Democracies and debt: Voters are now facing a harsh truth

Economist
September 1, 2012

Almost half the world’s population now lives in a democracy, according to the Economist Intelligence Unit, a sister organisation of this newspaper. And the number of democracies has increased pretty steadily since the second world war. But it is easy to forget that most nations have not been democratic for much of their history and that, for a long time, democracy was a dirty word among political philosophers.

One reason was the fear that democratic rule would lead to ruin. Plato warned that democratic leaders would “rob the rich, keep as much of the proceeds as they can for themselves and distribute the rest to the people”. James Madison, one of America’s founding fathers, feared that democracy would lead to “a rage for paper money, for an abolition of debts, for an equal division of property and for any other improper or wicked projects”. Similarly John Adams, the country’s second president, worried that rule by the masses would lead to heavy taxes on the rich in the name of equality. As a consequence, “the idle, the vicious, the intemperate would rush into the utmost extravagance of debauchery, sell and spend all their share, and then demand a new division of those who purchased from them.”

Democracy may have its faults but alternative systems have proved no more fiscally prudent. Dictatorships may still feel the need to bribe their citizens (eg, via subsidised fuel prices) to ensure their acquiescence while simultaneously spending large amounts on the police and the military to shore up their power. The absolute monarchies of Spain and France suffered fiscal crises in the 17th and 18th centuries, and were challenged by Britain and the Netherlands which, though not yet democracies, had dispersed power more widely. Financial problems contributed to the collapse of the Soviet Union.

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How to reduce high incarceration rates

by Ben Vollaard

Vox
August 24, 2012

How to reduce incarceration rates without fuelling a crime boom? This column argues that by being more selective over whom to lock up and for how long, scarce public funds can be put to better use.

Incarceration is costly – easily €100 to €200 per night per prisoner, depending on the country and the prison regime. That makes €36,500 to €73,000 per prisoner per year, excluding fixed costs of building prisons, and all other costs such as time not spent at work or with the family.

Given the pressure on government budgets, many states and countries are looking into reductions in prison expenditures. The short-term solution is to reduce the number of prisoners by way of early release. The longer-term solution is to change sentencing policy. This is all easier said than done, however, given public concerns about the effect of lower incarceration rates on crime. Incarceration also provides important benefits to society after all, including deterrence (Durlauf and Nagin 2011) and incapacitation (Owens 2009) of offenders.

We argue that a reduction in the number of inmates taxes these benefits of incarceration the least if it happens selectively. Being more selective in whom to incarcerate for how long puts scarce public resources to their best use.

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What explains political institutions? Evidence from colonial British America

by Elena Nikolova

Vox
August 17, 2012

Why do some states develop as democracies while others remain authoritarian? The question continues to puzzle social scientists. This column presents new data from 13 British American colonies from before the American Revolution. It shows that democratic institutions had a lot to do with the need to attract workers.

Under what circumstances do democratic as opposed to authoritarian institutions emerge? Although a large literature has tackled this question (see Acemoglu et al. 2001, Acemoglu and Robinson 2012, Engerman and Sokoloff 2000), we still have an imperfect knowledge of how representative institutions originate and change. Political institutions are difficult to study not only because they are usually endogenous to other variables, such as inequality, culture, or geography, but also because institutional change is rare or may happen very gradually.

In a recent paper (Nikolova 2012), I argue that institutional change depends on labour market conditions: elites opt for liberal representative institutions when labour is scarce, and vice versa. I use a unique data set covering a period of relatively rapid change in representative institutions in the thirteen British American colonies from their very establishment to the American Revolution. In contrast to theories arguing that inequality is the primary determinant of the quality of political institutions (Boix 2003, Acemoglu and Robinson 2005), I show that liberal representative institutions may arise even in cases of high inequality, as the positive impact of labour scarcity outweighs the usual negative relationship between inequality and democracy. The relative fluidity of political institutions in this setting and time period also questions the validity of arguments linking institutions to historical persistence. In terms of implications for contemporary countries, the theory predicts that as autocratic regimes – such as China – face more binding labour constraints, democracy will be more likely to emerge.

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What determines democracy? And what helps to maintain it?

by Martin Gassebner, Michael J. Lamla and James Raymond Vreeland

Vox
August 11, 2012

Will democracy establish itself in the Middle East? This column looks at what is needed to start democracies are what is needed to keep them going. It argues that that it is the level of economic development – not short-run economic growth – that is needed for democracy to survive.

Democracy is on the move in the Arab world. Whether democratic regimes will emerge and survive remains an open question, and the intense media coverage of the Arab Spring has revived public interest in the determinants of democracy. The quest to understand why democracy emerges and survives, however, has long been on the agenda of economists and political scientists.

Scientific findings suggest that life is better with more democracies in the world. People living under democracy have higher incomes and tend to enjoy more human rights than people living under authoritarian regimes (Hathaway 2003). Democracies also don’t go to war against each other, and make better trade partners (Russett and Oneal 2001).

So the promotion of democracy is laudable, but do we really know how to ‘cause’ democracy? Scholars have proposed and empirically tested many theories. Yet, no conclusive picture has emerged. Moreover, it is not clear whether the same set of variables that drives the democratisation process also guarantee its sustainability.

Economic explanations of democracy date back to Lipset (1959) who is often cited as father of 'modernisation theory'. The theory contends that as countries develop economically, social structures become too complex for authoritarian regimes to manage. At some point, dictatorship collapses and democracy emerges as the alternative. Przeworski et al. (2000) contend, however, that the emergence of democracy is random with respect to economic development. The correlation between development and democracy is driven instead by the survival of democracy. Przeworski (2005, 253) argues that "democracy prevails in developed societies because too much is at stake in turning against it." Conversely, in poor democracies, "the value of becoming a dictator is greater and the accumulated cost of destroying capital stock is lower" (Przeworski and Limongi 1997, 166). So democracy emerges idiosyncratically, but it survives in countries with high levels of economic development.

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Why the Dismal Science Deserves Federal Funding

by Gary S. Becker and James J. Heckman

Wall Street Journal
August 10, 2012

The federal deficit has ballooned in recent years, and even larger deficits are coming due to the expected growth of entitlement spending. There is little disagreement among members of both political parties that federal spending should be reduced. In such an environment it is crucial that the right criteria guide the cuts that will be made. Across-the-board cuts are not a thoughtful way to make choices.

The guiding principle is basic and obvious: We should cut federal government activities that can be performed at least as well by the private sector, and maintain, or even increase, productive federal activities that the private sector alone cannot handle effectively. There is legitimate disagreement about which activities belong in which category, but the great majority of economists have long agreed that the federal government should have an important role in the sponsorship of basic research. For-profit companies have weak incentives to invest in basic research partly because the results are not patentable, and partly because the culture of basic researchers, and the journals they publish in, makes the results of basic research available to all.

For these reasons the U.S. government has long played a leading role in supporting research in physics, chemistry, biology and medicine, and to a smaller extent in economics and other social sciences. It has also played a leading role in creating objective databases on which to make wise policy. This research and data have paid great dividends in helping to provide a better understanding of DNA, genetics and the human genome, and many other phenomena crucial to the modern world.

Indeed, the remarkable growth in life expectancy in the developed world in the past 60 years has been the result of the combined efforts of federally supported basic researchers at universities and elsewhere, and applied researchers in for-profit drug and biotech companies, and nonprofit institutes.

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The Perfect Non-Crime

by Michael L. Rich

New York Times
August 6, 2012

Even if we could make it impossible for people to commit crimes, should we? Or would doing so improperly deprive people of their freedom?

This may sound like a fanciful concern, but it is an increasingly real one. The new federal transportation bill, for example, authorized funding for a program that seeks to prevent the crime of drunken driving not by raising public consciousness or issuing stiffer punishments — but by making the crime practically impossible to commit. The program, the Driver Alcohol Detection System for Safety (Dadss), is developing in-vehicle technology that automatically checks a driver’s blood-alcohol level and, if that level is above the legal limit, prevents the car from starting.

The Dadss program is part of a trend toward what I call the “perfect prevention” of crime: depriving people of the choice to commit an offense in the first place. The federal government’s Intelligent Transportation Systems program, which is creating technology to share data among vehicles and road infrastructure like traffic lights, could make it impossible for a driver to speed or run a red light. And the Digital Millennium Copyright Act of 1998 has already criminalized the development of technologies that can be used to avoid copyright restrictions, making it effectively impossible for most people to illegally share certain copyrighted materials, including video games.

Or consider a more speculative scenario: some pharmaceuticals show the promise of blunting the “high” of cocaine use or reducing antisocial thoughts of the sort that often lead to crime. Widespread dissemination of such drugs — say, putting them in the public water supply — could make some crimes impossible by eliminating a potential offender’s desire to commit them.

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Scott Menchin

China's Growth: Planning or Private Enterprise?

by Paul Gregory

Library of Economics & Liberty
August 6, 2012

Introduction

China appears to have come through the world economic crisis better than many other countries. China's admirers claim that, under China's "state capitalism," planners have guided large state companies rationally and wisely through the rough seas of the world economy. The Chinese Communist Party (CPC) plans, oversees, and administers the interwoven network of state banks, airlines, railroads, utilities, oil companies, and large manufacturers, all of which make up the economy's "commanding heights" (to use Lenin's term). As Europe and the United States slump, the CPC can speedily launch infrastructure projects or shift millions of migrant workers from one locality to another. There is no messy democracy to gum up the works. New York Times columnist Thomas Friedman extols: "A one party system can just impose the politically difficult but critically important policies needed to move a society forward in the 21st century."

But Ludwig von Mises in the 1920s and F. A. Hayek in the 1930s discredited the idea that planners can manage an entire economy. Hayek pointed out that central planners lack "the knowledge of the particular circumstances of time and place." Because the planners do not have the information that rests with hundreds of thousands of companies and millions of consumers, planning fails, as it did spectacularly in the Soviet Union. Interestingly, even socialist economist Robert Heilbroner admitted as much. China is not an exception. Its economic growth has occurred despite the government's economic planning and because of its large, dynamic private sector.

China's Economic Growth

As Figure 1 shows, China's Gross Domestic Product grew from 1979 to the present at an average of slightly over 8.5 percent per annum. Although Japan and the Four Tigers (Hong Kong, Singapore, South Korea, and Taiwan) matched that growth rate at various points in the past, more than thirty years of such high growth is unique. The CPC would like us to believe its growth is due to its peculiar brand of socialism with a Chinese face. In fact, what deserves credit is the entrepreneurship of the Chinese people.

Figure 1. China's Growth Rate of GDP, 1983-2011

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What If Jurors Don’t Understand Standards of Evidence?

A scene from Twelve Angry Men

by Christopher Shea

Wall Street Journal
August 3, 2012

“Beyond a reasonable doubt,” a “preponderance of evidence”: Forests of trees have been sacrificed as judges and lawyers have hammered out the standards for evidence that should apply in different types of cases. The trouble is, as a new study demonstrates, in many instances it’s ultimately up to laypeople on juries to apply those standards. And ordinary people may not grasp the distinctions lawyers place so much weight on:

Three standards—preponderance of evidence, clear and convincing evidence, and beyond a reasonable doubt—are used by different jurisdictions in trials involving liability for punitive damages. We investigated whether individual mock jurors apply these standards appropriately by instructing them to read two personal injury trial summaries and to use one of three standards in either qualitative or quantitative format when deciding punitive liability. Results showed that jurors tended not to incorporate the standard into their judgments: defendants were just as likely to be found liable when the plaintiff’s burden was high (“beyond a reasonable doubt”) as when the burden was low (“preponderance of evidence”). The format of the instruction also had a negligible effect. We suggest that nonuse of the standard of proof is related to jurors’ preferences for less effortful or experiential processing in situations involving complicated or ambiguous material.

That last sentence sounds like a polite way of saying: If the question is too complicated, jurors wing it. Or, as the authors put it, in the conclusion of their paper, “[J]urors’ judgments in civil cases involving punitive damages may be influenced by their biases and commonsense interpretations of the law.”

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The Bad History Behind ‘You Didn’t Build That’

by Virginia Postrel

Bloomberg
August 3, 2012

The controversy surrounding President Barack Obama’s admonishment that “if you’ve got a business -- you didn’t build that. Somebody else made that happen” has defied the usual election-year pattern.

Normally a political faux pas lasts little more than a news cycle. People hear the story, decide what they think, and quickly move on to the next brouhaha, following what the journalist Mickey Kaus calls the Feiler Faster Thesis. A gaffe that might have ruined a candidate 20 years ago is now forgotten within days.

Three weeks later, Obama’s comment is still a big deal.

Although his supporters pooh-pooh the controversy, claiming the statement has been taken out of context and that he was referring only to public infrastructure, the full video isn’t reassuring. Whatever the meaning of “that” was, the president on the whole was clearly trying to take business owners down a peg. He was dissing their accomplishments. As my Bloomberg View colleague Josh Barro has written, “You don’t have to make over $250,000 a year to be annoyed when the president mocks people for taking credit for their achievements.”

Hectoring Entrepreneurs

The president’s sermon struck a nerve in part because it marked a sharp departure from the traditional Democratic criticism of financiers and big corporations, instead hectoring the people who own dry cleaners and nail salons, car repair shops and restaurants -- Main Street, not Wall Street. (Obama did work in a swipe at Internet businesses.) The president didn’t simply argue for higher taxes as a measure of fiscal responsibility or egalitarian fairness. He went after bourgeois dignity.

Bourgeois Dignity is both the title of a recent book by the economic historian Deirdre N. McCloskey and, she argues, the attitude that accounts for the biggest story in economic history: the explosion of growth that took northern Europeans and eventually the world from living on about $3 a day, give or take a dollar or two (in today’s buying power), to the current global average of $30 -- and much higher in developed nations. (McCloskey’s touchstone is Norway’s $137 a day, second only to tiny Luxembourg’s.)

That change, she argues, is way too big to be explained by normal economic behavior, however rational, disciplined or efficient. Hence the book’s subtitle: “Why Economics Can’t Explain the Modern World.”

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Robert D. Cooter & Hans-Bernd Schäfer, "Solomon's Knot: How Law Can End the Poverty of Nations"

Princeton University Press
August 2012

Sustained growth depends on innovation, whether it's cutting-edge software from Silicon Valley, an improved assembly line in Sichuan, or a new export market for Swaziland's leather. Developing a new idea requires money, which poses a problem of trust. The innovator must trust the investor with his idea and the investor must trust the innovator with her money. Robert Cooter and Hans-Bernd Schäfer call this the "double trust dilemma of development." Nowhere is this problem more acute than in poorer nations, where the failure to solve it results in stagnant economies.

In Solomon's Knot, Cooter and Schäfer propose a legal theory of economic growth that details how effective property, contract, and business laws help to unite capital and ideas. They also demonstrate why ineffective private and business laws are the root cause of the poverty of nations in today's world. Without the legal institutions that allow innovation and entrepreneurship to thrive, other attempts to spur economic growth are destined to fail.

Robert D. Cooter is the Herman F. Selvin Professor of Law at the University of California, Berkeley. His books include The Strategic Constitution (Princeton). Hans-Bernd Schäfer is professor of law and economics at the Bucerius Law School in Hamburg, Germany, and professor emeritus at the University of Hamburg. His books include The Economic Analysis of Civil Law.

Endorsements

Growth spurts that catapult a country or region to economic preeminence are fascinating but poorly understood. Cooter and Schäfer show that such spurts tend to track legal changes that facilitate the protection of property, the enforcement of contracts, and, most important, the launching of innovative business ventures. Consistently creative, insightful, and entertaining, Solomon's Knot makes a major contribution to the growing literature on the evolution of international differences in wealth."

Timur Kuran, Duke University

Cooter and Schäfer provide a thorough introduction to growth economics through the lens of law and economics. They do a masterful job of weaving in historical anecdotes from all over the world, detailed discussions of historical transformations, theoretical literature, empirical studies, and numerous clever hypotheticals. Scholars as well as general readers will find this book to be very useful and informative.

Henry N. Butler, George Mason University

Romney Hasn’t Done His Homework

by Jared Diamond

New York Times
August 1, 2012

Mitt Romney's latest controversial remark, about the role of culture in explaining why some countries are rich and powerful while others are poor and weak, has attracted much comment. I was especially interested in his remark because he misrepresented my views and, in contrasting them with another scholar’s arguments, oversimplified the issue.

It is not true that my book Guns, Germs and Steel, as Mr. Romney described it in a speech in Jerusalem, “basically says the physical characteristics of the land account for the differences in the success of the people that live there. There is iron ore on the land and so forth.”

That is so different from what my book actually says that I have to doubt whether Mr. Romney read it. My focus was mostly on biological features, like plant and animal species, and among physical characteristics, the ones I mentioned were continents’ sizes and shapes and relative isolation. I said nothing about iron ore, which is so widespread that its distribution has had little effect on the different successes of different peoples. (As I learned this week, Mr. Romney also mischaracterized my book in his memoir, No Apology: Believe in America.)

That’s not the worst part. Even scholars who emphasize social rather than geographic explanations — like the Harvard economist David S. Landes, whose book The Wealth and Poverty of Nations was mentioned favorably by Mr. Romney — would find Mr. Romney’s statement that “culture makes all the difference” dangerously out of date. In fact, Mr. Landes analyzed multiple factors (including climate) in explaining why the industrial revolution first occurred in Europe and not elsewhere.

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Regulation, Market Structure, and Role of the Credit Rating Agencies

by Emily McClintock Ekins and Mark A. Calabria

Cato Institute
Policy Analysis No. 704
August 1, 2012

During the financial crisis of 2008, the financial markets would have been better served if the credit rating agency industry had been more competitive. We present evidence that suggests the Securities and Exchange Commission’s designation of Nationally Recognized Statistical Rating Organizations (NRSROs) inadvertently created a de facto oligopoly, which primarily propped up three firms: Moody’s, S&P, and Fitch. We also explain the rationale behind the NRSRO designation given to credit rating agencies (CRAs) and demonstrate that it was not intended to be an oligopolistic mechanism or to reduce investor due diligence, but rather was intended to protect consumers. Although CRAs were indirectly constrained by their reputation among investors, the lack of competition allowed for greater market complacency. Government regulatory use of credit ratings inflated the market demand for NRSRO ratings, despite the decreasing informational value of credit ratings. It is unlikely that this sort of regulatory framework could result in anything except misaligned incentives among economic actors and distorted market information that provides inaccurate signals to investors and other financial actors. Given the importance of our capital infrastructure and the power of credit rating agencies in our financial markets, and despite the good intentions of the uses of the NRSRO designation, it is not worth the cost and should be abolished. Regulators should work to eliminate regulatory reliance on credit ratings for financial safety and soundness. These regulatory reforms will, in turn, reduce CRA oligopolistic power and the artificial demand for their ratings.

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It's Time To Break Up Massive Banks!

by Georg Mascolo

Spiegel
August 1, 2012

For decades, America's Glass-Steagall Act ensured a clean division of commercial and investment banking. But its repeal helped pave the way for the global financial crisis. Today politicians should restore the dual banking system to help ensure that banks that are too big to fail do not exist in the future.

The banks are blackmailing us, Sigmar Gabriel, the head of Germany's center-left Social Democratic Party wrote in a position paper for his party. But with the fuss over Gabriel's partly justified and partly exaggerated claim, one hopes that the most important words spoken last week will not get lost in the noise.

Those words were from Sandy Weill, who for eight years was the decisive figure at Citibank, the major American bank. This is the same Sandy Weill who forged a financial empire and successfully fought against just about every regulation that has been thrown at the banking sector. His message today? Split up the massive banks.

What Weill is calling for is a return to rules that already once served the world well. They were conceived during the 1930s financial crisis and then disposed of during the liberalization frenzy of the 1990s.

The Glass-Steagall Act is the name of the law that divided the banking world into two categories.

The first is banks that are dedicated to the classic business of managing customer deposits and issuing loans making them systemically relevant. These banks must be protected and, in an emergency, rescued by the state.

The second is investment banks, which too often have no problem at all with any risky business that comes its way as long as it promises to deliver profits. Weill believes that if things go awry at the investment banks that no one should be too quick to bail them out. These banks would be smaller and no longer the financial Goliaths that they are today. What is deemed too big to fail, would be deemed too large to even be allowed to exist in the future.

America, as well as the entire financial world, is discussing Weill's proposal.

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The Chicago Plan Revisited

by Jaromir Benes and Michael Kumhof

International Monetary Fund
Working Paper No. 12/202
August 1, 2012

At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher's claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.

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