| Craig Pirrong |

The American Economic Association/American Finance Association Meetings are just about over. I made a quick trip there to comment on a paper. Upon returning home, I downloaded a couple of the papers presented that seemed of interest. Good call on one, bad call on the other.

The bad one is “Centralized versus Over The Counter Markets” by Viral Acharya of LBS and NYU, and Alberto Bisin of NYU. Although the motivation of the paper is admirable, the execution is execrable, and is representative of a lot of what is wrong in the profession.

The motivation is to compare the efficiencies of alternative ways of organizing derivatives trades: centralized exchanges and over-the-counter (OTC) markets. Great. Big question. I’ve written a lot about it, and would be very interested in seeing other takes thoughtful on the subject.

The paper concludes that organized exchanges are (constrained) first best efficient, and more efficient than OTC markets. A quick review of the paper makes it clear, however, that they’ve rigged the game to produce that result.

Specifically, Acharya and Bisin assume that there are different “types” of traders; they differ based on the characteristics of their endowments. Due to their finite wealth, and the risks of derivatives positions, traders are sometimes unable to meet their derivative contract obligations. So far, so good: all that makes sense.

Then they go off the rails. Specifically, they assume that centralized exchanges set price schedules for a single derivative contract, and specifically, set a price for every trader that varies depending on (a) the trader’s type, and (b) the size of the trader’s positions. They motivate (b) by arguing that exchanges can view a trader’s entire position. That is, every trader pays a different price depending on his position and his type. In contrast, in OTC markets, they assume that no counterparty can observe any trader’s entire position, and hence although prices can be conditioned on type they cannot be conditioned on position.

It’s no surprise, then, that they find exchanges to be a more efficient way of trading. Exchange prices are conditioned on more information that is relevant in determining the likelihood of default, and the cost thereof, and hence can be set to control default and risk taking more efficiently than is possible in the OTC market.

Perhaps there is a planet somewhere in the universe in which exchanges can do what Acharya and Bisin claim they can do. All I can say is that on earth they can’t and don’t. In fact, the situation here on the planet in the Milky Way with the blue sky is almost an inversion of the what they assume.

Specifically, exchanges don’t condition trade prices on anything. Indeed, the whole idea of clearing on an exchange is to create fungible contracts in which prices are the same for all traders at a given point in time, and don’t depend on the traders’ endowments or positions. That is, exchanges facilitate anonymous trading among consenting adults by taking actions that make trader types and positions irrelevant to the price determination process.

In reality, collateral depends on position size, but not trade prices. Moreover, exchanges quite specifically do not condition collateral terms on trader type (e.g., on traders’ balance sheets). So, even if you argue that collateral variations are effectively price variations, the Acharya-Bisin assumptions are unwarranted. Exchanges are not, as Acharya and Bisin assume, central planners implementing a centrally imposed price schedule conditional on fine information on trader type and trades.

Put differently, clearing on exchanges creates a potential moral hazard that exchanges control at cost. The cost can be sufficiently high to make it inefficient to adopt clearing. Acharya-Bisin assume that exchanges have and can use costlessly the information required to control this moral hazard. Again, an inversion of the truth.

Also in reality, OTC market participants do condition trading prices on counterparty type, and explicitly take balance sheet risk into account. Although OTC traders don’t view their counterparties’ entire exposures/positions, they do have noisy signals on this and take it into account when setting trading terms. Moreover, as I’ve argued before, there are a variety of channels (e.g., the repricing of short term debt) by which diffuse information on the entire risk exposure of a financial institution is aggregated, and affects the incentives of said institution to take on risk.

So, the tradeoffs between exchanges and OTC markets are more complex: exchanges/CCPs have better information on some dimensions, worse on others. It’s not altogether clear a priori which dominates. Moreover, there are institutional innovations other than exchange trading and clearing that can mitigate the OTC markets possible information disadvantage: for instance, data warehouses that collect and disseminate information on positions could remedy the supposed weakness of the OTC markets.

And here’s where the Coase question comes into play: If a particular institution is inefficient, what transaction costs precludes agents from adopting it? Or, to put things differently, if you believe Acharya and Bisin, agents are leaving a lot of money on the table by trading in the OTC market: there are gains to trade to be captured by trading on exchanges. Why isn’t this happening? Why does a putatively inefficient mechanism survive, and indeed, thrive and grow relative to the putatively efficient one? This can happen, and policy can perhaps improve efficiency, but someone who claims that a given arrangement is inefficient, as Acharya and Bisin do, should identify the friction or frictions that precludes a change. They, suffice it to say, don’t do this.

This model wouldn’t be objectionable if it were a purely theoretical exercise. But Acharya and Bisin make broad policy recommendations based on their analysis. The problem is, they are like Humpty Dumpty, who declared: “When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”

Humpty Dumpty-like, they use the word “exchange” to mean just what they choose it to mean, even though it bears no relation to exchanges in the real world, or the kinds of exchanges that would be the beneficiaries of exchange trading mandates, or efforts to raise the cost of OTC trading. Their recommendation is a sort of bait and switch: sell the concept of exchange trading on the basis of an idealized model that assumes exchanges have decisive information advantages, and then deliver real world exchanges that are much more limited.

This is not uncommon, sad to say. But it is pernicious. And if this is the best that can be done to support exchange trading mandates, well, there you go.

The other, much better paper is “Danger on the Exchange: Counterparty Risk on the Paris Exchange in the 19th Century” by Angelo Riva of EBS and U-Paris X, and Eugene White of Rutgers. Rather than construct otherworldy exchanges and decree that their visions should be implemented here on earth, Riva and White do something radical: they actually take a detailed look at the evolution of counterparty risk sharing mechanisms and defaults on a real world exchange–the Paris Bourse. They carefully trace the evolution of mutualization of countparty risk on the PB, and pay close attention to a very real-world problem: namely, that mutualization creates the potential for moral hazard that is costly to control.

The empirical analysis could be improved (and when I have some time I’ll pass on some suggestions to them), but this paper undertakes a detailed analysis of actual institutions, and actual agents grappling with hard problems. The Paris Bourse was a real exchange. The problems it faced are inherent to any efforts to manage performance risk. We can learn a lot more from these sorts of analyses, than we can from constructing fanciful exchanges in a galaxy far away. Formalism is valuable — I even commit formalism from time to time, myself — but it is important that if formal models are intended to be the basis for far reaching policy conclusions, that they bear some relation to reality. Acharya and Bisin would put their modeling talents to much better use by trying to construct theories that reflect the gritty realities that Riva and White quite clearly document, instead of building models that bring to mind all those economist jokes with punch lines like “I assume the existence of a 100-story ladder.”

| Peter Klein |

Great opening from Robert Whaples’s EH.Net review of T.J. Stiles, The First Tycoon: The Epic Life of Cornelius Vanderbilt (Knopf, 2009):

Economists have always had a hard time dealing with entrepreneurs — as individuals and in the aggregate. We sort of know what entrepreneurship is and that it can have a profound impact on economic performance, but it’s usually just too difficult to model and measure. What we do not understand, we simply ignore and leave to others. After all, we are firm believers in comparative advantage and studying entrepreneurship — even if it is economically important — doesn’t seem to be our comparative advantage. In the view of most economic historians, it is the rules of the game — the incentives and the institutions — that really matter, not the players. American economic history has been cast as the story of millions of diligent and clever beavers working away and transforming the landscape. Take one of them away and nothing of great importance will really change. (In fact, most of us seem to believe that if you take away an entire technological complex, like the railroads, little of much importance would really change.)

Why, then, should economic historians study the careers of entrepreneurs? Not all of us should. But for some, the study of entrepreneurs will illuminate the past and the present — and put life into our cliometric narrative.

Joe Salerno has a valuable treatment of this problem in his 2008 paper “The Entrepreneur: Real and Imagined.”

| Peter Klein |

Congratulations to Nicolai and Teppo Felin for winning this year’s SO!WHAT Award for Scholarly Contribution for their 2005 paper “Strategic Organization: A Field in Search of Micro-Foundations” (ungated version). These are given by the journal Strategic Organization for the best paper published five years earlier (i.e., after some seasoning, based on impact as well as substance and originality). Look here (about half-way down the page) for praise from Jay Barney and Bruce Kogut. Way to go, guys!

Here are some prior O&M posts on microfoundations.

| Craig Pirrong |

I am reading Vernon Smith’s Rationality in Economics. I highly, highly recommend it. Largely a homage to Hayek, it explores the implications of Hayek’s distinction between constructivist rationality and what Smith relabels ecological rationality. It contains a wealth of methodological and substantive insights. Smith is knowledgeable and thoughtful. He is almost John Stuart Mill-like in his even handed and fair characterizations of competing views, even those he disagrees with. He integrates experimental economics, game theory, institutional economics, neoclassical economics, neurology, and much, much more.

What fascinates Smith is the ineffable process by which an ecologically rational order emerges from the actions of myriad imperfectly informed and incompletely rational (in the constructivist sense) individuals. This process — a sort of economic transubstantiation — is the most fascinating economic mystery. It is also, alas, one that has received far too little attention from economists whose formal tools permit them to analyze (constructively) equilibrium, but which are virtually powerless to analyze the process of getting there; the proverbial drunks looking for their keys under the lamppost.

We live in an era of constructivism regnant. In health care and finance, especially, constructivist schemes will reshape for better or worse — and almost certainly worse — vast swathes of the American economy. What’s more troubling still, this is constructivism refracted through the flawed lens of politics and public choice. Appreciation of the emergent order, the ecologically rational, is sadly rare. Vernon Smith appreciates it, deeply, with an almost religious sense of awe. Read his book and you will appreciate it too.

| Peter Klein |

“Microeconomics ain’t easy, and don’t let a regression — or division by a baseline — be a substitute for clear thought.” Steve Levitt is the target. Why does it take a statistics professor to remind economists of such an obvious truth?

| Peter Klein |

Arnold Kling on PAS:

[P]rior to Samuelson’s formalization in economics, there were a lot of papers published that lacked clarity and insight. Now that formalization dominates, we also see a lot of papers that lack clarity and insight. If you compare the most insightful mathematical papers with the average non-mathematical papers, math wins. But one can also run the comparison the other way and reach the opposite conclusion.

| Peter Klein |

Rejecta Mathematica is an open-access journal featuring papers rejected by peer-reviewed mathematics journals. Each article includes an author’s statement describing the peer-review experience and explaining why the paper shouldn’t have been rejected. Great concept! (Link from Sheen Levine via Konstantina Kiousis.)

I eagerly await the first issues of Rejecta Economica and Rejecta Stratetgica.

| Peter Klein |

In an oft-cited passage from The Mechanisms of Governance (1996), Williamson describes the research program of transaction cost economics this way:

Transaction cost economics (1) eschews intuitive notions of complexity and asks what the dimensions are on which transactions differ that present differential hazards. It further (2) asks what the attributes are on which governance structures differ that have hazard mitigation consequences. And it (3) asks what main purposes are served by economic organization. Because, moreover, contracting takes place over time, transaction cost economics (4) inquires into the intertemporal transformations that contracts and organization undergo. Also, in order to establish better why governance structures differ in discrete structural ways, it (5) asks why one form of organization (e.g., hierarchy) is unable to replicate the mechanisms found to be efficacious in another (e.g., the market). The object is to implement this microanalytic program, this interdisciplinary joinder of law, economics, and organization, in a “modest, slow, molecular, definitive” way.

A footnote explains the origins of the phrase “modest, slow, molecular, definitive,” tracing them to a (secondhand) quotation from Charles Péguy. Here’s the footnote:

The full quotation (source unknown) reads:

“The longer I live, citizen. . .” — this is the way the great passage in Peguy begins, words I once loved to say (I had them almost memorized) — “The longer I live, citizen, the less I believe in the efficiency of sudden illuminations that are not accompanied or supported by serious work, the less I believe in the efficiency of conversion, extraordinary, sudden and serious, in the efficiency of sudden passions, and the more I believe in the efficiency of modest, slow, molecular, definitive work. The longer I ive the less I believe in the efficiency of an extraordinary sudden social revolution, improvised, marvelous, with or without guns and impersonal dictatorship — and the more I believe in the efficiency of modest, slow, molecular, definitive work.”

Well, we are nothing if not pedantic here at O&M, and in that spirit, I share (with permission) a note from my colleague and former guest blogger Randy Westgren, written to Williamson in January 2007, explaining that the anonymous source has botched the Péguy quotation. Here’s Randy:

After a long search, I found the quote from Péguy that you cite in footnote nine of the Prologue of The Mechanisms of Governance and noted again in footnote eleven of the first chapter. I was not able to find the secondary quote that is printed in the footnote, but I did find the original passage from Péguy. I have been searching for this since The Mechanisms was published, because I could not fathom how Charles Péguy could have denounced sudden, wondrous conversion and sudden, extraordinary social revolution when he was (1) a famously devout Catholic;  a mystic whose poetry includes an exceptional hommage to Joan of Arc, and (2) a famously ardent socialist who believed strongly in the overthrow of the bourgeoisie. In fact, after giving up on the Catholicism of his youth while at the École Normale Supérieure, he returned to his faith in the middle of the first decade of the century, when he was in his early 30s. He was slain in the first battle of the Marne in 1914 at the age of 41.

Thus, it was hard to understand a quote that twice alludes to advancing age and a personal and social apostasy that was written by a man who died in full flower as a religious mystic and as a champion for human rights and the left.

The quote in your text contains two red herrings. The first is, “this is the way the great passage in Peguy begins.” In fact, the quoted passage begins with the second clause of the fourth sentence of the twentieth paragraph of an essay presented as a dialogue. The second confusion is that the quote appears to be a single argument against sudden personal illuminations and sudden social revolutions. In fact, the passage is two distinct arguments in counterpoint. One party to the dialogue denies the value of sudden personal revelation and the other denies the value of sudden social revolution.

The young socialist atheist revolutionary (Péguy) consults a “citizen doctor: socialist, revolutionary, moralist, internationalist” as he has come down with the grippe while preparing for the Socialist Congress.

– … “And genius demands patience to work, doctor, and the longer I live, citizen, the less I believe in the effectiveness of sudden illuminations that are not accompanied by or supported by serious work, the less I believe in the effectiveness of sudden, wondrous, extraordinary conversions, the effectiveness of sudden passions, – and the more I believe in the effectiveness of modest, slow, molecular, definitive work.”

– “ The longer I live, responded the doctor gravely, the less I believe in the effectiveness of a sudden, extraordinary social revolution, wondrously improvised, with or without guns and impersonal dictatorship, – and the more I believe in the effectiveness of modest, slow, molecular, definitive, work for society.

(My translations.) (Péguy is also noted for involuted literary style, so amateur translation isn’t easy.)

The conversation continues around the doctor’s thesis that one cannot believe in the “big questions” when unable to believe in the personal-level issue of faith. This essay was, in fact, written when Péguy was 26 and before his return to the church. He had just launched a publishing venture in support of socialist causes in January 1900, called Cahiers de la quinzaine, (Fortnightly Journals). This was to be his pulpit as a polemicist until his death, as well as a place where like-minded individuals published before they became famous.

The citation should read:

Péguy, Charles. “Encore de la grippe”, Cahiers de la quinzaine, volume I, number 6, March 20, 1900.

My source was reprinted in

Péguy, Charles. Oeuvres en Prose Complètes, Volume 1, Robert Burac (ed), Editions Gallimard, 1987, pp. 416-444.

I am sure that’s way more than you wanted to know.

| Dick Langlois |

Some of you may have seen Steven Pinker’s review of Malcolm Gladwell’s latest book in the New York Times this weekend. Pinker praises Gladwell’s writing and his instinct for interesting topics, but skewers him for his bad grasp of the underlying science of what he writes about, especially statistics. In Pinker’s view, Gladwell is in the end a character from one of his own essays, “a minor genius who unwittingly demonstrates the hazards of statistical reasoning and who occasionally blunders into spectacular failures.” One blunder seems to epitomize Pinker’s assessment: Gladwell’s report on an expert who talks of “igon values” instead of eigenvalues. Pinker call this the igon value effect.

As I read this, I thought back to a department seminar I had attended a couple of days earlier. Keith Chen from Yale gave one of the most dazzling presentations I’ve heard in a long time. He basically demolished 45 years of experimental results in social psychology that claim to have discovered cognitive dissonance in choices. According to this literature, it is among the best-documented results in psychology that people change their preferences after making a choice so as to rationalize the choice and make themselves feel better about their decision. Chen argues — persuasively — that essentially all these results are statistical artifacts. At a much more sophisticated level, social psychologists have fallen victim to the igon value effect. Here is the abstract of a working paper, though it gives only a hint of how clever this research is.

Cognitive dissonance is one of the most influential theories in social psychology, and its oldest experiential realization is choice-induced dissonance. Since 1956, dissonance theorists have claimed that people rationalize past choices by devaluing rejected alternatives and upgrading chosen ones, an effect known as the spreading of preferences. Here, I show that every study which has tested this suffers from a fundamental methodological flaw. Specifically, these studies (and the free-choice methodology they employ) implicitly assume that before choices are made, a subject’s preferences can be measured perfectly, i.e. with infinite precision, and under-appreciate that a subject’s choices reflect their preferences. Because of this, existing methods will mistakenly identify cognitive dissonance when there is none. This problem survives all controls present in the literature, including control groups, high and low dissonance conditions, and comparisons of dissonance across cultures or affirmation levels. The bias this problem produces can be fixed, and correctly interpreted several prominent studies actually reject the presence of choice-induced dissonance in their subjects. This suggests that mere choice may not be enough to induce rationalization, a reversal that may significantly change the way we think about cognitive dissonance as a whole.

Chen was also written up in the New York Times last year.

Oh, and by the way, that was our second seminar of the day. Earlier we listened to Bob Lucas, whom the grad students brought in to give a major lecture. (First time I had met him.) He talked about his paper in the inaugural issue of the new AEA macro journal: “Trade and the Diffusion of the Industrial Revolution.” (There wasn’t actually much trade in it.) Lucas and I had a nice conversation at lunch about Jane Jacobs, who we agreed was fantastic. “She was a theorist!” was Lucas’s assessment. High praise.

| Nicolai Foss |

Here is a nice discussion of Foucault by UChicago Law School professor Brian Leiter. It is not a smashing per se, but rather a critical discussion that indicates a central flaw in Foucault’s philosophy. Leiter points to Foucault’s well known discussion of the “pretence” of the “human sciences,” something Foucault seems to explain on the basis of  the “influence of economic, political, and moral considerations on their development” (Leiter, p. 16). As Leiter points out, however,

[I]t is now surely a familiar point in post-Kuhnian philosophy of science that the influence of social and historical factors might be compatible with the epistemically special standing of the sciences as long as we can show that epistemically reliable factors are still central to explaining the claims of those sciences. And that possibility is potentially fatal to Foucault‟s critique. For recall that central to Foucault‟s critique is the role that the epistemic pretensions of the sciences play in a structure of practical reasoning which leads agents concerned with their flourishing to become the agents of their own oppression. And the crucial bit of “pretense” is, as we noted earlier, that the human sciences illuminate the truth about how (normal) human beings flourish in virtue of adhering to the epistemic strictures and methodologies of the natural sciences. Recall also that Foucault, unlike Nietzsche, does not contest the practical authority of truth (i.e., the claim of the truth to determine what ought to be done); he rather denies that the claims in question are true or have the epistemic warrant that we would expect true claims to have. So the entire Foucauldian project of liberation turns on the epistemic status of the claims of the human sciences. And on this central point, Foucault has, surprisingly, almost nothing to say beyond raising “suspicion.”

| Nicolai Foss |

It is a sad fact that I spent a considerable part of my early 20s browsing the pages of the major economics journals of the interwar period. I was particularly interested in what was then called the “monetary theory of the trade cycle” and the role of expectations in the business cycle (Myrdal, Lindahl, Hawtrey, Robertson — and of course Hayek and his many followers and conversants, such as Lachman, Kaldor, and various UK Labour Party economists who until the advent of Keynes’ GT were surprisingly bent on Hayekian business cycle theory. (Here is one of the results of that work). My forays led to the “discovery” of Terence Hutchison’s 1937 paper, “Expectation and Rational Conduct,” in Zeitschrift für Nationalökonomie, a paper that, while over the top in a number of ways, is also an early anticipation of rational expectations and the problems of RE.  

Hutchison (1912-2007) is nowadays best known as an economic methodologist, perhaps the first explicit proponent of logical positivism and later Popper’s falsificationism. His 1938 book, The Significance and Basic Postulates of Economic Theory, is often taken as a response to Lionel Robbins’ strongly Austrian-influenced Essay on the Nature and Significance of Economic Science(1932/1935). Hutchison later engaged in a debate with Fritz Machlup, and Hayek buffs will know that Hutchison coined the notion of “Hayek I” and “Hayek II” (based on Hayek’s acceptance of Misesian praxeology).

The latest issue of the always-interesting Journal of Economic Methodology features a special issue symposium on Hutchison. Among the highlights is the publication of a hitherto unpublished, semi-autobiographical essay by Hutchison, and the reproduction by Bruce Caldwell of some revealing letters by Hayek and Hutchison (Hayek did not agree with Hutchison’s interpretation of his changes in the 1930s).

| Nicolai Foss |

Economic methodology, or, meta-theoretical discussion of (and in) economics, has gone significantly beyond with theme that many practicing economists associate with the field, namely the realism-of-assumptions theme prompted by Friedman’s famous 1953 essay, “The Methodology of Positive Economics.” Of course that theme is by no means unimportant, and it has, of course, resurfaced under the impact of the financial crisis.

However, the main themes of the current economic methodology discussion have shifted from the role of assumptions to economic models in their entirety. Two main perspectives are sometimes distinguished, namely the “isolationists” who literally see economic models as simplified redescriptions of the mechanisms and causal factors of the real world, and the “fictionalists” who, as the name indicate, ascribe much less realism to models and think of them as purely mental laboratories that may still, however, allow for certain inferences to the real world.

The January 2009 issue of Erkenntnis: An International Journal of Analytical Philosophy is a special issue, edited by Till Grüne-Yanoff, dedicated to exploring these two positions, and entitled “Economic Models as Credible Worlds or as Isolating Tools?” Among the heavyweight contributors are Robert Sugden, Uskali Mäki, and Nancy Cartwright. I particularly liked Mäki’s argument that the two positions are in actually very close rather than opposed. Highly recommended for those who want to acquaint themselves with frontier issues in economic methodology.

| Peter Klein |

A useful example of the methodological flaw that plagues the “great companies” and “great leaders” literature in management, from Graham Robb’s excellent The Discovery of France (Norton, 2007):

[N]early every autobiographical account of ordinary life in eighteenth- and nineteenth-century France comes from the early chapters of memoirs written by exceptional men who rose through the ranks of the army or the Church, woo wrote their way to fame or who were  plucked from obscurity by a patron, a lover or, eventually, an electorate. Few men and even fewer women had the means or the desire to write a book on “How I failed to overcome my humble origins.” Apart from the countless riches-to-riches tales written by aristocrats, almost all the lives that we know about follow the same untypical upward trend: the farmer’s son Restif de la Bretonne, the cutler’s son Diderot, the watchmaker’s son Rousseau, the Corsican cadet Napoleone Buonaparte.

These spectacular success are more typical of long-term trends than of individual lives. Categorical terms like “peasants,” “artisans,” and “the poor” reduce the majority of the population to smudges in a crowd scene that no degree of magnification could resolve into a group of faces. They suggest a large and luckless contingent that filled in the background of important events and participated in the nation’s historical development by suffering and engaging in a semblance of economic activity.

Likewise, business and entrepreneurial strategies can be understood by studying not only firms that tried them and succeeded, but also those that used the same strategies and failed. Reducing the majority of companies to smudges in an industry-wide or economy-wide crowd scene tells us little about what does and doesn’t work.

| Dick Langlois |

The new issue of the online journal Capitalism and Society has a number of articles that should interest readers of this blog. Each is probably deserving of its own post. (Ah, but time prohibits.)

Jon Elster has a piece called “Excessive Ambitions” that criticizes not only mainstream rational-choice models (as we would expect from Elster) but also modeling in general. Roman Frydman and Michael Goldberg have a piece that applies something like Leijonhufvud’s “corridor” to risk regulation: when swings of asset values are small, government should stay out, since such swings are actually beneficial; but when asset prices get too far from “underlying values,” government regulation is called for.

My favorite paper is by Thorbjørn Knudsen and Richard Swedberg. Here’s the abstract:

This is a theoretical paper in which we attempt to present an economic and sociological theory of entrepreneurship. We start from Schumpeter’s idea in Theory of Economic Development that the economy can be conceptualized as a combination and innovations as new combinations. Schumpeter also spoke of resistance to entrepreneurship. By linking the ideas of combination and resistance, we are in a position to suggest a theory of capitalist entrepreneurship. An existing combination, we propose, can be understood as a social formation with its own cohesion and resistance — what may be called an economic order. Actors know how to act; and profit is low and even in these orders. Entrepreneurship, in contrast, breaks them up by creating new ways of doing things and, in doing so, produces entrepreneurial profit. This profit inspires imitators until a new order for how to do things has been established; and profit has become low and even once more. Entrepreneurship is defined as the act of creating a new combination that ends one economic order and clears the way for a new one. The implications of this approach for a number of topics related to entrepreneurship are also discussed.

This has some affinities to arguments I have made in the past. I am thanked in the acknowledgements, presumably for conversations that Richard and I had at a Schumpeter conference at Harvard last year; but I’m not cited. (Assume sad-faced emoticon here.)

I will talk about the fourth paper in the issue soon in a separate post.

| Peter Klein |

Thanks to Teppo for linking to these interesting graphs. Since 1960, the page count and reference list of the average American Journal of Sociology article have risen dramatically, while those for the American Economic Review have remained about the same. I’d be curious to see these figures for the Academy of Management periodicals as well. What explains these trends? Are sociologists simply more verbose than economists?

Update: Here are some more graphs, this time including ASQ and Management Science, as well as some additional sociology journals. ASQ and MS appear to be somewhere in the middle.

| Peter Klein |

Avner Greif has written a response to Charles Rowley’s odd claim that Greif “denied Janet Landa her full intellectual property rights with respect to her contributions to the economic analysis of trust and identity.” Public Choice, which published Rowley’s critique, will run the reply. Avner kindly sent me an advance copy and gave me permission to post it here. Full text below the jump.

My $0.02: This is a very effective reply, pointing out that Landa’s and Greif’s explanations for trust are quite different (one based on preferences, the other on beliefs). Avner, perhaps wisely, steers clear of the general epistemological problem: How do you know if scholar A has cited predecessor B “enough”? Expecting A to show he hasn’t unfairly neglected B is asking A to prove a negative. Ultimately, the whole exercise seems petty to me. B’s defenders should focus on elevating B’s reputation, not complaining about A, C, and D’s failure to show the love.

The Curious Commentary on the Citation Practices of Avner Greif

By Avner Greif
August 2009
Forthcoming at Public Choice

Abstract: Rowley (2009) failed, among other faults, to recognize the substantive distinction between the lines of research pursued by Professor Landa and myself. Its claim that I have “expropriated” (p. 276) intellectual property rights from Professor Landa by insufficiently citing her works is vacuous.

Rowley (2009) has wrongly claimed that “Avner Greif, through his citation practices, has denied Janet Landa her full intellectual property rights with respect to her contributions to the economic analysis of trust and identity” (p. 275). This claim is unsubstantiated and incorrect for many reasons. To keep this response short, however, it focuses on the core issue Rowley (2009) ignores; the substantive distinction between the research pursued by Professor Landa and myself. Her analysis of trust is preferences-based while my analysis is beliefs-based. We talk about similar issues but what we say is very different. I gave credit where it was due.

Neither Professor Landa nor I have claimed to initiate the study of the relations between trust, exchange and merchants’ groups. For example, in her paper, “A Theory of Middleman Minorities,” Bonacich (1973) tried “to explain the development and persistence of the form … [and what affects] the solidarity and economic activity of the ethnic group” (p. 583). She noted that her theory might apply to middleman minorities such “as the Chinese in South East Asia, Jews in Europe, and Indians in East Africa” (p. 583).

Professor Landa has made valuable contributions since publishing her first paper (1981). She argued that trust is embodied in preferences, depends on social relations and progressively declines with social distance. One trusts his family more than members of his extended family and trusts his clansmen even less. Ethnicity and its code of ethics delineate an important boundary of social relations and ethnic groups are therefore an important conduit for exchange in the absence of the law. Rowley (2009) summarized Professor Landa’s thesis. “A cost-minimizing middleman, under conditions of contract uncertainty, will choose trading partners with shared and easily identifiable kinship and ethnic characteristics because the Confucian ethic of reciprocity is embedded in these close kinship/ethnic relations” (p. 277).

My research has been motivated by observed trust between merchants and overseas agents in medieval trade. The literature on this topic (e.g., Sombart 1953) has also argued that preferences-based trust within kinship groups mitigated agency problems. I naturally cited this preferences-based research given its priority and my interest in medieval trade. I noted that “scholars have examined the establishment of “trust” relations among traders, focusing in particular on the role of social control systems and ethics. W. Sombart pointed out the importance of relationships within “natural groups,” such as clans and tribes. … Following Max Weber, many scholars have stressed the role of ethics in surmounting contractual problems, emphasizing either implicitly or explicitly altruism…” (Greif 1989, p. 858).

Rowley (2009) fails to note that my analysis did not follow the preferences-based line of research, although I have made this distinction explicit. “It is important to note that the Maghribi traders did not … represent a “natural” group, which binds together individuals in all (or at least most) important aspects of their lives. The bonds of a natural group usually discourage dishonest conduct” (Greif 1989, p. 862). The observed “‘trust’ did not reflect a social control system or the internalization of norms of behavior” (Ibid., p. 881).

The theory I developed is beliefs-based. It focused on the role of beliefs in rendering honesty an equilibrium outcome among self-interested individuals, irrespective of kinship. “Observed ‘trust’ [among the Maghribis] reflects a reputation mechanism among economic self-interested individuals” (Ibid., pp. 858).¹ Beliefs in harsh economic retaliation following misconduct rendered effective a reputation mechanism that supported credible commitment to honesty and thus trust. These beliefs induced “an agent [to] remain honest out of desire to retain his position as an agent” (Ibid., p. 867).

In this beliefs-based framework ethnic groups, social networks, business associations, and credit bureaus are conduits of familiarity and the information required for an effective reputation mechanism. In particular, “the common religious-ethnic origin of the [Maghribi] traders provided the natural boundaries for the …[group] and served as a signal where information regarding past conduct could be obtained, while the commercial and social ties … served as a network for the transmission of information” (Ibid., p. 882). The traders’ group and their economic institution were therefore mutually constitutive. The ‘information-transmission mechanism generated by the social structure – the Maghribi traders group – supported the operation of an economic institution … which promoted organizing agency relations only among members of this social structure, … and thus … preserve their social structure, their distinct identity within the Jewish world” (Ibid.).

Professor Landa’s work and mine are therefore substantially different. She has made important contributions to the study of trust as exogenous, inherent in one’s preferences, and conditional on social relations. My work considers trust as endogenous, dependant on self-enforcing beliefs about others’ responses, and conditional on the information and knowledge necessary for such beliefs to be self-enforcing. In short, Professor Landa has focused on preferences as underpinning trust; I have focused on the role of beliefs. I may have failed to make this distinction crystal clear and update my references. This distinction, nevertheless, is among the many reasons that Rowley’s claim is incorrect.

As a matter of fact there is a positive correlation between the publication of my work and citations to Professor Landa’s work. Landa (1981) is her “first and most important paper on the economic of trust” (Rowley 2009, p. 277). Almost nine years later I published my first paper (Dec. 1989). Comparing the number of citations to Landa (1981) prior to and following my first publication is revealing. There were six times more citations in the second period.² Citation levels remained high in subsequent years and the number of citations in economics has similarly increased in each of these three sub-periods.³ My students and I have continuously contributed to this record including, as is easy to verify using Google book search, references to her works on pages 70 and 88 in my recent book (Greif 2006). The assertion in Rowley (2009, p. 282) that “Janet Landa’s name and publications are absent from” the text of Greif (2006) is obviously baseless and incorrect. Its broader claim is similarly vacuous. Scholarship is not necessarily a zero-sum game.

References:

Bonacich, Edna. 1973. “A Theory of Middleman Minorities.” American Sociological Review, 36(Oct): 583-94.

Greif, Avner. 1989. “Reputation and Coalitions in Medieval Trade: Evidence on the Maghribi Traders.” Journal of Economic History 49 (4): 857-82.

Greif, Avner. 2006. Institutions and the Path to the Modern Economy: Lessons from Medieval Trade. Cambridge University Press.

Landa, Janet T. 1981. “A Theory of the Ethnically Homogeneous Middleman Group: An Institutional Alternative to Contract Law.”  The Journal of Legal Studies, 10: 348-62.

Rowley, C.K. 2009. “The Curious Citation Practices of Avner Greif: Janet Landa Comes to Grief.” Public Choice, 140: 275-285.

Sombart, W.  1953. “Medieval and Modern Commercial Enterprise,” In F. C. Lane and J. C. Riemersa (eds.), Enterprise and Secular Change. Homewood.

Weber, M. 1927.  General Economic History, trans. by F. H. Knight. New York.

___________________

1. The page also notes the relations between the two frameworks. “By establishing ex ante a linkage between past conduct and future utility stream, an agent could acquire a reputation as honest, that is, he could credibly commit himself ex ante not to breach a contract ex post.” “Social control system and ethics mechanisms may constitute such a linkage. These mechanisms can thus be incorporated into the present approach.” Beliefs concerning others’ unobservable preferences are crucial in such linkages.

2. Specifically, the nine years after 1991 (inclusive).

3. “Social Science Citations Index” (SSCI), July 29, 2009. Without self-citations. I relied on the SSCI (automatic) calcification of citations to fields. Rowley (2009) claims that Professor Landa’s “writings on the economic analysis of trust and identity have received no citations from mainstream economists” (p. 283) but does not elaborate on the basis for this conclusion.

| Peter Klein |

And fewer economists, according to the sociologists interviewed by Inside Higher Ed:

Donald Tomaskovic-Devey, a professor of sociology at the University of Massachusetts at Amherst, described watching the news in December, as the economy was in a free fall and Barack Obama, as president-elect, was naming people to key positions in his administration. From the social sciences, he said, it was “the same old cast of characters,” and that means economists.

Obama’s election had brought “a sense of possibility,” but “as a sociologist I was pissed off,” he said.

“I have economist envy on a good day and worse things on a bad day,” he said.

I have great respect for my sociologically trained brethren and sistren (cistern?) but am not sure what, exactly, they are asking for. One sociologist thinks economists downplay race and gender — “their supply and demand curves don’t deal with these questions” — which is silly, as much of the analysis of subprimes by labor economists focuses exactly on this. I’m not claiming that sociology (or anthropology or history or psychology) has no useful policy implications, of course, only asking for specifics.

The pointer is from Rich Vedder who has a bit of fun with the whole thing:

One Nobel Prize winner in economics, Doug North, once told me that one of his proudest academic moments was convincing Washington U. in St. Louis to get rid of its sociology department. Jim Dorn, estimable editor of the Cato Journal, told me at lunch that Bill Meckling did the same thing at the University of Rochester, where the administration reallocated funds away from sociology towards economics and business. Whether Doug’s and Bill’s position was correct or not is debatable, but I think public policy has too many, not too few, experts guiding it, and adding sociologists to the mix would not be useful.

| Peter Klein |

So say Hal Varian, Erik Brynjolfsson, and Peter Orszag, among others quoted in this NY Times piece (via Laura M). “I keep saying that the sexy job in the next 10 years will be statisticians,” says Varian, who now toils away as chief economist at Google, though he’s not far from the hearts of most economics PhD students. Here’s Brynjolfsson: “We’re rapidly entering a world where everything can be monitored and measured. But the big problem is going to be the ability of humans to use, analyze, and make sense of the data.”

The article doesn’t actually say much about the substance of the “new” statistics, but the writer has in mind inductive, very-large-N, data-mining exercises (the kind of analysis not taught to social-science and business-administration graduate students, except perhaps some marketing and finance PhDs). Of course we still make our students take multiple semesters of classical statistics and econometrics.

| Lasse Lien |

Words like science, scientific, university, professor, etc. still command considerable respect in society. Why? I would suggest that the brand equity of “scientific” (and associated concepts) is almost entirely created by the great advances and visible impact of fields such as physics, engineering, chemistry, medicine, mathematics, and other natural sciences. The massive advantages and explanatory power these fields have provided to society have created a status that the social sciences benefit from, but offer (relatively) modest contributions to. If I were in, say, physics or medicine, I think I would be particularly provoked by those strands of the social sciences that seem to want all the benefits of the “brand,” but also insist on the freedom to break all the rules that created it. I would presumably cry out that if you don’t like our brand, build your own, don’t destroy ours. But then again, I might just have a bad case of physics envy.

| Nicolai Foss |

No doubt a sure sign of impending senility, I take a huge interest in economic methodology, that is, meta-theory as it applies to economics. I serve on the editorial board of the Journal of Economic Methodology and usually enjoy reading the journal. The latest issue of JEM features at least two papers that should be of direct interest to O&M readers, namely Alain Marciano’s “Buchanan’s catallactic critique of Robbins’ definition of economics” (basically a discussion of Buchanan’s famous 1964 presidential address to the Southern Economic Association), and Oliver Williamson’s “Pragmatic methodology: a sketch with applications to transaction cost economics” (pragmatic methodology meaning “keep it simple,” “get it right,” “make it plausible,” and “engage in predictions and empirical testing”). Ah, and for those who take delight in economic controversy there is a rather thorough smashing by Ken Binmore of a recent Deirdre McCloskey book.

| Peter Klein |

Great anecdotes on contemporary social-science methodology in Mario Rizzo’s post, “The Failure of Macroeconomics” (including the comments). Young economist to senior scholar: “All that is in Adam Smith.” Senior scholar: “Maybe — but until my theory it was not science.” Deepak Lal asks distinguished colleague what should be done about the current crisis. Reply: “I do not consider that an intellectually respectable question.” My own beloved dissertation adviser indulged my quirkier interests, but stated plainly: “Methodology is a swamp.” And of course there’s the famous Ed Leamer analogy.

Here’s Mario’s take:

This is the great problem with economics today: methodological exclusivism (or in my more intemperate moments I call it “methodological fascism”).A young person goes to graduate school. He or she is filled with the excitement of ideas. Today, in particular, some may come with a great desire to understand what has happened in the real world of the bailouts, recessions, stimulus, and so forth.  And then academic reality hits.

Formal modeling, axiomatic foundations, tractability, technical power, and topological studies. Shall I get an MA in mathematics? Do I need to take a third semester of macro-econometrics? . . .

It seems pretty clear that what we have is a collective insecurity. If we open the floodgates to methodological inquiry, or even worse, to methodological pluralism, we shall become like political science, or God forefend, like sociology. So let’s keep those with disruptive instincts out of the profession. If this is not possible, then let’s at least keep them out of the good schools.

If you’re feeling subversive, you can browse our methodology/theory of science archive for more forbidden thoughts.

Addendum: My former classmate and former colleague Menzie Chinn responds to Mario’s complaints about macroeconomic models. “I won’t deny that in the past 20 years, [I've] seen more than a few models that struck me as pretty irrelevant for analysis of real world issues. . . . [But] one can think of completely irrelevant frameworks for looking at the world even without a [formal] model, just as one can with a model.” True, but I don’t think this gets at Mario’s point, which is not that formal models per se should be abandoned, but that it’s okay to question their use in particular contexts, and to examine methodological issues more generally. Adds Menzie:

Furthermore, perhaps my experience in a Ph.D. program is atypical but I don’t remember being forced into a particular mode of analysis in writing my dissertation. . . . We studied Euler equations as well as the market for lemons. We knew what Arrow-Debreu markets were, but we also learned about the Great Depression (from Bernanke’s paper as well as Friedman and Schwartz). The time series econometrics taught did not presuppose optimizing behavior. We even studied models with sticky prices (gasp!). Doesn’t sound too doctrinaire to me.

That was my experience as well. But this is simply saying that there are many flavors of “orthodox” macroeconomics and many families of formal models, and some graduate programs teach more than one. It still begs the question of what counts as orthodoxy, whether other modes of theorizing (e.g., verbal logic) or empirical analysis (e.g., case studies) are legitimate, and so on. I think that is what Mario is getting at.

| Benito Arruñada |

One may doubt it after observing that Ben Bernanke was one of those believing in the Great Moderation — the claim that macroeconomic volatility had been reduced. Macroeconomic policymaking seems to be as unsafe as firefighting: extinguishing small fires creates the conditions for hell. Shouldn’t macroeconomists learn something from forest management? (For a start: “Fire Must Be Ally in Forest Management.”) Of course, if coupled with an acid-suppressing pill, they could even dare to read Hayek’s “Pretence of Knowledge.”

| Peter Klein |

I misquoted Sid Winter in this post. Here’s what he actually said:

“High standards for statistical techniques are tending to crowd out high standards for performance on the central scientific task, causal explanation.”

I was going from memory, then later found the exact wording in my notes. The meaning is the same, but I wanted to correct this for the historical record.

| Peter Klein |

I see that registered users of SSRN can now post comments on other people’s papers. Maybe this feature has been around for some time but I just noticed it. Is this a small step toward open-source peer review? Or a move toward social networking? (What’s next, the SSRN status update or Super Poke?)

| Peter Klein |

O&M, like other niche academic blogs, deals occasionally with the history and sociology of this or that school of economic or management thought. We think often about professional strategy — how to promote our ideas, how to secure financial and institutional support, how to recruit students and fellow-travelers (“groupies,” according to Nicolai), what competing and complementary movements and schools of thought (not to mention rival blogs) are up to, and so on.

Given our close association with the Austrian school, you might be surprised to learn that the founding Austrians were not at all “strategic” in this sense. They held strongly to the view that truth wins out in the long run, so there is no need to build formal institutions or establish a “movement.” This comes out in a passage from Mises’s recently released Memoirs (a new translation of his earlier Notes and Recollections):

It is necessary to correct the misunderstandings that can be called forth by using the expression “Austrian School.” Neither Menger nor Böhm-Bawerk wanted to found a school in the sense customarily used in university circles. They never attempted to turn young students into blind disciples, nor did they, in turn, provide these same students with professorships. They knew that through books and an academic course of instruction they could promote an understanding suited to dealing with economic problems, thus rendering an important service to society. They understood, however, that they could not rear economists. As pioneers and creative thinkers, they recognized that one cannot arrange for scientific progress, nor breed innovation according to plan. They never attempted to propagandize their theories. Truth would prevail of its own accord when man possessed the faculties necessary to perceive it. Using impertinent means to cause people to pay lip service to a teaching was of no use if they lacked the ability to grasp its substance and significance.

Menger made no efforts to extend favors to colleagues that would be reciprocated with recommendations for appointments. As minister and then ex-minister of finance, Böhm-Bawerk could have used his influence; he always spurned such behavior. Menger did make occasional attempts, without success, to prevent the promotion of those, for example, Zweideneck, who had no sense of what was going on in economics. Böhm-Bawerk made no such attempts. In fact, he advanced rather than hindered the appointments of Professors Gottl and Spann at the Brünner Technische Hochschule.[8]

Menger’s position on such questions is best illustrated by a note discovered by Hayek while perusing Menger’s scientific papers. It reads, “In science, there is only one sure method for the ultimate triumph of an idea: one should allow any contrary notion to run its course completely.”

See also Joe Salerno’s piece on economics as a vocation, not a profession. What do you think — how important  are the professional trappings of an academic “movement”?