The significance of economics

What is my advice for students worried about the recent financial crisis? Learn some economics,
said Greg Mankiw. It may seem counterintuitive to rely on the subject which has gotten so much so
wrongas exemplified by the financial crisis itself, in which theories such as the Efficient Markets
Hypothesis led to excessive deregulation and the falsely propagated Great Moderation. Yet
abandoning economics, either as a predictive tool or a policy science, would be an unhelpful
overreaction. Indeed, economics has progressed much from crises, and even if its prescriptions may
sometimes be wrong, as Anatole Kaletsky argued, economics can explain and describe what went
wrong, how it went wrong, and how we may avoid such a situation in the future.
For the individual:
1. Economics helps people understand the whirlwind of forces swirling around them.
2. Develops rigorous analytic skills
3. Makes students better citizens
4. Joan Robinson: The purpose of studying economics is not to acquire a set of ready-made
answers to economic questions, but to learn how to avoid being deceived by economists
5. (Statistics) Interpreting data
6. (Finance) Managing own finances e.g. diversification, going to college
How economics is progressing from the crisis
1. Behavioural economicspeople are
2. Ignoring advice: the future is far from certain
a. Black Swan events have such huge impacts precisely because they are unpredictable
3. Renewed role of Keynesian fiscal policy
a. Is this just a temporary swing? Or are we finally recognising that governments can
and should play an important role in their economies?
i. Governments need the capability to step in when they can make things
better, the humility to pull out when they are making things worse, and
most of all, the wisdom to know the difference. Ravi Menon, from
Singapores Ministry of Trade and Industry
The crisis has prompted a fundamental re-think of the relationship between markets and
governments. The contest is not just between economic theories but between competing systems of
political economy and models of governance.
- Barry Eichengreen: The crisis has cast into doubt much of what we thought we knew about
economics.
- Paul Krugman: much of the past 30 years of macroeconomics was spectacularly useless at
best, and positively harmful at worst.
- Gary Becker: free markets sometimes don't do a very good job ... but if I take the first
proposition of Chicago economics - that free markets generally do a good job - I think that
still holds.
- Blaug: Economics emphasizes technical puzzle-solving abilities at the expense of knowledge
of the economic system
Economists know a lot about how the economy works, and can offer some useful advice on things
like how to avoid hyperinflations (for sure) and depressions (usually). But theres a lot that they cant
cure. Above all, they dont know how to make a poor country rich, or bring back the magic of
economic growth when it seems to have gone away. These limitations are a big problem for
politiciansand a different group, the policy entrepreneurs, has arisen to fill the gap. (Krugman)
Market failure revealed by the crisis
1. Information asymmetry
2. Moral Hazard
3. Systemic risks
4. Behavioural or non-rational motivators of choice
5. Inherent limitations of government in a globalised and complex economy
Monetarism vs Keynesianism
- Monetarists argue that keeping the money supply steady is sufficient
- Friedman: monetary and fiscal policy work with long and variable lags, and thus instead of
smoothing out the business cycle, would make things worse
- Advocated rules not discretion
- Fiscal policy would result in the crowding out of productive investment
The usefulness of economics in predictions
- Friedman: The usefulness of a theory is judged not by its realism, but by its predictive power
Economics is to be judged by the precision, scope, and conformity with experience of the
predictions it yields. In short, positive economics is, or can be, an objective science, in
precisely the same sense as any of the physical sciences.
- Solow: A good theory is always trying to tell us something even if it is not the literal truth
- Marshall: Economic science is but the working of common sense aided by appliances of
organised analysis and general reasoning
- Anatole Kaletsky: Economics should recognise that, as a discipline, it cannot be about
predicting, but is instead about explaining and describing
- Galbraith: The only function of economic forecasting is to make astrology look respectable
- John Kay: A fiscal watchdog should not need a crystal ball Anyone confident in predicting
either a strong recovery or a collapse in business confidence is a fool. There will always be a
demand for forecasts, so there will always be a supply. But the reputation of economic
forecasters, like other quacks and charlatans, depends more on the slickness of their
presentations than the value of their work.
Unrealistic models are termed the Ricardian Vice; implausible assumptions may yield fascinating
results, but the fact remains that the models conclusions may hardly apply at all in real life.
A model tries to turn the normative into the positive.
John Milton: By misdirection we arrive closer at the truth
Blaug: When theories face empirical difficulties, as they always do, one attempts to modify them. If
some of the new predictions are confirmed, then the modification is empirically progressive, and
one has reason to reject the unmodified theory and to employ the new theory, regardless of how
unsuccessful in general either theory may be. What matters is empirical progress or retrogression
rather than empirical success or failure. This causes paradigm shifts (Kuhn), a result of the
intellectual competition between theories, and the challenge of conventional wisdom.

Economics as a science
1. Not scientific in the sense of predictive power (anyway, most natural sciences except
astronomy only work in controlled experiments)
2. Scientific in the sense of providing a causal mechanism
3. Cannot exist in isolation: social phenomena are constituted in relation to each other
4. No stability: economies are continually changing
a. Moreover, the study of economics itself affects economies and economic behaviour
i. E.g. game theory, profit/revenue maximisation
Lawson: If science is the move from phenomena of interest to underlying causes then this move is a
feasible in economics as in natural science. However, in some special cases natural scientists can
successfully carry out controlled experimentation. In such conditions, event regularities may be
produced in the course of their evaluating a theory about an underlying causal mechanism.
Economists, though, have typically not only restricted their focus to this special case, but also
universalized the wrong aspect of it. Instead of seeing the central moment as furthering our
understanding of some underlying causal mechanism, economists have focused on the experimental
production of event regularities. And they have generalized this inessential feature of science to a
context, namely the social realm, where typically the conditions are such that event regularities do
not occur.
Although a science of social phenomena remains entirely feasible, the reliance on methods of
mathematical modeling in economics, presupposing as it does a ubiquity of even regularities, mainly
serves as an obstacle to the disciplines realizing its scientific potential

- Marshall: The forces of which economics has to take into account are more numerous, less
definite, less well known, and more diverse in character than those of mechanics; while the
material on which they act is more uncertain and less homogeneous
- Keynes: Due to the nature of economic material, a generalisation to cover everything is
impossible and impracticable
Keynes: The master-economist... must be mathematician, historian, statesman, philosopher... He
must study the present in the light of the past for the purposes of the future.
- Unlike physics, economics yields no natural laws or universal constants Kagel and Roth
o However, Roth later clarified that economics could still be a science: laboratory
experiments, such as Kagel and Roths studies of market organizations, complement
other forms of investigation. Experiments in biology do not reveal universal
constants either, but biology is still as much of a science as physics.
o Then again it is difficult to conduct controlled laboratory experiments, and we want
to see whether theories apply in real life, not in controlled settings
- Can try to find natural experiments e.g. Angrist and Krugers study of whether education
increased peoples incomes
o However, there are only so many things that natural experiments can tell you
may end up avoiding big questions
- Need to use econometrics and data analysis to judge the accuracy of theories; otherwise,
sensible policy prescriptions are impossible

Economic methods
Both inductive and deductive methods in economics are problematic: Mill maintains that direct
inductive methods can study only phenomena with few causal factors in play (ceteris paribus).
Black Swan problem of inductive reasoning: a turkey that has not been killed for the past 100 days
may inductively conclude that it will not die on the 101
st
but the 101
st
day may be Thanksgiving.
Inductive and deductive reasoning may be used in combination: Economists believe that demand
curves slope down because of statistical evidence accumulating in journals. Yet more beliefs in the
hypotheses come from other sources: deduction (a higher price leaves less disposable income),
introspection (what would I do), and extrapolation (if the demand curve for iron slopes down, why
not for love?)
All historical explanations are pseudo-explanations, they may be true or false but we will rarely know
the case (Hempel)

Falsifiability
Popper holds that hypotheses are scientific only if their predictions are in principle falsifiable this is
the only way we can know if a theory is true: that it makes definite predictions about economic
events.
Theories have been falsified include:
The Philips Curve, which supposes a stable trade-off between inflation and unemployment,
and broke down in the stagflation of the 1970s
There is a stable velocity of circulation of money

However, empirical testing is difficult and ambiguous, given the near-impossibility of experiments,
and the lack of ceteris paribus conditions. The Duhem-Quine thesis in fact states that it is logically
impossible to decisively refute any theory, since a refutation can always be blamed on inappropriate
initial conditions. And in economics, subsidiary assumptions are often dubious or patently false.
Only 3 out of 500 empirical articles in top journals attempted to falsify the proposed hypotheses
(Canterbery), and 50% of American Economic Review articles had models but no data (Leontief).
Empirical testing is a safety valve protecting economics from falling prey to dogmatism.
Blaug: To predict and prescribe policy, economics must be first and foremost an empirical science.

Krugman: Economists have mistaken beauty for truth.
To succeed, an idea need not be true or even useful, as long as it has what it takes to propagate
itself
Statistics in economics
Statistical inference can be too stringent or too lax (Type 1/2 errors), and fudge factors are often
introduced into econometric models
- Epstein: Math is descriptive and not explanatory: we may accurately describe behaviour in
mathematical terms, but what happens inside the system remains unknown
- Kaletsky: Smith, Ricardo and Keynes produced no mathematical models. Their work lacked
the analytical rigour and precise deductive logic demanded by modern economics. If any
of these giants of economics applied for a university job today, they would be rejected. As
for their written work, it would not have a chance of acceptance in the Economic Journal or
American Economic Review.
- Krugman: The professions failure was the desire for an all-encompassing, intellectually
elegant approach that also gave economists a chance to show off their mathematical
prowess
- Hahn: Not only will our successors have to be far less concerned with general laws than we
have been, they will have to study complexity. Not for them the pleasure of theorems and
proofs. Instead, the uncertain embrace of history, sociology and biology
- Marshall: The most helpful applications of mathematics to economics are those which are
short and simple, which employ few symbols; and which aim at throwing a bright light on
some small part of the great economic movement rather than at representing its endless
complexities
o In line with Occams Razor, simpler theories should be preferred
Roosevelt: Economic laws are not made by nature. They are made by men and we decide how the
economy is to work

Assumptions
Assumptions may not have to be realistic; what matters may be the robustness of a theorythat its
predictions hold even if the assumptions are violated. There may be robustness to changes in the
models idealisations, changes in background conditions, or changes in the causal mechanism.
One major assumption is that of rational economic man. This removes the differences caused by
irrationality, so theorists need not worry about what peoples beliefs are. However, there are
limitations of human rationality due to imperfect information and herd mentality, as seen by the
formation of bubbles that disprove the Efficient Markets Hypothesis. Moreover, choices depend on
expectations: the true value of a stock depends on future profits, but what matters in the short run
is what people believe.
Bounded rationality may be a suitable alternative: economic actors display inertia in their reaction to
new information and are strongly influenced by emotional and hormonal reactions
The risk management models that underlay financial instruments were highly flawed, failing to take
into account tail-end risks, leverage, interconnectedness, and foreign currency exposure (IMF)

Fallacies
1. Fallacy of composition/aggregation: what is true for one person may not be true for the
economy as a whole
a. E.g. Nash equilibrium, systemic risk
2. Post-hoc fallacy: just because two events occur together doesnt mean one caused the other
a. E.g. Money supply growth and inflation
3. Other-conditions fallacy: even if two events always occurred in together in the past, they
may not always occur together in the future
a. E.g. Philips curve
4. Misleading comparison: comparing things in a way that does not reflect their true difference
5. Selection bias
a. Coase: If you torture the data long enough, it will confess


Industrial policy
Dani Rodrik: the proverbial road to hell is paved with well-meaning industrial development plans.
But Michael Porter argues that national prosperity is created, not inherited
Governments roles:
1. Enable markets by ensuring the rule of law, property rights, and public infrastructure
a. Going further: capability development
b. Agglomeration benefits (high growth industries e.g. previously chemicals, now
biomedical)
c. Positive externalities from information and learning spill-overs
2. Regulate markets, including supervising the financial sector, ensuring competition, and
taxing negative externalities.
a. Shift towards lighter regulation accompanied by risk-based supervision
3. Stabilise markets: macroeconomic management
a. In the recent financial crisis, economists advocated loose monetary policy and
expansionary fiscal policy; this was largely successful and much of the world is
rebounding, and the effects of what was once proclaimed the second Great
Depression have been comparatively muted
4. Legitimise markets by facilitating difficult transitions, redistributing incomes, or providing
social safety nets, so as to maintain public support for market-oriented policies
Ricardo Hausmann: What distinguishes a good industrial policy is not the ability to pick winners, but
the guts to let losers go.
In Paul Davids article, Clio and The Economics of QWERTY, he explained how historical factors can
lead to an inefficient allocation of resources becoming locked in.
The collective results of free choices may lock in a bad result. We may end up producing an inferior
technology, locating an industry in a congested metropolis when it could function better elsewhere,
or seeing another country lock in an advantage with timely government intervention, and thereby
be locked out ourselves.
Government failure
Japans attempts at fiscal policy have failed to pull it out of a nearly twenty-year depression. It is also
facing a liquidity trap. Japan has supply-side problems which are much more difficult to address:
structural unemployment and a mismatch of industries, with excess capacity in the property sector,
and a hollowing out of the manufacturing sector.
Lags in recognition, analysis, implementation, and effect
Friedman argued that discretionary policy would not only be ineffective but destabilising

There is no such thing as favouring producers over consumers. Each of us is a producer, typically
from nine to five, and a consumer the rest of the day (Krugman)

Nature of Economics
Krugman: Because the exchange of goods and services is a less complex, perhaps less human activity
than other social interactions, economics lends itself both to the development of theory and the
testing of that theory to a greater extent than other social sciences.
However, economics has a direct impact on government policies that affect almost everyone, and
therefore change the nature of the subject itself. Moreover, people care about economics only
enough to know what they want to believe.


International Trade and Globalisation
Ricardian model of comparative advantage
Countries should specialise in producing what they can produce at a lower opportunity cost.
Hecksher-Ohlin Theorem
(expanded on the theory of CA by introducing capital as a factor of production)
Countries will export products that use their abundant factors of production, and import products
that use their scarce factors of production. This is because the profitability of goods is determined by
input costs.
Expansions:
1. Rybczynski theorem: When the amount of one factor of production increases, the
production of the good which uses that particular factor of production intensively increases
relative to the increase in the factor of production
2. Stolper-Samuelson theorem: Relative changes in the prices of output goods will drive the
relative prices of the factors used to produce them
3. Factor-Price equalisation theorem: Free trade will make factor prices converge along with
traded goods prices.
a. For example, after NAFTA was signed, the wages of unskilled labour fell in the US,
and rose in Mexico
However, the assumption of factor-intensity reversal, that a commodity is always intensive in a given
factor regardless of relative factor prices, may not hold. Commodities may have different relative
factor intensity at different relative factor prices. This may explain why a labour-intensive country
such as India and a capital-intensive country like the US can export the same commodity. The H-O
theorem also assumes that production functions are identical, which is unrealistic, as the
technological gap between developed and developing countries is the main concern for the
development of poor countries.
Factor-price equalisation also does not prove that trade will pull up wages in developing countries,
due to the fallacy of aggregation of goods: trade economists ignore the impact of non-traded goods
on factor prices. Trade liberalisation may lower the price of the unskilled-labour intensive good
produced in a country, and thus hurt the wages of those at the very bottom.
Refutations:
1. Leontiefs paradox: the US exported more labour intensive products even though its
abundant factor of production was capital
a. However, this may possibly be explained by demand reversal: if demand in two
countries is so different such that the price of a good that uses the abundant factor
of production is higher, trade can flow in the opposite direction.
2. Vernons Product Life Cycle theory: production moves away from the point of origin as the
product matures
3. Keesing Human Skills Theory of Trade: based on human factor endowments
4. Dynamic comparative advantage: nations create their own comparative advantages
(Singapore especially; most recently in the biotechnology sector)
a. Michael Porter: nations succeed in industries where they are particularly good at
factor creation
New Trade Theory
Krugman (1985) propounded the theory of economic geography, which focuses on the role of
historical accident in determining patterns of trade. Increasing returns to scale lead to
agglomeration effects that governments can and should help to create, to promote major industries,
because a large industrial concentration may be needed to facilitate the flow of information.
Governments have the largest role in promoting external economies of scale, such as in Silicon
Valley, which prospered precisely because of a large pool of skilled labour, specialised suppliers, and
the flow of knowledge.
Industry localisation demonstrates path dependence: the role of historical accident in determining
the shape of the economy
The theory of comparative advantage explains a lot of international trade, but fails to explain why
increasingly similar advanced nations began to trade so much with each other, especially after WWII.
By 1990, 76% of advanced country exports went to other advanced nations.
Exports from one industrial country to another dont give us much indication that they are based on
any underlying national resource of characteristic (Krugman) At a broad level, trade reflects
resources: a country with a highly skilled labour force will, in general, export goods whose
production requires a high ratio of skilled to unskilled labour, and import goods for which the
reverse is true. But precisely which goods the country exports cannot be determined from its
resources alone. That final determination rests in the realm of chance and history, in the land of
QWERTY.
Strategic Trade Theory
In the Brander-Spencer Model, a government subsidy for one firm could give that firm a strategic
advantage over its rival.
Initial conditions Boeing
Enter Dont Enter
Airbus Enter -10, -10 100, 0
Dont enter 0, 100 0, 0

With subsidy of 20 for Airbus Boeing
Enter Dont Enter
Airbus Enter 10, -10 120, 0
Dont enter 0, 100 0, 0

Regardless of Boeings actions, it is profitable for Airbus to enter, but Boeing will lose money if it
enters along with Airbus. Thus, Airbus will enter, and Boeing wont. Airbus profits have gone from 0
to 120, despite the fact that the subsidy was only 20the extra 100 represents a shift of wealth
from Boeing to Airbus.
Yet Brander and Spencer never claimed they had offered a general argument for aggressive trade
policies: what they provided was only an example of how such a policy could work. As soon as the
idea of strategic trade began circulating, aggressive trade policies would begin to backfire.
Moreover, it is difficult to choose which industries to encourage, and infant industries might never
grow up.
Economists who take the theory of comparative advantage seriously, however, do not see the
international trade as a competitive sport. Import quotas, for example, may seem to create jobs, but
the jobs gained in the protected industry are lost by the crowding out of employment, leaving us
with nothing but higher prices and reduced competition, e.g. jobs saved in the American steel
industry are at the expense of American dock workers, etc. An export subsidy normally costs the
government and domestic consumers far more than it benefits producers in that industry (Harberger
triangles)
The nineteenth-century French economist Bastiat once said: Saying that our country should be
protectionist because other countries do not practice free trade is like saying that we should block
up our harbours because other countries have rocky coasts.
The statements, I understand the principle of comparative advantage, and I support free trade,
have become part of the economists credo. (Krugman)

The Thurow-Reich industrial policy prescribed that govts should help sunrise industries, in which you
have a high market share and the industry is expected to grow quickly; and bring sunset industries
to a soft landing. Yet this was based on the belief that there were strong, predictable learning
curves that would allow a firm to translate a dominant market share into a cost advantage over its
rivals; and in practice, these learning curves were much less reliable.
Gravity Model of World Trade (Krugman)
What determines the volume of trade between two countries are the size of their GDPs and the
distance between the countries
- Large countries spend more on imports and attract large shares of other countries spending
because they produce a wide range of products

Linder Hypothesis: Focuses on the pattern of demand. International trade in manufactured goods
will be more intense between countries with similar per capita income levels. Tastes of
representative consumers in a country yield product demands, and in turn generate a production
response. Trade occurs in goods that have overlapping demand.
This has empirically, proven to be right. However, countries with similar per capita incomes tend to
be geographically close, so intense trade may also reflect low transport costs and cultural similarity.
Also, this theory does not specify the direction of tradegoods may be sent in both directions, in
light of product differentiation.
Intra-Industry trade is also not based on comparative advantage
- Economic geography may be due to economies of scale created by historical accident
(Krugman)
- Ruffin: Intra-Industry trade enhances the gains from trade through better exploitation of
economies of scale, leading to a world expansion of output because of the savings on fixed
costs
- Ruffins Endogeneous Theory of Growth: Intra-Industry trade encourages monopolistic
competition, trade stimulates innovation
- Marvel and Ray (1987): Intra-industry trade reduces the demands for protection because
there are both exports and imports, making it difficult to achieve unanimity among those
demanding protection.
- Trade need not cause the dislocations associated with inter-industry trade. Intra-industry
trade beneficial because it stimulates innovation and exploits economies of scale
o Allows countries to benefit from larger markets: Study of the North American Auto
Pact in 1964 indicated that the gains from intra-industry trade can be substantial


Trade policy
Tariffs: transfer consumer surplus to producer surplus; efficiency loss in terms of Harberger triangles
The impact of a tariff depends on the effective rate of protection (which is not necessarily the same
as the tariff rate). Tariffs often have different impacts on different stages of production, e.g. the
assembly industry and parts industry in automobile manufacturing. American steel tariffs, for
example, may have caused even more job losses in industries depending on steel imports; steel-
using industries account for 57 times as many jobs as steel-producing industries.

Export subsidies: Same production and consumption losses, but export subsidies worsen a countrys
terms of trade by raising prices in the exporting country while lowering them in the importing
country
E.g. The EUs Common Agricultural Policy costs $60 billion per year to European taxpayers, not
including indirect costs to food customers (Krugman-Obstfeld)
Import quotas: always raise the domestic price of the imported good. This is an extreme case of
concentrated gains to favoured producers, diffuse costs to other producers and all consumers. The
transfer of quota rents to holders of import licenses can make the costs of a quota higher than an
equivalent tariff, but governments receive no revenue
E.g. US sugar quotas lead to a net loss of $883 billion per year to the US. Sugar producers, however,
have very strong lobbies, as they gain a subsidy of about $20 000 per employee. It is estimated that
with free trade, the consumer cost per job saved will be over $200 000 (Figures from US
International Trade Commission, 2007)
Voluntary Export Restraints: have political and legal advantages, but from an economic point of
view, VERs simply act like import quotas.
E.g. US asked the Japanese government to voluntarily limit its exports, and the Japanese agreed.
However, Japanese and US cars were not perfect substitutes, and the Japanese industry responded
to the quota by upgrading its quality and selling larger automobiles with more features. Most
importantly, the price of Japanese cars in the US rose significantly, with the rent captured by Jap
firms. The US government estimates the total costs to the US as $3.2 billion in 1984, primarily in
transfers to Japan.

Globalisation
Definition: (Peter Nolan) The era of capitalist globalisation witnessed an unprecedented pace of
technological progress [and reductions in trade barriers.] It witnessed an ever-deeper intermeshing
of national economies, drawn together by the bonds of trade and, even more, by cross-border
investment by international firms. To a lesser extent it also resulted in the freer flow of labour and
people around the world.
Jagdish Bhagwati, In Defence of Globalisation
Globalisation first became a buzzword. Davos and Thomas Friedman celebrated its virtues and its
inevitability; but economists such as Joseph Stiglitz were more wary, warning of its vices and its
vincibility.
Brazilian sociologist Cardoso invented the dependencia thesis, arguing that poor countries would be
relegated to a dependent status in the international economy. When he became President Cardoso
of Brazil, however, he sought to take Brazil into more, not less, globalisation.
According to a 2006 World Economic Forum survey, fears of malign impact have been more
prominent amongst richer nations, especially America
Rapid technological change has dramatically reduced costs of transport and communication: the
telegraph reduced communication time by 2500x, and the internet reduced it by a further 5x
The sense of vulnerability or economic insecurity is greater today because of intensified competitive
pressures from actual and potential rivals. The novel fear today is that globalisation places limits on
the ability of the state to provide for the welfare of their citizens.
David Humes concentric circles of reducing loyalty and empathy
Adam Smith wrote that The destruction of that immense multitude seemsless interesting to him
than this paltry misfortune of his own. To prevent, therefore, this paltry misfortune to himself would
a man of humanity be willing to sacrifice the lives of a hundred million of his brethren, provided he
had never seen them?
Capitalism and globalisation are not such an inexorable force that they propel society into a
headlong rush away from traditional communitarian values and ways
Throwing sand into the gears of globalisation is seen as a way to spit upon American hegemony, if
not to limit the exercise of it in the political, cultural and economic domains.
While globalisation may be economically benign (in the sense of increasing the pie), it may be
socially malign
If there was no way to significantly affect the share of the pie going to the bottom 30%, the most
important thing was to grow the pie. (Therefore, growth was not a passive, trickle-down strategy;
it was an active, pull-up strategy)
NB: Fallacy of aggregation! Globalisation does not have to come with both trade liberalisation and
financial liberalisation. While trade liberalisation may benefit an economy greatly, the reckless
freeing up of capital may be far more detrimental.
Greshams Law: Bad money drives out the good (especially when the exchange rate is fixed)
The reason why capital inflows are tricky is simply because when confidence is shaken, the fact that
the situation is inherently one of imperfect information implies that the actions of a few can initiate
herd action by others (Bhagwati)
The Economist: It seems natural to suppose that what goes for trade in goods must go for trade in
capital, in which case capital controls would offend us as violently as say, an import quota on
bananas. The issues have much in common, but they are not the same. Untidy as it may be,
economic liberals should acknowledge that capital controlsof a certain restricted sort, and in
certain caseshave a role.
Asian Financial Crisis highlights the potential vulnerabilities from unfettered financial liberalization,
and overexposure to hot money. The IMFs unrealistic demands for austerity helped to prolong and
worsen Indonesias recession (-13%), and when the Suharto government could not meet
requirements, investors panicked even further. Mahathir, on the other hand, ignored the IMFs
recommendations, and to its horror, imposed short-term capital controls. To its even greater
horror, Mahathirs capital controls were successful, and in 2002 the IMF changed tact and admitted
that capital controls might be necessary in times of severe panic
However we must not forget that the Asian economic miracle can be largely attributed to trade
liberalization in the first place. Significantly, after the AFC, countries did not close themselves off
from trade, but instead liberalized further and embarked on greater efforts at regional cooperation
e.g. ASEAN+3, Asian Development Bank, ASEAN Finance Ministers Work Plan
Terms of Trade between the Uruguay Round and 1995 establishment of the WTO saw the net effect
of tariff reductions to lower the prices some of the poorest countries in the world received relative
to what they paid for the imports (Stiglitz) Failure of negotiations at Cancun, Mexico further
demonstrate the developing nations lack of bargaining power.
Currently, however, developing countries are growing at much faster rates (10%) than the stagnating
rich world. Productivity in the developing world is rising significantly, boosted by technology and
globalisation. In 2002-08 more than 85% of developing economies grew faster than Americas,
compared with less than a third between 1960 and 2000, and virtually none in the century before
that. (The Economist)

Other issues:
Poverty
Free trade results in concentrated costs to competitors, but creates diffuse gains for millions of
workers in China and India
Opening up the Jamaican milk market to US imports in 1992 may have hurt local dairy farmers, but it
also meant poor children could get milk more cheaply (Stiglitz)
Sweatshops: Working in a dark, cramped factory is often better than slaving over backbreaking farm
work in the sweltering sun
Inequality
Globalisation may have increased the gap between skilled and unskilled workers, but it has reduced
wage differentials by gender, race, and citizenship. Bhagwati: The women and children who
returned to Japan became agents for change Women working in Bangladeshi garment factories
were provided with a degree of autonomy, self-respect, and freedom from traditional gender work
Munch and Skaksen (2008) find that wages are higher in Danish firms with high export
intensity and highly educated workers but lower in high-export-intensity Danish firms with workers
who have lower levels of education.
Schank et al. (2007) estimate separate regressions for blue-collar and white-collar German
manufacturing workers while controlling for a range of individual characteristics including age,
gender, level of education, and nationality. In contrast with much of the other literature, they find a
higher export wage premium for blue-collar workers than for white-collar workers.
Moser and Urban find that there is a significant export wage premium for workers in the two highest
skill categories and evidence of an export wage discount for lower-skilled workers. Their research
shows that the links between trade and inequality are subtle. An increase in the average export
share of the German economy raises wage inequality along the dimension of skill. But this same shift
in the economic profile of the economy lowers wage inequality along the dimensions of gender and
citizenship.
Lester Thurow in The Future of Capitalism (1996, pp. 69, 70) explains the "theory of comparative
advantage" and describes the assumptions required for it to hold:
"The classical theory of comparative advantage is often taught as if everyone benefits from trade. Technically
that is not true. The total income of every country that takes advantage of comparative advantage grows, but
there will be individuals within each country who lose. What the theory holds is that those who gain from
international trade receive enough extra income from their activities that they could compensate those who lose
when international trade commences. If that compensation isn't actually paid (and it almost never is), then those
who lose are quite rational to oppose international trade.
"But in the classical theory the losses usually will be quite small. First, full employment is assumed to exist.
Free trade does not push anyone into unemployment. Second, transition costs are assumed to be zero. There is
no region-, industry-, or firm-specific physical or human capital that is destroyed when workers are forced to
shift between regions, industries, or firms. Third, returns are assumed to be everywhere equal. Each industry has
the same rate of return on human or physical capital. Each firm and industry pays the same wage rate for a
worker's being willing to give up an hour of leisure. As a consequence, being forced to shift jobs doesn't change
wages very much, if at all."
Possible democratic deficit
Ann Pettifor: Globalisation has undermined democracy by making leaders accountable to nameless
Washington-based institutions rather than their own people
Bhagwati: Globalisation promotes democracy while constraining it at the same time
E.g. ITTs intervention in overthrowing Salvador Allende; United Fruit Company lobbied for the US
government to force Colombia to grant Panama independence even though it wasnt ready
- Guerillas in the Philippines were provided jobs by World Bank financed projects as they laid down
their arms (Stiglitz)
Technology
FDI provides access to technology: e.g. Japan forced IBM to share technology with local Jap firms in
return for market access
Intellectual Property rights
- Incentive to innovate; without IP rights, companies would not be able to make profits, and
thus would not develop the drugs in the first place
- However Stiglitz argues that the increased profits from sales in the developing world was
small, since few could afford the drugs, making the incentive effect limited. In the case of
AIDS, the fact that thousands were effectively condemned to death sparked international
outrage and forced drug companies to agree to sell the drugs at cost in 2001.

NB: Globalisation is not a new phenomenon.
Keynes (1919): What an extraordinary episode in the economic progress of man that age was which
came to an end in August 1914! The inhabitants of London could order by telephone, sipping his
morning tea in bed, the various products of the whole earth, in such quantity as he might see fit, and
reasonably expect their early delivery upon his doorstep
Transitions to market economies
Importance of managed transitions to market economieswhile in 1990 Chinas GDP was 60% that
of Russias, by the end of the decade the numbers had been reversed (Stiglitz). While Russia saw an
unprecedented increase in poverty, massive capital flight, and asset stripping, China managed to pull
over 800 million people out of poverty and gradually liberalized sectors (Special Economic Zones)
while maintaining political stability by using existing institutions (Town and Village Enterprises)


Behaviour of firms
Strategic competition
- Making credible early commitments to enter the market, or dropping out if it becomes
convinced that the other firm will enter
- Signalling:
o Investing in capacity it doesnt need to convince rivals that they will face a price war
if they challenge its position
o Charging a lower price than the market will bear, to signal to rivals that its costs are
too low for them to challenge
- Klemperer (1987): Large switching costs
- Fudenbergs Fat Cat (1986): a firm that invests in goodwill (out of advertising) to its
customers, and thus consumers will not switch
- Advertising to raise entrants sunk costs of entry (Farrell 1986)

Bureaucratic power
JKGs Economics and the Public Policy discusses the unequal deployment of power in the
corporation, and argues that the quality of life would suffer with bureaucratic power as the decisive
force in economic and political life.
Organization goes hand in hand with technological advance
The management of equipment requires specialists and more organization

Decisions to save and invest are concentrated at the hands of a few thousand firms
If investment is insufficient, the system will be subject to a downward spiral of prices

As income increases, needs continue to preempt all energy and eliminate all choice. This is the
artifice of the planning system

The prime purpose of improving income should be to increase the no of ppl who are removed from
the pressures of physical need or its equivalent and who are able, in consequence, to exercise choice
as to their style of economic life

Self-exploitation: workers may end up working for less than the economy usually pays for such effort
due to his lack of economic power
We only need look at IBM, Microsoft, Kodak and Fuji, the Wellcome Foundation in drug
research etc. to find evidence of large firms investing much more in R&D. Evidence from the
US in 1988 showed only 7% of manufacturing firms employing less than 1000 workers had a
formal R&D programme compared to 91% of large firms with >25000 employees.
However lest we get carried away on a wave of oligopoly enthusiasm evidence from John
Jewkes et al demonstrates how less than half of the most important inventions this century
came from the laboratories of large firms.

Efficiency
Tobin The most difficult issues of public policy are those where the goals of equality, freedom of
choice and efficiency conflict.
Okun You cannot have your market efficiency and distribute it fairly.
Kaldor-Hicks : if the amount that winners gain is more than sufficient to compensate losers, or the
amount that losers are willing to pay is less than what winners are willing to accept
However it does not take into account whether the compensation is actually paidthis is seldom the
case
Also it assumes constant marginal utilitybastardising Benthamite utilitarianism
John Rawls theory of justice (each person has an equal claim to basic rights and liberties, and that
inequality should only be permitted to the degree that it helps the people on the bottom)
Nozicks entitlement theory (justice in acquisition, transfer, redressing injustice. historical basis for
claims)
Amartya Sen: governments need to develop peoples capabilities
"Justice," Sen writes, "is ultimately connected with the way people's lives go, and not merely with
the nature of institutions surrounding them."
Arrows impossibility theorem: No voting system can represent all the preferences of individuals if
there is non-dictatorship, irrelevance of independent alternatives, and an unrestricted domain
Social welfare function is either democratic or consistent
i.e. voting systems are not fair. Game theory might be used to predict outcomes.


Inequality
Lipsey: Governments run into trouble when they try to eliminate equilibrium differentials, i.e. wage
differentials that arise out of differences in ability or skill
In Britain the richest 10% of the population are more than 100 times as wealthy as the poorest 10%
of society
Emmanuel Saez found that in 2007 the top .01 percent of American earners took home 6 percent of
total U.S. wages, a figure that has nearly doubled since 2000.
2007, the top decile (10%) of American earners, Saez writes, pulled in 49.7 percent of total wages, a
level that's "higher than any other year since 1917 and even surpasses 1928, the peak of stock
market bubble in the 'roaring" 1920s.'"
The top 1 percent incomes captured half of the overall economic growth over the period 1993-
2007," Saes writes.
Inequality contributed to the Great Recession
- Middle class incomes stagnated, higher demand for debt
- Richest ppl sought higher returns for their savings
- Poorest have highest MPC but their real incomes rose much less
Robert Frank: Expenditure cascade
'Even if envy and jealousy were non-existent, there would still be perceptions of quality that depend
on context. And so everybody would have a tendency to spend more when others spend more.
'When everybody spends more on high quality things, the things that used to seem high quality
don't seem so any more.'
Before 1991, elite American universities agreed among themselves not to compete for the best
students through merit-based scholarships in order to channel their money to truly needy students.
But the US Justice Department charged them with violating anti-trust legislation, prompting them to
end such cooperation. What ensued was a free for all as universities tried to match each other's
scholarship offers to attract the highest-scoring students, which drained funds available for financial
aid
However, Bhagwati: The preoccupation with inequality measures is ludicrous unless the economist
has bothered to put them into social and political contextInequality might be paradoxically
benign, if the extremely rich, such as Bill Gates, spend more money on the social good


The Tragedy of the Commons
The commons is a term for a shared resource in which stakeholders have equal interest
Common-pool resources (CPRs) are natural or human-made resources where one person's use
subtracts from another's use and where it is often necessary, but difficult and costly, to exclude
other users outside the group from using the resource.
- Acting in self-interest
- Externality
- Dominant strategy
- Deplete common pool resource
E.g. Overfishing or global warming
Coase Theorem
- Allocate property rights
o Private bargaining e.g. radio frequency
- Zero transaction costs (Coase: nothing further from the truth)
o Search, bargaining, policing and monitoring costs
o E.g. Paying Indonesians to stop slash-and-burn
- Property rights may not be well-defined
- Incentive to lieunderdeclare or overdeclare costs
o Possible solution: pay what the other person bargains, e.g. if you value it at $8, you
would hope that your partner wins if the bid was more than $8, and hope that your
partner loses if the bid is under $8
- Tragedy of the Anticommonsunderusage or overusage of resources e.g. Singapore, kids
cannot play football
- Property rights lie at the heart of our market need to define property rights in places like
China and India
Tragedy of the Anticommons (Michael Heller): underutilisation of resources because of numerous
right holders
Elinor Ostroms governing the commons
People are trapped by the Prisoner's Dilemma only if they treat themselves as prisoners by
passively accepting the suboptimum strategy the dilemma locks them into, but if they try to
work out a contract with the other players, or find the ones most likely to cooperate, or
agree on rules for punishing cheaters, or artificially change the incentive ratios - they can
create an institution for collective action that benefits them all. This resonates with Peter
Kollock's taxonomy of strategies for dealing with social dilemmas - one strategy is to change
the rules of the game.
Changing the rules of the game to turn zero-sum games into non-zero-sum games:
Groups can create contracts, agreements, incentives, constitutions, signals, media to enable
cooperation for mutual benefit.
However there may be a lack of information about the system.
o E.g. In water-sharing agreements in California, individual water-users knew whether
their wells were pumping salt, but none of them knew the overall pattern in the
watershed, and no one was willing to pay the price of gathering it.
In this case, the US Geographic Survey had the data, thus overcoming this obstacle.
Another obstacle is free-riding
In comparing the communities, Ostrom found that groups that are able to organize and
govern their behavior successfully are marked by the some basic design principles:
o Group boundaries are clearly defined.
o Rules governing the use of collective goods are well matched to local needs and
conditions.
o Most individuals affected by these rules can participate in modifying the rules.
o The rights of community members to devise their own rules is respected by external
authorities.
o A system for monitoring member's behavior exists; the community members
themselves undertake this monitoring.
o A graduated system of sanctions is used.
o Community members have access to low-cost conflict resolution mechanisms.
o For CPRs that are parts of larger systems: appropriation, provision, monitoring,
enforcement, conflict resolution, and governance activities are organized in multiple
layers of nested enterprises.

Studied management of pastures in Africa and irrigation systems in Nepal
The Great Recession
David Blanchflower:
Past recessions may have led to adverse effects on the supply potential of the
economy. Long-term unemployment, particularly at a young age, is damaging to
future labour market prospects both for the individuals involved and the economy as a
whole. Workers may lose their skills, causing a loss of human capital. High rates of
unemployment may mean there is a mismatch between those skills that workers
possess and those for which there is demand within the economy. People may also be
less likely to participate in the labour market the longer their spell of unemployment
persists.

Sustained unemployment while young, especially of long duration, has particularly
nasty effects. By preventing labour market entrants from gaining a foothold in
employment sustained youth unemployment may reduce their productivity. A range
of evidence indicates those that suffer youth unemployment have lower incomes and
poorer labour market experiences decades later4. These are important lessons for any
measures that may be taken to address higher unemployment in the near future.
Krugman: "We weren't supposed to find ourselves in this situation. For many
years most economists believed that preventing another Great
Depression would be easy... It turns out, however, that preventing
depressions isn't that easy after all..... Friedmans claim that monetary
policy could have prevented the Great Depression was an attempt to
refute the analysis of John Maynard Keynes, who argued that monetary
policy is ineffective under depression conditions and that fiscal policy
large-scale deficit spending by the government is needed to fight
mass unemployment. The failure of monetary policy in the current
crisis shows that Keynes had it right the first time".

Some economists have celebrated the triumph of economic theory in modern
macroeconomic research.
Over the last three decades, macroeconomic theory and the practice of
macroeconomics by economists have changed for the better.
Macroeconomics is now firmly grounded in the principles of economic
theory. Chari and Kehoe (2006).