Thursday, 14 June 2007

Look North

"In the analysis of economic performance through time it contained two erroneous assumptions: one that institutions do not matter and two that time does not matter...

...if the institutional framework rewards piracy then piratical organizations will come into existence; and if the institutional framework rewards productive activities then organizations - firms - will come into existence to engage in productive activities."

- Douglass C. North
Economic Performance Through Time, the 1993 Economics Nobel Prize lecture

"Douglass North could be the most important economist of the past fifty years. Yet ... North's work is little known and little recognized, even within the economics profession."

- Arnold Kling

If there is a need to articulate how my world-view on economics has changed after working for 3 years, looking and dealing with economics at a very practical level, is that I now finally could appreciate, empathise and be inspired by the work of Douglass North in a way that I could never do when I was still studying. It is my conviction that the insight is immense and the relevance even greater so, especially for one who aspire to be an applied economist.

Real-life economics analysis and policy cannot be untangled from a true understanding of institutions and norms and the impacts they have on economic performance and the future prosperity of a nation. Malaysians should know this - the most dangerous threat to Malaysia's future is not inflation, unemployment or the next currency/banking crisis, but the slow descent into an overarching but faceless crisis of norms and institutions in the socio-econo-political realm which would eventually lead us to global marginalisation. This, however, is a story for another day.

Back to North's idea, the famous online economist, Arnold Kling (adjunct professor at Cato Institute and previously an economist in FRB and Freddie Mac and author of Learning Economics) wrote this in his latest TCS Daily piece (it is a three-parter, but only the first is out):

Due North
Arnold Kling, 13 June 2007

Douglass North could be the most important economist of the past fifty years. Yet, notwithstanding his Nobel Prize, North's work is little known and little recognized, even within the economics profession.

...The most important economic problems we face are complex systemic issues, such as underdevelopment in Africa or the financial stresses caused by health care spending in the United States. For these sorts of issues, Douglass North is as important as Keynes was to macroeconomics. However, hardly any young economists have followed North's path.

Douglass North calls attention to three factors that are ignored by mainstream economists:

-- Institutions

-- Adaptation

-- Beliefs

In textbook economics, the only external environmental factors that affect the individual are technology and prices. Social norms, habits, and rules play no role. North shows that institutions are fundamental determinants of poverty and prosperity. ...

Textbook economics treats the economy as an allocative mechanism. The focus is on the extent to which resources are allocated efficiently and equitably. North treats the economy as an adaptive mechanism. As an economic historian, his focus is on how an economy evolves over the long term, constrained in many ways by its past. ...

Finally, textbook economics is devoid of cultural context. Mainstream economics assumes that any policy can be implemented anywhere at any time. In contrast, North sees economic behavior as anchored by institutions, which in turn are anchored by beliefs within the culture. ...

But perhaps North's idea is not as unappreciated as Kling conjectured; at least indirectly. Another Nobel Laureate, George Akerlof (Berkeley), together with Rachel Kranton (Maryland), has been very persuasive and forceful in spreading their latest and serious works on norms (identity and beliefs) and macroeconomic theory; which can be said to be an attempt to set economics on a new path, a path that departs from the theoretical foundations of modern macroeconomic models by including social norms for behavior into the theoretical structures. Anyone who are interested in where macroeconomics is heading to in the future should be interested in reading this: Identity and Macroeconomics, What are we missing?

This is taken from Akerlof's presidential address at the 2007 American Economic Association meetings:

The Missing Motivation in Macroeconomics, George A. Akerlof

The discovery of five neutralities surprised the economics profession and forced the re-thinking of macroeconomic theory. Those neutralities are: the independence of consumption and current income (given wealth); the independence of investment and finance decisions (the Modigliani-Miller theorem); inflation stability only at the natural rate of unemployment; the ineffectiveness of macro stabilization policy with rational expectations; and Ricardian equivalence. However, each of these surprise results occurs because of missing motivation. The neutralities no longer occur if decision makers have natural norms for how they should behave. This lecture suggests a new agenda for macroeconomics with inclusion of those norms.


... The incorporation of norms based on careful observation imparts an appropriate balance to macroeconomics. The New Classical research program was correct in viewing models of the early Keynesians as too primitive. They had not been sufficiently attentive to the role of human intent in choices regarding consumption, investment, wages and prices. But that research program itself has failed to appreciate the extent to which the Keynesians’ views of macroeconomics were also reflective of reality, since they were based on experience and observation.

A macroeconomics with norms in decision makers’ objective functions combines the best features of the two approaches. It allows for observations regarding how people think they should behave. It also takes due account of the purposefulness of human decisions.

Personally, I find the idea very appealing - a crucial step into a highly exciting direction?




Anonymous said...

Hey elanor,if you feel like it can you please explain the concept in simpler language for us not-as-proficient people....i dont mean this as criticism, but it seems very exciting stuff only i dont really get what those economists meant - the sweets example that you provided was really really good

Elanor said...

Hi Anon,

I am very sorry about the exclusivity of the post. About North's idea: economists have been increasing technical, relying on model building (equations), mathematics and statistics - in understand two things: history (what happened before really matters) and institutions (laws, regulations, political structures, social cohesion, mindset of the people, governance, education, corruption).

The more you look at Malaysia, the more you realise how truly true this is - mathematics and models explain very little about economic performance in Malaysia (and when they do explain scenarios, they are always not very interesting). Understanding the true fate of the nation does not lie in looking at the interest rates BNM sets, the exchange rates regime, the inflation rates and so on.

But rather, the fate is determined by what happened before (history) which shaped the institutional structures (institution) the way we have now. Sometimes history shapes good institutional structures - sometimes it shapes very negative ones. Malaysia, I am increasing convinced, is stuck in a very negative path - we are having a crisis of institution, shaped by our history.

My greatest fear is that this problem is faceless and everywhere - there is no single source. The problem is in all of us, all our organisations, all interlinked together, feeding on each other and giving strength to the decline of our nation. Institutional crisis in Malaysia - the extremely racist mindset, the prevalence of corruption, the need to separate performance-reward structure and replace it with ethnicity/connection-reward structure, the lack of social cohesion, the decline in educational quality - are all linked together, feeding on each other and are not promoted by a single source. No, it is not due to the ruling political party or the oppositions but by our history, our society and every single one of us.

As an example, even without government's direction, our companies have racist policies by themselves - Maybank, and the call by the Bumiputera 'intelligentsia' to retain the racist policies that makes no business/economics-sense is a case in point. The decline is self-sustaining.

If it has a single source, the solution is clear - if it is faceless, the solution is... sigh.

I do not have an answer for that. That is why it is my greatest fear - watching my beloved country's slow but painful demise.


ps: Akerlof's latest works is on how to systematically analyse economics by including identity - that is, instead of assuming everyone acting rationally, we have to consider how people will actually act based on their belief on who they should act based on society's expectation of how they should behave. Basically by making economics more personal again.

Anonymous said...

Thank you very much, Elanor...conveying messages online is very tough stuff, but you've done an amazing job...I only wish more people read blogs like yours and wake up from their contented state

Samuel Goh Kim Eng said...

Looking At Any Economist
(eg. Elanor?)

It's not easy to be an economist
With the head always in a mist
Trying very hard to explain amidst
Facts, figures, concepts and blitz!

Motivationinmotion(BLOGGER) 030907

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