William L. Silber: Invest Like Buffett…Buy Silver When It’s Cheap, but Don’t Repeat his Mistake

The global economy in 2019 may seem unsettled because of trade wars and friction in the European Union, but it is nothing compared with the Great Recession. Few worry today about the collapse of the world financial system, a serious concern ten years ago, and the decline of precious metal prices since then confirms that most investors do not expect a return of that sentiment. Which makes it the perfect time for Americans to learn a lesson from the recent history of the country’s most famous investor: Warren Buffett. He bought silver after it had collapsed in value but left more than four billion dollars on the table by selling too soon. 

Buffett is a contrarian, making investments that are unpopular and waiting for them to return to favor. He says: “You pay a very high price…for a cheery consensus…pessimism drives down prices to truly attractive levels.” This approach suggests that now is a good time to buy precious metals and to keep them for the long haul. Gold and silver are not popular today, but they should be viewed as insurance policies for everyday Americans. Both metals work when nothing else does, like during the Great Recession, when silver quadrupled in value between 2008 and 2011, and gold rose by 250 percent. Those increases mirrored the performance of precious metals 30 years earlier, in 1979, at the peak of the Great Inflation, when fear of runaway consumer prices had taken hold.

Warren Buffett, CEO of Berkshire Hathaway, bought silver in 1997 because it was cheap. The white metal had dropped more than 90 percent from its record price of $50 an ounce in January 1980. It was almost twenty years after Paul Volcker, Chairman of the Federal Reserve System, had cured the inflationary spiral that had griped the U.S. economy and Buffett pounced. He bought at the right time but sold much too soon and said, “I bought it very early and sold it very early.” Buffett’s experience provides guidelines for how to see precious metals today.

Buffett’s purchase of more than 100 million ounces of silver, about 25 percent of the world’s annual production of the white metal in 1997, was deeply out of character. The white metal did not belong among his investments. He had prided himself on picking companies that are “understandable, possess excellent economics, and are run by outstanding people.” Buffett traditionally dismissed owning assets like precious metals that “will never produce anything, but that are purchased in the buyer’s hope that someone else…will pay more for them in the future.” His least favorite investment is gold which he said would “remain lifeless forever.”

The CEO of Berkshire Hathaway gave silver a reprieve because the white metal is a cross between precious and industrial, a store of wealth for millions and productive in electronics and medicine. He explained his reasons for the investment, which totaled about two percent of Berkshire Hathaway’s portfolio: “I concluded that a higher price would be needed to establish equilibrium between supply and demand.” Buffett liked silver because annual consumption by industry outpaced mine production.

And Buffett was ideally positioned to benefit from silver’s low prices. The Berkshire Hathaway CEO had long understood the power of patience, having told his stockholders when he first bought Coca Cola stock in 1988, “Our favorite holding period is forever.” Patience is key to maximizing value from precious metals.

As it turned out, however, Buffett failed to stick to his principles, with serious consequences. An expanding U.S. economy spurred prices to about $7.50 in 2005 and Buffett began to worry about excess speculation. A year later he told his investors at their annual meeting that Berkshire Hathaway had sold all its silver. Buffett said “We made a few dollars,” but he was not pleased. Berkshire had earned about $275 million on an investment of $560 million in 1997, about a five percent annual return over the eight years, less than they would have earned investing in U.S. Treasury bonds. Buffett’s partner, Charlie Munger deadpanned, “I think we’ve demonstrated our expertise in commodities, if you look at our activities in silver.” Buffett added “We’re not good at figuring out when a speculative game will end.”

He did not realize the party was about to begin.

On September 15, 2008, Lehman Brothers filed for bankruptcy. It was the largest Chapter 11 filing in American history, and turned a mild recession into the worst financial crisis since the Great Depression. The failure destroyed trust in financial assets, triggered panicked withdrawals from money market mutual funds, until then considered the equivalent of cash, and forced the U.S Treasury to guarantee their safety.

The exploding financial chaos eventually sparked gold prices to an all-time record of $1,900 an ounce on September 5, 2011, an increase of 250 percent in the three years since Lehman’s collapse. Silver hit $42.92 that same day, for a 400 percent increase, almost twice the move in gold. Buffett’s uncharacteristic impatience, therefore, cost him dearly. Had Berkshire Hathaway sold at $42.92 on September 5, 2011, well below the $48 crisis peak, he would have made $4.2 billion on his investment of $560 million. His 14-year silver speculation would have earned a respectable 16.5 percent annual return.

No one expects to sell at the top so precious metals should remain in an investor’s portfolio forever, just like Warren Buffett’s Coca Cola. His allocation of two percent to silver makes sense — not too much to cause insomnia, but enough to provide for food, clothing and a driverless car during the next crisis. Today, we have recovered from the Great Recession, and precious metals are out of favor, a prime time for a contrarian purchase. Silver has declined to about $15 an ounce, one-third its 2011 peak, so it is relatively cheap to insure against the next financial upheaval. Once you’ve bought it, don’t touch it. Selling would be like cancelling insurance after an accident.

William L. Silber is the Marcus Nadler Professor of Finance and Economics at New York University’s Stern School of Business. His many books include When Washington Shut Down Wall Street (Princeton) and Volcker (Bloomsbury). He lives in Teaneck, New Jersey.

Opportunity costs: can carbon taxing become a positive-sum game?

Climate change, caused by human activity, is arguably the biggest single problem facing the world today, and it is deeply entangled with the question of how to lift billions of people out of poverty without destroying the global environment in the process. But climate change also represents a crisis for economists (I am one). Decades ago, economists developed solutions – or variants on the same solution – to the problem of pollution, the key being the imposition of a price on the generation of pollutants such as carbon dioxide (CO2). The idea was to make visible, and accountable, the true environmental costs of any production process. 

Carbon pricing could stabilise the global climate, and cap unwanted warming, at a fraction of the cost that we are likely to end up paying in other ways. And as emissions were rapidly reduced, we could save enough to compensate most of the ‘losers’, such as displaced coal miners; a positive-sum solution. Yet, carbon pricing has been mostly spurned in favour of regulatory solutions that are significantly more costly. Why?

Environmental pollution is one of the most pervasive and intractable failures of market systems (and Soviet-style central planning). Almost every kind of economic activity produces harmful byproducts, which are costly to dispose of safely. The cheapest thing to do is to dump the wastes into waterways or the atmosphere. Under pure free-market conditions, that’s precisely what happens. Polluters pay nothing for dumping waste while society bears the cost.

Since most energy in modern societies comes from burning carbon-based fuels, solving this problem, whether through new technology or altered consumption patterns, will require changes in a vast range of economic activities. If these changes are to be achieved without reducing standards of living, or obstructing the efforts of less developed countries to lift themselves out of poverty, it is important to find a path to emissions reduction that minimises costs.

But since pollution costs aren’t properly represented in market prices, there’s little use in looking at the accounting costs that appear in corporate balance sheets, or the market-based costs that go into national accounting measures such as Gross Domestic Product (GDP). For economists, the right way to think is in terms of ‘opportunity cost’, which can be defined as follows: The opportunity cost of anything of value is what you must give up so that you can have it. So how should we think about the opportunity cost of CO2 emissions?

We could start with the costs imposed on the world’s population as a whole from climate change, and measure how this changes with additional emissions. But this is an impossibly difficult task. All we know about the costs of climate change is that they will be large, and possibly catastrophic. It’s better to think about carbon budgets. We have a good idea how much more CO2 the world can afford to emit while keeping the probability of dangerous climate change reasonably low. A typical estimate is 2,900 billion tonnes – of which 1,900 billion tonnes have already been emitted.

Within any given carbon budget, an additional tonne of CO2 emitted from one source requires a reduction of one tonne somewhere else. So, it is the cost of this offsetting reduction that determines the opportunity cost of the additional emission. The problem is that, as long as the CO2 generated ‘disappears’ into the atmosphere (and, eventually, the oceans), corporations and households do not bear the opportunity cost of the CO2 they emit.

In a properly working market economy, prices reflect opportunity costs (and vice versa). A price for CO2 emissions high enough to keep total emissions within the carbon budget would ensure that the opportunity cost of increasing emissions would be equal to the price. But how can this be brought about?

In the 1920s, the English economist Arthur Pigou suggested imposing taxes on firms generating pollution. This would make the (tax-inclusive) prices paid by those firms reflect social cost. An alternative approach, developed by the Nobel laureate Ronald Coase, stresses the role of property rights. Rather than setting a price for pollution, society decides how much pollution can be tolerated, and creates property rights (emissions permits) reflecting that decision. Companies that want to burn carbon must acquire emissions permits for the CO2 they produce. Whereas the carbon-tax approach determines a price and lets markets determine the volume of polluting activity, the property-rights approach sets the volume and lets the market determine the price.

There is no necessary link between imposing a carbon tax and distributing the resulting payments. However, natural intuitions of justice suggest that the revenue from carbon pricing should go to those adversely effected. At a national level, the proceeds could be used to offset the costs borne by low-income households. More ambitiously, a truly just system of global property rights would give everyone equal rights, and require those who want to burn more than their share of carbon (mostly, the global rich) to buy rights from those who burn less.

This raises the question of whether emissions rights should be equalised going forward, or whether historical emissions should be taken into account, allowing poorer nations to ‘catch up’. This debate has been rendered largely irrelevant by dramatic drops in the price of renewable energy that have sidelined development strategies based on fossil fuels. The best solution seems to be ‘contract and converge’. That is, all nations should converge as fast as possible to an emissions level far below that of currently developed countries, then phase out emissions entirely.

Carbon taxes have already been introduced in various places, and proposed in many more, but have met with vigorous resistance nearly everywhere. Emissions-permit schemes have been somewhat more successful, notably in the European Union, but have not taken off in the way envisaged when the Kyoto Protocol was signed in 1997. This disappointing outcome requires explanation.

The ideas of Pigou and Coase provide a theoretically neat answer to the market-failure problem. Unfortunately, they run into the more fundamental problem of income distribution and property rights. If governments create emissions rights and auction them, they create public property out of a resource (the atmosphere) that was previously available for use (and misuse) free of charge. The same is true when a carbon tax is proposed.

Whether property rights are created explicitly, as in the Coase approach, or implicitly, through the carbon taxes advocated by Pigou, there will be losers as well as gainers from the resulting change in the distribution of property rights and, therefore, market income. Not surprisingly, those potential losers have resisted market-based policies of pollution control.

The strongest resistance arises when businesses that have previously dumped their waste into airways and waterways free of charge are forced to bear the opportunity costs of their actions by paying taxes or purchasing emissions rights. Such businesses can call on an array of lobbyists, think tanks and friendly politicians to defend their interests.

Faced with these difficulties, governments have often fallen back on simpler options such as regulations and ad hoc interventions, such as feed-in tariffs and renewable-energy targets. These solutions are more costly and frequently more regressive, not least as the size of the cost burden and the way it is distributed is obscure and hard to understand. Yet the likely costs of climate change are so great that even second-best solutions such as direct regulation are preferable to doing nothing; and the delays caused by resistance from business, and from the ideologically driven science deniers in their pay, have been such that, in the short run, emergency interventions will be required.

Still, the need to respond to climate change is not going away any time soon, and the costs of regulatory solutions will continue to mount. If we are to stabilise the global climate without hampering efforts to end the scourge of global poverty, some form of carbon pricing is essential.

Economics in Two Lessons: Why Markets Work So Well, and Why They Can Fail So Badly by John Quiggin is forthcoming via Princeton University Press.Aeon counter – do not remove

John Quiggin is the President’s Senior Fellow in Economics at the University of Queensland in Brisbane, Australia. His previous book, Zombie Economics: How Dead Ideas Still Walk among Us (Princeton), has been translated into eight languages. He has written for the New York Times and the Economist, among other publications, and is a frequent blogger for Crooked Timber and on his own website: www.johnquiggin.com. Twitter @JohnQuiggin

This article was originally published at Aeon and has been republished under Creative Commons.

Walter Mattli on Darkness by Design: The Hidden Power in Global Capital Markets

MattliCapital markets have undergone a dramatic transformation in the past two decades. Algorithmic high-speed supercomputing has replaced traditional floor trading and human market makers, while centralized exchanges that once ensured fairness and transparency have fragmented into a dizzying array of competing exchanges and trading platforms. Darkness by Design exposes the unseen perils of market fragmentation and “dark” markets, some of which are deliberately designed to enable the transfer of wealth from the weak to the powerful. Essential reading for anyone with money in the stock market, Darkness by Design challenges the conventional view of markets and reveals the troubling implications of unchecked market power for the health of the global economy and society as a whole.

How did you come to write this book?

Right after the 2007-2008 financial crisis I became interested in questions regarding the regulation of big banks in order to prevent abuse, market distortions, and further scandals and crises. I wanted to look at the ways in which the very same contributors to the financial crisis benefited from it, but I discovered that a number of financial experts were already examining the topic and producing very insightful research. I thus decided to shift my attention to an important related area that many knew little about: the structure and governance of capital markets. After talking to several dozen market actors and doing some preliminary research, what struck me as particularly interesting was the puzzling transformation of equity market structure: the move from centralized to fragmented markets in the early 2000s. I wasn’t convinced by the conventional view of this transformation; I therefore began to investigate the question of market structure and governance more carefully. In the process, I made interesting discoveries that I felt should be explored more fully and presented to a broad audience.

Can you explain the title? What exactly is being hidden?

A retired regulator with a distinguished 15-year record at the helm of two major financial regulatory organizations confessed to me that he no longer understands how these complex capital markets really work. The average investor is even more in the dark about these markets. When an investor sends an order to buy or sell a stock by the click of a mouse, the order may take a lightning journey through a maze of dark pools and exchanges before being filled. How does the investor know that on the journey to execution the order was treated fairly and was filled at the best available price?

The title, Darkness By Design, refers to almost invisible exploitative trading schemes or arrangements in today’s capital markets that are deliberately designed and governed to enable the transfer of wealth from the weak to the powerful.  

To understand the mechanism of such exploitation, it is important to go beyond conventional accounts of how markets work and acknowledge the extent to which markets are political organizations. What the many conventional accounts of the function of markets overlook is the extent to which markets are deeply political organizations or governance systems where what is being hidden is the extent to which power politics shapes markets. Contending groups intensely battle to shape market rules and structure according to their own narrow preferences. Power is central to explaining markets both in the sense of general power politics arguments about who wins or loses, and in the sense that markets themselves are political institutions governed by power relations.

What are the origins of the market fragmentation that we’re seeing today? 

It’s worth recalling that for over two centuries, securities markets in all major countries tended toward greater concentration. Concentration of trading in one large organized public market or trading “pool” seemed natural and inevitable, because the greater the number of users of an exchange the more attractive that exchange is to new or potential users, since new buyers and sellers are more likely to find a counter-party in a large market than in a small one. That is to say, a central market naturally has the highest concentration of orders: it has the greatest trading depth (volume of bids and offers) as well as breadth (range of tradeable securities). In other words, it has the highest liquidity, and liquidity begets liquidity: the bigger the flow of trades, the stronger the pull.

My book questions the conventional view of the move from centralization to fragmentation that says that centralized markets were monopolistic and inefficient and that this led to the fragmentation of the market. In this narrative, investors are the principal beneficiaries owing to narrower trading spreads and lower commissions, but this deeply entrenched conventional view is flawed. A key finding of my book is that power politics caused the market fragmentation—it was a plot by a coterie of powerful insiders who had grown weary of the traditional way of organizing trading, viewed the old model increasingly as contrary to their economic interests, and quietly pushed for a different market structure more aligned with those interests.

How is market fragmentation hurting us now?

In today’s fragmented markets characterized by many “shallow” pools of liquidity—a proliferation of public exchanges, broker-dealer dark pools, and other private off-exchange trading places—costly new technology is often used by powerful market operators in quiet and nearly invisible ways to maximize their profits at the expense of ordinary investors. Specifically, information asymmetries and secrecy—often deliberate governance-design strategies—have enabled a small but powerful group of unscrupulous market operators to milk conflicts of interest, often in undisclosed or hidden ways, at the expense of the unsuspecting investing public.

Latent in the minds of many victims of these strategies is a belief that “modern” markets are technologically determined and that technological progress must be good. But new technology is neither bad nor good; its social value is solely determined by the incentives or motives of the users of this technology. The rise of fragmentation, or market transformation more generally, matters because it shapes the incentives of market actors to invest in either good or bad governance.

Good governance is about managing conflicts of interest for the long-term benefit of all in society whereas bad governance milks the conflicts of interest for the benefit of the few on the backs of the many. Over the past decade and a half, fragmentation has given rise to bad governance. Market makers have fewer obligations, market surveillance is neglected or impossible, and enforcement is rendered ineffective.

It is important to note that market fragmentation is by no means limited to the US equity market. Elsewhere, too, market centralization has been replaced by varying levels of fragmentation.

Is this story all doom and gloom? Are there any positives? What would have to happen to address the issues related to market fragmentation?

Darkness by design is not inevitable—the mantle of darkness can be lifted through a combination of steps based on several fundamental principles, including market transparency based on stringent disclosure rules and robust market intelligence, a level playing field for market participants, proper accountability for market disruption and bad governance, and, crucially, market consolidation or centralization. The reason is that dominant exchanges in such market systems have particularly strong reputational concerns and the requisite financial resources to invest in good governance. Dominance means high public visibility, which brings with it great reputational vulnerabilities.

In highly fragmented market systems, the many market organizations have an incentive to cut corners. Why focus on delivering high quality public goods, such as price discovery, if competitors can simply free ride, and, in addition, good money can be made by milking conflicts of interest? Once such behavior becomes permissive and the unspoken norm, no significant reputational costs result from engaging in, abetting, or condoning bad market behavior.

Regulatory intervention in capital markets by governments plays a role in lifting the mantle of darkness. However, it is rarely the only answer and not necessarily the most effective one. It is bound to face considerable practical and especially political challenges, not least from powerful defenders of the status quo who will fight change tooth and nail. There is another answer: market solutions to market failures, sometimes nudged or facilitated by regulators. Specifically, greater consolidation and market centralization are possible—not through regulatory intervention but perhaps through market processes.

Consolidation of markets at the national or transnational level, with one or more dominant exchanges, is likely to generate a fairer, simpler, more transparent, and more efficient marketplace than the one created by a fragmented system and characterized by shallow liquidity scattered across a wide range of exchanges, dark pools, and internalizers. 

What do you hope readers will take away from reading this book?

A key contribution of this book is the empirical analysis into historical patterns of market structure and governance. The book shows the market transformation that took place over time. Central to the analysis is the role of power politics in shaping market structure and governance: changes in the distribution of power in capital markets alter market actors’ relative influence in pushing for or opposing change. Specifically, over the last decade and a half, transformations have taken place which have resulted in fragmentation and badly governed markets, thereby adversely affecting aspects of quality and fairness in these markets. I hope the book will encourage readers to become more cautious and will equip them to ask tough questions of their brokers in order to better protect their interests when investing in capital markets.

Walter Mattli is professor of international political economy and a fellow of St. John’s College, University of Oxford. His books include The New Global Rulers: The Privatization of Regulation in the World Economy and The Politics of Global Regulation. He lives in Oxford, England.

J. C. Sharman on Empires of the Weak

SharmanWhat accounts for the rise of the state, the creation of the first global system, and the dominance of the West? The conventional answer asserts that superior technology, tactics, and institutions forged by Darwinian military competition gave Europeans a decisive advantage in war over other civilizations from 1500 onward. In contrast, Empires of the Weak argues that Europeans actually had no general military superiority in the early modern era. J. C. Sharman shows instead that European expansion from the late fifteenth to the late eighteenth centuries is better explained by deference to strong Asian and African polities, disease in the Americas, and maritime supremacy earned by default because local land-oriented polities were largely indifferent to war and trade at sea. Bringing a revisionist perspective to the idea that Europe ruled the world due to military dominance, this book demonstrates that the rise of the West was an exception in the prevailing world order.

Scholars have long argued that the dominance of the West can be attributed to superior technology, tactics, and institutions. Your book takes an opposing view. Can you describe it?

The standard view is to see Western expansion as synonymous with Western dominance, but my book separates the two. For around three centuries, Western expansion was more often the result of deference and subordination to non-Western rulers. Africans and Asians tolerated a weak European presence because Europeans were generally fixated on the control of the seas, which more powerful but terrestrially-oriented non-Western rulers generally didn’t care about. Even in the Americas, European victories were much more partial and incomplete than often portrayed, and were generally the result of disease and demography rather than superior technology, tactics and institutions.

What accounts for the narrative that the West came to power through general superiority?

The conventional ‘military revolution’ thesis argues that Western expansion reflected superior technology and institutions, basically guns and states. Supposedly, these advantages were first developed in the fiercely competitive environment of European warfare, and then applied to conquer the rest of the world. I argue this thesis is wrong, for several reasons, but particularly because of a reading of history which starts at ‘the end’ of the story, i.e. Western superiority, and then views the historical record from this supposed end-point. So European victories get a lot of coverage, because Europeans won in the end, whereas the Ottoman, Mughal and successive Chinese empires, which were much more powerful than their European counterparts for most of their existence, can be written off, because these empires lost in the end. But of course everyone loses in the end. The Europeans lost their empires, and someday the United States will lose too. Interestingly, even post-colonial scholars and those most critical of European imperialism tend to play into the narrative of powerful Westerners dominating everyone else. 

If the dominance of the West is an aberration to the prevailing global international system, what does a typical system look like?

Very roughly we can say that we’ve had some sort of global international system for five centuries. In most of Africa and Asia, Europeans weren’t really dominant until the nineteenth century (and this didn’t last long). In the three hundred years before, the typical arrangement was for Westerners to interact with Asian and African polities on a basis of inferiority. But because culture, ideas, and legitimacy are so important for shaping the international system, it’s hard to say what a typical form is.

For example, in the late nineteenth century the consensus was that any great power worthy of the name had to have an empire, and so we had an international system of empires, even though most empires lost money and didn’t confer security benefits. Then in a huge change that social scientists spend far too little time thinking about, empires went out of fashion. Now we have an international system of formally equal states, even though most states are pretty hopeless at performing the functions that are meant to justify their existence.

What led you to write this book?

The first reason was historical: that there was this hugely important undiscovered early modern international system out there, or at least a neglected and misunderstood international system, waiting to be explored. To me what makes international politics in the period 1500-1800 so exciting is that it upends our presumptions of superior, more powerful Westerners dominating everybody else. Sometimes this happened, but for two to three centuries Westerners were more likely to be dominated by non-Westerners, including in Europe.

The second reason was a basic rejection of the standard functionalist presumption that on average organizations work well, i.e. efficiently and effectively, because of learning and competition. On the contrary, I think getting the job done efficiently has very little to do with how organizations are structured and how they work.

For example, it’s fairly uncontroversial to say that most meetings in universities, corporations, and government bureaucracies are a waste of time (and hence money). But people can simultaneously know this, while continuing to go to and schedule endless meetings, without any plans to change this situation. Organizations, including militaries and states, do not learn to become more efficient, and are not penalized for their inefficiency. In environments of overwhelming complexity, they mainly stick to ritualized ways of doing things, like going to meetings.

What does the book have to say about international politics today and in the future?

Historians have done an excellent job of showing how the way we think about the past affects our views of the present and the future, and this point certainly applies to international politics. All sorts of things we currently tend to take for granted about international politics are in fact strange, while some important things we tend to think of as strange, and perhaps worrying, are actually the historical norm. The fact that all the world’s polities are today organized as one homogenous type of unit, the sovereign state, is very unusual by historical standards. Looking to the future, if China or other non-Western states were to become the most powerful in the twenty-first century (and social scientists are lousy at predictions so I have no idea if this will happen), rather than being unprecedented, this would in fact be a return to the historical norm in international politics.

J. C. Sharman is the Sir Patrick Sheehy Professor of International Relations in the Department of Politics and International Studies at the University of Cambridge and a fellow of King’s College. His books include The Despot’s Guide to Wealth Management and International Order in Diversity. He lives in London.

Francesca Trivellato on The Promise and Peril of Credit

The Promise and Peril of Credit takes an incisive look at pivotal episodes in the West’s centuries-long struggle to define the place of private finance in the social and political order. It does so through the lens of a persistent legend about Jews and money that reflected the anxieties surrounding the rise of impersonal credit markets.

What are the promises and the perils of credit?

This is a book about the distant past, but to understand its import, we may think about the fallout of the 2008 financial crisis. After the collapse of Lehman Brothers and the foreclosure crisis, a few radical voices called for an end to capitalism. But most people, in one way or another, demanded a fairer capitalism in which Main Street gains as much as Wall Street, and in which ever more intricate financial instruments provide for all and not just for savvy and well-connected insiders. The problem is that we cannot agree on what constitutes fair capitalism. Variations of this ideological and regulatory struggle have existed in Europe since the year 1000, when the Commercial Revolution of the Middle Ages set in motion the first sustained period of demographic and economic expansion on the continent after the fall of the Roman empire. The more people participated in market exchanges, the more difficult it became to distinguish reliable from bad borrowers, trustworthy from shady bankers.

What is the legend that the books uncovers?

The legend tells the story of Jews fleeing the kingdom of France sometime between the seventh and the fourteenth centuries who invented marine insurance and bills of exchange in order to salvage whatever they could of their assets. The legend is false: Jews did not invent marine insurance and bills of exchange, though they were chased from France multiple times during the Middle Ages and every expulsion was accompanied by confiscation of goods. The first rendition of the legend appeared in print in 1647 in a collection of maritime laws.

What are bills of exchange?

Marine insurance at the time worked in the same way as modern insurance works, but bills of exchange are no longer in use. They were at once a credit instrument and a way of transmitting money abroad in a foreign currency. Picture MoneyGram meets a personal check. Materially, they were slips of papers even smaller than a modern check, scribbled in code (details can be gleaned on the book cover). Bills of exchange allowed merchants to transfer funds rather than risk the theft or the loss at sea of their silver coins. In the hands of the most experienced merchants, they were used to conduct complex speculative financial transactions that were entirely divorced from the purchase and sale of material goods. Bills of exchange symbolized all that was abstract, intangible, arcane, helpful but also potentially dangerous in the growing credit economy of early modern Europe. They were the derivatives of their time.

Why should we care about the legend that attributed to medieval Jews the invention of bills of exchange?

Because it was a preferred way in which until a hundred years ago writers discussed a question that is central to the history of the West: how can we expand the number and range of people who enter the marketplace but control their good behavior? The impersonality of the market is both appealing and threatening. Before and after Adam Smith, the invisible hand was only one of the idealized solutions to the problem of oligopolies. Many writers resorted to Jewish usury as a metaphor to denounce the asymmetries of powers that plagued the market. In this they were assisted by stockpiles of anti-Jewish prejudice images. In its original formulation the legend I discuss adapts this arsenal of anti-Jewish sentiments to denounce the dark forces that could led good Christian borrowers to loose small and large fortunes. Jews were a universal symbol of financial malpractice, to attribute the invention of Europe’s key credit instruments to Jews did not mean that Christians could not put those instruments to good use, but it meant that marine insurance and bills of exchange were tainted by usury as their original sin.

If the legend is as important as you claim, why does no one knows about it?

There are several reasons the legend is forgotten. Bills of exchange have fallen out of use and we have ceased to wonder where they came from. Moreover, economic historians now tend to search for the origins of those financial institutions that have survived into the present, notably the stock market, which developed in 1600 but affected many fewer people than the hundred thousands who handled marine insurance and bills of exchange. There is also a tendency to assume that Jews, both real and imaginary, mattered to European economic thought only in the Middle Ages, before the emergence of a secular “science of commerce” emerged. This is simply not true. Religious language continued to inform most economic writing in the early modern period. To accuse a Christian merchant of being “Jewish” was a way of equating their behavior to that of Jews, who supposedly wished to rob Christians of their wealth.

How did Jews react to the circulation of this legend?

I wish I knew what Jews told each other about a story that some of them surely heard in one version or another. Some Jewish writers did engage with the legend in writing, especially in the nineteenth century. To my knowledge, the first to do so was the father of British prime minister Benjamin Disraeli, who had his children baptized, making his son’s political career possible. In some quarters, the legend was a source of Jewish pride and fed the genre known as Jewish-contributions-to-civilization by touting Jewish financial prowess. Other Jewish authors firmly rejected a legend that they saw as mobilizing insidious stereotypes.

Why don’t you ever mention Shylock in a book about Jews and credit?

Some historians have tried to pin down the sources of Shakespeare’s imagination by establishing whether one Jewish merchant or another living in the Venice ghetto in the 1590s may have served as a model for the great English writer. I regard such efforts as futile: literary imagination is not more or less compelling because it is based on identifiable facts. But if we want to judge one of the masterpieces of Renaissance theater by its empirical validity, then The Merchant of Venice would fail the test. The pound of flesh is only one of the dubious references in the play. Shylock would have lent money to Antonio by means of a bill of exchange. Only poor Christians had to deposit a pledge to borrow a small sum in the ghetto. A patrician like Antonio could borrow by using his reputation as collateral. After 1589, when international Jewish merchants hailing from Iberia found a safe haven in Venice, Antonio would have found Jewish merchants able and willing to issue him a bill of exchange. The figure of Shylock really tells us that the Jewish usurer, one of the most long-lasting figments of the Western imagination, was a protean symbol that encompassed stereotypes of both the parasitic Jewish poor and the rapacious Jewish capitalist.

Francesca Trivellato is professor in the School of Historical Studies at the Institute for Advanced Study in Princeton. She is the author of The Familiarity of Strangers: The Sephardic Diaspora, Livorno, and Cross-Cultural Trade in the Early Modern Period.

Alberto Alesina, Carlo Favero and Francesco Giavazzi on Austerity

AusterityFiscal austerity is hugely controversial. Opponents argue that it can trigger downward growth spirals and become self-defeating. Supporters argue that budget deficits have to be tackled aggressively at all times and at all costs. In this masterful book, three of today’s leading policy experts cut through the political noise to demonstrate that there is not one type of austerity but many. Bringing needed clarity to one of today’s most challenging subjects, Austerity charts a sensible approach based on data analysis rather than ideology.

What is controversial about fiscal austerity?

The term austerity indicates a policy geared toward the sizeable reduction of government deficits and stabilization of government debt achieved by means of spending cuts or tax increases. Discussions about the relative benefits and costs of austerity policies have been toxic, often taking a very ideological, harsh tone. The anti-austerity front argues that austerity is counterproductive: it results in increases—rather than reductions—in the debt-over-GDP ratio since it generates reductions in the denominator of this ratio which more than offset the gains in the numerator. The pro-austerity front emphasizes the impact of expectations and confidence on government debt. Imagine a situation in which an economy is on an unsustainable path with an exploding public debt. Sooner or later a fiscal stabilization has to occur. The longer this is postponed, the higher the taxes that will need to be raised or the spending to be cut in the future. When the stabilization occurs it removes the uncertainty about further delays which would increase the costs of stabilization.

Why did you write this book?

The contentious discussion on the effects of austerity has distracted commentators and policymakers from meaningful discussion on the enormous difference, on average, between expenditure-based and tax-based austerity plans. This book discusses the theory and the evidence needed to better assess the consequences of the different types of austerity. 

What are the differences in the impact of tax-based measures versus expenditure-based measures?

Spending-based austerity plans are remarkably less costly than tax-based plans. Spending-based plans have, on average, a close to zero effect on output and lead to a reduction of the debt over GDP ratio. Tax-based plans have the opposite effect: they cause large and long lasting recessions and do not lead to the stabilization of the debt to GDP ratio. Two recent examples are the consolidations carried out by Ireland and Spain in response to the Eurozone crisis. The Spanish correction, which featured a larger share of tax hikes, markedly slowed the real GDP growth and did not result in a decline in the debt ratio. Contrast that with Ireland, where the spending-based correction had little output costs and led to a sharp decline in debt.

How should we change our thinking about austerity in order to assess its effectiveness properly?

The empirical analysis of the macroeconomic effect of different types of austerity is crucial. To this end one should start from the data. The book documents in detail close to 200 austerity plans carried out in 16 OECD economies from the late 1970s to 2014. To reconstruct these plans we have consulted original documents (some produced by national authorities, and some produced by organizations such as the OECD, the IMF or the European Commission) concerning about 3,500 individual fiscal measures. The second step is the proper modelling of fiscal actions. When legislatures decide to launch a fiscal consolidation program, this rarely consists of isolated shifts in this or that tax, or in this or that spending item; instead, what is adopted is typically a multi-year plan with the objective of reducing the budget deficit by a certain amount every year. To the extent that expectations matter for the planning of consumers and investors, the multi-year nature of a fiscal adjustment, and the announcements that come with it, impact their economic effects. Third, the effect of different plans on the economy should be assessed. We document a sharp difference between adjustment plans based mostly on tax increases and plans based mostly on expenditure reductions. This finding suggests that there is no “austerity” as such: the effects of austerity policies are sharply different depending on the way they are implemented.

In assessing the empirical evidence we needed to overcome three major obstacles.

The first is the so-called “endogeneity” problem, or the interaction between fiscal policy and output growth. Suppose you observe a reduction in the government deficit and an economic boom. It would be highly questionable to conclude that policies that reduced deficits have generated growth, as it could easily be the other way around. We address the endogeneity problem by considering only policy changes not motivated by the state of the business cycle but rather by a desire to reduce deficits.  

Second, once exogenous fiscal adjustments episodes have been identified, then the calculation of their impact on the economy requires the specification of an empirical model. An important tradeoff emerges here: the simpler the model the easier to calculate the multipliers, but the more likely that important relations among variables are missed. We adopt several models in this book to assess the robustness of our empirical results. 

Third, major episodes of austerity often are accompanied by changes in other policies: monetary policy; exchange rate movements; labor market reforms; regulation or deregulation of various product markets; tax reforms; and so on. In addition, austerity is sometimes adopted at times of crisis due to runaway debts, not in periods of business as usual. We assess explicitly the role of accompanying policies in the determination of the impact of austerity to conclude that the heterogenous effects of tax-based and expenditure-based plans does not depend on different accompanying policies.

In cases where austerity has “gone wrong,” what accounted for that? What should have been done differently?

During 2010-11 the collapse of confidence in sovereign European debt and the explosion of interest rates on government bonds in some countries (Italy, Spain, Greece, Portugal) led to a situation that was close to a debt-induced financial crisis. Could the governments of these countries have waited, postponing austerity to when the recession was over? Hard to say. We do not know what would have happened without austerity. What we can say, however, is that even in these cases, namely when austerity policies are implemented during a recession, the differences between the two types of austerity is very relevant: tax-based austerity plans have been much more costly than spending-based plans.

Can you give an example of a government that had the right idea about austerity?

In the 1990s Canada implemented a successful package of large government cuts which, coupled with accommodating monetary policy and structural reforms, was expansionary. In the book we document how since the 1993 elections almost all the contending parties accepted the need for such a reduction in government debt and deficit. In 2010, the Coalition government led by David Cameron in the UK responded to unsustainable and growing deficits with a program of large budget cuts. After this correction, the UK economy grew at respectable rates compared to the other major economies and proved the IMF predictions of a major recession wrong. Finally, and maybe most interestingly, the Irish government in its December 2009 Stability Programme Update was clear in acknowledging the unsuccessful effects of tax-based austerity. This in turn justified the adoption of a package of significant expenditure cuts.

What do you hope readers will take away from this book?

Talking about “austerity” without defining how austerity is implemented does not make any sense. The composition of austerity plans is crucial to understanding their effects on growth and fiscal sustainability. The data on 16 OECD countries over the period 1978-2014 show that a spending reduction plan and tax-based plans of the same dimension have different effects on growth. Tax-based plans lead to deep and prolonged recessions, lasting several years. Expenditure-based plans on average exhaust their very mild recessionary effect within two years after a plan is introduced. The component of aggregate demand which mostly drives the heterogeneity between tax-based and expenditure-based austerity is private investment. The effects of fiscal plans on the debt to GDP ratio depend on the initial level of the debt. In the high-debt high-cost of debt scenario, an expenditure-based plan has a stabilizing effect on the debt dynamics while a tax-based plan has a destabilizing effect; in a low-debt low-cost scenario the expenditure-based adjustment remains stabilizing, while the effect of a tax-based plan becomes neutral. The main goal of our work is to explain the evidence and the theory which underlies these results. To this end we discuss the theory; we construct a new data set; we propose to analyze fiscal plans to take the empirical modelling of fiscal policy closer to the real-life process of its implementation; and we consider case-studies and econometric evidence. We also study the role of accompanying policies: devaluations, monetary policy and structural reforms in the goods and labor markets. We devote special attention to the recent round of austerity plans implemented after the financial and Eurozone crises. Finally, we ask the political economy question of whether austerity is the kiss of death for the governments that implement it, concluding that the answer is much less obvious than the popular debate would seem to suggest.

Alberto Alesina is the Nathaniel Ropes Professor of Political Economy at Harvard University. He is the author, with Francesco Giavazzi, of The Future of Europe: Reform or DeclineCarlo Favero is the Deutsche Bank Chair in Quantitative Finance and Asset Pricing at Bocconi University in Italy. He is the author of Applied MacroeconometricsFrancesco Giavazzi is professor of economics at Bocconi University.

William L. Silber on The Story of Silver

SilberThis is the story of silver’s transformation from soft money during the nineteenth century to hard asset today, and how manipulations of the white metal by American president Franklin D. Roosevelt during the 1930s and by the richest man in the world, Texas oil baron Nelson Bunker Hunt, during the 1970s altered the course of American and world history. The Story of Silver explains how powerful figures, up to and including Warren Buffett, have come under silver’s thrall, and how its history guides economic and political decisions in the twenty-first century.

Why did you write this book?

In 2014 Bunker Hunt died and when I told my children – who had worked in finance all their lives—they thought Bunker was one of the guys who kept hitting the ball into the sand in my Sunday golf group. Right then I knew that I had to write this book to at least tell the story of the greatest commodities market manipulation of the 20th century – one that was perpetrated by the larger than life Nelson Bunker Hunt – the richest man in the world who ultimately went bankrupt trying to corner the silver market with his brothers, Herbert and Lamar, in the 1970s. The Hunts drove the price of silver to a record $50 an ounce in January 1980 and nearly brought down the financial markets in the process. But the Hunt brothers were not the first nor the last to be seduced by the white metal. In 1997 Warren Buffett, perhaps the most successful investor of the past fifty years, bought more than 100 million ounces, almost as much as the Hunts, and pushed the price of silver to a ten-year peak. In 1933 Franklin Delano Roosevelt raised the price for silver at the U.S. Treasury to mollify senators from western mining states while ignoring the help it gave Japan in subjugating China. Was FDR’s price manipulation in the 1930s less criminal than Nelson Bunker Hunt’s in the 1970s? Reading this book will let you make an informed judgment and it will also show that the white metal has been part of the country’s political system since the founding of the Republic. Perhaps the most famous speech in American electoral politics, Nebraska Congressman William Jennings Bryan’s “Cross of Gold” sermon at the 1896 Democratic convention, was all about silver. Bryan’s cause, the resurrection of silver as a monetary metal, aimed to rectify the injustice perpetrated by Congress in the Crime of 1873, which discontinued the coinage of silver dollars that Alexander Hamilton had recommended in 1791. Thus, the Story of Silver spans two centuries and is woven into the fabric of history like the stars and stripes.   

Why did Bunker Hunt become obsessed with silver in the 1970s?    

A member of the right-wing John Birch Society, Bunker became the richest man in the world at age forty in 1966 when oil was discovered in Libya where he owned the drilling rights. His ultraconservative politics made him distrust government and its paper currency and favor real investments, such as oil, land, and racehorses. The Arab oil embargo in 1973 provoked an outburst of inflation and Libya’s Muammar Qaddafi nationalized Bunker’s oil fields, forcing the Texan into precious metals to protect against the declining value of the dollar. He bought silver, rather than gold, because he thought the yellow metal was “too political” and “too easily manipulated” by outside forces. Bunker worried that central bankers could sell their massive gold reserves and depress its price. Silver, on the other hand, benefited from favorable fundamentals: the demand for the white metal by industry, for use in electronics, photography, and medicine, exceeded mine production by nearly 200 million ounces a year (Warren Buffett invested in silver in 1997 for the same reason). Moreover, in 1973 the price of silver was cheap relative to gold. The price ratio of gold to silver had been about 16 to 1 for a century before the Crime of 1873, meaning that it took 16 ounces of silver to buy an ounce of gold. In 1973, before Bunker began his accumulation, the price ratio was almost 40 to 1. Bunker thought silver’s industrial uses should have boosted its price to where only 5 ounces of silver were needed to get an ounce of gold. Bunker picked 5 to 1 because it was lower than 16 to 1 but he could have gone further. In ancient Egypt silver’s scarcity and medicinal uses had made it more valuable than gold.   

Did the Hunt Brothers really manipulate the price of silver?

The Commodity Futures Trading Commission (CFTC) argued that during the second half of 1979, the Hunt brothers and their Arab collaborators coordinated a scheme to drive up silver prices in the futures markets by purchasing over 200 million ounces of the white metal, more than the combined annual output of Canada, Mexico, Peru, and the United States, the four largest noncommunist producing countries. They pressured the market by controlling more than 40% of silver in exchange warehouses and by taking delivery of almost 50 million ounces of bullion. But the alleged manipulation was not the classic corner of futures markets, where the longs prevented the shorts from delivering. As silver prices accelerated in December 1979, for example, even the CFTC said that the shorts “anticipated no difficulties in making delivery on their positions.” Moreover, the Hunts denied manipulative intent, dismissed any coordination, even among themselves, and justified their demand for silver as a hard asset to protect against global risks in the second half of 1979, when inflation reached double digit levels, Iranian terrorists invaded the United States embassy in Teheran and seized American hostages, and when the Russians invaded Afghanistan.  Disentangling the impact of the alleged manipulators from legitimate speculation took extensive litigation in this case. In a civil trial in 1988 a jury easily concluded that the Hunts conspired with others to manipulate but disagreed about the impact on prices. The jury had to distinguish between the defendants’ accumulation and the unsettling news of 1979. The CFTC argued that gold prices reflect political and economic turmoil and silver increased twice as much during 1979, providing a benchmark for damage calculation for the jury. But that ignores the historical evidence that the white metal is normally twice as volatile as the yellow. For example, during the European debt crisis following Lehman’s bankruptcy in 2008, silver rose 400% and gold increased by 250% and none of that disparity came from manipulation. That evidence came too late to exonerate the Hunts.  

How did FDR’s silver subsidy help Japan subjugate China in the 1930s?

During the Great Depression, after the price of silver hit a record low of 24¢ an ounce, Democratic Senator Key Pittman of Nevada, the powerful chairman of the Senate Foreign Relations Committee, urged President Roosevelt to reverse the Crime of 1873 and restore the white metal’s full monetary status. In exchange, Pittman promised the support of fourteen senators from western mining states for Roosevelt’s controversial New Deal legislation. FDR agreed and responded with a series of purchase programs for silver by the U.S. Treasury that ultimately doubled the price of the white metal. The higher price attracted silver from the rest of the world, especially from China, whose currency was backed by the precious metal, and ultimately forced China to abandon the silver standard when that country was most vulnerable. It was 1935 and China, led by American ally Chiang Kai-shek, faced an internal threat from Mao Tse-tung’s communist insurgents and an external threat from Imperial Japan. Roosevelt’s Treasury secretary, Henry Morgenthau, worried that China’s insecure government, weak economy, and susceptibility to Japanese aggression made her especially vulnerable to the dislocations arising from American silver policy. Morgenthau was right to worry. Roosevelt’s pro-silver program to please western senators helped the Japanese military subjugate a weakened China and boosted Japan’s march towards World War II, demonstrating the danger of formulating domestic policy without considering international consequences.  It is a cautionary lesson for putting America First today, especially since the fallout from such narrow-minded policymaking may not materialize until it is too late, just like in the 1930s.

Was the Crime of 1873 really a crime?

The Crime of 1873 refers to legislation passed by Congress on February 12, 1873, negating Alexander Hamilton’s favorite law, that both gold and silver be monetary standards in the United States, and establishing gold as sole legal tender for all obligations. The new law omitted the free and unlimited coinage of silver dollars at the mint, an option since 1792, and restricted the legal tender status of subsidiary silver coins, such as dimes, quarters, and half-dollars, to five dollars or less. The U.S. Constitution allows Congress to “coin money” and “regulate the value thereof,” so no legislator voting for the act technically committed a crime. The allegations of impropriety arose because few people realized the full consequences of the shift to gold when the law was passed. Moreover, Senate Finance Committee Chairman John Sherman, who introduced the legislation, not only failed to sound the warning bell but also soft-pedaled the bill despite knowing its importance. Sherman’s removal of the silver dollar from the Coinage Act of 1873 eroded the value of the white metal, cutting its price in half by the mid-1890s, and altering the course of American history. Twenty-five years of price deflation during the last quarter of the 19th century increased the burden of debts like mortgages which remained fixed in dollar terms even though home prices declined. The drop in wages and agricultural prices launched a generation of social combat, pitting “silverites” against “goldbugs,” debtors versus creditors, and midwestern farmers against East Coast bankers, all combining to darken the political landscape like a dust storm. Many consider L. Frank Baum’s children’s story, The Wonderful Wizard of Oz, which has entertained millions since it was published in 1900, an allegory of the contemporary class warfare. William Jennings Bryan capitalized on the social upheaval, captured the Democratic nomination for the presidency in the 1896 election with his Cross of Gold speech promoting the monetary status of silver and easier credit. Bryan lost to William McKinley, leaving silver a second class monetary metal until Key Pittman and Franklin Roosevelt joined forces to rescue the white metal in the 1930s.  

Should investors own silver today?

The worldwide experiment in fiat currency, pure paper money, that began on August 15, 1971, when President Nixon suspended the right of foreign central banks to convert dollars into gold, almost failed at the start. The newly designed freedom from precious metals allowed America’s central bank, the Federal Reserve System, to deliver easy credit in response to political pressure, spawning the Great Inflation of the 1970s and nearly destroying the U.S. dollar. But the chaos unleashed popular support for making price stability the primary objective of an independent central bank. Since then, central bank independence throughout the world has replaced gold and silver as guardian of the currency. And if central bankers do their job that arrangement will continue, but public support can evaporate, undermining banker resolve. The U.S. Congress, for example, can abolish the Federal Reserve with a simple majority vote, suggesting that America’s central bank might run a printing press when rising interest rates bring an avalanche of protest to Capitol Hill. The Federal Reserve has survived the fifty-year trial of fiat currency, but that period is less than a heartbeat in world history. The Soviet Union’s experiment with communism challenged America for world domination for the better part of the twentieth century before expiring like the worthless paper currency of Germany’s Weimer Republic. Central bankers remain on trial, and the uncertain verdict sustains the ancient role of gold and silver as storehouses of value in the new millennium.

William L. Silber is the Marcus Nadler Professor of Finance and Economics at New York University’s Stern School of Business. His many books include When Washington Shut Down Wall Street (Princeton) and Volcker (Bloomsbury). He lives in Teaneck, New Jersey.

Matthias Doepke and Fabrizio Zilibotti on Love, Money, and Parenting

Doepke & ZilibottiParents everywhere want their children to be happy and do well. Yet how parents seek to achieve this ambition varies enormously. For instance, American and Chinese parents are increasingly authoritative and authoritarian, whereas Scandinavian parents tend to be more permissive. Why? Love, Money, and Parenting investigates how economic forces and growing inequality shape how parents raise their children. From medieval times to the present, and from the United States, the United Kingdom, Germany, Italy, Spain, and Sweden to China and Japan, Matthias Doepke and Fabrizio Zilibotti look at how economic incentives and constraints—such as money, knowledge, and time—influence parenting practices and what is considered good parenting in different countries. Love, Money, and Parenting presents an engrossing look at the economics of the family in the modern world.

What led you to write this book?

Everything started when we realized that two of our experiences had crossed paths: as researchers and as parents. As economists we have always been interested in inequality and human capital formation. Our work studies how the economy influences the transmission of values, preferences, and skills within families. The way in which parents interact with their children is a focal point of our recent research.

We have dealt with the same issues in our own families. We grew up in Italy and Germany, but our academic careers have brought us to live in several other countries. Fabrizio’s daughter was born in Stockholm, and has lived in Sweden, the UK, Italy, and Switzerland. Her parents are now in the US and she often visits Spain (her mother is Spanish). Matthias had his three sons in the US, but his family spends a lot of time in Germany and currently lives in Spain. We both have also frequent contacts with East Asian cultures, especially China and Japan.

We have been struck by the differences in parenting practices across countries and over time, such as the contrast between the liberal parenting that we experienced as children in Europe compared to the high-pressure parenting culture in the US today. At some point, we realized that the differences we observed in our own lives line up well with broader patterns in the data for many countries and time periods, and that all of this variation conforms surprisingly well with the predictions of our own economic theories. So, we decided to focus on parenting through the double lens of parents and social scientists. Having published most of our earlier work in academic journals that only few experts read, we felt the urge to communicate our findings and ideas to a larger public. We believe we have something novel to tell to parents and general readers.

How do you account for the difference in parenting between European, American and Chinese parents as exemplified in books like Battle Hymn of the Tiger Mother?

We love Amy Chua’s book. It is fun to read, well-written, full of self-irony—we recommend it. But our book takes a different tack. We do not believe that the main explanation for differences in parenting styles is limited to cultural factors. For instance, we do not think that Chinese parents are different just because they are Chinese or because of the Confucian heritage. Rather, we think that parents in different parts of the world behave differently because they respond to different economic incentives.

In today’s China, children grow up under enormous pressure to achieve at the highest level in academics. Grades determine which university they can attend, and Chinese universities vary widely in quality of education. Making it into Peking University or Tsinghua or Fudan is a ticket to a brilliant future. For those who fail, life can instead be tough. The US is less extreme, but also has large quality differences across schools and high income inequality. In both countries, parents emphasize the importance of children working hard and becoming achievers; even more so in China than in the US, because getting good grades and doing well in exams is even more important in China.

European countries (especially Scandinavian countries) are in comparison much less unequal. There, parents can afford to be more relaxed and let their children discover the world at their own speed and according to their own inclination. Excelling at school is less important; there are many second opportunities to do well in life, and safety nets are more robust. It is interesting to observe that parents in Japan (a country that has closer historical and cultural ties with China than with Western Europe) report some parenting values that are similar to those of parents in the Netherlands. What do the Dutch and the Japanese have in common? Culturally, very little, but they both have low income inequality. Amy Chua also emphasizes that the experience of being an immigrant has an impact on parenting. In our view, there are good economic reasons for that. Immigrants typically lack strong local connections that can help with getting ahead. So, school achievement is the best strategy for success.

Does your research lead you to draw value judgments on certain kinds of parenting over others? Or is it more the case that the type of parenting that is directly related to economic conditions is best suited to those very conditions?

We stay away from value judgments. Our book does not tell parents that a particular parenting style is better than another. This sets our book apart from many existing parenting guides, where experts try to teach “good parenting.” Experts often disagree, and so the market offers titles for any taste; there are books praising achievement-oriented (authoritative, as we call it) parenting, and other books that make the case for “free-range” (permissive) parenting. In contrast, we take the view that parents, by and large, know what they are doing. And so we don’t come out of the ivory tower to teach a more enlightened way to be a parent.

Our goal is to explain how parents respond to the environment in which they and their children live. Going back to China, the Chinese parenting style is an adaptation to the incentives of that society. Parents push their children hard, because this is what it takes to do well in China. Switching to free-range parenting might be a bad idea for them. Conversely, helicopter parenting would not work well in Scandinavia. That society rewards independence and teamwork; rampant individualism is not viewed as an asset and is not even especially appreciated by employers.

To be clear, we are not saying that parents around the world sit down and consider the different options and tradeoffs with scientific precision. They just try to do what feels right to them, but exactly what this means inevitably depends on the economic environment. Many of these mechanisms are subconscious and become part of what we informally call the local culture or parenting norms. These norms change over time and adapt to evolving economic conditions, something we document in detail in the book. When we were children in the 1970s, inequality was far lower, and our parents were much more relaxed about our upbringing. With our own children, we have adopted a more intensive, achievement-oriented parenting style, and certainly not because we are better parents. Rather, because the economic conditions have changed.

How do money, knowledge, and time come together to influence parenting?

The first word in the title of the book is ‘love,’ because we believe love to be the main motive of parenting. First and foremost, parents want their children to be happy in life. This premise is important to understand our book, especially because people often perceive economists as being fixated on a restricted set of financial objectives. Having said that, we do believe that money matters for a happy life. This is not our bias: dozens of empirical studies on subjective well-being point at a strong correlation between economic success and self-reported happiness.  Our argument is that when inequality is low, economic success is less salient in parenting, because stakes are lower. In contrast, in more unequal societies, parents become more concerned with how their children do economically. Being a mediocre artist may be sad on its own, but it is much worse in a society without safety nets where professional failure can lead to poverty and social exclusion. At the same time, if nobody tries, no talented artist will ever emerge.

Knowledge (or education) matters too, for two reasons. First, it is a vehicle to economic and social success—so parents typically push their children to do well in school. Second, education is an asset for parents; it sharpens their tools to influence and motivate their children. This might explain why we observe that less educated parents are more often authoritarian and prone to punish their children rather than to motivate them. Time is a crucial ingredient because much of parenting is about interacting directly with the child. But time and money are not independent; for example, richer parents often pay other people for doing basic housework tasks (such as cleaning) to make room for “quality time” with their children. Others do not have the same luxury.

Is it possible to track changes in permissiveness in parents over decades and see that those changes correlate with economic forces?

Let us first clarify that we use the term ‘permissive’ without any negative connotation. We do not mean ‘indulgent’ or, worse, ‘disengaged.’ We could as well label this style liberal or even free-range parenting (We borrow the term ‘permissive’ from child psychology literature). With this clarification in mind, we see that parents were much more permissive in the 1960s and 1970s than they are today. They were altogether less obsessed with supervising and guiding their children, and spent many fewer hours per week (as we see from time diaries) interacting with them. American parents half a century ago were more similar to the Swedish parents of today than to the frantic generation of American helicopter parents of the 21st century. Why? Fifty years ago inequality reached a historical trough. In a more equal society, there was less of a need to push children hard.

Another interesting observation is that the permissive mood of the 1960s came together with the rejection of the authoritarian methods that had been prevalent for centuries both at home and in school. We argue that this is due to the combination of declining inequality and increasing social mobility. Until the early 20th century, a large proportion of families lived in rural areas, and many children inherited their parents’ occupation and position in society. Most learning and education took place within the family, and the past, present, and future looked very much alike. In this society, parents perceived it as their duty to guide their children, forcing them if necessary, in their own footsteps, pretty much in the fashion as their own parents had done with them.

Since then, society has changed. Children learn most of what is useful for their future professional activity in schools, where parents cannot easily monitor their effort. Parents must then motivate their children. In addition, technological change has increased occupational mobility and caused old jobs to disappear and new jobs to take their place. Being like your father or your mother is often not an option. The old-style traditional parenting has then lost its appeal. Now, children must make independent choices and the best parents can do is shape their attitudes.

How do more financially privileged parents respond to the same economic forces differently from less privileged parents?

Both economic incentives and constraints matter. The rug rat race, namely the competition among frenetic parents in fostering their children’s success, imposes growing demands on families. Only some of them can live up to the daunting task. Driving children from music class to sports to an art exhibition requires lot of time and money. Many families cannot afford it. Take a single mother living in a disadvantaged area. She will have neither the time nor the financial resources to offer her children such luxuries. Moreover, her children will be around other children who suffer the same relative deprivation.

What’s worse, neighborhoods have become increasingly socially segregated. The result is that a large share of the population is excluded from the race. Helicopter parenting is the root of what we call a growing “parenting gap.” A gap between rich and poor families has of course always existed but it has been exacerbated by the intense overparenting of the upper middle class.

Blaming middle-class parents for overparenting is futile; they are simply responding to changing economic incentives. They try to be good parents in the competitive society in which their children live. This is why in the book we advocate policy interventions aimed at changing incentives and equalizing opportunities. We also discuss how the parenting gap can turn into a parenting trap, whereby disadvantaged families simply give up, and their children face ever-growing barriers to get out of poverty. This may be a channel behind the recent decline in social mobility in the lower echelons of society.   

What do you hope readers will take away from this book?

We are often asked which parenting style is the best. On that, we are happy to share our subjective experiences and beliefs as parents, but as social scientists we cannot give any definite answer. However, when it comes to the society as a whole, we are more assertive. We think that the overparenting frenzy is taking a toll on the happiness of families. Parents and children engage in a race with the main goal of getting ahead of others, rather than just building useful skills. Moreover, this frenzy is a barrier against equal opportunities.

Rather than educating parents about the virtue of free-range parenting, which will not work if economic incentives are unchanged, we advocate policies that change economic incentives, that reduce the stakes in parenting, and that open up new opportunities for disadvantaged families. Fabrizio’s daughter grew up in a free-range Swedish daycare with a mix of children from a wide range of social, economic, and ethnic backgrounds. When the family moved to London for one year, she attended a posh exclusive (and expensive) nursery school. She was a happier child in Stockholm than in London. Some wealthy parents may be skeptical that their children can be happier in a more inclusive society. We hope we can open some cracks in those views.

Matthias Doepke is professor of economics at Northwestern University. He lives in Evanston, Illinois. Fabrizio Zilibotti is the Tuntex Professor of International and Development Economics at Yale University. He lives in New Haven, Connecticut.

What is Your Parenting Style?

ParentingParents everywhere want their children to be happy and do well. Yet how parents seek to achieve this ambition varies enormously. For instance, American and Chinese parents are increasingly authoritative and authoritarian, whereas Scandinavian parents tend to be more permissive. Why? Love, Money, and Parenting investigates how economic forces and growing inequality shape how parents raise their children. From medieval times to the present, and from the United States, the United Kingdom, Germany, Italy, Spain, and Sweden to China and Japan, Matthias Doepke and Fabrizio Zilibotti look at how economic incentives and constraints—such as money, knowledge, and time—influence parenting practices and what is considered good parenting in different countries.

How does your parenting compare? Are you more authoritarian, authoritative, or permissive? Find out by taking this quiz! 

Your 17-year-old daughter would like to go on a week-long camping trip with her 19-year-old boyfriend of two months. What do you do?

Your son’s primary school teacher recommends that parents enroll their children in violin classes offered by the school, arguing that this will improve focus and concentration. Your child shows no enthusiasm. He would rather join a soccer team. What do you do?

Your 15-year-old son has a curfew of 11pm, but arrives home at 1am. How do you react?

You have some guests at your place. Your 6-year-old daughter refuses to sit quietly at the table and is generally being disruptive. How do you handle it?

Your 5-year-old son has pushed his 3-year-old friend in the playground. The smaller child has fallen and hit his head. Fortunately, it is nothing serious. However, the parents of the smaller child are upset. How do you handle the situation?

You are on a picnic with your son and some family friends. Your son gets bored and starts nagging. He wants to go home and play video games. What do you do?

You discover condoms in your 15-year-old daughter’s bag. How do you react?

Your 10-year-old boy is getting below average grades in school. According to his teacher, he is smart but does not work hard enough. What do you do?

Your child spends long hours watching TV and playing video games.

Your daughter is ambitious and achievement-oriented. Her teacher, however, thinks that she is trying too hard. Rather than encouraging and supporting her drive for excellence, he gives her lessons about taking it easy and being balanced. Your daughter is frustrated. How do you react?

Your child is a good student. However, he is dependent on his parents. He is leaving for college in another city and you are worried that he may not easily cope with the new situation. How do you react?

Your child is an enthusiastic basketball player, but she is neglecting the academic side of school and her grades are mediocre.

Your preschooler has poor eating habits. He only seems to want junk food and eschews anything healthy.

Your teenager has shown a great aptitude for mathematics, but she is not passionate about STEM. Instead, she wants to enroll in a specialized school for cartoon and graphic arts.

What is Your Parenting Style?
Permissive

According to Diana Baumrind, who coined the concept of a parenting style, a permissive parent “attempts to behave in a non-punitive, acceptant and affirmative manner towards the child's impulses, desires, and actions. … She makes few demands for household responsibility and orderly behavior. She presents herself to the child as a resource for him to use as he wishes, not as an ideal for him to emulate, nor as an active agent responsible for shaping or altering his ongoing or future behavior. She allows the child to regulate his own activities as much as possible, avoids the exercise of control, and does not encourage him to obey externally defined standards.”
Authoritative

You are an authoritative parent. You don’t think that children should have unlimited freedom, but neither do you expect blind obedience. Instead, you aim to guide your child through reasoning and persuasion. When you set limits you explain why you do so. According to Diana Baumrind, who coined the concept of a parenting style, an authoritative parent “attempts to direct the child's activities but in a rational, issue-oriented manner. She encourages verbal give and take, shares with the child the reasoning behind her policy, and solicits his objections when he refuses to conform. … She enforces her own perspective as an adult, but recognizes the child’s individual interests and special ways. The authoritative parent affirms the child's present qualities, but also sets standards for future conduct. She uses reason, power, and shaping by regime and reinforcement to achieve her objectives, and does not base her decisions on group consensus or the individual child’s desires.”
Authoritarian

You are an authoritarian parent. You believe it is best for children to obey the rules set for them by their parents. You monitor your child and are strict in enforcing rules. You don’t expect your child to understand the reasoning behind your decisions, and instead demand obedience as a matter of principle. According to Diana Baumrind, who coined the concept of a parenting style, an authoritarian parent “attempts to shape, control, and evaluate the behavior and attitudes of the child in accordance with a set standard of conduct, usually an absolute standard … She values obedience as a virtue and favors punitive, forceful measures to curb self-will at points where the child's actions or beliefs conflict with what she thinks is right conduct. She believes in keeping the child in his place, in restricting his autonomy, and in assigning household responsibilities in order to inculcate respect for work. She regards the preservation of order and traditional structure as a highly valued end in itself. She does not encourage verbal give and take, believing that the child should accept her word for what is right.”

Share your Results:

Matthias Doepke is professor of economics at Northwestern University. He lives in Evanston, Illinois. Fabrizio Zilibotti is the Tuntex Professor of International and Development Economics at Yale University. He lives in New Haven, Connecticut.

An Interview with the Authors of Dark Matter Credit

Imagine a world without banks. Because there are no credit cards, you have to pay cash for everything, and there’s no way to borrow either. How do you buy car or a house, or start a new business? You hide cash under your mattress. Such a world would be desperately poor, or so research in economics teaches us. Yet someone Europe managed to become rich long before banks spread across the continent. How was that possible?

Dark Matter Credit by Philip T. Hoffman, Gilles Postel-Vinay, and Jean-Laurent Rosenthal solves the mystery. Using data on 250,000 loans from France, the authors found that credit abounded in Europe well before banks opened their doors, thanks to a huge shadow credit system whose importance no one has ever measured before. The system let nearly a third of French families borrow way back in 1740, and by 1840 it funded as much mortgage debt as the 1950s US banking system. And when banks finally appeared, it out-competed them, helping people to borrow, save, and even make payments. It thrived right up to World War I, not just in France but Britain, Germany, and the United States, only to be killed off by government intervention after 1918.

According to the authors, their discovery overturns standard arguments about banks and economic growth and reveals a shadow system made up of thousands of loans between individuals, as in modern peer to peer lending.  Dark Matter Credit sheds light on the problems peer to peer lending will face as it spreads and suggests how those problems can be solved.

What led you to uncover a huge and unknown shadow banking system?

We knew that people were borrowing and lending long before banks existed, because thousands of loan contracts survived in the French archives. We wanted to know how that was possible without banks. How did the lenders know that the borrowers would repay? After all, there was no such thing as a credit score or even an easy way to tell if property had been mortgaged, and potential lenders had for centuries been worried about the risk of default. Could lenders only make loans to family members or close friends? Was that how credit markets worked? If so, lending would have been severely limited.  Early investigations suggested, though, that lending was not so small, and not as local as previous scholars had thought. We suspected that informal intermediaries were matching borrowers and lenders and increasing the level of confidence in the market. To get at what had actually happened, we set out to measure all this lending across France and to analyze what made it possible.

How much lending was there?

Well in 1840, outstanding mortgage debt came to 27 percent of GDP. That was almost as much as in the United States during the housing boom in the 1950s, when there were numerous banks, savings and loans, and government backed mortgages, but all the lending in France was done without any bank involvement, and without any of the government support that stimulated housing construction in the United States. Even way back in 1740, the credit system in France allowed a third of all families to borrow and lend. And the system was incredibly persistent: it was only killed off by government intervention after 1918, but even as late as 1931, it was still providing 90 percent of all borrowers with their loans

How did it work?

The loans, it turns out, were arranged by notaries, who had been drawing up legal documents and preserving official copies of records since the Middle Ages. Over time, they began serving as real estate brokers and providing legal and financial advice, and since they knew who had money to lend and who was creditworthy, they were soon matching lenders up with borrowers who had good collateral and were likely repay. And if they couldn’t find a match among their own clients, they referred borrowers and lenders to one another. One notary might send a good borrower off to another notary, or he might receive a lender from yet another notary. That allowed loans to be made when the borrowers and lenders didn’t know one another. The loans didn’t pass through banks at all—they were all loans between individuals, as in modern, web based peer to peer lending, but all without the web obviously.

Did it do anything else?

The notaries also helped people make payments and manage their savings. And their loan business continued to thrive after banks opened their doors. There were in fact more banks in France than anyone imagined (we know—we counted them), but it took them nearly a century to make any serious inroads into mortgage lending. We also discovered that notaries and bankers actually cooperated with one another to devise a new way for peasants to pay their bills at a time when doing so was difficult outside of cities. This sort of innovation is surprising because it runs counter to an influential argument that financial markets should have been stifled by the legal system prevailing in France and many other parts of the world—so called civil law, which was supposedly less favorable to financial development than British and American common law. That argument is also contradicted by the fact that the notaries themselves were thriving loan brokers, because the notaries kept the written records that were at the heart of the civil law.

How did you measure all the lending?

We visited a lot of archives! We had to because we started in a period before there were any government statistics about lending. So we assembled loan information from original contracts and fiscal sources. Of course, reading a quarter of a million loan contracts would have been impossible, but we also knew that summaries of the loans survived in French tax archives from the early eighteenth century up through the 1900s. The tax records plus some ingenious sampling allowed us to gather the data on our quarter of a million loans and to estimate what was happening in the credit market for France as whole across two centuries. With the sample, we could analyze the impact of urbanization, economic growth, financial crises, and enormous institutional changes during the French Revolution and the nineteenth century.   We also investigated the spread of banking in France and the interaction between bankers and notaries, and we compared French banking with banking in Britain. The comparison suggested that Britain probably lacked as strong a peer to peer lending system as in France, although it did have one. Evidence from other countries implies that similar systems operated in Germany, and the United States in 1900. They too had big peer to peer lending systems that have yet to be explored. And one has recently cropped up in China, but it has caused massive losses and triggered protests, because of problems that the French system avoided.

Philip T. Hoffman is the Rea A. and Lela G. Axline Professor of Business Economics and History at the California Institute of Technology. Co-author Gilles Postel-Vinay is professor emeritus at the Paris School of Economics, and co-author Jean-Laurent Rosenthal is the Rea A. and Lela G. Axline Professor of Business Economics and the Ronald and Maxine Linde Leadership Chair in the Division of the Humanities and Social Sciences at the California Institute of Technology.

Browse our 2019 Economics Catalog

Our new Economics catalog includes a candid assessment of why the job market is not as healthy we think, an engaging and enlightening account of why American health care is so expensive—and why it doesn’t have to be, and an international and historical look at how parenting choices change in the face of economic inequality.

If you’re attending the Allied Social Science Associations meeting in Atlanta this weekend, you can stop by Booth 405-407 to check out our economics titles! We’ll be celebrating the new titles on January 5 at a reception at the booth from 10 to 11 a.m.

 

Uwe Reinhardt was a towering figure and moral conscience of health-care policy in the United States and beyond. In Priced Out, Reinhardt offers an engaging and enlightening account of today’s U.S. health-care system, explaining why it costs so much more and delivers so much less than the systems of every other advanced country, why the situation is morally indefensible, and how we might improve it.

 

Blanchflower_Not Working book cover

Don’t trust low unemployment numbers as proof that the labor market is doing fine—it isn’t. In Not Working, David Blanchflower shows how many workers are underemployed or have simply given up trying to find a well-paying job, how wage growth has not returned to prerecession levels despite rosy employment indicators, and how general prosperity has not returned since the crash of 2008. Blanchflower draws on his acclaimed work in the economics of labor and well-being to explain why today’s postrecession economy is vastly different from what came before.

 

Doepke, Zilibotti, Love, Money, and Parenting book cover

Parents everywhere want their children to be happy and do well. Yet how parents seek to achieve this ambition varies enormously. For instance, American and Chinese parents are increasingly authoritative and authoritarian, whereas Scandinavian parents tend to be more permissive. Why? Love, Money, and Parenting investigates how economic forces and growing inequality influence parenting practices and what is considered good parenting in different countries.

Dave Colander: Where Economics Went Wrong

Economics

Milton Friedman once predicted that advances in scientific economics would resolve debates about whether raising the minimum wage is good policy. Decades later, Friedman’s prediction has not come true. In Where Economics Went Wrong, David Colander and Craig Freedman argue that it never will. Why? Because economic policy, when done correctly, is an art and a craft. It is not, and cannot be, a science. The authors explain why classical liberal economists understood this essential difference, why modern economists abandoned it, and why now is the time for the profession to return to its classical liberal roots. Contending that the division between science and prescription needs to be restored, Where Economics Went Wrong makes the case for a more nuanced and self-aware policy analysis by economists.

Where Economics Went Wrong is a somewhat audacious title. Can you briefly tell us what’s wrong with economics?

Why have a firewall? The firewall discourages applied policy economists from trying to be too scientific, and economic scientists from worrying too much about policy implications of their work. The firewall is necessitated by the values inherently applied policy analysis. Scientific methodology isn’t designed to resolve differences in values. If a theorist is thinking about policy, the theory won’t be as creative as it can be. And if applied policy economics is too related to current theory, it won’t be as creative as it can be. Applied policy work requires that scientific methodology be integrated with more open and discursive engineering and philosophical methodologies that are designed to narrow differences in values and sensibilities and arrive at solutions to policy problems.

Our central argument is that scientific work and applied policy work are best done when there is a firewall between science and policy. Classical liberal economists had such a firewall, and we are calling for a return to Classical liberal methodology.

There are a lot of books out there criticizing economics; how does your critique differ?

The biggest difference is that we aren’t criticizing all of economics, but only one aspect of it—how economics relates theory to policy. We see ourselves as friendly critics, critiquing from the inside the economics profession, rather than from outside. In our view most of the outside critiques of economics miss their mark—they don’t convey the way top economists see themselves doing economics, which leads top economists to discount the critiques. Our critique is focused narrowly on economists’ blending of economic science and economic policy methodology.

 How does the subtitle of the book, Chicago’s Abandonment of Classical Liberalism, fit into your story?

Chicago is a useful case study for us because it was the last bastion of Classical liberalism in U.S. economics. It was Classical liberalism’s Alamo. Classical liberalism included both a methodology and a set of policy recommendations. The methodology involved keeping a firewall between economics science and policy for the protection of both science and policy. Classical liberals argued that if scientific researchers had policy views, those policy views would influence their science and their science would be tainted. If economists used scientific justifications for policy, which didn’t make clear that policy had to have a value component, policy would be tainted. It was a broad tent, not a narrow tent, methodology, and it reached its high point with the work of John Stuart Mill.

In the 1930s that changed; Classical liberalism was abandoned and was replaced with a new semi-scientific Pigovian welfare economics that blended science and policy into one field. Solutions to policy problems were to be found in better science, not in reasoned discourse.

The applied policy revolution started outside Chicago—at schools such as MIT and Harvard,and was quite pro-government interventionist. It seemed as if economic science was directing government to intervene in the economy. Chicago economists, led by Frank Knight, objected to both the change in methodology and the interventionist nature of the policy recommendations.

With the advent of the Chicago school of economics, the intellectual leadership of Chicago economics moved from Knight to Milton Friedman and George Stigler. They gave up Knight’s methodological fight, and concentrated on objecting to the interventionist nature of the new policy approach. They developed a pro-market scientific economic theory based on the Coase Theorem that led to the policy results they wanted. They presented it as a scientific alternative to the newly developed government interventionist scientific economics theory. In doing so they abandoned Classical liberal methodology, which held that science did not lead to policy recommendations. So the Chicago case study nicely highlights where economics went wrong.

What’s your solution to what’s wrong with economics?

Our solution is to bring back the firewall between science and policy. Using the Classical liberal approach, economic science includes only those aspects of economic reasoning and thinking that all economists agree can be scientifically determined. By design, there should be almost no debate about scientific economic theory. If there is serious debate about the theory, then the theory hasn’t reached the level of scientific theory; it is simply an hypothesis that needs further empirical study. Policy analysis uses economic science, but it also uses any other insights and analysis that the policy economist finds useful to arrive at policy conclusions.

The approach we are advocating for applied policy has much in common with engineering methodology. It is much looser and more open than scientific methodology. Engineering methodology is designed to solve problems, not to find truth. For an applied policy economist a scientific theory is simply a useful heuristics, to be used when useful. Engineering methodology specifically allows for the integration of values and does not present itself as infallible. It invites challenges and discursive exploration. Using an engineering methodology will make values in economics more transparent, and more subject to philosophical debate that can clear up some of the value and sensibility differences.

Can you be more explicit about how an engineering methodology differs from a scientific methodology?

Adopting an engineering methodology involves a change in how economists think about theory and policy. For an applied policy economist, theory becomes simply a useful heuristic.Debates about science are reduced enormously because the domain of economic science is reduced. In policy analysis a much broader pluralistic methodology is used. Scientific methodology is designed to discover truth, which means it must be very precise. Engineering methodology is designed to solve problems in the least cost fashion. It is far less precise because precision is costly.

How do you see such a change coming about?

Slowly, but surely. We see it more as an evolutionary change than revolutionary change. The change is already occurring. Many top economists are already following the Classical liberal methodology we advocate—they just don’t call it that. So one of the goals of the book is   to highlight their work and encourage young economists to use it as a role model. In the last chapter of the book we consider the work of six top economists who do quite different types of economics—they include theorists,empirical economists, and applied policy economists—who are all currently following what we call a classical liberal methodology. We show how that methodology influences the work they do and the interpretation they give to their work.

Our advice to other economists is to follow their lead. That means that:

  • in policy work, economists should be far less worried about carefully following scientific methodological guidelines; they should replace those scientific guidelines with educated common sense engineering guidelines designed to answer the type policy questions they are dealing with.
  • in theoretical work economists should stop worrying about relating theory to policy and let their imagination roam without concern about policy. They should go where few economists have gone before.
  • in blended theoretical and empirical work, economists should be more creative and less concerned about dotting i’s and crossing t’s. Leave that for the theoretical clean-up crew.
  • in econometric work, economists should use all the evidence that sheds light on the issue, not just the limited evidence that meets the profession’s current version of scientific rigor.

Our advice is for economists to free themselves from historically determined methodological scientific conventions and replace those conventions with pragmatic state-of-the-art conventions that take advantage of technological computational and analytic advances.

David Colander is Distinguished College Professor at Middlebury College. His many books include The Making of an Economist, Redux and Complexity and the Art of Public Policy (both Princeton). Craig Freedman is the author of Chicago Fundamentalism and In Search of the Two-Handed Economist.