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 ill-

informed 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-power-parity

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. Comparison of global slowdowns

6 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 risk-

taking; 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 house-

price 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,

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.

5 From The Economist print edition Jun 11th 2009

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 third-

generation 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.