The Fundamental Problem Michael C Munger Earl D

The Fundamental Problem Michael C. Munger Earl D. Mc. Lean Professor Departments of Political Science, Economics, and Public Policy Duke University

Get Some Questions Out of the Way • I have no idea why flammable and inflammable are synonyms • No, it is NOT a perm. • Yes, I have proof.

Mark put up one of his books… I don’t want to be outdone…. So, here is…. One of Mark’s books

The Fundamental Human Problem: The fundamental human problem is the design, or maintenance, of institutions that make selfinterested individual action not inconsistent with the welfare of the community. (Munger, 2000)

Two Approaches • Madisonian “Ambition must be made to counteract ambition…” • Rousseauvian Transform the self, solve the problem of amour propre. Inscribe the law on the hearts of men. Some preferences are better than others.

Project 1 —Madisonian Approach: Perfectability of Institutions through Mechanism Design—Adam Smith, James Madison, John Stuart Mill, F. A. Hayek, Robert Nozick, and others have contributed to this point of view. It works like this: take self-interest as given, with “interests” themselves exogenous. Then try to design mechanisms (with markets being one archetype) where the collective consequences of individual self-interest are not harmful, and may even, “led by an invisible hand” lead to a better world.

Madison—Federalist #51 [T]he great security against a gradual concentration of the several powers in the same department, consists in giving to those who administer each department the necessary constitutional means and personal motives to resist encroachments of the others. The provision for defense must in this, as in all other cases, be made commensurate to the danger of attack. Ambition must be made to counteract ambition. The interest of the man must be connected with the constitutional rights of the place. It may be a reflection on human nature, that such devices should be necessary to control the abuses of government. But what is government itself, but the greatest of all reflections on human nature? If men were angels, no government would be necessary. If angels were to govern men, neither external nor internal controls on government would be necessary. In framing a government which is to be administered by men over men, the great difficulty lies in this: you must first enable the government to control the governed; and in the next place oblige it to control itself.

Project 2 --The Rousseauvian Approach Project 2—Rousseauvian Approach: Perfectability of humans in societies, through moral education. This is the project that makes culture relevant. We spend much of our time, in schools, churches and around the dinner table, trying to instill “values” in our children. The reason is that “self-interest” may be malleable, especially in the young. But this is very different from an institutional design that imposes external constraints in the forms of laws and punishments. Moral perfectability means that law and morals cannot be external constraints. We must inscribe the laws on mens’ hearts. In this view, the self is reconceptualized intersubjectively, with a focus on the notion that each of us is imbedded in a larger context, with ties to each other and to the larger good.

Democracy Unbound…. Rousseau But it is asked how a man can be both free and forced to conform to wills that are not his own. How are the opponents at once free and subject to laws they have not agreed to? I retort that the question is wrongly put. The citizen gives his consent to all the laws, including those which are passed in spite of his opposition, and even those which punish him when he dares to break any of them…. (From The Social Contract)

Democracy Unbound…. When in the popular assembly a law is proposed, what the people is asked is not exactly whether it approves or rejects the proposal, but whether it is in conformity with the general will, which is their will…. When therefore the opinion that is contrary to my own prevails, this proves neither more nor less than that I was mistaken, and that what I thought to be the general will was not so. If my particular opinion had carried the day I should have achieved the opposite of what was my will; and it is in that case that I should not have been free.

Loyal Opposition? This conception of democracy is logical. The actions of government are driven by the people; the general will is sovereign. Opposition to the general will is treason, and must be punished. No need for two parties: only one general will. All those countries with “Peoples’ Democratic Republic of ___” were not perversions of democracy, but examplars. That is what pure democracy, with no limits on scope, looks like. Cannot be otherwise. Democracy, in and of itself, is an attractive concept that must constitute a recipe for tyranny, unless the scope of collective sovereignty is strictly limited.

Che Guevara’s “Man and Socialism in Cuba” (1965). Society as a whole must become a huge school. . We can see the new man who begins to emerge in this period of the building of socialism. His image is as yet unfinished; in fact it will never be finished, since the process advances parallel the development of new economic forms. Discounting those whose lack of education makes them tend toward the solitary road, towards the satisfaction of their ambitions, there are others who, even within this new picture of over-all advances, tend to march in isolation from the accompanying mass. What is more important is that people become more aware every day of the need to incorporate themselves into society and of their own importance as motors of that society

The Problem…. • The nature of exchange: gains from trade. Both are better off. • But only if the exchange takes place: transactions costs are the ex ante costs of negotiating and measuring, and the ex post costs of enforcing. Transactions costs can overwhelm the potential gains from exchange. • Institutions and cultural beliefs: closely related to "common knowledge" problem in game theory. Shared meanings, iconography, language, symbols.

The Problem…. • Closely related to Zak’s problem of trusting strangers. Norwegians trust OTHER NORWEGIANS. But then not really a stranger; some shared experiences. Shared culture expands the set of people I “know, ” and can trust. • If you drop a wallet in Oslo, sure it gets returned. But if Norwegians see THIS man…. . …they would hide their daughters! No trust, because NO Shared cultural cues

The Problem…. Flip side: institutions and culture can also entirely block progress, lock in institutions that are not Pareto optimal. Consequently, cultures have two properties 1. Some are objectively better than others 2. They persist, and are very resistant to change

“Voluntary” exchange: preconditions require justice • For an exchange to be “voluntary” in any interesting sense, the preexisting distribution of wealth and power must be just, or morally legitimate • These conceptions are culturally determined. • I have a gun, you have a wallet. • Now, I have a gun AND a wallet….

What is Dishonesty? • When does something “count” as dishonesty? When am I cheating? When do I incur negative moral judgments of others in the society? • What matters more, external enforcement and threats of punishment, or our internal psychological reactions to shame/guilt? • ANSWER: No society that relies on external enforcement of all contracts could possibly be productive or prosperous.

Paradox of Human Affairs • Rationally, we should all want to be able to commit to acting irrationally • I will not steal from you, I will not kill or beat you. • You make the same promise to me. • Hobbes’ Problem: Too much liberty. We must either (a) make a personal, credible commitment of forebearance or (b) make a collective, credible commitment to accept punishment from an external enforcer • Much cheaper to use (a). Is it possible? Essentally a restatement of the FHP: can it be solved this way?

Trust Game Honor Trust A +$20 B +$20 Total: +$40 Trust B B A Do Not Trust B A $10 B +$30 Do Not Honor Trust A +$0 B +$0 Total: +$20 Total: +$0

An Example of “Cultural” Difference • “shibboleth”--The word is often combined with the word “cultural. ” • Its general meaning is an unspoken but shared understanding of something that identifies insiders, and distinguishes outsiders because they do not share this understanding. • Origin: The Hebrew word , שבולת meaning a torrent, a flooding stream or an ear of grain.

Shibboleth • Judges 12, 5 -7, King James 21 st Ed. Bible 5 And the Gileadites seized the passages of the Jordan before the Ephraimites; and it was so, that when those Ephraimites who had escaped said, "Let me go over, " that the men of Gilead said unto him, "Art thou an Ephraimite? " If he said, "Nay, " 6 then said they unto him, "Say now Shibboleth. " And he said "Sibboleth, " for he could not frame to pronounce it right. Then they took him and slew him at the passages of the Jordan; and there fell at that time of the Ephraimites forty and two thousand. • Imagine twins, separated at birth. One raised Ephraimite, and the other raised Gileadite….

My Definition of “Culture” • Culture: The set of “inherited” beliefs, attitudes, and moral strictures that a people use to distinguish outsiders, to understand themselves and to communicate with each other.

My Definition of “Culture” • Does a completely isolated people have a “culture”? • We “inherit” culture from the people we grow up with. But it is hard-wired in the set of mental connections we create around certain relationships we see in the world around us. • Different cultures pose different answers to the FHP. And some of those are better than others.

Move from the “Trust” Game to Versions of the PD • Prisoner’s Dilemma is the generic cooperation problem. Overused, overly simplistic, but illustrative. • Two ways “out”: external enforcement, which changes the payoffs • Internalize collective welfare, changing the way I value the payoffs. • Mathematically identical, but fundamentally different in terms of the nature of the solution

Prisoner’s Dilemma Cooperate Defect Cooperate (2, 2) (4, 1) Defect (1, 4) (3, 3) (note: Payoffs are of the form (Row, Column), and rankings are ordinal, with 1 best and 4 least preferred)

Prisoner’s Dilemma with Enforcement: Defectors are Tortured Cooperate Defect Cooperate (1, 1) (2, 4) Defect (4, 2) (3, 3) (note: Payoffs are of the form (Row, Column), and rankings are ordinal, with 1 best and 4 least preferred)

Prisoner’s Dilemma with Guilt: Defectors Feel Bad Cooperate Defect Cooperate (1, 1) (2, 4) Defect (4, 2) (3, 3) (note: Payoffs are of the form (Row, Column), and rankings are ordinal, with 1 best and 4 least preferred)

Say Again: Culture Is “Inherited” I have put quotations around the word inherited above, not because I am quoting anyone, but because the sense of the word is strained. Hair texture, eye color, general build…those sorts of things are inherited. They are hard-wired into the genetic structure of humans, and children are directly and entirely the product of their parents. Culture is obviously not inherited like this. We teach it to our children, or they learn it by tacit and perhaps unconscious exposure over time. But it makes sense to think of culture as an inheritance, or legacy from the past.

Say Again: Culture Is “Inherited” Perhaps more important, different cultures rely on different mixes of shame, or guilt, or external enforcement, to reduce the transactions cost of exchange and to encourage cooperation. All cultures are answers to the FHP, but some cultures are better answers than others Any culture must be locked in. If it is plastic and adaptable, it is not a credible commitment. The culture may honor adaptation, but the culture itself must be relatively stable and unchanging.

Origins: Two Concepts— “Design” or “Maintain” • Spontaneous Order • Intelligent Design Does order imply design? Strange disconnect —Many people who believe fervently in evolution in biology insist on the need for design and control in social and economic settings.

Choices Emerge…. Do Preferences? • Is there some evolutionary process that governs preferences? • Are human moral systems, cure for dishonesty, “getting better” over time? • The key difference is the absence of any feedback mechanism by which the merits of the emergent order might be judged, or subjected to modification. Douglass North makes this point quite forcefully:

Competition and Feedback …Efficient markets are created in the real world when competition is strong enough via arbitrage and efficient information feedback to approximate the Coase zero transaction cost conditions and the parties can realize the gains from trade inherent in the neo-classical argument. But the informational and institutional requirements necessary to achieve such efficient markets are stringent. Players must not only have objectives but know the correct way to achieve them. But how do the players know the correct way to achieve their objectives? The instrumental rationality answer is that even though the actors may initially have diverse and erroneous models, the informational feedback process and arbitraging actors will correct initially incorrect models, punish deviant behavior and lead surviving players to correct models. (North, 1993).

Order vs. Design: Which is Culture? Which is “Better”? • Coyote—Evolution • Dachshund / Chihuahua—Survival • Dandelion—Evolution • Rose—Survival • Wild Turkeys—Evolution • Domesticated Turkeys—Survival

My Choices, Your Alternatives The essence of social spontaneous order: Individuals, acting of their own volition, will do things that (1) accomplish the ends of those individuals, and (2) do not violate the expectations of other people in the society. It is tempting to think that spontaneous orders also have good normative properties, but this is by no means obvious. Well-functioning market, does have good normative properties, in the sense that individual self-interest is consistent with the public good. But such consistency between individual choices and aggregate consequences is not assured.

Emergence of “Culture”: David Hume has Lunch at Café Hayek Three claims: 1. “Order” requires only regularity and consistency. Human beings choose actions based on moral conceptions, but also incentives and calculated gains that accrue to one action rather than another. 2. Purposive Action: I am going to adopt the convention that humans act purposively. I didn’t say “rationally, ” mind you. 3. People choose actions that they believe (rightly or wrongly) will lead to a goal that they consider (rightly or wrongly) desirable.

Culture, Manners are Conventional Acting purposively, on its own, is neither ethically good nor bad. It just is. From what do our judgments arise about whether an action is morally laudable, or detestable, or perhaps neutral? My answer is that given by Hume (for example, in Treatise of Human Nature, bk III)—These labels are entirely conventional: what is culturally acceptable in one society might be appalling in another. Manners differ broadly, showing internal consistency (that is, people in a society all recognize good manners, though they may violate them), but may be sharply inconsistent across nations (a person acting according to what his society considers acceptable manners may profoundly offend someone from another society. )

Manners • I've always followed my father's advice: He told me, first, to always keep my word and, second, to never insult anybody unintentionally. If I insult you, you can be g*dd*mned sure I intend to. And, third, he told me not to go around looking for trouble. (John Wayne, 1909 -1979)

The Problem…. • The nature of exchange: gains from trade. Both are better off. • But only if the exchange takes place: transactions costs are the ex ante costs of negotiating and measuring, and the ex post costs of enforcing. Transactions costs can easily overwhelm the potential gains from exchange. • Institutions and cultural beliefs: closely related to "common knowledge" problem in game theory. Shared meanings, iconography, language, symbols. • But also may entirely block progress, lock in institutions that are not Pareto optimal.

Is There an Analogous “Feedback” Mechanism for Preferences, for Moral Beliefs? • That is, if some preferences are better than others, IF some moral systems are better than others, is there any process of natural selection, or conscious design, that would lead toward the good? • Is “evolution” in human institutions in pursuit of a telos?

Argentinaness v. Taiwanicity "Economic policy is not a random variable that varies freely across countries. Rather, policy is the result of deliberate and purposeful choices by individuals and groups, who have specific incentives and constraints. If we maintain that it is policy differences that explain growth differences, what we ultimately have to explain is why these deliberate and purposeful choices differ systematically across countries. To us, the most promising avenue toward such an explanation is to be found in the study of political incentives and political institutions. “ (Persson and Tabellini 1992: 5)

Growth Rate Pooled Growth Regression: Observations Economic Resources per Unit Time

Growth Rate Pooled Growth Regression: Regression Economic Resources per Unit Time

Growth Rate Pooled Growth Regression: Taiwan in Red Economic Resources per Unit Time

Growth Rate Pooled Growth Regression: Argentina in Red Economic Resources per Unit Time

Problem: Serial Correlation? • Taiwan’s growth is consistently under-predicted in an aggregate model • Argentina’s growth is consistently overpredicted • So errors exhibit serial correlation. Should we correct for that? • Can’t correct for specification error! Omitted variable is culture, the variable that conditions how economic resources are translated into growth, output and prosperity. • “Growth models” ignore transactions costs, commitment problems

Will Culture Disappear? • Ronald Heiner (1983) argues that as human interaction becomes more complex and uncertain, successful social institutions must reduce the information needed to achieve cooperation among individuals. • A person’s “overall behavior may actually be improved by restricting flexibility to use information or to chose particular actions” (p. 564). • Mom and Pop hardware store vs. Walmart • Farmers’ Market vs. Piggly Wiggly

Limiting Choice Improves Cooperation What is the cheapest way of achieving cooperation? Formal rules and external enforcement, or culture and shame/guilt “enforcement”? Heiner (1983): “In general, further evolution toward social interdependence will require institutions that permit agents to know about successively smaller fractions of the larger social environment. That is, institutions must evolve which enable each agent in the society to know less and less about the behavior of other agents and about the complex interdependencies generated by their interaction” (580; emphasis in original).

But will our minds allow this to take place? • Aspirin • Food • In-group vs. out-group perceptions of benefits • Special snowflakes: All of us are unique and special…. . • Grocery store loyalty cards: actually give private information about ourselves, because it makes us feel special (!)

But will our minds allow this to take place? Why do people hate Wal-Mart? If you go there, you won’t find many college professors shopping. It is not helping us. It is not FOR us. • The expansion of Wal-Mart over the 1985 -2004 period significantly reduced consumer prices. The expansion of Wal -Mart was associated with a decrease of 9. 1% in food-athome prices, a 4. 2% decline in commodities (goods) prices, and a 3. 1% decline in overall consumer prices as measured by the Consumer Price Index (CPI). • Wal-Mart generated savings for consumers through several channels, including: higher levels of capital investment in distribution and inventory control assets, lower import prices, and greater efficiency in its whole supply chain.

Why Do We Hate Wal-Mart? Consumer Savings by Income Class 2004 All Low 20% 2 nd 20% 3 rd 20% 4 th 20% Hi 20% Income $54453 $9618 $24102 $41614 $65100 $132158 Spending $43395 $17837 $27410 $36980 $50974 $83710 WM Savings $1345 $553 $850 $1146 $1580 $2595 WM Saving/Inc 2. 5% 6. 0% 3. 5% 2. 8% 2. 4% 2. 0%

Why Do We Hate Commerce? Is it because we hate merchants? This mean and despicable idea which they had of merchants greatly obstructed the progress of commerce. The merchant is, as it were, the mean between the manufacturer and the consumer. The weaver must not go to the market himself, there must be somebody to do this for him. This person must be possessed of a considerable stock, to buy up the commodity and maintain the manufacturer. But when merchants were so despicable and laid under so great taxations for liberty of trade, they could never amass that degree of stock which is necessary for making the division of labour and improving manufactures. Adam Smith, Lectures on Jurisprudence

Why Do We Hate Commerce? Is it because factories make pin heads? Accordingly we find that in the commercial parts of England, the tradesmen are for the most part in this despicable condition; their work through half the week is sufficient to maintain them, and through want of education they have no amusement for the other but riot and debauchery. So it may very justly be said that the people who clothe whole world are in rags themselves. Adam Smith, Lectures, pp. 256 -7