Two followups, in way too many words
1. Asymmetry of information about information
[I]nformation asymmetry is that the sellers know what they are selling much better than the buyers know what they are buying. However, I do not think this is what distinguishes those four industries. There are plenty of other situations of information asymmetry, including buying a house, buying a car, or buying a piece of electronic equipment.
I think what distinguishes these four industries is that the sellers themselves know less than what people expect. Educators do not know what, if anything, actually adds value. For all we know, test scores are determined by the backgrounds (mostly genetic) of the students, with remaining differences that are random and irreproducible.
Kling is right, of course. When writing the previous post, I considered switching to the term “uncertainty industries”, as both buyers and sellers of government, healthcare, education, and financial services are often in the dark about the degree to which transactions will provide value. But “uncertainty industries” suggests a similarity of confusion between buyers and sellers, which isn’t right. Sellers still have substantially better information. First, there is plenty of old-style information asymmetry in all of these industries: Politicians sometimes do know they are favoring or overpaying financially supportive suppliers. Health care providers sometimes do recommend tests and procedures that from a distance they would recognize as superfluous (even accounting for defensive medicine concerns). Educational institutions notoriously play up successes among graduates they know to be outliers. And, of course, the Wall Street tradition of “putting lipstick on a pig” is denied before every jury but widely and even fondly acknowledged when the context is nonspecific.
Still, as Kling observes, this kind of thing goes on in almost all industries. Sellers know more than buyers, salesman overstate benefits and downplay weaknesses of which they are aware, etc. So what makes these four industries different? Two things:
Information asymmetries are unusually difficult to resolve in these industries. A substantial fraction of people who buy a low quality house, car, or stereo eventually come to notice that. This makes it possible for new purchasers of these goods to manage their information problem by researching others’ experience and seller reputations. But in the four industries I’ve described, even after we have purchased services, we are often unable to evaluate their quality.
- Lots of Harvard grads do well, so reputation “yay!”. But people accepted to Harvard probably would have done well regardless of their choice of college. To the degree Harvard grads do unusually well, it’s hard to disentangle socialization and signaling effects from the benefits of education.
- In finance, if a merger destroys value or an investment performs poorly, it is rare that the loss can be traced back to poor work by an intermediary. It’s clear that a lot of RMBS were constructed shoddily, even criminally. Yet impeccably produced RMBS of a 2006 vintage would also have performed poorly. Ex post, with full benefit of hindsight, most investors can’t easily tell the difference. Investment banks that put shoddy deals together have not taken reputational hits relative to their peers.
- Government programs work well or poorly, perhaps provide some value but not as much as we hope. We rarely have apples-to-apples benchmarks by which to evaluate them.
- Health care outcomes are jointly determined by health care services and often unobservable aspects of patient health. These are hard to disentangle just to evaluate effectiveness. Ranking health-care services in terms of value-for-money, while stakeholders with diverse interests necessarily participate in the research, is very challenging.
In fact, despite ostentatious use of high technology and sometimes desperate fetishization of metrics, one might describe all four of these industries as premodern.
More interesting is Kling’s point: “sellers themselves know less than what people expect”. That is, service providers in these industries are themselves uncertain of the value they are able to provide. Yet providers work hard to hide and downplay their uncertainty. Politicians pushing new programs offer authoritative projections of brilliant outcomes, although many initiatives fail once the lights of the bill-signing fade. Healthcare, finance, and education are built around credentials and prestige, despite questionable correlations between these tokens and value provided. Healthcare, finance, and educational institutions market themselves hard, portraying themselves as professional, competent, and above all, effective. These claims are not certain to be lies: High competence might sit within the wide confidence intervals that would surround a fair evaluation. But successful institutions do, and must, misrepresent those confidence intervals (to others, and sometimes to themselves). After all, would you go under the knife of a surgeon who told you that he thinks he might be competent? In all of these industries, there is an information asymmetry surrounding the degree of certainty that the services provided will in fact provide value. Providers have reason to be far less confident of their ability to deliver than they lead their customers to believe.
Note that these problems are not just a matter of bad actors. These industries face intrinsically difficult information problems. We can condemn a used car salesman who finesses odometers, but we can’t condemn the surgeon who thinks he is a god. We need him to think he is a god, despite the evidence, so that he is willing to come to work and we are willing to permit the violence he will do to us. Absent reliable markers of quality, we imagine that unreliable self-evaluations are probably better than nothing. “At least he his willing to put his reputation on the line,” we say of the confident doctor when we choose him over his modest colleague, although an egotist’s reputation may not suffer more than anyone else’s when things fail to work out. If our heuristic is to take self-evaluations as informative, competitive forces demand that providers offer “aggressive” self-evaluations. And so they do, in all four industries.
That doesn’t mean politicians, doctors, teachers, and bankers should get a free pass for all the ways they mislead us. There are corrupt practices in these professions that we can detect, that we should condemn and sometimes criminalize. But as long as these are fields in which providers themselves can’t reliably evaluate the quality of the services provided, the rest of us will have a very hard time distinguishing between corrupt practices and natural variability of outcomes. Moreover, these industries are likely to foster particularly insidious forms of corruption. Human beings want both to do well and to do good. Uncertainty leaves insiders ample room to persuade themselves, genuinely, that practices they find remunerative are in fact “best practices”. Under most circumstances, corrupt actors try not to be discovered, and when they are discovered, they are ashamed. When corrupt practices are discovered among bankers, lobbyists, health insurers, pharmaceutical companies, and teachers, our op-ed pages overflow with explanations of how activities that may smell questionable to the uninformed nose are in fact in the public interest. The columnists may be quite sincere. In fact, if you had the sort of detailed understanding available only to industry insiders, you would surely agree with them.
Which brings us back to the original point: We need the “information asymmetry industry”. One way or another, we’ll have bankers, health care providers, educators, politicians, and other sorts of professionals the quality of whose work is difficult to evaluate, by practitioners or by outsiders, ex ante or ex post. But we should acknowledge these are problematic industries for a capitalist economy and a democratic polity. Forecasts that they will dominate, or prescriptions that we should specialize in these sectors to exploit alleged comparative advantage, should be greeted unenthusiastically. I hope that Timothy Geithner takes note.
2. You know that you are getting old when explaining how Marx was wrong now makes you a Marxist
Okay. This is kind of trivial, but it made me giggle.
Your Tyrone has lots of hair on his head and a gray bushy beard.
Matt Yglesias makes the reference more explicit:
[S]ome recent posts from Steve Randy Waldman and Ryan Avent that seemed to me to be walking up toward a Marx-style theory of overproduction, crisis, and the collapse of capitalism.
John Halasz is a good commenter, but I don’t know how old he is. Wikipedia tells me that Matt Yglesias is just over a decade younger than I am. What made me laugh is that the story he describes as “walking up toward a Marx-style theory of overproduction, crisis, and the collapse of capitalism” is basically a retread of the story my parents and high school history teacher told me about why Marx was wrong. That led me to wonder — were Halasz and Yglesias ever told the same story?
Specifically, the story I was told in my impressionable youth was this: Karl Marx had been a sharp analyst, but he was a terrible futurist. He did a good job of describing the dynamic of capital accumulation and the near-term stresses that dynamic would put on the 19th and early 20th century societies. But his prescriptions about how societies would and should respond to those stresses were catastrophically mistaken. In particular, Marx thought that capitalists were trapped in an unstable dynamic of capital accumulation from which they benefited, on the one hand, but which led inevitably to collapse and from which they could not, as a class, escape. Individual capitalists who tried to be “enlightened” in some sense would simply be sloughed off by competitive forces and join the ranks of masses. In modern economic lingo, there was a collective action problem. Capitalists would not, could not, surrender their privilege voluntary, therefore violent revolution by the working classes was the only possible way forward.
I remember pride in my businessman father’s voice when he explained to me that this was wrong. Marx had underestimated the ingenuity and flexibility of capitalist societies, and particularly of the United States during the New Deal. Government intervened to solve Marx’s collective action problem, enabling capitalists secure their enlightened self-interest by keeping a distribution of prosperity sufficiently broad that the predicted collapse could be avoided. My parents were (and still are) center-left, but staunchly anti-Communist. My mother had “escaped” — that was always the word — Communist Romania; she was (and remains) deeply grateful to the countries (Israel and the United States) into which she was rescued. To my father, American capitalism’s adaptability and ingenuity had proved Marx definitively wrong, in the best possible way — by producing a stable society that served the vast majority of its citizens, while countries whose politicians had followed Marx’s prescriptions grew into monsters.
I am not a particularly original thinker. Most of my posts are mutations of ideas that people better than me have whispered in my ears. I used Tyrone, in the previous post, as an exaggeratedly arrogant mouthpiece for my father’s story, with the minor twist of letting technology rather than capital dynamics be the force that would lead to collapse, but for the ability of the system to adapt via new institutions. Having heard essentially the same explanation in high school history class, I took this story to be widely shared conventional wisdom, at least within the mainstream, slightly center-left milieu in which I adolesced.
That would have been 1985 or 1986, Ronald Reagan’s America. Communism was a living rival then. Stories of our relative material success, of our system’s ability to deliver far better lives, even to the “working classes”, than the Communists, were a matter of national security. Matt Yglesias lived his 16th year in a very different world. America was triumphant and forging the “Washington consensus”. “Right-sizing” had already been invented as a euphemism for firing people. The project that Reagan had begun by “standing up to” the nation’s air traffic controllers was well underway. If a young Matt Yglesias had the misfortune of chatting with me in, say 1997, I would have had little good to say to him about labor unions but would have enthused about the transformative power of free markets and technology. I like to think of myself as unconventional, but I like to think a lot of things. I think it fair to say that the conventional wisdom that surrounded a curious, very bright teenager in 1997 would have been different from what I experienced a decade earlier, for better and for worse. I think this matters, it affects us all a lot more than we think it does.
Anyway, I really did giggle when I realized that an argument I thought of as conventional wisdom about how America proved Marx wrong sounded, perhaps because my audience was of a different generation, vaguely Marxist.
I’m not taking issue at all with the substance of Yglesias’ post, which I think is smart and quite right. Health care costs are millions of people’s livelihood, and inefficient health care costs are a big part of that. Much of how modern economies survive is by protecting information problems and barriers to competition that sustain overpayments. This broadens the wealth distribution while permitting recipients the fiction that flows of purchasing power involve no transfers (“welfare”), only proud, self-reliant income. The theory of labor unions and the theory of an inefficient health sector are identical, except one is more transparent and the other has proved more capable of buying political protection. The problem, in both cases, is not that there are transfers, but whether the distribution of transfers — to whom, from whom — is wise and fair. By forcing ourselves to pretend there are no transfers, we prevent ourselves from even posing the question.
Perhaps I am a creature of the conventional wisdom of my day, but I want to tell it strong. It is not those who advocate, but those who prevent, stabilizing transfers of purchasing power, who are the true Marxists. These self-styled capitalists do not espouse Marx’s theories, but they do something much worse: They perform them. They behave in precisely the way that Marx expected capitalists to behave. They cripple the American system’s greatest strength — its ingenuity, flexibility, adaptability. They prevent the sort of collective action through which earlier generations proved that capitalism could made be consonant with decent, stable, and broadly prosperous societies. In doing so, they risk proving Marx right.
Update: Not unusually, commenters have had much more interesting things to say than I’ve said. Nicholas Gruen @ Club Troppo has made a full post of an excellent comment by Indy. Also, Arnold Kling has responded.
- 21-February-2011, 7:45 a.m. EST: Added bold up about Nicholas Gruen hoising Indy’s post, and noting Arnold Kling’s response