

The Armchair Economist

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Steven Landsburg’s book seems to be the first of the recent wave of popular  “think like an economist about subjects not traditionally thought of as economics” books.  It features some great thought experiments and some great sentences, some of which are reproduced below.

“I do not know why people leave anonymous tips in restaurants, and the fact that I leave them myself in no way alleviates my sense of mystery.”

“So if you are thinking of remembering the Treasury in your will, and if you are something of an egalitarian, consider a bonfire instead.”

Only Individuals Matter and All Individuals Matter Equally.  These are the rules of the cost-benefit game.  You don’t have to follow them, but if you don’t, you are playing some other game”

“Strictly speaking, statistics never lie, but the truths they tell are often misinterpreted” [This reminds me of the Wheel of Time, ‘An Aes Sedai never lies, but the truth she tells is not the truth you think you hear’.  The Eye of the World was published 3 years before The Armchair Economist]

“Harry Truman wouldn’t like where this discussion is headed.” [Since Landsburg is no one-armed economist]

“It is sheer superstition to think that an Iowa-grown Camry is less ‘American’ than a Detroit-built Taurus” [From an analogy of how we can think of trade as a technology]

I recommend the book to anyone, regardless of the level of their background in economics.


Written by James Bailey

June 10, 2010 at 11:42 am

Intro to Economics Recommended Reading

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*The following is the list I am giving my Principles class.  I tried to focus on blogs and books that are 1)primarily about economics 2)understandable by someone with no econ background and 3) not deadly boring.   I look forward to comments and suggestions*

Principles of Macro Recommended Reading

Daily News:

Financial Times

New York Times

Wall Street Journal


The Economist Magazine: Analysis of world economic and political news


Econtalk: A weekly podcast featuring interviews with interesting and often well-known people on economics-related subjects.  The archives go back to 2006 and most are not “dated”.

The Economist: some material from the magazine can be found in podcast form for free on iTunes.

Planet Money: National Public Radio’s tri-weekly podcast, easy to understand


Becker-Posner Blog: Nobel prize-winner Gary Becker and father of Law and Economics Richard Posner debate an issue once a week.

Freakonomics: The authors of the book Freakonomics do more non-traditional applications of economics

Free Exchange: The economics blog of the Economist magazine, with clear analysis and daily links to the best economics writing

Marginal Revolution: In my opinion the best economics blog.  Updated daily, sometimes technical but usually accessible.

Overcoming Bias: A unique outlook based on economics, signaling and status.  Focus on prediction markets and the far future.

Paul Krugman:  The most active econ-Nobel-prize blogger.  Very good when he isn’t being a partisan, and not to be dismissed lightly even when he is.

Extra Credit:  Read one of the following books.  Come to office hours prepared to discuss the book for at least 10 minutes.  What parts were most interesting?  What did our class help you understand about the book, or what did the book help you understand about our class?  What did you disagree with or have questions about in the book?

If our discussion convinces me that you have read and thought about the book, you will get up to 5 points added to your final course grade.


Capitalism and Freedom, Milton Friedman: The great economist puts forward a lot of ideas about how to improve public policy.  All the ideas were new and radical when the book was written in 1962; today a few have been implemented and seem normal, while others may still surprise most readers.

Freakonomics, Levitt and Dubner: Applies economic methods to non-economics subjects in interesting ways.  This book is a good introduction to the power of econometrics / statistics.

Superfreakonomics, Levitt and Dubner: More application of economic ways of thinking to interesting non-economic subjects.

The World is Flat, Thomas Friedman: A readable introduction to a “globalizing” economy.  Many interesting stories.

The Worldly Philosophers, Robert Heilbronner: A book about the lives and ideas of some of the best and most interesting economists.


Written by James Bailey

May 19, 2010 at 9:34 am

Better Living Through Economics

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That is the title of a new book edited by John Siegfried which tells the story of 12 ways in which economists have changed policy and made the world a better place.

I had hoped that it would be accessible to a popular audience so that principles students and others could get an idea of some of the good things economists do.  But most of the chapters involve a lot of techincal jargon and many have math as well.  However, it will be good for economists and advanced economics students to get a sense of what economics can accomplish.  Perhaps more people will be inspired to work on applied policy instead of arid theory.

The most surprising chapter in the book was the one on the draft and the all-volunteer-force.  It turns out that economists were central in both persuading congress to end the draft and in the design of the AVF.

I think the best stories are the ones in which new markets are created.  There it is easiest to see both how big the change was and how involved economists were.  Thanks to the work of economists in doing research and changing policy, we now have auction markets in sulphur dioxide permits and wireless spectrum, and matching markets for school admission, kidney donation, and medical fellowships.  I hope that the future holds much of this “economics as engineering” rather than as a science, social science, or especially as applied math.  In the book’s “overview”, Charles Plott makes the claim that the FCC auction (which economists pushed for and designed) yielded benefits “that far exceed all research funding for economics summed over all of history”.


Written by James Bailey

May 13, 2010 at 4:17 pm