REALITY BITES[1]
Elinor Ostrom and Oliver Williamson win this year’s Nobel prize for economics
BUILDING economic models usually involves stripping the world down to its most essential features. But simple theories often struggle to explain the way things really work. Elinor Ostrom of Indiana University and Oliver Williamson of the University of California at Berkeley, the winners of this year’s Nobel prize for economics, have both been honoured for recognising this complexity. Their research provides insights into economic institutions that play crucial roles in the real world, but to which economists have not paid enough attention.
In the case of Mr Williamson, that institution is the company. With hierarchical decision-making processes based on rules and authority, firms ought to be less efficient than decentralised market exchange based on relative prices, which is how standard economic theory assumes that transactions occur. So why do companies exist at all? This question was first addressed in 1937 by Ronald Coase, the winner of the 1991 Nobel prize for economics and the intellectual forefather of both of this year’s winners. Mr Coase argued that all economic transactions are costly—even in competitive markets, there are costs associated with figuring out the right price. The most efficient institutional arrangement for carrying out a particular economic activity would be the one that minimised transaction costs. This would often be the market. But using authority and rules within a firm would sometimes prove to be more efficient.
Mr Coase’s theory explained why companies existed but it was not specific enough to predict the conditions under which firms, or markets, would be the superior form of organisation. Clarifying this was Mr Williamson’s signal contribution. In a series of papers and books written between 1971 and 1985, he argued that the costs of completing transactions on spot markets increase with their complexity, and if they involve assets that are worth more within a relationship between two parties than outside it (a rear-view mirror made to the specifications of a particular car manufacturer, for example).
Both these features make writing and enforcing contracts which take every possible eventuality into consideration difficult, or even impossible. At some point, therefore, it makes sense to conduct the associated transaction within a single legal entity rather than on a market. The car company might prefer to produce its rear-view mirrors in-house, for example, perhaps by buying the mirror company. This would reduce the time and resources spent haggling over profits, because decisions would simply be taken by fiat.
Mr Williamson’s theory helpfully specified measurable attributes of transactions that would make them more or less amenable to being conducted on markets. That meant his thinking could be tested against decisions by companies to integrate parts of their supply chain. It has held up remarkably well. Several studies find, for instance, that when an electricity generator can choose between the output of many nearby coalmines that produce coal of a particular quality, it tends to buy its coal on an open market. But if there is only one nearby mine that can be relied upon as a supplier, the electricity generator tends to own it. A transaction that could be done on the market moves into the firm.
According to Mr Williamson, one lesson from organisational theory is the importance of identifying common patterns of behaviour in seemingly disparate situations. That sums up the way Elinor Ostrom has spent her working life. The first woman to win a Nobel prize for economics, she studies the governance of “common resource pools”—such as pastures, fisheries or forests—to which more than one person has access. Unlike pure public goods such as the atmosphere, where one person’s use does not reduce the amount available to others, people deplete these resources when they use them. Standard economic models predict that in the absence of clearly defined property rights, such common resources will be overexploited, with individuals acting without regard for the effects of their actions on the overall pool. Overfishing or overgrazing (the “tragedy of the commons”) will result. Over time, stocks of the common resource will dwindle.
But in 40 years of studying how common resources—from lobster fisheries in Maine to irrigation systems in Nepal—are actually managed by communities, Ms Ostrom found that people often devise rather sophisticated systems of governance to ensure that these resources are not overused. These systems involve explicit rules about what people can use, what their responsibilities are, and how they will be punished if they break the rules. In particular, she found that self-governance often worked much better than an ill-informed government taking over and imposing sometimes clumsy, and often ineffective, rules. In this, she too shadows Mr Coase, who argued that those who advocated government ownership of common resources ignored the transaction costs associated with collecting taxes.
Tit for tat
One problem with the idea of the tragedy of the commons, Ms Ostrom found, was that it did not account for the fact that people sharing a pool of resources tend to interact repeatedly, making all sorts of clever punishments for wrongdoing feasible. Being able to threaten credible retaliation makes co-operation possible. This is the province of game theory, to which Ms Ostrom has contributed, both through formal modelling of what she found in the field and subsequent laboratory tests of her models.
Both Mr Williamson and Ms Ostrom have built on Mr Coase’s idea that all transactions have costs but that these costs will be minimised by different institutional arrangements in different situations. Their work uses methods and insights from fields that many economists are not sufficiently familiar with: detailed case studies, in the case of Ms Ostrom, a political scientist by training, and insights from the law in Mr Williamson’s case. Their win reminds economists that borders between disciplines, like those between the firm and the market, can be profitably crossed.
MEASURING WHAT MATTERS[2]
Man does not live by GDP alone. A new report urges statisticians to capture what people do live by
HOW well off are Americans? Frenchmen? Indians? Ghanaians? An economist’s simplest answer is the gross domestic product, or GDP, per person of each country. To help you compare the figures, he will convert them into dollars, either at market exchange rates or (better) at purchasing-power-parity rates, which allow for the cheapness of, say, haircuts and taxi rides in poorer parts of the world.
To be sure, this will give you a fair guide to material standards of living: the Americans and the French, on average, are much richer than Indians and Ghanaians. But you may suspect, and the economist should know, that this is not the whole truth. America’s GDP per head is higher than France’s, but the French spend less time at work, so are they really worse off? An Indian may be desperately poor and yet say he is happy; an American may be well fed yet fed up. GDP was designed to measure only the value of goods and services produced in a country, and it does not even do that precisely. How well off people feel also depends on things GDP does not capture, such as their health or whether they have a job. Environmentalists have long complained that GDP treats the despoliation of the planet as a plus (via the resulting economic output) rather than a minus (forests destroyed).
In recent years economists have therefore been looking at other measures of well-being—even “happiness”, a notion that it once seemed absurd to quantify. Among those convinced that official statisticians should join in is Nicolas Sarkozy, the French president. On September 14th a commission he appointed last year, comprising 25 prominent social scientists, five with Nobel prizes in economics, presented its findings. Joseph Stiglitz, the group’s chairman and one of the laureates, said the 292-page report was a call to abandon “GDP fetishism”. France’s national statistics agency, Mr Sarkozy declared, should broaden its purview.
The commission divided its work into three parts. The first deals with familiar criticisms of GDP as a measure of well-being. It takes no account of the depreciation of capital goods, and so overstates the value of production. Moreover, the value of production is based on market prices, but not everything has a price. The list of such things includes more than the environment. The worth of services not supplied through markets, such as state health care or education, owner-occupied housing or unpaid child care by parents, is “imputed”—estimated, using often rickety assumptions—or left out, even though private health care and schooling, renting and child-minding are directly measured.
The report also argues that official statisticians should concentrate on households’ incomes, consumption and wealth rather than total production. All these adjustments make a difference. In 2005, the commission found, France’s real GDP per person was 73% of America’s. But once government services, household production and leisure are added in, the gap narrows: French households had 87% of the adjusted income of their American counterparts. No wonder Mr Sarkozy is so keen.
Sizing up the good life
Next the commission turns to measures of the “quality of life”. These attempt to capture well-being beyond a mere command of economic resources. One approach quantifies people’s subjective well-being—divided into an overall judgment about their lives (a “ladder of life” score) and moment-by-moment flows of positive and negative feelings. For many years researchers had been spurred on by an apparent paradox: that rising incomes did not make people happier in the long run. Recent studies suggest, though, that countries with higher GDP per person do tend to have higher ladder-of-life scores. Exactly what, beyond income, affects subjective well-being—from health, marital status and age to perceptions of corruption—is much pored over. The unemployed report lower scores, even allowing for their lower incomes. Joblessness hits more than your wallet.
Third, the report examines the well-being of future generations. People alive today will pass on a stock of exhaustible and other natural resources as well as machines, buildings and social institutions. Their children’s human capital (skills and so forth) will depend on investment in education and research today. Economic activity is sustainable if future generations can expect to be at least as well off as today’s. Finding a single measure that captures all this, the report concludes, seems too ambitious. That sounds right. For one thing, statisticians would have to make assumptions about the relative value of, say, the environment and new buildings—not just today, but many years from now. It is probably wiser to look at a wide range of figures.
Some members of the commission believe that the financial crisis and the recession have made a broadening of official statistics more urgent. They think there might have been less euphoria had financial markets and policymakers been less fixated on GDP. That seems far-fetched. Stockmarket indices, soaring house prices and low inflation surely did more to feed bankers’ and borrowers’ exaggerated sense of well-being.
Broadening official statistics is a good idea in its own right. Some countries have already started—notably, tiny Bhutan. There are pitfalls, though. The report justifies wider measures of well-being partly by noting that the public must have trust in official statistics. Quite so; which makes it all the more important that the statisticians are independent of government. The thought of grinning politicians telling people how happy they are is truly Orwellian. Another risk is that a proliferation of measures could be a gift to interest groups, letting them pick numbers that amplify their misery in order to demand a bigger share of the national pie. But these are early days. Meanwhile, get measuring.
WHEN IS A RECESSION NOT A RECESSION?[3]
1 The most conventional rule of thumb for defining a national recession is at least two consecutive quarters of negative GDP growth. Unfortunately, this simple rule does not translate well to the global context. First, quarterly real GDP data are not always available - for a number of major emerging market countries, quarterly output data do not exist before the mid-1990s, and there are still many countries that only report GDP annually rather than on a quarterly basis. Even among those that do report quarterly, national methods for seasonally adjusting output data differ to such an extent that meaningful aggregation is difficult. Second, while we cannot measure it exactly, it is likely that quarterly global growth does not turn negative nearly as often as does GDP within the typical country. Indeed, annual global growth has never been negative for any year in recent history - but this should not be interpreted as evidence that the world has not experienced a recession.
2 The principal reason that global growth is rarely negative is that world output is more diversified than national output. For example, the USA, Europe, and Japan do not always experience downturns at the same time. Data on annual real GDP indicate that the current slowdown has a similar level of synchronisation as earlier episodes in the mid-1970s and early 1980s, even though growth in China (in particular) has remained relatively robust during this slowdown. The lower level of synchronisation in the early 1990s was an exception - largely reflecting specific regional events, including the asset price bubble in Japan and the consequences of German unification activity in continental Europe. It is also the case that trend growth for the world is higher than for most advanced economies because developing countries grow faster on average, so it takes a steeper dip to hit negative territory.
3 While global output may rarely decline, it is useful to have a simple benchmark for identifying slowdowns that could be labelled as global recessions. One reasonable solution to this conundrum is to adjust world output growth for growth in world population, and declare that a sufficient (although not necessary) condition for a global recession is any year in which world per capita growth (measured on a comparable basis) is negative. In the figure overleaf, the first bars show unadjusted world GDP growth during the major recent slowdowns, 1975, 1982, 1991 and 2001. In no case did world growth dip below 1 per cent, much less turn negative.
4 In 1975, GDP growth of 1.9 per cent was almost exactly offset by world population growth, so that per capita GDP growth was about zero. However, per capita GDP growth actually turned negative in 1982 and, to a lesser extent, in 1991. By contrast, per capita GDP growth in 2001 was over 1 per cent, well above zero. Compared with the earlier episodes, unadjusted growth was stronger at 2.5 per cent, instead of dipping below 2 per cent as in the previous episodes. Also, world population growth is lower today (1.3 per cent) than it was a decade earlier. Thus, the current slowdown has not come close to meeting the hurdle of negative per capita annual GDP growth, which would automatically qualify it as a recession. This partly reflects the relatively high weight of China, which has continued to grow strongly.
5 Can we declare that the world is not in recession simply because annual global per capita growth is positive? No, not necessarily. Whilst negative per capita GDP growth is a sufficient condition to identify a global recession, by itself it would probably be unduly conservative. As in the case of individual recessions, one cannot rely absolutely on any mechanical rule, but instead some element of judgement is required. That is how recessions are identified in the USA by the National Bureau of Economic Research (NBER), for example. Comparison of global slowdowns
6 The NBER defines a recession as a significant decline in activity spread across the economy and lasting more than a few months, and focuses on economy-wide monthly series (especially non-farm employment and real personal income less transfers). It also looks at data from manufacturing (real manufacturing and trade sales and industrial production), although - as the NBER notes - this is a relatively small part of the US economy whose movements often differ from those of other sectors. The rule of thumb of at least two quarters of negative growth often referred to by commentators is simply a useful way of approximating this system. Indeed, in a downturn, the NBER committee chose to identify the US slowdown as a recession even though, based on current information, GDP growth was only negative in the third quarter.