Elinor Ostrom as a Mentor

On this episode of the Hayek Program Podcast, we continue the Hayek Program's celebration of Elinor Ostrom as Vlad Tarko, assistant professor and author of 'The Intellectual Biography of Elinor Ostrom,' interviews Hayek Program distinguished senior fellow Bobbi Herzberg on Elinor Ostrom's role as a mentor and friend. Herzberg recounts heartwarming memories from her time working with Elinor Ostrom, including those on Elinor Ostrom's work ethic, humble personality, and role as a bridge to Vincent Ostrom. Herzberg also describes her journey from rational choice theory to the Ostrom's teaching and tells how both Vincent and Elinor Ostrom helped guide her through "being a student again" before briefly discussing the history of the Bloomington workshop.

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Bobbi Herzberg
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May 29, 2019
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An Interview Between Vlad Tarko and Bobbi Herzberg

Public Governance and the Classical-Liberal Perspective

June, 2019

Classical liberalism entails not only a theory about the scope of government and its relationship with the market but also a distinct view about how government should operate within its proper domain of public choices in non-market settings. Building on the political economy principles underpinning the works of diverse authors such as Friedrich Hayek, James Buchanan and Vincent and Elinor Ostrom, this book challenges the technocratic-epistocratic perspective in which social goals are defined by an aggregated social function and experts simply provide the means to attain them. The authors argue that individualism, freedom of choice, and freedom of association have deep implications on how we design, manage and assess our public governance arrangements. 

The book examines the knowledge and incentive problems associated with bureaucratic public administration while contrasting it with democratic governance. Aligica, Boettke, and Tarko argue that the focus should be on the diversity of opinions in any society regarding "what should be done" and on the design of democratic and polycentric institutions capable of limiting social conflicts and satisfying the preferences of as many people as possible. They thus fill a large gap in the literature, the public discourse, and the ways decision makers understand the nature and administration of the public sector.

Decentralize Financial Regulation

Wednesday, November 22, 2017

The 2007–2008 financial crisis upended conventional wisdom for financial companies, government regulatory bodies, and economists. We are still feeling the effects a decade later, as post-recession growth has been meager by historical standards. Moreover, as our new research shows, many assumptions about what caused the financial crisis are mistaken — making a repeat more likely.

Both sides of the political aisle are responsible for the inaccurate narrative. The Left tends to highlight lenders’ alleged greed in exploiting “subprime” borrowers, while the Right has focused on the “moral hazard” created by government bailouts and the bad investment caused by government subsidies. Such explanations are at best incomplete. The truth is more complex — and more disturbing — than these morality tales let on.

A well-functioning financial sector requires firms to assess and manage the risk of their actions accurately and carefully. In reality, these companies’ worst-case scenarios have turned out to be naively optimistic. The truth is that just about everyone was taken by surprise in 2008, not only by the crash, but also by its sheer magnitude. No one — including financial firms — anticipated that things could get as bad as they did.

In fact, the financial system is too complex for anyone to understand all its intricacies and dangers. Thus securing financial stability requires acknowledging this complexity as a starting point. Admitting what we don’t know is more productive than pretending to understand more than we do know.

Economists have paid too little attention to the problem of fragmented and incomplete knowledge, especially on the part of regulators trying to engineer stability. As a consequence, economists and regulators rally around technocratic solutions to financial instability that are ill-equipped to accommodate unanticipated change.

Take the current fascination with “macroprudential” regulation. This approach focuses on systemic risk within the entire financial system. In practice, it’s the same old regulatory dance to a slightly jazzed-up tune: Economists and regulators claim they can keep the financial system safe by keeping an eye on system-wide variables such as asset structures and credit ratios. The problem is that, at best, these variables provide a bird’s-eye view of an incredibly complex process. Ultimately, macroprudential regulation amounts to increased regulatory discretion by would-be financial czars who — despite their expertise — will inevitably make some human errors.

Good intentions aside, such policies threaten to make an already brittle system even less resilient. A system is fragile if it works well only when the people in charge are benevolent and have all the information they could possibly need.

That describes our current, highly regulated financial system precisely. To work properly, it requires too much knowledge, generosity, and rationality on the part of everyone involved — whether in the private or public sectors. Even fairly small departures from the assumptions of omniscience and benevolence can create large-scale problems. 

A more promising way to achieve financial stability lies in the concept of “institutional resilience,” developed by 2009 Nobel Laureate Elinor Ostrom. In Ostrom’s system, an institution is robust if it continues to perform well even when powerful players are selfish and ignorant. A resilient system of this sort punishes or offers corrections for errors of judgment, gaps in knowledge, and irresponsible behavior before they unfold into a full-blown financial crisis. 

Is this type of analysis useful beyond diagnosing institutional problems? That is, how can we correct our current institutions or even design better ones? 

One of Ostrom’s other insights is the concept of “polycentricity.” She points outthat because institutional design is so difficult and rife with uncertainties, systems must be allowed to evolve by embracing market-like features with numerous players and independent rule-making authorities. This is the opposite of what currently prevails in our financial system, which is regulated in a top-down fashion.

Because they are decentralized and allow solutions to emerge and spread organically, polycentric systems have some important advantages. First, problems generally remain relatively contained at small scales. Second, when problems occur, one part of the system is able to absorb some of the turbulence occurring in others. Third, experimentation can discover “best practices” that can be shared or even generalized. 

Historically, the financial-banking system that comes closest to being polycentric is what is known as “free banking.” This is a bit of a misnomer, as free banking does not mean that the system is unregulated. Rather, such systems eschew top-down federal regulation, relying instead on a combination of formal and informal rules that promote resilience, many of which are enforced by bankers themselves. 

The backbone of a free-banking regime is a system of private clubs. Historically, the most important clubs were the private clearinghouses created by banks for the purpose of settling liabilities. As they evolved, the clearinghouses created safety-promoting rules, such as minimum reserve requirements, and monitored banking activities to ensure members were not behaving irresponsibly. Unfortunately, this system was gradually eliminated by the creation of modern central banks and government financial regulators.

Polycentricity suggests a solution to our own fragile financial system: Governmental authorities should make some room for financial institutions to self-govern. Doing so would require a judicious repeal of much existing regulation, in a manner that allows private networks of exchange and regulation among banks to emerge once again.

The need for stability in the financial system remains one of the most significant public policy challenges today. Worryingly, policymakers and regulators appear to be doubling down on the same tried-and-failed strategies of centralization and micromanagement by government regulators. A better approach would be to embrace a genuinely polycentric financial system, which could more readily absorb the shock — and perhaps even reduce the likelihood — of future financial crises. 

Governing the Financial System

November 8, 2017

The 2008 financial crisis has sparked a renewed discussion of ways to combat financial instability. Alexander W. Salter and Vlad Tarko argue that a system of multiple, interlocking financial regulatory institutions—a polycentric system—could be a more effective policy tool for combating potential instability of financial and banking systems, which are largely governed today by top-down regulatory institutions (a monocentric system).

Lessons from Free Banking Systems

Institutional resilience is key to stable governance and is defined by robustness (the ability to absorb and recover from shocks) and adaptability. Contrary to their reputation for instability, banking systems in which banks issued their own money and operated without oversight from a central bank (free banking systems) were remarkably resilient, in large part because of three nested mechanisms:

  • The distinction between the medium of redemption and the medium of exchange. Today, money created by the central bank is the medium of redemption, but it can also be spent in the economy as the medium of exchange. In a free banking system, each bank printed its own currency but held the medium of redemption (historically, gold or silver) in its vault. Since an inability to fulfill withdrawal (redemption) requests would require a bank to sell its assets to meet demand, this encouraged banks to maintain adequate liabilities in circulation to meet the needs of trade.
  • The interbank clearinghouse enforced minimum-quality standards, cleared liabilities, and provided emergency loans to minimize transactions costs.
  • The hard budget constraint, or the fact that the amount of money in circulation was finite, was the result of extended liability, which made the owners of banks liable if banks couldn’t meet their obligations. These mechanisms provided strong incentives to banks to avoid taking on too many risky assets.

Using Design Principles to Understand Robust Governance

Whether or not a transition to a fully polycentric banking system is plausible or contemplated, lessons from free banking can improve understanding of what makes polycentric financial regulation resilient, which, in turn, can provide guidance for more effective financial regulation.

Salter and Tarko build upon the broader literature on polycentric governance and institutional resilience, and adapt the Nobel laureate Elinor Ostrom’s “design principles” for robust governance institutions to the problem of financial stability. Accordingly, they argue that in a successful system,

  • Boundaries are clearly defined, such as those established by clearinghouses and financial exchanges.
  • The price system and bankruptcy match benefits with costs as banks compete for customers by offering lower prices, but will remain in business only if they can earn enough to cover their costs.
  • Those affected by the rules have the ability to change them. In free banking systems the banks were self-regulating, whereas currently they do not play a direct role in rulemaking.
  • Those who monitor and enforce the rules are accountable, such as through members contesting the actions of clearinghouses.
  • The price system and the rules for settling property and contract disputes under the common law provide gradually increasing penalties for breaking the rules.
  • Low-cost options for dispute resolution encourage banks to solve disputes without costly legal battles under free banking.
  • Outside authority respects the rulemaking rights of the community, a major challenge for a financial system with a single, external regulator.
  • Responsibility for governing the system is dispersed through nested levels of governance through the entire system, allowing free banking systems to accommodate the wide variety of services offered in the financial system in a way that is difficult for top-down regulation.

Crony Capitalism: Rent Seeking, Institutions and Ideology

May 1, 2014

This paper elaborates the notion of “crony capitalism” and advances an innovative approach to the analysis of the phenomenon in case, seen as a type of rent-seeking society. The argument leads to a pioneering attempt to elaborate an original theory of crony capitalism as a sui generis system and with that end in view it combines three complementary perspectives: microeconomics (dealing with the basic economics of rent-seeking), institutional or structural (dealing with the specific structures and configurations of institutions, policies and processes via which rent seeking gets materialized), and ideological (dealing with the ideas, rhetoric, beliefs, doctrines and other forms of legitimization and justification of the specific policies and institutions). The paper identifies significant functional differences between crony capitalism in high-income and developing countries and advances a novel interpretation of the special nature of crony capitalism by focusing on the distinctive features of its ideological component.

Find the article at Wiley Online Library.

State Capitalism and the Rent-Seeking Conjecture

November 1, 2012

The notion that state capitalism (an economic system “in which the state functions as the leading economic actor and uses markets primarily for political gain”) is a new form of capitalism emerging in the global arena has been recently advanced by several authors. This paper explores the problem of the nature of this system in the light of these claims to novelty. What are its main features as described by these authors? Is state capitalism distinctive from other forms of capitalism or other types of economic systems? Are we really witnessing the emergence of a new type of economic system? To address such questions the paper starts by trying to place the model of state capitalism within the traditional comparative economic systems framework. The inconclusive result leads to a different approach in which the concept of rent-seeking society is used to underlie the structural similarities between mercantilism, real life socialism and state capitalism. The article argues that the conjecture that what has been labeled “state capitalism” is yet another form of rent-seeking system is both robust and worth further investigating.

Find the article at link.springer.com