The perpetual innovation machine that drives the modern economy owes its existence not mainly to science (which is its beneficiary more than its benefactor); nor to money (which is not always a limiting factor); nor to patents (which often get in the way); nor to government (which is bad at innovation). It is not a top-down process at all. Instead, I am going to try now to persuade you that one word will suffice to explain this conundrum: exchange. It is the ever-increasing exchange of ideas that causes the ever-increasing rate of innovation in the modern world.

Why is Ridley a “rational optimist”?  Because, in his words, he has “arrived at optimism not through temperament or instinct, but by looking at the evidence”.  As Ridley sees it, throughout history, when the free exchange of ideas has been hampered by natural disasters, disease, war, wrong-headed government policy and monopolistic business practices, the result has been a reverse in development and a regression of health and happiness.  Despite these periods of regression, Ridley remains optimistic that the world will continue to get better as long as we ensure that society remains open.  Recent developments in communication technology have only accelerated what Ridley sees as an already robust atmosphere for ideational mating.  This, combined with the progress already achieved in medicine, agriculture, and human rights gives him more hope than not that as a global society we will avoid the many catastrophic predictions making the rounds.

Overall, the book was quite enjoyable.  Ridley spares no sacred cows and marshalls logical and empirical evidence to make his point–whether he is eviscerating the organic farming and climate change movements or patent rights.  He traces over 200,000 years of human history to make the case that we are, on balance, far better today than we have ever been.  This isn’t to gloss over the many problems that persist.  Rather, Ridley freely admits the issues we face while arguing that the past should give us confidence that these issues will also be overcome.  History has shown us that when ideas are allowed to freely move about and reproduce with each other, society is able to drastically improve itself and solve seemingly intractable problems.  I would have liked to see more explicit discussion of ideational “mating”, rather than it’s sprinkling through various chapters, but overall the point is well taken.  My biggest peave with the book is Ridley’s treatment of government.

Ridley is clearly not a “big government” advocate, and that is a totally reasonable position.  The idea that innovation and economic growth is primarily driven by bottom-up activity versus top-down planning and decree is correct.  However, at many points in the book, Ridley seemingly fails to adequately wrestle with the fact that much of the progress he lauds is a by-product of optimal government policy, not despite it.

For example, when discussing how the country of Botswana could have developed at an incredible rate despite facing many of the same crushing obstacles as other perpetually underdeveloped African states, Ridley succintly notes that the main difference was that Botswana had “good institutions”:

In particular, Botswana turns out to have secure, enforceable property rights that are fairly widely distributed and fairly well respected. When Daron Acemoglu and his colleagues compared property rights with economic growth throughout the world, they found that the first explained an astonishing three quarters of the variation in the second and that Botswana was no outlier: the reason it had flourished was because its people owned property without fear of confiscation by chiefs or thieves to a much greater extent than in the rest of Africa. This is much the same explanation for why England had a good eighteenth century while China did not.

I agree whole heartedly with Ridley’s emphasis on property rights. Here, he is following such eminent economic historians as Douglass North (whom he cites) by emphasizing that good institutions are critical to shaping the economic outcomes we hope to achieve.  However, Ridley goes on to argue that property rights cannot simply be imposed from above by government, but must evolve from the bottom-up.  The bottom-up evolution of institutions and the importance of government are not mutually exclusive or at odds.  Optimal property rights, particularly those that allow for robust exchange in an impersonal economy, must at some point be formalized and enforced through fully functioning legal and court systems.  Additionally, they must be codified in a such a way where they can be changed if necessary to improve their efficiency and functionality.  The only way to formalize such rules, ensure their proper enforcement, and allow for occasional ”tweaking” is to have in place a government system that is at once robust in it’s authority and responsive enough to citizens to minimize the abuse of property rights (e.g. through the creation of a rentier class).  In other words, liberal Democracy.  This is not to say that governments are optimal or do not, in some cases, harm innovation and economic growth (surely they do).  Rather, the point is that the dynamics that Ridley so covets cannot flourish despite government, but rather require “good” governments and institutions that can facilitate free idea exchange and commerce.

Our main finding is that lobbyists connected to US Senators suffer an average 24% drop in generated revenue when their previous employer leaves the Senate. The decrease in revenue is out of line with pre-existing trends, it is discontinuous around the period in which the connected Senator exits Congress and it persists in the long-term. The sharp decrease in revenue is also present when we study separately a small subsample of unexpected and idiosyncratic Senator exits. Measured in terms of median revenues per ex-staffer turned lobbyist, this estimate indicates that the exit of a Senator leads to approximately a $177,000 per year fall in revenues for each affiliated lobbyist. The equivalent estimated drop for lobbyists connected to US Representatives leaving Congress is a weakly statistically signicant 10% of generated revenue.  The equivalent estimated drop forlobbyists connected to US Representatives leaving Congress is a weakly statistically signicant 10% ofgenerated revenue.We also find evidence that ex-sta ffers are more likely to leave the lobbying industry after their connected Senator or Representative exits Congress. (emphasis mine)

They also show that ex-staffers revenues has grown at a faster rate than non ex-staffers since the late 1990′s.

Here’s a graphical representation of the findings from Tyler Cowen:

Ridley explains how exchange–or barter–is qualitatively different from reciprocity (an activity that can be found in other species):

at some point, after millions of years of indulging in reciprocal back-scratching of gradually increasing intensity, one species, and one alone, stumbled upon an entirely different trick. Adam gave Oz an object in exchange for a different object. This is not the same as Adam scratching Oz’s back now and Oz scratching Adam’s back later, or Adam giving Oz some spare food now and Oz giving Adam some spare food tomorrow. The extraordinary promise of this event was that Adam potentially now had access to objects he did not know how to make or find; and so did Oz. And the more they did it, the more valuable it became. For whatever reason, no other animal species ever stumbled upon this trick – at least between unrelated individuals.

As I read this it occurred to me that Ridley is likely right, but also that exchange is just as dangerous an activity as it is a transformative one.  Why?  Because to base one’s existence on exchange means making oneself vulnerable to and dependent on others for what one needs.  As Ridley notes, earlier humans were self-sufficient.  But moving from self-sufficiency to exchange means trusting others that they will provide what you need and will honor the exchange.

In the present, we take this somewhat for granted.  I assume that my local grocer will have the fruits, vegetables, etc, that I need to feed myself and my family.  I don’t worry about the possibility that they either won’t have my food or that they will refuse to provide it to me in exchange for the money that I have.  But imagine back about 100,000 years ago.  At some point, someone had to take a very big leap and become dependent on someone else for what they required for survival.

As a political scientist, my initial reaction is that trust both emerged from repeated interactions with barter partners and was then institutionalized through the emergence of government.  Too often government is derided as an impediment to economic growth, but we often forget that without it one is hard pressed to explain sustained progress.  A capitalist economic system cannot function without a robust legal system that includes rules for exchange and a system that monitors and enforces violators.  It provides the structural conditions that facilitate such a system.  That isn’t to say that government can’t also play a negative role–often it has.  But ignoring the positive, necessary role that it plays is quite dangerous in my view.  It also requires us to ignore the lessons of history.

I am only up to Chapter 2, and it appears that Ridley will take up this question of how trust emerged in Chapter 3.  I’ll be curious to see how he deals with this question and what answer he proposes.

Beggs is a Ph.D. Candidate at Harvard and focuses on behavioral economics (incentives, generally).  She has a great sense of humor and does a great job of relating the sometimes complex and arcane concepts of economics to the average reader through her humor.  As she notes:

In a perfect world I would be some sort of odd hybrid of Steve Levitt (see Freakonomics), Demetri Martin (see here) and Jon Stewart (hopefully you don’t need any clarification on that one). Stated another way, I want to trick people into learning stuff and entertain them in the process.

Enjoy!

Traditionally, credit rating agencies–such as S&P, Moody’s and Fitch–served as a sort of signal or barometer for investors as to the level of risk attached to specific corporate bonds.  Over time, they began rating additional types of investment products, including new financial instruments such as collateralized debt obligations (CDOs) that consisted of massive bundles of subprime mortgages.  Amazingly, these agencies rated these products AAA–the highest possible rating, indicating “the highest level of capacity of the obligor to honor its financial commitment on the obligation.”  The importance of this cannot be understated.  What makes this particularly troublesome is that the firms that issued the debt were the ones paying the CRA’s for the ratings, creating a significant conflict of interest.  Common practice, sure.  But given what transpired in this particular case such a conflict cannot help but be scrutinized.

What was once a reliable indicator for measuring the level of risk attached to an investment has now come into question as possibly nothing more than a rigged instrument.  Now, US Congressional leaders are focusing aspects of their financial reform bill on the CRA’s.  Senator Dodd’s version of the bill included a number of provisions aimed at restoring trust and confidence in these vital agencies.  Just yesterday, the Senate passed an amendment offered by Sen. Franken (MN) that would require a newly-formed government body to assign the task of rating a specific asset-backed security to a specific CRA.  The hope is that such a move would end the practice of ratings shopping that many believe led to creation of perverse incentives by CRA’s and the misleading rating of unstable securities.

I am not by any means an expert on the CRA industry (I know just enough to be dangerous, I guess), but here is my take.

The overall goal should be to create a ratings system that is both widely used and viewed as credible by the investment community. The major issue here is that we need to end the conflict of interest (or perception thereof) that exists when you have a ratings agency being paid to evaluate and rate the level of risk of a complex financial instrument by the very organization that is issue the instrument.  I think the Franken amendment is coming from the right place, but in the end it might be misguided.  Creating a federal agency to determine who gets to rate which security may continue and further perpetuate the false sense of security that investors have in the accuracy of these ratings.  The governmental seal of approval can also induce perverse behvavior.

What I would suggest is the creation of an agency that would manage the oversight of CRA’s in a way that still allows for the market to not only evaluate risk but also evaluate the CRA’s and the ratings they issue.  Here are a few approaches that I think would be helpful:

• (Good) Require multiple ratings for any single security: As with anything, there is power in numbers.  If the government agency is going to determine who rates a single security why not involve more than one firm?  Why not three CRA’s and the eventual rating is some kind of weighted average of all three?  This could help remove the false sense of security from the government seal as well as the conflict of interest between issuer and CRA.
• (Better) Provide greater transparency into the ratings process: A better understanding of how the CRA came to it’s conclusion would allow investors to contextualize the rating and how reliable that rating is.  How we cast the die is important when it comes to risk analysis.  Knowing the model, the assumptions, and the data sources provides investors a chance to weight how reliable the rating actually is.  Even if the issuer pays off the CRA investors can independently evaluate the reliability of the particular rating.  Requiring a standard period of review before the security is available for sale would allow for independent evaluation.
• (Best) Institute rigorous evaluations and independent rankings of ratings agencies (Moneyball-approach): Right now I believe the federal government can register a CRA, but lacks the tools and ability to continuously evaluate and possibly deregister a poorly performing CRA.  What we should be able to do is come up with a way to rank CRA’s against each other based on the reliability of their risk assessment for securities over time.  Think of it as a Value-Over-Replacement-Rater or VORR, similar to the way that professional athletes are now rated and their value determined (Value-Over-Replacement-Player or VORP).  Given the mass of historical data on securities ratings and their performance it shouldn’t be too hard to create a VORP-like rating system that could be updated in real-time as the value of securities rise and fall.  This way, it isn’t simply a government’s stamp of approval or a firm’s reputation that determines the level of trust investors should have in a CRA’s ratings.  Instead, investors can see in real-time how reliable a firm’s AAA ratings are versus the average CRA.  With such a methodology we might be able to avoid both the government providing a misleading seal of approval as well as the damaging conflicts of interest between raters and issuers.  Issuers could still shop around, however if they choose to use a CRA that will give them a favorable rating but has a very low, public VORR they will likely suffer in the end as investors will be less likely to buy the security.  In fact, you would likely see the buy-side institute rules that incorporate VORR ratings into their buy decisions (i.e. no security may be purchased if rated by a CRA whose VORR is less than X).

Like I said, this is not an area I know particulary well.  Any readers at there more steeped in the CRA area that can offer some perspective.

At a time when many economists and financial commentators where underplaying, if not downright ignoring, the looming credit crunch, Roubini was warning of the impending chaos of the markets.  Some may claim that he was simply lucky (even a broken clock is right twice a day), but Roubini’s arguments were always couched in explicit logic and backed by relevant data.  I can remember reading his musings while still in graduate school and hoping that his analysis was flawed.  Unfortunately, it wasn’t.  Lately, he has been warning about the potential problems of sovereign debt and there are signs that once again his perspective should be taken quite seriously.

Even if he never goes on to predict another major economic event he still managed to be on point with the meltdown of 2008, and that is no small accomplishment.

Some folks are leveraging newly available data in urban areas as analytical shortcuts:

Ted Egan, chief economist in the San Francisco Controller’s Office, said he could wait six months for California to release the detailed sales-tax data he needs for city revenue projections. But it’s quicker to look at passenger tallies from the station closest to the Union Square shopping district, which generates roughly 10% of the city’s sales-tax revenue. The Bay Area Rapid Transit District releases the data within three days, he said: “Why should I have to wait?”

Mr. Egan is among a growing number of economists and urban planners who scour for economic clues in unconventional urban data—oddball measures of how people are moving, spending and working.

Egan has essentially found an analytical shortcut which allows him to see the world as it is more quickly.  Rather than wait for the actual tax receipts, Egan can look at a related measure and extrapolate from there about tax revenues.  Notice, Egan isn’t interested in why tax revenues and sales activity is low or high, he’s just trying to quickly get a handle on what the amount is.

This is illustrates the utility of correlational analysis and the promise of Big Data and data mining.  The danger, of course, is that many of these new indicators may be untested and more volatile.  On the other hand, new data may actually do a better job of capturing people’s patterns and motivations under certain circumstances and such a preview allows for business and policy makers to adjust more quickly to a rapidly changing environment.  For example:

Mr. Leamer discovered that truckers’ diesel purchases on Interstate Highway 5 from California to Oregon, a major timber-trucking route, are a leading indicator of construction employment in California. Diesel sales on Interstate Highway 80 from Sacramento to Salt Lake City, a trucking route for the San Francisco Bay area’s manufactured goods, can help predict California’s manufacturing employment, he said.

If only he had the diesel-fuel data in the first half of 2008, when major government-issued indicators failed to hint at the U.S. economy’s impending downward spiral. At the time, Mr. Leamer said, UCLA forecasters chose not to announce a recession because GDP was still growing and the Bureau of Labor Statistics was reporting relatively mild job losses.

Bad call. The government later revised the GDP and jobs data downward, and the National Bureau of Economic Research concluded that the recession started in December 2007. The jobs data are unreliable because they are based on sample surveys and don’t adequately capture company openings and closings, Mr. Leamer said in hindsight.

When the UCLA economists reviewed the fuel-purchases data late last year, they saw diesel buying had peaked in mid-2007, indicating that fewer goods were being made and moved across the country in the months after. “Had we been aware of that data in 2008,” Mr. Leamer said, “we would have made a different call.”

In business and government, sometimes quickly knowing “what” is happening is more valuable than waiting to know precisely “why” it is happening.

Further confirming this notion is Anna Katherine (A.K.) Barnett-Hart and her brilliant senior thesis from Harvard on the subprime mortgage CDO meltdown.  Her thesis has been getting tons of attention, including praise from leading economists and author Michael Lewis who, in the acknowledgments to his new book, said the thesis was “more interesting than any single piece of Wall Street research on the subject”.  The data collection alone is masterful and a coup given the opaque nature of this market.

Barnett-Hart concludes that the meltdown in the CDO market resulted from “poorly constructed CDOs, irresponsible underwriting practices, and flawed credit rating procedures.”

A pdf  version of her thesis can be found here.

The problem is not just that specific rules – higher bank capital requirements, for instance – threaten profits and are therefore opposed. It is that all governments see themselves as partners of their industries in world competition. Regulators seek not a level playing field but one tilted to their own groups’ advantage. This is not a hidden bias. It is proudly advertised. A government that did less than stand up for its own companies would be seen as failing in its duty.

In finance, a footloose industry, this striving for regulatory advantage undermines rules imposed by other countries. Financial regulation will underperform until regulators work more closely with counterparts abroad than with those they police.

[...] Pieces of the needed reforms are reasonably clear. They include higher capital and liquidity requirements, linked to size and to the credit cycle. Orderly resolution arrangements must be designed for non-bank financial groups as well as banks. There is growing support for requiring contingent capital (bonds that convert to equity under stress) and subordinated debt (increasing creditors’ exposure to writedowns). These should strengthen market discipline over risk-taking.

Such measures will meet resistance, especially if done unilaterally. The industry will cry competitive disadvantage. International co-operation is therefore essential. But discussions among regulators are moving slowly. While America’s turf fights remain unresolved, it is not even clear who should speak for US regulators.

I would agree with Crook.  If policy makers focus too much on the domestic arena their best efforts will be doomed to fail.  Not only must they take into consideration how the effectiveness of their reforms will be partially determined by similar actions in other countries, but they should be using the international arena to their advantage.

One way would be to use international negotiations and commitments as a way to gain leverage over the powerful interests of the financial industry who see less regulation (even sensible regulation) as against their interests. There is a rich literature on the use of international organizations and agreements as commitment mechanisms, a way of “tying one’ hands” so that what are normally tough reforms domestically due to lobbying and special interest pressure become easier to resist. If the Obama administration wants to pass sensible financial reform it might consider focusing more on finalizing international standards across, say, the OECD in order to shift the domestic playing field to its advantage.

As he eloquently demonstrates, the old terms of First World and Third World really no longer apply. Rather, the majority of the world is either highly developed or moving significantly in that direction. However, there is a portion of the world—about 1 billion people—whose countries are on the outside looking in when it comes to economic development. Collier’s work, and this book, offers an explanation as to why the countries that make up the bottom billion have failed to develop and what can be done about it. Books of this nature typically stake out a position along one of the ideological poles and hammers away at the other pole for three-hundred pages or so—Aid is bad and does nothing but fill the coffers of corrupt leaders and make the population dependent and lazy! Capitalism is the enemy! Rich countries use their power to exploit the labor and resources of these countries for profit, therefore protectionism and transfers of wealth from the developed world are needed! As it so often does, the truth can be found in the middle.

Collier lays out various “traps” that countries can find themselves in–conflict, resources, geography, and governance–all of which provide extensive barriers to economic development. All of these have been hypothesized by others, but Collier & Co. tease out the specific ways that these traps work. For example, while landlocked countries generally find themselves without realistic alternatives to growth there does appear a way out–development by their neighbors (particularly in terms of infrastructure) leads to increased growth for the landlocked country. Understanding that geography is a powerful variable, but does not equate to fate, leads to various policy prescriptions that can credibly be applied to these particular cases. It also highlights the friction that is politics. Collier acknowledges the powerful role of politics in both his explanations and his prescriptions for the least developed nations. Countries and leaders are generally self-interested, and this makes political solutions difficult to come by when dealing with the poorest countries in the world. Collier has a few ideas, some of which have been adopted by leading countries and organizations. However, it is too early to tell if they have the kind of effect he hopes they will.

My one complaint is that Collier does not provide a graphical summary of the numerous hypotheses that he confirms and nullifies. Nor does he provide a summary guide to the additional theories and mechanisms that he proposes. The book is stuffed with propositions and results that after a while it was hard to remember just what was proven and falsified, what mechanisms Collier suggested that may explain the peculiar relationship between, say, aid and coups. Now, I read the Kindle version, so maybe such graphics were available in the dead-tree version.

Overall, Collier’s book was well worth my time. I am excited to read his follow up, War, Guns and Votes, but it will have to wait as I’ve got a few others ahead of it in the queue.