Tag Archives: Adam Smith

Why did the ratings agencies mess up so badly?

When companies or countries issue debt, ratings agencies assign grades based on how creditworthy the issuers are believed to be. Low grades can cost the issuers dearly.

But during the housing crisis, the major ratings firms gave the highest grades to mortgage-based securities that proved worthless. This month, the government sued one of the three dominant agencies, Standard & Poor’s, saying its evaluations of some of those securities were fraudulent.

What should be done to reform the ratings industry?

That is the introduction to the latest New York Times Room for Debate forum. There are contributions from:

Reggie Middleton: “The root cause of the agencies’ problems is the outrageous conflict created by having their primary revenue sources be the entities they rate, or the agents of those entities.”

Lawrence J. White: “The Dodd-Frank Act of 2010 instructed federal regulators to eliminate their mandated reliance on ratings, and some bank regulators have done so. But, maddeningly, for money market funds and broker-dealers, the Securities and Exchange Commission continues to mandate reliance on ratings.”

James H. Gellert: “The poor work of credit rating agencies undoubtedly played a role in the subprime mortgage crisis. But the government’s lawsuit against Standard & Poor’s is freighted with unintended consequences.”

Claire A. Hill: “Ideally, ratings would matter less. Fewer and less precipitous actions would be taken solely because of ratings. A money manager should not be able to justify having purchased a badly performing investment by saying that he relied on the rating agencies.”

And yours truly: “Since the days of Adam Smith, economists have known that a tightly restricted market will often result in higher prices and lower quality. So it was—and continues to be—with the ratings industry.”


Progressives and Libertarians Agree: Cronyism Stinks

Last week, I came across this photo. In my view, it succinctly and accurately sums up our greatest economic and social problem: government-granted privileges to the wealthy and well-connected.

Laura S., Movement To Strengthen Progressive Values


Brilliant though the point is, it is not novel. Market-oriented economists from Adam Smith to  Milton Friedman to Luigi Zingales have been making this point for decades (and in some cases, centuries). What is remarkable, however, is that the photo appeared on MoveOn.org’s website. They, in turn, attribute it to the Movement To Strengthen Progressive Values’ Facebook page. A similar sentiment was expressed by the left-of-center Nobel Laureate Joseph Stiglitz at an OWS rally several months ago.

It is heartening that self-described progressives and self-described libertarians can agree on matters so central to our political and economic ailments. My new paper explores these issues in greater depth. Here is the introduction (I plan to blog parts of the paper over the next few weeks):

Despite the ideological miles that separate them, activists in the Tea Party and Occupy Wall Street movements agree on one thing: both condemn the recent bailouts of wealthy and well-connected banks. To the Tea Partiers, these bailouts were an unwarranted federal intrusion into the free market; to the Occupiers, they were a taxpayer-financed gift to the wealthy executives whose malfeasance brought on the financial crisis. To both, the bailouts smacked of cronyism.

In this paper, I show that the financial bailouts of 2008 were but one example in a long list of privileges that governments occasionally bestow upon particular firms or particular industries. At various times and places, these privileges have included (among other things) monopoly status, favorable regulations, subsidies, bailouts, loan guarantees, targeted tax breaks, protection from foreign competition, and noncompetitive contracts. Whatever its guise, government-granted privilege is an extraordinarily destructive force. It misdirects resources, impedes genuine economic progress, breeds corruption, and undermines the legitimacy of both the government and the private sector.

Spreading ideas through the urban process

A shorter version of this post originally appeared at Next American City, where I was live blogging at the 20th anniversary of Living Cities.

Steven Johnson and Paula Ellis, of the John S. and James L. Knight Foundation, discussed some of the themes in his new book, Where Good Ideas Come From: The Natural History of Innovation, including the unique environment for innovation that cities provide. Johnson draws on the work of Jane Jacobs and Geoffrey West to demonstrate that innovation is most likely to happen in places where humans are densely clustered because entrepreneurs rely on the work of others. Both to see through the uncertainties of the future to realize profitable ideas, and to overcome the challenges of product development, entrepreneurs need to live in urban areas.

Johnson began his conversation explaining that many of the ideals that emerged in the Scottish Enlightenment came out of coffeehouses, through the spontaneous conversations that many brilliant men had, and the evolution of their ideas in this urban space. Looking back to these Enlightenment ideals, we can see that Adam Smith, perhaps one of the original urbanists, explained that the division of labor is limited by the size of the market. Continued urban growth provides individuals with growing opportunities to specialize, as both the consumers and technological developments that fuel the market process are consolidated in the same place.

In West’s work that Johnson referenced, he explains that, unlike firms that become increasingly bureaucratic and inefficient as they grow, cities continue to become more productive as they grow in size and density. As Johnson explained, cities have a “liquid property because they have the convergence of diverse people sharing a space. This is an incredible asset.” West demonstrates that the relationship between city size and innovation is exponential. “What the data clearly shows, and what [Jacobs] was clever enough to anticipate, is that when people come together, they become much more productive.” Smith demonstrated that wealth grows through the exchange that urban environments make possible.

However, unlike other scholars of entrepreneurship, Johnson diminishes the importance of profit in facilitating entrepreneurial alertness. Megan McArdle points out that he places a greater importance on “openness and inspiration” than on the profit motive in facilitating entrepreneurial innovation. Of course, entrepreneurs don’t operate in vacuums. Entrepreneurs living in a densely populated city will draw on each other’s work — and find markets for their products — more so than in less densely populated places. And the legal environment surrounding intellectual property, or openness, certainly affects innovation. Despite these outside influences, though, the profit motivation and the essential feedback mechanism that profits and losses provide cannot be downplayed in the market process.

Urban scholars from Jacobs to West to Johnson have built on the insight that dense populations facilitate innovation, where the size of the market is continually growing. While it’s often easy to fall into critiques of urban policies and focus on the challenges facing individuals in cities, yesterday’s conversation struck a happily optimistic note.


What is Economic Freedom and What Can it Say About Prosperity?

My post in the NYT’s Room for Debate blog elicited a good number of comments and questions. So today I thought I might elaborate on the most-important of these questions: What exactly is economic freedom and what do we know about the way it affects prosperity?

First, its impact. The economists Chris Doucouliagos and Mehmet Ali Ulubqasoglu recently reviewed 45 studies examining the freedom-growth relationship. They concluded:

[R]egardless of the sample of countries, the measure of economic freedom and the level of aggregation, there is a solid finding of a direct positive association between economic freedom and economic growth.

Studies also find that economic freedom tends to be associated with a whole host of other factors that humans tend to value such as:

  • Higher income levels: Faria and Montesinos (2009) Dawson (1998), De Haan and Siermann (1998), De Haan and Sturm (2000), Cole (2003), Gwartney et al. (2004) and Weede (2006);
  • Lower poverty levels: Norton (2003);
  • Less volatility in the business cycle: Dawson (2010);
  • Better environmental outcomes: Norton (1998), ch. 2);


  • Fewer homicides: Stringham and Levendis (2010); and 
  • Greater levels of reported happiness: Ovaska and Takashima (2006)

But what is economic freedom?

The concept is quite old, dating back to well-before Adam Smith. For his part, he called it “a system of natural liberty” and gave us a view of what he meant by it when he wrote:

Little else is requisite to carry a state to the highest degree of opulence from the lowest barbarism but peace, easy taxes, and a tolerable administration of justice: all the rest being brought about by the natural course of things.

This, however, is still pretty vague.

So in the last quarter-century, a number of economists have focused on defining and—importantly—measuring economic freedom. There are now a number indices of economic freedom at both the national and sub-national levels. Among academics, the most-widely cited of these is the Economic Freedom of the World index, the latest of which is authored by Professors James Gwartney, Joshua Hall, and Robert Lawson. This index grew out of a series of conferences initiated by (Nobel Laureate) Milton Friedman and the Fraser Institute’s Michael Walker in the mid-1980s to early 1990s. Other attendees included economic luminaries such as “Lord Peter Bauer, Gary Becker, Douglass North, Armen Alchian, Arnold Harberger, Alvin Rabushka, Walter Block, Gordon Tullock, and Sir Alan Walters” (a number of whom have either won Nobel prizes in own their right or are likely to in the years that come). Out of these conferences, a consensus began to emerge that the four cornerstones of economic freedom were:

  • Personal choice,
  • Voluntary exchange coordinated by markets,
  • Freedom to enter and compete in markets, and
  • Protection of persons and their property from aggression by others.

From these conceptual cornerstones, the authors of the index began to gather data with an eye toward objectively measuring the degree to which the laws of different nations permit (or don’t) the exercise of economic freedom. Their index includes factors such as government consumption spending as a share of total consumption, top marginal income tax rates, the degree of judicial independence, growth in the money supply, taxes on international trade, and regulation of private sector credit (among 17 other components). The index now covers more than 140 countries, with data on many going back to 1970. And now there are literally hundreds of peer-reviewed articles that are based on this index or one of many others like it.

Since the publication of this index, a number of others have gotten in on the game. There are now indices that measure freedom at the sub-national level, the most-recent of which is Sorens and Ruger’s Freedom in the 50 States, published by Mercatus (the next addition of which is coming out soon). 

As I have recently noted, these state level indices suggest that economic freedom is a powerful predictor of prosperity.

So that, in a nutshell, is economic freedom.

Buy Local, Potomac Edition

The greatest improvement in the productive powers of labour, and the greater part of the skill, dexterity, and judgment with which it is any where directed, or applied, seem to have been the effects of the division of labour.

So said Adam Smith.

In other words, the day that two humans decided, “I’ll hunt; you gather” was the day that economic growth was invented. Since then, the division of labor (or labour if you are Scottish) has gone far beyond what even Adam Smith could have imagined. Today, we are uber-specializers: I concentrate on understanding panel data regression techniques so that I don’t have to know how to hunt, gather, or shelter myself. Others specialize in those skills and are far better at those things than I could ever hope to be. By specializing and trading, we each stand to gain.   

But Smith had a caveat. He warned us:

The Division of labour is Limited by the Extent of the Market.

If there are few people with whom we can trade, then our ability to specialize is limited and so is our ability to produce. Imagine how unproductive you would be if you could only rely on the specialized labor of a few people?

Well some in the greater Washington, D.C. area have imagined it and are eager to try it. They have introduced a new local currency which they have called the “Potomac.” According to Wikipedia, they have coined 1145 of them. The goal is “to strengthen the local economy.” 

The economics of this are pretty straight forward. As Russ Roberts recently wrote:

We have tried buy local before. It is called the Middle Ages.

The political economy of it is also pretty straight forward: even though this is unlikely to benefit the overall community, it is likely to benefit a few producers if it helps them lock-in customers (especially if the producers continue to accept greenbacks from other customers).

What I can’t understand is why the buy local movement seems to have such moral force among otherwise completely moral people. To me, the notion that I should only deal with those who are similar to me—those who happen to share my culture or geography—seems downright ugly.