Oliver Hart and Bengt Holmstrom Share the 2016 Nobel Price in Economics

The Nobel committee announced today that for their work in contract theory Oliver Hart and Bengt Holmström won the 2016 Sveriges Riksbank Prize in Economic Science in Honor of Alfred Nobel. Charles Duxbury and Mike Bird report on it in the Wall Street Journal today. Moreover the Journal reported in a video:

Evan Peterson, "Why Bengt Holmström, is An Economist You Should Know," Open Markets, October 21, 201.

Will Airbus Give Up on the A380?

 Two strategic bets
When Boeing committed to the Dreamliner (AKA the B787), it made a very different strategic bet from Airbus which had made its own huge bet on the A380.  Both manufacturers forecast world traffic growth of near 5% per year over twenty years.  The demand for planes is a demand derived from air travel. Thus the straegic question:  How were the duopolists' customers–the world's airlines–going to meet a doubling of passenger miles/kilometers in less than two decades? 

Two different answers
Airbus decided they airlines would move more people through the key international hubs with a bigger jumbo jet that would increase those hubs' throughput capacity.  Their solution was the A380 which could both fly 8-10,000 nautical miles and hold up to 950 people. The massive size of the plane would also allow it to be marketed with a smaller seating capacity and hitherto undreamed of luxuries like an airborne gym, three cocktail lounges, and other amenities.

Boeing predicted that the world's airline would meet the growing demand with more point-to-point flights.  The Dreamliner would have a similar long range, but would hold only 250-350 passengers.  Boeing bet the airlines would try to attract their most lucrative customers with direct flights maximizing the time value of flying executives rather than the luxury that also required large numbers of the unwashed masses to meet load factors. Boeing also committed later than Airbus and may have gone to school on the European's putt.


With hindsight is there a winner?
So are the results in yet?  No, but there is preliminary evidence Boeing may have made the better bet.        
So far Airbus has failed to get a single new buyer this year.  And now in this video, Bloomberg's Benedikt Kammel suggests Airbus's might discontinue its A380 superjumbo as soon as 2018.  

Has Airbus misjudged the market? 


(Source: Bloomberg, Dec. 11)

Surprise: Institutions Matter and Ours Are going Downhill!

The decline of America's institutions, and the related rise in red tape that hinders business, may spell the nation's economic doom. Harvard's Niall Ferguson talks to WSJ's Charles Forelle about the theory outlined in his new book The Great Degeneration (Penguin Press, 174 pages, $26.95):



On June 20th, George Melloan reviewed Ferguson book in the Journal. Melloan characterizes it as a jeremiad, but warns, "Doomsayers are never popular, but sometimes they're right."

The Birth of Arbitrage

Arbitrage is the simultaneous buying and selling of an asset in two separate markets to exploit a price difference.

The Benchmarks Aren't Speaking to Each Other!

For many years, Brent crude oil sold a a very similar price to West Texas Intermediate crude oil.  The former is the benchmark price for oil in Europe; the latter for the U.S.  In the early years of the Brent field (between Great Britain and Norway in the North Sea), Brent sold at a discount to WTI.  Thereafter they sold at parity.  In the last year, Brent has opened a big premium up over WTI, averaging $27 for one recent month.  What happened to arbitrage and the Law of One Price?  A glut of oil in cushing, OK where the market for  WTI is and a shortage in Europe.

That is about to change.

Chip Cummins reports in the Wall Street Journal that Entbridge of Canada is buying the recalcitrant half of Seaway pipeline and will reverse its flow south.   Let the arbitrage begin!

For Kansas:

This means lower margins for Kansas refiners, higher income for Kansas oil producers, and probably higher local gasoline prices.

WSJ's Liam Denning and Mean Street host Evan Newmark discuss WTI's price spike back over the $100 per barrel mark on news of a Canadian company's investment in a gulf coast-to-Oklahoma pipeline.

Thomas J. Sargent and Christopher A. Sims Win the Nobel Prize for Economics

Rational Expectations and the Ability to Distinguish Cause and Effect Empirically

Macroeconomics has long been the theology of economics.  Sargent and Sims tried to take the common sense reality that it is what people expect in the future, not what we currently observe, that drives their decisions.  They developed a type of econometrics (the statistical modeling of economic reality) that would deal with expectations.  In the process they transformed macroeconomics, generally for the better.  This morning the Nobel Prize committee announced they won the Nobel Prize in Economics.

Today central bank credibility is central to economists' thinking about monetary policy.  Guess why.

One drawback of their revolution is that empirical and theoretical models became farther removed from what we can picture in our imagination.  The great oversimplification of the financial sector that Keynes introduced and Hicks the Younger systematized became more imbedded in economists mindset.  We need a revitalization of economists' imaginations to refertilize their mental pictures of the world.

Quote of the Day: Might Institutions Matter?

"We economists hadn't focused on financial interactions and how that can lead to financial instability. Believe it or not, most models used by central banks only looked at savings, ignoring credit institutions and securities markets. That reflected a mainstream view that institutions don't matter. This was cognitive dissonance of a high order."

Joseph Stiglitz in Barron's.

Elinor Ostrom and Oliver E. Williamson Win the Nobel Prize In Economics

"Governance" is the key word in this year's economics announcement.   How do people come up with organizational solutions to problems other than individulalistic market transactions or centrally imposed solutions?  How do they solve issues of collective rights?

The Committee tells us "Economic transactions take place not only in markets, but also within firms, associations, households, and agencies. Whereas economic theory has comprehensively illuminated the virtues and limitations of markets, it has traditionally paid less attention to other institutional arrangements. The research of Elinor Ostrom and Oliver Williamson demonstrates that economic analysis can shed light on most forms of social organization.

"Elinor Ostrom has challenged the conventional wisdom that common property is poorly managed and should be either regulated by central authorities or privatized. Based on numerous studies of user-managed fish stocks, pastures, woods, lakes, and groundwater basins, Ostrom concludes that the outcomes are, more often than not, better than predicted by standard theories. She observes that resource users frequently develop sophisticated mechanisms for decision-making and rule enforcement to handle conflicts of interest, and she characterizes the rules that promote successful outcomes."


Understanding why the firm exists is one of the crucial questions of economics and not one extensively explored in mainstream economics. 

I am fascinated by Ostrom's award.  How people work out collective rights with neither a simple market solution nor government imposing one is a great area of inquiry.  Here we get to the nexus between law and spontaneous order.   What is the relationship between economic regulation and property rights?  When does positive law harm collective decision making? I have some reading to do!

One issue from the financial crisis to which Ostrom and Williamson's work is directly relevant is whether investment banks behave more responsibly as partnerships rather corporations.  Their excessive risktaking seems directly related to their going public.

Speaking of the financial crisis and organizational forms, maybe the committee should give George Benston the Nobel prize posthumously for demonstrating empirically that banks with investment affiliates performed better than those without.  In other words,  Glass Steagall's separation of investment from commercial banking was more about Senator Glass's Anglophilia than economic sense. Glass Steagall left investment banks outside prudential regulation. If the SEC had that responsibility, it is hard to see it in its history. Thanks to the structure set up by Graham Leach Bliley, all the major investment banks are either owned by a commercial bank or have become bank holding companies and are now under the Fed's prudential regulation.

Plain Vanilla Banks Must Wax and Wall Street Must Wane

John the Baptist told his disciples, "He must increase, but I must decrease." (John, 3:30.) I doubt we will see the same humility from the Masters of the Universe, those investment bankers whose universe has come crashing down on all of us.

The harsh reality is that commercial banks must wax while Wall Street wanes. Over the last fifty years security markets have grown enormously at the expense of plain vanilla banking. Wall Street's juggernaut has finally ended and the whole world is suffering from the hangover. The metaphor is apt: early British visitors of India coined the term, "juggernaut" to describe their highly colored description of Hindu processions. They maligned Hindus as drugged frenzied fanatics who in the processions for their Lord of the Universe would throw themselves under the cart wheels to be crushed in the insane state of their delirium. Does that sound like the buyers of many financially engineered securities?


John Kay with his usual perspicacity and disdain for cant, advises us to "Wind down the market in five-legged dogs."

What's that you say? Read on:

"Abraham Lincoln posed the question: “How many legs does a dog have if you call a tail a leg?” Honest Abe’s answer was four. A tail is still a tail even if you call it a leg.

"The world of finance is a bit more complicated, but not much. How can a package of loans be worth more than the sum of their individual values? The amount borrowers pay is just the same even if you call the loans an asset-backed security or a collateralised debt obligation."

As usual his analysis is good economics and good sense. Do read it all.

One implication is that both the City of London and Wall Street will have to shrink, but that, in my opinion, is a good, necessary, but painful reality.

To quote John Kay's conclusion: "The objective should not be to revive the originate and distribute model of banking, which has demonstrably failed, but to secure its orderly winding down. Banks should retire to the traditional and profitable business of taking deposits to make loans: the business we want them to do and the business they really understand. The British government plans to provide insurance for new asset-backed securities. That is like helping a junkie to detox by guaranteeing drug supplies until the local dealer resumes normal service."

What Tesco knows and Woolies forgot

John Kay is an economist who believes markets do a better job than governments in organizing the economy, but his understanding is nuanced. He is keenly aware of the value of institutions and he knows that "market economies function because they are embedded in a social, political and cultural context, and cannot work otherwise."

He writes in his current column,"I do not think children should be taught that greed is the most powerful human motivation. The people who are most successful in business in the long run are people who are passionate about business, not money."

It is not greed that drives capitalism's success but the dynamism that freedom and incentives set in play to unleash human creativity. Some of its defenders are its worse enemies: they talk "about 'wealth creation', although most of what they described seemed to be a diversion of wealth for the benefit of particular individuals rather than the creation of new wealth."

John Kay is mostly devoting himself to writing these days. He has a weekly column in the Financial Times. His forthcoming book (The Long and the Short of It - everyone's guide to investment and financial markets ) is recommended by the Institute for Economic Affairs, the think tank that supplied Maggie Thatcher with economists.

Use Pricing to Get the Traffic Moving in Manhattan!

Ken Livingstone argues in "Clear Up the Congestion-Pricing Gridlock" (New York Times , July 2, 2007) that New York City could learn from London. Pricing entry into the city would reduce congestion sufficiently to more than make up for the burden of the tax.

He tells us that four years ago, "London’s business district was undergoing rapid growth, but it was at capacity in terms of traffic. Efforts to channel more cars into the city center simply led to ever lower traffic speeds, which in turn led to business losses and a decrease in quality of life. Simultaneously, carbon emissions were mounting because of the inefficiency of engine use.

In 2003, London put in place a £5 (about $9) a day congestion charge for all cars that entered the center city (the charge is now £8). This led to an immediate drop of 70,000 cars a day in the affected zone. Traffic congestion fell by almost 20 percent. Emissions of the greenhouse gas carbon dioxide were cut by more than 15 percent.

The negative side effects predicted by opponents never materialized. The retail sector in the zone has seen increases in sales that have significantly exceeded the national average. London’s theater district, which largely falls within the zone, has been enjoying record audiences. People are still flocking to London — they’re simply doing so in more efficient and less polluting ways."

"Booms, Technological Bubbles and Busts."

Milton Friedman died yesterday.

When I was in graduate school in the late 1960s, many of my peers were disciples of Mao and romanticized that thug Che Guevara. They carried around with them The Thoughts of Chairman Mao ("The Little Red Book") as if it were a badge of honor. I vividly remember the ugliness at the American Economic Association meetings when Friedman gave his Nobel Laureate lecture amid angry prrotests and demonstrations.

The "Little Green Book" (his Capitalism and Freedom) was the first book that made me think critically and creatively in economics. From today's vantage point, it appears to have won the long war with "The Little Red Book." His ideas have seized the commanding heights. It is a great irony that the best words to put on his tomestone would be those of John Maynard Keynes, the dominant intellectual force in economics from 1936 to the 1970s and the king whom Friedman deposed:

"The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood . . . Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back."

- J.M. Keynes, General Theory, ch. 24.

Today's Wall Street Journal is a must read. Not only is there a lead editorial on Uncle Milton (no surprise) and a front page article, but they published a new article by Friedman himself ("Why Money Matters") on the editorial page that is a gem. It could as easily have been titled "Booms, Technological Bubbles and Busts." Personally, I can't imaging still writing so lucidly and perceptively at 94. In fact, still breathing would be an accomplishment.

Fellow economist Michael Boskin leaves us with the image of Milton and Rose dancing at her birthday. The perfect signature on a full and fruitful life!

Pray for his soul and the wife who has lost a soulmate. May he be smiling down at us from the true commanding heights.