It’s hard to generalize about Tirole’s views. On the one hand, he understands the powerful role of incentives, understands why free trade is good for a country, thinks through the unintended consequences of legislation and regulation, and understands that the political system is filled with perverse incentives. On the other hand, he favors some highly intrusive regulations in the labor market, has too much confidence in the ability of economists and governments to improve on free markets, misunderstands how to judge the tightness or looseness of monetary policy, misstates the nature of externalities, and doesn’t seem to understand adverse selection in insurance markets.
Value of markets / To illustrate how thinking about incentives and unintended consequences can help inform good policy, Tirole considers a hypothetical case in which a nongovernmental organization (NGO) “confiscates ivory from traffickers who kill endangered elephants for their tusks.” The NGO can either destroy the ivory or sell it. Tirole points out that most people would advocate destroying the ivory. But he urges the reader to think further. Destroying the ivory means that the supply of ivory is lower than otherwise, making the price higher than otherwise. How does a higher price affect the incentives of poachers? That’s right: it encourages them to kill more elephants. Another example, which many economics professors use in class, is the perverse effects of price ceilings. Not only do they cause shortages, but also, as a result of these shortages, people line up to purchase the scarce provisions and thus waste time in queues. The time spent in queues wipes out the financial gain to consumers from the lower price, while also hurting the suppliers. No one wins and wealth is destroyed.
Tirole, like most economists, is strongly pro–free trade. He argues that French consumers gain from freer trade in two ways: it exposes French monopolies and oligopolies to competition; and goods imported from low-wage countries are cheaper. On the former, Tirole notes, “Renault and Peugeot-Citroen sharply increased their efficiency” in response to car imports from Japan. He estimates that the monthly gain from free trade per French household is between 100 and 300 Euros. That translates to an annual gain per household ranging from $1,400 to $4,200.
Incidentally, when economists refer to economics as “the dismal science,” they almost always get the origin of that term wrong. Tirole gets it right. He explains that Thomas Carlyle, in an 1849 publication calling for bringing back slavery, called economics the dismal science because the economists of the time strongly opposed slavery. The economists who dominated in 1849, although Tirole doesn’t mention this, were strongly pro–free market.
Economists, including Tirole, have been very critical of the French government’s labor policies. Their regulations make it hard for employers to fire people, and this makes employers less likely to hire people in the first place. The result: unemployment in France has not fallen below 7% at any time in the last 30 years. This especially affects young people: the unemployment rate for 15–24 years old was a whopping 24% at the time Tirole wrote this book. Their employment rate—the percent of those in the age group who had jobs—was a dismal 28.6%, compared to the OECD average of 39.6%, Germany’s 46.8%, and the Netherlands’ 62.3%.
To solve this problem, Tirole advocates grandfathering job protection for current employees but getting rid of the regulations that protect newly hired workers from being fired. But he doesn’t stop there. He argues that because employees “are not responsible for and have no control over technological change or demand shocks faced by their employers,” they must “be insured against the risk that their jobs might become obsolete or simply unprofitable.” So he wants to maintain the current unemployment insurance system. Nowhere in the relevant chapter does he suggest reducing France’s duration of unemployment benefits, which is now two years for people under age 50 and three years for people over age 50.
Tirole recognizes that the current system gives the employer an incentive to officially “fire” an employee who actually quits. The employee gains and the employer loses nothing by firing. His solution is to charge employers who fire employees an amount reflecting the cost that the unemployment insurance system imposes on French taxpayers. This would probably work better than the current system, but it is awfully intrusive compared to, say, reducing both the amount and duration of unemployment benefits.
Government intervention / Throughout the book, Tirole shows his understanding of basic public choice. He tells of a 1999 report by French economist Jean-Jacques Laffont to an audience of “senior officials, academics, and politicians” discussing the need to reduce obstacles to youth employment. The reaction was negative. One critic claimed that Laffont was likely to corrupt French youth. And what had Laffont said? Writes Tirole, “Politicians and officials respond to the incentives they face” and “the way government is organized should take this reality into account.”
Unfortunately, he himself fails to follow through consistently on this understanding. In the chapter on finance, he writes, “The role of the economist is to help mitigate market failures.” One can accept that that is one role of economists, but is it the role? To say so is to set up economists as critics of markets and not as critics of government policies. Fortunately, even though he says that is the role of economists, he shows in much of the rest of the book that he is also a critic of government intervention.
One type of market failure that most economists recognize is externalities. At one point, though, Tirole finds an externality where there isn’t one. He considers a bank that holds a risky asset whose value falls. When that happens, the bank’s shareholders lose, the bank’s creditors lose, and “perhaps also its employees and borrowers” lose. All potentially true. Then he writes, “This is a negative externality affecting all the stakeholders.” But consider all these “stakeholders.” First, shareholders suffer, but they invested in the bank knowing that there was a risk. Creditors may suffer, but they lent to the bank knowing that there was a risk. Employees may suffer, but they knew there was a risk when they decided to work for the bank. As for borrowers, divide them into current borrowers and potential future borrowers. Current borrowers may suffer if the bank calls in their loans, but they knew that was a risk when they borrowed. Future potential borrowers may find themselves unable to borrow from the bank in the future if it’s in bad enough shape, but is it really an externality when a bank’s decisions limit its business with future customers?
Tirole does add, “Moreover, the bank might be able to continue borrowing despite the risk, if lenders think the government will bail out the bank if it gets into difficulties.” This is the problem and the government creates the externality. But the “Moreover” is misplaced. The government here is the sole source of the externality.
Finance / In his discussion of last decade’s financial crisis, Tirole puts part of the blame on monetary policy for creating a real estate boom. He gets it wrong, though, claiming that monetary policy led to abnormally low interest rates. Monetary policy cannot keep interest rates low for long unless it is geared toward creating low inflation or even deflation, thus reducing nominal interest rates by reducing expected inflation. The cause of the low interest rates—as former Federal Reserve chairman Ben Bernanke recognized and as Jeffrey Hummel and I described in “Greenspan’s Monetary Policy in Retrospect” (Cato Policy Report, November 2008)—was a surge of saving by Asian countries and elsewhere, resulting in more money available for lending and investment. Monetary policy did affect the financial crisis in the United States, but by not being loose enough. As Hummel wrote in “Explanation versus Prescription” (Cato Unbound, Sept. 21, 2009):
Beginning with the Fed’s creation of the Term Auction Facility in December 2007, nearly every dollar that Bernanke injected into financial institutions was sterilized with the withdrawal of dollars through the sale of Treasury securities. Not until September 17, 2008, did a panicked Fed finally set off a monetary explosion, doubling the base in less than four months.
In various places in the book, Tirole discusses financial bubbles. There is a question, even after the fact, about whether a bubble did in fact occur: was it a bubble, or did some subtle change in fundamentals lead to a reduction in value? Even if one grants after the fact that, yes, it was a bubble, can one identify a bubble in advance? That’s what really matters.
To his credit, Tirole doesn’t seem confident that one can. He does cite 2013 Nobel Prize winner Robert Shiller, who claimed before the fact that the real estate market was in a bubble. But he doesn’t point out that Shiller claimed that stock prices were in a bubble in 2000, when the Dow-Jones Index stood just below 12,000. It is now above 22,000. And that understates the gain from holding stocks because many holders reinvest the dividends. Had I sold my stocks in response to Shiller’s 2000 warning, I would be a much poorer man. Tirole also mistakenly labels paintings by Picasso and Chagall as bubbles. The aesthetic value, he argues, “could be replicated for a few thousand dollars using modern technology,” which he believes shows the originals are overpriced. His claim ignores a basic fact from economics: values are subjective. By their willingness to pay millions for the original painting, people show that they do, indeed, value it highly. They would not value a copy as much.
Industrial organization / Much of Tirole’s research is in the economics of industrial organization, and in his chapters on related topics he shows much insight. In writing about industrial policy, for example, he questions whether small and medium-sized enterprises need any special treatment from government and, instead, suggests removing obstacles that governments put in their way. He points out that when a French firm moves from 49 to 50 employees, it faces 34 additional legal obligations. Sure enough, in a chart in his book showing the number of enterprises with various numbers of employees, a spike occurs at 47 to 49 employees, and then the number of firms with 50 to 69 employees is much lower.
Although Tirole believes in antitrust laws to limit monopoly power, he points out that regulators must be cautious in bringing the law to bear against firms in “two-sided markets.” An example of a two-sided market is a manufacturer of videogame consoles. On one side are game developers; on the other are game players. He notes that it is very common, and not indicative of a lack of competition, for a company in such a market to set low prices on one side of the market and high prices on the other. But, he writes, “A regulator who does not bear in mind the unusual nature of a two-sided market may incorrectly condemn low pricing as predatory or high pricing as excessive, even though these pricing structures are adopted even by the smallest platforms entering the market.”
Tirole points out that when a French firm moves from 49 to 50 employees, it becomes subject to 34 additional legal obligations.
In his discussion of competition, Tirole refers to Joseph Schumpeter’s concept of “creative destruction.” The new product or production method makes consumers substantially better off but, in doing so, upends the old order. He is nervous, though, about relying only on creative destruction, seeming to want “vigorous competition between companies at a point in time” rather than settling for a situation in which “today’s dominant firm is replaced by another that has made a technological or commercial leap.” But what he misses is a point that, admittedly, Schumpeter didn’t make clear but left implicit: having vigorous competition at a point in time reduces the incentive for firms to invest in the “technological or commercial leap.”
Risk / In his discussion of insurance, Tirole displays a misunderstanding of adverse selection. Adverse selection occurs when insurers are not able to distinguish between degrees of risk and, therefore, don’t set premiums based on risk. When people buying insurance know their own risk better than the insurance company does, a large percentage of low-risk people find the insurance unattractive, while a large percentage of high-risk people find it attractive. The result: the selection of buyers is adverse to the insurance company. The straightforward solution is for insurance companies to reduce the asymmetry by getting more information about potential customers and then pricing accordingly. But, writes Tirole, “Information kills insurance,” meaning that costs won’t be borne equally by a large insurance pool of customers with different risk levels. But this doesn’t kill insurance; what does is government requirements that insurance companies not be allowed to price for risk.
Tirole also seems not to understand insurance pricing. He writes, “I can get a policy specifying a reasonable premium to insure my house because the chances that my house will burn down are about the same as the chances that your house will burn down.” He would be surprised if he saw the high premium I pay for insuring my Canadian cottage, whose structure is worth under $100,000, compared to the much lower premium I pay on my California house, whose structure is worth over three times as much. Clearly, those probabilities are not the same. One bad forest fire would wipe out my cottage; a forest fire near my California house is much less likely and, even if it occurred, is far less likely to do damage.
All of the discussion above is about Tirole’s thinking on economic analysis. What about his views on freedom? I’ll end with a hopeful note. While he is no libertarian, he does have a pro-freedom streak. He opposes the condemnation of behavior “that has no identifiable victim.” Presumably his opposition to condemnation would lead him to oppose government regulation of that behavior. It seems from context that he does.
