REALITY BITES1
Elinor Ostrom and Oliver Williamson win this year’s Nobel prize for economics
BUILDING economic models usually involves stripping the world down to
its most essential features. But simple theories often struggle to explain the
way things really work. Elinor Ostrom of Indiana University and Oliver
Williamson of the University of California at Berkeley, the winners of this
year’s Nobel prize for economics, have both been honoured for recognising
this complexity. Their research provides insights into economic institutions
that play crucial roles in the real world, but to which economists have not paid enough attention.
In the case of Mr Williamson, that institution is the company. With hierarchical decision-making processes
based on rules and authority, firms ought to be less efficient than decentralised market exchange based on
relative prices, which is how standard economic theory assumes that transactions occur. So why do
companies exist at all? This question was first addressed in 1937 by Ronald Coase, the winner of the 1991
Nobel prize for economics and the intellectual forefather of both of this year’s winners. Mr Coase argued
that all economic transactions are costly—even in competitive markets, there are costs associated with
figuring out the right price. The most efficient institutional arrangement for carrying out a particular
economic activity would be the one that minimised transaction costs. This would often be the market. But
using authority and rules within a firm would sometimes prove to be more efficient.
Mr Coase’s theory explained why companies existed but it was not specific enough to predict the conditions
under which firms, or markets, would be the superior form of organisation. Clarifying this was Mr
Williamson’s signal contribution. In a series of papers and books written between 1971 and 1985, he argued
that the costs of completing transactions on spot markets increase with their complexity, and if they involve
assets that are worth more within a relationship between two parties than outside it (a rear-view mirror made
to the specifications of a particular car manufacturer, for example).
Both these features make writing and enforcing contracts which take every possible eventuality into
consideration difficult, or even impossible. At some point, therefore, it makes sense to conduct the
associated transaction within a single legal entity rather than on a market. The car company might prefer to
produce its rear-view mirrors in-house, for example, perhaps by buying the mirror company. This would
reduce the time and resources spent haggling over profits, because decisions would simply be taken by fiat.
Mr Williamson’s theory helpfully specified measurable attributes of transactions that would make them
more or less amenable to being conducted on markets. That meant his thinking could be tested against
decisions by companies to integrate parts of their supply chain. It has held up remarkably well. Several
studies find, for instance, that when an electricity generator can choose between the output of many nearby
coalmines that produce coal of a particular quality, it tends to buy its coal on an open market. But if there is
only one nearby mine that can be relied upon as a supplier, the electricity generator tends to own it. A
transaction that could be done on the market moves into the firm.
1
From The Economist print edition Oct 10th 2009
According to Mr Williamson, one lesson from organisational theory is the importance of identifying
common patterns of behaviour in seemingly disparate situations. That sums up the way Elinor Ostrom has
spent her working life. The first woman to win a Nobel prize for economics, she studies the governance of
“common resource pools”—such as pastures, fisheries or forests—to which more than one person has
access. Unlike pure public goods such as the atmosphere, where one person’s use does not reduce the
amount available to others, people deplete these resources when they use them. Standard economic models
predict that in the absence of clearly defined property rights, such common resources will be overexploited,
with individuals acting without regard for the effects of their actions on the overall pool. Overfishing or
overgrazing (the “tragedy of the commons”) will result. Over time, stocks of the common resource will
dwindle.
But in 40 years of studying how common resources—from lobster fisheries in Maine to irrigation systems in
Nepal—are actually managed by communities, Ms Ostrom found that people often devise rather
sophisticated systems of governance to ensure that these resources are not overused. These systems involve
explicit rules about what people can use, what their responsibilities are, and how they will be punished if
they break the rules. In particular, she found that self-governance often worked much better than an illinformed government taking over and imposing sometimes clumsy, and often ineffective, rules. In this, she
too shadows Mr Coase, who argued that those who advocated government ownership of common resources
ignored the transaction costs associated with collecting taxes.
Tit for tat
One problem with the idea of the tragedy of the commons, Ms Ostrom found, was that it did not account for
the fact that people sharing a pool of resources tend to interact repeatedly, making all sorts of clever
punishments for wrongdoing feasible. Being able to threaten credible retaliation makes co-operation
possible. This is the province of game theory, to which Ms Ostrom has contributed, both through formal
modelling of what she found in the field and subsequent laboratory tests of her models.
Both Mr Williamson and Ms Ostrom have built on Mr Coase’s idea that all transactions have costs but that
these costs will be minimised by different institutional arrangements in different situations. Their work uses
methods and insights from fields that many economists are not sufficiently familiar with: detailed case
studies, in the case of Ms Ostrom, a political scientist by training, and insights from the law in Mr
Williamson’s case. Their win reminds economists that borders between disciplines, like those between the
firm and the market, can be profitably crossed.
MEASURING WHAT MATTERS2
Man does not live by GDP alone. A new report urges statisticians to capture what people do live by
HOW well off are Americans? Frenchmen? Indians? Ghanaians? An
economist’s simplest answer is the gross domestic product, or GDP, per
person of each country. To help you compare the figures, he will convert them
into dollars, either at market exchange rates or (better) at purchasing-powerparity rates, which allow for the cheapness of, say, haircuts and taxi rides in
poorer parts of the world.
To be sure, this will give you a fair guide to material standards of living: the Americans and the French, on
average, are much richer than Indians and Ghanaians. But you may suspect, and the economist should know,
that this is not the whole truth. America’s GDP per head is higher than France’s, but the French spend less
time at work, so are they really worse off? An Indian may be desperately poor and yet say he is happy; an
American may be well fed yet fed up. GDP was designed to measure only the value of goods and services
produced in a country, and it does not even do that precisely. How well off people feel also depends on
things GDP does not capture, such as their health or whether they have a job. Environmentalists have long
complained that GDP treats the despoliation of the planet as a plus (via the resulting economic output) rather
than a minus (forests destroyed).
In recent years economists have therefore been looking at other measures of well-being—even “happiness”,
a notion that it once seemed absurd to quantify. Among those convinced that official statisticians should join
in is Nicolas Sarkozy, the French president. On September 14th a commission he appointed last year,
comprising 25 prominent social scientists, five with Nobel prizes in economics, presented its findings.
Joseph Stiglitz, the group’s chairman and one of the laureates, said the 292-page report was a call to abandon
“GDP fetishism”. France’s national statistics agency, Mr Sarkozy declared, should broaden its purview.
The commission divided its work into three parts. The first deals with familiar criticisms of GDP as a
measure of well-being. It takes no account of the depreciation of capital goods, and so overstates the value of
production. Moreover, the value of production is based on market prices, but not everything has a price. The
list of such things includes more than the environment. The worth of services not supplied through markets,
such as state health care or education, owner-occupied housing or unpaid child care by parents, is
“imputed”—estimated, using often rickety assumptions—or left out, even though private health care and
schooling, renting and child-minding are directly measured.
The report also argues that official statisticians should concentrate on households’ incomes, consumption
and wealth rather than total production. All these adjustments make a difference. In 2005, the commission
found, France’s real GDP per person was 73% of America’s. But once government services, household
production and leisure are added in, the gap narrows: French households had 87% of the adjusted income of
their American counterparts. No wonder Mr Sarkozy is so keen.
Sizing up the good life
2
From The Economist print edition Sept 17th 2009
Next the commission turns to measures of the “quality of life”. These attempt to capture well-being beyond a
mere command of economic resources. One approach quantifies people’s subjective well-being—divided
into an overall judgment about their lives (a “ladder of life” score) and moment-by-moment flows of positive
and negative feelings. For many years researchers had been spurred on by an apparent paradox: that rising
incomes did not make people happier in the long run. Recent studies suggest, though, that countries with
higher GDP per person do tend to have higher ladder-of-life scores. Exactly what, beyond income, affects
subjective well-being—from health, marital status and age to perceptions of corruption—is much pored
over. The unemployed report lower scores, even allowing for their lower incomes. Joblessness hits more
than your wallet.
Third, the report examines the well-being of future generations. People alive today will pass on a stock of
exhaustible and other natural resources as well as machines, buildings and social institutions. Their
children’s human capital (skills and so forth) will depend on investment in education and research today.
Economic activity is sustainable if future generations can expect to be at least as well off as today’s. Finding
a single measure that captures all this, the report concludes, seems too ambitious. That sounds right. For one
thing, statisticians would have to make assumptions about the relative value of, say, the environment and
new buildings—not just today, but many years from now. It is probably wiser to look at a wide range of
figures.
Some members of the commission believe that the financial crisis and the recession have made a broadening
of official statistics more urgent. They think there might have been less euphoria had financial markets and
policymakers been less fixated on GDP. That seems far-fetched. Stockmarket indices, soaring house prices
and low inflation surely did more to feed bankers’ and borrowers’ exaggerated sense of well-being.
Broadening official statistics is a good idea in its own right. Some countries have already started—notably,
tiny Bhutan. There are pitfalls, though. The report justifies wider measures of well-being partly by noting
that the public must have trust in official statistics. Quite so; which makes it all the more important that the
statisticians are independent of government. The thought of grinning politicians telling people how happy
they are is truly Orwellian. Another risk is that a proliferation of measures could be a gift to interest groups,
letting them pick numbers that amplify their misery in order to demand a bigger share of the national pie.
But these are early days. Meanwhile, get measuring.
WHEN IS A RECESSION NOT A RECESSION?3
1
The most conventional rule of thumb for defining a national recession is at least two consecutive
quarters of negative GDP growth. Unfortunately, this simple rule does not translate well to the global
context. First, quarterly real GDP data are not always available - for a number of major emerging market
countries, quarterly output data do not exist before the mid-1990s, and there are still many countries that
only report GDP annually rather than on a quarterly basis. Even among those that do report quarterly,
national methods for seasonally adjusting output data differ to such an extent that meaningful aggregation is
difficult. Second, while we cannot measure it exactly, it is likely that quarterly global growth does not turn
negative nearly as often as does GDP within the typical country. Indeed, annual global growth has never
been negative for any year in recent history - but this should not be interpreted as evidence that the world has
not experienced a recession.
2
The principal reason that global growth is rarely negative is that world output is more diversified than
national output. For example, the USA, Europe, and Japan do not always experience downturns at the same
time. Data on annual real GDP indicate that the current slowdown has a similar level of synchronisation as
earlier episodes in the mid-1970s and early 1980s, even though growth in China (in particular) has remained
relatively robust during this slowdown. The lower level of synchronisation in the early 1990s was an
exception - largely reflecting specific regional events, including the asset price bubble in Japan and the
consequences of German unification activity in continental Europe. It is also the case that trend growth for
the world is higher than for most advanced economies because developing countries grow faster on average,
so it takes a steeper dip to hit negative territory.
3
While global output may rarely decline, it is useful to have a simple benchmark for identifying
slowdowns that could be labelled as global recessions. One reasonable solution to this conundrum is to
adjust world output growth for growth in world population, and declare that a sufficient (although not
necessary) condition for a global recession is any year in which world per capita growth (measured on a
comparable basis) is negative. In the figure overleaf, the first bars show unadjusted world GDP growth
during the major recent slowdowns, 1975, 1982, 1991 and 2001. In no case did world growth dip below 1
per cent, much less turn negative.
4
In 1975, GDP growth of 1.9 per cent was almost exactly offset by world population growth, so that per
capita GDP growth was about zero. However, per capita GDP growth actually turned negative in 1982 and,
to a lesser extent, in 1991. By contrast, per capita GDP growth in 2001 was over 1 per cent, well above zero.
Compared with the earlier episodes, unadjusted growth was stronger at 2.5 per cent, instead of dipping
below 2 per cent as in the previous episodes. Also, world population growth is lower today (1.3 per cent)
than it was a decade earlier. Thus, the current slowdown has not come close to meeting the hurdle of
negative per capita annual GDP growth, which would automatically qualify it as a recession. This partly
reflects the relatively high weight of China, which has continued to grow strongly.
3
J Nellis, d Parker Principals of Macroeconomics Pearson Education, 2004 p 39
5
Can we declare that the world is not in recession simply
because annual global per capita growth is positive? No, not
necessarily. Whilst negative per capita GDP growth is a
sufficient condition to identify a global recession, by itself it
would probably be unduly conservative. As in the case of
individual recessions, one cannot rely absolutely on any
mechanical rule, but instead some element of judgement is
required. That is how recessions are identified in the USA
by the National Bureau of Economic Research (NBER), for
example.
6
Comparison of global slowdowns
The NBER defines a recession as a significant decline in activity spread across the economy and lasting
more than a few months, and focuses on economy-wide monthly series (especially non-farm employment
and real personal income less transfers). It also looks at data from manufacturing (real manufacturing and
trade sales and industrial production), although - as the NBER notes - this is a relatively small part of the US
economy whose movements often differ from those of other sectors. The rule of thumb of at least two
quarters of negative growth often referred to by commentators is simply a useful way of approximating this
system. Indeed, in a downturn, the NBER committee chose to identify the US slowdown as a recession even
though, based on current information, GDP growth was only negative in the third quarter.
DOES AMERICA NEED A RECESSION?4
An intriguing, if unpopular, thought
THE late Rudi Dornbusch, an economist at the Massachusetts Institute of Technology, once remarked:
“None of the post-war expansions died of old age. They were all murdered by the Fed.” Every recession
since 1945, with the exception of the one in 2001, was preceded by a sharp rise in inflation that forced the
central bank to raise interest rates. But today's Federal Reserve is no serial killer. It seems keener on blood
transfusions than on bloodletting.
When the Fed cut its discount rate on August 17th, it admitted for the first time that the credit crunch could
hurt the economy. The markets are betting it will soon cut its main federal funds rate. Economists are
arguing vigorously about how much damage falling house prices and the subprime mortgage crisis will do.
But there is one question that is rarely asked: even if a downturn is in the offing, should the Fed try to
prevent it?
Most people think the question smacks of madness. According to received wisdom, the Fed should not cut
interest rates to bail out lenders and investors, because this creates moral hazard and encourages greater risktaking; but if financial troubles harm spending and jobs the Fed should immediately ease policy so long as
inflation remains modest. Central bankers should be guided by the “Taylor rule”—and set interest rates in
response to deviations in both output and inflation from desired levels.
A necessary evil
But should a central bank always try to avoid recessions? Some economists argue that this could create a
much wider form of moral hazard. If long periods of uninterrupted expansions lead people to believe that the
Fed can prevent any future recession, consumers, firms, investors and borrowers will be encouraged to take
bigger risks, borrowing more and saving less. During the past quarter century the American economy has
been in recession for only 5% of the time, compared with 22% of the previous 25 years. Partly this is due to
welcome structural changes that have made the economy more stable. But what if it is due to repeated
injections of adrenaline every time the economy slows?
Many of America's current financial troubles can be blamed on the mildness of the 2001 recession after the
dotcom bubble burst. After its longest unbroken expansion in history, GDP did not even fall for two
consecutive quarters, the traditional definition of a recession. It is popularly argued that the tameness of the
downturn was the benign result of the American economy's increased flexibility, better inventory control and
the Fed's firmer grip on inflation. But the economy also received the biggest monetary and fiscal boost in its
history. By slashing interest rates (by more than the Taylor rule prescribed), the Fed encouraged a houseprice boom which offset equity losses and allowed households to take out bigger mortgages to prop up their
spending. And by sheer luck, tax cuts, planned when the economy was still strong, inflated demand at
exactly the right time.
Many hope that the Fed will now repeat the trick. Slashing interest rates would help to prop up house prices
and encourage households to keep borrowing and spending. But after such a long binge, might the economy
not benefit from a cold shower? Contrary to popular wisdom, it is not a central bank's job to prevent
4
From The Economist print edition Aug 23rd 2007.
recession at any cost. Its task is to keep inflation down (helping smooth out the economic cycle), to protect
the financial system, and to prevent a recession turning into a deep slump.
The economic and social costs of recession are painful: unemployment, lower wages and profits, and
bankruptcy. These cannot be dismissed lightly. But there are also some purported benefits. Some economists
believe that recessions are a necessary feature of economic growth. Joseph Schumpeter argued that
recessions are a process of creative destruction in which inefficient firms are weeded out. Only by allowing
the “winds of creative destruction” to blow freely could capital be released from dying firms to new
industries. Some evidence from cross-country studies suggests that economies with higher output volatility
tend to have slightly faster productivity growth. Japan's zero interest rates allowed “zombie” companies to
survive in the 1990s. This depressed Japan's productivity growth, and the excess capacity undercut the
profits of other firms.
Another “benefit” of a recession is that it purges the excesses of the previous boom, leaving the economy in
a healthier state. The Fed's massive easing after the dotcom bubble burst delayed this cleansing process and
simply replaced one bubble with another, leaving America's imbalances (inadequate saving, excessive debt
and a huge current-account deficit) in place. A recession now would reduce America's trade gap as
consumers would at last be forced to trim their spending. Delaying the correction of past excesses by
pumping in more money and encouraging more borrowing is likely to make the eventual correction more
painful. The policy dilemma facing the Fed may not be a choice of recession or no recession. It may be a
choice between a mild recession now and a nastier one later.
This does not mean that the Fed should follow the advice of Andrew Mellon, the treasury secretary, after the
1929 crash: “liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate...It will purge
the rottenness out of the system.” America's output fell by 30% as the Fed sat on its hands. As a scholar of
the Great Depression, Ben Bernanke, the Fed's chairman, will not make that mistake. Central banks must
stop recessions from turning into deep depressions. But it may be wrong to prevent them altogether.
Of course, even if a recession were in America's long-term economic interest, it would be political suicide. A
central banker who mentioned the idea might soon be out of a job. But that should not stop undiplomatic
economists asking whether a recession once in a while might actually be a good thing.
FATALISM V FETISHISM5
How will developing countries grow after the financial crisis?
1
Forty years ago Singapore, now home to the world’s busiest port,
was a forlorn outpost still garrisoned by the British. In 1961 South
Korea was less industrialised than the communist north and
dependent on American aid. In 1978 China’s exports amounted to
less than 5% of its GDP. These countries, and many of their
neighbours, have since traded their way out of poverty. Given their
success, it is easy to forget that some development economists were
once prey to “export fatalism”. Poor countries, they believed, had little to gain from venturing into the world
market. If they tried to expand their exports, they would thwart each other, driving down the price of their
commodities.
2
The financial crisis of the past nine months is stirring a new export fatalism in the minds of some
economists. Even after the global economy recovers, developing countries may find it harder to pursue a
policy of “export-led growth”, which served countries like South Korea so well. Under this strategy,
sometimes called “export fetishism”, countries spur sales abroad, often by keeping their currencies cheap.
Some save the proceeds in foreign-currency reserves, rather than spending them on imports. This strategy is
one reason why the developing world’s current-account surplus exceeded $700 billion in 2008, as measured
by the IMF. In the past, these surpluses were offset by American deficits. But America may now rethink the
bargain. This imbalance, whereby foreigners sell their goods to America in exchange for its assets, was one
potential cause of the country’s financial crisis.
3
If this global bargain does come unstuck, how should developing countries respond? In a new paper,
Dani Rodrik of Harvard University offers a novel suggestion. He argues that developing countries should
continue to promote exportables, but no longer promote exports. What’s the difference? An exportable is a
good that could be traded across borders, but need not be. Mr Rodrik’s recommended policies would help
countries make more of these exportables, without selling quite so many abroad.
4
Countries grow by shifting labour and investment from traditional activities, where productivity is
stagnant, to new industries, which abound in economies of scale or opportunities to assimilate better
techniques. These new industries usually make exportable goods, such as cotton textiles or toys. But
whatever the fetishists believe, there is nothing special about the act of exporting per se, Mr Rodrik argues.
For example, companies do not need to venture abroad to feel the bracing sting of international competition.
If their products can be traded across borders, then foreign rivals can compete with them at home.
5
As countries industrialise and diversify, their exports grow, which sometimes results in a trade surplus.
These three things tend to go together. But in a statistical “horse race” between the three—industrialisation,
5
From The Economist print edition Jun 11th 2009
exports and exports minus imports—Mr Rodrik finds that it is the growth of tradable, industrial goods, as a
share of GDP, that does most of the work.
6
How do you promote exportables without promoting exports? Cheap currencies will not do the trick.
They serve as a subsidy to exports, but also act like a tax on imports. They encourage the production of
tradable goods, but discourage their consumption—that is why producers look for buyers abroad.
7
Policymakers need a different set of tools, Mr Rodrik argues. They should set aside their exchange-rate
policies in favour of industrial policy, subsidising promising new industries directly. These sops would
expand the production of tradable goods above what the market would dictate. But the subsidy would not
discourage their consumption. Indeed, policymakers should allow the country’s exchange rate to strengthen
naturally, eliminating any trade surplus. The stronger currency would cost favoured industries some foreign
customers. But these firms would still do better overall than under a policy of laisser-faire.
Return of the cargo cult
8
Mr Rodrik offers a solution to an awkward problem: how policymakers can restore the growth strategies
of the pre-crisis era without reviving the trade imbalances that accompanied them. But is his solution as neat
as it sounds? Start with the theory. Mr Rodrik claims there is nothing special about exporting. He is probably
right. But his statistical test is unlikely to be the last word on the matter, given the difficulties of
disentangling variables that move together. Mr Rodrik’s model also assumes a single tradable good. Under
his policies, countries sell the same kind of stuff at home that they formerly sold to foreigners. In a more
elaborate model, foreign and local tastes would differ. China, for example, made most of the world’s thirdgeneration mobile phones long before 3G telephony was available at home. Firms in poor countries can learn
a lot from serving richer customers abroad.
9
What about the practice? Subsidies are notoriously prone to error and abuse. Even before the crisis, Mr
Rodrik was keen to rehabilitate industrial policy in the eyes of many economists, who doubt governments’
ability to pick winners but have every faith in their aptitude for favouring corporate friends. In these circles,
a cheap currency is often seen as the least disreputable form of industrial policy, because it benefits
exporters in general, without favouring any particular industry or firm.
10
This ingenious economist may also be preparing for a future that is further off than you might think.
American policymakers are certainly worried about their country’s trade deficit. But they are far more
concerned about unemployment. Most of their efforts to revive demand will tend to widen the trade gap, at
least in the short run. The American government is also more anxious than ever to sell its paper, and
whatever they say in public, the central banks of China and other big emerging economies still seem happy
to buy. Export fetishism seems fated to endure.