Wrong lesson from Adam Smith's pin factory

We commonly use stories to teach new ideas, but all too often end up taking the wrong lessons from them. My favourite example is the Coase theorem. Economics textbooks describe theorem as saying that it doesn’t matter where you place the liability for pollution, because in a world of zero transaction costs the right to pollute will end up in the hands that value is most. This is the exact opposite of the point Coase made. As Deidre McCloskey wrote,

Economists have gotten the “theorem” wrong; in fact, backwards
…
Coase’s actual point, the core of a Coasean economics, was to note what happens in the many important cases in which transactions costs cannot be neglected. If the situation does have high transactions costs, then it does matter where the liability for pollution is placed.

I was alerted to another example in Joan Robinson’s long forgotten textbook. In it she dismisses the division of labour as a primary factor in the great surge in productivity of the industrial revolution, noting that this is the wrong lesson to take from Adam Smith’s pin factory story.

First let me recount the relevant part of Smith’s writing where he describes the productivity boon enabled by the division of labour.

To take an example, therefore, from a very trifling manufacture; but one in which the division of labour has been very often taken notice of, the trade of the pin-maker; a workman not educated to this business (which the division of labour has rendered a distinct trade), nor acquainted with the use of the machinery employed in it (to the invention of which the same division of labour has probably given occasion), could scarce, perhaps, with his utmost industry, make one pin in a day, and certainly could not make twenty.  

But in the way in which this business is now carried on, not only the whole work is a peculiar trade, but it is divided into a number of branches, of which the greater part are likewise peculiar trades. One man draws out the wire, another straights it, a third cuts it, a fourth points it, a fifth grinds it at the top for receiving the head; to make the head requires two or three distinct operations; to put it on, is a peculiar business, to whiten the pins is another; it is even a trade by itself to put them into the paper; and the important business of making a pin is, in this manner, divided into about eighteen distinct operations, which, in some manufactories, are all performed by distinct hands, though in others the same man will sometimes perform two or three of them.  

I have seen a small manufactory of this kind where ten men only were employed, and where some of them consequently performed two or three distinct operations. But though they were very poor, and therefore but indifferently accommodated with the necessary machinery, they could, when they exerted themselves, make among them about twelve pounds of pins in a day.  

There are in a pound upwards of four thousand pins of a middling size. Those ten persons, therefore, could make among them upwards of forty-eight thousand pins in a day. Each person, therefore, making a tenth part of forty-eight thousand pins, might be considered as making four thousand eight hundred pins in a day.  

But if they had all wrought separately and independently, and without any of them having been educated to this peculiar business, they certainly could not each of them have made twenty, perhaps not one pin in a day; that is, certainly, not the two hundred and fortieth, perhaps not the four thousand eight hundredth part of what they are at present capable of performing, in consequence of a proper division and combination of their different operations.

This insight has attracted so many followers and is so embedded in economic thinking, that it was quite a shock for me to see it dismissed. Robinson merely states that people can equally divide their own labour across different tasks through time and thus Smith is incorrect in attributing the productivity of the pin factory to the division of labour.

The 18 distinct operations Smith recounts could just as easily be conducted by the same labourer on 18 different days to create the same output per person over an 18 day period as in the case where labour is divided between workers.

I’ll be honest. Dismissing one of the key elements of accepted economic theory in a single sentence is bold. But again, Robinson had a lot to get through in a short book.

So what is the real lesson? To me the lesson of productivity is not about division of labour, but of capital accumulation. 

Smith suggested it was the division of labour that had ‘given occasion’ to the invention of machinery. But this gets causality backwards; it is the new tools and production techniques that allowed both the division of labour and the great increase in efficiency. 

Imagine that each on the 18 separate tasks could be achieved more efficiently with 18 different new tools. Drawing the wire used a particular apparatus, straightening another, and cutting yet another, and so on.

For the individual labourer to be equally efficient as the factories of the time, each labourer would need 18 different tools that each sat idle for 17/18ths of the time. Thus it is the search for returns on the investment in new tools and equipment that allowed for both the observed division of labour and the radical increase in productivity.

You might interject that if 18 labourers joined together they could each buy a single different tool and simply share their own tools on the off days, that they would be equally efficient as a group. But in fact, they would simply be a factory, with the only difference to Smith’s example that workers owned all the capital.

Thus it is capital investment that leads to larger firms, internal coordination via division of labour, and increases in productivity. That is the real lesson of Smith’s pin factory.

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Are Australian universities just not good enough?

The reserved and mild-mannered American Canadian law Professor James Allan, who works at an under-performing Australian university, has recently written a long tirade against the bureaucratisation of higher education in Australia.

While it contains a few home truths which need public acknowledgement - like the centralisation of decision-making and the power of university executives to make inappropriate rules, and also set their own pay - it also misses important context, and offers personal biases and anecdotes instead evidence and constructive suggestions for improvements.

I want to respond here to that article. First let me attempt to summarise Allan’s points about what is wrong with Australian universities.

• University administrators seem to value research grants as outputs rather than inputs
• Bureaucratic decisions at universities are quite centralised
• Students work and study, meaning they want lectures recorded and don’t want to do extra reading
• Students don’t travel to other cities to study
• University ranking tables are a sham, and Australian universities are not performing as well as these tables make out

However Allan doesn’t actually explain what a suitable output performance measure should be for a university. The most we get is this

In Canadian law schools (and US ones, and UK ones) you are expected to be working on your degree full-time. You are expected to do lots of reading. You are expected to think. You are expected to pursue things on your own. You are not expected to schedule classes all on two days of the week so you can work the other three. Or tell your professor that you can’t do something because it conflicts with work. Or be so tired that you do as little reading as you can get away with. 

Yet that is now standard practice in Australia. I can still, just, get away with refusing to record any of my lectures and so insist that students come (or not, since as adults it is up to them, but if not they are on their own). But the university administration detests that position and is making it harder and harder to take. As I came to Australia already with a chair I can ignore the students who get infuriated about this practice of mine in their course evaluations. But no junior academic wanting to be promoted can do so. It is no exaggeration to say that the incentives are slanted heavily in favour of caving in, of spoon-feeding students, of recording all lectures for viewing from home (with much reduced class attendance as a result)—anything to facilitate the job commitment of the supposedly full-time undergraduate. 

The flip-side of this situation is that the demands on students (even at our Group of Eight universities) are noticeably below what they are in good Canadian and UK and US universities. As for a serious Ivy League or Oxbridge undergraduate education, well, we are not in the same league as those institutions because we demand so little of our students.

Australian universities are not good enough, apparently, because students need to read more, and think, and pursue things on their own. 

He also makes a personal judgement that what you learn at university must be superior to the skills you learn at work, or that working and earning a living is not ‘pursuing things on your own’. That doesn’t really sound like a typical Australian attitude to me. My personal experience in economics is that a degree gets you in the door, then it is all down to experience. Working while studying, especially in your chosen field, is quite advantageous.

But he really doesn’t elaborate any further. Is university performance measured by research output? Is it measured by revenue? If so, he doesn’t have much of a case against the administrative bias towards academics who generate research grants.

Or is it the number of peer reviewed journal articles? If so, is it quantity or quality? Who will judge quality? Is it student numbers per academic? Or is it student quality? Who will assess that? Or do we judge performance on the gut feel of visiting academics with their own personal biases?

I don’t want to sound harsh, but for a senior academic writing about the underperformance of Australian universities, a little note about what underperformance really means, framed within the role of universities within society, would be nice. He signals that it should be research output, noting that people

…could see the difference between judging people based on what they wrote and produced versus one that judged them based largely on winning as many grants as possible.

but fails to return to how this measure fits into his picture of a competitive university system.

Whinging about the rules doesn’t really help. It is like an Apple employee coming into the company and saying they have a lot of centralised decision-making and that engineers were slugged with bureaucratic tasks, such as getting central approvals to spend money on new equipment. Whereas at their last job they could do as they please.

Sure, from the employee perspective this seems like a horrible system to work in. But any outsider assessing the performance of the company as a whole would feel it is worth it. That’s because we have an agreed measure of what company performance is. For universities we don’t, and that is usually the recipe for a growing bureaucracy.

Allan lays some of the blame at a lack of competition, perhaps due to some cultural norm of families not sending their sons and daughters interstate to the ‘best’ university in their field. Apparently this lack of competition means that universities can slack off and amuse themselves with ever more burdensome central rule-making and ever-greater executive pay.

Allan writes

In this sense, Australia and its universities are at a disadvantage. Imagine what would happen if parents were as likely to send their kids to Melbourne University as to Sydney University or the University of Queensland or Australian National University, and the deciding factors came down to what the universities had to offer, say in terms of class sizes or contact with professors or the “undergraduate experience”.

There are two problems with this point. First, is that the universities are full of international students. Outside of law especially. Surely these students are discerning about their university choice and hence provide a great deal of competitive pressure. According to the ABS 22% of students at university in Australia are international students, while at some universities that figure is over 40%. Monash and Melbourne universities seem to be competing quite fiercely, with Melbourne experimenting with student offerings at great risk.

Second, the central rules that Allan hates so much are just as much the result of competitive forces, than on the lack of such forces; of trying to attract students by ensuring the get the easiest path through their study. We’ve seen the gimmicks about giving new student iPads. Allan mentions the imposition of consistent marking systems, PhD criteria for lecturing positions, timing of student evaluations; all of these are about managing university-wide quality in order to assure new students of what they will be getting. Haven’t you seen advertisements?

This is what happens with competition for students (customers), and students mean revenue. If you want universities run competitively like private businesses, you must expect that they will measure their success in similar ways.

So where does research output fit into his competitive picture? It certainly doesn't raise revenues, and most undergraduates, the customers of universities, wouldn’t have a clue about their school’s research anyway.

Regarding the lack of travel to university, if I can sum up the Australian view very roughly, it is that university is more like advanced vocational training. Degrees that used to be provided by technical colleges are now integrated into universities. Students don’t travel because their local university usually maintains standards high enough to get them into their chosen field. Why travel if you can be assured of equally good local training? After all, once you are in the door, your experience counts much more than your degree in most fields.

He writes

When I try to point out the advantages of sending one’s kids away to university here in Australia I am generally met with blank stares of incredulity.

But of course, he didn’t mention any of those advantages in his article. Could it be that there really aren’t many? Or is he saying that Australians are just too stupid to see them?

Which leads to the more entrenched problem. The competition that drives student selection and travel for study in the US and the UK is the result of monopoly power of universities so that students must compete rather than universities. And this competition between students is also driven from a higher level. Reputation and insider connections within top universities to political and corporate elites means the payoff to getting into those universities is much higher. A degree at Princeton or Harvard is a meal ticket with a value far higher than cost of tuition itself. This not only means that students want to travel to get in to these universities, but that they (and their parents) are willing to pay through the nose for it as well. Here’s just one example of the political connections a degree at Oxford brings.

In Australia we don’t have that ‘boys club’ mentality to such an extent, especially not in most degrees. Having a teaching degree from QUT doesn’t open doors at Goldman Sachs, unlike a finance degree from MIT.

While I am sure Allan feels much better getting this all off his chest, I can’t help but think he has missed the important points to focus on his personal gripes. He overlooks exactly why Australian universities aren’t good enough, and then appeals to competition as some magical remedy to all organisational problems like some evangelical Chicago economist. Lastly, his suggestions for improving the situations include a bunch of central administrative tools!

One of his suggestions, the publication of remuneration of the highest paid employees, is generally already complied with in the annual financial accounts, where executive pay is itemised (here’s UQ, here’s QUT). But of course, executive pay exploding is not limited to universities. It is a general problem of power that competition alone does not solve.

Another suggestion is to publish the ratio of academic to non-academic staff, which is essentially a meaningless ratio because it absolutely depends on the tasks each staff is responsible for. If administrative staff are freeing up time for academics, then that is a good thing. I could imagine these suggestions being implemented and a future version of Professor Allan writing another article deriding them!

He suggests scrapping the ARC grant system, but makes no suggestion of alternative funding allocation mechanisms, as if by magic money will find worthy researchers. I agree the system is poor, but we need to be discussing better alternatives. Why didn’t Allan tell us a bit about the funding systems in those hot-shot universities he so reveres?

When push comes to shove Allan goes for the practical over the ideological, which is a good thing. But it leaves you wondering what the point of all those words really were. Will they merely be interpreted as at the ravings of a sheltered and entitled academic? We have quite enough of that already.

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Wages share and investment

Kieran Latty produced this chart on wages share and investment share in OECD countries. If we take this at face value it implies the existence of a wage share that maximises investment - which in the long run is what makes us wealthier. 

To me this seemed a little too neat. Economists love the inverted U-shape relationship, or concave relationships in general, because it implies the existence of some kind of equilibrium - just set labour share correctly and you will maximise investment. Or something like that.

It turns out to produce the ‘inverted U-shape’ curve Latty used a time fixed effect and a non-linear estimator on data from AMECO. While this may be somewhat normal in the literature on this topic - for such reasons as removing the effects of international business cycles and to control for any secular trend in international growth rates - ultimately these model choices fundamentally determine the results. Like most observational data from complex systems, we are applying models as mere plausible stories, with no objective criteria for assessing their validity.

Often the details (including the outliers) in these types of international comparisons reveal much more of the story than the general trends. To satisfy my curiosity I constructed a similar chart from OECD and World Bank data.

Below is the scatterplot of my sample (you will notice the chart is animated to show country data connected through time) . Eyeballing the data there seems to be no general time-independent inverted U-shape. This is confirmed by regressions on the sample without controls, and indeed, with a quadratic specification we find a positive coefficient on the squared term.

 

Notice that each country seems to occupy a distinct section of the chart. Such divergence between countries should be of great interest to macroeconomists. In my smaller sample below Japan has consistently high labour share and investment share, while New Zealand is consistently low on both measures. Then we have the US and UK with consistently low investment accompanying a rather high labour share. 

My expectation is that a high labour share of income would result in greater investment share, if only because owners of capital would have greater incentives to invest and innovate in order to gain a return, rather than simply hold existing assets. Who knows whether this is the case at all. But it’s my current speculation.

What is, for me, more fascinating in this data is the trend over time. We know that the labour share of national income has been falling in most countries since the 1970s. We can see that trend, along with short-term cycles, in the animated chart below that tracks my six country sample since 1970. 

In broad terms the maturing nature of these economies may mean that such a downward trend in labour share is naturally expected. Or it could be that policy choices for the past four decades have directed national income towards owners of capital, which resulted in lower investment in some cases but not others. The answer still seems completely unclear. If you want more analysis, you can read the Productivity Commissions recent work on the topic. 

Like many macroeconomic curiosities, the relationship between wage share and investment is a puzzle unlikely to find a satisfactory conclusion any time soon. 

What does affordable housing mean?

In my submission to the Senate Inquiry on Housing Affordability I wrote the following

Home ownership and reducing housing costs are not necessarily related policy goals. Housing can be cheap with extremely low rates of home ownership, and expensive with high rates of ownership. Clarity about what housing affordability means as a social policy goal is necessary.

There is usually an implicit stance in the housing affordability debate in Australia that a high rate of home ownership is a desirable policy goal. For some reason, a renting society is frowned upon. I put this down to tradition.

In Switzerland and Germany for example, around 60% of households rent. In Denmark and Austria it is around 50%. In Australia 30% of households rent.

We must remember that affordability of buying homes is not the same as making housing cheaper. Making housing cheaper means focussing on rental prices and their share of household income. If rents fell by 25% but prices didn’t, surely we would say housing has become more affordable. And vice-versa, if home prices increase 25% but rents were flat, we should say that housing has become less affordable.

A home is a financial asset that produces a place to live. Why do we care about owning the financial asset that produces our housing, but we don’t care about owning the assets used to produce our food, clothing and other goods? No one ever talks about a BHP share affordability problem!

The exact meaning of affordable housing is a crucial question to consider before any constructive housing policy can be developed.

Some may argue home ownership is about security. Home owners can put down roots because they know they won’t be evicted by a greedy landlord. But security of tenure can equally apply to rental housing, as it does in many countries. We just choose not enact the regulation to enable this to happen. Maybe readers have other reasons that home ownership is socially desirable.

For my part, I believe it is actually counterproductive to tackle housing affordability by encouraging greater home ownership.

Here’s why.

High home-ownership rates imply that most of the electorate has a financial interest in keeping prices high. This implies an interest in keeping rents high in order to maintain those prices. Thus, the interests of the home owner and the investor are aligned against the interests of the renter. 

When the bargaining power of renters is curtailed it merely enables investors to extract the full share of rents - that is, they are able to charge the maximum that renters are willing to pay. Any reduction in rents is merely a transfer of wealth from investors and home owners to renters.

With a higher proportion of rental households governments would be forced to improve conditions for tenants, and by doing so, increase their bargaining power.

Buying a home in Australia currently costs between 1.5 and 2 times more than renting, meaning that few rental households have an outside option of buying. They rent because they have to.

We can improve the bargaining power of renters either though changes to rental regulations, or through improving the home-buying outside option. This means that the very act of reducing prices, via LVR restrictions, removing the FHOG, and limiting CGT discounts and negative gearing, means that home buying will reduce in cost compared to renting, allowing buying to be a financially viable alternative to more currently renting households.

For more discussion on the issue I recommend this paper, which contains a wealth of data on rental housing in the OECD, and reasonable discussion about these important issues, including rent controls and the need to shift bargaining power towards tenants to reduce housing costs.

Once we focus on the rental price of housing, and not the price of the financial asset of residential property, we get a very different picture of the housing affordability debate. In fact, we get a picture where housing affordability has remained relatively stable in Australia over the past 20 years. And one where home ownership may even be a policy goal at odds with the goal of affordable rental housing.

But that doesn’t mean we can’t change the situation if we wanted to. We just have to accept that doing so involves a massive transfer of wealth.

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Inequality is a capital vs labour story

I was in a seminar recently where the presenter explored some trends in income inequality in Australia, Canada and the US over the past century. While there was much to like about economists trying to unravel this issue, including the repeated reminders that representative agent models cannot deal with this problem, I had some niggling doubts that the whole story was being considered. I thought this presenter was sticking to only the issues deemed acceptable to discuss in the economics community, while ignoring the more important political issues.

First the good parts. Education is not a solution to income inequality. Canada and the US in particular are very highly educated countries, whose average educational attainments have soared for the past 30 years - the exact period that also saw huge growth in inequality. 

It was acknowledged that the greater the degree of inequality, the easier it is to buy favours within political processes, further entrenching the income divide. It was nice to see economists raise these political points, but equally it highlighted how much of a disgrace it is that economists (and economic theory) play such a key role in capturing political processes for the 1%. 

Now to the issue I believe is the crux of the income equality debate.

I was informed in the presentation that the inequality story of the past 20 years is not about the division of income between capital and labour. Labour incomes in the top 1% are increasing very rapidly too. Sure. But we know that CEO and executive pay is more closely linked to capital returns than ever before, following the wide acceptance of the principle of incentive pay and aligning executive pay to share market performance. 

When I look at the data from the Henry tax review, I find that in fact that the distribution of income from capital is far more distorted towards the upper end than income alone. 

I’ve borrowed the chart below from the Henry Review website. What we see is that the top 5% of income earners in Australia get half of total national income from owning capital assets. While they only get 15% of the wages. 

We can even see that the bottom 20% are making capital losses (capital gains and dividends), highlighting the process by which the poor are becoming more dependent on labour income. 

Many researchers do in fact note that decreasing labour share, and therefore increasing capital share, of national income has been a global trend since the 1970s. What few say however is that this is trend is a result of policy choices informed by neoliberal ideology. We certainly could have avoided this trend if we desired. It was simply a matter of different policy choices. And to reverse the trend is also very simple, should be desire to do so. 

There is no 'natural' outcome when it comes to inequality.

In a mere technical sense, reversing the trend couldn’t be easier. Off hand I can think of dozens of policies; from inheritance taxes, greater public transparency of personal income data (including trusts), land taxes, improving the power of shareholders in the determination of executive pay, grants of land or capital for public service, and more. The options are limitless. 

The barrier to change is modern realpolitik. Those at the top have captured the political process, partly by capturing the media. Any change will entail a massive redistribution of wealth from those who bankroll the political parties, to those with the least resources, the least education and the least interest. 

This is the heart of the matter, and one we repeatedly avoid discussing.

Pretending to care about housing affordability

Australia is embarking on another Inquiry into housing affordability. In the past decade almost every government body, at every level of government, that has any function related to any aspect of housing policy, has conducted similar inquiries. With zero results.

Is it time we stopped pretending to care?

I made a submission (pdf here) to the inquiry, not because I think things will change, but to highlight the 'big picture' considerations in any housing policy. You know, the ones we don't talk about because the Overton window has been slammed shut by decades of well-funded propaganda by wealthy interest groups. Just look at the content of other submissions to see how they miss the big picture, either simply promoting their own financial interests or preserving their reputation by reiterating arguments deemed acceptable in polite company.

My main point is this - any policy that successfully reduces housing rents, and subsequently home prices, entails a massive redistribution of wealth from the richest to the poorest. I wrote the following in my submission.

At current prices Australia’s total housing stock is valued at around $5 trillion. If a policy successfully reduced rents and prices by 20% it would wipe $1 trillion of value from this market. Purchasing power of around $40 billion per year would be redistributed from the almost 6 million current home owning households and 1.8 million residential property investors, to the 2.8 million renters, along with future home buyers and owners of other non-residential domestic assets. 

There is no win-win scenario. Housing affordability is almost completely a question about the distribution of wealth in society. 

To understand the magnitude of potential redistribution from successful policy to improve housing affordability, a reduction in housing rents by even as little as 10%, would lead to possibly the largest redistribution of wealth from the richest to the poorest in Australia's recent history.

Politically it makes sense to pander to the majority. And while the majority of households still own their own home, absolutely nothing will be done to reduce rents and home prices. Even the ridiculous fig leaf of the First Home Owners Grant is actually a subsidy to existing home owners. It's the most fantastical piece of doublespeak to not call it what it really is - the Current Home Owners Grant.

This is the elephant in the room on housing policy. Here. Right here. I'm pointing at it.

Watch me be ignored.

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The 140 year cycle in macroeconomic thought

I am reading Progress and Poverty: An Inquiry into the Cause of Industrial Depressions and of Increase of Want with Increase of Wealth: The Remedy by Henry George (free ebook available here).

I’ve been fascinated so far that the economic debates that occurred during the long recession of the 1870s are almost identical to those still occurring during the great recession. I would have expected more progress in macroeconomic thought in 140 years.

Here’s George describing the utter disarray of the economic elite of that time in explaining how the depression had arisen, and where to look for a remedy.

This is shown by the widely-varying attempts to account for the prevailing depression. They exhibit not merely a divergence between vulgar notions and scientific theories, but also show that the concurrence which should exist between those who avow the same general theories breaks up upon practical questions into an anarchy of opinion.

Upon high economic authority we have been told that the prevailing depression is due to over-consumption; upon equally high authority that it is due to over-production; while the wastes of war, the extension of railroads, the attempts of workmen to keep up wages, the demonetisation of silver, the issues of paper money, the increase of labour-saving machinery, the opening of shorter avenues to trade, etc., etc., are separately pointed out as the cause by writers of reputation.

The modern equivalents are

1870s excuses		2000s excuses
over-consumption	→	excess household debt
over-production	→	excess housing construction
wastes of war	→	government waste or regulation
high wages	→	high wages
currency debasement	→	currency debasement
labour-saving machinery	→	robots

I found even more interesting the debates about the nature of capital and wealth that occurred at the time. George criticised the writers of common textbooks for not being specific in their definitions which caused much confusion when applying economic reasoning to the problems of the day. It seems an awful lot like the Cambridge Capital debates of the 1970s and reminded me of debates (or indeed lack of debate) around foreign investment that appear to have subsided in the past few decades. 

Here’s a snippet, which shows George would firmly be on the side of Cambridge, England, in the capital debates, and would be firmly of the position that foreign investment is merely a transfer and is not wealth-creating. 

As commonly used, the word " wealth " is applied to anything having an exchange value. But when used as a term of political economy it must be limited to a much more definite meaning, because many things are commonly spoken of as wealth which in taking account of collective or general wealth cannot be considered as wealth at all.
...
Increase in the amount of bonds, mortgages, notes, or bank bills cannot increase the wealth of the community, that includes as well those who promise to pay as those who are entitled to receive.

The enslavement of a part of their number could not increase the wealth of a people, for what the enslavers gained the enslaved would lose. Increase in land values does not represent increase in the common wealth, for what land owners gain by higher prices, the tenants or purchasers, who must pay them, will lose. 

And all this relative wealth, which, in common thought and speech, in legislation and law, is undistinguished from actual wealth, could, without the destruction or consumption of anything more than a few drops of ink and a piece of paper, be utterly annihilated. 

By enactment of the sovereign political power debts might be cancelled, slaves emancipated, and land resumed as the common property of the whole people, without the aggregate wealth being diminished by the value of a pinch of snuff, for what some would lose others would gain. 

There would be no more destruction of wealth than there was creation of wealth when Elizabeth Tudor enriched her favourite courtiers by the grant of monopolies, or when Boris Godoonof made Russian peasants merchantable property. 

All things which have an exchange value are, therefore, not wealth in the only sense in which the term can be used in political economy. 

Only such things can be wealth the production of which increases and the destruction of which decreases the aggregate of wealth. If we consider what these things are, and what their nature is, we shall have no difficulty in defining wealth.

What amused me is that George looked for answers in political economy

It must be within the province of political economy to give such an answer. For political economy is not a set of dogmas. It is the explanation of a certain set of facts. It is the science which, in the sequence of certain phenomena, seeks to trace mutual relations and to identify cause and effect, just as the physical sciences seek to do in other sets of phenomena.Maybe it’s time to follow his lead, again, and look outside of sterile economic theory to resolve problems of macroeconomic instability.

Open borders: A morality play by the 1%

Alex Tabarrok, who I rarely agree with, has recently argued his moral position on open borders here. There is no doubt that most moral frameworks also support his position. As do I in the mere theoretical sense. As Tabarrok argues

How can it be moral that through the mere accident of birth some people are imprisoned in countries where their political or geographic institutions prevent them from making a living?

I have argued before that redistribution of wealth from the world’s richest to the world’s poorest should be at the top of the policy agenda for any economist who believes in the utilitarian foundations of their discipline. Open borders is an indirect method for pursuing similar goals of increasing wellbeing for the poorest, and usually promoted by those who fall on Mankiw’s side of the political spectrum; by those who typically argue that the rich ‘deserve’ their wealth (counterargument here).

Open borders is merely the logical outcome of any type of ‘natural rights’ approach to moral reasoning. People should have the opportunity to flourish irrespective of the patch of Earth they were born. Yet the idea boils down to being the policy you support when you want to help the world’s poor but don’t support actually giving them money. Tabarrok’s argument equally applies within borders between the rich and poor, and I paraphrase his comment to make this point. 

“How can it be moral that through the mere accident of birth some people are imprisoned in towns and suburbs where their financial and geographic constraints prevent them from making a living?”.

That open borders within countries does not automatically eliminate poverty reminds us be skeptical of claims that opening borders between them will reduce poverty automatically.

It helps to identify the potential winners and losers from opening borders in order to better understand the motivations of its proponents. If open borders works, and large scale migration occurs, the net effect is that the poorest in the world’s richest countries would have their wages reduced due to competition for unskilled jobs. By contrast, the richest individuals in rich countries, whose incomes are derived mostly from owning capital, would increase due to the greater demand for their domestic assets (such as land) following high levels of immigration. 

Even the wildest proponents of open borders agree that

…open borders could not on its own eliminate poverty and that international migration could only help the relatively better off among the global poor

The rich get richer; that we know with some degree of confidence. The poor get, well, we don’t know. Probably poorer in relative terms, maybe richer in absolute terms. We just don’t know. But we can be fairly certain that the poorest in the world are unlikely to walk away from their homes and straight into the most exclusive enclaves of New York and London. Indeed, one suspects that the most highly educated from the poorest countries will be the first to leave (as they often are now).

Open borders in a global sense is therefore likely to be a game that benefits the richest from the poorest countries and still leaves the poorest with few options to improve their economic fortunes.

Putting this raw economic analysis to one side for a moment, one question seems completely overlooked by proponents of open borders. Why do borders exist in the first place? If we can’t satisfactorily answer that question we won’t get far understanding the many important social issues that would accompany open borders.

A very brief and abstract story of borders is as follows. National borders typically exist as a result of previous wars, or the negotiations that took place between competing interests under the threat of war. These borders now serve as moral boundaries, whereby we see those within our border as part of our tribe. Tribes reinforce their internal cohesion through social signals, customs and rituals which foster stability. This process, however, can distance them from other tribes (countries).

It is these tribal and moral values of borders that make integrating tribes quite difficult. Immigration is always contentious not because of the existence of a line on a map, but because of these deeper social customs, norms and rituals are often in conflict. It takes a mighty will for immigrants to adapt to their new countries, and for citizens of destination countries to patiently accept new people with often conflicting customs and beliefs in their towns and suburbs. I generalise here probably a little too much, but the point I hope to make is that social integration is not automatic and is an extremely complex issue that needs to be properly considered in arguments for open borders.

While I don’t have a disagreement with open borders on moral principles, I disagree on practical grounds that they should be promoted as a first-best way to improve the lives of the world’s poorest. Any economic success from such a fantastical global open borders policy would come at cost of social challenges arising from what I’ve described as ‘tribal integration’. The greater the economic benefits to the, the higher the social costs at both source and destination countries. 

In many ways open borders is the type of policy you support to display street cred in the company of the economically rational, particularly when discussions turn to inequality and, god forbid, redistribution. Making the poor richer is as simple as giving them money and therefore access to resources, whether they are fellow citizens of your country, or your planet.

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Economics is applied morality

The ignorance of many highly experienced economists to the moral foundations of their work is quite alarming. As a group, economists typically internalise the utilitarian morality embedded in their methodology to such a degree that they are happy to promote economic theory and practice as an objective scientific approach.

To set a more honest course for the discipline I pushed hard during the development of Australian Learning Standards in Economics to include criteria for the teaching of moral foundations, in addition to professional ethics. Indeed, I have argued previously for adopting standards of professional ethics in economics. You know, to cover the usual expected standards of professionalism such as not making comments in public forums without disclosing financial interests. 

I couldn’t get the actual words morals and ethics into the new learning standard. But the result was very good I think, with the fifth learning standard being called Reflection, and containing the following. 

Bachelor graduates will be able to reflect on the:

• nature and implications of assumptions and value judgments in economic analysis and policy
• interactions between economic thinking and economic events, both historical and contemporary
• responsibilities of economists and their role in society.

You wouldn’t believe it, but one concern was that there may be insufficient expertise within the cohort of university professors to achieve this standard. So in the interests of raising awareness, I want to provide a very brief comment on the moral foundations of economics.

Utilitarianism is the moral foundation of economics. The idea of the greatest good for the greatest number is intuitively appealing. But applying a utilitarian framework relies on value judgments about the desires, and a comparable measure of their intensity, of every individual. Some of the defining debates in economics over the past century have centred around the measurement and comparability of utility between individuals.

Thus any application of economics requiring estimation of costs or benefits is applying a judgment about the worthiness of competing desires of the population at large. That judgment is necessarily a moral one.

Further, most economic analysis applies utilitarianism in an ad hoc manner, by considering only the population within national borders. Unless you are a ‘national utilitarian’ (a distinct moral position), it can never be appropriate to consider domestic policy in terms of the utility of local residents while ignoring effects on the utility of those abroad. 

A truly utilitarian analysis must always and everywhere adopt a global perspective, which would make it exceeding difficult to justify any domestic policy in the developed world that didn't entail a massive redistribution from that country’s wealthiest to the world’s poorest. 

Then there’s the moral position that only the utility of humans counts.

Other times economic analysis is more clearly a case of applied morality. In analysis of public health economists usually appeal explicitly to the idea of utils, or some metric of quality-adjusted life years. The adoption of this metric relies on a moral judgement, for it implies that the elderly are less deserving of health resources than the young. But an equally valid moral position is that the elderly are more deserving as a repayment for their lifetime of work contributed to the community. Another moral position is that the young are easily and cheaply replaced, while the wisdom held in those elderly bodies has a high value and is costly to replace.

In more general terms we face the morality problem when measuring progress. Economists prefer GDP because their utilitarian framework implies that more consumption leads to greater utility. Apart from the obvious problem that GDP only includes goods traded in markets, ignores household production and externalities, it also contains a compositional problem.

What I mean is that many of the ‘goods’ that people trade are actually what we would call precautionary spending and increase utility only because they compensate for a loss of utility arising from outside of the market. Home security is one example.

Isn’t it better to not need to have home security, than for people to feel the need to spend 5% of their income on security, including locks, alarms, surveillance, insurance and so forth?

Other measures of progress have been proposed to overcome these issues. Each of these simply reflects and alternative moral judgment.

Lastly, there are the moral positions surrounding the degree of wealth distribution, the degree of community support to offer the unemployed, the elderly, and so forth that are perennially topical. These are all moral judgements, which are easy enough to see when we get down to the nitty-gritty debate and words such as worthy come out.

There is of course much more to the story of morality in economics than can be covered in this short post. One important thing to remember is that in practice utilitarianism can be, and has been, applied to justify almost every policy position.

What we need to remember is that you can’t escape morality in economics. But understanding the moral foundations of economics is the best way to properly grasp the limits of economic reasoning. It is my hope that the next generation of economists will learn to discuss and criticise the moral foundations of economics, and by doing so see policy debates as far more complex than is typically realised when alternative moral perspectives are ignored.

Organ markets and the problem of real options

The fanfare surrounding organ markets within the economics community is often extreme. For many it is the last frontier of market fundamentalism, with some even promoting a futures market in organs.

For others however, organ markets are so obviously ethically and morally questionable that these ‘non-economic’ concerns override their otherwise vigorous support for market solutions.

One purely practical consideration is whether markets for organs will fulfil their promise of increasing supply at all, especially from living donors. Will the ‘intrinsic’ motive of one’s moral commitment be crowded-out by the ‘extrinsic’ incentive of financial compensation?

The crowding-out hypothesis is supported by evidence of reduced blood donations in areas that pay for blood compared to those that don’t. In a classic study on conflicting motivations between financial incentives and social incentives, the introduction of a fine for late pick-ups at a selection of Israeli day-care centres actually increased the number of late pickups. The social motive to do the right thing by the centre was replaced with a financial relationship, where the fine became a fee for longer day care.

Medical professionals are much more cautious in their approach to organ markets. This survey of 739 individuals from the transplant-related medical community found that while 70% support indirect compensation for organ donation, 66% opposed direct compensation, while 84% approved of the role of next-of-kin in this decision. Other studies have found that 85% of families of donors reject any payment at all. Clearly there is more to the story that financial incentives.

I offer here a more standard economic reason why most estimates of increased organ supply from establishing a market for organs, especially by live donors, are massively overestimated. Typically organs are treated as commodities in the abstract sense used by neoclassical models of demand and supply. But in reality, organ donation is a once off irreversible and costly event for each individual, and therefore has the characteristics of a real options problem. 

Potential donors have a real option to delay donation for a better price in the future. Yep, the same constraint that determines the rate of housing development occurs in this situation, where donors face decision of when to exercise their one-shot option to donate. 

If the price of organs is rising rapidly, it will pay for potential donors to withhold their organs till a future time. Perhaps ultimately till their death, at which time they may exercise their option and bequeath the earnings to their heirs. Or they may not, since there is no financial motivation any longer (apart from bequeath motives, which are actually similar to the ‘intrinsic’ motives discussed earlier).

How such financial dynamics will effect the market for organs (including from live donors) is a concern for policy makers seeking stable reliable supply. There is clearly scope for organ price bubbles to occur, which will compromise the medical intentions of the policy in the first place.

Attempted legal markets for organs are generally compromised by unscrupulous behaviour and high levels of donations by the poorest in society, meaning potential organ donation success typically comes with associated social costs.

Non-market organ donation policies have proven to have great benefits. Setting the national default to opt-in to organ donation, rather than opt-out, seems to generate significant (usually 20-30%) increases in donations, although raising its own moral and ethical dilemmas.

My personal view is that the default option appears worthwhile and should be on the table for public discussion. But the moral controversy surrounding organ donation seems to suggest that developments in lab-grown organs will be a more attractive, potentially medically and morally. This a complex area of social policy and I am no expert. Simply offer yet another argument to quell the enthusiasm of the market zealots, and point interested readers to the variety of challenges, both moral and practical, in this area of policy.