Living/minimum wage: what we know

Version 1.0 (April 24, 2019)

A couple of weeks ago, I got ensnarled in one of these debates on Facebook that do not go anywhere; it was triggered by the Australian Labor Party’s recent Living Wage policy proposal and the related discussion about the merits of minimum wages, and there specifically whether increases in minimum wages have negative employment effects and even more specifically whether such detrimental employment effects hit those at the low end of the wage distribution. These debates tie into other current debates like the one about lacking wages growth about which even the RBA is now concerned; see also Fig 17.17 here, or the one about wage theft which even the current government — not known for its charitable inclinations — says it wants to address, or the one about growing inequality which, as it affects aggregate demand, has to be a growing concern for any economist worth her or his money.

The debate on Facebook I referred to at the outset did not go anywhere because it turned out that the conceptual and empirical issues of the effects of minimum wages on employment are quite different from what most people have learned in basic Econ 101. And, unfortunately, about 99 percent of those currently engaging in the debate about the effects of minimum wages have not gone beyond that level of understanding, even if they claim economics expertise. So, I bowed out of that debate at some point and read up on it. Here is what I understand the current state of the science to be. I am open to suggestions on where I might get it wrong. Feel free to comment away.

The traditional understanding results from what is (still) being taught in most principles courses: that the demand curve for any good, or factor of production, is downward sloping, i.e.. the higher the price (e.g., of labor) the less of it will be demanded. That given, a simple graph establishes that equilibrium price and quantity are determined by the interaction of demand and supply. If a binding floor is established (i.e., if a price is set by some law or ordinance above the equilibrium price), quantity demanded will be constrained and less of it will be employed. Ignoring for now the important question whether labour should be considered just another factor of production or whether there is more to it – a point for another overdue debate –, the fact that less labor might be employed is not necessarily a bad thing, a point that many people do not seem to grasp. It all depends on the “elasticity of demand” which is a measure that relates the responsiveness of the quantity demanded to price changes. If the price increases (brought about by a law or ordinance that sets a price above the equilibrium price) are large but negative employment effects not quite as much, a case can possibly be made for some such law or ordinance.

So far so good and probably uncontroversial even among most economists and journalists who write on economic issues. It is also fairly uncontroversial that long-run measures of responsiveness of employment to price changes (“elasticities”) tend to be larger than short-term measures and that these elasticities might be different for different locations on the demand curve and for that matter different demand curves. What exactly the appropriate elasticity estimate is for various contexts is arguably more controversial. On balance, economists are sceptical about market interventions of this kind, and often for good reasons (e.g., the well documented consequences of rent-controls although even here a more critical attitude is emerging).

In come Card & Krueger (1994) with a study published in one of the top journals of economics, and a provocatively titled book a year later with one of the top presses, in which they seem to be able to show, relying on an intriguing natural experiment that inspired hundreds of studies and contributed to the credibility revolution in economics, that raising the minimum wage has no adverse effect on employment. Wow.

Not surprisingly, this study was heavily contested.

The debate continues to the day and I will below discuss some key contributions to the debate and also some of the kerfuffle surrounding the recent Seattle minimum wage experiment which is ongoing.

As you will see there are many moving parts, conceptually and empirically, confounding these debates. My list of things to keep in mind follows; below I will refer to them as “caveats”.

Caveat 1: The simple Econ 101 model of the effects of a minimum wage (or price floor) is flawed because it does not take into account dynamic effects. For example, in a growing economy (such as the Seattle market has been for a while), it is important to study a minimum wage effect against the counterfactual which is not easy to establish. Among the ways labor market researchers have approached the topic is the “synthetic approach” of identifying districts outside of an urban center that are, however, in their sum well matched in observable characteristics. Another strategy has been natural experiments across state borders when one state changed the minimum wage and the other did not.

Caveat 2: Any minimum wage increase (especially when drastic) will not only have, possibly, employment effects for those whose wages go up but for those that have wages above the price floor. It is unclear conceptually how some such “ripple effect” could pan out: Will those workers that earn more (as apparently a considerable number of workers in the restaurant industry do), suddenly put in less effort, and/or will those that have their wages increased provide more? What are the results of the long-term adjustments processes of what is the relative efficiency wage between those with lesser skills and those with more?

Caveat 3: An important issue is temporary job-seekers (e.g., students on their holidays or teenage workers to earn some change, or other part-time workers, etc.) and to what extent adverse employment efects will disproportionately fall on them. In his simulation exercise, MaCurdy makes the important point that, even if one accepts that there are no adverse employment effects, those benefitting from an increase in minimum wages are not necessarily low-income families.  In fact according to his data “low-wage families are typically not low-income families.” (p. 534) And, “The increased earnings received by the poorest families are only marginally higher than those of the wealthiest. One in four families in the top fifth of the income distribution has low-wage worker which is the same share as in the bottom fifth.” (pp. 534-5) The problem is that while “fewer than one in four low-income families benefit from a minimum wage increase of the sort adopted in 1996, all low-income families pay for this increase through higher prices, rendering three in four low-income families as net losers.” (p. 535) Clearly the incidence of price increases is an important consideration, and needs to be controlled for.

Caveat 4: Relatedly, there is the issue of the gig-economy which tends to put pressure on wages in the low-skill sector and allows price floors for labor to be circumvented by making participants into “entrepreneurs” of sorts. This seems currently a completely understudied area.

Caveat 5: Another important issue is whether wage increases are implemented locally, regionally, or on the national level. Minimum wages on the national and even the regional level are presumably less easily circumvented than those on the local level, although it is probably a mistake to underestimate the attractiveness of big urban centers.

Caveat 6: An important issue is anticipation effects which can pollute supposed quasi RCTs. This explicitly motivated the study by Bell & Machin (2018).

Caveat 7: If the simple Econ 101 model of the effects of a minimum wage (or price floor) is flawed because it does not take into account dynamic effects, then the question has to be asked which alternative model could explain the results. Prominent competing labour market theories are those of monopsonistic, or oligopolistic, competition with search costs, or efficiency wages. Belman & Wolfson (2014) have a useful discussion of such models in graphical form. See also this or this.

Caveat 8: As for the abatement of carbon emissions there are typical several other policy options and therefore it is important to keep in mind that there may be other policy tools such as earned income tax credits that would address the policy goal of a minimum, or living, wage more effective- and efficiently. In this context the important question arises who ultimately pays for minimum wages. Assuming no adverse employment effects, the question is whether employers manage to push increased labor costs through to consumers, or whether they have to take some hit to their profits. This seems to be another poorly understudied area. The available evidence (see MaCurdy 2015 and Draca et al. 2011), Bell & Machin 2018, and this very interesting paper by Harasztosi & Lindner 2017) is inconclusive. More about these papers below.

Caveat 9: Debates about minimum or living wages should not be backward looking. They ought to happen in the context of an ever increasing automatization and inequality (in Australia surely in terms of wealth and quite possibly also in terms of income).

Caveat 10: Many of the empirical findings that we have are from The United States. Naturally, we should not take for granted that the findings (to the extent that we might agree on them) translate to the Australian context. There is, fortunately, an interesting literature documenting the effects of the (1999) introduction of minimum wages in England (including at least one meta-study), and an emerging literature documenting the effects of the (2015) introduction of a living wage in England (Bell & Machin (2018). There will soon be yet another emerging literature that draws on the minimum wage experiment that Germany launched in 2015. And importantly, there is the very interesting paper by Harasztosi & Lindner (2017) on the Hungarian experience with a dramatic increase of 60 percent in the minimum wage in 2001.

Back now to the debate and some key contributions and also some of the recent kerfuffle about the Seattle experiment which are ongoing.

Card & Krueger (1994, 1995a, 1995b, 2000, 2016, chapter 1, 2017) studied the fast-food industry in New Jersey and Pennsylvania. The former increased the minimum wage in April 1992. The original Card & Krueger 1994 findings suggested – to many economists’ surprise — that there was no employment effect of that increase in the minimum wage. This finding was contested by Neumark & Wascher (2000) who argued that the Card & Krueger data – because they were collected through telephone surveys – were unreliable. Drawing on payroll administrative data, they argued furthermore that the New Jersey minimum-wage increase led to a decline in fast-food employment. Neumark has emerged as arguably the most influential critic of Card & Krueger and maintains, for example in this recent IZA primer, that ”A great deal of evidence indicates that the wage gains from minimum wage increases are offset, for some workers, by fewer jobs. Furthermore the evidence on distributional effects, though limited, does not point to favourable outcomes from minimum wage hikes, although some groups may benefit.” In their response to Neumark & Wascher, Card & Krueger questioned the representativeness of the Neumark & Wascher data and instead used two different kinds of longitudinal and repeated cross-sectional administrative data reported to the BLS.  They conclude that “the increase in the New Jersey minimum wage in April 1992 had little or no systematic effect on total fast-food employment in the state, although there may have been individual restaurants where employment rose or fell in response to the higher minimum wage.” (p. 1398) In chapter 1 of the 2016 version of their book Card & Krueger re-iterate this finding and argue “This book presents a new body of evidence showing that recent minimum-wage increases have not had the negative employment effects predicted by the textbook model. Some of the new evidence points toward a positive effect of the minimum wage on employment; most shows no effect at all. Moreover, a reanalysis of previous minimum wage studies finds little support for the prediction that minimum wages reduce employment.” (Chapter 1, page 1)

Building on a meta-analysis that Card & Krueger did in the same year they published their book, Doucouliagos & Stanley (2009) provided a meta-regression analysis of minimum wage research  drawing on  64 (!) minimum wage studies. Importantly, they controlled for publication selection bias and they find that, when selection effects are filtered out, “no evidence of a meaningful adverse selection effect” (p. 422) (thus confirming the earlier results of Card & Krueger). Specifically, “In the minimum-wage literature, the magnitude of the publication selection is large or larger, on average, then the underlying reported estimate. … Even under generous assumptions about what might constitute ‘best practice’ in this area of research, little or no evidence of an adverse effect remains in the empirical research record, one the effects of publication selection are removed.” (p. 423) In passing, Doucouliagos & Stanley, who have no recognizable dog in this fight (as much of their work involves meta-analyses of various areas), suggest that the “subjective narrative review” provided by Neumark & Wascher (2007) that covers the same literature (but comes to a very different conclusion) is wanting because it does not control for publication bias. A more recent meta-analysis by Belman & Wolfson (2014) of minimum wage studies published between 2000 and 2013 also confirms the Card & Krueger results, finding a median elasticity of employment or hours with respect to the minimum wage of between -0.05 and -0.03, not controlling, however, for publication bias.

Dube and his colleagues (including Michael Reich, one of the protagonists of the Seattle minimum wage study controversy) provided yet more evidence in support of the results claimed by Card & Krueger. Inspired by their identification strategy, they compare restaurant and retail employment in contiguous countries across state borders, and there in particular segments with minimum wage differences over a 17-year period. The border discontinuity design has attractive features spelled out in Dube (2017) where one can also find a succinct summary of his later work, a good discussion of related work, and of alternative approaches. Acknowledging that “the topic of employment effect of minimum wages remains controversial, with sometimes conflicting evidence” (p. 820), in his own work he finds employment elasticity close to zero (also for teens), and “even when we considered the longer-terms effects (e.g., four or five years out), we found employment estimates to be fairly small.” (p. 820) Reflecting on his recent work with Lester and Reich (2016), he notes “We found a striking pattern … This trifecta of results – strong positive wage effect, small employment effect, and strong negative turnover effect – is a signature of a model with search frictions  … “ (p. 821) None of these papers, however, controls for the effects of minimum wages on prices (recall MaCurdy’s results) and/or profits, something which seems necessary if one wants to understand the net effect of a minimum wage increase.

Additional empirical evidence in favour from the UK, where a national minimum wage was introduced in 1999, and a national “living wage” in 2015 (by a conservative government, no less), is reviewed in Lemieux (2017) and Card & Krueger (2017); summarizes Lemieux, “By moving from a situation of no minimum wage to one with a large and differentiated (by age) minimum wage, the United Kingdom was an ideal laboratory … . A clear consensus in the British literature supports that the new minimum wage had, and continues to have, no effects on employment. … On balance, it appears that the evidence accumulated since 1995 has, if anything, reinforced Card and Krieger’s conclusion of no (or modest) employment effects of the minimum wage.” (p. 824) While Lemieux mentions the results by Machin, Manning, & Rahman (2003) … he does not mention Leonard, Doucouliagis, & Stanley (2013) which is puzzling.

Card & Krueger point out that these new data allow also inferences about how the wage distribution is affected. “Relative to the literature on the employment effects of minimum wages, there are fewer recent studies of the distributional impacts. …Exploiting the remarkable history of minimum wage legislation in the United Kingdom, Dickens et al. (2012) concluded that the introduction of the national minimum wage had a strong effect on the lower tail of British wages, pushing up the wages of workers as high as the 35th percentile in the overall wage distribution.” (p. 829) That is a remarkable result that, if true, speaks to Caveat 2 that I formulated above and it suggests that restricting attention to those directly affected by wage increases is a problematic strategy.

As stated by Dube, “the topic of employment effect of minimum wages remains controversial, with sometimes conflicting evidence”. (p. 820) Another prominent contrarian, apart from Neumark, is Jonathan Meer. Meer & West (2016), who estimate a large negative effect of minimum wages on aggregate employment, is discussed in Dube (2017) who suggests – based on his empirical work – that these putative job losses happen higher in the wage distribution, “raising questions about the causal import of their estimates”. (p. 820) Meer (2018) summarizes his take on the literature, including his own work and that of the Jardim et al. (2017) study of the Seattle minimum wage experiment. Says he, riffing on an even more partisan earlier assessment of the literature (Meer 2017): “Following the minimum wage increase [to $13 per hour in 2016 [January] from $11 in 2015 [April] and $9.32 in 2014], total payroll for low-wage workers actually fell by an average of $125 per month: those workers for whom the increase was supposed to help were actually receiving fewer dollars on average after the minimum wage increase than before. Unsurprisingly, the study came in for immediate criticism from minimum wage advocates, but its methodological approach is sound and most of the critiques are groundless.” (p. 6) These are strong claims and they would be more credible if his literature review would be less partisan (e.g., no word about the meta-studies by Doucouliagos & Stanley 2009 and Belman & Wolfson 2014, also no word really about the English experiment which is of interest for the simple reason that minimum wage is differentiated by age, thus having the potential to address one of Meer’s concerns).

The Seattle experiment, and some of the ugly politics around it (also academically) has been widely reported on (here and here and here and here and here and here).

Since the Jardim et al. (2017) paper, the same group of researchers has published a follow-up study (Jardim et al. [October] 2018) that assesses the impact of the first and second min wage increases in 2015 and 2016, using again longitudinal workforce data (“employment trajectories of thousands of individual employees  engaged in low-wage work immediately before each increase”, p. 4) collected by the state of Washington’s Employment Security Department. The new analysis follows the same identification strategy as the earlier study (of trying to compare Seattle low-wage workers with matched controls from outlying Washington State) but comes to a different conclusion: “While these workers experienced a modest reduction in hours worked, on net their pretax earnings increased an average of around $10 a week” (p. 4, see also p. 25) However, the bulk of these gains went to more experienced workers, with less experienced workers being about as well of as before. As Jardim et al. (2018) admit, “The findings contrast with our earlier work, which showed that the total amount paid to workers in low-wage jobs in Seattle declined after the second minimum wage increase in 2016.” (p. 25) I am tempted at this point to paraphrase Meer (2017), If your immediate reaction to this study is to dismiss it, “it is time to admit your views cannot be swayed by science. They might as well be religion.” (p.7) Say it as it is, Jonathan.

But, seriously, it is important to understand that any one single case (study) is only so telling and often a work in progress. The case of Seattle is so unique (see also this excellent recent story about Amazon) that the caveat in Jardim et al. (2018) not to generalize this finding to state and federal policy changes seems warranted.

Looking at all the evidence that is currently out there (and that I paraded above), I conclude that the balance of the evidence seems to provide considerable support in favour of policy recommendations that contradict the standard Econ 101 narrative, even if we accept that labor should be considered just any old factor of production.

Local circumstances have, of course, to be part of any attempt to implement minimum wages and/or living wages. It is also worthwhile remembering Alan Krueger’s admonition from 2015 that “$15 an hour is beyond international experience, and could well be counterproductive. Although some high-wage cities and states could probably absorb a $15-an-hour minimum wage with little or no job loss, it is far from clear that the same could be said for every state, city and town in the United States.” (Krueger 2015) Krueger, however, issued that caveat before the results in Harasztosi & Lindner (2017) started to circulate which are remarkable indeed. These authors analyse a very large (~60% in real terms) minimum wage increase in Hungary in 2001. Among the remarkable results are that this very large increase displaced four years out only 1 out of 10 minimum wage workers while those that held on to their job experienced a 50% wage increase. Importantly, while firms predictably responded to the increase by trying to substitute away from labor to capital, they showed that “around 80% of the wage increase paid by consumers of goods produced by minimum wage workers and only 20% was paid by firm owners.” (abstract) Not surprisingly, there is considerable heterogeneity to be found in firms’ ability to pass through the increased minimum wage. Interestingly the result that forced increases in labor cost can be for the most part pushed through to consumers contradicts the results reported for the English minimum and living wages experiences. Draca et al (2011), based on the 1999 minimum wage increases, find that they find their way directly into profit reductions. Bell & Machin (2018), based on the 2015 minimum wage increase, find that it finds its way directly into lower firm value, a story consistent with Draca et al.’s but not with MaCurdy or the story Harasztosi & Lindner (2017) tell. Hmmmh.

The implications of the currently available evidence for Australia are worth thinking through carefully. Taking into account purchasing power parity which probably means that a wage of around 15 Aussie dollars seems a safe proposition in particular if age – adjusted following the English model. Importantly, there may be better policy interventions out there such as earned income credit and other active labor market programs.  Card et al. (2018) have recently reviewed the available options.

It seems very desirable to think through these issues in non-partisan matter (i.e., have what we know assessed through forms of adversarial collaborations by knowledgeable people representing key stakeholders in the debate) and with a longer-term perspective that takes into account the nature of work in the future. Not being a labor market researcher, one of the frustrations I experienced when reading up on this literature is the often very partisan assessment of the findings out there. For example, if you are an opponent of minimum wages and selectively point at evidence to support your stand, you lose credibility right away when not mentioning the meta-studies out there that do exist (and that so far support the Card & Krueger findings).

I appreciate, without implicating, Stepan Jurajda’s and Jonathan Meer’s pointers towards relevant literature and Stepan’s and my colleague Gigi Foster’s feedback on an earlier draft. Needless to say, they are not to blame for errors in fact or opinion.

 

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Comments on the Interim Report of the Royal Commission into Misconduct in the Banking, Superannuation, and Financial Services Industry

October 26, 2018

  1. The following remarks are informed by discussions during a by-invitation-only roundtable on October 19 that was organized by the UNSW Business School research networks on Cyber Security and Data Governance and Behavioural Insights for Business and Policy. It was attended by a judicious mix of 14 legal academics and (behavioural, experimental, and financial) economists as well as representatives of behavioural insights units from government and firms in the banking industry. The roundtable took part under the Chatham House Rule and was meant to facilitate an open discourse about the issues identified in the Royal Commission’s Interim Report, especially its chapter 10 and therein pages 327 – 342 and pages 345 – 7, as well as other chapters (namely 1, 8 and 9).
  2. While my comments draw on those discussions, the following comments reflect my opinion only. Importantly, my opinion below does not necessarily reflect my employer’s view.
  3. Kudos first to Commissioner Hayne and the senior counsels assisting (namely Rowena Orr and Michael Hodge) for a job well-done in uncovering plenty of misconduct when, in the run-up, representatives of the government du jour repeatedly argued, and strenuously so, that there was nothing to see here, that the call for a Royal Commission (RC) was a populist whinge, and that an RC would endanger economic growth by undermining trust in the banks, superannuation providers, and the financial services industry more generally. It seems obvious now that these claims were made despite better knowledge. It seems important to recall this fact, as the implementation of effective solutions – even if evidence-based – is likely to encounter considerable opposition and attempts to water them down. Strategic dishonesty is a thing and it is at the heart of the problems so competently ferreted out by the RC.
  4. Kudos also to ASIC – much maligned these days – since it clearly has provided a considerable portion of the relevant systematic evidence under not always favourable conditions (e.g., the substantial reduction in its resources announced in the 2014 budget; the fact that some of these resources were restored in 2016 cannot distract from the fact that any such disruption is counterproductive).
  5. For an economist who knows the empirical (including the experimental) evidence on the effects of market power, incentives (especially those in social dilemma situations), and on human actors’ frequent failure to be ethical (honest) and in violations of existing norms of conduct, there is nothing surprising in the Interim Report. Likewise, the failure of the regulators to interfere effectively was hardly surprising, although the discussion of effective remedies among economists is likely to be more robust than on the other topics.

5.1. We know for example that market power begets socially suboptimal outcomes (e.g., Huck et al. JEBO 2004, or any textbook on Industrial Organization worth its cost).

5.2. We know, for example, that incentives, especially when in conflict with organizational or societal welfare, lead to undesirable outcomes (e.g., the huge literature on trust games reviewed in Ortmann et al. EE 2000, or more systematically in Johnson & Mislin JoEP 2011)

5.3. We know, for example, that, even for low stakes, there is a considerable amount of people that will always be unethical, with many more people being easily tempted by dishonest behaviour as the stakes increase (e.g., Rosenbaum et al. JoEP 2014; Abeler et al. JPublE 2014; Kajackaite & Gneezy GEB 2017; Capraro JDM 2018; Heck et al. JDM; Abeler et al. ECMTA forthcoming). People’s susceptibility to norm violations has been documented since Adam Smith wrote his The Theory of Moral Sentiments. For more recent evidence, see some of the evidence from psychology and related behavioural sciences in Gentilin (2016; for a critique of that evidence see Ortmann CE 2016 and references therein).

5.4. The question of effective remedies is a more complicated one. It touches on numerous mechanism design issues, although even there one can tap into a considerable empirical (and experimental) literature that addresses questions such as the relative efficacy of self-regulation (possibly under the threat of government intervention; see Van Koten & Ortmann 2017), certification, and other institutions such as independent standards boards that administer ethical culture surveys and whiste-blower protection, and provide pools of principal integrity officers, as suggested in Dennis Gentilin’s submission. More on these issues below under 7.

  1. That breaches were so many and so widespread will, especially in light of the significantly larger stakes at stake, not surprise any economist who knows the literature on the negative effects of market power, poorly designed and calibrated incentives, and many human actors’ tendency to be economical with the truth, and in violation of norms (especially if the chance that they are found out is minimal – see Dana et al. ET 2007)). Pages 268 – 270 of the Interim Report get it exactly right: “There being little threat of failure of the enterprise, and there being little competitive pressure, pursuit of profit has trumped consideration of how the profit is made. The banks have gone to the edge of what is permitted, and too often beyond that limit, … because they can; and because they profit from the misconduct that is described in this report.” (p. 269)

7.  So what needs to be done to prevent the conduct from happening again?

7.1. It seems obvious that extant law be applied to lay charges for unconscionable acts such as charging customers fees for advice they did not receive. (While it is laudable that ASIC has secured hundreds of millions in refunds for affected customers, it has come through enforceable undertakings which let the perpetrators of criminal actions off the hook.) Other potentially criminal offences have been committed and they should be pursued under current law wherever possible. Unfortunately, the current state of affairs has considerable reputational spill-over effects and contributes to the wide-spread decline of trust in key institutions.

7.2.  It seems clear that the light-touch approach of ASIC, and APRA, has not served the community well although it is hard to tell from the outside whether tough cops – such as Allan Fels and Graeme Samuel – alone can do the trick (Irvine SMH September 22, 2018).

7.3. It also seems abundantly clear that Commissioner Hayne’s assessment of the sorry state of internal compliance assessment and reporting within CBA and NAB (and possibly other banks) justifies immediate action (p. 10 of Interim Report).

7.4. I do agree with Fels that structural separation of banks from their financial advisory arms is the way to go (Irvine SMH September 22, 2018). The same applies in my view for superannuation providers. The conflicts of interest are just too obvious to ignore and some proposed remedies (such as disclosure of conflicts of interests) seem to have counterproductive effects (e.g., Taguchi & Kamijo 2018, for a recent review of the literature).

7.5. Relatedly, the whole commission business has to be reconsidered. See also the relevant discussion on the broken model of broker remuneration in the Productivity Commission’s June 29 report on Competition in the Australian Financial System (pp. 21- 23) Financial advisors are effectively glorified salespeople and incentivizing them through commissions is a recipe for disaster under the best of circumstances.

7.6.  Relatedly, the variable-remuneration provisions for accountable persons according to BEAR have to be rethought. I endorse fully Recommendation One and Two in Dennis Gentilin’s submission on the RC’s Interim Report.

7.7. I also endorse fully Recommendations Four through Eight of Dennis Gentilin’s submission on the RC’s Interim Report and the rationale they are based on. What exactly the relation of an Independent Standards Board would be to Treasury, APRA, ASIC, and possibly ACCC, is as worthy of a good discussion as is a discussion of appointment procedures to that Board. See also the discussion of “a competition champion” in the Productivity Commission’s June 29 report on Competition in the Australian Financial System (pp. 15 – 19). Preferably the appointment of the Chair of some such Board would be consensus-driven and not partisan. (The sorry partisan transition from the first to the second ACNC Commissioner is not a recommended template.) I believe that Mr. Gentilin’s Recommendation Six – to have the proposed Independent Standards Board oversee the recruitment and appointment of Principal Integrity Officers to designated ADIs — is a brilliant one that will be key in guaranteeing the independence of Principal Integrity Officers. With Mr. Gentilin (specifically Recommendation Eight and its rationale), I believe that the establishment of a Whistleblowing Protection Authority is an indispensable and complementary step if indeed reducing misconduct in the banking, superannuation, and financial services industry is a serious concern and not just public posturing.

7.8. Last but not least, I would urge the Royal Commission – rather than adding more regulation that then is likely not enforced – to explore ways to let reputational feedback systems (e.g., Bolton et al MS 2013; see also systems such as TripAdvisor or Serviceseeking.com.au) work their magic. Considerably more transparency, and data, should be provided to the public to let interested researchers identify anomalies and developments that might be otherwise go unnoticed too long. Take the fascinating Figure 3 in the Productivity Commission’s April 2018 draft report on Superannuation: Assessing Efficiency and Competitiveness. Making that data available in a timely fashion would do wonders for the alignment of incentives. No traditional regulatory action I can think of would have the same effect.

References

Abeler et al. (2014), Representative evidence on lying costs. Journal of Public Economics pp. 96 – 104.

Abeler et al. (forthcoming), Preferences for truth-telling. Econometrica forthcoming.

Bolton et al. (2013), Engineering Trust: Reciprocity in the Production of Reputation Information. Management Science pp. 265 – 85.

Capraro (2018), Gender Differences in lying in sender-receiver games: A meta-analysis. Judgement and Decision Making pp. 345 – 55.

Dana et al. (2007), Exploiting moral wiggle room: experiments demonstrating an illusory preference for fairness. Economic Theory pp. 67 – 80.

Gentilin (2016), The Origins of Ethical Failures. Lessons for Leaders. Routledge.

Heck et al. (2018), Who lies? A large-scale reanalysis linking basic personality traits to unethical decision making. Judgement and Decision Making pp. 356 – 71

Huck et al. (2014), Two Are Few and Four Are Many: Number Effects in Experimental Oligopolies. Journal of Economic Behavior & Organization pp. 435 – 46.

Irvine (2018), ‘Stop being bastards’: how the royal commission could reform banks. Sydney Morning Herald 22 September.

Johnson & Mislin (2011), Trust Games: A Meta-analysis. Journal of Economic Psychology pp. 865 – 89.

Kajackaite & Gneezy (2017), Incentives and cheating. Games and Economic Behavior p. 433 – 44.

Ortmann et al. (2000), Trust, Reciprocity, and Social History: A Re-examination. Experimental Economics pp. 81 – 100.

Rosenbaum et al. (2014), Let’s be honest: A review of experimental evidence of honesty and truth-telling. Journal of Economic Psychology 181 – 96.

Taguchi & Kamijo (2018), Intentions behind disclosure to promote trust under short-terminism: An experimental study. Kochi University of Technology working paper.

Van Koten & Ortmann (2017), Self-regulatory organizations under the shadow of governmental oversight: An experimental investigation. In: Deck et al. (2017), Experiments in Organizational Economics, Research in Experimental Economics 19, 85 – 104.

Comments welcome.

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A Nobel prize for breaking through the hurdles placed by economists

This year’s Nobel Prize in Economics has been shared by Bill Nordhaus and Paul Romer for “integrating innovation and climate with economic growth.” That is one way to thread the needle to link these fine recipients and I applaud the Nobel Committee for finding a way to do it. That said, there is a real reason that Nordhaus and Romer should be linked and it turns on the way they have made their ideas persuasive — not to the general public or even politicians but to economists.

Back in the 1980s, both climate policy and science/innovation policy faced significant barriers moving forward. In each case, the main constituents who were holding up such policies were economists — they were trained in textbook tools of economics and had very strong influence throughout governments due to their ability to frame arguments. In the case of climate policy, while the science pushed for action, the big unknown was precisely what the economic cost of mitigating greenhouse gases would be. In the case of innovation policy, while the costs were known, the big problem was what the return would be. Thus, for each type of policy, economists who had won the push for cost-benefit analysis in government, were able to point out — somewhat accurately — that one-side of the equation was missing in each case. My personal opinion is that uncertainty should not necessarily be a barrier to action but when it comes to dealing with policy advocacy uncertainty is a weapon that can be used by special interests to generate inaction and, at the time, economists were the, perhaps unwitting, wielders of that weapon.

Let me start will Bill Nordhaus. If we choose to mitigate greenhouse gas pollution, it will impact all manner of activity in the economy. From energy to food production to transportation networks, the effects would be widespread and profound. They would impact on different regions differently. In other words, the economic impact was complex and hard to think through. And there was a possibility the costs could be overwhelming.

What Nordhaus did was embed climate change and climate policy into our general equilibrium models of economic growth. He then found ways to quantify the costs that everyone was hitherto conjecturing about. As it turned out, the costs were significant but nowhere near the doomsday assertions that interested parties opposed to climate policy were claiming. Even without technological change, there were existing ways economies could adapt to climate policy and, in the process, self-limit the costs that many were worried about. It moved the debate away from economic assertion and I guess pushed interested parties from “reasonable” arguments to “denialism,” thereby, exposing their naked interests more clearly. While progress has been far from what we would want, the progress that has happened can be attributed to this critical work.

Moving on now to Paul Romer. I have known Paul for 30 years since I was a graduate student. I was deeply interested in economic growth as an undergraduate and felt it had been neglected and was fortunate to be doing my PhD soon after Paul’s work had been published. It drove my interest further and into the fields of innovation and entrepreneurship that I have worked on since. There was even a time I contemplated an offer to join Paul’s education startup but that is another story.

Romer’s contribution is the inventing of what has become termed, endogenous growth theory. The first real theories of economic growth — starting with Robert Solow and Trevor Swan — examined how investment could generate growth and found that it could not explain the growth we had seen over the past two centuries. The missing component was technological change but they had no theory of it. It was well-known that science and innovation were not costless and so such activity would likely be driven by markets, competition and prices just as other economic activity was. But it was also known that these activities were special in that they generated positive externalities although some returns could be internalised through the use of formal intellectual property protection. Many people knew this was the missing ingredient in growth as documented by David Warsh’s terrific history of economic thought (including the contributions of Romer). As an undergraduate in Australia, even I saw this piece of the puzzle and, without knowledge of Romer and others, wrote my thesis about it leading to my very first published article.

I wasn’t the only one. Phillipe Aghion, Peter Howitt, Gene Grossman and Elhanan Helpman all saw it too and made their own separate contributions to endogenous growth theory. Those models, however, still, in many respects, had a microeconomic flavour that meant their main contribution would be to an understanding of how competition (and its potential limitors including patents) would impact on innovation in a growth context. This is very important but it was not as closely related to the growth puzzle that Romer was tackling.

Romer took his time making progress. His PhD thesis led to some technical advances that showed it was possible to have a balanced growth path — consistent with what we knew about economic growth — and also have a role for increasing returns. But to do things properly, the standard assumption of perfect competition was not going to cut it. And so in 1990 Romer published his most famous paper that (a) put the foundations of growth on a model of monopolistic competition (as those in trade theory and economic geography had done previously) and (b) divided the economy into a real and an ideas sector (something that no one had really done). In so doing, the Romer model was able to articulate and identify the key determinants of the returns to innovation.

The first was that the returns to innovation were limited by competition. Even with perfect patents, knowledge itself would promote entry and compete both for profits and scarce resources that limit the returns to past innovation and, as a consequence, to future innovation itself. The second was that by allocating resources — particularly science and engineering human capital — to the production of ideas, those limitations could be mitigated and economic growth itself would accelerate. In other words, front and centre for the promotion of economic growth was the direct promotion of science. Yes, science had been seen as a public good before. But now science was firmly seen as an engine of economic growth. Things that promoted the creation and, importantly, diffusion of scientific research were not just like the arts — there for consumption — but instead were an economy and indeed world-wide force for economic prosperity. To be sure, identifying the precise returns to any particular project would be difficult. But the idea that it is was critical to have a system for science and innovation promotion was now on a solid foundation.

As a person who was closely involved in economic policy in Australia on both the environment and innovation, it is difficult to understate how important Nordhaus and Romer’s work were. They were present in every, single policy discussion and tipped the balance towards action in cases where there were significant barriers and hurdles. In so doing, each showed how a careful accounting of economic forces can lead to progress, reduce uncertainty and make the case. That is what ties these two together and I am very pleased to see the Nobel committee recognising this long and sustained contribution to our knowledge and discourse.

Kalle and me. Schumpeter, too.

[One of my intellectual heroes, Karl Marx, had his 200th birthday (May 5) this weekend. So I decided to reflect on his influence.]

My first encounter with Kalle was when I was still in (the equivalent of) high school. Things were heating up in (West) Germany around that time: students started marching against a “system” that had allowed atrocities abroad (Remember Vietnam, that last and long-lasting proxy battle of the Cold War?) and also at home where the old Nazis (Remember “Silver Tongue” Kiesinger?) were still very much in power and, it seemed, had adopted the Social Democrats (being themselves quite an old-boys network, although of another kind) via a Grand Coalition with him and his.

The suffocating stuffiness that still hung over Germany in the early sixties soon fell by the wayside, culturally as much as politically, and by the late sixties Kiesinger was gone and in the fall of 1969 that “traitor”, Willy Brandt, was German chancellor. People like Udo Lindenberg, and a number of the Krautrock and Schneeball groups, started to sing in German and it was not embarrassing. Alles klar auf der Andrea Doria! Keine Macht fuer Niemand! (Of course, all of these German bands had to fight the onslaught of bands from Great Britain and the United States … .) There were charismatic figures such as the informal leader of the extraparliamentary opposition, Rudi Dutschke, the Kommune 1  with its fun guerilla faction, and the no-fun guerilla of the Red Army Faction (Baader, Ensslin, Mahler, Meinhof, et al.) which soon after went from agitating to murder and brought about, in 1977, The German Autumn. There was also an emerging environmental movement in the seventies that did its fair share, and then some, to change the policy discourse in Germany for decades to come. All of this happened against the backdrop of a divided Germany, in a key theatre of the Cold War, where one part called itself the German Democratic Republic but was hardly that.

Around the same time (ca 1967 – 1970) my parents fought hard a battle of the roses that saw my (younger, by three years) brother’s life derailed (and him dead of an overdose a decade later) and me dropping out of school, leaving “home” prematurely, moving to the big city (well for me, that was what Bielefeld was then), and becoming part of the proletariat at age 18, working for about a year as warehouse worker and delivery driver for Thyssen-Schulte, before — after a few months of hitch-hiking through Europe –, I joined the army. I spent much of the next two years deep in the heart of conservative and catholic Bavaria (1972 – 1974), much of it in an alpine communication unit.  Quite an experience it was.

After the years in the military, I entered an experimental college back in Bielefeld, studying political economy, math, Russian, and Portuguese during 1974 – 1978. I also spent a couple of weeks in Oberhof, Thuringia (then part of the German Democratic Republic), on an all-expenses paid trip where I was taught the Socialist way of thinking in the morning and got to ski in the afternoon, with enough space left for plenty of drinking and carousing in the evenings. Paid by the Konsumgenossenschaft, the trip was the East-German Communist Party’s attempt to pry away from the West promising young things. I was not quite persuaded and did not take it up on the invitation.

It was during that first year in Bielefeld, and way before my trip to Oberhof, when I started reading Marx. In reading groups we slugged our way through The Communist Manifesto (quickly) and then (way more slowly) through Das Kapital, volume one.  Never quite finished it from what I vaguely recall. Not even close.  And, frankly, we all got quite bored reading it and had trouble buying into the promises of the discussion leaders that, in the end, it all would make sense. It did get me interested enough though that — when I entered that experimental college in Bielefeld — political economy was my choice of major, together with math. And it was there that I studied Marx’s work more carefully. And I was not the only one … several fellow students and teachers were into it … (a couple of the teachers being true armchair Marxists who thought that interpreting the world on a decent salary was good enough after all.)

I read a lot those years, often sitting in my small rented basement room in the Von-Ossietzky-Strasse until deep in the wee hours, sipping cheap Moroccan red wine, popping Adumbran to be able to sleep, with good old Brecht looking over my shoulder from a huge poster. Among the things I read – I can tell because I still have the marked-up copy — was Wygodski’s book, published in East Berlin in 1976, on how Das Kapital emerged from Marx’s early writings. Wygodski’s books were remarkable in that they showed how early some of Marx’s (and Engels’s) theories about society, economics, politics, and culture were fixed. There are interesting parallels here to how the ideas underlying Adam Smith’s Wealth of Nations emerged over decades of thinking about them. I also read Theorien über den Mehrwert, often called the fourth volume of Das Kapital which demonstrates that Marx knew his stuff and was indeed a first-rate historian of thought to start with. But of course, he was much more: Philosopher, sociologist, economist, political scientist, activist, agitator, …

As I progressed in my career, I lost sight of the insights to be found in Marx’s writings. With the fall of socialism, in the USSR and its satellite states in Central Europe, the evidence seemed to suggest that certain realizations of Marxian ideas (or what some people considered them) had overstayed their welcome. Of course, Marx’s ideas do live on these days in China where Xi Jinping just recently made clear the importance of The Communist Manifesto. Marx’s ideas havea also lived on in some academic branches such as sociology. The authors of the Wikipedia entry on Kalle seem to assert correctly that he is typically cited as one of the principal architects of modern social science. Even that curmudgeon of a historian, Schumpeter, who thought little of Adam Smith but can hardly be accused of having communist sympathies, was surprisingly positive about Marx, calling him a “first-rank economist” (History of Economics Analysis p. 224), among other laudatory names.  It was no coincidence that Schumpeter featured Marx prominently in Ten Great Economists. In contrast, Smith did not make the cut. Go figure.

Here are some selected excerpts from Schumpeter’s History of Economic Analysis (Perlman edition), for your easy perusal:

p. 370 Any economist who wishes to study Marx at all must resign himself to reading carefully the whole of the three volumes of Das Kapital and of the three volumes of Theorien über den Mehrwert.Fn

Further, there is no point whatever in tackling Marx without preparation. Not only is he a difficult author but, owing to the nature of his scientific apparatus, he cannot be understood without a working knowledge of the economics of his epoch, Ricardo in particular, and of economic theory in general. This is all the more important because the necessity for it does not show on the surface. Again, the reader must be on his guard against being misled by traces of Hegelian terminology. It will be argued below that Marx did not allow his analysis to be influenced by Hegelian philosophy. But he sometimes uses terms in their specifically Hegelian sense, and a reader who takes them in their usual sense misses Marx’s meaning.

Fn. The Communist Manifesto is also indispensable, of course. But for any purpose short of becoming a Marxologist, I think that nothing need be added except the Class Struggles in France, articles written in 1848–50, published as a book, with an introduction by Engels in 1895. Only the Marxologist need go into Marx’s correspondence.

p. 366 … nobody will ever understand Marx and his work who does not attach appropriate weight to the erudition that went into it—the fruit of incessant labor that, starting from primarily- philosophical and sociological interests in his early years, was concentrated increasingly on economics as time went on, until his working hours were all but monopolized by it. Nor was his the kind of mind in which scholarly coal puts out the fire: with every fact, with every argument that impinged upon him in his reading, he wrestled with such passionate zest as to be incessantly diverted from his main line of advance. On this I cannot insist too strongly. This fact would be my central theme were I to write a Marxology. Perusal of his Theorien über den Mehrwert suffices to convince one of it. And, once proved, it serves to establish in turn another fact and to solve a much discussed riddle: it serves to establish that he was a born analyst, a man who felt impelled to do analytic work, whether he wanted to or not and no matter what his intentions were; … our information warrants the statements that he was very much a philosopher dabbling in sociology and politics (as do so many philosophers) until he went to Paris; that there he quickly made headway and found his feet as an economist; and that by the time he and Engels wrote the Communist Manifesto (1847; published 1848); that is to say, at the age of 29,7 he was in possession of all the essentials that make up the Marxist Social Science, the only important lacunae being in the field of technical economics. For the rest, the main line of his intellectual life may be described as a series of efforts to work out that Social Science and to fill those lacunae—tasks which, I believe, Marx did not expect would involve any insurmountable difficulties, though he did expect that a great deal of further work would be required to straighten out and co-ordinate everything that was to find a place within the vast structure.

p. 33 Half a century before the full importance of this phenomenon [ideological bias, AO] was professionally recognized and put to use, Marx and Engels discovered it and used their discovery in their criticisms of the ‘bourgeois’ economics of their time. Marx realized that men’s ideas or systems of ideas are not, as historiography is still prone to assume uncritically, theprime movers of the historical process, but form a ‘superstructure’ on more fundamental factors, as will be explained at the proper place in our narrative. Marx realized further that the ideas or systems of ideas that prevail at any given time in any given social group are, so far as they contain propositions about facts and inferences from facts, likely to bevitiated for exactly the same reasons that also vitiate a man’s theories about his own individual behavior. That is to say, people’s ideas are likely to glorify the interests and actions of the classes that are in a position to assert themselves and therefore are likely to draw or to imply pictures of them that may be seriously at variance with the truth. … Such systems of ideas Marx called ideologies.4 And his contention was that a large part of the economics of his time was nothing but the ideology of the industrial and commercial bourgeoisie. The value of this great contribution to our insight into the processes of history and into the meaning of social science is impaired but not destroyed by three blemishes, …

p. 20 … an economics that includes an adequate analysis of government action and of the mechanisms and prevailing philosophies of political life is likely to be much more satisfactory to the beginner than an array of different sciences which he does not know how to co-ordinate—whereas, to his delight, he finds precisely what he seeks ready-made in Karl Marx. An economics of this type is sometimes presented under the title Political Economy.  …

p. 363 The difficulty is that in Marx’s case we lose something that is essential to understanding him when we cut up his system into component propositions and assign separate niches to each, as our mode of procedure requires. To some extent this is so with every author: the whole is always more than the sum of the parts. But it is only in Marx’s case that the loss we suffer by neglecting this2 is of vital importance, because the totality of his vision, as a totality, asserts its right in every detail and is precisely the source of the intellectual fascination experienced by everyone, friend as well as foe, who makes a study of him. Marx figures in this book only as a sociologist and an economist. Of course, that creed-creating prophet was much more than this. And his creed-creating activity, on the one hand, and his policy-shaping and agitatorial activity, on the other hand, are inextricably interwoven with his analytic activity. So much is this the case that the question arises whether he can be called an analytic worker at all. This question may be answered in the negative from two very different standpoints.  …

p. 364 My answer to our question is, however, in the affirmative. The warrant for this affirmative answer is in the proposition that the bulk of Marx’s work is analytic by virtue of its logical nature, for it consists in statements of relations between social facts. For instance, the proposition that a government is essentially an executive committee of the bourgeois class may be entirely wrong; but it embodies a piece of analysis in our sense, acceptance or refutation of which is subject to the ordinary rules of scientific procedure. It would be absurd indeed to describe the Communist Manifesto, in which this proposition occurs, as a publication of scientific character or to accept it as a statement of scientific truth. It is not less absurd to deny that, even in Marx’s most scientific work, his analysis was distorted not only by the influence of practical purposes, not only by the influence of passionate value judgments, but also by ideological delusion. Finally, it would be absurd to deny the difficulty that in some cases rises to impossibility of disentangling his analysis from its ideological element. But ideologically distorted analysis is still analysis. It may even yield elements of truth. …

To sum up: … we simply recognize him as a sociological and economic analyst whose propositions (theories) have the same methodological meaning and standing and have to be interpreted according to the same criteria as have the propositions of every other sociological and economic analyst; we do not recognize any mystic halo.

p.367 The ‘pieces’ divide up into two groups, one sociological and the other economic. The sociological pieces include contributions of the first order of importance such as the Economic Interpretation of History, which, as I shall argue, may be considered as Marx’s own, quite as much as Darwin’s descent of man is Darwin’s own. But the rest of Marx’s sociology—the sociological framework that, like every economist, he needed for his economic theory—is neither objectively novel nor subjectively original. His preconceptions about the nature of the relations between capital and labor, in particular, he simply took from an ideology that was already dominant in the radical literature of his time. If, however, we wish to trace them further back, we can do so without difficulty. A very likely source is the Wealth of Nations. A.Smith’s ideas on the relative position of capital and labor were bound to appeal to him, especially as they linked up with a definition of rent and profits—as ‘deductions from the produce of labour’ (Book I, ch. 8, ‘Of the Wages of Labour’)—that is strongly suggestive of an exploitation theory. But these ideas were quite common during the enlightenment and their real home was France. French economists, ever since Boisguillebert, had explained property in land by violence, and Rousseau and many philosophers had expanded on the subject. There is, however, one writer, Linguet, who, more explicitly than others, drew exactly the picture that Marx made his own: the picture not only of landlords who subject and exploit rural serfs, but also of industrial and commercial employers who do exactly the same thing to laborers who are nominally free, yet actually slaves.This sociological framework offered most of the pegs that Marx needed in order to have something upon which to hang his glowing phrases. And since historians are primarily interested in these, no matter whether they admire them or are shocked by them, it is difficult to gain assent to what is the obvious truth about the nature of thepurely economic pieces of the Marxist system. This obvious truth is that, as far as pure theory is concerned, Marx must be considered a ‘classic’ economist and more specifically a member of the Ricardian group. Ricardo is the only economist whom Marx treated as a master. I suspect that he learned his theory from Ricardo. But much more important is the objective fact that Marx used the Ricardian apparatus: he adopted Ricardo’s conceptual layout and his problems presented themselves to him in the forms that Ricardo had given to them. No doubt, he transformed these forms and he arrived in the end at widely different conclusions. But he always did so by way of starting from, and criticizing, Ricardo—criticism of Ricardo was his method in his purely theoretical work.

p.369 … admit that Marx could ever grow out of date in any respect. However, in order to drive home a point that seems important, I have strictly confined myself in the preceding paragraph to Marx’s theoretical technique. But there are two features of Marxist theory that transcend technique. And these were not period-bound. The one is his tableau économique. In his analysis of the structure of capital, Marx developed Ricardo once more. But there is an element in it that does not hail from Ricardo but may hail from Quesnay: Marx was one of the first to try to work out an explicit model of the capitalist process. The other is still more important. Marx’s theory is evolutionary in a sense in which no other economic theory was: it tries to uncover the mechanism that, by its mere working and without the aid of external factors, turns anygiven state of society into another.

p.408 … the period’s great performance in the field of political sociology stands in the name of Karl Marx. …  I wish merely to say by way of anticipation that Marx’s theories of history, of social classes, and of the state (government) constitute, on the one hand, the first serious attempts to bring the state down from the clouds and, on the other hand, the best criticism, by implication, of the Benthamite construct. Unfortunately, this scientific theory of the state, like so much else in Marxist thought, is all but spoiled by the particularly narrow ideology of its author. What a pity, but at the same time, what a lesson and what a challenge!

p.413 [Marxist Evolutionism] I have just adverted to the possible implications for sociology that a despiritualized Hegelian philosophy might harbor. This suggests that here we have after all more than a phraseological influence of Hegel upon Marx. If, nevertheless, we maintain substantive autonomy of Marx’s so-called Materialistic Interpretation of History as against Hegelism, and if we list it as a separate type of evolutionism, we allow ourselves to be guided by two considerations. First, Marx’s theory of history developed independently of Marx’s Hegelian affiliation. We know that his analysis started from a criticism of the current (and apparently immortal) error that the behavior that produces history is determined by ideas (or the ‘progress of the human mind’), and that these in turn are infused into actors by purely intellectual processes. To start with this criticism is a perfectly sound and very positive method but has nothing to do with Hegelian speculation. Second, Marx’s theory of history is a working hypothesis by nature. It is compatible with any philosophy or creed and should therefore not be linked up with any particular one—neither Hegelianism nor materialism is necessary or sufficient for it. What remains is, again, Marx’s preference for Hegelian phrasing—and his own and most, though not all, Marxists’ preference for anything that sounds anti-religious.

p.414 Both the achievement embodied in that hypothesis and the limitations of this achievement may be best conveyed by means of a brief and bald statement of the essential points. (1) All the cultural manifestations of ‘civil society’—to use the eighteenth-century term—are ultimately functions of its class structure.8 (2) A society’s class structure is, ultimately and chiefly, governed by the structure of production (Produktionsverhältnisse), that is, a man’s or a group’s position in the social class structure is determined chiefly by his or its position in the productive process. (3) The social process of production displays an immanent evolution (tendency to change its own economic, hence also social, data). To this we add the essential points of Marx’s theory of social classes, which is logically separable from points (1) to (3) that define the economic interpretations of history but forms part of it within the Marxian scheme. (1′) The class structure of capitalist society may be reduced to two classes: the bourgeois class that owns, and the proletarian class that does not own, the physical means of production, which are ‘capital’ if owned by employers but would not be ‘capital’ if owned by the workers who use them. (2′) By virtue of the position of these classes in the productive process, their interests are necessarily antagonistic. (3′) The resulting class struggle or class war (Klassenkampf) provides the mechanisms—economic and political—that implement the economic evolution’s tendency to change (revolutionize) every social organization and all the forms of a society’s civilization that exist at any time. All this we may sum up in three slogans: politics, policies, art, science, religious and other beliefs or creations, are all superstructures (Überbau) of the economic structure of society; historical evolution is propelled by economic evolution; history is the history of class struggles.

This is as fair a presentation of Marx’s social evolutionism as I am able to provide in a nutshell. The achievement is of first-rank importance although the elements that enter into it are of very unequal value or, rather, unequally impaired by obvious ideological bias. … … the economic interpretation of history … . If we reduce it to therole of a working hypothesis and if we carefully formulate it, discarding all philosophical ambitions that are suggested by the phrases Historical Materialism or Historical Determinism, we behold a powerful analytic achievement. Points (1) and (3) may then be defended against objections, most of which turn out to rest upon misunderstandings. We have reached a point of vital importance for a proper understanding of Marx’s work. … we can now visualize his unitary Social Science, the only significant all-comprehensive system that dates from this side of utilitarianism: we see the manner and the sense in which he welded into a single homogeneous whole all branches of sociology and economics—a venture that might well dazzle the modern disciple even more than it dazzled Engels, who stood too near the workshop. .. Here I wish only to insist on the greatness of the conception and on the fact that Marxist analysis is the only genuinely evolutionary economic theory that the period produced.14 Neither its assumptions nor its techniques are above serious objections—though, partly, because it has been left unfinished. But the grand vision of an immanent evolution of the economic process— that, working somehow through accumulation, somehow destroys the economy as well as the society of competitive capitalism and somehow produces an untenable social situation that will somehow give birth to another type of social organization—remains after the most vigorous criticism has done its worst. It is this fact, and this fact alone, that constitutes Marx’s claim to greatness as an economic analyst.

Some of Marx’s insights have stayed with me,. Here is a list of ten great insights and phrases, straight from the horse’s mouth. Memorable, and still rather pertinent.

10. “The philosophers have only interpreted the world, in various ways. The point, however, is to change it.” [These words are also inscribed upon his grave]” (Eleven Theses on Feuerbach)

9. “There is no royal road to science, and only those who do not dread the fatiguing climb of its steep paths have a chance of gaining its luminous summits.” (Capital, Vol 1: A Critical Analysis of Capitalist Production)

8. “The tradition of all dead generations weighs like a nightmare on the brains of the living.” (The Eighteenth Brumaire of Louis Bonaparte)

7. “In the social production of their existence, men inevitably enter into definite relations, which are independent of their will, namely relations of production appropriate to a given stage in the development of their material forces of production. The totality of these relations of production constitutes the economic structure of society, the real foundation, on which arises a legal and political superstructure and to which correspond definite forms of social consciousness. The mode of production of material life conditions the general process of social, political and intellectual life. It is not the consciousness of men that determines their existence, but their social existence that determines their consciousness. At a certain stage of development, the material productive forces of society come into conflict with the existing relations of production or – this merely expresses the same thing in legal terms – with the property relations within the framework of which they have operated hitherto. From forms of development of the productive forces these relations turn into their fetters. Then begins an era of social revolution. The changes in the economic foundation lead sooner or later to the transformation of the whole immense superstructure.” (A Contribution to the Critique of Political Economy)

6. “It is not the consciousness of men that determines their being, but, on the contrary, their social being that determines their consciousness.” (A Contribution to the Critique of Political Economy)

5. “The ideas of the ruling class are in every epoch the ruling ideas, i.e. the class which is the ruling material force of society, is at the same time its ruling intellectual force. The class which has the means of material production at its disposal, has control at the same time over the means of mental production, so that thereby, generally speaking, the ideas of those who lack the means of mental production are subject to it. The ruling ideas are nothing more than the ideal expression of the dominant material relationships, the dominant material relationships grasped as ideas.” (The German Ideology)

4. “The history of all hitherto existing society is the history of class struggles.

Freeman and slave, patrician and plebeian, lord and serf, guildmaster and journeyman, in a word, oppressor and oppressed, stood in constant opposition to one another, carried on an uninterrupted, now hidden, now open fight, that each time ended, either in the revolutionary reconstitution of society at large, or in the common ruin of the contending classes.” (The Communist Manifesto)

3. “Modern bourgeois society with its relations of production, of exchange, and of property, a society that has conjured up such gigantic means of production and of exchange, is like the sorcerer, who is no longer able to control the powers of the nether world whom he has called up by his spells.” (The Communist Manifesto)

2. “Let the ruling classes tremble at a Communistic revolution. The proletarians have nothing to lose but their chains. They have a world to win. Workingmen of all countries unite!” (The Communist Manifesto)

1. “Religion is the sigh of the oppressed creature, the heart of a heartless world, and the soul of soulless conditions. It is the opium of the people.” (A Contribution to the Critique of Hegel’s Philosophy … )

Prediction Machines

My book with Ajay Agrawal and Avi Goldfarb is out now. It is called Prediction Machines: The Simple Economics of Artificial Intelligence.

We have written some pieces that provide little excursions into the book.

Also, we had a book launch and a video of it is available here.

Suffice it to say, if you like the material in this blog, it is a safe bet that you or your robot partner will like this book.

Ethical failures: Where they come from and how to address them

A review of

Gentilin, Dennis. The Origins of Ethical Failures. Lessons for Leaders. A Gower Book. Routledge (2016). ISBN: 978-1-138-69051-6

Ethical failures were in the press big-time in 2017. Prominently, creeps like Harvey Weinstein, James Toback, Bill Cosby, Larry Nassar, etc. were accused of sexual transgressions of various sorts (and in some cases admitted them to varying degrees). The sheer number of accusations leaves little doubt that, in their substance, they are correct. One thing that was truly shocking, on top of the specifics of many of the allegations, was that some of these transgressions went on for literally decades, that many people seem to have known about them for years (if not decades), and that the perpetrators did get away with them for an unconscionably long time. It is clear that organizational failures must have played a major role. This was implicitly acknowledged in the name of  The Royal Commision (RC) into Institutional Responses to Child Sexual Abuse, established under the Gillard government in 2013 and which reported all 17 volumes of its findings on December 15, 2017. The RC also laid out recommendations.

It did not really come as a surprise that once again massive organizational failure, in particular of the Catholic Church, was identified as a major finding. It did not come as a surprise because for years there had been a never-ending stream of trials, not just in Australia, suggesting just that, and providing plenty of evidence that the Catholic Church – in its (continued) belief that it is a law and world unto itself — had engaged for decades in what might generously be called economy with the truth.

Two weeks earlier, after another year of numerous reports of questionable practices, and record profits of the four major banks, the Turnbull government saw itself forced — by its own backbenchers, no less — to announce that it would establish a RC into misconduct in the banking industry. It was a step that Labor and the Greens had urged for more than a year. (The recent draft report of the Productivity Commission has made clear that some such RC is indeed overdue.) The Turnbull government’s acceptance of something that it could not prevent, and its subsequent attempts to undermine the effectiveness of the RC by simultaneously widening its scope and imposing an essentially unrealistic timeline, demonstrates, at the minimum, the kind of myopic opportunism that Australian politics seems drenched in.

Having graduated in 2001, Gentilin became a member of the FX trading desk of the National Australian Bank (NAB), one of the four major banks.  In 2004 that trading desk became involved in a trading scandal that rocked NAB and led, within a couple of weeks, to the resignation of both its chairman and CEO, the reconfiguration of the board of directors, and significant financial and reputational losses. Gentilin was the young trader who blew the whistle. Contrary to many other whistleblowers (who are typically harrassed out of the organizations on which they blew the whistle), he stayed with NAB for more than a decade – as head of the institutional sales team and a member of the corporate strategy team — before he resigned in January 2016 to found Human Systems Advisory, a name meant to be programmatic. The foreword of his book was written by the current chairman of NAB who states: “There are no simple answers in this book. But there are answers. And there are important truths, supported by deep and rigorous analysis. These should be of interest to all corporate leaders, in both executive and non-executive roles.” (p. xvi).   One such truth, says the chairman – apparently quoting Gentilin – is that “leaders must strive to articulate a meaningful social purpose for their organizations that is underpinned by a virtuous set of values.” That’s quite a mouthful, and the impending Royal Commission on the banking system suggests strongly that the major banks (that tried at first to fight off the RC until they realized that fight had been lost) have continuing trouble to understand that particular message, as does the recent draft of the related Productivity Commission report.

Below, I am interested in both the depth and rigor of the analysis and the truths that Gentilin establishes.  I am also interested in the implementability of the measures that he proposes.

In his Introduction, Gentilin states that he draws his evidence from “behavioural business ethics” which he defines as the intersection of business ethics and psychology (p. 5). While he is credited on his website with a degree in psychology, Gentilin makes clear that he wrote this book as a “practitioner” rather than “an academic, a philosopher or an ethicist” (p. 4). He does so in four chapters that explore “The Power of Context”,  “Group Dynamics”,  “Our Flawed Humanity”, and “What We Fail to See”.  A conclusion follows.

Gentilin relies heavily on summaries of articles from psychology that explore human nature and the circumstances under which nice behaviour might turn into, well, not so nice behaviour of different shades. While there is brief perfunctionary nod (p. 3) to the replicability crisis that has afflicted psychology, throughout the book there is little discussion of relevant laboratory design and implementation issues such as incentivisation, experimenter expectancy effects, external validity, and so on (Hertwig & Ortmann 2001; Ortmann 2005). Never mind the fact that much of the evidence on unethical behaviour paraded in this book has been produced with deceptive practices, arguably an unethical practice itself (Ortmann & Hertwig 2002; Hertwig & Ortmann 2008). There is no discussion of statistical issues such (lack of) power computations, p-hacking, publication biases, and what not here either.

Claiming that “explanations of unethical conduct rarely give proper consideration to the system within which people operate … (and) tend to focus on identifying ‘bad apples’ or ‘rogues’” (p. 7), in Chapter 1, Gentilin explores how the environment can impact human (mis)behaviour and, on balance, concludes that “the ‘barrel’ within which the ‘bad apples’ operate must be given as much (if not more) attention as the ‘bad apples’ themselves.” (p. 8). Before he reviews the lessons to be learned from the Stanford Prison Experiment, Gentilin reviews literature on social norms and how they affect behaviour.  The well-known Cialdini et al. littering and Mazar et al. (dis)honesty studies are paraded, as is an interesting lab study by MacNeil & Sherif (1976) in which the authors demonstrate generational transfer of (questionable) practices, and a related field study by Pierce & Snyder (2008). Distinguishing between descriptive (“derived from what is”) and injunctive (“derived from what ought to be”) norms, Gentilin documents cases where unethical descriptive norms tear to smithereens injunctive ones. He relates this to his reading of what led to the FX trading scandal at the NAB: “young people in particular are vulnerable and endorsing immoral social norms … In the FX trading scandal that engulfed the NAB, immoral social norms emerged that promoted excessive risk taking and misstating the true value of the currency options portfolio.” (pp. 18 – 19). This is hardly surprising, and indeed Gentilin mentions the LIBOR rate-fixing scandal and the professional cycling drug-taking as other high-visibility events. He could have also mentioned the lending practices of major US banks before the housing and mortgage crises (e.g., Gjerstad & Smith 2014), the despicable transgressions at Abu Ghraib, or zillions of other real-world examples.  After having reviewed the Stanford Prison experiment in some detail, Gentilin identifies two important take-home lessons from it: first, a specific context “can cause people of sound character to behave in totally uncharacteristic and inappropriate ways.” (p. 24) and, second, the emergence of such contexts is possible only when leaders allow it. Drawing on more experimental evidence (such as Bandura’s children imitating adults’ behaviour experiments), he suggests the obvious parallel for what happened at NAB: “Just as the adults were the role models in Bandura’s experiments, leaders that control the bases of power are the role models in large organizations. For these leaders there will inevitably appear some key moments where, through their actions, choices and decisions, they will send powerful messages that shape the ethical climate for their organizations and types of social norms that emerge.  … how a leader responds in these ‘defining moments’ shapes the ‘character of their companies’.” (p. 30). Only leaders who are veritable role models will be able to prevent formal mechanism being eroded by informal mechanisms that hammer away at them. Again, Gentilin suggests that such failure of leadership is what happened at NAB and at the Barclays Bank during the LIBOR rate-fixing schedule, and for that matter in the phone-hacking scandal that led to the demise of News of the World. Gentilin concludes the chapter with a list of “ten questions for senior leaders within any organization” (pp. 37 – 38). Presumably, these questions are unlikely to be answered in an honest manner where it matters. It is the evidence accumulated in this chapter but also elsewhere (Dana et al. 2007 comes to mind, or Miller & Ross 1976) that suggests that much.

Gentilin starts off Chapter 2 with a Nietzsche quotation that sets the stage: “Madness is the exception in individuals but the rule in groups.” (p. 45). The basic point made is that group membership can reinforce – cue social media echo chambers – the drifting away from injunctive norms to descriptive ones. Writes he: “In my experience at the NAB, dysfunctional group dynamics in the currency options business played a significant role in promoting the emergence and maintenance of immoral social norms and unethical behaviour [such as flagrant and persistent limit breaches or excessive risk taking, AO]”.  To buttress the case, Gentilin presents Milgram’s 1974 obedience studies, as well as Gina Perry’s recent critique of them (Perry 2012) which, in light of considerable supporting evidence of the original studies (e.g., Haslam et al. 2014), he dismissesin their substance. He then highlights what we learn from Milgram’s inclusion of a variation that drew on the group paradigm.  That motivates a discussion of the conformity experiments through which Asch (1956) tried to identify the conditions under which participants would contradict a majority.  In this context, Gentilin also briefly discusses a between-subjects study by Woodzicka & LeFrance (2001) who had a male interviewer ask female applicants inappropriate questions. The basic result was that 6 out of 10 subjects claimed they would object (hypothetically) but none in the control group refused the answer in a “real-life” scenario.  That seems the kind of pattern that allowed the Weinsteins of this world to get their way for too long. Only in the case of Weinstein and similar assholes (here used in the technical sense of Sutton 2007), the stakes were arguably considerably higher. People’s lack of willingness to stand up and be counted is, unfortunately, so widespread that it is well documented and it is a recurrent theme of great movies such as Hidden Figures.  Gentilin makes clear that, based on his experience at NAB, “facing the fork in the road in a hypothetical scenario is vastly different from facing it in reality.” (p. 67) He also states, “I am personally sceptical of other research into whistleblowing that focuses on ascertaining the types of personality or dispositional characteristics that may predict whether an observer of wrongdoing will take action and report it. …This line of enquiry fails to properly consider the power of the situation.” (p. 67). Gentilin concludes the chapter with another list of “ten questions for senior leaders (and followers) within any organization” (pp. 73). I doubt that these questions will be answered in an honest manner where it matters, for essentially the exact reason that Gentilin has identified in the chapter.

In Chapter 3, Gentilin – notwithstanding his, in my considered opinion, sensible stand on the relative importance of context and dispositional characteristics – dives into “our flawed humanity”. Programmatically, he starts with an epigraph featuring a quotation from Kant, “Out of the crooked timber of humanity, no straight thing has ever been made.” (p. 80).  Gentilin then tries to answer questions such as “Are Humans Self-Interested?”, cursorily sampling evidence from experimental economics, neuroscience, and evolutionary biology. Predictably he concludes that this research shows that “human nature (is) far different from the one suggested by the axiom of self-interest” (p. 86), though he qualifies the statement with the caveat that we are not always altruistic and cooperative.  This alleged “paradigm shift” (p. 87) is, unfortunately, the major bone of contention between those marketing Behavioural Economics (and often shamelessly benefitting from it) and those doing Experimental Economics, and I believe that the social-preferences literature that has created it has as much merits as the IN oxytocin, ego depletion, and power poses research now, for all I can see, thoroughly debunked. Better not plan your life, or organization, on such flimsy evidence. From an evidence point of view, and also a theory point of view (e.g., the important insights stemming from repeated game situations), this chapter is the weakest.  Gentilin’s sampling of the evidence strikes me as scattershot and unsystematic. After discussions of issues such as power and its corrupting influence and fear and awareness of our own mortality that feeds into it, Gentilin concludes the chapter with a list of “eleven questions for senior leaders within any organization” (pp. 118)  I fear, these questions, again, are unlikely to be answered in an honest manner where it matters.

In Chapter 4, Gentilin starts with a quotation from Kahneman’s best-seller Thinking Fast and Slow: “We can be blind to the obvious, and we can also be blind to our blindness.”  This double-whammy – a variant of the Dunning – Krueger effect — is why questions to senior leaders are unlikely to be answered honestly and self-critically.  After a brief mention of another persistent bone of contention – the System 1 / System 2 delineation  – and our alleged propensity to rely too much on automatic system 1 which makes us, presumably, liable to various biases (in this chapter loss aversion, framing, overconfidence, moral disengagement, euphemistic labelling), Gentilin lays out the slippery-slope argument that in his view was at the heart of the events that led to the NAB trading scandal: “The FX trading incident at the NAB classically illustrated the slippery slope in action. Not only did ethical standards erode over time, but the seriousness of the ethical transgressions accelerated … “ (p. 130). Laboratory evidence is provided to  make that point (e.g., the interesting Gino & Bazerman 2008 study) along with field evidence from the NAB case (pp. 131). An intervention discussed here is to give people more time and essentially get them to break out of their System 1 mode: “There are now numerous studies that illustrate how providing a person with more time whenever they are confronted with an ethical dilemma tends to lead to a more virtuous decision being made.” (pp. 146-7). I have serious doubt about the relevance of, say, the Good-Samaritian study mentioned here for real-world decision making and suspect that a theoretical grounding in organizational economics and repeated game theory would really help to address the challenges that organizations and their leaders face.

Gentilin concludes his book with a plea for more (business ethics) education, a call for the installation of Chief Ethics Officers, and more Lessons for Leaders. He wants business schools to challenge their students intellectually, emotionally, and spiritually. That sounds like something straight out of a high-gloss advertisement such schools produce. The reality, however, of Australian business schools (and undoubtedly business schools everywhere) is that they are rarely intellectually demanding. Their inability to challenge their students emotionally and spiritually is shown effectively by their treatment of casuals and staff. What business schools typically do not have are, in particular, truly independent ethics officers, and HR departments, that could hold the feet of currently widely unaccountable senior leadership to the fire. So, while the idea of a Chief Ethics Officer, who has “a genuine ‘seat at the table’” (p. 161), and is independent, able to freely raise matters of concern, and able to freely “speak truth to power” (p. 161), is conceptually on the money, realistically it is very unlikely to be implemented any time soon, as are truly independent HR departments. As to Lessons for Leaders, Gentilin wants them to be virtuous in the sense of having some community-oriented values.  There is a lot of wishful thinking on display here (e.g., that others are willing to take the same risks that he took in 2004) but I think, after everything we learned through the flurry of recent examples mentioned at the beginning of this review, there is not much reason for hope. Even something that should have been uncontroversial, such as the Royal Commission on banking, and the way it came about, demonstrates that common ground is hard to find and cannot be relied on. I fear much harder thinking will be needed to address ethical failures and I fear some strategies will be of the innovative kind provided by the #MeToo campaign that not only has brought down some true monsters but is likely to have changed power and gender relations in the working world irreversibly.

In summary then, Gentilin tackles arguably the most important issue of our times – ethical failures within organizations and for that matter ethical failures more generally. His book is strongest where he illustrates the emergence of his insights with examples from his own NAB 2004 experience. His illustration of various arguments he makes with evidence from behavioural business ethics is wanting. As pointed out above, to his credit Gentilin himself – although unaware of important methodological debates among psychologists as well as between psychologists and economists – grasps intuitively the lack of external validity of some of the evidence that he presents and it is clear that his NAB 2004 experience has been a good guide to identify which laboratory evidence has some external validity, and which does not. I think the book could be considerably improved with a more even-handed and complete assessment of the evidence from psychology and other social sciences (and here in particular economics) as well as an additional focus on incentive-compatible organizational design.  To rely on business ethics education in business schools (whether in Australia or elsewhere) or a sense of community oriented-ness of business leaders is just not going to cut the mustard, as the widely perceived need for the Royal Commission in the banking system demonstrates.

Having recently interacted with NAB, once again, with mortgage related issues, I have no doubt that NAB culture is pervaded with everything but a meaningful social purpose that is underpinned by a virtuous set of values (e.g., the loan officer I dealt with did everything to prevent me from comparison shopping, and essentially gave me misleading information about the rates that I would be getting), and I have little doubt that the same applies to each of the other three major banks. There is a reason why the major banks in Australia have had outsized profits and some of the highest returns on equity in the world. The recent draft of the related Productivity Commission report spells them out.

 

I appreciate Dennis Gentilin’s comments on a draft of this review.

 

How to tax the platform economy?

In the engine room of nation states, ie the tax departments, the coming battle with platform providers is taking shape. Uber, airbnb, facebook, linkedin, ebay, jobseek, and a myriad of specialised platform providers facilitate micro-trades that are largely untaxed by the authorities. In stead, the platform providers themselves take a cut, partially via advertising and partially via a direct fee for their services. They have taken over an activity that has mainly been provided by governments in the past: places to trade. The town square, the stock exchange, public infrastructure, and the unemployment office are relics of a past where governments were market providers that facilitated trades. Now, it is largely private companies with tax-avoidance structures that have taken on this role on the internet. That role is set to expand hugely.

This is a crucial battle that, so far, the tax authorities are losing because they have not yet grasped the magnitude of the shift. They lack the key new power that they must attain: the power to deny the operation of a platform provider in their country.

At the moment, tax authorities around the world, lead by the Scandinavians whose tax needs are high, are going the usual ‘reporting route’. They are trying to get Uber, Airbnb, and all the other ones to report the trades and the value of the trades that they have facilitated. Understandably, these companies are refusing to play ball because they of course are taxing the same trades themselves in a different way. They are competing with national tax authorities and hence their business model depends on tax evasion, so of course they refuse to help their competitors. Their lawyers make millions from refusing to play ball. The horror example for these companies is the 2015 data on Uber that had to be released to the Dutch tax authorities and that was subsequently shared with Denmark which promptly went after the drivers for added tax payments. This reflected the circumstance that the administration of Uber was in the Netherlands at that time, which allowed the Dutch to force Uber to hand over some of their data, a mistake Uber wont make again. The others too will have learned a salutary lesson from that episode.

Frustrated, the tax authorities are turning to pretty hopeless measures, such as new international treaties on the reporting of micro-trades by private entities. In a race to the bottom between countries trying to attract large companies, that is just a hopeless avenue where the authorities will always be many steps behind the tax-advisers of the big trading platforms.

What are the next moves we might then see when the tax authorities get up to speed? I think two developments are likely: full internet observation by national agencies and government-lead internet firms.

Full internet observation follows the model of China, which now has the capacity to track most of the internet activity of most of the population. That allows it to observe the trades facilitated on internet platforms, which in turn can be used for tax purposes. Those observations can be used to directly go after individual traders or can be used to go after the platform providers, simply by making their activities illegal if the platforms do not assist in tax observations. Adopting the China route would spell the end of internet privacy, but it probably works. And tax is such a key part of the nation state that it in the end trumps privacy concerns.

The second possibility is for the government to re-enter the market for platforms and set up its own internet firms for micro-trades and social media. It can simply copy the best examples on the internet for how to set these things up. The transition will come with losses, but authorities can appeal to national pride to get support from their populations and companies cannot compete with that. For micro-trades within a country or tax region (the US and, in the future, the EU) that should work. For international trades, one should expect more difficulties because government-backed firms from different countries might then directly compete with each other, which in turn might lead to competency battles and new dispute resolution mechanisms.