The Economics Book

POST-WAR ECONOMICS 249

See also: Economic man 52–53 ■ Economic bubbles 98–99 ■ Risk and uncertainty 162–63 ■
Irrational decision making 194–95 ■ Behavioral economics 266–69

A probability experiment offered a choice of bets. A further choice offered $100 if a red or yellow ball was
Players were told there were 30 red balls in an urn, together drawn, or $100 if a black or yellow was drawn. This time,
with 60 balls that were an unspecified mixture of black and most players opted for black or yellow. In each case,
yellow. Drawing a red ball would win $100; a black would players showed a preference for known odds over
win $100. Most players opted for a bet on the red. unknown odds.

drawing on an idea originally experiments since Ellsberg Daniel Ellsberg
described by John Maynard Keynes published his paper. It
(p.161) in the 1930s. has become known as “ambiguity Born in 1931, Daniel Ellsberg
aversion,” and sometimes studied economics at Harvard
Aversion to ambiguity “Knightian uncertainty” after the University, and joined the US
Ellsberg described a thought US economist Frank Knight (p.163). Marine Corps in 1954. In 1959,
experiment in which a cash prize In seeking to know more about he became an analyst for the
was offered if a ball of a particular “unknown unknowns,” people may White House. He received his
color was drawn from an imaginary act inconsistently with previous, PhD in 1962, in which he first
urn (see above). The bets made by more logical choices, and put presented his paradox.
the experiment’s participants questions of probability aside Ellsberg, then working with
demonstrated that people tend to when making their choice. top security clearance, became
make a reasoned choice when disillusioned with the Vietnam
given some information from which Know the unknowns War. In 1971, he leaked top
the degree of probability, and Ellsberg’s paradox has proved secret reports detailing the
therefore risk, can be assessed. controversial. Some economists Pentagon’s belief that the war
However, their behavior changes if claim that it can safely be could not be won, before
a future outcome seems contained within conventional handing himself over to the
ambiguous, and this is the paradox theory, and that experimental authorities. His trial collapsed
that departs from expected utility conditions do not properly when it was revealed that
theory. People prefer to know more reproduce people’s behavior White House agents had used
about the uncertainties they face, when faced with real-life illegal wiretaps of his house.
rather than less. In the words of ambiguity. However, the financial
former US Defense Secretary crisis of 2008 has provoked Key works
Donald Rumsfeld (1932– ), people fresh interest in the problem
prefer the “known unknowns” to of ambiguity. People want to 1961 Risk, Ambiguity, and
the “unknown unknowns.” The know more about the unknown, the Savage Axioms
outcome of the experiment has unquantifiable risks that expected 2001 Risk, Ambiguity, and
been reproduced in several real utility theory cannot account for. ■ Decision

SIMILAR ECONOMIES

CAN BENEFIT

FROM A SINGLE

CURRENCY

EXCHANGE RATES AND CURRENCIES



252 EXCHANGE RATES AND CURRENCIES

IN CONTEXT B y the early 1960s the imports by using the proceeds
institutions of the post-war of their exports. Alongside this,
FOCUS economies were well a series of moves toward the
Global economy established. Toward the end of integration of European economies
World War II the Bretton Woods began to float the possibility of a
KEY THINKER system (pp.186–87) was set up to currency union between European
Robert Mundell (1932– ) regulate the financial relations countries. This started with the
between the big industrial states, Treaty of Paris in 1951, which
BEFORE basing Western capitalism on a established common trading
1953 Milton Friedman argues system of fixed exchange rates that areas for coal and steel. In 1961,
that freely floating exchange controlled the flows of capital and Canadian economist Robert
rates would enable market money worldwide. International Mundell was the first to attempt
forces to resolve problems trade had recovered after the slump an analysis of what he called an
with balance of payments (the of the interwar years, and economic “optimal currency area.”
difference between the value growth was rapid.
of exports and imports). Currency areas
However, there were glitches in Mundell sought to answer what
AFTER this system. First there were might at first seem an odd
1963 US economist Ronald problems with balance of payments question: over what geographical
McKinnon shows that small —the difference between what a area should one type of currency be
economies would benefit from country pays for imports and what used? At the time this issue had
a currency union since they it earns from exports. Balance of barely been posed. It had simply
can mitigate shocks better payments crises occurred because been taken for granted that national
than large economies. countries could not easily adjust economies used their own national
their exchange rates within the currencies. The idea that this might
1996 US economists Jeffrey international system. Coupled with not be the best arrangement had
Frankel and Andrew Rose tight labor markets and inflexible not really occurred to anyone.
argue that the criteria for domestic prices, the previously Mundell realized that while history
a currency area are automatic, market-led mechanisms had provided nations with their
themselves affected by prior that allowed countries to adjust to own currencies, this did not mean
economic development. external economic shocks did not it had provided them with the best
function very well. The result was possible currency arrangements.
a series of crises that arose when There were clearly costs involved in
countries were unable to pay for

Different regions Specialization leads to But trading in multiple
specialize in producing trade between regions. currencies creates
additional costs.
different goods.

Similar economies … there is no need for These costs can be
can benefit from a exchange rates tailored eliminated if the regions are
in similar phases of growth
single currency. to local conditions.
and slump because…

POST-WAR ECONOMICS 253

See also: Boom and bust 78–79 ■ Comparative advantage 80–85 ■ International trade and Bretton Woods 186–87 ■
Market integration 226–31 ■ Speculation and currency devaluation 288–93

A small region that crosses national
borders may benefit from a single
currency. An area may import electricity
from a power station across the border
without the costs of exchange rates.

using many different currencies, to offset trade imbalances. Suppose manfacturing economy—is in fact
since these had to be exchanged if a country specializing in made up of several nation-states. It
trade was to take place. At one agriculture is trading with a would therefore be efficient for
extreme, having a different manufacturing economy. A sudden them to share a currency.
currency for every zip code in a city increase in productivity in the
would be very inefficient. On the manufacturing economy might Business cycles
other hand one currency for the cause an excess demand for Later thinking on the subject
entire world would be an agricultural products and an excess helped clarify the conditions under
undesirable straitjacket on so many supply of manufactured goods. The which a currency area would be
diverse economies. Mundell asked manufacturing economy slips into most economically viable. For a
what was the most efficient point a balance of payments deficit, region to be best suited to a single
between these two extremes. importing more (by value) than it currency, it would need flexible
exports. The deficit causes the markets for capital and labor,
First of all it is important to manufacturing country’s currency allowing both to move freely in
understand why countries need to depreciate, making its exports response to market demands.
different currencies. A country cheaper, and therefore boosting Prices and wages would, as a
with its own currency can make them and restoring equilibrium. result, need to be flexible, adjusting
decisions about its money supply to demand and supply changes and
and interest rates, and can But suppose instead that the signaling to mobile capital and
therefore set its monetary policy manufacturing economy and labor where they should move.
tailored to its own domestic the agricultural economy shared a The different parts of the region
economic conditions. Also, when currency. In this case the type of would also need to share broadly
the exchange rates of its currency adjustment described above would similar business cycles, allowing
are not fixed, the exchange rate not be possible, and it might be the shared central bank for the
with its trading partners can adjust that separate currencies would be single currency to act appropriately
more beneficial. It might also be the for the whole region. There would
It hardly appears case that a single economic area— also need to be mechanisms for ❯❯
within the realm of such as that constituted by the
political feasibility that
national currencies would
ever be abandoned in
favor of any other

arrangement…
Robert Mundell

254 EXCHANGE RATES AND CURRENCIES

Crowds gather in Frankfurt,
Germany, for the launch of the euro,
the single currency of the eurozone, on
January 1, 1999. For a while the euro
traded alongside national currencies.

dealing with situations when
business cycles weren’t completely
synchronized across the region.
The most obvious of these would
be fiscal transfers—taking taxes
from one area enjoying growth
and redistributing to another in
recession. This last condition,
and the failure to implement it,
was to have grave consequences
for Europe.

Introducing the euro implement further constraints on attempted to fix national currencies
The idea of a single currency for euro membership to ensure that the against each other within the EU.
Europe began taking shape in 1979, currency could function effectively. The euro went a step further,
when the European monetary removing all national currencies
system (EMS) was formed to The “convergence criteria,” and, in effect, permanently fixing
stabilize exchange rates. Finally, in enshrined in the 1992 Maastricht exchange rates. Important new
1999, the eurozone (the area of the Treaty, were drawn up to make sure rules on government debt were
single currency) was established that all those countries wishing to introduced. Under the stability and
with 11 member states of the join the euro would share similar growth pact of 1997, no country
European Union (EU). While EU economies and be at similar stages was to have a national debt of
states traded heavily with each in their business cycles (growth or more than 60 percent of its gross
other and their institutions had recession). The previous exchange domestic product (GDP) and the
removed restrictions on the rate mechanism (ERM) had already
movement of labor, capital, and
goods, it was deemed necessary to

Robert Mundell Born in Kingston, Canada, in 1932, the International Monetary
Robert Mundell studied at the Fund. Alongside his work
University of British Columbia in on optimal currency areas,
Vancouver before moving to the Mundell developed one of the
University of Washington in first models to show how
Seattle. He earned his PhD at the macroeconomic (whole economy)
Massachusetts Institute of policy interacts with foreign
Technology in 1956. He was trade and exchange rates. He
professor of economics at the was awarded the Nobel Prize in
University of Chicago from 1966– economics in 1999 in recognition
74, when he moved to Columbia of his work on macroeconomics.
University in New York.
Key works
Apart from his academic work,
Mundell has acted as adviser to 1968 International Economics
the governments of Canada and 1968 Man and Economics
the US, and to organizations 1971 Monetary Theory
including the United Nations and

POST-WAR ECONOMICS 255

… countries with tight regions and redistribute to those in growing trade surpluses that were
international trade deficit—for example, to tax matched by rising deficits in the
ties and positively Germany and spend in Greece. But south. Without the mechanisms to
correlated business the political will to perform this provide for fiscal transfers between
was lacking. Instead, Europe’s surplus and deficit countries, these
cycles are more likely to join, leaders hoped that the stability and deficits were (in effect) funded by
and gain from [European growth pact would provide enough the creation of rising debts in the
Monetary Union]… of a bind on government activities south. When the financial crisis
Jeffrey Frankel that an explicit fiscal transfer broke in 2008, the unbalanced
Andrew Rose mechanism would not be needed. system was pushed over the edge.

annual deficit was not to exceed Eurozone crisis The euro crisis has raised
3 percent of GDP. A new European For nearly a decade after its launch questions about whether Europe
Central Bank would act for the euro the euro functioned well. European is an optimal currency area. Some
area, replacing the national central trade increased by up to 15 percent countries have seemed ill-matched
banks and setting monetary policy by some estimates. Capital and in trading terms, and the absence
across all the member states. labor markets became more of a fiscal transfer mechanism has
flexible. Growth, particularly in the meant that these imbalances could
Fatal flaw poorer countries of Ireland and not be overcome. The stability and
However, the provisions for the euro southern Europe was impressive. growth pact was not robust enough
did not contain a mechanism for But underneath this picture were to force distinct national economies
risk-sharing—crucially, they did profound problems. Differences in to converge.
not include a means for fiscal (tax labor costs helped exacerbate trade
revenue) transfers across European imbalances between different Euro member countries face
countries. The reason for this was countries. The euro area as a whole difficult choices. If a mechanism
simple, and political. Despite the was broadly in balance with the to undertake fiscal transfers can
long establishment of some transfer rest of the world, exporting roughly be constructed, euro countries
mechanisms, such as the Common as much as it imported. But within may be able to overcome their
Agricultural Policy, there was no the euro area, huge differences own unevenness. If the political
desire in any EU country to lose appeared. Northern Europe had consensus for such a mechanism
its ability to set its own taxes and can’t be reached, the existence of
spending levels. Fiscal transfers the euro may be threatened. ■
across the continent would have
required a strong, central authority,
able to take taxes from surplus

The eurozone was established in
1999 as the monetary union of the 11
European Union states shown here. By
2012, there were 17 eurozone members,
with eight more scheduled to join.

256

FAMINE CAN
HAPPEN IN
GOOD HARVESTS

ENTITLEMENT THEORY

IN CONTEXT Families exchange their I ndian economist Amartya Sen
labor for money, with which grew up during the Great
FOCUS Bengal famine of 1943. He was
Growth and development they buy food to survive. only nine years old when a man
arrived in his school who hadn’t
KEY THINKER If there is a change in the eaten in 40 days. Prior to this
Amartya Sen (1933– ) price of their labor or food… meeting, Sen had been unaware of
the suffering that was taking place
BEFORE … and wages become too low in his region. None of his family, nor
1798 Thomas Malthus to buy the minimum amount his friends’ families, were affected.
concludes that an increasing Even at this young age, Sen was
population will lead to famine of food a family needs… shocked at the class-based nature
and death in An Essay on the of the suffering. Almost 40 years
Principle of Population. … the family will starve, later, the memory of the Bengal
even if plenty of food famine drove Sen to research and
1960s The commonly held is being produced. write about the subject in Poverty
view is that famine is due to and Famines: An Essay on
a decline in food availability. Famine can happen Entitlement and Deprivation in
in good harvests. 1981. Sen concluded that, contrary
AFTER to popular belief, famine is not
2001 British economist caused primarily by a shortage of
Stephen Devereux argues that food. Bad harvests, droughts, or
entitlement theory misses the reductions of food imports are
political causes of famine. often contributing factors, but a
more important factor is the way
2009 Norwegian academic the food is distributed.
Dan Banik publishes
Starvation and India’s Entitlement
Democracy, showing how An absolute scarcity of food is very
starvation and undernutrition rare; it is far more common for food
can still occur despite a supplies to be unavailable to those
functioning democracy. who need them the most. Sen
termed the bundles of goods and
services that individuals have

POST-WAR ECONOMICS 257

See also: Markets and morality 22–23 ■ Demographics and economics 68–69 ■ Supply and demand 108–13 ■
The poverty problem 140–41 ■ Development economics 188–93

Famines such as the Congo famine of
2008 were caused by economic failure,
according to Amartya Sen. He claimed
that famine has never been known
to occur in a functioning democracy.

access to as their “entitlements.” evidence to support his theory. In rule, was going through a boom
Famines are an example of an Bengal he discovered that the total as the British government pumped
entitlement failure, and entitlements food production, although lower in money as part of its war effort.
depend on more than just the than the year before the famine This resulted in laborers suffering
amount of food produced. In a began, was still higher than in a reduction in their ability to buy
modern, exchange-based economy previous, famine-free years. He food, and so they starved.
most people do not produce their concluded that the principal cause
own food; they exchange a of the famine was the inability of Sen argued that democratic
commodity (their labor) in return for farm laborers’ wages to keep pace countries in particular should be
another commodity (money), which with the inflation-fueled rising able to prevent the worst famines.
is then exchanged again for food. price of food in Calcutta (now His groundbreaking approach led
Whether a family has enough food Kolkata). India, then under British to an overturning of beliefs and
to live on depends on what it can approaches to famine. ■
sell or exchange in comparison to
the price of food. A famine occurs
when families’ entitlements (the
goods they have access to, not
the amount generally available) fall
below the minimum amount needed
to survive. This may happen if the
price of food rises or wages fall.

Sen analyzed the Bengal famine
of 1943 and more recent famines in
Africa and Asia to collect empirical

Amartya Sen Amartya Sen was born in in the US; and Oxford and
Santiniketan, West Bengal, India, Cambridge in the UK. In 1988,
in 1933. His father was a professor he received the Nobel Prize for
of chemistry, but Sen chose economics. He moved to Harvard
economics, graduating from the University in 2004, where he is
University of Calcutta (now Kolkata) professor of economics and
in 1953. In the same year he philosophy. Sen has married
attained a second degree from twice and has four children.
Cambridge University, UK. At 23,
Sen became the youngest ever Key works
Head of Economics at Jadavpur
University, Calcutta. A prize 1970 Collective Choice and
fellowship enabled him to diversify Social Welfare
his studies into philosophy. Sen 1981 Poverty and Famines:
has taught at universities in An Essay on Entitlement
Kolkata and Delhi in India; MIT, and Deprivation
Stanford, Berkeley, and Cornell 1999 Development as Freedom

CONTEM
ECONOM

1970–PRESENT

PORARY
ICS

260 INTRODUCTION

George Akerlof OPEC, a group of Arthur Laffer explains Edward Prescott and
describes markets where oil-producing countries, the Laffer curve, which Finn Kydland
begin an oil embargo, argue for
one buyer has better plunging the world into shows how increased independent
information than taxes can lead to
economic crisis. central banks.
another, and opens up decreased revenue.
a new field of

information economics.

1970 1973 1974 1977
1971 1973 1974 1979

President Richard Nixon Augusto Pinochet seizes Hyman Minsky Psychologists Amos
breaks the link power in a coup in Chile, outlines his Tversky and Daniel
Kahneman publish
between the US dollar which becomes financial instability
and the price of gold the first country to hypothesis, showing Prospect Theory,
implement monetarist how stability leads the foundation of
on the advice of economic policies. behavioral economics.
Milton Friedman. to instability.

I n the 25 years following rather than tackling unemployment, born economist Friedrich Hayek
World War II Keynesian inflation should be the focus of (p.177), who put the individual, not
policies, which advocated an economic policy, and the only role the state, at the heart of economic
active state intervention in the of the state should be in controlling thinking, and by economists
economy, made the Western world the money supply and allowing who saw tax cuts as a means
prosperous. In the words of British markets to work—a doctrine of increasing tax revenue.
Prime Minister Harold Macmillan, known as monetarism.
people had “never had it so good.” Liberalization became the
However, in the early 1970s an Rise of the Right new watchword. Deregulation of
oil crisis triggered an economic As faith in Keynesian policies financial institutions not only made
downturn. Unemployment and waned, the right-wing parties it easier for firms to borrow, but also
inflation both rose rapidly. The of Ronald Reagan and Margaret allowed lenders to indulge in the
Keynesian model no longer Thatcher, both staunch believers in new forms of financial engineering
seemed to be working. Friedman’s monetarist economics, that promised high returns with
took power in the US and Britain. zero risk. Throughout the 1980s
For some years conservative The policies they introduced in the the economic mood was changing
economists had been arguing for a 1980s marked a return to the old worldwide. Reforms in the Soviet
return to more free market policies, beliefs in the stability, efficiency, Union were to lead to the eventual
and now their arguments were and growth of markets if left breakup of the Soviet bloc,
being taken more seriously. US to their own devices. reinforcing conservative
economist Milton Friedman (p.199), economists’ views that socialist
was now the foremost economist of The social policies of so-called policies did not work. Mainland
the Chicago School, which opposed Reaganomics and Thatcherism Europe, however, resisted the
Keynesian ideas. He suggested that were influenced by the Austrian- American swing from Keynes

CONTEMPORARY ECONOMICS 261

Mikhail Gorbachev Alice Amsden Alberto Alesina Nicholas Stern
begins a process of describes the rise and Dani Rodrik work describes global
economic reform in warming as the
the Soviet Union of East Asian on the relationship “biggest collective
Tiger economies. between economic action problem”
known as perestroika. facing human society.
growth and
inequality.

1985 1989 2000S 2006

1988 1994 2005 2008

Marilyn Waring’s Robert Flood and In The End of Poverty, A banking crisis causes
If Women Counted Peter Garber create Jeffrey Sachs suggests worldwide recession
gives a gender- the first of a number as credit is withdrawn
based perspective that debt relief
of currency can kick-start economies and housing
on economics. crisis models. bubbles burst.
in the Third World.

to Friedman and only gradually that the “scientific” models of the political instability. At the same
adopted more free market economy were based on the wrong time the technology that had
economic policies. sciences: new ideas in mathematics brought economic prosperity now
and physics, such as complexity posed an economic threat in the
Rethinking free markets theory and chaos theory, were form of global warming and climate
Although monetarism and the perhaps better analogies, and change, which needed to be dealt
liberalization of markets may have behavioral psychology could with at an international level.
helped to make markets more better explain the actions of
efficient through the 1980s and 90s, “economic man” than economists’ In the first decade of the 21st
some economists were uneasy standard notion of rationality. century a succession of financial
about the sustainability of these crises rocked the Western
policies. As early as 1974, US Meanwhile, younger economies economies, and it seemed that
economist Hyman Minsky (p.301) were developing, especially in Asia, free market policies had failed.
had warned of the inherent where reforms were transforming Once again, economics became
instability of financial institutions. the Chinese and Indian economies. concerned with the inequalities
An acceleration of the “boom and A new economic bloc emerged to and social consequences of free
bust” cycles seemed to confirm rival the West, in the form of the markets. A few economists even
his hypothesis. Deregulation BRIC nations (Brazil, Russia, India, wondered whether the failure of
encouraged risky borrowing, and China). The prosperity of these free markets was heralding the
which led to the collapse of firms new economic powers stimulated collapse of capitalism that Karl
and banks. Other economists a renewed interest in so-called Marx (p.105) had predicted. Not
challenged the efficiency and development economics since other for the first time, the world seemed
rationality of the market, arguing countries remained locked in to be on the verge of profound
poverty by crippling debt and economic change. ■

262 IN CONTEXT

IT IS POSSIBLE FOCUS
TO INVEST Banking and finance
WITHOUT RISK
KEY THINKERS
FINANCIAL ENGINEERING Fischer Black (1938–95)
Myron Scholes (1941– )

BEFORE
1900 French mathematician
Louis Bachelier demonstrates
that stock prices follow a
consistent but random process.

1952 US economist Harry
Markowitz proposes a method
to build optimal portfolios
based on diversifying risk.

1960s Capital Asset Pricing
Model (CAPM) is developed to
determine the correct rate of
return for a financial asset.

AFTER
1990s Value-at-Risk (VaR) is
developed to measure the risk
of loss on a portfolio.

Late 2000s Global financial
markets collapse.

D uring the 1960s the
institutional foundations
of the post-war world were
steadily eroded. The Bretton Woods
system (pp.186–87) of fixed exchange
rates, pegged against a US dollar
that was in turn locked into a fixed
price against gold, was starting to
buckle. The US was running
persistent trade deficits (where
imports outstrip exports), while
recurrent balance-of-payments
crises elsewhere provoked calls for
the introduction of freely floating
exchange rates. In 1971, President
Richard Nixon took definitive
action: he unilaterally canceled the
dollar to gold relationship, ending
the whole Bretton Woods system.

CONTEMPORARY ECONOMICS 263

See also: Financial services 26–29 ■ Public companies 38 ■ Risk and uncertainty 162–63 ■
Behavioral economics 266–69 ■ Efficient markets 272 ■ Financial crises 296–301

If we assume that financial … the probabilities of reduce risk and insure against the
markets are efficient, future price variations future. This is known as a “hedge.”
However, the derivative contract
and prices will rarely can be calculated. can work the other way around.
differ widely from Instead of providing insurance
an average value… This means a contract against the future, it can be used
to buy goods at a future to gamble on the future. A forward
It is possible to contract locks in the delivery of
invest without risk. price can be valued goods for a certain price on a certain
accurately and used date. But if the immediate market
At the same time domestic to insure against risk. price (the “spot price”) on that date
economies were experiencing is less than the price in the forward
steadily rising rates of inflation. derivative contract is a “forward,” contract, an easy profit could be
Keynesianism (pp.154–61), the which specifies the price and future made. Of course if the market price
economic thinking that had date for delivery of a commodity, is more than the one specified, it
dominated the post-war years, such as coffee. The advantage of results in a loss. Furthermore, as
came under sustained intellectual this arrangement is that it allows derivative contracts do not involve
attack. The financial markets, producers to lock their customers payment for actual assets or
which had been tightly regulated into a price in the future, regardless commodities, but only for the right
since the 1930s, pushed for a of how—in agricultural commodities to buy those products in the future,
removal of restrictions on their —harvests and production actually they allow people to deal in huge
activities. These restrictions were turn out. The derivative aimed to quantities. Derivatives give traders
finally lifted in 1972, when the leverage—more “bang for their buck.”
Chicago Mercantile Exchange was
allowed to write the first derivative Letting go of the asset
contract on exchange rates. Derivative contracts became
standardized and could then be
bought and sold on a market like
any other commodity. The first ❯❯

Futures contracts
Derivatives have existed for centuries.
A derivative is a contract written not
directly for a commodity itself, but
for some attribute associated with
it. For instance, a typical early

The price of rice may vary with
changes in weather. A forward
contract, where one party agrees to buy
the rice at a certain price on a certain
day, allows the grower to manage risk.

264 FINANCIAL ENGINEERING

exchange to offer tradeable Option contracts are a type of incorporate all the information
derivatives in agricultural products derivative that give someone the option you are basing your hedge on.
was the Chicago Board of Trade, in to buy or sell something, such as coffee, The second assumption was that it
1864. However, the possibility for at a certain price on a certain date. is always possible to put together
speculation that all derivative The option need not be exercised. an option contract that mirrors a
contracts contain led to repeated portfolio of assets. In other words
bans on their use. “Cash-settled” controlled. Exchanges were not every possible portfolio of assets
contracts provoked particular allowed to trade them. But with that can be assembled can be
concern. These were derivative the collapse of the fixed exchange- perfectly hedged by options. All
contracts in which the delivery of rate system in 1971, a need rapidly risk vanishes with this insurance.
the underlying asset did not have emerged for hedging against
to take place on the specified day. potentially volatile floating Third, they assumed that
Cash could be exchanged in its place. exchange rates. Restrictions were although asset prices fluctuate
At this point all real connection lifted, and the market for derivatives randomly over time, they vary
between the underlying product and quickly expanded. in a regular way, known as the
the derivative had been lost, and the “normal distribution.” This
possibilities for purely speculative This provided the background implies that, in general, prices
behavior were immense. to a critical problem. There was no will not move very far over a
reliable means to accurately price short time period.
Deregulation derivatives since they were, by
Recognition of this speculative nature, highly complex contracts. By using these assumptions,
potential motivated governments Even a simple “option” (providing Black, Scholes, and Merton were
to introduce strict regulations. the right but not the commitment able to provide a mathematically
From the 1930s onward, cash- to trade an underlying asset at a robust model for pricing a standard
settled derivatives in the US were certain point in the future) had option contract on the basis of
classified as a form of gambling, a price that was determined by the underlying asset’s price
rather than investment, and strictly several variables, such as the movements. Derivative contracts,
current price of the underlying once seen as unreliable instruments,
asset, the time to the option’s could now be processed on a huge
deadline, and the expected price scale using computer technology.
variation. The problem of providing The path was cleared for a vast
a mathematical formula for this expansion of derivatives trading.
problem was finally solved in 1973
by US economists Myron Scholes The option pricing model Black,
and Fischer Black, and expanded Scholes, and Merton devised
upon by fellow American Robert provided a whole new way to think
C. Merton the same year. about financial markets. It could
even run in reverse. Existing option
These economists built on prices could be fed backward
certain assumptions and insights
about financial markets to simplify Don’t cross a river
the problem. First, they made use if it is four feet deep
of the “no arbitrage” rule. This
means that prices in a properly on average.
functioning financial market reflect Nicholas Taleb
all the information available. An
individual share price would tell
you both the value of the company
today, and what market traders
expect of it in the future. It should
be impossible to earn guaranteed
profits by hedging against future
risk because prices already

CONTEMPORARY ECONOMICS 265

In the years leading to the 2008 crash, banks assumed that investment risk Low risk, high rewards
followed a “normal distribution” pattern (the blue line), where there is a high
probability of making a small gain, and a very low probability of making an US-Lebanese economist
extreme gain or loss. However, investment risk actually follows a different Nicholas Taleb claims that by
pattern (the dotted line), in which extreme events are far more common. underestimating the risk of
extreme price movements,
High the apparently sophisticated
probability, financial models overexposed
small gain investors to the real risk.
FREQUENCY OF EVENTS Collateralized debt obligations
Low Low (CDOs) are a prime example.
probability, probability, These are financial instruments
big loss big gain that raise money by issuing
their own bonds before
LOSS 0 GAIN investing that money in a
mixture of assets such as
into the pricing model to generate secure, profitable new ways to loans. CDOs took on the risks
“implied volatilities.” This created manage the risks associated of very low-quality (subprime)
a new way to manage risk: instead with lending. housing debts that had a high
of trading on the basis of prices chance of defaulting, and
or expected prices, portfolios of By September 2008, when the mixed them with high-quality
assets could be put together US investment bank Lehman debt, such as US Treasury
directly on the basis of their Brothers filed for bankruptcy, it had bills. They apparently offered
riskiness as implied by the market become clear that this expansion low risk and high rewards. But
price. Risk itself, as described by had fatal weaknesses. Critical this relied on an assumption
the mathematical models, could among these was the dependence that the combined risk of
be traded and managed. on the assumption of a normal default followed a normal
distribution: the idea that most distribution pattern and
The 2008 crash prices cluster around an average, was stable. As US subprime
The explosion in financial innovation, and extreme price movements mortgages defaulted in
aided by sophisticated mathematics are very rare. But this had been increasing numbers, it became
and ever-increasing computing disputed as early as 1963, when clear that this assumption did
power, helped drive the French mathematician Benoît not hold, and the enormous
extraordinary expansion of the Mandelbrot suggested that extreme CDO market imploded.
financial system over several price movements were much more
decades. From negligible amounts common than expected. Black swans are rarely sighted
in the 1970s the global market for but do exist. Nicholas Taleb refers
derivatives grew on average by 24 Post-crash, these models are to the highly unexpected, extreme
percent a year, reaching a total of being reexamined. Behavioral movements of the market as
$596 trillion by 2008—about 20 economists (pp.266–69) and “black swan events.”
times global GDP. Applications econophysicists use models and
multiplied as firms found apparently statistical techniques drawn from
physics to better understand
financial markets and risk. ■

266 IN CONTEXT

PEOPLE FOCUS
ARE NOT Decision making
100 PERCENT
RATIONAL KEY THINKERS
Amos Tversky (1937–96)
BEHAVIORAL ECONOMICS Daniel Kahneman (1934– )

BEFORE
1940s US economist Herbert
Simon argues that rational
decision alone does not explain
human decision making.

1953 French economist
Maurice Allais criticizes
expected utility theory, saying
that real-life decisions are not
always taken rationally.

AFTER
1990 Economists Andrei
Shleifer and Lawrence
Summers show that irrational
decisions can affect prices.

2008 US psychologist and
economist Dan Ariely publishes
Predictably Irrational, showing
irrationality has a pattern.

U ntil the 1980s standard
economic theory was
dominated by the idea of
“rational economic man” (pp.52–53).
Individuals were understood to be
agents who look at all decisions
rationally, weighing the costs and
benefits to themselves and making
a decision that will give them the
best outcome. Economists thought
that this was how people behaved
in situations of both certainty and
uncertainty, and they formalized
the idea of rational decision making
in expected utility theory (pp.162–
63). In reality, however, people often
make irrational decisions that don’t
give them the highest payoffs and
may even hurt their own prospects.

CONTEMPORARY ECONOMICS 267

See also: Economic man 52–53 ■ Free market economics 54–61 ■ Economic bubbles 98–99 ■
Risk and uncertainty 162–63 ■ Irrational decision making 194–95 ■ Paradoxes in decision making 248–49

When faced with making a … people do not calculate apply whether the individual was
decision where outcomes gains and losses through facing risks that involved gains
mathematical probability. or losses. However, Tversky and
are uncertain… Kahneman found that individuals
They are affected more are risk-averse when facing gains
People are not by whether they stand to but risk-loving when facing losses:
100 percent rational. gain or lose, and how the the nature of individual preference
seems to change. Their work
Early studies of these quirks of question is framed. showed that people are “loss
behavior were made in 1979 by two averse,” and so are willing to take
Israeli-American psychologists, Economists had long understood risks to avoid losses, where they
Amos Tversky and Daniel that people are often “risk-averse.” would not be willing to take risks
Kahneman. They looked at the For example, if given a choice to gain something. For example,
psychology involved in decision between definitely receiving $1,000 the loss in utility from losing $10
making and backed up their or having a 50 percent chance of appears to be greater than the gain
hypotheses with empirical receiving $2,500, people are more in utility from gaining $10.
examples. Their key paper, likely to choose the guaranteed
Prospect Theory: An Analysis $1,000—despite the fact that the These quirks in behavior
of Decision under Risk, outlined a average expectation of the second, show that the way that choices
theory that marked the start of uncertain, option is higher, at are presented influences people’s
a new branch of study known $1,250. The psychologists decisions, even if the ultimate
as behavioral economics. This constructed the opposite situation, outcomes are the same. For
aimed to make economists’ giving the same people the choice example, consider a situation
theories about decision making of either definitely losing $1,000, or where a disease is projected
more psychologically realistic. having a 50 percent chance of no to kill 600 people. Two programs
loss and a 50 percent chance of exist to counter the disease: A,
Dealing with risk losing $2,500. In this situation, which saves 200; and B, which
Tversky and Kahneman found people who chose the safe option offers a one-third chance that
that people commonly violate in the previous example now 600 people will be saved versus a
economists’ standard assumptions chose the riskier alternative of two-thirds chance that no one will
about behavior, particularly when the gamble between no loss and be saved. When the problem is
consequences are uncertain. Far a large loss. This is known as explained to them in this way, the
from acting with rational self- risk-seeking behavior. majority of people show themselves
interest, people were found to be to be risk-averse—they opt for the ❯❯
affected by the way a decision is The standard economic
presented and responded in ways approach to decision making A government wishing to persuade
that violate standard theory. under uncertainty assumed that people to be vaccinated should stress
any one individual was risk-averse, the increased probability of death if
risk-loving, or didn’t mind either they are not vaccinated. People hate
way. These risk preferences would losing more than they love winning.

268 BEHAVIORAL ECONOMICS

Q: This is a two-stage People’s choices in multistage certainty of saving 200 people.
game. There is no choice at games vary according to how If the question is restated,
stage 1, just a 25 percent chance questions are framed. If they are however, with the choice being
directed to ignore factors that both between program C, which
of moving on to stage 2. choices have in common, such as guarantees the death of 400 people,
Do you want to play? Stage 1 in this example, they may or program D which offers a one-
make inconsistent choices. third chance that nobody will die
Q: At stage 2 versus a two-thirds chance that
you have two choices: A: Yes. 600 people will die, most people
either A—a guaranteed $3,000, will pick the risky program D.
or B—an 80 percent chance A: I’ll take A,
of $4,000. But you have to decide please—the The ultimate outcomes of the
before you start stage 1 which guaranteed $3,000. pairs of choices are the same: in
of these two options you want both A and C we definitely end up
to take at stage 2—if Really?… with 400 dead, while with B and D,
you make it that far. In that case there is an expected outcome of
I’ll take B! 400 dead. Yet now people prefer
Q: Final answer? the option that is more of a gamble.
Do you realize that People are more willing to take
Option A actually gives you risks to prevent lives being lost
a 25 percent chance of winning (a loss) than they are to save lives
$3,000, while Option B gives (a gain). We place more subjective
you a 20 percent chance of value on losing something than
winning $4,000? gaining something—losing
$10 feels worse, apparently,
than gaining $10 feels good.

This tendency toward loss
aversion means that, when choices
for change are framed in such a
way that the consequences are
seen as negative, people are more
likely to perceive the change as a
problem. Knowing this can be used
to influence people. For instance,
if a government wants to encourage

Behavioral economics in action

The new field of behavioral might be most profitable for the interest rate. The
economics has provided firms the bank. They sent out 50,000 experiment discovered that
with new ways to drive their letters offering different interest the interest rate was only the
businesses. In 2006, a group rates—some high, some low. third most important factor
of economists devised an The letters also featured photos in stimulating demand, and
experiment for a bank in South of employees, and a simple or including a photo of a female
Africa that wanted to grant complicated table showing the employee in its marketing had
more loans. Traditional different chances of winning a an effect equal to dropping
economists would have advised prize if the letter was replied to. the interest rate by five points.
the bank to lower its interest This is a groundbreaking result:
rate to stimulate demand. By tracking which customers identifying psychological
Instead, the bank allowed the responded, it was possible factors to stimulate demand
economists to experiment with to quantify the effect of can be a lot cheaper than
various options to find out which psychological factors against lowering the interest rate.
the purely economic factor of

CONTEMPORARY ECONOMICS 269

people to adopt something, it
is more likely to be successful
if it emphasizes the positive gains
involved in making that decision. If,
on the other hand, it wants people
to reject something, it should focus
on what they stand to lose.

Processes and outcomes the idea of “rational economic man.” A scalper sells a sports ticket for
Kahneman and Tversky also The theory is a founding pillar of cash. The amount that seller and buyer
showed that the process by which behavioral economics, and has also value the ticket depends not just on its
decisions are made can affect had wide-ranging influence perceived utility, but also on factors
choices even when the process on marketing and advertising. By such as the way the seller obtained it.
doesn’t affect the final payoffs. understanding the way we make
decisions, marketers are able to For example, the theory explains
For example, imagine a game market their products much more why people may travel to a different
of two stages in which a player is effectively. A good example of part of town in order to save $5 off
given a choice of two options at the this is in-store promotions, a $15 DVD, but they are unlikely to
second stage if they make it that which offer “huge discounts” on make the same trip in order to save
far. However, they must make their items with initially inflated prices. $5 off a $400 TV, even though their
choice before the first stage. An net wealth is impacted by the same
example of such a game is laid Prospect theory has amount in each case. Loss aversion
out on the opposite page. implications for many kinds of also explains what is known as the
common economic decisions. endowment effect: people tend to
In this two-stage game, most place a higher value on an object
people choose the guaranteed One may discover that when they own it—and do not want
$3,000 option. However, when the the relative attractiveness of to lose it—than before they own it,
decision is shown as a straight options varies when the same when it is only a “potential gain.”
choice between a lower chance of decision problem is framed
winning $4,000 or a higher chance Behavioral economics is
of $3,000, most people choose the in different ways. vital to our understanding of the
lower chance of winning more Amos Tversky economy and has introduced
money. Why the change? Daniel Kahneman psychological realism into modern
economics. Prospect theory was the
In the two-stage process first to suggest that people are not
people ignore the first stage simply 100 percent rational
because it is common to both machines. The implications of this
outcomes. They see the options as realization—for economic theories
a choice between a guaranteed and government policies—are wide-
win and merely the chance of a win, ranging. For example, giving people
even though the probabilities are a sense of ownership may affect how
altered by the first stage. This well they look after something. ■
contradicts standard economic
rationality in which decisions are
only influenced by final outcomes.

The end of rational man?
The key insights to this work—that
we hate to lose more than we like
to gain, and that we interpret
losses and gains in terms of
context—have helped illuminate
why people make decisions that are
not consistent with utility theory or

270

TAX CUTS
CAN INCREASE
THE TAX TAKE

TAXATION AND ECONOMIC INCENTIVES

IN CONTEXT C ommon sense tells us that the case, and that cutting
if a government wants to taxes can result in governments
FOCUS raise more money to spend collecting more, not less, money.
Economic policy on public services, it must raise
taxes, however unpopular that may This is a key idea of 1980s
KEY THINKERS be. Likewise, cutting taxes seems to “supply-side” economists. The
Robert Mundell (1932– ) imply cutting public services. supply side is the part of an
Arthur Laffer (1940– ) However, some economists have economy that makes and sells
suggested that this is not always things, as opposed to the demand
BEFORE side, which is the buying of goods.
1776 Adam Smith suggests
that moderate taxes might If the government If the tax rate is 100 percent,
bring in more revenue than takes no tax, it the government receives
high ones. receives no revenue. no revenue because
no one will bother to work.
1803 French economist
Jean-Baptiste Say argues If taxes are set too high, Somewhere between
that supply creates its workers are encouraged to 0 and 100 percent lies the
own demand. work less and so pay less tax point where tax revenues
overall, so revenues decline.
AFTER are at a maximum.
1981 US President Ronald
Reagan cuts top-rate tax and But if taxes are lowered, it Tax cuts can increase
capital gains tax. encourages workers to work the tax take.
more and revenues increase.
2003 US President George W.
Bush ignores criticism from
leading economists and
pursues a policy of tax cuts.

2012 In January the US
government deficit hits an
unprecedented $15 trillion.

CONTEMPORARY ECONOMICS 271

See also: The tax burden 64–65 ■ Gluts in markets 74–75 ■ Borrowing and debt 76–77 ■
The Keynesian multiplier 164–65 ■ Corporate governance 168–69 ■ Monetarist policy 196–201

GOVERNMENT REVENUE maximum no revenue. If it takes 100 percent
revenue tax, it will get no revenue either,
since no one will work. But even Many tax havens formed in the
ideal tax below 100 percent, very high 1970s, when small islands and
point income tax rates discourage people countries such as Monaco chose to
from working. This reduction in impose low taxes—or none at all
0 100 hours worked outweighs the high —in order to attract investment.
TAX RATE (PERCENT) tax rate, and the result is a fall
in tax revenue. When top-rate taxes curve lies. Those on the political
The Laffer curve displays the are very high, revenue can also be Right argued that the economy was
relationship between tax rates and lost by the highest income earners at a point to the right of the peak of
government revenue. It shows that leaving the country or putting their the curve, meaning that tax cuts
higher taxes do not always result in money in tax havens—countries would increase revenue. Those on
increased revenues. charging little or no tax. Laffer the Left disagreed.
drew a bell-shaped curve (left) to
Supply-side economists argue that show that somewhere between the A win–win situation
the best way to make the economy extremes of no tax and 100 percent For politicians on the Right, Laffer’s
grow is to improve conditions for tax, there is a point at which a theory was attractive. It meant that
the supply side, freeing companies government will maximize revenue. they could make themselves
from regulations, and cutting popular by cutting taxes, yet
subsidies and high-rate taxes. The argument then is that from pledge to maintain public services,
a starting point of high tax rates, too. In 1981, President Ronald
From tax to tax havens tax cuts, along with other policies Reagan was able to cut top-rate
The revenue argument for cutting to strengthen the supply side, can taxes and still be a hero to many of
taxes came from US economist enhance economic efficiency and the poorest US citizens. However,
Arthur Laffer. He said that if a generate more tax revenues. In the there is little evidence that the idea
government takes no tax, it will get 1970s, when Laffer developed his actually works. In the US and other
theories, some countries taxed countries tax rates are far below
Supply-side economics some people at 70 percent, and a the level of the 1970s. However, the
few taxed the highest earners at supposed tax revenue bonanza has
The theory of supply-side 90 percent. Economists disagreed not arrived. Instead, tax cuts have
economics generated a about where the peak on the Laffer been funded largely by rising
considerable amount of borrowing deficits. ■
controversy when it was but it was US economist Arthur
developed in the 1970s. It Laffer’s tax curve that caught
emerged in response to the economists’ attention. The
apparent failure of Keynesian Laffer curve was developed
policies of government under the guidance of Canadian
intervention (pp.154–61) to deal economist Robert Mundell
with a flat economy combined (p.254), who argued that if tax
with high inflation—a condition rates were cut, national output
known as stagflation. The would increase, and tax
term was popularized by revenues would rise. After a
US journalist Jude Wanniski, quick dip revenues did actually
rise, but there has been huge
debate ever since over whether
he was proved right.

272

PRICES TELL
YOU EVERYTHING

EFFICIENT MARKETS

IN CONTEXT A commonly held belief In an efficient market
among investors is that at any point in time the
FOCUS they can “beat,” or actual price of a security
Markets and firms outperform, the stock market. will be a good estimate
The US economist Eugene Fama
KEY THINKER disagreed. His study, Efficient of its intrinsic value.
Eugene Fama (1939– ) Capital Markets (1970), concluded Eugene Fama
that it is impossible to beat the
BEFORE market consistently. His theory the Dotcom bubble of the 1990s,
1863 French broker Jules is now known as the efficient where “irrational exuberance” was
Regnault publishes Playing the market hypothesis. blamed for artificially inflating
Odds and the Philosophy of the technology stock, and the more
Stock Exchange, which states Fama claimed that all investors recent financial crisis of 2007–08.
that fluctuations in the stock have access to the same publicly
market cannot be predicted. available information as their rivals, After these crises many
so the prices of stocks fully reflect observers have declared the theory
1964 US economist Paul all the knowledge available. This is redundant; some have even blamed
Cootner develops Regnault’s the “efficient market.” No one can it for the crashes. Eugene Fama
ideas on fluctuating markets in know what new information will be himself has conceded that
his The Random Character of released, so it should be almost uninformed investors can lead the
Stock Market Prices. impossible for investors to make a market astray and result in prices
profit without using information becoming “somewhat irrational.” ■
AFTER unavailable to the competition, or
1980 US economist Richard “insider trading,” which is illegal.
Thaler publishes the first study
of behavioral economics. However, problems with the
hypothesis have been highlighted
2011 Paul Volcker, former by behavioral economists. They
chairman of the US Federal point to the theory’s failure to
Reserve, blames an account for investor overconfidence
“unjustified faith in rational and the “herd” instinct. These
expectations and market problems manifested themselves in
efficiencies” for the 2008
financial crash. See also: Economic bubbles 98–99 ■ Testing economic theories 170 ■
Financial engineering 262–65 ■ Behavioral economics 266–69

CONTEMPORARY ECONOMICS 273

OVER TIME, EVEN THE
SELFISH COOPERATE
WITH OTHERS

COMPETITION AND COOPERATION

IN CONTEXT I n 1984, US economist Robert found to produce mutually
Axelrod wrote The Evolution beneficial outcomes. But one must
FOCUS of Cooperation. It was based not be too nice—if someone is
Decision making on the results of a series of games, betrayed, it is essential to hit back
in which the strategies of game in the next move. To maintain
KEY THINKER theory specialists were pitted credibility, players must retaliate
Robert Axelrod (1953– ) against each other via computer immediately if they are “sold out.”
programs to see which was most This approach to the analysis of
BEFORE successful. The game they played competition and cooperation has
1859 British biologist Charles was the prisoner’s dilemma developed into a rich field that
Darwin publishes On the (p.238), a game involving two examines how social and even
Origin of Species, arguing that thieves captured by the police. moral rules emerge. ■
the best-adapted species are Should each thief choose to
those most likely to survive. confess, stay silent, or “sell out”
the other thief? The game explores
1971 US biologist Robert whether it is wiser to cooperate for
Trivers publishes The mutual benefit or to act selfishly.
Evolution of Reciprocal
Altruism, which shows how The best strategy When President Bush and Russian
altruism and cooperation Axelrod discovered that cooperation President Putin signed the Treaty of
can benefit individuals. can arise through self-interested Moscow in 2002, they cooperated to
actions. His series of games tested greatly reduce their nuclear arsenals,
AFTER many strategies. The most despite mutual distrust.
1986 US economists Drew successful strategy was simple
Fudenberg and Eric Maskin tit-for-tat, where a player cooperates
explore cooperation strategies on the first move and then mirrors
for repeated games. his or her opponent, so is never
the first to “sell out.” The most
1994 British economist successful approaches were those
Kenneth Binmore publishes that were “nice.” Cooperation was
Playing Fair, using game
theory to explore the See also: Economic man 52–53 ■ Effects of limited competition 90–91 ■
development of morality. Economics and tradition 166–67 ■ Game theory 234–41

274

MOST CARS
TRADED WILL
BE LEMONS

MARKET UNCERTAINTY

IN CONTEXT The buyer of a This inequality
second-hand car has of information
FOCUS less information about its creates uncertainty
Markets and firms quality than the seller. for the buyer…

KEY THINKER Sellers with good cars … who becomes reluctant
George Akerlof (1940– ) therefore withdraw their to pay a high price for
any car on the market.
BEFORE cars from the market.
1558 English financier Sir
Thomas Gresham advises that The market begins … most cars traded
“bad money drives out good.” to collapse because… will be inferior—
lemons.
1944 John von Neumann and
Oskar Morgenstern publish U ntil US economist George His key work, The Market for
the first attempt to analyze Akerlof started studying Lemons (1970), explains how
strategic behavior in prices and markets in the uncertainty caused by limited
economic situations. 1960s, most economists believed information can cause markets to
that markets would allow everyone fail. Akerlof stated that buyers and
AFTER willing to sell goods at a certain sellers have different amounts of
1973 US economist Michael price to make deals with anyone information, and these differences,
Spence explains how who wanted to buy goods at that or asymmetries, can have
people signal their skills price. Akerlof demonstrated that disastrous consequences for the
to potential employers. in many cases this is not true. workings of markets.

1976 US economists Michael
Rothschild and Joseph Stiglitz
publish Equilibrium in
Competitive Insurance
Markets, a study of the
problem of “cherry picking”
when insurance companies
compete for customers.

CONTEMPORARY ECONOMICS 275

See also: Free market economics 54–61 ■ Market information and incentives 208–09 ■ Markets and social outcomes
210–13 ■ Signaling and screening 281

Asymmetric information that “bad money drives good A car dealer can reduce a buyer’s
The buyer of a second-hand car money out of circulation.” In the risk when selling a car by offering
has less information about its same way sellers with better- guarantees. In many cases
quality than the seller who already than-average cars to sell will markets adjust to account for
owns the car. The seller will have withdraw them from the market, asymmetric information.
been able to assess whether the because it is impossible for them
car is worse than an average to get a fair price from a buyer policies, but firms are still
similar car—whether, it is a who is unable to tell whether that unable to identify them accurately.
“lemon”—an item with defects. car is a lemon or not. This means This is known as “adverse
Any buyer that ends up with a that “most cars traded will be selection,” and the potential for
lemon feels cheated. The lemons.” In theory this could lead adverse selection means that
existence of undetectable lemons to such low prices that the market insurance companies end up
in the market creates uncertainty would collapse, and trade would with, on average, much greater
in the mind of the buyer, which not occur at any price, even if risks than are covered by the
extends to concerns about the there are traders willing to premiums. This has resulted
quality of all the second-hand buy and sell. in the withdrawal of medical
cars on sale. This uncertainty insurance policies for people
causes the buyer to drop the price Adverse selection over a certain age in some areas. ■
he is willing to offer for any car, Another market in which lemons
and as a consequence prices drop affect trade is the insurance
across the market. market. In medical insurance,
for instance, the buyers of policies
Akerlof’s theory is a modern know more about the state of their
version of an idea first suggested health than the sellers. So insurers
by English financier Sir Thomas often find themselves doing
Gresham (1519–79). Gresham business with people they would
observed that when coins of rather avoid: the least healthy
higher and lower silver content people. As insurance premiums
were both in circulation, people rise for older age groups, a greater
would try to hold on to those of a proportion of “lemons” buy
higher silver content, meaning

George Akerlof Born in Connecticut in 1940, 1978, he taught at the London
George Akerlof grew up in an School of Economics before
academic family. At school he returning to Berkeley as
became interested in the social professor. He was awarded the
sciences, including history and Nobel Prize for Economics in
economics. His father’s irregular 2001, alongside Michael Spence
employment patterns fostered his and Joseph Stiglitz.
interest in Keynesian economics.
Akerlof went on to study for an Key works
economics degree at Yale, then
gained a PhD from MIT 1970 The Market for Lemons
(Massachusetts Institute of 1988 Fairness and
Technology) in 1966. Shortly after Unemployment (with Janet
joining Berkeley as an associate Yellen)
professor, Akerlof spent a year in 2009 Animal Spirits: How
India, where he explored the Human Psychology Drives the
problems of unemployment. In Economy (with Robert J. Shiller)

276

THE GOVERNMENT’S
PROMISES ARE
INCREDIBLE

INDEPENDENT CENTRAL BANKS

IN CONTEXT If governments can act at their F ollowing World War II,
discretion, they can break economics was dominated
FOCUS their promises, therefore… by Keynesian thinking
Economic policy (pp.154–61). This claimed that
… the government’s governments could maintain high
KEY THINKERS promises are employment through two types of
Edward Prescott (1940– ) not credible. discretionary policies, which are
Finn Kydland (1943–) introduced to achieve specific goals
Rational individuals forecast through a particular set of actions.
BEFORE this breaking of promises, The two types of policy used for
1961 John Muth publishes and change their own controlling employment were fiscal
Rational Expectations and the behavior to suit. policy (government spending and
Theory of Price Movements. taxation) and monetary policy
This prevents discretionary (interest rates and the money supply).
1976 US economist Robert government policy
Lucas argues that it is naive to from working. In 1977, two economists—Finn
model government policy on Kydland of Norway and Edward
solutions that have worked in Governments should credibly Prescott of the US—published a
the past. commit to following paper entitled Rules Rather than
Discretion, which argued that
AFTER simple rules, not use discretionary policy was in fact
1983 US economists Robert discretionary policy. self-defeating. Their argument was
Barro and David Gordon based on the concept of rational
suggest that high inflation expectations, which was developed
arises from discretionary by the US economist John Muth
government policy and (p.247). Muth argued that since
propose central bank having incorrect beliefs about
independence. prices is costly, rational individuals
seek to minimize their errors by
From 1980s Independent planning ahead to avoid this.
central banks are established
in many countries worldwide Before this, macroeconomic
and commit to simple models had operated on the
policy rules. assumption that individuals only
look backward, naively expecting
the future to look like the past. The

CONTEMPORARY ECONOMICS 277

See also: Economic man 52–53 ■ The Keynesian multiplier 164–65 ■ Monetarist policy 196–201 ■ Inflation and
unemployment 202–03 ■ Rational expectations 244–47

A government may try to deter the To see how this works, imagine a that higher wages will be offset
building of homes in a flood-prone area lenient teacher who is trying to by higher prices. Accounting for
by not subsidizing flood insurance. But make a lazy pupil do his homework. rational expectations, the effect of
if it has bailed people out after a flood The teacher tells the student that if the boost is simply higher inflation.
in the past, they will not be deterred. he doesn’t hand his homework in,
he will be punished. But the pupil An uncompromising rule
new model predicted that if people knows that the teacher is lenient The solution for our teacher would
collect information and are rational, and does not like to punish. The be a compulsory school rule for
they can—and will—anticipate pupil anticipates that if he doesn’t punishing late homework so he
government interventions. They hand in the work, he won’t be would have to comply. In a similar
then adapt their actions to the punished. Knowing this, he does way Kydland and Prescott
government policy they expect, and not do the homework. The teacher’s proposed that instead of having a
that policy is in turn rendered less aim of getting the pupil to hand in free reign to set economic policy,
potent. Discretionary policy can his homework is undermined by governments should commit to
only work when individuals are the pupil’s rational behavior. following clear rules. A more radical
taken by surprise, and it is hard solution of the teacher’s dilemma
to surprise rational individuals. Kydland and Prescott said would be to delegate punishment-
that government promises of low giving to a strict principal. In
inflation face the same problem. macroeconomic policy this kind of
The government does not like high role can be taken by independent
unemployment. So it will boost the central banks, which place less
economy to keep unemployment weight on employment and more
low, but this will push up inflation. weight on low inflation than the
Like the teacher who threatens a government does. Their control
punishment he will not inflict, the of monetary policy allows the
government has conflicting aims. government to credibly commit
Individuals know this and so do not to low inflation. The period of low
believe the government’s promise of inflation that arose in the 2000s
low inflation. This undoes the aim of is often attributed to the rise of
increasing demand to lead to higher independent central banks. ■
employment, because people know

Finn Kydland Born on a farm in Gjesdal, Norway, taking Kydland with him.
in 1943, Finn Kydland was the Returning to NHH in 1973,
oldest of six children. After high Kydland published his key paper
school he taught in a junior school with Edward Prescott. In 1976,
for several years, where a fellow Kydland returned to the US,
teacher suggested he study where he has taught ever since.
accountancy, which awakened In 2004, he was awarded the
his interest in business. He Nobel Prize for Economics.
started an economics degree at
the Norwegian School of Economic Key works
and Business Administration
(NHH) in 1965. Kydland intended 1977 Rules Rather than
to become a business manager, Discretion (with E. Prescott)
but after graduation he became an 1982 Time to Build and
assistant to economics professor Aggregate Fluctuations
Sten Thore, who moved to 2002 Argentina’s Lost Decade
Carnegie Mellon University, (with Carlos E. J. M. Zarazaga)

278

THE ECONOMY IS
CHAOTIC EVEN WHEN
INDIVIDUALS ARE NOT

COMPLEXITY AND CHAOS

IN CONTEXT N o system yet discovered Looking for complexity
guarantees a good return If the real world does indeed
FOCUS in the stock market. One behave like this, why do we find it
The macroeconomy might have hoped that economics, so hard to predict stock market
with its theoretical models in which crashes? Some economists feel
KEY THINKERS the economy always reverts to an the entire linear approach is
René Thom (1923–2002) equilibrium, would give us such a obsolete. Austrian economist
Jean-Michel Grandmont tool. Most economic theory is Friedrich Hayek (p.177) believed
(1939– ) modeled on the laws of motion that economics is far too complex
Alan Kirman (1939– ) developed in the 1680s: every to model in the same way as
action leads to an outcome, and physics. One response to such
BEFORE every event is linked in a causal doubts is complexity theory,
1887 French mathematician chain backward and forward in which emerged from the work
Henri Poincaré’s analysis time in what is called a “linear” on thermodynamics of Russian-
of the interaction between process. Standard economics Belgian chemist Ilya Prigogine
three bodies orbiting each builds its large-scale predictions— (1917–2003). Unlike standard
other lays the foundation the equilibrium that an economy economics, this approach
for chaos theory. will arrive at—from the combined recognizes that predictable,
effect of the behavior of rational regular actions by individuals
1950s French mathematician individuals reacting to prices. do not necessarily lead to a
Benoît Mandelbrot finds stable, predictable economy.
recurring patterns in the
variation of cotton prices. In 1975, French economists
Jean-Michel Grandmont and Alan
1960 US mathematician and Kirman argued that economies are
meteorologist Edward Lorenz “complex systems.” In standard
discovers the butterfly effect economic models of perfect
in meteorology. competition individuals do not

AFTER Tiny changes in initial conditions can
1980s Northern Irish cause large changes in outcomes. This
economist Brian Arthur is known as the “butterfly effect:”
develops complexity theory. Edward Lorenz’s suggestion that a
butterfly flapping its wings in Brazil
could lead to a cyclone in Texas.

CONTEMPORARY ECONOMICS 279

See also: Economic man 52–53 ■ Economic bubbles 98–99 ■ Wild randomness
Testing economic theories 170 ■ Behavioral economics 266–69
In the 1960s and 70s French-
Economists assume that This means that the economy American mathematician
individuals act rationally should be predictable. Benoît Mandelbrot argued
that economists are wrong
and that all events are to try to smooth out
determined by cause economic figures by looking
for averages and ignoring
and effect. extremes. He argued that
it is the extremes that give
These small differences But economies are the true picture.
can lead to a myriad of complex systems, and
different outcomes. individuals may each act Mandelbrot’s criticism
slightly differently to was aimed at those who
model prices for shares
any given event. and commodities on the
assumption that one price
The economy is leads directly to another and
chaotic even when things average out in the long
individuals are not. run. He believed that the
mild elements of randomness
directly interact with each Lorenz was trying to discover built into these models are
other; they just respond to prices, why the weather could not be misleading. Models should
constantly changing their predicted far into the future. His be based on the assumption
behavior and prices to achieve computer analyses revealed that of “wild randomness”—the
the best outcome. In a complex minute changes in the atmosphere idea that individual freak
system such as an economy, might multiply to produce dramatic occurrences matter as a
individuals interact directly with changes in the weather. change takes place. For
each other using simple “rules of Mandelbrot markets are far
thumb” rather than rational To analyze chaotic movements, more volatile than economists
calculations, a little like bees in theorists have developed a form suggest, and the mistake they
a hive. This can lead to complex of “non-linear” mathematics. continually make is to try to
patterns of behavior in the economy Much like the weather, they argue come up with laws that work
as a whole. that a minute change in starting in the same way as the laws
conditions can produce such a of classical physics.
Chaotic economies different outcome that the process
Ideas related to Grandmont and appears chaotic, whether for stock Small variations in velocity will
Kirman’s arguments are found in market movements or economic shoot a pinball in totally different
chaos theory, first developed in the growth. If they are right, then the directions. Like a pinball player,
1950s by US mathematician and predictable equilibriums that are economists cannot always predict
meteorologist Edward Lorenz. the bedrock of most economic which way stocks will go.
theories are very far off the mark. ■

280

SOCIAL NETWORKS
ARE A KIND OF
CAPITAL

SOCIAL CAPITAL

IN CONTEXT T he word “capital” is most networks are also important to
commonly used to refer economic performance. Just as
FOCUS to the machinery used a screwdriver (physical capital)
Society and the economy in production: physical capital. or a university education (human
A broader definition includes the capital) can increase productivity,
KEY THINKER skills of the labor force: human so do social contacts, because
Robert Putnam (1941– ) capital. The efficient use of they affect the productivity of
physical and human capital has individuals and groups. The
BEFORE long been recognized as key to interactions between people at
1916 The term “social capital” an economy, but in the 1990s US work, in their community, and in
appears in an article by US political scientist Robert Putnam their leisure time, can be
educator Lyda J. Hanifan. suggested a less tangible form of considered “social capital.”
capital, made up of social
1988 US sociologist connections. He argued that social Social networks help individuals
James Coleman describes improve their skills, advance their
social capital, applying it A society of many virtuous careers, and increase overall
to the phenomenon of but isolated individuals productivity by encouraging
high school dropouts. is not necessarily rich cooperation and information
in social capital. sharing. Conversely, when these
AFTER Robert Putnam connections dwindle, economic
1999 US political scientist performance suffers. Putnam
Francis Fukuyama argues that pointed out that since the 1960s
social capital has not declined people in developed countries have
in developed countries such become more isolated, living in
as the US. urban areas with little sense of
community. He argues that this has
2001 British Marxist contributed to economic decline.
economist Ben Fine criticizes While not all economists agree with
the concept of social capital. his analysis, social capital is now
generally accepted as a significant
2003 British sociologist John element of economic performance. ■
Field says social capital theory
means “relationships matter.” See also: Protectionism and trade 34–35 ■ Comparative advantage 80–85 ■
Economies of scale 132 ■ Market integration 226–31

CONTEMPORARY ECONOMICS 281

EDUCATION IS
ONLY A SIGNAL
OF ABILITY

SIGNALING AND SCREENING

IN CONTEXT A new field of economics The subject area of a student’s
was developed in the degree and their knowledge of it are of
FOCUS 1970s, when US economist secondary importance when applying
Decision making George Akerlof published his for many jobs. Rather, their degree
insights on how disparities of signals ability and a capacity for work.
KEY THINKERS access to information might be
Michael Spence (1943– ) overcome (pp.274–75). The opposite of this process, for
Joseph Stiglitz (1943– ) example where an employer uses
US economist Michael Spence the interview to elicit information,
BEFORE said that, in practice, if Person 1 is known as screening. Someone
1963 Kenneth Arrow has more information than Person 2 buying a used car, or considering
addresses the problems in a transaction, Person 1 is likely granting a loan, will use screening
of information economics, to send a signal to allow Person 2 to questions to glean information
such as when one party make a more informed decision. before deciding. Signaling and
to a transaction has better screening are used in all forms of
information than another. The example Spence gave was business transactions. ■
that of the job interview, where an
1970 George Akerlof describes employer has less information than
markets with information the applicant about his or her
disparities in The Market potential productivity. The
for Lemons. applicant provides a resume
detailing educational
AFTER achievements, which may have no
1976 Michael Rothschild relevance to the post applied for but
and Joseph Stiglitz pioneer do signal a willingness for hard
“screening,” by which an work and application. In Spence’s
uninformed party can induce view higher education, unlike
another to impart information. vocational training, mostly has a
signaling function, and prospective
2001 Michael Spence, George “good” employees will invest in
Akerlof, and Joseph Stiglitz more education to signal their
win a Nobel Prize for their work higher potential productivity.
in information economics.
See also: Behavioral economics 266–69 ■ Market uncertainty 274–75 ■
Sticky wages 303 ■ Searching and matching 304–05

THE EAST ASIAN STATE

GOVERNS

THE MARKET

ASIAN TIGER ECONOMIES



284 ASIAN TIGER ECONOMIES

IN CONTEXT East Asian This required a
countries aimed to build range of investments
FOCUS competitive advantage that private firms could
Growth and development
in new industries. not provide.
KEY EVENT
Japanese investment This allowed the state The state made the
begins flowing into South to promote industrial investments and then
Korea’s economy in 1965. enforced performance
development in criteria on those firms,
BEFORE certain directions.
1841 German economist helping efficiency.
Friedrich List argues that In this way the state
protecting industry would led the market, rather The East Asian
help economies to diversify. state governed
than just following it.
1943 Polish economist Paul the market.
Rosenstein-Rodan argues that
poor countries need a “big
push” to develop through
state investment.

AFTER
1992 US economist Alice
Amsden claims South Korea’s
use of performance criteria
fostered industrial growth.

1994 US economist Paul
Krugman argues that the East
Asian takeoff was a result of
increases in physical capital
rather than true innovation.

A fter World War II the domestic product, or total national The environment from which the
economies of a cluster of income from goods and services) is Asian Tigers emerged was shaped
East Asian nations grew often used to measure a nation’s by government intervention and
dramatically. Led by a new set of wealth. In 1950, South Korea’s GDP- dense links between the state and
actively interventionist governments, per-person (GDP divided by the size the economy, an economic model
these countries were transformed of the population) was half that of that came to be known as the
from economic backwaters into Brazil’s; by 1990, it was double; by “developmental state.” After World
dynamic industrial powers in just 2005, three times as high. This kind War II there had been huge
a few decades. The so-called Asian of growth resulted in a remarkable expectations of development in
Tigers—South Korea, Hong Kong, decline in poverty. By the late 20th poorer nations, and the goal of rapid
Singapore, and Taiwan—were century the original four Asian economic advancement became the
followed by Malaysia, Thailand, and Tigers had living standards that driving force behind government
Indonesia, and then by China. These rivaled those of Western Europe, a economic policy. Powerful
countries achieved sustained historically unprecedented change bureaucracies were involved in
growth in income per head faster in fortunes that has been dubbed directing the economic activities
than in any other region. GDP (gross the “East Asian miracle.” of the private sector in ways that

CONTEMPORARY ECONOMICS 285

See also: The emergence of modern economies 178–79 ■ Development economics 188–93 ■
Economic growth theories 224–25 ■ Market integration 226–31 ■ Trade and geography 312

South Korea’s rapid development was sees the state’s job as correcting macroeconomic stability, vital
initiated by Park Chung-hee, an army market failures—governments for giving certainty to investors.
general, in 1961. He restored relations provide public goods, such as They intervened to correct market
with Japan, Korea’s former occupier, defense and street lighting, which failures through the provision of
and attracted Japanese investment. private markets alone tend not to defense and schooling. They also
deliver. They ensure that institutions built infrastructure such as ports
seemed to go far beyond anything such as courts function properly so and railways, whose high set-up
attempted in Western Europe. that contracts can be enforced and costs deterred private firms. The
However, their governments property rights protected, but East Asian developmental states
preserved private enterprise, and beyond that their role is minimal. were held to be successful because
their new model had little in Once the basic prerequisites for they followed the market.
common with the state planning market activity are in place, classical
of the communist bloc. Asian Tiger economics suggests that the state Leading the market
states shaped development by should withdraw and let the price The New Zealand economist
steering investment toward mechanism do its work. It is Robert Wade argues that the East
strategic industries and promoting thought that market-friendly Asian development states both
the technological upgrading of institutions and a limited state led and followed markets. They
producers. This induced a shift were key to Britain’s economic drove the expansion of favored
of workers from agriculture to the success during industrialization. industries by providing cheap
expanding industrial sector. Large credit and subsidies. By leading
investments in education gave Some economists contend that markets their chosen allocation of
workers the skills needed for new this also occurred in successful resources was markedly different
industries, and industrial enterprises East Asian economies: when these from what it would have been, had
soon began to export their products, states fostered development, they it been dictated by markets alone.
becoming the motors for sustained, did so by supporting markets, not
trade-driven growth. by interfering with them. Their US economist Alice Amsden
interventions helped to allocate has characterized this as the state
resources and investment in ways deliberately “getting prices wrong”
that were in line with markets: in a in order to build new types of
sense the state “got prices right.” competitive advantage. A crucial
To do this, governments cultivated part of this was that the new ❯❯

A new kind of state
This type of state had never been
seen before. It challenged orthodox
views about government’s role in
the economy. Standard economics

Now a major center of international
finance, Hong Kong plays an important
role in China’s ongoing economic
success while preserving its own
system of government.

286 ASIAN TIGER ECONOMIES

The rapid rise of the Asian Tigers
was based on exports. Large facilities
to handle container ships, such as
these in Singapore, were built by the
state to promote growth.

“infant industries,” pumped up Korea’s steel industry. In the 1960s generating resources. “Getting
with subsidies and trade protection, the Korean government was prices wrong” did not help to
were eventually made to grow up. advised by the World Bank not to build comparative advantages
The state could enforce enter the steel sector because it in new industries. It led instead
performance criteria on firms had no comparative advantage to inefficient production and
because it was able to withdraw there—others could easily beat its economic stagnation.
preferential treatment as needed. prices. By the 1980s Posco, a large
Korean firm, had become one of the In East Asia successful states
Robert Wade argues that the world’s most efficient steel producers. seemed better able to resist
way these states chose to lead pressures from private interests.
the markets explains the creation Political interference After setting up its new steel firm
of comparative advantages in Attempts at interventionist policies in the 1960s, the South Korean
industries where none previously in regions outside East Asia were government ensured that the firm
existed. Initially, the prices of unsuccessful, which tarnished the was meeting efficiency targets.
goods from a new industry would reputation of the developmental If political interests had emerged
normally be internationally state. In Latin America and Africa that had prevented the state from
uncompetitive. In addition, the the preferential treatment of firms disciplining the firm, the state
production of a new product often and sectors generated poor would have become the servant
requires the simultaneous setting incentives: firms were shielded of narrow interests, not of the
up of other industries and from competition, but the state did overall economic efficiency of the
infrastructure. The coordination of not enforce performance criteria. economy. The state had to remain
this process is difficult if left to Infant industries never grew into autonomous and resist pressures
private firms rather than the state. successful exporters. for favoritism from particular
groups. At the same time the state
Moreover, these protected, infant In Latin America especially, provided firms with credit and
industries became competitive preferential treatment became linked technical assistance—to do this
when they were given classical to politics with little economic and to monitor firms’ performance,
incentives to learn how to become payoff: some firms received it was necessary for the tentacles of
more efficient. In order to achieve subsidies and tariff protection but the state to reach into the smallest
the economic education of new did not become more productive. cogs of the economy. The economic
firms and the coordination of initial Over time these firms became
production, governments needed to a drain on their governments’ The state… has set relative
act in violation of narrow market budgets, absorbing rather than prices deliberately ‘wrong’
prices. This occurred in South in order to create profitable
investment opportunities.

Alice Amsden

CONTEMPORARY ECONOMICS 287

bureaucracy needed to hold China began a series of reforms Industrial policy
detailed information about all of its communist system in the and incentives
potential investments, and to late 1970s. It created its own brand
maintain effective relationships of developmental state, which The East Asian developmental
with industrial managers. resembled the Asian Tigers, and states gave preferential
had an authoritarian government treatment to firms in favored
US economist Peter Evans has that was responsible for promoting sectors while creating
called these markers of successful the private sector and exports. incentives for performance.
developmental states “embedded Agriculture was de-collectivized, They did this by requiring
autonomy.” Only when this is in and state-owned industries enterprises to meet
place is there a chance for a state were given more autonomy and performance criteria, partly
to “get prices wrong” without subjected to greater competition. through contests in which
being co-opted by vested interests. These reforms helped unleash firms competed for prizes.
Embedded autonomy is not easy a vast expansion of private
to create, and its absence may be economic activity, without the Typically, the criterion
a factor behind the poor outcomes introduction of Western-style for winning was successful
of state intervention in other property rights. exports. The prize was credit
developing regions. lines or access to foreign
Alternative incentives emerged exchange. In South Korea and
The rise of China from China’s unique institutions: Taiwan, for instance, firms
With the East Asian financial crisis for example, from the “Household had to show proof that they
of the 1990s the developmental Responsibility System,” whereby had won an export order. Only
state model was again called into local managers are held responsible then did they receive their
question. Many sensed that the for an enterprise’s profits and prize. South Korea launched
institutions that had fostered rapid losses, without the need for private competitions in which private
industrial growth after World War property ownership. The results firms bid for large projects
II had lost their potency by the late have been dramatic. While China in new industries such as
20th century. On the other hand remains poor relative to Western shipbuilding. Successful firms
the spectacular rise of China Europe, its rapid growth took 170 received protection from the
has resurrected the idea of the million people out of poverty during international market for a
developmental state, or at the very the 1990s, accounting for three- time. Performance criteria
least of policies and institutions quarters of the poverty reduction involved firms becoming
that produce rapid economic in developing regions. internationally competitive
transformation while deviating by a certain deadline. Failing
from the prescriptions of standard, The histories of China and firms were punished.
classical economics. the Asian Tigers show that there
is no unique path to development. The South Korean steel
Like most Chinese cities, the eastern The way that their states industry was a big success of
city of Hangzhou has seen rapid intervened in the economy was the developmental state. By 2011,
growth and a spreading urbanization very different from anything that South Korea was the sixth largest
as China has industrialized. took place in Europe when it was steel producer in the world.
developing. However, it seems that
all development models, even
successful ones, eventually run
into constraints. The benefits of
the development state petered out
in the Asian Tigers in the 1990s—
institutions that had worked in one
decade began to fail in the next.
One day the Chinese state, too,
may lose its potency. It may have
to reinvent itself if its spectacular
rise is to continue. ■

BELIEFS

CAN TRIGGER CURRENCY

CRISES

SPECULATION AND CURRENCY
DEVALUATION



290 SPECULATION AND CURRENCY DEVALUATION

IN CONTEXT A currency crisis is a large when money was based on
and sudden collapse in precious metals, a currency usually
FOCUS the value of one nation’s lost its value through currency
Global economy currency relative to other currencies. debasement, which occurred when
For about 30 years after World a ruler reduced the precious metal
KEY THINKER War II the world’s main currencies content of the coinage. After money
Paul Krugman (1953–) were governed by the Bretton began to be printed on paper by
Woods system (pp.186–87), central banks, high inflation would
BEFORE which was based on fixed, but cause a country’s currency to
1944 Greece experiences adjustable, exchange rates. collapse. This happened in
the largest currency crash Germany in 1923, where at one
in history. When this system ended in point prices were doubling every
1971, currency crises became more two days. However, a country does
1978 US economic historian common. In general a currency not need hyperinflation to have a
Charles Kindleberger stresses crisis is triggered by people selling currency crisis. For example during
the role of irrational behavior a country’s currency in large the Great Depression of 1929–33,
in crises. amounts. This behavior seems prices of commodities such as
to stem from the interaction of minerals and food collapsed, and
AFTER people’s expectations and certain the currencies of Latin American
2009 US economists Carmen underlying economic weaknesses countries, which were reliant on
Reinhart and Kenneth Rogoff (known as “fundamentals”)—in this export trade, fell with them.
publish This Time is Different: other words people’s reactions to
Eight Centuries of Financial perceived problems. Economists Inconsistent policies
Folly, in which they draw have tried to model this interaction Writing in 1979, US economist
similarities between crises mathematically, but every time they Paul Krugman showed that for a
over the centuries. think they have found a model that currency crisis to happen, all that is
fits the data, a new type of crisis needed is for a government to carry
2010–12 Divergent national seems to emerge. out policies that are inconsistent
priorities, serious policy with the exchange rate.
errors, and huge speculative Currency crises in context
pressures threaten the Like hurricanes, financial crises Krugman’s argument is the
breakup of the euro. happen surprisingly often but are foundation for a first generation of
hard to predict. Centuries ago, currency crisis models. These
models start by assuming that
EXCHANGE RATE (PESOS PER $) Currency is In “first generation” there is a fixed exchange rate
attacked when crisis models, when between the home currency and an
the shadow rate one currency is fixed to external currency, and that the
rises above the another, its “real” value, home government is running a
fixed rate or shadow rate, may fall budget deficit (it is spending more
below the value at which than it is collecting in tax), which
it is financing by printing money.
Fixed rate is it is fixed. In this case By increasing the supply of the
currency, this policy creates an
2 pesos/$1 this is the point at inconsistency with the value of the
currency set by the fixed exchange
which the shadow rate. Other things being equal, the
policy will cause the “real” value
Fixed rate exchange rate rises of the home currency to fall.
above 2 pesos/$1.
Next, the models assume
When this happens, the that the central bank sells its own
reserves of foreign currency in order
Shadow rate currency is vulnerable to support the currency. However,
starts at 1.5 to attack as speculators
pesos/$1 but buy the country’s
rises over time foreign currency
reserves in anticipation

of a devaluation.

0

TIME

CONTEMPORARY ECONOMICS 291

See also: Economic bubbles 98–99 ■ Rational expectations 244–47 ■ Exchange rates and currencies 250–55 ■
Financial crises 296–301 ■ Bank runs 316–21 ■ Global savings imbalances 322–25

it is assumed that people can see at the fixed exchange rate than at Women examine a new Zimbabwean
that eventually the foreign currency the shadow exchange rate, they dollar bank note in 2009. After a period
reserves of the central bank will be will launch a speculative attack of hyperinflation, the government
exhausted. The exchange rate will and buy all the foreign currency revalued the currency by removing
then have to “float” (be traded reserves at the central bank. The 12 zeroes from the old notes.
freely) and decline. The model home currency will then be forced
proposes that there is a “shadow to float, and the depreciating
exchange rate,” which is what shadow exchange rate will become
the exchange rate would be if the the actual exchange rate. The
central bank were not defending speculative attack occurs at
the fixed exchange rate. People the point where the steadily
know what this shadow exchange depreciating shadow exchange
rate is (and will be) at any given rate equals the fixed exchange rate.
time by looking at the government
deficit. The moment they see that it This model seemed relevant
is better to sell the home currency to the currency crises in Latin
America in the 1970s and 1980s, ❯❯

If people believe that…

… government policies … government’s … an exchange rate
are inconsistent with commitment to an is vulnerable due
a fixed exchange rate exchange rate is
constrained by conflicting to weak banks, a financial
and there is an opportunity domestic priorities… bubble, misinformation,
to make a profit… or the actions of other

speculators…

… a speculative attack on the currency
may be launched.

Beliefs can trigger
currency crises.

292 SPECULATION AND CURRENCY DEVALUATION

Internal and external
economic factors put
downward pressure on
the currency’s value.

The value
of the
currency
to which
currency
“X” is fixed
remains
the same.

Currency “X” is When one country's currency is pegged
forced to devalue. to another, pressures from outside or inside the
country can force the link to be broken. At
that point the currency's value may collapse.

such as the crisis in Mexico in models allowed the government to one outcome is possible,
1982. However, in 1992–93, a have a choice. It may be committed what economists call “multiple
currency crisis erupted in the to a fixed exchange rate, but this equilibriums.” A speculative attack
European Monetary System (EMS), “rule” has an escape clause. If might occur if enough people
which appeared to contradict this unemployment becomes very high, believe that other people are going
model. Under this system’s the government may abandon its to attack the currency. They
Exchange Rate Mechanism (ERM), commitment to the fixed exchange will then attack it, and a crisis will
European countries effectively rate because the social costs of unfold. But if people don’t hold
fixed, or pegged, their currencies defending the currency (for these beliefs, the crisis may not
to the German Deutsche Mark instance through high interest happen. In these models crises are
(DM). Several currencies came rates) are too great. We can see “self-fulfilling.” At an extreme they
under pressure from speculators, these hard choices in the plight suggest that a crisis could happen
notably the financier George Soros. of Greece in 2012. However, irrespective of the economic
It would be difficult to argue that without a speculative attack these fundamentals of a country. These
countries such as the UK were extra social costs would not arise. new models, based on the work of
running policies inconsistent with These models imply that more than economists such as the American
the targeted exchange rate. The Maurice Obstfeld, seemed more
UK had a very small budget deficit The only absolutely sure- realistic than the earlier ones since
and had previously been running at fire way not to have they allowed for governments’ use
a surplus, yet in 1992, the country of instruments, such as interest
was forced to withdraw from one’s currency speculated rates, to defend the currency,
the ERM, to the great political against… is not to have an raising interest rates to prevent
embarrassment of Chancellor of devaluation. They also seemed to
the Exchequer (finance minister) independent currency. dovetail with the experience of the
Norman Lamont. A new model was Paul Krugman ERM crisis, where government
needed to explain these events. policies were constrained by high
levels of unemployment.
Self-fulfilling crises
In the first generation models, the Financial fragility
government’s policy is “fixed:” The East Asian crisis of 1997 (see
the authorities mechanically use up opposite) seemed not to fit the first
their foreign reserves to defend the two types of model. Unemployment
currency. A second generation of was not a concern, yet East Asian

CONTEMPORARY ECONOMICS 293

currencies came under sudden, foreign markets. Economists argue The East Asian
massive speculative attack. In the that by monitoring such warning financial crisis
second generation models the signs, crises may be predictable up
escape clause of devaluation was to one or two years in advance. The 1997 East Asian
supposed to relieve the economy crisis seemed to come from
from social costs, but the sharp Avoiding crises nowhere, overwhelming
collapse of their currencies was Studies suggest that between countries with strong growth
followed by a severe—though short- 5 and 25 percent of recent history records and government
lived—downturn. Financial has been spent in one crisis or surpluses. Before the crisis
fragility, caused by a banking boom another. New crises will continue most countries in the region
and bust, played an important role. to surprise us, but there are signals had pegged their exchange
In light of this economists began —such as the real exchange rate, rates to the US dollar. The
to focus on the interaction of exports and the current account, first signs of trouble were
weaknesses in the economy and the amount of money in the businesses failing in Thailand
and speculators’ self-fulfilling economy relative to the central and South Korea. On July 2,
expectations. This third generation bank’s international reserves— 1997, after months of battle
model now took into account new that may help to warn us to save its pegged rate,
kinds of financial fragilities, such when currency hurricanes are Thailand devalued. The
as those that arise when firms and approaching. The experiences Philippines was then forced
banks borrow in foreign currency of the last few decades have to float on July 11, Malaysia
and lend in local currency. Banks exposed the financial roots on July 14, Indonesia on
would be unable to pay their of crises. Economists now talk of August 14. In less than a year
debts in the event of currency “twin crises”—vicious spirals the currencies of Indonesia,
devaluation. These kinds of currency and banking crises. Thailand, South Korea,
of weaknesses could spark Rapid financial deregulation and Malaysia, and the Philippines
speculative attacks and crises. liberalization of international fell by between 40 and 85
capital markets are thought to percent. Only Hong Kong held
As well as developing theories, have led to crises in countries with out against the speculators.
economists have looked at the weak financial and regulatory
evidence for possible warning signs institutions. As well as paying The crisis has been blamed
of currency crises. In a 1996 article attention to the macroeconomic on a severe banking crisis.
Jeffrey Frankel and Andrew Rose signs of future crises, governments Borrowing was often short-
reviewed currency crashes in 105 also need to attend to these term, and when foreign
developing countries from 1971 to institutional vulnerabilities. ■ lenders withdrew their
1992. They found that devaluations capital, contagion ensued,
occur when foreign capital inflows and currencies collapsed.
dry up, when the central bank’s
foreign currency reserves are low,
when domestic credit growth is
high, when major external
(especially US dollar) interest rates
rise, and when the real exchange
rate (prices of traded goods from
home relative to those abroad) is
high, which means that a country’s
goods become uncompetitive in

Icelanders take to the streets of
Reykjavik to denounce the state's
handling of the currency crisis in 2008,
which saw the krona lose more than
one third of its official value.

294

AUCTION
WINNERS PAY
OVER THE ODDS

THE WINNER’S CURSE

IN CONTEXT In an auction where the value A uctions have been
of the sale item is uncertain, around for a long time,
FOCUS every bidder makes his own but economists have only
Decision making recently come to realize that they
decision on its value. are an ideal proving ground for the
KEY THINKERS competitive strategies of game
William Vickrey (1914–96) If they decide their theory. Game theory came to
Paul Milgrom (1948– ) valuations privately, prominence in the 1950s when
Roger Myerson (1951– ) there will be a range of mathematicians saw that simple
different valuations. games could illuminate situations
BEFORE in which people compete directly.
1951 US mathematician The true value of the item This idea proved hard to apply to
John Nash develops a concept will tend to be around the the real world. However, the strict
of equilibrium in games, midrange of the different rules of an auction, with limited
which becomes a tenet of participants and pokerlike buying
auction theory. bidders’ valuations. strategies, seemed much closer to
the theory.
1961 Canadian economist The sale will go to the
William Vickrey uses game bidder who overestimates Types of auction
theory to analyze auctions. The first person to apply game
its value the most. theory to auctions was Canadian
AFTER economist William Vickrey in the
1971 It is shown that oil Auction winners pay 1960s. He compared the three most
companies bidding for drilling over the odds. common types of auctions. An
leases may not be aware of the “English auction” is the method
“winner’s curse.” used in British art houses, where
bidding goes up until only one
1982 US economists Paul bidder is left. In a “Dutch auction,”
Milgrom and Robert J. Weber used in Dutch flower markets for
show that when bidders know example, the price drops until it
their competitors’ valuations, reaches a price someone will pay.
an “English auction” gives the In a “first-price auction” bidders
best price for the seller. submit sealed bids, and the highest
bidder wins. Vickrey proposed a

CONTEMPORARY ECONOMICS 295

See also: The competitive market 126–29 ■ Risk and uncertainty 162–63 ■ Selling the spectrum
Social choice theory 214–15 ■ Game theory 234–41
Auction theory came into
$90 phenomenon of the “winner’s its own with a dramatic spate
$100 curse:” an item goes to the of government auctions in the
$98 bidder who overvalues it the US in the 1990s as industries
most. Imagine that you submit a were privatized. The biggest
In an auction there is a danger that successful bid of $100 for a picture. sell-off came when mobile
the winning bid will come from a You win because your bid is higher phone companies prepared
bidder who has overvalued the item, than all the others. Suppose the to pay huge sums for a share
a misfortune known as winner’s curse. next highest bid had been $98. You of the electromagnetic
could have bid lower—$98.01—and spectrum (the airwaves) on
fourth type of auction, similar to still been successful. In general the which to transmit. The US
the first-price auction, but in which winning bidder pays “too much,” government wanted to
the winner pays as much as the in this case to the tune of $1.99. maximize its return, but it
second-highest bid. also wanted to ensure that
Auction theory can be used the sale went to the bidder
Using mathematics, Vickrey to design auctions that maximize who valued it most.
proved that when bidders value the seller’s revenue and ensure that
items independently, all four types the good goes to the buyer who In 1993, the Federal
of auction yield the same revenue values it most. The success of Communications Commission
for the seller, a discovery known the US government’s spectrum (FCC) brought in auction
as “revenue equivalence theory.” auctions in the 1990s (see box, theorists to design the
right) created a buzz about this new auctions for the 2,500 so-
Shaded bids area of economics. For many it was called spectrum licenses.
Vickrey showed that it is better proof that game theory was not just The telecom companies,
for bidders to bid less than their theory but really did apply in actual meanwhile, hired auction
valuations, a strategy auction markets. Others insist that auctions theorists to design their bid
theorists call “shading,” otherwise are a special type of market, and strategies. The FCC decided
they may end up paying over the that even they might not be fully on an English-style auction
odds. Shading gained special explainable using game theory. but with a twist: the identity
significance in the 1970s, when it What does seem true is that of the bidders was kept secret
seemed that oil companies bidding auctions have now expanded well to avoid retaliatory bidding or
for offshore drilling rights often beyond their traditional domains collusion to keep prices down.
ended up paying far too much. of government procurements and The auctions broke all records,
Auction theorists discovered the public bond sales. ■ and the approach has been
widely copied.

In Dutch auctions, as used in
Holland’s Aalsmeer flower market,
the price starts high and then begins
to drop. The first bidder to stop the
price as it drops takes the flowers.

STABLE

ECONOMIES CONTAIN

THE SEEDS OF

INSTABILITY

FINANCIAL CRISES



298 FINANCIAL CRISES

IN CONTEXT T he instability of economic Pictured here after his arrest in 1910,
systems has been debated Charles Ponzi ran investment scams in
FOCUS throughout the history of the US promising unrealistic returns.
Banking and finance economic thought. The view of Minsky compared capitalist booms to
classical economists, following in Ponzi schemes, doomed to collapse.
KEY THINKER the tradition started by Adam Smith,
Hyman Minsky (1919–96) is that an economy is always driven Financial Instability Hypothesis.”
toward a stable equilibrium. There The paper suggested that the
BEFORE will always be disturbances that modern capitalist economy contains
1933 American economist create booms and slumps—a the seeds of its own destruction.
Irving Fisher shows how pattern that is sometimes called
debt can cause depression. the business cycle—but ultimately In Keynes’s view the modern
the tendency is toward stability capitalist economy was different
1936 British economist with a fully employed economy. from the economy that had existed
John Maynard Keynes claims in the 18th century. The major
the financial markets have a The Great Depression of 1929 difference was the role played by
larger role in the functioning led some economists to examine money and financial institutions.
of the economy than was business cycles in more detail. In In 1803, the French economist
previously thought. 1933, US economist Irving Fisher Jean-Baptiste Say (p.75) gave a
described how a boom can turn to classical interpretation of the
AFTER bust through instabilities caused economy as essentially a refined
2007 Lebanese-American by excessive debts and falling prices. barter system, in which people
risk theorist Nassim Nicholas Three years later John Maynard produce goods that they exchange
Taleb publishes The Black Keynes (p.161) questioned the idea for money, which is used to
Swan, which criticizes the that the economy is self-righting. In exchange for the goods they want.
risk-management procedures his General Theory, he developed The real exchange is good for good:
of financial markets. the idea that an economy could money is just a lubricant. Keynes
settle into a depression from which argued that money does more than
2009 Paul McCulley, former it had little hope of escaping. this: it allows transactions to occur
managing director of a large over time. A firm could borrow
US investment fund, coins the These works were the genesis of money today to build a factory,
term “Minsky moment” for understanding the unstable nature which it hopes will generate profit
the point at which booms bust. of modern economies. In 1992, that can be used to pay back the
Hyman Minsky looked at the loan and the interest in the future.
problem again in his paper “The Minsky pointed out that it is not

PRICE (IN THOUSANDS) $300 House prices in the
$275 US climbed steeply
$250 from the late 1990s
$225 Inflation-adjusted until 2007 as banks
$200 house prices increasingly granted
$175 mortgages to people
$150 without the income to
$125 pay the money back.
$100
$75
$50 Actual house
$25 prices at the time

$0

1975
1979
1983
1987
1991
1995
1999
2003
2007

YEAR