So, About That Externality Business…

I have a friend who isn’t a big fan of the word “externality”.

I’m an economist, and we’ve been force-fed gallons of the stuff back when we were in college, so I couldn’t for the life of me understand why anybody would object to such a simple, obvious and (to me, at any rate) useful term.

My friend, who happens to be a lawyer, explained that his disdain from the term was because externality is a word that didn’t say anything at all about intent, which was a major problem. And it is from here that we begin our journey today down a rather surprising path.

A couple of things to bear in mind: this is just a quick trip down what seems to be a very interesting rabbit hole. Second, the legal nuances are well beyond my ken.

First, what do we economists mean by the word externality?

In economics, an externality is a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit.

https://en.wikipedia.org/wiki/Externality

The canonical example that every single student of economics knows is that of the fishery and the steel mill. It is to be found in Stigler’s “The Theory of Price”, but has been made famous because of Coase’s seminal paper, The Problem of Social Cost:

To give another example, Professor George J. Stigler instances the contamination of a stream. If we assume that the harmful effect of the pollution is that it kills the fish, the question to be decided is: is the value of the fish lost greater or less than the value of the product which the contamination of the stream makes possible.
It goes almost without saying that this problem has to be looked at in total and at the margin.

https://www.law.uchicago.edu/files/file/coase-problem.pdf

Think of it this way: there’s a steel mill upstream, that releases effluents into the river. Said effluents kill the fish in the river, which puts the downstream fishery out of business. The steel mill didn’t mean to kill the fish, and so the steel mill releasing effluents into the river is an externality. An unintended consequence. Or as per Wikipedia’s definition above, “a cost or benefit that is imposed on a third party who did not agree to incur that cost or benefit

Me, personally, I prefer the Naseeruddin Hodja story.

Still, that’s what externalities are.

And as I said, I have for all of these years been perfectly ok with the word and what I thought was its meaning. But after the discussion, I asked myself a question: when did we economist start using the word externalities?

Milton Friedman has a paper on education, which I chanced upon a while back, in which he uses the concept, but doesn’t mention the word. He uses instead the term “neighborhood effect”:

A stable and democratic society is impossible without widespread acceptance of some common set of values and without a minimum degree of literacy and knowledge on the part of most citizens. Education contributes to both. In consequence, the gain from the education of a child accrues not only to the child or to his parents but to other members of the society; the education of my child contributes to other people’s welfare by promoting a stable and democratic society. Yet it is not feasible to identify the particular individuals (or families) benefited or the money value of the benefit and so to charge for the services rendered. There is therefore a significant “neighborhood effect.”

http://la.utexas.edu/users/hcleaver/330T/350kPEEFriedmanRoleOfGovttable.pdf

The Wikipedia article on externalities has this rather intriguing line, unfortunately without a citation:

Similarly, Ludwig von Mises argues that externalities arise from lack of “clear personal property definition.”

https://en.wikipedia.org/wiki/Externality#:~:text=Similarly%2C%20Ludwig%20von%20Mises%20argues%20that%20externalities%20arise%20from%20lack%20of%20%22clear%20personal%20property%20definition.%22

Exactly the kind of thing that’ll raise the hackles of a lawyer!

And so I asked myself, do we have any paper that saves me the research I might have to do in terms of trying to figure out how the term came about?

And I’m happy to report that we do!

Donald J. Boudreaux and Roger Meiners have a paper titled “Externality: Origins and Classifications“.

Marshall, in his oft-cited 8th edition of his Principles of Economics, explained that external economies were factors relevant to a firm that were from the outside, such as better technology that could be adopted. Internal economies were factors under the control of those running a firm, for example, a clever manager figuring out how to run a firm better. “External economies,” Marshall wrote, are related to scale of production; they are “those dependent on the general development of the industry,” whereas “internal economies” are “those dependent on the resources of the individual houses of businesses engaged in it [a particular kind of production].”

Boudreaux, D. J., & Meiners, R. (2019). EXTERNALITY. Natural Resources Journal59(1), 1-34.

Would that mean that externalities and what we would these days call “exogenous” factors are the same thing? I’d say no, because as I understand it, it is up to us, the modeler, to decide which factors to exclude from our analysis. That is, labeling something as ‘exogenous’ to the model is a deliberate act of omission on our part. But legal/economic theory experts reading this, please do tell me if I’m wrong!

They go on to point out that Pigou builds upon the concept – but neither Marshall nor Pigou use the specific term “externality”, and neither does Tibor Scitovsky, who appears next in chronological order. He identifies, as the authors of the paper point out four types of “direct interdependence”:

  1. “when one’s satisfaction is related to the satisfaction of another person (what we’d call, I think, interpersonal comparisons of utility”. Think 3 Idiots, when Madhavan and the other guy find out that Aamir has come first in class);
  2. “when one’s satisfaction is affected by inconveniences, such as smoke from production”; (the topic of this blogpost)
  3. The third would be what we would recognize today as increased producer efficiency because of competition (which merits a longer discussion that I will not attempt here)
  4. And the fourth would be also what we would today recognize as a positive externality. The example cited in the paper is that of the apple orchard and beekeepers. Should beekeepers get a cut of the profits made by apple orchard owners?

The term “externality” seems to have been mathematically explained for the first time in a paper written by FM Bator . His definition in this paper is the following:

But I think it more natural and useful to broaden rather than restrict, to let “externality” denote any situation where some Paretian costs and benefits remain external to decentralized cost-revenue calculations in terms of price

(Bator, F. M. (1958). The anatomy of market failure. The quarterly journal of economics72(3), 351-379.)

The footnote associated with that quote is also instructive:

Recall that it is the existence of such “externality,” of residue, at the bliss-point, of Pigouvian “uncompensated services” and “incidental uncharged disservices” that defines market failure. It may be objected that to generalize the externality notion in this way is to rob it of all but descriptive significance. But surely there is not much to rob; even in its strictest neoclassical formulation it begs more than it answers. In its generalized sense it at least has the virtue of suggesting the right questions.

(Bator, F. M. (1958). The anatomy of market failure. The quarterly journal of economics72(3), 351-379.)

But to understand both of these points above, we also need to understand the definition of nonappropriability:

If a competitive advantage is to form the basis of corporate success, it must also be appropriableAppropriability is the capacity of the firm to retain the added value it creates for its own benefit.

https://oxford.universitypressscholarship.com/view/10.1093/019828988X.001.0001/acprof-9780198289883-chapter-12#:~:text=If%20a%20competitive%20advantage%20is,creates%20for%20its%20own%20benefit.

But as Bator goes on to say, that is not the only way to think about externalities. The gain from bridges, as is mentioned in his paper, are non-appropriable, but is precisely the point of the bridge being built by the government. Alex Tabarrok has a view on this we’ve mentioned earlier, but that’s a separate story.

Bator then goes on to speak about three different types of externalities: ownership externalities (apples and bees), technical externalities (bridges) and public good externalities (national armies, for example. We’d call these “pure” public goods today).

At which point, in our chronological history, we get to Coase, and the story from there on on is familiar (should be, at any rate) to both students of law as well as economics. (If it ain’t, to you, then please listen to this podcast. And that’s just for starters!)

Although I would still recommend that you read “Externality: Origins and Classifications” for its entertaining take on the “Stiglerian, Hayekian and Stiglitzian responses” to the presence of externalities.

So, ok, if you’re still here, what does this have to do with the disdain my lawyer friend has for the word externalities? We reach what I think is the core point of that discussion with this definition of externalities:

In sum, in a world in which people adjust activities to reflect their expectations, externalities exist only when spillover effects are unexpected.

Boudreaux, D. J., & Meiners, R. (2019). EXTERNALITY. Natural Resources Journal59(1), 1-34.

They have another (I think better) definition in a footnote later on: “That is, externalities occur only when an existing property-rights arrangement is changed or violated.”

So all spillovers need not be externalities, but all externalities are spillovers.

Words matter, and so I’ll try and use the word spillover rather than the word externality, but it’ll involve breaking the habit of a lifetime – so it might well take time.

Still, the discussion did give rise to this blogpost after all, when I least expected it to.

Externality, or spillover?

A Conversation With Rationality

I’d gone to the RTO the other day for some work, and I suppose you know what comes next.

I wouldn’t say it is impossible to get work done without the help of an agent, but it is certainly true that it isn’t a breeze either. And if one teaches opportunity costs, it makes sense to take the “help” of an agent. Sure you can do it yourself, but it then becomes eye-wateringly expensive in terms of time. And therefore, money.

And while I waited in the numerous byzantine lines to get my work done, I reflected, like every good economist should, on what could be done to reform the system.

Just ban agents, my understandably irrational brain screamed as a first pass solution. Why doesn’t the bureaucracy come up with a better process map that just gets out of the way instead, Cold Calculating Rationality suggested.

Because they aren’t incentivized to, C.C.R went on to reason, proceeding to shut me out of the conversation altogether. Although I was, truth be told, a very interested bystander by now.

But why aren’t they incentivized to – isn’t that the next logical question to ask, mused C.C.R.

I mean, won’t it make their job easier if they make their processes easier?

Well, yes, but they earn the same either way, no? It’s not like payments are linked to productivity increases.

How would they earn more?

Maybe through a Coasean solution in which there’s connivance with the agents, and they get a cut? That is, make the process impossibly cumbersome, and continue to keep it cumbersome, no matter what any well meaning committee proposes. That then facilitates agents stepping in and “helping” blissfully ignorant citizens get their work done faster – for a fee, of course.

They take a cut of the fee – and hey, there you have it! Bureacracts have an incentive – but not to simplify the system! They have an incentive to continue to clog up the system.

C.C.R needed a break at this point in time, so it and I played a couple of rounds of Fruit Ninja on my phone.

But why, C.C.R asked – for it can take only so many minutes of mindless swiping – would anybody want to be an agent? I mean, there are surely better, more remunerative ways to earn a living.

C.C.R. and I stared at each other in part jubilation, and part horror.

“There aren’t better ways, no?!”, we said in unison.

“I mean, if markets are weakly efficient, nobody would willingly work as an agent, surely”, said C.C.R triumphantly.

“And so”, C.C.R went on to say in that insufferably smug way that is its wont, “if you really want to reform the system, you need to create better employment opportunities everywhere else. Reforming this particular system is just putting a band-aid on a cancer. Because yes middle-mean are bad, but nobody grows up dreaming of being a middleman. Of course the middlemen, and that entire nightmare of a system is going to be up in arms if you seek to eliminate it. The lack of alternative, viable careers: that’s the real problem.”

“So, just more pro-growth policies, you’re saying?”, poor old irrational me asked timidly.

“Well, yes. Easy answer, tough implementation, I’ll concede that point”, replied C.C.R.

“I wonder where else we can apply this line of thinking”, I was about to ask C.C.R… but then it was my turn at the window, and I was so happy that I was finally done with the whole thing that I stopped thinking about it altogether.

So it goes.

In Memoriam: Oliver Williamson

Why does Gokhale Institute exist? Why did all of the students at Gokhale Institute not choose to try and fashion their own degree, by independently getting in touch with faculty members of various universities the world over, and negotiating rates for teaching each subject?

Similarly, why did I join Gokhale Institute as a faculty member? Why do I not try and advertise myself as a guy who can teach different subjects in econ, finance and stats to students the world over, every semester?

Why, as I said at the start of this post, does the firm I work in exist at all?

For that matter, why do firms exist in general? The “miracle” that is Walrasian economics guarantees that in a perfectly competitive economy with no frictions and perfect foresight, everything will be in a state of eternal bliss.

Except, economies are not perfectly competitive. Who teaches you which subject is important to you as students – which is another way of saying that labor is not homogeneous. There are frictions, such as teachers falling ill, or monsoons disrupting schedules, or uh, pandemics occurring every 100 years or so. And there isn’t perfect foresight (see pandemics, previous sentence).

And because we live in an imperfect world, we outsource, as students, the difficult job of finding appropriate professors, managing the physical infrastructure, and awarding degrees to an entity we call “the firm”. The firm exists in order to make it worth our while to get an education without having to spend time figuring everything else out.

Professors outsource the grunt work too the college too. It would be too painful for me to try and figure out which students across the world will want to learn Principles of Economics next year. I outsource the job of filtering the students out so that I get sixty students to teach to the Gokhale Institute. Plus, Gokhale Institute fixes the fees, arranges for the whiteboard, the benches. I just have to strut over into the classroom and teach.

We – you and I – minimize transaction costs by using the Institute as an intermediary. That’s Ronald Coase’s answer to why the firm exists. Read both of his papers (The Nature of the Firm, and The Theory of Social Cost). Here are past mentions of Prof. Coase on EFE.

Now, Prof. Coase had a student. His name was Oliver Williamson.

He extended Coase’s ideas about the firm, and that is why he really and truly matters when it comes to economics. There are many things to learn by reading Williamson, but three concepts stand out, in my opinion:

  1. Contract incompleteness: Imagine that the director of Gokhale Institute tells me that my performance as the course coordinator for the BSc programme hasn’t been good enough, and that he’ll be letting me go by the end of the year (I’m hoping this is only an example.) Will I muster up the same enthusiasm for coming up with new stuff this year, now that I know I am going to be out of a job? Or, on the other hand, imagine that the director says that my performance has been so good that I’m guaranteed this job for the next decade. Will there be a drop in my performance, now that I’m guaranteed the post no matter what? So how to write a contract that overcomes these hurdles? That’s one of the problems he tackled.
  2. Asset specificity: There are many definitions on the internet, but I liked the one supplied by Alex Tabarrok on Marginal Revolution the best. I’ll get to it in a while, but here’s the textbook-ish statement first: “Asset specificity is a term related to the inter-party relationships of a transaction. It is usually defined as the extent to which the investments made to support a particular transaction have a higher value to that transaction than they would have if they were redeployed for any other purpose.”
    And here’s Alex Tabarrok’s explanation:
    “Marriage, for example, takes away some possibilities but it adds others. With marriage, for example, comes a greater willingness to invest in children (n.b. asset specificity, the child is of extra value but only to the specific parties involved in the marriage)”. Asset specificity can help lock in a relationship – whether it be marriage or an employment contract.
  3. Appropriable quasi-rents: Let’s say I create software to enter marks and grades while at Gokhale Institute. I wouldn’t have created this software without being employed at Gokhale Institute, and it is valuable enough to sell to other firms (let’s assume). These AQR’s exist precisely because of the fact that I (with my skill-sets) was hired by Gokhale Institute. Discernible value has been created precisely because the employee was hired by the employer – this specific employee, by this specific employer (non-homogeneity of labor)

There is a whole can of worms that opens up as a consequence of thinking through the implications of what is written above. That can of worms is called industrial organization. Long story short, if you want to study the field of IO – and as a student of economics, you do! – you really need to start with Profs. Coase, and Williamson.

Ec101: Links for 21st November, 2019

  1. What is the Coase Theorem? Watch.
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  2. Why does it matter? Listen.
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  3. Where all is it applicable? Laugh.
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  4. “Coasean solutions exist. But governments need to set up the relevant property rights and create an exchange, and then trust its prices to incentivize the appropriate action.”
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    And here’s the first reason why  we learn about the Coase theorem today
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  5. “Some also suggest that we create a market for the stubble. But how do you get it out in the first place? Indeed, that’s why it is burnt as the cheapest form of disposal.”
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    And here’s the second!

EC101: Links for 10th October, 2019

  1. “Coase’s originality was not in his reasoning, but in recognizing that economic exchange is not the mere trading of physical goods but trading rights to property or rights to engage in certain types of conduct affecting property.”
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    Was Ronald Coase the first to come up with the Coase theorem?
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  2. “However, the joy of this book is less in the big picture than in the detail. And what a lot of it! The mind boggles at Smil’s extensive reading and absorption of information. We get the speed at which marathons are run – over the entire course of human history; the growth rates of piglets and weight of chicekns over time; sales of small non-industrial motors over time; the envelope for the maximum speed of travel; Kuznets cycles; Zipf’s law for city size…. The middle section of chapters offer a fantastic overview of technical progress over long periods in a wide range of technologies. I love all this detail.”
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    Diane Coyle thoroughly approves of Growth and Civilization.
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  3. “When a daughter is married, we do worry about her future. But why should I worry when the government of India is my son-in-law who married my daughter Syndicate Bank,” asked the late Tonse Madhav Ananth Pai in 1969, in the aftermath of the nationalization of the first-generation private-sector banks. Fondly known as “Brahma of Manipal”, Pai was the founding father of Syndicate Bank in 1925.”
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    A lovely read on bank mergers, bank nationalization and banks from a particular part of Karnataka.
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  4. “This is where the popcorn enters the picture. Pricey popcorn makes those lower ticket prices possible, And that is why you should buy popcorn at the movies.”
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    Expensive popcorn? Uh, no, cheap movie tickets. Yes, really. Cheap for whom, you ask? Welcome to microeconomics.
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  5. “This leads to the question: Why try these markets at all? This is quite similar to creation of super highways which help reach destinations much quicker but lead to accidents as well. Should we then not create highways?Policies always raise such trade-offs and hopefully, the regulator will take steps which minimise the negative aspect of creation of these markets.”
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    Amol Agarwal, in Moneycontrol, on securitization in real estate loans in India. Me, I think this is not such a great idea.

EC101: Links for 25th July, 2019

Five economic theorems you may not have heard of. They are somewhat abstruse, but all are truly interesting. All Wikipedia articles too – like Twitter, grossly underrated.

 

  1. “In game theory, Aumann’s agreement theorem is a theorem which demonstrates that rational agents with common knowledge of each other’s beliefs cannot agree to disagree. It was first formulated in the 1976 paper titled “Agreeing to Disagree” by Robert Aumann, after whom the theorem is named.”
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  2. “The Alchian–Allen effect was described in 1964 by Armen Alchian and William R Allen in the book University Economics (now called Exchange and Production [1]). It states that when the prices of two substitute goods, such as high and low grades of the same product, are both increased by a fixed per-unit amount such as a transportation cost or a lump-sum tax, consumption will shift toward the higher-grade product. This is true because the added per-unit amount decreases the relative price of the higher-grade product.”
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  3. Revenue equivalence is a concept in auction theory that states that given certain conditions, any mechanism that results in the same outcomes (i.e. allocates items to the same bidders) also has the same expected revenue.”
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    Unless you are an avid student of math and economics (and, not or), feel free to Ctrl-F the word “Implication” and skip straight to that section.
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  4. Mandeville’s paradox is named after Bernard Mandeville, who posits that actions which may be qualified as vicious with regard to individuals have benefits for society as a whole. This is alluded to in the subtitle of his most famous work, The Fable of The Bees: ‘Private Vices, Public Benefits’. He states that “Fraud, Luxury, and Pride must live; Whilst we the Benefits receive.”) ”
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    This is a painfully short article – I have set myself a target of using only Wikipedia links in today’s set, but I am breaking my own rule.
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  5. “In law and economics, the Coase theorem describes the economic efficiency of an economic allocation or outcome in the presence of externalities. The theorem states that if trade in an externality is possible and there are sufficiently low transaction costs, bargaining will lead to a Pareto efficient outcome regardless of the initial allocation of property. In practice, obstacles to bargaining or poorly defined property rights can prevent Coasean bargaining. This ‘theorem’ is commonly attributed to Nobel Memorial Prize in Economic Sciences winner Ronald Coase during his tenure at the London School of Economics, SUNY at Buffalo, University of Virginia, and University of Chicago.”
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    Perhaps the most important, and certainly the most misunderstood of all the theorems above – and I probably misunderstand it myself!

ROW: Links for 10th July, 2019

  1. “The radio station, whose call letters are KHIL, has long been the daily soundtrack for this frontier town (population 3,500) that prides itself on its cowboy culture and quiet pace of life. But six decades after the founding of the station, the property is in foreclosure, with utility disconnect notices coming nearly every month.”
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    Culture and Coase (an updated version) in rural America. For both of these reasons and more, worth your time.
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  2. “When Amnesty International U.S.A. started looking for a new headquarters in New York City, the human rights group settled on office space in a modest skyscraper in Lower Manhattan known as Wall Street Plaza.But just as the organization was about to sign a lease last week, the building’s owner said that its new parent company, a giant shipping conglomerate owned by the Chinese government, decided to veto the offer. The company, Cosco Shipping, did not want the United States chapter of Amnesty International, which has produced scathing reports highlighting human rights abuses in China, as a tenant, according to the group.”
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    Business, culture, nationalism, America and China.
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  3. “When you’re doing everything wrong, the best way to fix the problem isn’t usually to go through the list of things you’re doing wrong and fix them one by one. It’s best to step back and ask why you’re so bad at everything, whether a systemic problem is causing you to make so many separate mistakes. And in the case of the MTA, the root cause of its capital-construction failures is usually diagnosed as unaccountability: Nobody knows who’s in charge, so nobody has to be terrified of taking the blame for obscene costs and endless delays.”
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    Coordinating stuff is hard. The New York version of this story. Also, this is why Singapore deserves all the admiration it gets (and more)
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  4. “During the French referendum on the Treaty of Maastricht in 1992, we observed that 60% of the voters with the lowest incomes, personal wealth or qualifications voted against, whereas the 40% of the electorate with higher incomes voted in favour; the gap was big enough for the yes vote to win with a small majority (51%). The same thing happened with the Constitutional Treaty in 2005, except that this time only the top 20% were in favour of the yes vote, whereas the lower 80% preferred to vote no, whence a clear victory for the latter (55%). Likewise for the referendum on Brexit in the UK in 2016: this time it was the top 30% who voted enthusiastically to remain in the EU. But, as the bottom 70% preferred to leave, the leave vote won with 52% of the votes.”
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    An article which helps you think a little bit more about the European Union and what plagues it.
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  5. “China’s overall external surplus is down. That’s not surprising—China’s general government deficit is somewhere between 4 percent of GDP and 12 percent of GDP, depending on what measure you use. The gap between China’s fiscal stance and that of Korea is even bigger than the gulf between Germany’s surplus and the deficit of France—and the gap between the euro area’s (tight) overall fiscal stance and the much looser stance of the United States.But the surplus of China’s neighbors, who have responded, in many cases, to the “rise” of China with policy stances designed to maintain weak currencies and protect their exports, has soared over the past ten years, and now is substantially larger than it was prior to the global crisis.”
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    A useful article about Korea’s macroeconomic choices, and the reasoning behind them.