The Economics Prize Went to ...

Sunday, when I took a stab at predicting that the Swedish central bank would do, I distinguished two different sorts of recent award recipient -- those who may not have any economic background, but whose work drew economic applications from game theory considerations, and those who certainly had an economic background, and whose work fits within the traditional, autonomous, body of economic theory.

Monday, the prize committee gave its award to two people -- one of each of those two descriptions.

Today I'll say something about one of them, leaving the other for next week (and leaving the latest developments in the Bear Stearns trial until tomorrow).

Let's begin with the phrase "the tragedy of the commons," which was coined by Garrett Hardin, in a seminal article in 1968. This is a variant of the game theory conception of the "prisoner's dilemma (PD)" As you may know, the point of the PD is that decisions rational for each of the prisoners taken separately will lead to a sub-optimal result for both of them. In Hardin's variation, there are no human interrogators getting between the "prisoners," so the focus not on who outsmarts whom, but on how humans use their natural resources.

Hardin asked his readers to think of a common patch of land in the middle of an agrarian village, in which custom provides that any village member can let his cattle graze on that land.

The tragedy is that actions that are individually rational will prove collectively disastrous. Each herdsman will fatten up his own cows as much as possible, increasing their value as beef. All the benefit of that over-grazing goes into his own pocket, whereas he only bears a fraction of the risk from it -- the risk of overgrazing.

Wars or disease may delay a day of reckoning over time -- even for centuries. But when there is a social equilibriumn for long enough to allow full sway to the profit maximizing choice, then the commons will be over-grazed, and will become useless.

Hardin's parable has been invoked by two different sets of people -- regulators and libertarians. The former say, "This shows why we have to regulate the use of common property, such as the atmosphere or water rights, to avoid the equivalent of over-grazing." The latter say, "The best choice is generally to privatize the commons -- each rancer will worry about the long-time future of his own plot when it really is his own," though in the case of the atmosphere, applying that insight requires some ingenuity.

Hardin's parable continues both to fascinate and to depress. For one wants to believe that a smal group, a village or a co-op, not necessarily organized on hierarchical lines, and not necessarily reliant on a charter from Delaware, could manage to maintain a commons over a long period of time. Are we so pathetic as a species we can't manage that?

This brings us to the work of Elinor Ostrom, one of the two new economics laureates. She is not trained in economics, but in political science, and she approached the problem of the tragedy of the commons with the instincts of a historian. Thus, she came to write Governing the Commons: The Evolution of Institutions for Collective Action (1990).

She has asked in effect: have there in fact been communities that have handled their common property well over a long period of time? and, if so, what can we say about how they have done this? She applied the old rule: whatever is actual, is possible. Various sorts of commons' -- forests and fisheries, for example -- have proven susceptible to community use without over-use along the lines Hardin's model predicts.

I don't think she gets us to a "comedy of the commons," but her work does help to mitigate the sense of tragedy.

So what does "trader realism" tell us, Ben?

According to Stein, professional traders, (like judges in the "legal realism" model) start from their desired conclusion, and work backward to rig up the necessary premises.

"Traders can see masses of data any minute of any day. They can find data to support hitting the 'buy' button or the 'sell' button. They don’t act on the basis of what seems to them the real economic situation, but on what’s in it for them."

Of course, classical economists would say, traders act on what's in it for them! So does everybody in the system, at least according to the classical model Stein may think he's refuting here. The difference may be this: Stein thinks the decision whether a "sell" or a "buy" has more "in it for them" has a non-rational, even an irrational, element based on, say, the corporate politics of the broker-dealer, quirks of bonus policies, idiosyncratic personalities.

A classicist who doesn't wish to conform to stereotype too tightly can of course acknowledge that traders sometimes act in ways hard to model. Still, those who consistently act on irrational factors will lose money. They won't stay in business for long. And if there are a lot of traders, and a lot of trading going on, then the irrational aspects are factored out within the whole system, the noise is filtered out and the market conveys information efficiently.

Stein's reason for believing this model is wrong and his "trader realism" has pierced a veil? An uncheckable anecdote. A "close friend of mine, now deceased," who used to be a trader in London for a major financial house, told him a story about shorting IBM on a dare from the boss, and then geting on the phone to spread rumors, talking down the price of IBM so his short position would pay off.

That's it. After the household meatloaf, the law school memories, the trader/judge analogy, we get around to a theory based on a single recollected story from one unnamed person who has shuffled off the mortal coil. Wow! On such evidence, many people seem to believe that Elvis continues to walk about and order Slurpees at various Quickie Marts.

Those of you who wish to follow reactions to his column ... as I've noted, the blogosphere is full of them. Here are just two links to get you going:

Blodgett.

Weiss.

Blodgett is harsh, Weiss is critical-but-sympathetic.

It's a tad anachronistic, but I can't help feeling that Oscar Wilde had Stein in mind when he had a character in one of his plays warn that "even these metallic problems have their melodramatic side."