voxecon101b

What Do We Owe Our Great Grandchildren?

For Project Syndicate...

What do we owe our great-great-great grandchildren? What actions are we obligated to do now in order to diminish the risks to our descendants and our planet from the increasing likelihood of significant global warming and its associated climate change?

Everybody--well, almost everybody: ExxonMobil, U.S. Vice President Richard Cheney, and their paid-for servants and deluded acolytes are exceptions or pretend to be exceptions--understands that when human burn hydrocarbons carbon dioxide goes up into the atmosphere, where it acts like a giant blanket, absorbing infrared radiation coming up from below and warming the earth.

Everybody understands that we really do not know how much global warming a given amount of extra carbon dioxide produces. We have models, we have forecasts, we have projections, but global warming might be a much smaller and might be a much larger problem than the central-case projections of climate models suggest. Everybody--well, almost everybody: ExxonMobil, U.S. Vice President Richard Cheney, and their paid-for servants and deluded acolytes are exceptions or pretend to be exceptions--understands that here uncertainty is not our friend, and certainly not an excuse for inaction. Uncertainty about its effects should lead us to do more to guard against global climate change than if we knew global warming would proceed exactly as the central-case projections forecast.

Everybody--well, almost everybody: ExxonMobil, U.S. Vice President Richard Cheney, et cetera, et cetera--understands that the world's governments, non-profit institutions, and energy companies ought to be spending a much bigger fortune than they currently are on research: research into technologies that generate power without adding carbon dioxide to the atmosphere, research into technologies that such carbon out of the atmosphere into forests or oceans, research into technologies that cool the earth by reflecting more of the sunlight that lands on us.

Everybody--well, almost everybody: U.S. Vice President Richard Cheney, et cetera, et cetera--understands that the burden of dealing with global climate change over the next two generations should be carried by the rich countries of the world. They got to take an easy carbon emissions-intensive path to industrialization and riches. It looks like China, India, and company will not be able to take such an easy path, and it would be unfair to penalize them for the loss of the easy hydro-carbon burning road.

Everybody--well, almost everybody, et cetera, et cetera--understands that now is the time to build the international institutions that will manage our reactions to global climate change over the next several centuries. Now is not the time to disrupt these institutions, or to prevent their creation.

What there is real dispute about is what else we should be doing right now and in the next decade. We economists like to think of things in terms of prices. And when we economists see something going wrong in the sense of having destructive side-effects, we like to tax it. Taxing it makes the individuals who are undertaking actions feel in their wallets the destruction they are causing elsewhere. Maybe the action is still worth doing, and maybe not. Imposing a tax--imposing the right tax--on those who are, say, driving low-mileage SUVs is a way of harnessing the collective intelligence of humanity to deciding in which case the bad side-effects are a reason to stop. But it has to be the right tax.

An SUV going ten miles in the city and burning a gallon of gasoline pumps about 3 kilograms--6.5 pounds--of carbon in the form of carbon dioxide into the atmosphere. Should the extra tax on this--and on all carbon emissions--appropriate for global warming be on the order of five cents a gallon, fifty cents a gallon, or a dollar fifty a gallon? Our views will change as we learn more, but at the moment whether the tax should be five or fifty cents a gallon hinges on a question of moral philosophy: how much do we believe that we owe our distant descendents?

Australian economist John Quiggin has a very illuminating discussion on his website <http://johnquiggin.com/wp-content/uploads/2006/12/sternreviewed06121.pdf>. The *Stern Review on Global Climate Change* (on the internet at <http://www.hm-treasury.gov.uk/independent_reviews/stern_review_economics_climate_change/sternreview_index.cfm>) which comes down more on the side of fifty cents a gallon, immediately, does so because they project that spending today to reduce carbon emissions is a very good investment for the future. If the world grows in per capita income at about 2% per year, a marginal expenditure of roughly $70 today in cutting carbon emissions would be worth it if it were to enrich the world of 2100 by about an extra $500 of year-2006 purchasing power, once all the damages to the world economy and environment from global warming, costs of adjustment, and so on are taken into account. This looks like a very good deal to Nick Stern and his team.

On the other hand, critics point out that the world today is poor: average GDP per capita at purchasing power parity today is roughly $7000. We expect improvements in and the spread of technology to make the world of 2100, at a 2% per year growth rate much richer than the world of today: $50,000 per capita of year-2006 purchasing power. We today can use the marginal $70 per capita, critics say, much more than the richer people of 2100 will need the $500 they would gain from not having to suffer from the effects of global climate change.

What critics don't often say is that the same logic applies to the world today. The U.S., Japan, and Western Europe today have average incomes of roughly $40,000 per capita. The poorer half of the world's population today have incomes of less than $6,000 per capita. I believe that the same logic which says that we today need our $70 more than the people of 2100 need an extra $500 also tells us that we ought to tax the world's rich in the OECD more and more to fund world development as long as each extra $500 in first-world taxes generates even as little as $70 in extra poor-periphery incomes. If we in the world's rich now are stingy toward the (likely to be much richer) future and want to leave them our environmental mess to deal with, we should be lavish toward our poor brothers and sisters today. If we today are stingy toward our poor brothers and sisters now, we should be lavish toward our descendents.

At least, that is what we should do, if our actions are based on some moral principle--rather than on the principle that what we have, we hold.

KQED Forum: 9 AM December 13, 2006: Interest Rate Update

On the Radio: mp3 files:

• http://delong.typepad.com/Audio/2006_12_13a-forum.mp3

KQED | Programs A-Z: Forum: Home: Wed, Dec 13, 2006 -- 9:00 AM:

Interest Rate Update -- Forum discusses the impact of the Federal Reserve's decision to leave interest rates unchanged.

Guests include:

• Brad De Long, professor of economics at UC Berkeley and research assistant at the National Bureau of Economic Research;
• John Karevoll, analyst at Data Quick Information Systems, a nationwide real estate information service;
• Adam Posen, senior fellow at the Peterson Institute for International Economics, member of the Council on Foreign Relations, and former economist at the Federal Reserve Bank of New York.

Host: with Michael Krasny

KQED Forum 20061213

KQED Public Radio

• http://delong.typepad.com/Audio/2006_12_13a-forum.mp3

KQED | Programs A-Z: Forum: Home: Wed, Dec 13, 2006 -- 9:00 AM:

Interest Rate Update -- Forum discusses the impact of the Federal Reserve's decision to leave interest rates unchanged.

Guests include:

• Brad De Long, professor of economics at UC Berkeley and research assistant at the National Bureau of Economic Research;
• John Karevoll, analyst at Data Quick Information Systems, a nationwide real estate information service;
• Adam Posen, senior fellow at the Peterson Institute for International Economics, member of the Council on Foreign Relations, and former economist at the Federal Reserve Bank of New York.

Host: with Michael Krasny

KQED Forum 20061213

KQED Public Radio

Lord, Enlighten Thou Our Enemies

Where Oh Where Are the Smart Conservatives?

Let us start with John Stuart Mill's prayer: "Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuarrt MIll: http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength..."

In economics, John Stuart Mill's prayer have been answered. We neoliberal types are, I think, a bare plurality, but the Chicago School is powerful, articulate, brilliant, and energetic. On our left thing are less healthy, but improving: the left has escaped its destructive embrace of Marxism. And there are signs of a fundamental rethinking of economics in embryo as the borderland between economics, sociology, and psychology becomes more active.

Outside economics, however, things are much less healthy. John Stuart Mill's prayer has not been answered. Witness Mark Bauerline in the Chronicle of Higher Education, which leads me to beg: Can we please ask the Chronicle of Higher Education to print the works of a smarter class of conservatives? Calls for a diversified intellectual portfolio fall flat when the conservative assets on offer are intellectual shell corporatilns. The benefits of a Millian clash of views to stimulate and deepen our thoughts are nonexistent when one side in the battle of wits is unarmed.

I mean, what can one make of Mark Bauerlein's charge that liberals--like The Baffler's Thomas Frank--are biased against Friedrich Hayek because they talk about what Hayek actually said in his 1956 preface to The Road to Serfdom?

The Chronicle: 12/15/2006: How Academe Shortchanges Conservative Thinking: Public intellectuals are less parochial, and even some of those on the left do acknowledge Hayek's eminence -- but too often with just a dismissive tack.... Thomas Frank, the editor of The Baffler, briefly summarizes Hayek's legacy with a run of high-handed jibes. He mentions Hayek's seminal The Road to Serfdom, but only to disparage it for equating "British-style socialism with the Nazi obscenity."...

But, Mark, Thomas Frank is right. I am a Hayek fan, or at least somebody who thinks it is important to wrestle with Hayek at least once once a month. Nevertheless, here is Hayek, in the 1956 preface to The Road to Serfdom:

Of course, six years of socialist government in England have not produced anything resembling a totalitarian state. But those who argue that this has disproved the thesis of The Road to Serfdom have really missed one of its main points: that "the most important change which extensive government control produces is a psychological change, an alteration in the character of the people." This is necessarily a slow affair... attitude[s] toward authority are as much the effect as the cause of... political institutions under which it lives.... [T]he change undergone... not merely under its Labour government but in the course of the much longer period during which it has been enjoying the blessings of a paternalistic welfare state, can hardly be mistaken.... Certainly [Weimar Germany's] Social Democrats... never approached as closely to totalitarian planning as the British Labour government has done.... The most serious development is the growth of a measure of arbitrary administrative coercion and the progressive destruction of the cherished foundation of British liberty, the Rule of Law... [E]conomic planning under the Labour government [has] carried it to a point which makes it doubtful whether it can be said that the Rule of Law still prevails in Britain...

In other circumstances, I might cavil at Thomas Frank--I would say that Hayek draws a line connecting Britain's Labour Party and Germany's Nazi Party, but that he does not quite equate them: In Hayek's view, the Labour Party has not established Nazi-like serfdom, but only placed Britain on the road to Nazi-like serfdom. However, not hear: the Road to Serfdom that the Labour Party placed Britain on leads, in Hayek's estimation, to serfdom and nowhere else. And I cannot read Bauerlein's complaint as anything other than saying that it is rude and biased for Thomas Frank to, you know, talk about things Hayek actually believed and cite things Hayek actually wrote.

Bauerline is similarly irate at Michael Berube for "bias." What is the bias? It is pointing out that George Will, Michelle Malkin, and David Horowitz self-identify as conservatives. An unbiased writer, Bauerline claims, would pretend that Will, Malkin, and Horowitz do not exist at all. To note their existence is "stigmatizing" and unfair to conservatives:

In What's Liberal... ?, conservatism suffers similarly from stigmatizing references. [Michael] Bérubé focuses on the anti-academic conservatives and fills his descriptions with diagnostic asides. Gay-rights debates "transform otherwise reasonable cultural conservatives into fumbling, conspiracy-mongering fanatics." The columnist George Will is "furious," and the columnist Michelle Malkin writes "shameful" books pressing "'interpretations' that no sane person countenances," while Horowitz exaggerates "hysterically." Such psychic wants explain why, according to Bérubé, "we just don't trust cultural conservatives' track record over the long term, to be honest. We think they're the heirs of the people who spent decades dehumanizing African-Americans and immigrants, arguing chapter and verse that the Bible endorses slavery and the subjection of women"...

Note the lineage: Not a line of reasoning, but a swell of mad wrath. Not Burke, Alexis de Tocqueville, T.S. Eliot, and Leo Strauss, but slaveholders, nativists, and sexists. Nothing from Elizabeth Fox-Genovese, E.D. Hirsch Jr., Harvey C. Mansfield, and the late Philip Rieff, to cite more-recent writers who may be termed "educational conservatives." The scholarly conservative case against higher education is overlooked, while Bérubé devotes too many words to the claims of discrimination by a conservative student on television's Hannity & Colmes, to a worry by a state legislator about "leftist totalitarianism," and so on...

I truly don't get Bauerlein here. First, by what warrant does Bauerline call Alexis de Tocqueville a "conservative"? Why not call John Maynard Keynes, Max Weber, and Oliver Cromwell "conservatives" as well? Burke, too, has conservative moods but is only a conservative thinker in a modern American sense if you take a chainsaw and reduce him to selected passages from Reflections on the Revolution in France. In Reflections Burke does make the argument that we should respect the traditions and institutions we have inherited because they incorporate the Wisdom of the Ancestors, but he only makes that argument because he thinks that in this case the Ancestors--not his personal ancestors, note--were wise. The argument that it was one of the traditions and institutions of Englishmen that they would conquer, torture, and rob wogs cut no ice with Edmund Burke when he was trying to prosecute Warren Hastings. The argument that it was one of the traditions and institutions of England that power flowed to Westminster cut no ice with Burke when he was arguing for conciliation with and a devolution of power to the American colonists. To Burke, conservative arguments based on respect for the Wisdom of the Ancestors are to be deployed in support of traditions, institutions, and practices that he approves of--they are not trumps. Burke is no more a conservative than Adam Smith is a Thatcherite. And anyone who classifies Burke as a conservative has not read much beyond scattered selections from Reflections on the Revolution in France.

Second, does Bauerline really think that Berube's take on Leo "The Text Means What I Say It Means" Strauss or Harvey C. Mansfield--a man who regards the admission of Blacks to Harvard as the cause of the baneful curse of grade inflation--would be significantly different than his take on Will, Malkin, Horowitz? I agree that we should get Michael to write on Mansfield as soon as possible. But I guarantee you that it won't lead to a more favorable view of modern American conservatism.

And I truly don't get what Bauerlein means when he says "the scholarly conservative case against higher education is overlooked." Does he mean that Michael Berube overlooks the scholarly conservative case against higher education? If so, then why not say so: what is Bauerlein's purpose in removing the active subject from his sentence by placing it in the passive voice? And what is "the scholarly conservative case against higher education" anyway? Is it that people shouldn't learn about science because it will undermine their trust in throne and altar? Is it that only a small, narrow elite should go to college because the masses will get bad ideas if they read Voltaire? Bauerline never says.

Lord, enlighten thou our enemies. Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength...

Let us start with John Stuart Mill's prayer: "Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuarrt MIll: http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength..."

In economics, John Stuart Mill's prayer have been answered. We neoliberal types are, I think, a bare plurality, but the Chicago School is powerful, articulate, brilliant, and energetic. On our left thing are less healthy, but improving: the left has escaped its destructive embrace of Marxism. And there are signs of a fundamental rethinking of economics in embryo as the borderland between economics, sociology, and psychology becomes more active.

Outside economics, however, things are much less healthy. John Stuart Mill's prayer has not been answered. Witness Mark Bauerline in the Chronicle of Higher Education, which leads me to beg: Can we please ask the Chronicle of Higher Education to print the works of a smarter class of conservatives? Calls for a diversified intellectual portfolio fall flat when the conservative assets on offer are intellectual shell corporatilns. The benefits of a Millian clash of views to stimulate and deepen our thoughts are nonexistent when one side in the battle of wits is unarmed.

I mean, what can one make of Mark Bauerlein's charge that liberals--like The Baffler's Thomas Frank--are biased against Friedrich Hayek because they talk about what Hayek actually said in his 1956 preface to The Road to Serfdom?

The Chronicle: 12/15/2006: How Academe Shortchanges Conservative Thinking: Public intellectuals are less parochial, and even some of those on the left do acknowledge Hayek's eminence -- but too often with just a dismissive tack.... Thomas Frank, the editor of The Baffler, briefly summarizes Hayek's legacy with a run of high-handed jibes. He mentions Hayek's seminal The Road to Serfdom, but only to disparage it for equating "British-style socialism with the Nazi obscenity."...

But, Mark, Thomas Frank is right. I am a Hayek fan, or at least somebody who thinks it is important to wrestle with Hayek at least once once a month. Nevertheless, here is Hayek, in the 1956 preface to The Road to Serfdom:

Of course, six years of socialist government in England have not produced anything resembling a totalitarian state. But those who argue that this has disproved the thesis of The Road to Serfdom have really missed one of its main points: that "the most important change which extensive government control produces is a psychological change, an alteration in the character of the people." This is necessarily a slow affair... attitude[s] toward authority are as much the effect as the cause of... political institutions under which it lives.... [T]he change undergone... not merely under its Labour government but in the course of the much longer period during which it has been enjoying the blessings of a paternalistic welfare state, can hardly be mistaken.... Certainly [Weimar Germany's] Social Democrats... never approached as closely to totalitarian planning as the British Labour government has done.... The most serious development is the growth of a measure of arbitrary administrative coercion and the progressive destruction of the cherished foundation of British liberty, the Rule of Law... [E]conomic planning under the Labour government [has] carried it to a point which makes it doubtful whether it can be said that the Rule of Law still prevails in Britain...

In other circumstances, I might cavil at Thomas Frank--I would say that Hayek draws a line connecting Britain's Labour Party and Germany's Nazi Party, but that he does not quite equate them: In Hayek's view, the Labour Party has not established Nazi-like serfdom, but only placed Britain on the road to Nazi-like serfdom. However, not hear: the Road to Serfdom that the Labour Party placed Britain on leads, in Hayek's estimation, to serfdom and nowhere else. And I cannot read Bauerlein's complaint as anything other than saying that it is rude and biased for Thomas Frank to, you know, talk about things Hayek actually believed and cite things Hayek actually wrote.

Bauerline is similarly irate at Michael Berube for "bias." What is the bias? It is pointing out that George Will, Michelle Malkin, and David Horowitz self-identify as conservatives. An unbiased writer, Bauerline claims, would pretend that Will, Malkin, and Horowitz do not exist at all. To note their existence is "stigmatizing" and unfair to conservatives:

In What's Liberal... ?, conservatism suffers similarly from stigmatizing references. [Michael] Bérubé focuses on the anti-academic conservatives and fills his descriptions with diagnostic asides. Gay-rights debates "transform otherwise reasonable cultural conservatives into fumbling, conspiracy-mongering fanatics." The columnist George Will is "furious," and the columnist Michelle Malkin writes "shameful" books pressing "'interpretations' that no sane person countenances," while Horowitz exaggerates "hysterically." Such psychic wants explain why, according to Bérubé, "we just don't trust cultural conservatives' track record over the long term, to be honest. We think they're the heirs of the people who spent decades dehumanizing African-Americans and immigrants, arguing chapter and verse that the Bible endorses slavery and the subjection of women"...

Note the lineage: Not a line of reasoning, but a swell of mad wrath. Not Burke, Alexis de Tocqueville, T.S. Eliot, and Leo Strauss, but slaveholders, nativists, and sexists. Nothing from Elizabeth Fox-Genovese, E.D. Hirsch Jr., Harvey C. Mansfield, and the late Philip Rieff, to cite more-recent writers who may be termed "educational conservatives." The scholarly conservative case against higher education is overlooked, while Bérubé devotes too many words to the claims of discrimination by a conservative student on television's Hannity & Colmes, to a worry by a state legislator about "leftist totalitarianism," and so on...

I truly don't get Bauerlein here. First, by what warrant does Bauerline call Alexis de Tocqueville a "conservative"? Why not call John Maynard Keynes, Max Weber, and Oliver Cromwell "conservatives" as well? Burke, too, has conservative moods but is only a conservative thinker in a modern American sense if you take a chainsaw and reduce him to selected passages from Reflections on the Revolution in France. In Reflections Burke does make the argument that we should respect the traditions and institutions we have inherited because they incorporate the Wisdom of the Ancestors, but he only makes that argument because he thinks that in this case the Ancestors--not his personal ancestors, note--were wise. The argument that it was one of the traditions and institutions of Englishmen that they would conquer, torture, and rob wogs cut no ice with Edmund Burke when he was trying to prosecute Warren Hastings. The argument that it was one of the traditions and institutions of England that power flowed to Westminster cut no ice with Burke when he was arguing for conciliation with and a devolution of power to the American colonists. To Burke, conservative arguments based on respect for the Wisdom of the Ancestors are to be deployed in support of traditions, institutions, and practices that he approves of--they are not trumps. Burke is no more a conservative than Adam Smith is a Thatcherite. And anyone who classifies Burke as a conservative has not read much beyond scattered selections from Reflections on the Revolution in France.

Second, does Bauerline really think that Berube's take on Leo "The Text Means What I Say It Means" Strauss or Harvey C. Mansfield--a man who regards the admission of Blacks to Harvard as the cause of the baneful curse of grade inflation--would be significantly different than his take on Will, Malkin, Horowitz? I agree that we should get Michael to write on Mansfield as soon as possible. But I guarantee you that it won't lead to a more favorable view of modern American conservatism.

And I truly don't get what Bauerlein means when he says "the scholarly conservative case against higher education is overlooked." Does he mean that Michael Berube overlooks the scholarly conservative case against higher education? If so, then why not say so: what is Bauerlein's purpose in removing the active subject from his sentence by placing it in the passive voice? And what is "the scholarly conservative case against higher education" anyway? Is it that people shouldn't learn about science because it will undermine their trust in throne and altar? Is it that only a small, narrow elite should go to college because the masses will get bad ideas if they read Voltaire? Bauerline never says.

Lord, enlighten thou our enemies. Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength...

The Kelly Risk Criterion

The intelligent and thoughtful Felix Salmon makes a subtle and interesting error--an error that I would make on at least a monthly basis had Robert Waldmann not patiently explained all this to me in the winter of 1986--in discussing Kelly risk analysis. Pushing leverage beyond the Kelly point does not decrease expected return. Rather, it decreases the likelihood of organizational survival and the chance that you will be wealthy. If you are acting as one of many agents for a well-diversified principal, you will in general want to ignore the Kelly point and leverage yourself up to the gills. If your objective is, instead, to maximize your own chances of remaining in the game with boasting rights, you will position yourself at the Kelly point.

A stark way of seeing this difference is to think of the following situation: Matt Rabin from the office beneath mine comes up the stairs and offers me the following: I start with a stake $1. I can wager none, some, or all of my stake. He flips a fair coin. If it is tails, I lose my wager. If it is heads, I win twice my wager. We do this ten times in a row, with my stake growing or shrinking.

To maximize expected return--this is, after all, a very advantageous game for me--I should be my whole stake, and let it ride time after time. After 10 rounds, there is one chance in 1024 that I have $59,049 and 1023 chances in 1024 that I have zero, for an expected portfolio value of $57.67.

The Kelly point, by contrast, says that I should wager 1/4 of my current stake each round. If Matt flips ten heads, then I have only $57.67 instead of $59,049. And my expected final wealth is only $3.25 instead of $57.67. But my median final wealth is not $0 but is instead $1.80. I make money not 1/1024 of the time but 638/1024 of the time. And if Robert were here he could prove in five lines that as the number of rounds goes to infinity an agent wagering according to the Kelly criterion almost surely ends up wealthier than an agent choosing his wager from his or her stake according to any other rule. The Kelly point makes sense if you are risk averse (and if this portfolio is a major component of your wealth) or if organizational survival and relative organizational prosperity is your major goal.

If Matt showed up at my office and announced that we were going to play this game on each of the next 1024 days, I would have no trouble choosing to follow the bet-the-limit strategy rather than the Kelly strategy on each day. 1024 x $3.25 is only $3328, which is a lot less than 1024 x $57.67 = $59049. But what if Matt says that this is my one and only one day? The right way to think about it is that my marginal utility of wealth is surely pretty flat over the range of $50,000 or so, and so I ought to be risk-neutral in this particular situation. The right way to think about it is that I "buy" lots of lottery tickets of various types during my life, and that the right strategy is to maximize the expected value of each lottery ticket--not to apply the Kelly criterion to each situation individually. (Of course, the generalized Kelly criterion--maximizing the expected value of the log of your portfolio--for 1024 rounds is not to apply the Kelly criterion to each round independently.)

But I would find it hard. I would have a hard time giving the 1/1024 chance of winning $59049 its proper weight in the face of the 1023/1024 chance of suffering the humiliation of bankruptcy.

In the end, however, I would be the limit. The humiliation for an economist like me of violating the axioms of expected utility is much worse than the humiliation of losing my entire stake.

Kelly Criterion finger exercises at: http://spreadsheets.google.com/pub?key=p_zylRhg4towI71xZsP62Fg

Chris Lydon's Open Source Radio, December 4, 2006

Chris Lydon Open Source Radio: <http://www.radioopensource.org/barney-franks-grand-bargain/> Barney Frank's Grand Bargain

Barney Frank wants to make a deal... a Congressionally-mediated "Grand Bargain" between economic populists and free traders. The populists get federal subsidies for health care, an increase in the minimum wage, more freedom to create unions and better access to college loans. The free traders get, well, free trade.

Health care and free trade have long been debated as unrelated subjects, but like Lyndon Johnson... Frank is attempting the impossible. He accepts that tariff-free borders are crucial to long-term economic growth, and that long-term economic growth is, in fact, good for everyone.

At the same time, he points out that economic dislocation is particularly hard on the ones being dislocated, and that perhaps a part of what voted the Democrats in this year is a general sense that even if the economy is doing well right now, we the people are not.

Is such a bargain even possible? Who has to give up what? Is there a such thing as a win-win in American politics?

Chris Lydon Open Source Radio: <http://www.radioopensource.org/barney-franks-grand-bargain/> Barney Frank's Grand Bargain

Barney Frank wants to make a deal... a Congressionally-mediated "Grand Bargain" between economic populists and free traders. The populists get federal subsidies for health care, an increase in the minimum wage, more freedom to create unions and better access to college loans. The free traders get, well, free trade.

Health care and free trade have long been debated as unrelated subjects, but like Lyndon Johnson... Frank is attempting the impossible. He accepts that tariff-free borders are crucial to long-term economic growth, and that long-term economic growth is, in fact, good for everyone.

At the same time, he points out that economic dislocation is particularly hard on the ones being dislocated, and that perhaps a part of what voted the Democrats in this year is a general sense that even if the economy is doing well right now, we the people are not.

Is such a bargain even possible? Who has to give up what? Is there a such thing as a win-win in American politics?

"Friedman Completed Keynes," Project Syndicate, December 2006

Friedman Completed Keynes

J. Bradford DeLong

J. Bradford DeLong

The most famous and influential American economist of the past century died in November. Milton Friedman was not the most famous and influential economist in the world -- that honor belongs to John Maynard Keynes. But Milton Friedman ran a close second.

From one perspective, Milton Friedman was the star pupil of, successor to, and completer of Keynes’s work. Keynes, in his General Theory of Employment, Interest and Money , set out the framework that nearly all macroeconomists use today. That framework is based on spending and demand, the determinants of the components of spending, the liquidity-preference theory of short-run interest rates, and the requirement that government make strategic but powerful interventions in the economy to keep it on an even keel and avoid extremes of depression and manic excess. As Friedman said, “We are all Keynesians now.”

But Keynes’s theory was incomplete: his was a theory of employment, interest, and money. It was not a theory of prices. To Keynes’s framework, Friedman added a theory of prices and inflation, based on the idea of the natural rate of unemployment and the limits of government policy in stabilizing the economy around its long-run growth trend – limits beyond which intervention would trigger uncontrollable and destructive inflation.

Moreover, Friedman corrected Keynes’s framework in one very important respect. The experience of the Great Depression led Keynes and his more orthodox successors to greatly underestimate the role and influence of monetary policy. Friedman, in a 30-year campaign starting with his and Anna J. Schwartz’s A Monetary History of the United States , restored the balance. As Friedman also said, “and none of us are Keynesian.”

From another perspective, Friedman was the arch-opponent and enemy of Keynes and his successors. Friedman and Keynes both agreed that successful macroeconomic management was necessary - that the private economy on its own might well be subject to unbearable instability ­and that strategic, powerful, but limited economic intervention by the government was necessary to maintain stability. But, while for Keynes, the key was to keep the sum of government spending and private investment stable, for Friedman the key was to keep the money supply -- the amount of purchasing power in readily spendable form in the hands of businesses and households-- stable.

A relatively minor, technical difference in means, you might say. A difference of opinion that rested on different judgments about how the world works, which could (and ultimately was) resolved by empirical research, you might say. And you would be half right. For this difference in means, tactics, and empirical judgments rested on top of deep gulf in Keynes’s and Friedman’s moral philosophy.

Keynes saw himself as the enemy of laissez-faire and an advocate of public management. Clever government officials of goodwill, he thought, could design economic institutions that would be superior to the market -- or could at least tweak the market with taxes, subsidies, and regulations to produce superior outcomes. It was simply not the case, Keynes argued, that the private incentives of those active in the marketplace were aligned with the public good. Technocracy was Keynes’s faith: skilled experts designing and fine-tuning institutions out of the goodness of their hearts to make possible general prosperity -- as Keynes, indeed, did at Bretton Woods where the World Bank and IMF were created.

Friedman disagreed vociferously. In his view, it usually was the case that private market interests were aligned with the public good: episodes of important and significant market failure were the exception, rather than the rule, and laissez-faire was a good first approximation. Moreover, Friedman believed that even when private interests were not aligned with public interests, that government could not be relied on to fix the problem.

Government failures, Friedman argued, were greater and more terrible than market failures. Governments were corrupt. Governments were inept. The kinds of people who staffed governments were the kinds of people who liked ordering others around.

At the same time, Friedman believed that even when the market equilibrium was not the utilitarian social-welfare optimum, and even when government could be used to improve matters from a utilitarian point of view, there was still an additional value in letting human freedom have the widest berth possible. There was, Friedman believed, something intrinsically bad about government commanding and ordering people about -- even if the government did know what it was doing.

I do not know whether Keynes or Friedman was more right in their deep orientation. But I do think that the tension between their two views has been a very valuable driving force for human progress over the past hundred years.

Haig-Simons Income vs. GDP

Partha Dasgupta Makes a Mistake in His Critique of the Stern Review

Partha Dasgupta makes a mistake. This is a rare, rare, rare event. Dasgupta writes, criticizing the Stern Review:

http://www.econ.cam.ac.uk/faculty/dasgupta/Stern.pdf: To give you an example of what I mean, suppose, following the Review, we set delta equal to 0.1% per year and eta equal to 1 in a deterministic economy where the social rate of return on investment is, say, 4% a year. It is an easy calculation to show that the current generation in that model economy ought to save a full 97.5% of its GDP for the future! You should know that the aggregate savings ratio in the UK is currently about 15% of GDP. A 97.5% saving rate is so patently absurd that we must reject it out of hand. To accept it would be to claim that the current generation in the model economy ought literally to starve itself so that future generations are able to enjoy ever increasing consumption levels...

In the "deterministic economy where the social rate of return on investment is, say, 4% a year" model that Dasgupta is using, the concept of "output" Y is Haig-Simons output--what you could consume and still leave the economy next year with the same productive capacity as it has this year. With that definition of output Y, with consumption level C, and with social rate of return on investment r, it is indeed the case that the growth rate g(Y) of a zero-population-growth economy is:

g(Y) = r(1 - C/Y)

Take the expression for the rate of growth of consumption g(C) as a function of the parameters δ and η:

g(C) = (r - δ)/η

And see that the assumed values for r, δ, and η give us a 3.9% per year growth rate of consumption. If you impose the steady-state requirement that the growth rates of consumption and output be the same, you do indeed get a 97.5% savings rate--that consumption is 2.5% of Haig-Simons output:

C/Y = .025

because with r=4% per year that is the only way to get g(Y)=3.9%

But suppose that you use a different concept of output--GDP--and say that productive capacity increases not just because you save some of GDP but also because of improvements in knowledge and technology g(A), so that:

g(Y) = r(1 - C/Y) + g(A)

with worldwide g(A) equal, say, to 3% per year. Then our g(C) equation still gives us a 3.9% per year total economic growth rate, but our g(Y) equation is then:

3.9% = g(Y) = r(1 - C/Y) + g(A) = 4%(1 - C/Y) + 3%

which gives us a savings rate not of 97.5% of Haig-Simons output but rather of 22.5% of GDP, leaving 77.5% of GDP for consumption.

A consumption-to-output ratio of 77.5% is far from absurd, and so Dasgupta's critique of Stern fails. His mistake is in failing to remember that in his model Haig-Simons output is very, very different indeed from standard reported GDP.

That being said, I agree with most of Dasgupta's major point: the action here is in the choice of the parameter η. I think it's appropriate to consider different ηs in the range from 1 to 5, and think the Stern Review should have done so.

(I'm also enough of a utilitarian fundamentalist to believe that the right value for δ is zero, and that Nordhaus's δ of 3% per year is unconscionable--it means that somebody born in 1960 "counts" for twice as much as somebody born in 1995, who in turn "counts" for twice as much as somebody born in 2020; somebody born in 1960 "counts" for 256 times as much as somebody born in 2160. That's not utilitarianism.)

Partha Dasgupta makes a mistake. This is a rare, rare, rare event. Dasgupta writes, criticizing the Stern Review:

http://www.econ.cam.ac.uk/faculty/dasgupta/Stern.pdf: To give you an example of what I mean, suppose, following the Review, we set delta equal to 0.1% per year and eta equal to 1 in a deterministic economy where the social rate of return on investment is, say, 4% a year. It is an easy calculation to show that the current generation in that model economy ought to save a full 97.5% of its GDP for the future! You should know that the aggregate savings ratio in the UK is currently about 15% of GDP. A 97.5% saving rate is so patently absurd that we must reject it out of hand. To accept it would be to claim that the current generation in the model economy ought literally to starve itself so that future generations are able to enjoy ever increasing consumption levels...

In the "deterministic economy where the social rate of return on investment is, say, 4% a year" model that Dasgupta is using, the concept of "output" Y is Haig-Simons output--what you could consume and still leave the economy next year with the same productive capacity as it has this year. With that definition of output Y, with consumption level C, and with social rate of return on investment r, it is indeed the case that the growth rate g(Y) of a zero-population-growth economy is:

g(Y) = r(1 - C/Y)

Take the expression for the rate of growth of consumption g(C) as a function of the parameters δ and η:

g(C) = (r - δ)/η

And see that the assumed values for r, δ, and η give us a 3.9% per year growth rate of consumption. If you impose the steady-state requirement that the growth rates of consumption and output be the same, you do indeed get a 97.5% savings rate--that consumption is 2.5% of Haig-Simons output:

C/Y = .025

because with r=4% per year that is the only way to get g(Y)=3.9%

But suppose that you use a different concept of output--GDP--and say that productive capacity increases not just because you save some of GDP but also because of improvements in knowledge and technology g(A), so that:

g(Y) = r(1 - C/Y) + g(A)

with worldwide g(A) equal, say, to 3% per year. Then our g(C) equation still gives us a 3.9% per year total economic growth rate, but our g(Y) equation is then:

3.9% = g(Y) = r(1 - C/Y) + g(A) = 4%(1 - C/Y) + 3%

which gives us a savings rate not of 97.5% of Haig-Simons output but rather of 22.5% of GDP, leaving 77.5% of GDP for consumption.

A consumption-to-output ratio of 77.5% is far from absurd, and so Dasgupta's critique of Stern fails. His mistake is in failing to remember that in his model Haig-Simons output is very, very different indeed from standard reported GDP.

That being said, I agree with most of Dasgupta's major point: the action here is in the choice of the parameter η. I think it's appropriate to consider different ηs in the range from 1 to 5, and think the Stern Review should have done so.

(I'm also enough of a utilitarian fundamentalist to believe that the right value for δ is zero, and that Nordhaus's δ of 3% per year is unconscionable--it means that somebody born in 1960 "counts" for twice as much as somebody born in 1995, who in turn "counts" for twice as much as somebody born in 2020; somebody born in 1960 "counts" for 256 times as much as somebody born in 2160. That's not utilitarianism.)

The Five Karl Marxes

Communist revolution is necessary and inevitable because...

The Technology Marx: ...capital is not a complement to but a substitute for labor, and so technological progress and capital accumulation that raise average labor productivity also lower the working-class wage. Hence the market system cannot and will be seen to be unable to deliver the good society we all deserve, and it will be overthrown.

The Market Extent Marx: ...businessmen continually extend the domain of captalism, and competition from poor workers in newly-incorporated peripheral regions puts a lid on the wages of labor. Hence inequality grows in the core, and triggers revolution.

The Unveiling Marx: ...previous systems of hierarchy and domination maintained control by hypnotizing the poor into believing that the rich in some sense "deserved" their high seats in the temple of civilization. Capitalism unveils all--replaces masked exploitation by naked exploitation--and without its ideological legitimation, unequal class society cannot survive.

The Ideology Marx: ...although the ruling class could appease the working class by sharing the fruits of economic growth, they will not. They are trapped by their own ideological legitimation--they really do believe that it is in some sense "unjust" for a factor of production to earn more than its marginal product. Hence social democracy will inevitably collapse before an ideologically-based right-wing assault, income inequality will rise, and the system will be overthrown.

The Solidarity Marx: ...factory work--lots of people living in cities living alongside each other working alongside each other develop a sense of their common interest and of class solidarity, hence they will be able to organize, and revolt.

Who is the real Marx? Ah, grasshopper, not until you have learned not to ask that question will you be able to snatch the pebble from my hand...

---

Total Installed Steam Horsepower in Britain:

In 1800: the equivalent of seven SUVs
In 1870: the equivalent of the motor vehicles registered in Berkeley today...

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006)

We Are Live at Salon, with an Obituary for Milton Friedman

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

Also see:

Sam Brittan at the Financial Times: Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/
Greg Ip at the Wall Street Journal: http://online.wsj.com/article/SB116369744597625238.html?mod=hps_us_at_glance_most_pop
Steven Pearlstein at the Washington Post: http://www.washingtonpost.com/wp-dyn/content/article/2006/11/16/AR2006111601779_pf.html

---

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

"Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuart Mill in his Essay on Coleridge http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength."

For every left-of-center American economist in the second half of the twentieth century, Milton Friedman (1912-2006) was the incarnate answer to John Stuart Mill's prayer. His wits were smart, his perceptions acute, his arguments strong, his reasoning powers clear, coherent, and terrifyingly quick. You tangled with him at your peril. And you left not necessarily convinced, but well aware of the weak points in your own argument.

General William Westmoreland, testifying before President Nixon's Commission on an All-Volunteer [Military] Force, denounced the idea, saying that he did not want to command an army of mercenaries. Milton Friedman interrupted him: "General, would you rather command an army of slaves?" Westmoreland got angry: "I don't like to hear our patriotic draftees referred to as slaves." And Friedman got rolling: "I don't like to hear our patriotic volunteers referred to as mercenaries. If they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general." And he did not stop: "We are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher" http://www.davidrhenderson.com/articles/0199_thankyou.html. As George Shultz likes to say: "Everybody loves to argue with Milton, particularly when he isn't there."

Thinking as hard as he could until he got to the root of the issues was his most powerful skill. "Even at 94," Chicago economist and Freakonomics http://www.amazon.com/exec/obidos/ASIN/006073132x/ author Steve Levitt wrote on his website yesterday, "he would teach me something about economics whenever we talked" http://www.freakonomics.com/blog/2006/11/16/sad-news-milton-friedman-has-died/. In this morning's New York Times http://www.nytimes.com/2006/11/17/business/17milton.html?ex=1321419600&en=a0db578046e72e19&ei=5088&partner=rssnyt&emc=rss, Chicago economist Austen Goolsbee quotes from Milton Friedman's Nobel autobiography:

Friedman said that when he arrived [at the University of Chicago] in the 1930s, he encountered a "vibrant intellectual atmosphere of a kind that I had never dreamed existed."

"I have never recovered."

His world-view began with a bedrock faith in people, in their ability to make judgments for themselves, and thus an imperative to maximize individual freedom. On top of that was layered a deep faith and conviction that free markets were almost always the best and most magical way of coordinating every conceivable task. On top of that was layered a powerful conviction that a look at the empirical facts--a marking-to-market of your beliefs to reality--would generate the right conclusions. And on top of that was layered a fear and suspicion of government as an easily-captured tool for the enrichment of cynical and selfish interests that sought to grab whatever they could. Suffusing all was a faith in the power of argument and the utility of reason. He was an optimist: people could be taught the truths of economics, and if they were properly taught then institutions could be built to protect all against the corruption and overreach of the government.

And he did fear the government. He hated government's and society's sticking their nose into people's private business. And he interpreted "people's private business" extremely widely. He hated the War on Drugs, which he saw as a cruel and destructive breeder of crime and violence. He scorned government licensing of professions--especially doctors, who heard over and over again about how their incomes were boosted by restrictions on the number of doctors that made Americans sicker. He feared deficit spending: cynical politicians could pretend that the costs of government were less than they were by pushing the raising of taxes to pay for spending off into the future. He sought to innoculate citizens against such political games of three-card-monte: "Remember," he would say, "to spend is to tax."

This did not mean that government had no role to play. Enforcement of property rights, adjudication of contract disputes--the standard powerful rule-of-law underpinnings of the market--plus a host of other government interventions when empirical circumstances made them appropriate: Mayor Ken Livingstone's congestion tax on cars in central London is Milton Friedman's. Friedman's negative income tax is one of the parents of what is now America's largest anti-poverty program: the Earned Income Tax Credit. And, most important, government had a very powerful and necessary role to play in keeping the monetary system working smoothly through proper control of the money stock. If there was always sufficient liquidity in the economy--enough but not too much--then you could trust the market system to do its job. If not, you got the Great Depression, or hyperinflation.

In his belief that the government was required to undertake relatively narrow but crucially important strategic interventions in order to stabilize the macroeconomy--keep production, employment, and prices on an even keel--Milton Friedman was in the same chapter if not on the same page as John Maynard Keynes, the economic giant of the previous generation whose doctrines and influence Friedman worked tirelessly to supplant and minimize. The Great Depression had convinced Keynes that central bankers alone could not rescue and stabilize the market economy. In Keynes's view, stronger and more drastic strategic interventions were needed to boost or curb demand directly. Friedman and his coauthor Anna J. Schwartz argued in their Monetary History of the United States that this was a misreading of the lessons of the Great Depression, which in Friedman's view was caused by monetary mismanagement or perhaps could have been rapidly alleviated by skillful monetary management alone. Over the course of forty years, Friedman's position carried the day. Federal Reserve Chair Ben Bernanke right now holds Milton Friedman's view, not John Maynard Keynes's, of what kind of strategic interventions in the economy are necessary to provide for maximum production, employment, and purchasing power, and stable prices.

Milton Friedman's thought is, I believe, best seen as the fusion of two strongly American currents: libertarianism and pragmatism. Friedman was a pragmatic libertarian. He believed that--as an empirical matter--giving individuals freedom and letting them coordinate their actions by buying and selling on markets would produce the best results. It was not that he thought this was natural law--that markets always worked best. It was, rather, that he believed that places where markets failed were atypical; that where markets did fail there were almost always enormous profit opportunities from entrepreneurial redesign of institutions; that the market system would create now opportunities for trade that would route around market failures; and that government failure was pervasive--that any expansion of government beyond the classical liberal state would be highly likely to cause more trouble than it could solve.

For right-of-center American libertarian economists, Milton Friedman was a powerful leader. For left-of-center American liberal economists, Milton Friedman was an enlightened adversary. We are all the stronger for his work. We will miss him.

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

Also see:

Sam Brittan at the Financial Times: Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/
Greg Ip at the Wall Street Journal: http://online.wsj.com/article/SB116369744597625238.html?mod=hps_us_at_glance_most_pop
Steven Pearlstein at the Washington Post: http://www.washingtonpost.com/wp-dyn/content/article/2006/11/16/AR2006111601779_pf.html

---

J. Bradford DeLong (2006), "A Man Who Hated Government," Salon (November 16, 2006) http://www.salon.com/news/feature/2006/11/17/milton_friedman/

"Lord, enlighten thou our enemies," prayed nineteenth-century British economist and moral philosopher John Stuart Mill in his Essay on Coleridge http://olldownload.libertyfund.org/Texts/MillJS0172/Works/Vol10/PDFs/Mill_1277.pdf. "Sharpen their wits, give acuteness to their perceptions, and consecutiveness and clearness to their reasoning powers: we are in danger from their folly, not from their wisdom; their weakness is what fills us with apprehension, not their strength."

For every left-of-center American economist in the second half of the twentieth century, Milton Friedman (1912-2006) was the incarnate answer to John Stuart Mill's prayer. His wits were smart, his perceptions acute, his arguments strong, his reasoning powers clear, coherent, and terrifyingly quick. You tangled with him at your peril. And you left not necessarily convinced, but well aware of the weak points in your own argument.

General William Westmoreland, testifying before President Nixon's Commission on an All-Volunteer [Military] Force, denounced the idea, saying that he did not want to command an army of mercenaries. Milton Friedman interrupted him: "General, would you rather command an army of slaves?" Westmoreland got angry: "I don't like to hear our patriotic draftees referred to as slaves." And Friedman got rolling: "I don't like to hear our patriotic volunteers referred to as mercenaries. If they are mercenaries, then I, sir, am a mercenary professor, and you, sir, are a mercenary general." And he did not stop: "We are served by mercenary physicians, we use a mercenary lawyer, and we get our meat from a mercenary butcher" http://www.davidrhenderson.com/articles/0199_thankyou.html. As George Shultz likes to say: "Everybody loves to argue with Milton, particularly when he isn't there."

Thinking as hard as he could until he got to the root of the issues was his most powerful skill. "Even at 94," Chicago economist and Freakonomics http://www.amazon.com/exec/obidos/ASIN/006073132x/ author Steve Levitt wrote on his website yesterday, "he would teach me something about economics whenever we talked" http://www.freakonomics.com/blog/2006/11/16/sad-news-milton-friedman-has-died/. In this morning's New York Times http://www.nytimes.com/2006/11/17/business/17milton.html?ex=1321419600&en=a0db578046e72e19&ei=5088&partner=rssnyt&emc=rss, Chicago economist Austen Goolsbee quotes from Milton Friedman's Nobel autobiography:

Friedman said that when he arrived [at the University of Chicago] in the 1930s, he encountered a "vibrant intellectual atmosphere of a kind that I had never dreamed existed."

"I have never recovered."

His world-view began with a bedrock faith in people, in their ability to make judgments for themselves, and thus an imperative to maximize individual freedom. On top of that was layered a deep faith and conviction that free markets were almost always the best and most magical way of coordinating every conceivable task. On top of that was layered a powerful conviction that a look at the empirical facts--a marking-to-market of your beliefs to reality--would generate the right conclusions. And on top of that was layered a fear and suspicion of government as an easily-captured tool for the enrichment of cynical and selfish interests that sought to grab whatever they could. Suffusing all was a faith in the power of argument and the utility of reason. He was an optimist: people could be taught the truths of economics, and if they were properly taught then institutions could be built to protect all against the corruption and overreach of the government.

And he did fear the government. He hated government's and society's sticking their nose into people's private business. And he interpreted "people's private business" extremely widely. He hated the War on Drugs, which he saw as a cruel and destructive breeder of crime and violence. He scorned government licensing of professions--especially doctors, who heard over and over again about how their incomes were boosted by restrictions on the number of doctors that made Americans sicker. He feared deficit spending: cynical politicians could pretend that the costs of government were less than they were by pushing the raising of taxes to pay for spending off into the future. He sought to innoculate citizens against such political games of three-card-monte: "Remember," he would say, "to spend is to tax."

This did not mean that government had no role to play. Enforcement of property rights, adjudication of contract disputes--the standard powerful rule-of-law underpinnings of the market--plus a host of other government interventions when empirical circumstances made them appropriate: Mayor Ken Livingstone's congestion tax on cars in central London is Milton Friedman's. Friedman's negative income tax is one of the parents of what is now America's largest anti-poverty program: the Earned Income Tax Credit. And, most important, government had a very powerful and necessary role to play in keeping the monetary system working smoothly through proper control of the money stock. If there was always sufficient liquidity in the economy--enough but not too much--then you could trust the market system to do its job. If not, you got the Great Depression, or hyperinflation.

In his belief that the government was required to undertake relatively narrow but crucially important strategic interventions in order to stabilize the macroeconomy--keep production, employment, and prices on an even keel--Milton Friedman was in the same chapter if not on the same page as John Maynard Keynes, the economic giant of the previous generation whose doctrines and influence Friedman worked tirelessly to supplant and minimize. The Great Depression had convinced Keynes that central bankers alone could not rescue and stabilize the market economy. In Keynes's view, stronger and more drastic strategic interventions were needed to boost or curb demand directly. Friedman and his coauthor Anna J. Schwartz argued in their Monetary History of the United States that this was a misreading of the lessons of the Great Depression, which in Friedman's view was caused by monetary mismanagement or perhaps could have been rapidly alleviated by skillful monetary management alone. Over the course of forty years, Friedman's position carried the day. Federal Reserve Chair Ben Bernanke right now holds Milton Friedman's view, not John Maynard Keynes's, of what kind of strategic interventions in the economy are necessary to provide for maximum production, employment, and purchasing power, and stable prices.

Milton Friedman's thought is, I believe, best seen as the fusion of two strongly American currents: libertarianism and pragmatism. Friedman was a pragmatic libertarian. He believed that--as an empirical matter--giving individuals freedom and letting them coordinate their actions by buying and selling on markets would produce the best results. It was not that he thought this was natural law--that markets always worked best. It was, rather, that he believed that places where markets failed were atypical; that where markets did fail there were almost always enormous profit opportunities from entrepreneurial redesign of institutions; that the market system would create now opportunities for trade that would route around market failures; and that government failure was pervasive--that any expansion of government beyond the classical liberal state would be highly likely to cause more trouble than it could solve.

For right-of-center American libertarian economists, Milton Friedman was a powerful leader. For left-of-center American liberal economists, Milton Friedman was an enlightened adversary. We are all the stronger for his work. We will miss him.

Comment on J. Christina Wang (2006), "Financial Innovations, Idiosyncratic Risk, and the Joint Evolu

At night in the suburbs of San Francisco, some of us awake as the hills echo and re-echo with the howls of the coyotes that have fed well on Glenn Rudebusch's chickens. We then lie awake, worrying. We worry why the Great Moderation in the U.S. business cycle on the real side that we have seen since the mid-1980s has not carried a big reduction in financial-side variability with it. We toss and turn, worrying that the real-side volatility decline has been part good transitory luck and part statistical illusion, all because people in financial markets putting their money where their mouths were do not project the continuation of the Great Moderation into the future.

Christina Wang's paper lets us sleep more easily, even if the coyotes continue to prey upon the chickens of Federal Reserve Bank Vice Presidents. It teaches us an important and valuable lesson: a financial system that is doing a better job will be highly likely to have both higher financial and lower real volatility.

When a firm goes bankrupt and defaults on its debt, it may be because it has had bad luck, it may be because it was badly managed, or it may be because it suffered from moral hazard--took account of the fact that in the lower tail the losses are eaten not by the firm but by the bank that loaned it the money. Banks that have a hard time distinguishing between these possibilities will be averse to lending--charge a high interest rate premium on loans--to firms seen as having a high degree of undifferentiated idiosyncratic risk. Improvements in data collection and analysis that allow firms to differentiate will cause banks to fear undifferentiated firm-level idiosyncratic risk less, and charge lower interest rate premiums for such lending. Other things being equal, firms will smooth production more, and smooth cash-borrowing requirements less, seeking to squeeze out more productive efficiencies by taking on more financial risk. To the extent that improvements in data collection and analysis reduce banks' fixed costs of monitoring loans, other things being equal banks will do more to diversify away firm-level idiosyncratic risk.

When a bank goes bankrupt and defaults on its debt, it may be because it has had bad luck, it may be because it was badly managed, or it may be because it suffered from moral hazard--took account of the fact that in the lower tail the losses are eaten not by the banks' shareholders but by those who hold or guarantee its liabilities. Improvements in data collection and analysis by those to whom banks owe their liabilities will allow them to better classify banks, and so the cost to banks of portfolios with bank-level idiosyncratic risk will fall. Other things being equal, banks will be willing to take on more bank-level idiosyncratic risk.

Of course this function that Christina Wang identifies is the primary job--one of the primary jobs--of financial markets: to diversify away idiosyncratic risk, as was ably explicated by that notable predecessor of Lintner and Markowitz, William Shakespeare. As Shakespeare writes, Antonio, the Merchant of Venice, does not fear that the lower tail of his portfolio return distribution extends far enough down to the state in which his heart is cut out with a knife. Antonio he has a properly-diversified portfolio. The banker lending him the money uses the highest information technology of that day: wandering down to Venice's Grand Canal, loitering on the High Bridge, and gossiping. The banker concludes that Antonio has:

an argosy bound to Tripolis, another to the Indies; I understand moreover, upon the Rialto, he hath a third at Mexico, a fourth for England, and other ventures...

Here the analogy breaks down. Negative transitory systematic news does indeed provoke a crisis in Antonio's affairs, but he is rescued not by a competent, technocratic lender of last resort but by his bride disguised as a teenage judge.

Christina Wang hopes that starting sometime in the mid-1980s we took a jump toward the ideal financial world in which one of CAPM's cousins holds, in which idiosyncratic risk is not priced because it is properly diversified away, and in which as a result the real economy can grab for all the production-smoothing efficiency benefits without worrying about firm- or bank-level costs of default or illiquidity. This shift could drive a reduction in real-side volatility coupled with an increase or no change in financial-side volatility.

She has a nice theoretical costly-state-verification model of the effects of improved data collection and analysis technologies. She has a very interesting theoretical Dixit-Stiglitz-based three-period model of the joint determination of real and financial volatility. The key insight is a very good one: that production-smoothing has not just manufacturing-side and labor-side efficiency benefits but financial-side efficiency costs: only if banks are confident in their ability to monitor firms and large depositors confident in their ability to monitor banks will firms be able to easily and cheaply borrow the money they need in recession to enable a production-smoothing corporate strategy. The fact that times of recession are times when a firm's free cash is likely to be uniquely valuable and not to be best invested in building up inventories is a potentially powerful explanation of why we have, historically, seen the reverse of production-smoothing in the American economy. She has interesting empirical results that suggest that banks and firms have reacted to a likely information-driven fall in the cost of idiosyncratic financial risk to take on more of it. The theory is sound and convincing. The micro empirics are interesting and suggestive.

But how much can this channel add up to on the macro level? How, exactly, does ICT help bankers? Working for the original J.P. Morgan, Charlie Coster was on the boards of 88 railroads at the turn of the last century and died of overwork--Morgan is reputed to have recruited Coster's successor while they were together carrying Coster's coffin to its grave. What would today's ICT have done to increase Coster's contribution to Morgan's bottom line, exactly?

And how much of the Great Moderation in real-side economic volatility can this channel account for? Recall the size of the Great Moderation: a 40% fall in the standard deviation of the cyclical component of GDP, more or less the same however you choose to measure it. A fall in spite of the fact that technology and cost shocks have in all likelihood been quantitatively greater in the past ten years than in any other post-WWII decade save possibly the 1970s.

As Christina Wang says, her paper as written can't do the job. It can only do about a third of the job--although Doug Elmendorf said half last hour. The model as extended quite possibly could.

In this literature, the game that is being hunted is the positive correlation between production and inventory investment that we saw in the past. In a standard production-smoothing model inventory investment should be relatively high when production is relatively low, and sales are very low. Instead--back before 1985--inventory investment was high when production was high. This shift could be possibly traced to Christina Wang's mechanisms. But it can account, in my back-of-the-envelope guess, for not a 40% but a 15% decline in the standard deviation of the cyclical component, whatever that is.

The big game for this model--as Chistina Wang says in her conclusion--will, I think, come from applications of models like this to the household sector. It's not just firms that have benefitted from the application of information technology to credit screening. I have gotten three offers of VISA cards and two offers of what were described as "guaranteed low interest" home-equity loans so far this week. Plus the people behind the counter at my most local Starbucks have started asking me if I'm interested in a no-annual-fee Starbucks VISA that will come with $25 of free caffeinated drinks. I don't know whether they are doing this to everybody or whether there is something special in my file. The smoothing-out of household durables purchases will, I think, be an important part of the Great Moderation when we finally nail it down. And I think that's where the high returns from Christina Wang's model will come.

Last, the smoothing out of residential construction--if it indeed stays smoothed-out--may well turn out to be the heart of the matter. One branch of the conventional wisdom is that the smoothing-out of residential construction is a result of good luck that is about to end: that America's banks have been offered too much rice wine by the People's Bank of China, and have responded by lending like drunken bankers: $600,000 zero-down floating-rate loans to single-earner middle-class families buying three-bedroom houses in Vallejo, CA: and we will be sorry.

Christina Wang's paper suggests a second possible explanation. That recent residential investment financed by so-called "non standard" mortgage loans is a result at least in part not of the inebriation of the banking sector but of the ability to more finely calculate risk and return than was possible in the days when your mortgage had to be 30-year-fixed, 20% down, with amortization plus real estate taxes amounting to no more than 33% of last year's household income. That was an inadequate screen. What, really, are the current screens? How good are they? The application of models like this to residential financing may be the real big game here.