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Home , Austerity, Economist, General glut, George Akerlof, Harry Gordon Johnson, Hyman Minsky

Economics briefs Six big ideas 2 Briefs The

Six big economic ideas

A collection of briefs on the discipline’s seminal papers T IS easy enough to criticise : too superior, too blinkered, too often Iwrong. , one of the discipline’s great figures, once lampooned asymmetry stockmarkets for predicting nine out of the last five . Economists, in 4 Secrets and agents contrast, barely ever see downturns coming. They failed to predict the 2007-08 ’s 1970 paper, . “The for Lemons”, is a foundation stone of information Yet this is not the best test of success. Much as doctors understand diseases but economics. The first in our series cannot predict when you will fall ill, economists’ fundamental mission is not to on seminal economic ideas forecast recessions but to explain how the world works. During the summer of 2016, ran a series of briefs on important economic that did just that—from the , a cornerstone of game , to the Mundell- Financial stability Fleming , which lays bare the -offs countries face in their manage- 6 Minsky’s moment ment of flows, exchange rates and monetary ; from the financial-in- The second article in our series stability hypothesis of to the insights of Samuelson and Wolfgang on seminal economic ideas looks at Stolper on trade and ; from ’s thinking on the fiscal Hyman Minsky’s hypothesis that to George Akerlof’s work on . We have assem- booms sow the seeds of busts bled these articles into this collection. The six breakthroughs are adverts not just for the of economics, but also Tariffs and wages for three other things: theory, maths and outsiders. More than ever, economics to- 8 An inconvenient iota of truth day is an empirical discipline. But theory remains vital. Many policy failures might The third in our series looks at the have been avoided if theoretical insights had been properly applied. The trilemma Stolper-Samuelson theorem was outlined in the 1960s, and the dates back to the 1930s; both

illuminate the current struggles of the zone and the sometimes self-defeating pursuit of . Nor is the body of economic theory complete. From “secular Fiscal multipliers stagnation” to climate change, the discipline needs big thinkers as well as big data. 10 Where does the buck stop? It also needs mathematics. Economic papers are far too formulaic; models Fiscal , an idea should be a means, not an end. But the symbols do matter. The job of economists championed by John Maynard is to impose mathematical rigour on intuitions about markets, and peo- Keynes, has gone in and out of ple. Maths was needed to formalise most of the ideas in our briefs. fashion In economics, as in other fields, a fresh eye can also make a big difference. New ideas often meet resistance. Mr Akerlof’s paper was rejected by several journals, one on the ground that if it was correct, “economics would be different”. Recogni- 12 Prison breakthrough tion came slowly for many of our theories: Minsky stayed in relative obscurity un- The fifth of our series on seminal til his death, gaining superstar status only once the financial crisis hit. Economists economic ideas looks at the Nash still tend to look down on outsiders. Behavioural economics has broken down equilibrium one silo by incorporating insights from psychology. More need to disappear: like

anthropologists, economists should think more about how individuals’ decision- making relates to social mores; like physicists, they should study instability instead The Mundell-Fleming trilemma of assuming that economies naturally self-correct. 14 Two out of three ain’t bad A fixed , monetary autonomy and the free flow of capital are incompatible, according to the last in our series of big economic ideas

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GRE-ad-NB-edits.indd 1 1/7/2016 4:44:53 PM 4 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

ers might struggle to tell the difference: scratches can be touched up, engine prob- lems left undisclosed, even odometers tampered with. To account for the risk that a car is a lemon, buyers cut their offers. They might be willing to pay, say, $750 for a car they perceive as having an even chance of be- ing a lemon or a peach. But dealers who know for sure they have a peach will re- ject such an offer. As a result, the buyers face “”: the only sellers who will be prepared to accept $750 will be those who know they are offloading a lemon. Smart buyers can foresee this prob- lem. Knowing they will only ever be sold a lemon, they offer only $500. Sellers of lemons end up with the same as they would have done were there no am- biguity. But peaches stay in the garage. This is a tragedy: there are buyers who would happily pay the asking-price for a peach, if only2 they could be sure of the car’s quality. This “information asymmetry” between buyers and sellers kills the market. Is it really true that you can win a just for observing that some Information asymmetry people in markets know more than oth- ers? That was the question one journalist Secrets and agents asked of , who, along with Mr Akerlof and , was a joint recipient of the 2001 Nobel award for their work on information asymmetry. His in- credulity was understandable. The lemons paper was not even an accurate descrip- tion of the used-car market: clearly not George Akerlof’s 1970 paper, “”, is a foundation stone of every used car sold is a dud. And insurers . The first in our series on seminal economic ideas had long recognised that their customers N 2007 the state of Washington intro- just that, and later won its author a Nobel might be the best judges of what risks they Iduced a new rule aimed at making the prize, the paper was rejected by three lead- faced, and that those keenest to buy insur- labour market fairer: firms were banned ing journals. At the time, Mr Akerlof was ance were probably the riskiest bets. from checking job applicants’ scores. an assistant professor at the University Yet the idea was new to mainstream Campaigners celebrated the new law as a of California, Berkeley; he had only com- economists, who quickly realised that it step towards equality—an applicant with a pleted his PhD, at MIT, in 1966. Perhaps as made many of their models redundant. low credit score is much more likely to be a result, the Further breakthroughs soon followed, as poor, black or young. Since then, ten other thought his paper’s insights trivial. The Re- researchers examined how the asymme- states have followed suit. But when Robert view of Economic Studies agreed. TheJour- try problem could be solved. Mr Spence’s Clifford and Daniel Shoag, two economists, nal of Political had almost the flagship contribution was a 1973 paper recently studied the bans, they found that opposite concern: it could not stomach the called “Job Market Signalling” that looked the laws left blacks and the young with paper’s implications. Mr Akerlof, an at the labour market. Employers may fewer jobs, not more. emeritus professor at Berkeley and married struggle to tell which job candidates are Before 1970, economists would not to , the chairman of the Federal best. Mr Spence showed that top workers have found much in their discipline to Reserve, recalls the editor’s complaint: “If might signal their talents to firms by col- help them mull this puzzle. Indeed, they this is correct, economics would be differ- lecting gongs, like college degrees. Crucial- did not think very hard about the role of ent.” ly, this only works if the signal is credible: information at all. In the labour market, for In a way, the editors were all right. Mr if low- workers found it easy example, the textbooks mostly assumed Akerlof’s idea, eventually published in the to get a degree, then they could masquer- that employers know the productivity of Quarterly Journal of Economics in 1970, ade as clever types. their workers—or potential workers—and, was at once simple and revolutionary. Sup- This idea turns conventional wisdom thanks to , pay them for exact- pose buyers in the used-car market value on its head. Education is usually thought ly the value of what they produce. good cars—“peaches”—at $1,000, and sell- to benefit society by making workers You might think that research upend- ers at slightly less. A malfunctioning used more productive. If it is merely a signal ing that conclusion would immediately be car—a “lemon”—is worth only $500 to buy- of talent, the returns to in celebrated as an important breakthrough. ers (and, again, slightly less to sellers). If education flow to the students, who earn Yet when, in the late 1960s, George Akerlof buyers can tell lemons and peaches apart, a higher at the expense of the less wrote “The Market for Lemons”, which did trade in both will flourish. In reality, buy- able, and perhaps to universities, but not 1 Economics brief The Economist 5

2 to society at large. One disciple of the idea, making sure that each attracts only the go haywire. The old economics, noted Mr of George Mason Univer- customers it is designed for. The trick is to Stiglitz in his Nobel-prize lecture, paid con- sity, is currently penning a book entitled offer one pricey full- deal, and siderable lip- to incentives, but had “The Case Against Education”. (Mr Spence an alternative cheap option with a size- remarkably little to say about them. In a himself regrets that others took his theory able deductible. Risky drivers will balk completely transparent world, you need as a literal description of the world.) at the deductible, knowing that there is not worry about incentivising someone, Signalling helps explain what hap- a good chance they will end up paying because you can use a to specify pened when Washington and those other it when they claim. They will fork out for their behaviour precisely. It is when infor- states stopped firms from obtaining job- expensive coverage instead. Safe drivers mation is asymmetric and you cannot ob- applicants’ credit scores. Credit history is a will tolerate the high deductible and pay a serve what they are doing (is your - credible signal: it is hard to fake, and, pre- lower price for what coverage they do get. man using cheap parts? Is your employee sumably, those with good credit scores are This is not a particularly happy resolu- slacking?) that you must worry about en- more likely to make good employees than tion of the problem. Good drivers are stuck suring that are aligned. those who default on their . Messrs with high deductibles—just as in Spence’s Such scenarios pose what are known Clifford and Shoag found that when firms model of education, highly productive as “principal-agent” problems. How can a could no longer access credit scores, they workers must fork out for an education in principal (like a manager) get an agent (like put more weight on other signals, like order to prove their worth. Yet is an employee) to behave how he wants, education and experience. Because these in play almost every time a firm offers its when he cannot monitor them all the are rarer among disadvantaged groups, it customers a menu of options. time? The simplest way to make sure that became harder, not easier, for them to con- Airlines, for instance, want to milk rich an employee works hard is to give him vince employers of their worth. customers with higher , without some or all of the . Hairdressers, for Signalling explains all kinds of behav- driving away poorer ones. If they knew instance, will often rent a spot in a salon iour. Firms pay to their share- the depth of each customer’s pockets in and keep their takings for themselves. holders, who must pay tax on the advance, they could offer only first-class But hard work does not always guaran- payouts. Surely it would be better if they re- tickets to the wealthy, and better-value tee success: a star analyst at a consulting tained their earnings, boosting their share tickets to everyone else. But because they firm, for example, might do stellar work prices, and thus delivering their sharehold- must offer everyone the same options, pitching for a project that nonetheless ers lightly taxed capital gains? Signalling they must nudge those who can afford goes to a rival. So, another option is to pay solves the mystery: paying a is a it towards the pricier ticket. That means “efficiency wages”. Mr Stiglitz and Carl sign of strength, showing that a firm feels deliberately making the standard cabin Shapiro, another economist, showed that no need to hoard cash. By the same token, uncomfortable, to ensure that the only firms might pay premium wages to make why might a restaurant deliberately locate people who slum it are those with slim- employees value their jobs more highly. in an area with high rents? It signals to po- mer wallets. This, in turn, would make them less likely tential customers that it believes its good to shirk their responsibilities, because they food will bring it success. Hazard undercuts Eden would lose more if they were caught and Signalling is not the only way to over- Adverse selection has a cousin. Insurers got fired. That insight helps to explain a come the lemons problem. In a 1976 paper have long known that people who buy in- fundamental puzzle in economics: when Mr Stiglitz and Michael Rothschild, anoth- surance are more likely to take risks. Some- workers are unemployed but want jobs, er economist, showed how insurers might one with home insurance will check their why don’t wages fall until someone is “screen” their customers. The essence of smoke alarms less often; health insurance willing to hire them? An answer is that screening is to offer deals which would encourages unhealthy eating and drinking. above-market wages act as a carrot, the re- only ever attract one type of punter. Economists first cottoned on to this phe- sulting , a stick. Suppose a car insurer faces two differ- nomenon of “” when Ken- And this reveals an even deeper point. ent types of customer, high-risk and low- neth Arrow wrote about it in 1963. Before Mr Akerlof and the other pioneers risk. They cannot tell these groups apart; Moral hazard occurs when incentives of information economics came along, only the customer knows whether he is a the discipline assumed that in competi- safe driver. Messrs Rothschild and Stiglitz tive markets, prices reflect marginal costs: showed that, in a competitive market, in- charge above cost, and a competitor will surers cannot profitably offer the same undercut you. But in a world of - deal to both groups. If they did, the premi- tion asymmetry, “good behaviour is driven ums of safe drivers would subsidise pay- by earning a surplus over what one could outs to reckless ones. A rival could offer get elsewhere,” according to Mr Stiglitz. The a deal with slightly lower premiums, and wage must be higher than what a worker slightly less coverage, which would peel can get in another job, for them to want to away only safe drivers because risky ones avoid the sack; and firms must find it pain- prefer to stay fully insured. The firm, left ful to lose customers when their product is only with bad risks, would make a loss. shoddy, if they are to invest in quality. In (Some worried a related problem would markets with imperfect information, price afflict Obamacare, which forbids Ameri- cannot equal . can health insurers from discriminating The concept of information asym- against customers who are already unwell: metry, then, truly changed the discipline. if the resulting high premiums were to de- Nearly 50 years after the lemons paper ter healthy, young customers from signing was rejected three times, its insights re- up, firms might have to raise premiums main of crucial relevance to economists, further, driving more healthy customers and to . Just ask any away in a so-called “death spiral”.) young, black Washingtonian with a good The car insurer must offer two deals, credit score who wants to find a job. n 6 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

derstanding the tumult of the past decade. But the history of the hypothesis itself is just as important. Its trajectory from the margins of academia to a subject of main- stream debate shows how the study of economics is adapting to a much-changed reality since the global financial crisis. Minsky started with an explanation of investment. It is, in essence, an exchange of today for money tomorrow. A firm pays now for the construction of a factory; profits from running the facility will, all going well, translate into money for it in coming years. Put crudely, money today can come from one of two sources: the firm’s own cash or that of others (for example, if the firm borrows from a ). The balance between the two is the key question for the financial system. Minsky distinguished between three kinds of financing. The first, which he called “ financing”, is the safest: firms rely on their future cashflow to re- pay all their borrowings. For this to work, they need to have very limited borrow- ings and healthy profits. The second, spec- ulative financing, is a bit riskier: firms rely on their cashflow to repay the on Financial stability their borrowings but must roll over their to repay the principal. This should Minsky’s moment be manageable as long as the economy functions smoothly, but a downturn could cause distress. The third, Ponzi financing, is the most dangerous. Cashflow covers neither principal nor interest; firms are betting only that the underlying asset will appreciate by enough to cover their liabili- The second article in our series on seminal economic ideas looks at Hyman Min- ties. If that fails to happen, they will be left sky’s hypothesis that booms sow the seeds of busts exposed. ROM the start of his academic career ing emphasis on quantitative methods. In- Economies dominated by hedge fi- Fin the 1950s until 1996, when he died, stead, he pieced his views together in his nancing—that is, those with strong cash- Hyman Minsky laboured in relative ob- essays, lectures and books, including one flows and low debt levels—are the most scurity. His research about financial crises about John Maynard Keynes, the econo- stable. When speculative and, especially, and their causes attracted a few devoted mist who most influenced his thinking. Ponzi financing come to the fore, financial admirers but little mainstream attention: He also gained hands-on experience, serv- systems are more vulnerable. If asset val- this newspaper cited him only once while ing on the board of Mark Twain Bank in St ues start to fall, either because of mone- he was alive, and it was but a brief men- Louis, Missouri, where he taught. tary tightening or some external , the tion. So it remained until 2007, when the Having grown up during the Depres- most overstretched firms will be forced subprime-mortgage crisis erupted in Amer- sion, Minsky was minded to dwell on to sell their positions. This further under- ica. Suddenly, it seemed that everyone was disaster. Over the years he came back to mines asset values, causing pain for even turning to his writings as they tried to make the same fundamental problem again and more firms. They could avoid this trouble sense of the mayhem. Brokers wrote notes again. He wanted to understand why fi- by restricting themselves to hedge financ- to clients about the “” en- nancial crises occurred. It was an unpopu- ing. But over time, particularly when the gulfing financial markets. Central bankers lar focus. The dominant belief in the latter economy is in fine fettle, the temptation to referred to his theories in their speeches. half of the 20th century was that markets take on debt is irresistible. When growth And he became a posthumous media star, were efficient. The prospect of a full-blown looks assured, why not borrow more? with just about every major outlet giving calamity in developed economies sounded add to the dynamic, lowering their column space and airtime to his ideas. The far-fetched. There might be the occasional credit standards the longer booms last. If Economist has mentioned him in at least stockmarket bust or crash, but defaults are minimal, why not lend more? 30 articles since 2007. modern economies had, it seemed, van- Minsky’s conclusion was unsettling. Eco- If Minsky remained far from the lime- quished their worst demons. nomic stability breeds instability. Periods light throughout his life, it is at least in part Against those certitudes, Minsky, an of prosperity give way to . because his approach shunned academic owlish man with a shock of grey hair, de- With overleveraged banks and no- conventions. He started his university veloped his “financial-instability hypoth- money-down mortgages still fresh in the education in mathematics but made lit- esis”. It is an examination of how long mind after the global financial crisis, Min- tle use of calculations when he shifted to stretches of prosperity sow the seeds of sky’s insight might sound obvious. Of economics, despite the discipline’s grow- the next crisis, an important lens for un- course, debt and matter. But for 1 Economics brief The Economist 7

2 decades the study of economics paid lit- But this virtue also points to what some rates his ideas in calculations. One Levy tle heed to the former and relegated the might see as a shortcoming. In trying to paper, published in 2000, developed a latter to a sub-discipline, not an essential paint a more nuanced picture of the econ- Minsky-inspired model linking investment element in broader theories. Minsky was a omy, he relinquished some of the potency and cashflow. A 2005 paper for the Bank maverick. He challenged both the Keynes- of elegant models. That was fine as far as for International Settlements, a forum for ian backbone of and a he was concerned; he argued that general- central banks, drew on Minsky in building prevailing belief in efficient markets. isable theories were bunkum. He wanted a model of how people assess their assets It is perhaps odd to describe his ideas to explain specific situations, not econom- after making losses. In 2010 , as a critique of Keynesian doctrine when ics in general. He saw the financial-insta- a Nobel prize-winning economist who Minsky himself idolised Keynes. But he bility hypothesis as relevant to the case of is best known these days as a New York believed that the doctrine had strayed too advanced capitalist economies with deep, Times columnist, co-authored a paper that far from Keynes’s own ideas. Economists sophisticated markets. It was not meant to included the concept of a “Minsky mo- had created models to put Keynes’s words be relevant in all scenarios. These days, for ment” to model the impact of deleverag- to work in explaining the economy. None example, it is fashionable to ask whether ing on the economy. Some researchers are is better known than the IS-LM model, is on the brink of a Minsky moment also starting to test just how accurate Min- largely developed by and Alvin after its alarming debt growth of the past sky’s insights really were: a 2014 discus- Hansen, which shows the relationship be- decade. Yet a country in transition from sion paper for the Bank of Finland looked tween investment and money. It remains to a and with at debt-to-cashflow ratios, finding them to a potent tool for teaching and for policy an immature financial system is not what be a useful indicator of systemic risk. analysis. But Messrs Hicks and Hansen Minsky had in mind. largely left the financial sector out of the Shunning the power of equations and Debtor’s prism picture, even though Keynes was keenly models had its costs. It contributed to Min- Still, it would be a stretch to expect the fi- aware of the importance of markets. To sky’s isolation from mainstream theories. nancial-instability hypothesis to become a Minsky, this was an “unfair and naive rep- Economists did not entirely ignore debt, new foundation for economic theory. Min- resentation of Keynes’s subtle and sophis- even if they studied it only sparingly. sky’s legacy has more to do with focusing ticated views”. Minsky’s financial-instabil- Some, such as and on the right things than correctly structur- ity hypothesis helped fill in the holes. , who would later become ing quantifiable models. It is enough to His challenge to the prophets of ef- chairman of the , looked at observe that debt and financial instability, ficient markets was even more acute. how credit could amplify cycles. his main preoccupations, have become and Robert Lucas, among Minsky’s work might have complemented some of the principal topics of inquiry others, persuaded most of academia and theirs, but they did not refer to it. It was as for economists today. A new version of policymaking circles that markets tended if it barely existed. the “Handbook of Macroeconomics”, an towards equilibrium as people digested Since Minsky’s death, others have influential survey that was first published all available information. The structure of started to correct the oversight, grafting his in 1999, is in the works. This time, it will the financial system was treated as almost theories onto general models. The Levy make linkages between finance and eco- irrelevant. In recent years, behavioural Economics Institute of in nomic activity a major component, with economists have attacked one plank of New York, where he finished his career at least two articles citing Minsky. As Mr efficient-market theory: people, far from (it still holds an annual conference in his Krugman has quipped: “We are all Min- being rational actors who maximise their honour), has published work that incorpo- skyites now.” gains, are often clueless about what they Central bankers seem to agree. In a want and make the wrong decisions. But speech in 2009, before she became head years earlier Minsky had attacked another: of the Federal Reserve, Janet Yellen said deep-seated forces in financial systems Minsky’s work had “become required propel them towards trouble, he argued, reading”. In a 2013 speech, made while with stability only ever a fleeting illusion. he was governor of the Bank of , Mervyn King agreed with Minsky’s view Outside-in that stability in credit markets leads to exu- Yet as an outsider in the sometimes clois- berance and eventually to instability. Mark tered world of economics, Minsky’s influ- Carney, Lord King’s successor, has referred ence was, until recently, limited. to Minsky moments on at least two occa- were faster than professors to latch onto sions. his views. More than anyone else it was Will the moment last? Minsky’s own Paul McCulley of PIMCO, a fund-manage- theory suggests it will eventually peter ment group, who popularised his ideas. out. is still shaky and He coined the term “Minsky moment” to the scars of the global financial crisis vis- describe a situation when debt levels reach ible. In the Minskyan trajectory, this is breaking-point and asset prices across the when firms and banks are at their most board start plunging. Mr McCulley initially cautious, wary of repeating past mistakes used the term in explaining the Russian fi- and determined to fortify their balance- nancial crisis of 1998. Since the global tur- sheets. But in time, memories of the 2008 moil of 2008, it has become ubiquitous. turmoil will dim. Firms will again race to For investment analysts and fund manag- expand, banks to fund them and regula- ers, a “Minsky moment” is now virtually tors to loosen constraints. The warnings synonymous with a financial crisis. of Minsky will fade away. The further we Minsky’s writing about debt and the move on from the last crisis, the less we dangers in had the want to hear from those who see another great virtue of according with experience. one coming. n 8 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

mists: with low-wage nations could hurt workers in a high-wage country. This commonsensical complaint had tradi- tionally cut little ice with economists. They pointed out that poorly paid labour is not necessarily cheap, because low wages of- ten reflect poor productivity—as Kaduna Textile Mills showed. The Stolper-Samuel- son theorem, however, found “an iota of possible truth” (as Samuelson put it later) in the hoary argument that workers in rich countries needed protection from “pauper labour” paid a pittance elsewhere. To understand why the theorem made a splash, it helps to understand the pool of received wisdom it disturbed. Economists had always known that tariffs helped the industries sheltered by them. But they were equally adamant that free trade ben- efited countries as a whole. showed in 1817 that a country could bene- fit from trade even if it did everything bet- ter than its neighbours. A country that is better at everything will still be “most bet- ter”, so to speak, at something. It should concentrate on that, Ricardo showed, importing what its neighbours do “least worse”. Tariffs and wages If bad grammar is not enough to make the point, an old analogy might. Suppose An inconvenient iota of truth that the best lawyer in town is also the best typist. He takes only ten minutes to type a document that his secretary fin- ishes in 20. In that sense, typing costs him less. But in the time he spent typing he could have been lawyering. And he could have done vastly more legal work than his secretary could do, even in twice the time. The third in our series looks at the Stolper-Samuelson theorem In that sense typing costs him far more. It N AUGUST 1960 Wolfgang Stolper, an try which required high duties impover- thus pays the fast-typing lawyer to - IAmerican economist working for Nige- ished the country and wasn’t worth hav- ise in legal work and “import” typing. ria’s development ministry, embarked on a ing,” he believed. This was not a popular In Ricardo’s model, the same industry tour of the country’s poor northern region, view among his fellow planners. But Stolp- can require more labour in one country a land of “dirt and dignity”, long ruled by er’s ideas carried unusual weight. He was than in another. Such differences in la- conservative emirs and “second-rate Brit- a successful schmoozer, able to drink like bour requirements are one motivation for ish civil servants who didn’t like business”. a fish. He liked “getting his hands dirty” in trade. Another is differences in labour sup- In this bleak commercial landscape one empirical work. And his trump card, which plies. In some nations, such as America, strange flower bloomed: Kaduna Textile won him the respect of friends and the ear labour is scarce relative to the amount Mills, built by a Lancashire firm a few years of superiors, was the “Stolper-Samuelson of land, capital or education the country before, employed 1,400 people paid as lit- theorem” that bore his name. has accumulated. In others the reverse is tle as £4.80 ($6.36) a day in today’s prices. The theorem was set out 20 years ear- true. Countries differ in their mix of la- And yet it required a 90% tariff to compete. lier in a seminal paper, co-authored by Paul bour, land, capital, skill and other “factors Skilled labour was scarce: the mill had Samuelson, one of the most celebrated of production”. In the 1920s and 1930s Eli found only six northerners worth training thinkers in the discipline. It shed new light Heckscher and his student, , pi- as foremen (three failed, two were “so- on an old subject: the relationship between oneered a model of trade driven by these so”, one was “superb”). Some employees tariffs and wages. Its fame and influence differences. walked ten miles to work, others carried were pervasive and persistent, preceding In their model, trade allowed countries the hopes of mendicant relatives on their Stolper to Nigeria and outlasting his death, like America to economise on labour, by backs. Many quit, adding to the cost of find- in 2002, at the age of 89. Even today, the concentrating on capital-intensive activi- ing and training replacements. Those who theorem is shaping debates on trade agree- ties that made little use of it. Industries stayed were often too tired, inexperienced ments like the Trans-Pacific Partnership that required large amounts of elbow or ill-educated to maintain the machines (TPP) between America and 11 other Pacif- grease could be left to foreigners. In this properly. “African labour is the worst paid ic-rim countries. way, trade alleviated labour . and most expensive in the world,” Stolper The paper was “remarkable”, accord- That was good for the country, but was complained. ing to Alan Deardorff of the University of it good for workers? Scarcity is a source of He concluded that Nigeria was not yet Michigan, partly because it proved some- value. If trade eased workers’ rarity value, ready for large-scale industry. “Any indus- thing seemingly obvious to non-econo- it would also erode their bargaining power. 1 Economics brief The Economist 9

2 It was quite possible that free trade might ately—by more than 10%—while rents, is consistent with the Stolper-Samuelson reduce workers’ share of the national in- paradoxically, rise a little. theorem. Globalisation has hurt the scarce come. But since trade would also enlarge This combination of slightly pricier “factor” (unskilled labour) and helped the that income, it should still leave workers land and much cheaper labour restores abundant one. better off, most economists felt. Moreo- the modus vivendi between the two in- But look closer and puzzles remain. ver, even if foreign competition depressed dustries, halting the watchmakers’ contrac- The theorem is unable to explain why “nominal” wages, it would also reduce the tion and the wheat-farmers’ expansion. skilled workers have prospered even in price of importable . Depending on Because the farmers need more land than developing countries, where they are not their patterns, workers’ pur- labour, slightly higher rents deter them as abundant. Its assumption that every coun- chasing power might then increase, even if forcefully as much lower wages attract try makes everything—both watches and their wages fell. them. The combination also restores the wheat—may also overstate trade’s dan- profits of the watchmakers, because the gers. In reality, countries will import some Working hypothesis much cheaper labour helps them more things they no longer produce and others There were other grounds for optimism. than the slightly pricier land hurts them. they never made. Imports cannot hurt a Labour, unlike oil, arable land, blast fur- The upshot is that wages have fallen local industry that never existed (nor keep naces and many other productive resourc- by more than watch prices, and rents have hurting an industry that is already dead). es, is required in every industry. Thus no actually risen. It follows that workers are Some of the theorem’s other premises matter how a country’s industrial mix unambiguously worse off. Their versatil- are also questionable. Its assumption that evolves, labour will always be in . ity will not save them. Nor does it matter workers will move from one industry to Over time, labour is also versatile and what mix of watches and wheat they buy. another can blind it to the true source of adaptable. If trade allows one industry to Stolper, Samuelson and their succes- their hardship. Chinese imports have not expand and obliges another to contract, sors subsequently extended the theorem squeezed American manufacturing work- new workers will simply migrate towards to more complicated cases, albeit with ers into less labour-intensive industries; the sunlit industrial uplands and turn some loss of crispness. One popular varia- they have squeezed them out of the labour their backs on the sunset sectors. “In the tion is to split labour into two—skilled and force altogether, according to David Autor long run the as a whole has unskilled. That kind of distinction helps of the Massachusetts Institute of Tech- nothing to fear from international trade,” shed light on what Stolper later witnessed nology and his co-authors. The “China concluded , an Austrian in Nigeria, where educated workers were shock”, they point out, was concentrated economist, in 1936. vanishingly rare. With a 90% tariff, Kaduna in a few hard-hit manufacturing localities Stolper was not so sure. He felt that Oh- Textile Mills could afford to train local fore- from which workers struggled to escape. lin’s model disagreed with Haberler even men and hire technicians. Without it, Nige- Thanks to globalisation, goods now move if Ohlin himself was less clear-cut. Stolper ria would probably have imported textiles easily across borders. But workers move shared his doubts with Samuelson, his from Lancashire instead. Free trade would uneasily even within them. young Harvard colleague. “Work it out, thus have hurt the “scarce” factor. Wolfie,” Samuelson urged. In rich countries, skilled workers are Grain men The pair worked it out first with a sim- abundant by international standards and Acclaim for the Stolper-Samuelson theo- ple example: a small economy blessed unskilled workers are scarce. As globalisa- rem was not instant or universal. The with abundant capital (or land), but scarce tion has advanced, college-educated work- original paper was rejected by the Ameri- labour, making watches and wheat. Subse- ers have enjoyed faster wage gains than can Economic Review, whose editors quent economists have clarified the intui- their less educated countrymen, many of described it as “a very narrow study in tion underlying their model. In one telling, whom have suffered stagnant real earn- formal theory”. Even Samuelson’s own watchmaking (which is labour-intensive) ings. On the face of it, this wage pattern textbook handled the proposition gingerly. benefits from a 10% tariff. When the tariff After acknowledging that free trade could is repealed, watch prices fall by a similar leave American workers worse off, he add- amount. The industry, which can no long- ed a health warning: “Although admitting er break even, begins to lay off workers this as a slight theoretical possibility, most and vacate land. When the dust settles, economists are still inclined to think that what happens to wages and land rents? its grain of truth is outweighed by other, A layman might assume that both fall by more realistic considerations,” he wrote. 10%, returning the watchmakers to profit. What did Stolper think? A veteran of A clever layman might guess instead that economic practice as well as principles, he rents will fall by less than wages, because was not a slave to formalism or blind to the shrinkage of watchmaking releases “realistic considerations”. Indeed, in Nige- more labour than land. ria, Stolper discovered that he could “sus- Both would be wrong, because both pend theory” more easily than some of ignore what is going on in the rest of the his politically minded colleagues (perhaps economy. In particular, wheat prices have because theory was revealed to them, but not fallen. Thus if wages and rents both written by him). decrease, wheat growers will become He was nonetheless sure that his paper unusually profitable and expand. Since was worth the fuss. He said he would give they require more land than labour, their his left eye to produce another one like it. expansion puts more upward pressure on By the paper’s 50th anniversary, he had rents than on wages. At the same time, the indeed the use of that eye, he pointed watch industry’s contraction puts more out wistfully. The other side of the bargain downward pressure on wages than on was, however, left unfulfilled: he never did rents. In the push and pull between the write another paper as good. Not many two industries, wages fall disproportion- people have. n 10 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

economy available for borrowing is fixed. If the commandeered capital to build new roads, for instance, it would simply be depriving private firms of the same amount of money. Higher spending and in one part of the econ- omy would come at the expense of lower spending and employment in another. As the world slipped into depression, however, and Britain’s economic crisis deepened, the voices questioning this view grew louder. In 1931 Baron Kahn, a British economist, published a paper es- pousing an alternative theory: that public spending would yield both the primary boost from the direct spending, but also “beneficial repercussions”. If road-build- ing, for instance, took workers off the dole and led them to increase their own spend- ing, he argued, then there might be a sus- tained rise in total employment as a result. Kahn’s paper was in line with the thinking of John Maynard Keynes, the leading British economist of the day, who was working on what would become his masterpiece, “The General Theory of Employment, Interest and Money”. In it, Keynes gave a much more complete ac- Fiscal multipliers count of how the multiplier might work, and how it might enable a government to Where does the buck stop? drag a slumping economy back to health. Keynes was a singular character, and one of the great thinkers of the 20th cen- tury. He looked every inch a patrician figure, with his tweed suits and walrus moustache. Yet he was also a free spirit by the standards of the day, associating with Fiscal stimulus, an idea championed by John Maynard Keynes, has gone in and the artists and writers of the out of fashion Group, whose members included Virginia T THE height of the euro crisis, with past 80 years the significance it has been Woolf and E.M. Forster. Keynes advised Agovernment-bond yields soaring in accorded has fluctuated wildly. It was once the government during the first world several southern European countries and seen as a matter of fundamental impor- and participated in the Versailles defaults looming, the European Central tance, then as a discredited notion. It is conference, which ended up extracting pu- Bank and the healthier members of the now back in vogue again. nitive reparations from . The ex- currency club fended off disaster by offer- The idea of the multiplier emerged from perience was dispiriting for Keynes, who ing bail-outs. But these came with condi- the intense argument over how to respond wrote a number of scathing essays in the tions, most notably strict fiscal discipline, to the Depression. In the 1920s Britain had 1920s, pointing out the risks of the agree- intended to put government back sunk into an economic slump. The first ment and of the post-war economic sys- on a sustainable footing. Some economists world war had left prices higher and the tem more generally. argued that painful budget cuts were an pound weaker. The government was none- Frustrated by his inability to change unfortunate necessity. Others said that the theless determined to restore the pound to the minds of those in power, and by a cuts might well prove counterproductive, its pre-war value. In doing so, it kept mon- deepening global , Keynes set by lowering growth and therefore govern- etary policy too tight, initiating a spell of out to write a magnum opuscriticising the ment revenues, leaving the affected coun- prolonged and economic weak- economic consensus and laying out an tries even poorer and more indebted. ness. The economists of the day debated alternative. He positioned the “General In 2013 economists at the IMF ren- what might be done to improve conditions Theory” as a revolutionary text—and so it dered their verdict on these austerity pro- for suffering workers. Among the sugges- proved. grammes: they had done far more eco- tions was a programme of public invest- The book is filled with economic in- nomic damage than had been initially ment which, some thought, would put un- sights. Yet its most important contribu- predicted, including by the fund itself. employed Britons to work. tion is the reasoning behind the proposi- What had the IMF got wrong when it The British government would counte- tion that when an economy is operating made its earlier, more sanguine forecasts? It nance no such thing. It espoused the con- below , demand rather had dramatically underestimated the fiscal ventional wisdom of the day—what is often than supply determines the level of invest- multiplier. called the “”. It believed that ment and national income. Keynes sup- The multiplier is a simple, powerful and public spending, financed through borrow- posed there was a “multiplier effect” from hotly debated idea. It is a critical element ing, would not boost overall economic ac- changes in investment spending. A bit of of Keynesian macroeconomics. Over the tivity, because the supply of in the additional money spent by the govern-1 Economics brief The Economist 11

2 ment, for instance, would add directly to variations in the to growth Keynesian economic models were “fatal”. a nation’s (and income). In the first (or decline) in the . Fancy Keynesian macroeconomic models were instance, this money would go to contrac- Keynesian multipliers were not needed to “of no value in guiding policy”. tors, suppliers, civil servants or re- keep an economy on track, he reckoned. These attacks, in turn, prompted the cipients. They would in turn spend some Instead, simply needed to emergence of “New Keynesian” econo- of the extra income. The beneficiaries of pursue a policy of stable money growth. mists, who borrowed elements of the that spending would also splash out a bit, An even greater challenge came from freshwater approach while retaining the adding still more to economic activity, and the emergence of the “rational expecta- belief that recessions were market failures so on. Should the government cut back, tions” school of economics, led by Robert that could be fixed through government the ill effects would multiply in the same Lucas. Rational-expectations economists intervention. Because most of them were way. supposed that would be un- based at universities on America’s coasts, Keynes thought this insight was espe- dermined by forward-looking taxpayers. they were dubbed “saltwater” economists. cially important because of what he called They should understand that government The most prominent included Stanley Fis- “liquidity ”. He reckoned that borrowing would eventually need to be cher, now the vice-chairman of the Federal people like to have some liquid assets on repaid, and that stimulus today would Reserve; Larry Summers, a former treas- hand if possible, in case of emergency. In necessitate higher taxes tomorrow. They ury secretary; and , head of times of financial worry, demand for cash should therefore save income earned as George W. Bush’s Council of Economic or similarly liquid assets rises; investors a result of stimulus in order to have it on Advisers. In their models fiscal policy was begin to worry more about the return of hand for when the bill came due. The mul- all but neutered. Instead, they argued that capital rather than the return on capital. tiplier on might in central banks could and should do the Keynes posited that this might lead to a fact be close to zero, as each extra dollar is heavy lifting of economic : “”: a world in which every- almost entirely offset by increased private exercising a deft control that ought to can- one tries to hold more money, depressing . cel out the effects of government spend- spending, which in turn depresses pro- ing—and squash the multiplier. duction and income, leaving people still Rubbing salt in Yet in Japan since the 1990s, and in worse off. The economists behind many of these crit- most of the rich world since the recession In this world, lowering interest rates icisms clustered in colleges in the Midwest that followed the global financial crisis, to stimulate growth does not help very of America, most notably the University cutting interest rates to zero has proved much. Nor are rates very sensitive to in- of . Because of their proximity to inadequate to revive flagging economies. creases in government borrowing, given America’s Great Lakes, their approach to Many governments turned instead to fis- the glut of saving. Government spending macroeconomics came to be known as cal stimulus to get their economies going. to boost the economy could therefore gen- the “freshwater” school. They argued that In America the administration of Barack erate a big rise in employment for only a macroeconomic models had to begin with Obama succeeded in securing a stimulus negligible increase in interest rates. Clas- equations that described how rational in- package worth over $800 billion. sical economists thought public-works dividuals made decisions. The economic As a new debate over multipliers flared, spending would “crowd out” private in- experience of the 1970s seemed to bear out freshwater types stood their ground. John vestment; Keynes saw that during peri- their criticisms of Keynes: governments Cochrane of the ods of weak demand it might “crowd in” sought to boost slow-growing economies said of Keynesian ideas in 2009: “It’s not private spending, through the multiplier with fiscal and monetary stimulus, only to part of what anybody has taught gradu- effect. find that and interest rates rose ate students since the 1960s. They are fairy Keynes’s reasoning was affirmed by even as unemployment remained high. tales that have been proved false. It is very the economic impact of increased govern- Freshwater economists declared victo- comforting in times of stress to go back to ment expenditure during the second world ry. In an article published in 1979 and en- the fairy tales we heard as children, but it war. Massive military spending in Britain titled “After ”, Robert doesn’t make them less false.” and America contributed to soaring eco- Lucas and Tom Sargent, both eventual No- The practical experience of the reces- nomic growth. This, combined with the bel-prize winners, wrote that the flaws in sion gave economists plenty to study, determination to prevent a recurrence of however. Scores of papers have been pub- the Depression, prompted policymakers to lished since 2008 attempting to estimate adopt Keynesian economics, and the mul- fiscal multipliers. Most suggest that, with tiplier, as the centrepiece of the post-war interest rates close to zero, fiscal stimulus economic order. carries a multiplier of at least one. The IMF, Other economists picked up where for instance, concluded that the (harmful) Keynes left off. and Paul multiplier for fiscal contractions was often Samuelson constructed equations to pre- 1.5 or more. dict how a rise or fall in spending in one Even as many policymakers remain part of the economy would propagate committed to fiscal consolidation, plenty across the whole of it. Governments took of economists now argue that insufficient it for granted that managing economic fiscal stimulus has been among the biggest demand was their responsibility. By the failures of the post-crisis era. Mr Summers 1960s Keynes’s intellectual victory seemed and Antonio Fatas suggest, for example, complete. In a story in Time magazine, that austerity has substantially reduced published in 1965, de- growth, leading to levels of public debt clared (in a quote often attributed to Rich- that are higher than they would have been ard Nixon), “We are all Keynesians now.” had enthusiastic stimulus been used to re- But the Keynesian consensus fractured vive growth. Decades after its conception, in the 1970s. Its dominance was eroded by Keynes’s multiplier remains as relevant, the ideas of Friedman himself, who linked and as controversial, as ever. n 12 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

one stays quiet while the other snitches, then the snitch will get a reward, while the other will face a lifetime in jail. And if both hold their tongue, then they each face a minor charge, and only a year in the clink (see diagram). There is only one Nash-equilibrium so- lution to the prisoner’s dilemma: both con- fess. Each is a to the other’s ; since the other might have spilled the beans, snitching avoids a lifetime in jail. The tragedy is that if only they could work out some way of co-ordinating, they could both make themselves better off. The example illustrates that crowds can be foolish as well as wise; what is best for the individual can be disastrous for the group. This tragic is all too com- mon in the real world. Left freely to plun- der the sea, individuals will fish more than is best for the group, depleting fish stocks. Employees competing to impress their boss by staying longest in the office will encourage workforce exhaustion. Banks have an incentive to lend more rather than sit things out when house prices shoot up.

Crowd trouble Game theory The Nash equilibrium helped economists to understand how self-improving indi- Prison breakthrough viduals could lead to self-harming crowds. Better still, it helped them to tackle the problem: they just had to make sure that every individual faced the best incentives possible. If things still went wrong—par- ents failing to vaccinate their children against measles, say—then it must be be- cause people were not acting in their own The fifth of our series on seminal economic ideas looks at the Nash equilibrium self-interest. In such cases, the public-poli- OHN NASH arrived at Princeton Univer- one such equilibrium. cy challenge would be one of information. Jsity in 1948 to start his PhD with a one- His insights expanded the scope of eco- Nash’s idea had antecedents. In 1838 sentence recommendation: “He is a math- nomics. In perfectly competitive markets, August Cournot, a French economist, ematical genius”. He did not disappoint. where there are no barriers to entry and theorised that in a market with only two Aged 19 and with just one undergraduate everyone’s products are identical, no in- competing , each would see the economics course to his name, in his first dividual buyer or seller can influence the disadvantages of pursuing market share by 14 months as a graduate he produced the market: none need pay close attention to boosting output, in the form of lower pric- work that would end up, in 1994, winning what the others are up to. But most mar- es and thinner profit margins. Unwittingly, him a Nobel prize in economics for his kets are not like this: the decisions of rivals Cournot had stumbled across an example contribution to game theory. and customers matter. From auctions to la- of a Nash equilibrium. It made sense for On November 16th 1949, Nash sent a bour markets, the Nash equilibrium gave each firm to set production levels based note barely longer than a page to the Pro- the dismal science a way to make real- on the strategy of its competitor; consum- ceedings of the National Academy of Sci- world predictions based on information ers, however, would end up with less ences, in which he laid out the concept about each person’s incentives. stuff and higher prices than if full-blooded that has since become known as the “Nash One example in particular has come to competition had prevailed. equilibrium”. This concept describes a sta- symbolise the equilibrium: the prisoner’s Another pioneer was John von Neu- ble outcome that results from people or in- dilemma. Nash used algebra and mann, a Hungarian mathematician. In stitutions making rational choices based on to set out this situation in an expanded pa- 1928, the year Nash was born, von Neu- what they think others will do. In a Nash per published in 1951, but the version fa- mann outlined a first formal theory of equilibrium, no one is able to improve miliar to economics students is altogether games, showing that in two-person, zero- their own situation by changing strategy: more gripping. (Nash’s thesis adviser, Al- sum games, there would always be an each person is doing as well as they pos- bert Tucker, came up with it for a talk he equilibrium. When Nash shared his find- sibly can, even if that does not mean the gave to a group of psychologists.) ing with von Neumann, by then an intel- optimal outcome for society. With a flour- It involves two mobsters sweating in lectual demigod, the latter dismissed the ish of elegant mathematics, Nash showed separate prison cells, each contemplating result as “trivial”, seeing it as little more that every “game” with a finite number of the same deal offered by the district at- than an extension of his own, earlier proof. players, each with a finite number of op- torney. If they both confess to a bloody In fact, von Neumann’s focus on two- tions to choose from, would have at least murder, they each face ten years in jail. If person, zero-sum games left only a very 1 Economics brief The Economist 13

2 narrow set of applications for his theory. as a best response to the behaviour of oth- Most of these settings were military in na- he prisoners dilemma er drivers—with very different outcomes, ture. One such was the idea of mutually depending on where they live; they stick assured destruction, in which equilibrium Prisoner B to the left-hand side of the road in Britain, is reached by arming adversaries with nu- Confess Keep quiet but to the right in America. Much to the clear weapons (some have suggested that disappointment of algebra-toting econo- oth go to risoner the film character of Dr Strangelove was Confess ail for ten gets life mists, understanding strategy requires based on von Neumann). None of this years imprisonment, knowledge of social norms and habits. A goes free was particularly useful for thinking about Nash’s theorem alone was not enough. risoner A situations—including most types of mar- isoner A oth go to A second refinement involved ac- ket—in which one party’s victory does not Pr Keep gets life ail for one counting properly for non-credible threats. quiet imprisonment, year automatically imply the other’s defeat. goes free If a teenager threatens to run away from Even so, the economics ini- home if his mother separates him from his tially shared von Neumann’s assessment, mobile phone, then there is a Nash equi- and largely overlooked Nash’s discovery. librium where she gives him the phone to He threw himself into other mathematical Nash equilibrium, and ended up raising retain peace of mind. But , pursuits, but his huge promise was under- a cool £22.5 billion ($35.4 billion)—though a German economist who shared the 1994 mined when in 1959 he started suffering some of the bidders’ shareholders were Nobel prize with Nash and , from delusions and paranoia. His wife less pleased with the outcome. Nash’s argued that this is not a plausible outcome. had him hospitalised; upon his release, insights also help to explain why adding The mother should know that her child’s he became a familiar figure around the a road to a transport network can make threat is empty—no matter how tragic the Princeton campus, talking to himself and journey times longer on average. Self- loss of a phone would be, a night out on scribbling on blackboards. As he struggled interested drivers opting for the quickest the streets would be worse. She should with ill health, however, his equilibrium route do not take into account their effect just confiscate the phone, forcing her son became more and more central to the dis- of lengthening others’ journey times, and to focus on his homework. cipline. The share of economics papers cit- so can gum up a new shortcut. A study Mr Selten’s work let economists whittle ing the Nash equilibrium has risen seven- published in 2008 found seven road links down the number of possible Nash equi- fold since 1980, and the concept has been in London and 12 in New York where clo- libria. Harsanyi addressed the fact that in used to solve a host of real-world policy sure could boost traffic flows. many real-life games, people are unsure problems. of what their opponent wants. Econo- One famous example was the Ameri- Game on mists would struggle to analyse the best can hospital system, which in the 1940s The Nash equilibrium would not have strategies for two lovebirds trying to pick was in a bad Nash equilibrium. Each indi- attained its current status without some a mutually acceptable location for a date vidual hospital wanted to snag the bright- refinements on the original idea. First, in with no idea of what the other prefers. est medical students. With such students plenty of situations, there is more than By embedding each person’s beliefs into particularly scarce because of the war, one possible Nash equilibrium. Drivers the game (for example that they correctly hospitals were forced into a race whereby choose which side of the road to drive on think the other likes pizza just as much they sent out offers to promising candi- as sushi), Harsanyi made the problem dates earlier and earlier. What was best for solvable.A different problem continued the individual hospital was terrible for the to lurk. The predictive power of the Nash collective: hospitals had to hire before stu- equilibrium relies on rational behaviour. dents had passed all of their exams. Stu- Yet humans often fall short of this ideal. dents hated it, too, as they had no chance In experiments replicating the set-up of to consider competing offers. the prisoner’s dilemma, only around half Despite letters and resolutions from all of people chose to confess. For the econo- manner of medical associations, as well mists who had been busy embedding ra- as the students themselves, the problem tionality (and Nash) into their models, this was only properly solved after decades was problematic. What is the use of setting of tweaks, and ultimately a 1990s design up good incentives, if people do not fol- by Elliott Peranson and Alvin Roth (who low their own best interests? later won a Nobel economics prize of his All was not lost. The experiments also own). Today, students submit their prefer- showed that experience made players ences and are assigned to hospitals based wiser; by the tenth round only around 10% on an algorithm that ensures no student of players were refusing to confess. That can change their stated preferences and taught economists to be more cautious be sent to a more desirable hospital that about applying Nash’s equilibrium. With would also be happy to take them, and complicated games, or ones where they no hospital can go outside the system and do not have a chance to learn from mis- nab a better employee. The system har- takes, his insights may not work as well. nesses the Nash equilibrium to be self-re- The Nash equilibrium nonetheless inforcing: everyone is doing the best they boasts a central role in modern microeco- can based on what everyone else is doing. nomics. Nash died in a car crash in 2015; Other policy applications include the by then his mental health had recovered, British government’s auction of 3G mo- he had resumed teaching at Princeton and bile-telecoms operating licences in 2000. It he had received that joint Nobel—in rec- called in game theorists to help design the ognition that the interactions of the group auction using some of the insights of the contributed more than any individual. n 14 BritainEconomics Briefs The Economist AprilThe Economist 25th 2012

trilemma obliged would-be members to follow the of Germany, the regional power. The head of the Dutch , Wim Duisenberg (who sub- sequently became the first president of the ), earned the nickname “Mr Fifteen Minutes” because of how quickly he copied the interest-rate changes made by the Bundesbank. This monetary serfdom is tolerable for the Netherlands because its commerce is closely tied to Germany and business conditions rise and fall in tandem in both countries. For economies less closely aligned to Germany’s business cycle, such as Spain and , the cost of losing monetary independence has been much higher: interest rates that were too low during the boom, and no option to deval- ue their way out of trouble once crisis hit. As with many big economic ideas, the trilemma has a complicated heritage. For a generation of economics students, it was an important outgrowth of the so-called Mundell-Fleming model, which incorpo- rated the impact of capital flows into a more general treatment of interest rates, exchange-rate policy, trade and stability. The Mundell-Fleming trilemma The model was named in recognition of research papers published in the early Two out of three ain’t bad 1960s by , a brilliant young Canadian trade theorist, and Marcus Flem- ing, a British economist at the IMF. Build- ing on his earlier research, Mr Mundell showed in a paper in 1963 that monetary policy becomes ineffective where there is full capital mobility and a fixed exchange A fixed exchange rate, monetary autonomy and the free flow of capital are in- rate. Fleming’s paper had a similar result. compatible, according to the last in our series of big economic ideas If the world of economics remained ILLEL THE ELDER, a first-century reli- autonomy, it has to allow its currency to unshaken, it was because capital flows Hgious leader, was asked to summarise float (side B). were small at the time. Rich-world cur- the Torah while standing on one leg. “That To understand the trilemma, imagine a rencies were pegged to the dollar under which is hateful to you, do not do to your country that fixes its exchange rate against a system of fixed exchange rates agreed fellow. That is the whole Torah; the rest is the US dollar and is also open to foreign at Bretton Woods, New Hampshire, in commentary,” he replied. Michael Klein, capital. If its central bank sets interest rates 1944. It was only after this arrangement of Tufts University, has written that the above those set by the Federal Reserve, broke down in the 1970s that the trilemma insights of international macroeconom- foreign capital in search of higher returns gained great policy relevance. ics (the study of trade, the balance-of-pay- would flood in. These inflows would raise Perhaps the first mention of the Mun- ments, exchange rates and so on) might be demand for the local currency; eventually dell-Fleming model was in 1976 by Rudiger similarly distilled: “Governments face the the peg with the dollar would break. If in- Dornbusch of the Massachusetts Institute policy trilemma; the rest is commentary.” terest rates are kept below those in Ameri- of Technology. Dornbusch’s “overshoot- The policy trilemma, also known as the ca, capital would leave the country and the ing” model sought to explain why the impossible or inconsistent trinity, says a currency would fall. newish regime of floating exchange rates country must choose between free capital Where barriers to capital flow are unde- had proved so volatile. It was Dornbusch mobility, exchange-rate management and sirable or futile, the trilemma boils down to who helped popularise the Mundell-Flem- monetary autonomy (the three corners of a choice: between a ing model through his bestselling text- the triangle in the diagram). Only two of and control of monetary policy; or a fixed books (written with , now the three are possible. A country that wants exchange rate and monetary bondage. Rich vice-chairman of the Federal Reserve) and to fix the value of its currency and have an countries have typically chosen the former, his influence on doctoral students, such as interest-rate policy that is free from outside but the countries that have adopted the Paul Krugman and . The influence (side C of the triangle) cannot al- euro have embraced the latter. The sacri- use of the term “policy trilemma”, as ap- low capital to flow freely across its borders. fice of monetary-policy autonomy that the plied to international macroeconomics, If the exchange rate is fixed but the coun- single currency entailed was plain even be- was coined in a paper published in 1997 try is open to cross-border capital flows, fore its launch in 1999. by Mr Obstfeld, who is now chief econo- it cannot have an independent monetary In the run up, aspiring members pegged mist of the IMF, and Alan Taylor, now of policy (side A). And if a country chooses their to the Deutschmark. Since the University of California, Davis. free capital mobility and wants monetary capital moves freely within , the But to fully understand the provi-1 Economics brief The Economist 15

2 dence—and the significance—of the tri- But some of the most influential re- lemma, you need to go back further. In he polic trilemma cent work on the trilemma has been done “”, published in 1930, by a Frenchwoman. In a series of pa- Free capital John Maynard Keynes pointed to an in- mobility pers, Hélène Rey, of the London Business evitable tension in a monetary order in School, has argued that a country that is which capital can move in search of the open to capital flows and that allows its highest return: currency to float does not necessarily en- A B This then is the dilemma of an international Pick one joy full monetary autonomy. monetary system—to preserve the advantages side of Ms Rey’s analysis starts with the ob- of the stability of local currencies of the vari- the triangle servation that the prices of risky assets, ous members of the system in terms of the such as shares or high-yield bonds, tend international standard, and to preserve at the Exchange- Monetary to move in lockstep with the availability same time an adequate local autonomy for rate C autonomy management of bank credit and the weight of global each member over its domestic rate of interest capital flows. These co-movements, for Ms and its volume of foreign lending. Rey, are a reflection of a “global financial This is the first distillation of the policy vice. For his part, Mr Mundell drew his cycle” driven by shifts in investors’ appe- trilemma, even if the fact of capital mobil- inspiration from home. tite for risk. That in turn is heavily influ- ity is taken as a given. Keynes was acutely In the decades after the second world enced by changes in the monetary policy aware of it when, in the early 1940s, he set war, an environment of rapid capital mo- of the Federal Reserve, which owes its down his thoughts on how global trade bility was hard for economists to imagine. power to the scale of borrowing in dollars might be rebuilt after the war. Keynes be- Cross-border capital flows were limited in by and householders world- lieved a system of fixed exchange rates part by but also by the caution wide. When the Fed lowers its interest was beneficial for trade. The problem with of investors. was an exception. rate, it makes it cheap to borrow in dol- the interwar , he argued, was Capital moved freely across its border with lars. That drives up global asset prices and that it was not self-regulating. If large trade America in part because damming such thus boosts the value of collateral against imbalances built up, as they did in the flows was impractical but also because which can be secured. Global credit late 1920s, deficit countries were forced to US investors saw little danger in parking conditions are relaxed. respond to the resulting outflow of gold. money next door. A consequence was that Conversely, in a recent study Ms Rey They did so by raising interest rates, to Canada could not peg its currency to the finds that an unexpected decision by the curb demand for imports, and by cutting dollar without losing control of its mon- Fed to raise its main soon wages to restore export competitiveness. etary policy. So the Canadian dollar was leads to a rise in mortgage spreads not This led only to unemployment, as wages allowed to float from 1950 until 1962. only in America, but also in Canada, Brit- did not fall obligingly when gold (and thus A Canadian, such as Mr Mundell, was ain and New Zealand. In other words, the money) was in scarce supply. The system better placed to imagine the trade-offs oth- Fed’s monetary policy shapes credit condi- might adjust more readily if surplus coun- er countries would face once capital began tions in rich countries that have both flex- tries stepped up their spending on im- to move freely across borders and curren- ible exchange rates and central banks that ports. But they were not required to do so. cies were unfixed. When Mr Mundell won set their own monetary policy. Instead he proposed an alterna- the Nobel prize in economics in 1999, Mr tive scheme, which became the basis of Krugman hailed it as a “Canadian Nobel”. Rey of sunshine Britain’s negotiating position at Bretton There was more to this observation than A crude reading of this result is that the Woods. An international clearing bank mere drollery. It is striking how many policy trilemma is really a dilemma: a (ICB) would settle the balance of trans- academics working in this area have been choice between staying open to cross-bor- actions that gave rise to trade surpluses Canadian. Apart from Mr Mundell, Ronald der capital or having control of local finan- or deficits. Each country in the scheme McKinnon, and Ja- cial conditions. In fact, Ms Rey’s conclusion would have an overdraft facility at the cob Viner have made big contributions. is more subtle: floating currencies do not ICB, proportionate to its trade. This would adjust to capital flows in a way that leaves afford deficit countries a buffer against the domestic monetary conditions unsullied, painful adjustments required under the as the trilemma implies. So if a country is gold standard. There would be penalties to retain its monetary-policy autonomy, it for overly lax countries: overdrafts would must employ additional “macropruden- incur interest on a rising scale, for instance. tial” tools, such as selective capital controls Keynes’s scheme would also penalise or additional bank-capital requirements to countries for hoarding by taxing big sur- curb excessive credit growth. pluses. Keynes could not secure support What is clear from Ms Rey’s work is for such “creditor adjustment”. America that the power of global capital flows opposed the idea for the same reason Ger- means the autonomy of a country with a many resists it today: it was a country with floating currency is far more limited than a big surplus on its . But the trilemma implies. That said, a flexible his proposal for an international clearing exchange rate is not anything like as lim- bank with overdraft facilities did lay the iting as a fixed exchange rate. In a crisis, ground for the IMF. everything is suborned to maintaining a Fleming and Mundell wrote their pa- peg—until it breaks. A domestic interest- pers while working at the IMF in the con- rate policy may be less powerful in the face text of the post-war monetary order that of a global financial cycle that takes its cue Keynes had helped shape. Fleming had from the Fed. But it is better than not hav- been in contact with Keynes in the 1940s ing it at all, even if it is the economic-policy while he worked in the British civil ser- equivalent of standing on one leg. n TURE O U F F

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