Monday, May 4, 2009

Incentives matter. That is central to economics. It also is important for political economy

TO BE NOTED: From EconLog:

More Thoughts on Masonomics
Tyler and Alex have new textbooks on micro and macro. Both begin with the same anecdote.

In 1787, the British government had hired sea captains to ship convicted felons to Australia...On one voyage, more than a third of the males died and the rest arrived beaten, starved, and sick...

Instead of paying the captains for each prisoner placed on board ship in Great Britain, the economist suggested paying for each prisoner that walked off the ship in Australia. In 1793, the new system was implemented and immediately the survival rate shot up to 99 percent.

That is economics on one foot--incentives matter.

What to do, then, about macroeconomics? In crude Keynesian economics, incentives do not matter. Consumption depends on income, investment depends on animal spirits, and prices have no impact. Much of the post-Keynesian synthesis has been devoted to bringing incentives back into the picture. The results have satisfied neither hard-core microeconomists nor hard-core Keynesians. Tabarrok and Cowen devote some space to Real Business Cycle theory, which is all about incentives. They also devote some space to the sticky-price version of New Keynesianism, in which incentives are combined with imperfect price flexibility.

I think a more promising approach is to look at the macroeconomic impact of signaling. Workers view wage rates as signals of their employer's long-term commitment to their welfare. Thus, a wage cut is a particularly negative signal, and it is difficult to cut wages in a downturn without causing major problems. See Lectures on Macroeconomics, number 4.

Also, as I have been arguing in recent posts, financial markets depend crucially on signaling. Perfect transparency in financial intermediation is impractical--if you can see through the intermediary you could have done without the intermediary and invested yourself. Thus, investorrs necessarily rely on signals when dealing with financial intermediaries. Under those circumstances, it is easy for confidence to fluctuate. We saw in recent years that there was extreme over-confidence in the financial engineering related to home mortgages. Now that confidence is gone. When confidence is high, financial intermediaries enlarge their balance sheets and economic activity expands. See lecture number 9.

So, here are some thoughts on Masonomics in general.

1. Incentives matter. That is central to economics. It also is important for political economy--Masonomics uses public choice, which says that government officials, rather than acting as benevolent omniscient stewards, respond to incentives.

2. Signaling matters. It matters in education, health care, finance, politics, marketing, and personal relationships. I would suggest that if there is to be a Masonomics perspective on macro, then signaling should be central.

3. Institutions matter. Formal and informal rules shape economic behavior, for better or worse. For example, differences across countries in the standard of living are determined largely by institutions.

4. Evolution matters. When others see a lack of planning or central direction as chaos, Masonomists see Hayek's spontaneous order. A system of decentralized trial-and-error decisions works better than many people realize. Central regulation works less well than many people expect."

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