Laws are ink on paper

Laws are ink on paper, as argued by the chief economist of the World Bank, Kaushik Basu. What he means is that the fact that laws prescribe something does not automatically change the incentives of agents affected by the law. To be effective, laws must be enforced, and the enforcers must find it in their interest to apply the law. At most, laws can be focal points that make it possible for individuals to coordinate around one particular course of action among many. But in general there is no guarantee that individuals will coordinate around a legal focal point as opposed to some other focal point, arising for example from tradition or from violence. Important institutions may be formal as well as informal, as it has been argued by institutional economists such as North, Greif or Aoki. The latter has been the one that has most emphasized the importance of words, in the sense that words facilitate the cognitive salience of features of institutions that sustain individuals' beliefs. The relationship between institutions, laws and language has also been stressed by the philosopher John R. Searle, for example in his book "Making the Social Order. The Structure of Human Civilization." In practical terms, in my view the lesson of this is that it is very incomplete to suggest policy reforms that are merely based on legislative changes, which has implications for issues such as political reform, the fight against corruption or the legal creation of new institutions.

It is hard to be Swedish

A group of American and Swedish economists lead by Harvard professor Richard B. Freeman published in 2010 an analysis of the reforms undertaken by Sweden to recover from an acute financial crisis in the early 1990s. Against all forecasts, these reforms were rapidly successful, and allowed Sweden to recover the balance in the public accounts, to increase productivity and to rapidly restart economic growth, at the same time as keeping a large welfare state and high fiscal pressure. Many of these reforms included short term painful measures such as reducing the benefits of unemployment insurance and the pension system. Perhaps the most important lesson for other countries from the Swedish experience is that it isn’t easy to be Sweden, or as the economists like to say, there is no free lunch. But the experience proves that it is possible to fight against a financial crisis and at the same time keep intact the essence of the welfare state and the institutions that make it possible to fight poverty and inequality. Sweden was helped by the fact that it had its own currency (which was left to free float) and by economic growth of its main trading partners, but many of the reforms had to do with policies that can be implemented by any country, and that try to find the best combination of economic efficiency and social justice. Not by coincidence, Nordic countries, having been exposed to social democratic policies for decades, are at the top in the rankings for income per capita, income distribution, low corruption, respect for the environment and many other good things. The challenge is to apply the same principles and similar policies to societies that are larger and less homogeneous. It will not be easy, but there is no better example to follow.

The multiplier exists

I taught a three hour lecture on introductory economics to journalism students last Friday. Besides being a great pleasure (why do they call it teaching “load”?), the lecture included explaining to prospective journalists the meaning of the “multiplier”. As textbook, we used the updated version (in its Spanish translation) of Krugman, Wells and Graddy. By the multiplier, when government spends 1 euro in public investment, this has an impact on the gross domestic product (the value of production, which is the same as income) of more than one euro. Why is that? Because this euro produces by itself some good of service (which is part of GDP), but it also goes to the pocket of someone (a public sector worker, for example), who spends it in part (depending on the ratio of income that is spent and saved) on some good or service. This also goes to the pocket of someone, who also spends a fraction of it, and so on. Conversely, when government cuts spending by one euro, this has a more than one euro impact in the reduction of GDP. Of course, the cost of public spending is that taxation is usually distortionary, or that high debt has economic costs. It is then an empirical issue to compare the effects of increasing or not reducing public expenditure with the costs of taxation of debt. But it is official (at least in the textbooks, that is, it is also the orthodox thing): the multiplier does exist. I finished by recommending to my students that they read the recent article by Paul Krugman in the NewYork Review of Books on the promoters of austerity who decided to forget about the multiplier.

Problems with cost-benefit analysis

As previously pointed out in this blog, experts and policy makers have their own biases. French scholars Yolande Hiriart and David Martimort explore these biases (in the field of risk regulation) in a forthcoming article in Annales d’Economie et Statistique. The study of these biases is a crucial ingredient of the current debate about the limits of technocracy. The article also includes interesting thoughts about the limits of cost-benefit analysis as it is usually performed. This type of analysis does not take information rents into account, that is, the rents that are necessary to induce the revelation of private information by firms involved in public projects, for example in the context of public-private partnerships. The presence of these rents requires the introduction of distributive criteria, which contradicts the exclusive use of efficiency criteria and the isolated analysis of projects. The isolated analysis of efficiency also tends to ignore issues related to dynamic learning in the public sector and in democratic societies, which may be more important than the strict optimality of a given project, according to the theses of “pragmatism” espoused by the American philosopher John Dewey. This criticism seems to go beyond the criticism raised by environmental groups against cost-benefit analysis for not giving enough weight to catastrophic states of the world even when these have low probability, but in my view it also suggests that cost-benefit analysis should be expanded to take into account all these considerations, rather than be abandoned.

Public Private Partnerships: the web

The web on PPPs of the Public-Private Sector Research Centre of the IESE business school is now public. A great deal of information on centres, publications and research tools on this important topic can be found in it. These partnerships are acknowledged to be an important source to improve the efficiency of public services, especially when they are combined with an infrastructure. Since private incentives work better in projects with a low number of dimensions, private operators can be focused on specific projects for a given time period under the control of public objectives. This tends to work better than full blown privatization. Of course, PPPs are no panacea, and they must be well designed and regulated, and they must avoid the risk of unfair and inefficient renegotiations. An important problem with them is the existence, potential or suspicion of corruption, as was explained yesterday by Elisabetta Iossa in an interesting workshop on this topic at IESE.

Easter Island as a metaphor

I started reading the papers and books by Jared Diamond as a result of his review of “Why Nations Fail,” the book by Acemoglu and Robinson. Since then, I read his most recent book, “The World Until Yesterday” (about what we can selectively learn from primitive societies) and now I’m reading the previous one, "Collapse." The latter contains a chapter about the environmental (complete deforestation) and social collapse (leading to violent changes of leadership and cannibalism) of Easter Island prior to the arrival of expeditions from European origin. This Pacific island had the worst geographic conditions in terms of those that facilitate overuse of natural resources. Although the deep reasons of the collapse are geographical (enormous physical distance from other societies, temperature, soil conditions), the irreversible decline was accompanied by destructive competition among clans (which led to the construction –requiring the employment of huge amounts of resources- of those ever bigger giant sculptures, or moais). Diamond notes that there is a potential metaphor about the likely fate of our planet, which cannot rely for help from other civilizations. I note another interesting analogy: worsening environmental conditions coincided with identity wars and social disruption. Social, environmental and “national” issues cannot be artificially separated.