Decentralized Knowledge, Charter Cities and Economic Development

Poverty, misery, economic disparity and inequality are the salient characteristic of the modern world. These problems are one of the main concerns of the almost everybody and I was no exception to the rule. Though poverty sometimes seems to have a geographic pattern, in my view the problem of poverty is not directly related to geography, but it is closely related to the human capital of the people living within a "politically defined" territories which have been evolved through the ages of ebbs and flows of war and peace.

A quick look at the geopolitics and economics of poverty and development shows that the poverty and misery usually is confined in these political entities. In some instances, it can be seen that two states roughly within the same geography have two absolutely different standards of living. The bottom-line is that the poverty is not a natural or geographic phenomenon, but it is a human problem caused by humanity itself and could be dealt with human intervention. It seems that it is the cooperation and coordination failure which creates such problems or at least cannot prevent them from happening. Why is it so? And what can be done about it? What role legal and economic theory can play in dealing with these grave human problems?

In this short note, I see the status quo in international law and generally acknowledged theory of the state as the first culprit for having such a situation in place. The current system of international law is the debris of tumultuous history of wars. The suboptimal Nash equilibriua generated by the failure of cooperation and coordination along with innumerable prisoners' dilemma the humanity has been trapped into, in Westphalia in 1648, caused states to adopt the principle of sovereignty which normatively fortified states, isolated them and used the international law as a tool to reinforce their territorial sovereignty.

In this new geopolitical order states are defined firstly by their territories and secondly by the people. This is the territory which determined what laws should be applicable to the individuals. The policies and institutions of non-intervention and absolute sovereignty and territorial integrity are clear evidences for this claim. The peace treaty of Westphalia gave birth to the territorial integrity which afterwards made its way into the Charter of the United Nations. Within these territories each country has an absolute sovereignty, of which the governments tend to present a quite generous interpretation.

This abusive construction of the principle of territorial integrity has its roots in the double-degree agency problems the statesmen have in their international missions. The diplomatic mission participating in an international convention or meeting thinks of his own interest how to perpetuate his position and job in the career and forgets about the interest of the government he or she is representing and on the other hand, the government who chooses the agent/diplomat to send to the international conferences, thinks of its own interest how to perpetuate the government and his party in power; the forgotten man is the nation.

Though the states wanted to territorially define themselves and isolate themselves, the point is that many of the human problems cannot confine and accord themselves to the political borders, and they increasingly become global. On the other hand, Decentralized knowledge and the impossibility of central planning are among the biggest concerns of the economists from almost the outset of the modern economic thinking. In this paper, I want to analyze the implications of dispersed and decentralized knowledge for the size and structure of the state to see how the policy makers can take advantage of this local and decentralized knowledge to make a difference in the development studies.

The line of reasoning will be as follows: Economic misery has its roots in human mismanagement and misadministration. The optimal way of dealing with this problem is establishing knowledge-based economies. Since the human knowledge is dispersed, mechanisms that can involve everybody (free entry and exit) to voluntarily contribute to the public policy are the optimal ways of dealing with those problems. This model is a model which should be based on the free market for ideas. I will argue that one of the mechanisms to give the opportunity to citizens to engage and share his knowledge in the public policy is localism and creating strong networks among people. Given the flaws (coercion/involuntariness) and the problems of localism, one might take the idea of charter cities as an alternative way toward development; it might be considered as an alternative or a complementary way of the existing model toward development, as a constant and steady growth over a considerable period of time. The problem with this alternative idea is that it challenges the exiting conservative structure of international law.

Localism as a Mechanism of Exploitation of the Dispersed Knowledge
Let me start with the history to see how the dispersed knowledge in administering the territory caused even the greatest empires and states to abide by the special governance rules and structures. By a quick overview of history, we can see that even the most potent of empires of the world were restricted by the geographic and economic realities which played a very delicate role in their size and structure. Indeed, local governments have their roots in the long history of civilization and the rules of governance in large scale empires. As historians demonstrate; Cyrus, the Emperor of Persia, appointed the local officials for governing every region within the Empire. According to Herodotus, after conquering Lydia, Cyrus decided to appoint the ex-king of Lydia, Croesus, who was defeated by Cyrus as the governor of Lydia within the Persian Empire. Thereafter, Darius, the Persian king, did the same and appointed the local officials for the administration of the then Persian territories which at that time were constituted of about 20 provinces called “satrapies”. Though there might be a host of reasons behind these appointments, ex-post, it seems that one of the reasons was the difficulty of getting involved in the management of those vast and diverse territories without having a proper local knowledge.

As the above example shows, many of the empires who conquered a vast territory appointed the local governors for the administration of those occupied territories. This became a tradition in governance at least in the Middle East and the Minor Asia in ancient times. For instance, when Alexander conquered Persia, he made use of such a policy as well. The conquerors like Teymour Khan and Chingis Khan followed suit (again ex-post) partly because of the expertise problem and partly the common sense and intuitively known idea of the diseconomies of scale arising from such a big territory under administration, decentralized nature of the knowledge which made central planning impossible for them and would have frustrating effects on their territories and their strength of traditional sovereignty.

This continued tradition had its special advantages and economic justifications for those emperors. Although many of the ancient empires officially claimed that they had a universal sovereignty, save King Canute, they were well aware of the limits of their power. Van Creveled puts it this way, [because of] “the problems of time and distance as well as the limits of the information at their disposal, many emperors preferred to deal with entire communities – tribes, chiefdoms, villages, cities, even client-kings – rather than with individuals”. This insightful phrase is the gist of what I am going to say and almost perfectly shows how the case for local governments was established. This comment also shows that almost from the advent of urban life and civilization, how great empires with vast territories severely suffered from the transaction costs, agency problems and diseconomies of scale. Add to the scope of the country the problems arising from the lack of means of communication that the industrial revolution partly solved for their modern counterparts. These limits imposed multilevel or multilayer system of governance even to those ancient empires. The insightful lesson that we can take from history is that decentralized knowledge breeds decentralized government, unless you live in a body politic in which "La République n'a pas besoin de savants" (the Republic does not need the erudite).

Theoretically speaking, localism can promote the use of local and dispersed knowledge and contribute to the socio-economic development. Many of the adherents of localism argue that smaller governments provide a better context in which the citizens can have a better sense of community. Some of these proponents go farther and argue that the constitutional and legal rights should be context sensitive. These advocates of localism believe in a broader decentralized constitutionalism. They argue that the courts should respect the “geographical variations of constitutional requirements in the aid of community”. In addition, the existence of large number of local governments who are much more familiar with the needs of the special communities and certain localities, with the amount of services and consumption which is usually limited to their own jurisdiction increases the economic efficiency in the provision of public goods and certain utilities.

Localism can promote economic efficiency by taking account of the differences in preferences and cost differentials in the locally needed public goods. Therefore, it appears that the efficient level of output in local public goods seems to be variable in the local jurisdictions and likewise governments provide the better allocation of local services in a decentralized structure. Other economic adherents of localism argue that the very existence of the localities brings about plurality of localities and extend the opportunities of the citizens to move into better localities which provide the better allocation of services and taxes and eventually serves the economic efficiency. Tiebout was the first theorist who elaborated the idea of the “voting with the feet”. However, it seems that he overlooked some costs affiliated with his idea such as tremendous migration costs, externalities and asymmetric information, which adversely affect the outcome of the theory. All in all, these local governments play an extremely important role as a channel through which local knowledge channels into the federal level and makes planning in a central level a bit less onerous.

Unfortunately there were inefficiencies in the localism as well which could not bring about the desired result we might have expected to reach. But why do we see inefficiencies even with having local governments in place for centuries? The answer is in the inefficiencies embedded in the localism. Inefficiencies resulting from the diseconomies of scale, high costs of communications among many local governments, duplication of efforts and the forgone opportunities of network economic effect in a sub-optimally organized networks of local governments, existence of the commons in the regions, free riding problem, and problems arising from the taxation, transactions costs and hold-out problems hindered the local governments from flourishing and the long fought battle between home rule and Dillon's rule was resolved in favor of the latter.

Let's have a quick look at the history to see why this form of government could not be efficient enough. With the gradual evolution of urban life, consciously or unconsciously, some other problems and thereafter concepts came into existence; the concepts similar to annexation and incorporation in the history of urban life. The rising of these phenomena signaled that the network economic effects (having bigger entities with lots of individual components) prevailed over the benefits of the having small local governments.

First let's see why would people like to migrate and live in prosperous places rather than the isolated underdeveloped places? The answer lies in a concept known as network externality. Network externalities appear when greater numbers of users join to a network. This theory assumes that “the utility that a given user derives from a good depends upon the number of other users who are in the same “network” as is he or she.” This network can appear for example when the municipalities join together in a unified network to share their resources. Although this fact may generate some unintended consequences like diseconomies of scale, but it seems that taking the size and number into a serious consideration and not letting them grow more than necessary, this will increase the positive externalities of networking.
One of the best historical examples of network effects which caused some cities to grow immensely, is the city of Baghdad at the time of Abbasid Caliphate (Rome might be a good approximate to a western mind). At that time, the city of Baghdad had a position in the world comparable to world cities of today. Ibn-e-Khaldun describes the City of Baghdad as follows:

“[T]he town will extend farther and farther. Eventually, the layout of the town will cover a wide area, and the town will extend so far and wide as to be almost beyond measurement. This happened in Baghdad and similar cities. Baghdad included over forty of the adjacent neighboring towns and cities. It was not just one town surrounded by one wall. Its population was much too large for that, the same was the case with al-Qayrawan, Cordoba, and al-Mahdiyah in Islamic times. It is the case with . . . Cairo at this time, so we are told.” (Badi, 1988, p. 86)

This discussion of the growth of large cities such as Baghdad is similar in essence to what is referred today as the process of suburbanization, a phenomenon that in turn causes sprawl. With the growing number of districts within a country or a city, other problems come into being as well, i.e., coordination problem embedded in the decentralized and (more recently) separated power structure of the state. So from the above examples and economic history indications, one can see that neither large nor small sizes are optimal for the states/cities.

The further complication is that the size of the population of societies does not remain constant and increasingly changes with the fluctuations in the labor, capital and technologies, while the supply of the land almost remains constant. Furthermore, there exists an optimal size for the states. But who knows what that optimal size is? Therefore, the restructuring of the state will not mitigate the problems and if it does, further problems will arise (coordination problem & the like). As above examples show, many of the problems could not be dealt with either by centralization or decentralization. There must be a way out.

International Law and the Exchange of Authority: Towards Creation of Charter Cities
The idea of comparative advantage based on the division of labor and ensuing expertise simply states that each country can be good in producing or providing some special goods or services, and they can enter into a contract to exchange goods and services that can create new economic value for both sides of a transaction. Based on this theory and upon the demise of the zero-sum fallacy, rise of the marginalism, and new theory of economic value, we almost see the end to the beggar thy neighbor policies that the states pursued in the pre-modern era by waging extremely costly wars against their neighbors or rivals. These theoretical transformations gave birth to the new theory of international law, i.e., the economic theory of international law, the goal of which is to let the states to achieve their preferences with better and greater efficiency through exchanges of authority and transactions in Jurisdiction. This is a very good point to set the stages to establish our argument for charter cities. This approach to international law can explain how a metamorphosis in international law; i.e., from sovereignty based international law to market based international law can contribute to the economic prosperity and development of the nations.

Although, the economic approach to international law states that the states can do more efficiently by exchanges of authority and transactions in jurisdictions, we can push the argument one step further in the sense that nation-states exchange their sovereignty over the defined pieces of territory. This model proposes that to enhance efficiency, nations should bargain on their territories and hence this model supports the creation of a market for the national territories (specially barren and undeveloped national territories) so that the territories will go to their most valued use. This is roughly what the idea of "charter city" proposed by Paul Romer is.

First let's see what a charter city essentially is. The concept of charter city, as formulated by Paul Romer, is a city which is composed of three elements: host state, source state and the guarantor. The host country provides undeveloped lands, the source country or countries provide the residents and guarantor ensures that the charter of the city (which is essentially the constitution of the city) is enforced. The host country is supposed to ensure that it will not apply his internal rules and regulations on that specified undeveloped land and the charter will ensure that the basic requirements of rule of law will be in place. Notice that each of these countries has comparative advantage in goods, capital and services they provide for the Charter city.

Successful historical examples of charter cities are Lübeck in twelfth century, Pennsylvania/Philadelphia in the 17th century, and Hong Kong in the 20th Century, each with different stories which in this paper, for the sake of brevity is forgone. The argument is that if these models of the charter city achieve success, other countries will follow suit as other states and countries did in case of Pennsylvania and Hong Kong.

The difference between localism and the charter city mechanism is that localism is an attempt to involve everybody by creating incentives and increasing differential value of voting to increase the marginal value of voting to make it attractive for voter to become involved in the elections. Charter city is an attempt to provide an alternative pattern to the existing patterns of democracy and development to make the environment and context more dynamic. Charter city is an attempt to involve those who see it in their interest to involve and those who will.

Unfortunately, the principle of territorial integrity in international law was abusively construed by national authorities not to let nations to enter into a bargain on their territories while history documented several transactions transferring national lands such as Louisiana and Alaska purchase. The biggest problem in the way of such an idea is the double-degree agency problem in international law. As stated above, the government or the diplomats who are negotiating such a deal might have conflict of interest with the nation they are representing. Though the mechanism of checks and balances can mitigate this problem to a considerable extent, it can never eliminate it. And maybe this is the reason why many countries in their constitutions do not allow any negotiations on their territories.

The requirements of the modern complicated world with its extreme problems imposed on the isolated fortified states, requires more cooperation, coordination of the efforts and contribution of the capacities in which every individual state might have comparative advantage, to solve the problems of global magnitude.
The status quo is that there are many underdeveloped countries with vast territories under their rule and simultaneously there exists geographically small countries with almost fully-developed lands and in need of more lands. A salient example of an inefficiency caused by the "sacred", fortified boundaries is the example of Japan and Russia. Large population of Japan living on a bunch of small vulnerable islands while vast pieces of lands remains underdeveloped in Russia. It might be said that those lands are not inhabitable, but evidence shows that people even can make use of the swamps to live in if they do not have any better choice.

There is certainly tremendous amount of deadweight loss negatively affecting the lives of millions just because we drew some lines around us and made a lot of taboos around it, murdered and were murdered because of those usually fictive lines.
I know that the history of international law was a very sad one. And this history of wars which gave rise to the present extremely conservative international legal system, but the increasing realities may not wait for that conservatism of international law to vanish gradually. The population growth and the interconnectedness of this population will impose greater challenges on the international law than the immigration and other present environmental challenges. This time the target will be the very principles of international law.

As the last point, It should be noted that though the idea of charter city seems unrealistic and utopian, given the growing rate of obsolescence of ideas due to the accumulation of dispersed knowledge of the people through the virtual networks which connect the individuals from all over the globe, it will not be too far that everybody will see the flourishing of ideas which were considered too unlikely and unfamiliar. What seems à la mode today, will be obsolete tomorrow, special thanks and tribute to fiber optics, microchips/processors, satellite and internet.

International Trade and Race to the Bottom

"Should other states be concerned about your environmental protection choice?" This is a fundamental question in trade policy and regulation which is asked almost everywhere to set the stage for starting the debate about international trade regulation and our class in Economics of International Law was no exception. Most of the answers offered to justify the governments' intervention in the international trade policy are based on the externalities (jobs displacement, protection of the infant industries), strategic trade theory and race to the bottom argument. What I will be talking about is the last argument offered for having restrictions on international trade.

What constitutes the core idea in the race to the bottom argument for restricting the international trade and perceived to be the strongest argument for a hidden protectionism is the race to the bottom. It is argued that the free international trade will be in favor of the countries with less restrictive labor, environmental and human rights measures and will be detrimental to the countries with higher standards with regard to the above mentioned standards, so trading with those countries not only puts the countries with higher standards in comparative disadvantage, but also makes the acute problems of the environment and human rights worse, so there should be either no trade with countries with low standards or there should be some restriction on trading with them.

I my view there are problems with this argument.
1. In terms of economics, since the advent of the marginalist revolution based on the modern theory of economic value, no sound economist could be found to be thinking that there should be no trade at all. One of the fundamental methods of thinking like an economist is thinking marginally. It means that most of the times, we are not dealing with the problems involving either/or, but problems of different degrees or levels taking account of other available alternatives at disposal. Marginalism should be understood as part of the fundamentals of the theory of the microeconomics dealing with the optimal allocation of the limited resources to the unlimited wants and desires. It implies that most of the choices we are making in our life is not about whether we want something or not, but how much of something we want in combination of how much of some other things. So, when the question is not about all or none, but about how much, the answer should be about how much trade with those countries and how much restrictions should be put on those trades.

2. Second and more logically based argument against the race to the bottom is about the fallacy/problem of equivocation lying in the context of the debates on the international trade. The repeated use of the race to the bottom argument makes economists to take it as granted. I think the question we should ask should concern with the meaning and implications of the word "bottom". We should come up with an idea of what this bottom means and after setting the reference/anchor points in the definition of the bottom, proceed to make use of this argument against international trade. Someone sitting in the developed country may see a situation as bottom while the other one in an underdeveloped / undeveloped / emerging market sees it as top. This fallacious argument arising from the improper use of the language and ambiguity in the meaning of the words is called equivocation. If we want to resolve this problem, the parties to an argument should first agree about the meaning of the concept or the conception of the particular concept they have in their minds in that particular context.

The other days, I was watching an interview with an ex-Chinese teacher who was working in a factory at that moment, he was telling to the interviewer that when he was a teacher he earned one hundred Yuan per month (I am not sure about the currency and the period, but sure about the numbers), while working in the factory he could earn 3.000 and despite being in a very modest situation he was very happy. What developed world sees a bottom, to him it was top.

There is a nice and almost untranslatable verse in Persian which best describes this problem with a very palpable analogy. It goes as follows:
حوران بهشتی را دوزخ بود اعراف
از دوزخیان پرس که اعراف بهشت است
A'raf is a place located in between the heaven and hell. The verse says that for the angels of heaven, A'raf is a hell, while for the residents of hell, it is a heaven. So two categories of people with two different socio-economic! standings, see one thing differently and consequently if these two with the above specifications argue about the a'raf, they have two distinct conceptions in their minds and cannot come to a proper conclusion on that.

It appears that in the race to the bottom argument convergence on the word "bottom" has yet to be achieved. Though this "bottom" concept could be roughly taken as granted when we are talking about one domestic legal system, we should not hastily and unthinkingly borrow the concepts from the domestic legal or economic system and apply it to a different legal structure.

Another important argument against restricting the trade with countries with looser standards is that it will prevent the evolutionary process of divergence of the conception of the concept of the "bottom" which trade with those countries can bring about. As the basic principles of economics imply, no trade/ voluntary exchange can occur unless it is beneficial to both parties, when we see that one enters into a voluntary exchange of goods or services, it is appropriate to assume it is in the interest of both parties to engage in that particular trade. Having this in mind, it will become clear that imposing restrictions on the trade with these countries will wipe out both producer and consumer surpluses and will be detrimental to both parties, especially it will make barriers for developing countries to reap the profits of the trade and will leave them in their regrettable status quo, i.e., poverty and starvation, while having trade can fill the gap between those countries and more developed ones to a considerable degree and pushes the "bottom" up.

3. I personally believe that the main reason behind this kind of argument is nothing more than a hidden filthy protectionism formulated and propagated by the more organized producers to the detriment of the non-organized consumers and society trapped in the collective action problem unable to further their interests.

The last point I want to make is that we cannot judge and evaluate the arguments in vacuum, when we want to assess the implications of particular policies we are supposed to look at the alternatives we have at hand. There seems to be two alternatives for having trade with countries with looser standards, first having no trade with them and sanctioning their products, second having limited trade imposing higher tariffs and quotas on their product. I think both of these arguments are doomed to fail. Why? The first one is quite obvious, it will end up in huge losses in the forgone gains of trade and both parties to the trade will lose. The second one will result in a huge deadweight loss arising from the restrictions on the trade. Though less detrimental than the first one, it will bring more restrictive measures to the trade in favor of the organized interest groups which will endure even after the change in circumstances. After an institution is established, it will be very hard to unravel it. On the other hand, this institution will generate public officials and bureaucrats seeking their interest to the detriment of the society as a whole.
So it seems appropriate to ask whether a free trade with emerging markets even with looser human rights, environmental or labor standards will result in the race to the bottom or race to efficiency.

Hawkin's Round Trip Fallacy

Mr. Hawkin knows very well how to play (maybe he does not really play). Once he wrote there is a God and Millions of copies of his book were sold, now he claims on the contrary but confusing no evidence of Heavens/God with evidence of no heavens again. A big round trip fallacy which seems to be very delightful for many, and once again will turn him into another bestseller. Once I have read this quotation somewhere: "Without education we are in a horrible and deadly danger of taking educated people seriously" and as time passes, I realize it is the most plausible justification for getting educated.

Regulatory Paternalism and its Unanticipated Consequences

One of the ironies of the modern word is the unwanted and unanticipated (who knows?) consequences of the regulatory intervention in economic activities. One of these consequences is in the securities regulation in which regulators had hard times regulating recently. Regulators are supposed to protect investors and one of the mechanisms of investor protection is the disclosure requirements in public offerings. They think that the disclosure of information will protect the investors while many unsophisticated individual investors cannot make heads or tails of the disclosed information. I do not like to focus on this issue, what I would like to discuss is the problems arising from the paternalistic approach of the regulators. As I said, this disclosure requirement is limited to public offering while laws and Regulations made some exceptions to this general requirement and one of those exceptions is the private placement.

As defined in the famous case of 1953 SEC v. Ralston Purina Co. "a transaction not involving a public offering" is "an offering to those who are shown to be able to fend for themselves." Who is able to fend for himself, SEC Rule 501 (a) defines such a person as an "accredited investor". Accredited investor is any "natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000”; any “natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year”; plus executive officers and directors of the issuers.

There are some other details into which there is no need to enter. The hedge funds and private equity funds are among those issuers of securities taking advantage of the above mentioned provisions who can sell securities to accredited investors. Having a quick look at the hedge funds returns and a quick comparison of their overall returns to S&P 500 and other indices returns reveal that hedge funds either in times of economic prosperity or in times of turmoil earns much more and lose much less than other indices. It means that both in upturns and downturns they outperform the market. Thanks to the SEC/securities regulation which does not restrict the hedge funds and some other private equity funds' strategies while doing so for other financial institutions. Taking advantage of this laxity in regulation for hedge funds and more stringent regulation for other financial institutions, hedge funds are able to have better risk management strategies because a wide variety of the financial strategies, especially short selling mechanism, at their disposal, .

Anyhow, the hedge funds outperform the market with having a helping hand from regulators who create an economic rent for them. The irony is that only the so called "accredited investors" can invest in these funds and general public are banned from investing in them. It means that if you are poor, you cannot invest in them and have higher return on your equity, but if you are rich enough, you can do so and get increasingly richer than the poor in market upturns and in the market downturns lose lot less than the poor does.

Promoting Individual Responsibility by Social Mechanisms

Let's start with an example. In the Netherlands, to use the public transportation, you should get a card/ticket, called OV chipcard, that is basically a rechargeable/reloadable card that one can reload it whenever s/he wants to use the public transportation, but how it works. The mechanism is basically as follows: when you want to check in the public transportation, you should introduce your card to the automatic machines (screen gates), the machine automatically reduces 4.00 Euros from your card, when you want to check out, you should introduce your card again and based on the number of kilometers traveled, that machine reduces the proportionate number of Euros. If you forget to check out, your total 4.00 will be gone.
Compare this to Italy. In Italy, and especially in Bologna where there is no subway system, you have a host of deals in getting the tickets to get on the buses. Hourly, daily, three days, monthly and annual passes. When you check in, these passes should be validated once and will be valid till the end of the period printed on the ticket. If you have an hourly pass, you should swipe it into the machine; otherwise you just do nothing if you have already validated it. There is a random check by the public transportation (ATC) officers to see whether the passengers have the tickets or not. If you do not have the tickets, you will be fined, how much is the fine, at the time I were in Bologna, it was around 40 Euros. And the hourly ticket was 1 euro (it is now 1.50). The fine was calculated as the one time travel fare times 40. Anyway, given the enforcement of this law by the ATC officers, if you multiply the probability of being caught by the inspectors by the amount of fine, it economically makes sense not to buy the ticket, get a free ride and be fined for violating the law, overall you would have paid less, if you wanted to get a free ride.
This is a law which is inherently self-defeating and encourages its own violation. One can see how one law encourages people to be alert and punishes the forgetfulness and absentmindedness and the other encourages irresponsibility and violation of the laws, though there might be some justifications for having these kinds of laws in place, the downside is drastically dangerous, spreading the irresponsibility in the society. These are small (micro) distinctions which make big (macro) differences in the long run.

The Interesting World of Finance

The world of finance amazes me all the time. I cannot help thinking about a saying of a friend of mine who once said that he could not understand why someone buys and someone else sells the same stocks at the same moment, think of it, the transaction happens at the same point in time. Needless to say, this transaction does not arise from a need to exchange goods or services, the parties just exchange financial assets. This is one of the most interesting phenomena I have ever seen in my life. This I cannot understand either. Information asymmetry, different technical and fundamental analyses, different expectations … Now, the thing that amazes me more is the mechanism by which speculators speculate on credit default swaps …

Petitio Principii in Economic Analysis

The current trend in the economic analysis is to analyze almost everything through the lens of economists. Today while attending the class (and when the class got so much boring that no one cannot resist dreaming), I was thinking much about the economic analysis and its foundations. Maybe it is mostly because I have started to read a book titled The Foundations of Economic Method: A Popperian Perspective. It is a very thought-provoking book. It starts with the point that why methodology does not matter in the mainstream in economics viewpoints. It provides some insight about the issues which is worth reading. As a PhD student, I was expected to have methodology based courses in the EDLE, but unfortunately except one, we did not receive any. Thanks to Prof. Parisi who turned the class of Economic Analysis of Law into a class similar to how to think like an economist about law and how to build models in Law & Economics.
Anyway, I was talking about the importance of economic method. In the modern mainstream economics, which is mostly based on the neoclassical economics (enshrined with lots of insights from game theory and behavioral economics), what matters is the economic value and utility. Roughly speaking everything enters into the utility function in the economic analysis. Needless to say, in order for something to be included in the utility function, it should be quantifiable and for economists monetized. But in addition to many critics of the economic method about non-quantifiability and et cetera, et cetera, there seems to be a fundamental flaw in this kind of reasoning. And that is the extreme reliance of economists on the revealed preferences while studying the utility functions and the value that the individuals attach to the phenomena.
Since the whole idea of at least normative (and at most positive) economics revolves around the pivotal word "incentive", and what makes people to be incentivized to do something or to avoid doing that, is the utility they derive from their economic activities. So the word utility and its definition should be scrutinized very carefully in economics.
It says that everything (i.e., incentives which is almost everything in economics) depends on the utility individuals derive from their choices/activities. The problem is that no one knows about individuals' utility. Just after the fact, on the basis of revealed preferences, the economists say that something which is done had more utility that something forgone, or the choice made is preferable to the choice forgone because it had more utility for the individual. The difference is mostly about the difference between ex-post and ex-ante. What we cannot do is reading the mind of economic men, so we are forced to assume that what people do, had more utility for them than something forgone.
In order to understand the fallacy, let's see what the fallacy of petitio principii is. The key issue in this fallacy, which is also known as the fallacy of "begging the question" is the assumptions made in the process of the argument (and economics is replete with the assumptions). In this fallacy, the asserted part in the conclusion is assumed in the very premises. In such a setting, the argument becomes circular because the same statement is used to prove itself.
In economics we say that the economic choices of people depend upon their utilities they derive from their choices. The same thing could be said about the economic value. When you value something over the other, it means that you are deriving more utility from that "something" over the other "something". So how can we know who values what more? The criterion as I said above is the revealed preference, when someone chooses something over the other, ex-post, it is said that she preferred/valued that thing over the other and hence she derives more utility from that than the thing forgone. So the fallacy lies behind the revealed preference. One can easily see the circularity in the definition of the utility/economic value. What is utility? Utility is something which measures level of satisfaction from an economic activity (including the usefulness of such an activity), what is satisfaction from the economic activity? The act that gives more utility to the actor and it is never known ex-ante.
Fortunately, economics cannot say ex-ante what should be preferred to what, because it is something quite subjective. Different individuals have different tastes and behave on the basis of their individual preferences and economics avoids making value judgment about those preferences. So the good news is that the economics is quite neutral about the preference, and after the preference made, it suggest how we can rationally get to the objective we have chosen. In fact, economics does not deal with the objectives; it just comes into play when we need instruments we are taking to get to those objectives. And the most important tool it uses is the rational behavior which itself is a quite controversial topic to ponder on. But I think this distinction in the concept of rationality cannot be limited just to the ways and methods we are using to get to our objective, but it necessarily spills-over the preferences of individuals too (an issue that will be addressed later) and that is what makes the utility and its definition more important.

Crime and Punishment: the Problem of Proportionality

One of the main principles in criminal law is the proportionality of crime and punishment. Opening every criminal law textbook, one of the main topics which pops up immediately is this proportionality. But to the best of my knowledge there was no study of what really proportionality means. (Of course I am not a criminal law expert and my knowledge about that is quite limited). This proportionality could be studied from many different points of view. From psychology, philosophy, sociology, economics to mathematics!!! Which in my view of one the interesting views should be the psychological one.
Anyhow, to me it seems there is no universal criterion for this proportionality. If there was, the intensity of the punishment to the like crimes in different countries should be the same or at least alike. But it is not. This is an evidence of subjectivity of this proportionality. And it absolutely depends on the anchor points or reference points each society sets in his social norms and code of laws by historical accident or consciously. So it is not enough just to repeat and repeat and emphasize that the crime should be proportional to the punishment, it is also important to embark on the experimental, behavioral and empirical studies to show what these anchor points are.
The importance of this point becomes critical when we take proportionality into fairness and justice consideration. If so, for designing a fair or just or economically optimal criminal system, the perceptions of proportionality in that specific legal system should be studied to find a basis for criminalization. For instance, in some countries, like China, this anchor points are set very high for the economic crimes such as corruption, while in other countries these crimes are responded more gently. As an extreme example, same sex sexual relationships in some countries are not even a crime, while in others responded by capital punishment.
What is clear is the fact that the social norms, religions, ideologies and cultures play a substantial role in creating these reference points. Different historical incidents every society has gone though have significant impact on those points. What encouraged me (a non-expert in criminal studies) to write these few lines was the importance of building models for measuring this proportionality (which is totally context dependent) in different societies by designing experiments and having empirical research on the subject.

CENTRAL BANK INDEPENDENCE & MONETARY-FISCAL POLICY COORDINATION

The debate over the independence of the central banks is a very deep rooted one and discussed from many legal, economic and political standpoints. In this short paper, I will discuss the issue in a game theoretic setting and using a simple model of game theory will argue for the independence of central banks (uncoordinated monetary and fiscal policy making) rather than having one authority or two authorities with coordinate policy making powers. The problem of the coordination of the monetary and fiscal policy is a question of constitutional law as well as a question of the economic policy making. The power over issuing money is the most critical instrument for having ones policies implemented and it is mostly assigned to the Independent Central Bankers. Since there are many structural and institutional links between Central Banks and Parliament and sometimes other government bodies, the independence does not mean isolation, what we speak about here, is a relative independence, as it is a common knowledge, in most countries the head of the Central Banks are appointed collaboratively by Parliaments and the Administration (Presidents), so no one can expect an absolute independence in an extremely interdependent political systems.
On the other hand, the power over taxation and expenditure is almost equally important and basically regulated by constitutions. Historical origins of constitutions show that the taxation played a prominent role in the emergence of the modern state and democracies. And hence, almost every modern constitution has a provision or provisions about the power to taxation.
Here, the question is whether there is any plausible justification for having independent central banks and having almost no coordination between parliaments (as fiscal policy makers) and central banks (as monetary policy makers) and what is the logic behind the prescription of the constitutions and laws on having two separate and almost independent policy makers for fiscal and monetary policy which seem to be pursuing one common goal. At first blush and intuitively, it seems that having one institution taking care of both monetary and fiscal policies is better than having two coordinate institutions and also it intuitively seems plausible that the coordinate institutions are preferred to uncoordinated ones. In order to deal with this problem we should first delve deeply into the incentive systems that they might have and study the incentives of both monetary policy-making and fiscal policy making institutions.

Incentives of Fiscal and Monetary Policy Making Authorities
Each of these two institutions might have different incentives and the incentives are basically dependent upon many factors among which the institutional design is of critical importance. On the other hand, their incentives are also dependent upon the effects of the policy instruments of these two institutions which I will categorize those policies into two general categories of expansionary and contractionary policies.
Institutionally and somewhat traditionally, Central Banks are in charge of the stability of the economy by controlling inflation rate and accordingly, many central bankers think that they should control inflation rate before dealing with many other policy objectives. Controlling price stability is not as easy as it appears. There are lots of complexities involved and it requires playing many different games in many different manipulated contexts. For example, when they try to beat the inflation with increasing interest rate by manipulating the policy instruments they have at their disposal, there will be concerns about unemployment and in turn if they want to have the expansionary policies to beat the unemployment there will be other problems, since fiscal expansion will increase the real interest rates, rising interest rates will make capital accumulation for the businesses extremely hard and hence slowing the growth of the aggregate supply, when the central bankers want to beat the inflation by increasing interest rate, they will found themselves under pressure of diminishing growth. On the other hand, monetary expansion has the effect of decreasing the interest rates and hence easing capital formation and increasing aggregate supply but the cost is higher inflation, something that central bankers do not like at all. Though there are lots of complexities in pursuing one or more policies, for the sake of simplicity, we assume that Central Banks can achieve their targets by instruments they are legally and institutionally conferred.
In addition to these formal incentives and objectives these institutions have, there are other incentives which might be helpful in analyzing the behavior of the two institutions. For example, parliament and administration who are mutually in charge of the fiscal policy making are both elected bodies of the government and they tend to be mostly in favor of short sighted popular policies and hence pursue expansionary policies, but expansionary policies also lead to huge budget deficits, and one of the key concerns about the government budget deficit comes into play when we want to consider the impact of savings on economic growth. Since savings will result in capital formation and capital formation in growth, government's huge borrowing may have a crowd out effect on the private firms' borrowings, because large government borrowing will deplete the borrowing resources for the private firms and in the long run will inhibit economic growth. Now, we might be able to see why dealing with the budget deficit is not as easy as it seems.
On the contrary, the Central Bankers with their longer tenure, are assumed to be in charge of long term economic policies (mostly because of the fact that the tenure of the chairmen of the central banks outlive the tenure of the office of the elected bodies of the government) and their first concerns by law or in fact is dealing with inflation and having a price stability. This might explain why the Central Bankers prefer the contractionary policies and because the administration and the parliaments are elected bodies, they prefer the expansionary policies to deal with at least problems that they face today and to pass the burden of the problems to the next generation of law makers and hence increasingly increasing the budget deficit through time.
Furthermore, nevertheless they have different objective and opinions about the state of the economy and also they have different views about the instruments that should be used to deal with the problems encountered in an economy, we assume both of these institutions making rational decision with respect to the status of the economy. What gives rise to a game theoretic setting in this context is not that one of these or both of these institutions might have perverse incentives, we assume that both of them are benign policy makers and do what they think to be beneficial for the economy. Otherwise, we could have a very complicated settings which should have broken down to many other games to be solved, so for the sake of simplicity we assume they are benign and their difference on policy issues is rooted in the fact that they have different opinions on dealing with the economic issues except the fact that the fiscal policies tend to be expansionary and monetary policies tend to be contractionary. In addition to the above mentioned complexities, there are externalities associated with every decision or policy that each of the players on the other player, this is exactly what gives rise to the game theoretic setting in this context.
The question firstly arises is why these two bodies should not be consolidated into one body so that we have a single body deciding on the fiscal and monetary policy? If the answer to the above question is no, we should think of the coordination between these two major policy makers of the nations. Why should not we have a single authority to decide about the coordination issues between Central bank which is in charge of the monetary policy and the parliament which is in charge of the fiscal policies?
In this simple model, among the possible mix of coordination, i.e., a single unified policy maker, uncoordinated policy makers, and coordinate policy making (leader follower arrangement), I choose two uncoordinated policy makers playing a simultaneous game and then an uncoordinated leader follower arrangement in which the two institutions will engage in a sequential game and will analyze the two situations to see if it fits well with the optimal total payoff which the society as a whole pursues from both monetary and fiscal policy. So, I will confine myself to the study of two uncoordinated policymakers which best fits with reality of the many legal and political systems with regard to the fiscal and monetary policy making.

The model: Designing the Game
In designing the game we should take into account at least three elements of the game i.e., players, strategies and the payoffs. For analytical ease we will simplify our game as much as possible so that by isolation and then adding other elements and considerations into our simple model we can develop a better and much complicated model.
Players are central Bankers (Assumed as the sole monetary policy makers) and Parliaments (as a single body considered as the fiscal policy maker, though the executive has a great deal of say in designing the budget and there are game played in drafting the budget between the administration and the parliament, for the ease of analysis, we just consider the parliament as the ultimate decision maker in this study.)
Strategies come from incentives. As partly discussed above, incentives of the central banks can be categorized as macroeconomic stabilization and controlling the inflation. Central banks are perceived to pursue long run economic objectives. On the other hand, the growth, having higher output and the unemployment are the two most important concerns of the fiscal policy makers who are perceived to pursue the short run economic objectives. So it seems plausible for central bankers to embark on the contractionary policies and for the parliaments to pursue expansionary policies. Therefore, I will group the strategies into two inclusive strategies: expansionary or contractionary fiscal or monetary policies. Although these strategies could be divided into its composing elements and make some other games within the larger game played by the central bankers and parliaments, for the sake of simplicity, we assume that the result of those sub-games will constitute expansionary or contractionary policies at large.
Timing: This game could be formulated both simultaneously and sequentially in which once parliament leads and Central Bank follows and once central bank leads and government follows. But in this short study first we will limit it to a simultaneous move, as it evident, simultaneity does not mean that the decisions are taken at the same time, but it also implies simultaneity when the other player is not aware of the other player's strategy. After analyzing the simultaneous game, we will turn to the sequential game and will study the case in which these two institutions of governments acting asynchronously and repeatedly.
Payoffs: In this game, which is a kind of prisoner's dilemma, we assume 4 is the best payoff and 1 is the worst for every player. And in the combination of the two outcomes, we assume that the expansion by the monetary policy and contraction by the fiscal policy is preferable for the both (3, 3) to the contraction of monetary policy and expansion of the fiscal policy (2, 2).



The above matrix illustrates the payoffs for both players trying both strategies. The best response from the monetary policy making authority to the expansionary policies from the fiscal policy maker, is to take contractionary measures and hence get 2 instead of one, and the best response of Central Bank to the contractionary policy of the parliament is to have a contractionary policy (4 is preferred to 1). On the other hand, the best response to the expansionary policy of central bank is to take the contractionary policy for the parliament and the best response to contractionary policy of the central bank is to take the expansionary policy. So the Nash equilibrium which is the intersection of Nash strategies is the pair (2, 2) which is not a Pareto optimal or is a bad equilibrium. Although in this step of analysis, it seems that the coordination of these two major economic policy makers might yield higher payoffs by moving from bad equilibrium to a good one (or Pareto Optimal equilibrium), we shall see that, if the game is played repeatedly, the good equilibrium could be achieved.

More on Timing & Repetition:
Let's have a more realistic approach to this setting, by realistic, I mean that, in reality almost always we have a sequential game played by the parliaments and the Central Bankers. It means that there is a leader follower arrangement in which first one player decides what to do and then the other having seen the other player's move, moves. In this context it gets more complicated to find out who gets to move first. In reality, we observe that the central bankers make their policies more frequently than the fiscal policy makers. Fiscal policy makers usually make their policies annually and the monetary policy makers do it almost every other week or monthly depending on the different legal frameworks, but generally they make their policies more frequently.
In this case, too, suppose that first the fiscal authority moves and decides how much to tax and spend. Making this decision, it is fully aware that the fed is watching them and will respond with a strategy which will maximize its payoffs, so as the above matrix shows parliament will anticipate that the response of the central bank will be contraction, so it will respond with expansion. The fiscal policy maker will predict that the Central bank will play contraction, whatever the parliament's decision is. So the parliament will decide to play expansion, so we will be in (a sub-optimal) Nash equilibrium again. The same line reasoning can be applied to the case that the central bank moves first and the parliament follows. In this case too, the central bank knows that the dominant strategy for the parliament is expansion and then responds with contraction and once again, we have the (sub-optimal) Nash equilibrium.
What will repetition contribute to this setting? In other words, what will happen if we have a repeated game in this setting, the assumption which best fits the reality, it means not only parliaments and central banks play a sequential game, but also they play a repeated game too. In this sense, as anticipated, the follower knows that his decision in the first period will affect the leader's decision in the second period and acting rationally, it will take it into account. So this repeated interaction should play an important role in giving a spontaneous order to the interaction between parliament and central bank so that in the long run they can achieve a Pareto optimum (3, 3) and reduce the losses arising from the difference between 2 (which was attained in a one shot game) and 3 attained in a repeated game. In fact having this kind of arrangement (uncoordinated fiscal and monetary policy making) is equal to creating a system of checks and balances in which the Central Banks can discipline the fiscal policy and also the Parliaments can exercise certain degrees of discipline on the Central Bankers. So this interaction in time and repetition will make the leader to make decisions and take actions more in tune with and taking into account the targets and the objectives of the follower. And in turn, it will cause the follower to do so as well. This spontaneous cooperation (and not coordination) will emerge because they are entering an almost never ending game, if the game were a game of finite repetition, one might argue that because game will be finished at some point, by backward induction, none of the players might not enter a cooperation because they know that the other player will be cheating in the last game and so every player might think that it might be screwed up, therefore, neither player has the incentive to enter that cooperation, but since both the players know that the game will be played infinitely and more importantly, if by any change there would be a disruption in the continuity, no players know the period in which the game might be disrupted, they will end up playing cooperatively, and will move from the sub-optimal equilibrium to the optimal one.
The other objection might be that, because generally the tenure of the members of the parliaments ends after around 4 years, because of the lame duck effect that these limitations over the tenure might cause for the members of the parliament, we should expect a disruption in the repetition of the game, but this objection misses another important point and that is it ignores the fact that the members of the parliament have the incentive to be reelected, and this reelection which in almost most countries, is infinite. So, the incentive to be reelected as a member of parliament infinitely, can guarantee an infinity to the game played by both monetary and fiscal authorities and hence the cooperation and achieving a Pareto-optimum equilibrium. On the contrary, the limitation on the participation in consecutive elections to be elected to be a president might cause the lame duck effect, so one might guess why constitutions did not granted the fiscal policy making to presidents (executive power) instead of parliaments. Although this problem might be mitigated in countries with small number of established parties competing with each other over taking over the government.
All in all, quite contrary to the intuition, it seems that the uncoordinated fiscal and monetary policy making may yield higher payoffs and result in an optimal equilibrium than the coordinated one which might impose the one political or economic ideology over a system which if turns out to be false, might have catastrophic effects on the economy. These higher payoffs will emerge from the repetition of the games played by the fiscal and monetary policy making authorities under specific circumstances and having particular infrastructures such as the free and repeated and fair elections and established political parties.