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It’s the Thought that Counts: A Review of Stephen Davies’ The Wealth Explosion, Part Two– The Davies Difference: Elite Buy-in



Click here to read Part 1 of this review.


The Davies Difference: Elite Buy-in 

The first part of this review ended with the observation that what Deirdre McCloskey sees as vital for the kind of “wealth explosion” that she and Davies discuss is the reorientation of  human perception away from an earlier focus upon limits and constraints to one of potentialities and opportunities.

Both McCloskey and Davies recognize that one can almost see just such a shift occurring in other places like Song China. Both the experience of material betterment as well as certain philosophical orientations to various conceptions of improvement might well have afforded similar processes of advancement. But they were eventually thwarted (85-98). Why? For Davies, it is not sufficient that the ruling classes were unable to squelch the ideas of betterment circulating in the West. That is too passive an understanding of history. “There has to be,” Davies contends, “another agent that accounts for the impact of ideas” (50). For Davies, the key factor is not the ideas nor the specific value of betterment alone, but who buys into those beliefs. 

Certainly it is necessary that the value of personal betterment permeate society as a whole, but it matters more, at least initially according to Davies, that certain groups get there early in the historical process. If those with the power to compel and kill do not also buy into those ideas, then the growth and potential for improvement remain only precarious at best. Thus, according to Davies, when the emperor of China and his vast retinue of military and bureaucratic retainers shifted the focus away from commerce and the seas after the end of the Song Dynasty and compelled their commercial classes to divert attention away from invention and entrepreneurship, they essentially damned up the streams of betterment for everyone else.  

This, then, is the explanation for why the wealth explosion occurred where it did. For Davies we must first explain why those who wielded power did not squelch or suppress the value of self-improvement, but actively came to embrace and encourage it (65). Interestingly, this story is one that can cut two ways depending on how one conceptualizes the human condition. It is either the story of competition and anti-monopoly or it is one of improved administration and state capacity. From my vantage point as a historian, I favor the first, and have argued this with Johnson and Koyama before. Davies sharpens the historian’s perception of why that explanation must be so.

Competition has a powerful role in preventing monopoly in both economics and politics. As any good economist accepts, the ability to constrain others from entering a market can have serious deleterious consequences both for the betterment of consumers but also for innovation and adaptation. There are, of course, anecdotal examples that seem to go counter to that tendency, but everywhere these are temporary and unstable. Such is the case with the great German industrial cartels. Where productivity and even production are enhanced by such state fostered conglomerations, there eventually arise strong counter currents of path dependency leading to ossification and the reduction of opportunities for adaptation. But is it enough simply to prevent monopoly from taking hold to ensure the spread of the value of betterment?

If you are born to the purple, you are already “better.” What necessity is there to become better still? Even more problematic, why would you want to increase the well-being of those beneath you? It could very likely lead to the possibility of others displacing your particular place in the great chain of being. Davies contends that there must be a further hook to get those in power to buy into the betterment movement. Dreaming of the glories of Rome, and the potential for empires in the future, the ruling elites of Europe had an incentive to think differently than their Chinese counterparts who were already well ensconced within a coherent and still functioning imperial system. 

To the initial condition of decentralized and fractured politics in Europe, Davies adds the active, even desperate, searching for new channels of power among the aristocrats of late medieval times. What this means is that the elites were ready and waiting for any indication that would signal the chance to overcome a rival neighboring power, and this fostered a search both for innovative ways to raise money and develop new military techniques (115-119). 

From here Davies can establish the primacy of ideas in the processes of institutional context for a very specific kind of phenomenon. The lords soon recognized that one way to deal with the limits of their rural lives was to hitch a ride on the carts of merchant wealth, because only this could serve as a source for the constant flow of income necessary to sustain permanent military establishments: “Above all it required a much larger tax base and a more efficient means of raising funds through either taxes or loans” (114). 

Ideas and Competition 

Davies sets out an extensive bibliographic trail at the end of each chapter that leads the reader to see that many different modes of tapping the wealth of commerce were tried ranging from predatory to parasitic to symbiotic. The context of Europe’s divisions ensured a long interval for many experiments and the result was a variety of more or less parasitic/symbiotic hybrids. One tributary would lead to the modern nation-state. But here I believe Davies could have emphasized, far more than he does, a very particular kind of institutional development that went hand in hand with the fractured, decentralized politics of the European peninsula.  

I would have stressed the crucial role of cities and especially the leagues of cities like the Hansa, which eventually fed into the rise of the great merchant republic of the Dutch. The seedbed of thought for these developments was already well fertilized before the modern nation-state had come into being. Davies mentions Jane Jacobs and Hendrik Spruyt  among other authors, but I think the phenomenon gets lost in his rush to make the competitive argument. Cites were cultural centers as well as the quintessential expression of Europe’s decentralized state of affairs (4, 40, 42, 68-69).

The importance of cities as the seed bed for most of the ideas of betterment has of course been long known, and McCloskey has also given them a powerful place in her narrative. If we enter in closely to understand them we find that they were not modern states, nor were they the completely free products of spontaneous action. They were something far more interesting and heterogeneous in nature, reflecting their origins within the interstices of more traditional territorial powers.

Writers in camps favoring either endogenous ideational or exogenous environmental processes have long pinpointed the fact that the cities developed between landed, predominantly rural, fiefdoms. One finds this both in Harold Berman and Randal Collins, for example, and in Douglas North and E. L. Jones. Such cities were meeting places of merchants, and while they might have a charter from one lord, they were never adverse to switching allegiance to another. 

As was true among most of the earliest examples of chartered corporations, cities possessed a strong element of private voluntary association about them. Their relations with particular lords partook of the quasi-private and public relations that permeated all medieval social ties. Lords were themselves as much proprietors of the soil as they were the overlords of their vassals. 

But like the lords on their manors, the cities also made and enforced their own laws. They made their own wars. And they formed their various alliances both with landed elites and with other cities.  Rather than proto-modern states, as Hendrik Spruyt has pointed out (a book that ought to be in Davies’s otherwise extensive surveys) , they were an early and viable alternative form of defensible order. They attracted the attention of all the great lords and soon-to-be greater kings. Along with the attraction of their wealth there was the explicit culture of betterment already on display. 

As it is though, Davies’s essential point comes through loud and clear. All of the various polities of whatever form in Europe became increasingly better at fielding armies and fostering innovations in the arts of war. More importantly though, they preserved enough parity with one another that none succeeded in monopolizing power over the whole of the continent. 

Charles V and Phillip II provide Davies with his major illustration of the failure to establish a European wide hegemon or monopoly of imperial control. Exhausted, Charles retired and broke up large chunks of his empire among his heirs, and Phillip overreached after his initial victories in Holland, resulting in the resurgence of the low countries in 1587 and the rise of the English and French as countervailing forces (144-152). All of this meant that the elite would continue to compete, and betterment would continue to permeate the cultural landscape.


Conclusion: State Capacities or Limited States?

So how should this story be characterized? 

Certainly more efficient political units are one result of competitive processes, and that might tempt some to privilege the role of state capacity in the creation of the subsequent boom that was the wealth explosion. At best, however, such a conception puts the cart before the horse. This can be garnered from Koyama and Johnson’s own work: “State capacity” they argue, “need not promote economic growth.” In fact, even “States with high capacity can pursue destructive economic policies.” Rather, it is only when we get states who are “constrained by law” that we get the desired boom. But what will do this? 

As Davies’s summation of the literature shows, the boom was entirely the product of the competition that decentralization enforced. It is not a foregone conclusion that the only political form that has capacity is the nation state (see again, Spruyt’s The Nation State and Its Competitors). Various types of states can be held more or less in check by the processes of competition, and in these arrangements cities and leagues formed the most salient spaces for the early development of the ideas of equal protection of the laws and individual moral equality. 

To focus on capacity, then, merely begs the question of capacity for what end? Betterment for the sake of destroying your enemy is not quite the same as betterment for betterment’s sake. To privilege the political tempts us to take our eyes off the needful limits that must always be imposed on coercive power. Davie’s history places our attention right where it needs to be: anti-monopoly and competition. While he has not addressed the state capacity writers directly, he has in fact provided a powerful response to their position, one that is more consonant with what we know of ourselves, past and present. When it comes to human action, it’s the thought that counts.


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How not to lose your mind in the Covid-19 age



here are as many responses to the Covid-19 pandemic as there are people to respond. Some have of us have children to home-school. Some of us have elderly relatives to worry about; some of us are the elderly relatives in question. Some of us have never been busier; others have already lost their jobs.

One experience is common, however: wherever the virus has started to spread, life is changing radically for almost everyone. It’s a strange and anxious time, and some of the anxiety is inevitable. For many people, however, much of the stress can be soothed with – if you will pardon the phrase – one weird trick.

First, a diagnosis. Most of us, consciously or not, have a long list of things to do. At the virus and the lockdowns have spread, many of the items on the to-do list have simply evaporated. At the same time, a swarm of new tasks have appeared, multiplying by the day: everything from the small-yet-unfamiliar (“get toilet paper” and “claim refund on cancelled holiday”) to the huge-and-intimidating (“organise an inspiring home-school curriculum” or “find a new job”).

The change is so fast and comprehensive that for most of us it is unprecedented. Even a divorce or an international relocation is more gradual. The death of a spouse might be the only experience that comes close. No wonder that even those of us who are safe and well and feel loved and financially secure find ourselves reeling at the scale of it all.

To the extent that the problem is that the to-do list is unrecognisable, the solution is oddly simple: get the to-list back in order. Here’s how.

Get a piece of paper. Make a list of all the projects that are on your mind. David Allen, author of the cult productivity manual Getting Things Done, defines a project as “any multistep outcome that can be completed within a year”. So, yes: anything from trying to source your weekly groceries to publishing a book.

That list should have three kinds of projects on it.

First, there are the old projects that make no sense in the new world. For those that can be mothballed until next year, write them down and file them away. Others will disappear forever. Say your goodbyes. Some part of your subconscious may have been clinging on, and I’m going to guess that ten seconds of acknowledging that the project has been obliterated will save on a vague sense of unease in the long run.

Second, there are the existing projects, some of which have become more complicated in the mid-pandemic world. Things that you might previously have done on automatic may now require a little thought. Again, a few moments with a pen and paper will often tell you all you need to know: what’s changed? What do I now need to do? What, specifically, is my next action? Write it down.

Third, there are brand new projects. For me, for example, I need to rewrite the introduction to my forthcoming book (‘How To Make The World Add Up, since you were wondering). It’s going to seem mighty strange without coronavirus references in it. Many of us need to devote more than a little attention to the sudden appearance of our children at home. Some of us need to hunt for new work; others, for a better home-office set-up. Many of us are now volunteering to look after vulnerable neighbours.  In each case, the drill is the same: sketch out the project, ask yourself what the very next step is, and write it down.

Occasionally, you may encounter something that’s on your mind – the fate of western civilisation, for example, or the fact that the health service desperately needs more ventilators and more protective equipment. For my family, it’s an elderly relative, suffering from dementia, in a locked-down nursing home. We can’t visit him. He can’t communicate on the phone or comprehend a video chat. There is, for now, literally nothing we can do but wait and hope. Acknowledging that fact – that there is no action to be taken – is itself a useful step.

I won’t pretend that in this frightening time, working through your to do list in a systematic way will resolve all anxieties. It won’t. But you may be surprised at how much mental energy it saves – and at the feeling of relief as all these confusing and barely-acknowledged new responsibilities take shape and feel more under your control.

Or so it seems to me. Good luck, and keep safe.


Oh – and in case it wasn’t obvious, this week’s Book of the Week is David Allen’s superb Getting Things Done.

My NEW book The Next Fifty Things That Made the Modern Economy is out in the UK in May and available to pre-order; please consider doing so online or at your local bookshop – pre-orders help other people find the book and are a huge help.

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Guest Contribution: “Banks on the Brink”



Today we are fortunate to be able to present a guest contribution written by Mark Copelovitch  (University of Wisconsin – Madison) and David Singer (MIT).

“The peculiar essence of our financial system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it.” –Walter Bagehot (1873), Lombard Street: A Description of the Money Market, pp.158-9.

Why do banking crises occur? In our new book, Banks on the Brink: Global Capital Securities Markets, and the Political Roots of Financial Crises, we seek to understand why some countries are more prone to banking crises than other countries or at different times.

At the simplest level, banks collapse because customers lose trust in them. Trust is ubiquitous in the financial system. Banks trust that customers will repay their loans. Depositors trust that banks will manage their money carefully. And banks trust other banks to provide liquidity and to remain standing day after day. But as Walter Bagehot noted in his famed account of London’s 1866 financial panic, trust in the financial system can erode from “hidden causes.” When trust is weakened, even seemingly small accidents—like the collapse of London bank Overend, Gurney, and Company, which triggered the 1866 panic—can cause systemic financial crises.

The details of individual banking crises vary, but rarely does trust in the banking system evaporate without due cause.  In the Panic of 1907, banks collapsed because they were complicit in speculation and market manipulation that led to massive financial losses. During the Asian financial crisis of the late 1990s, the trigger for the collapse of Thai banks was speculative lending to real estate developers, which led to a boom and bust in the real estate market. And in 2008, after a decade of easy mortgages to borrowers with shaky credit histories and a growing bubble in the real estate market, investors grew fearful that banks and holders of mortgage-backed securities might never get their money back.

Our book highlights two key triggers of banking crises. The first, levels of foreign capital inflows, sets the stage for potential distortions in the financial system. Large capital inflows have been found to be a consistent correlate of banking crises. Indeed, many scholars believe that the malignancy of global capital flows is the most likely culprit behind banking crises.  In Lost Decades, their analysis of the Great Recession, Chinn and Frieden (2011) point to the enduring prevalence of the capital flow cycle, in which “capital floods into a country, stimulates an economic boom, encourages high-flying financial and other activities, and eventually culminates in a crash.” They note that many previous crises fit this pattern, including the Mexican and Asian crises in the 1990s, and dozens of others.  Reinhart and Rogoff, in this This Time is Different (2009), suggest that the pattern has deep historical roots. One of their key findings, backed by data covering 800 years of financial crises, is that large current account deficits, asset price bubbles, and excessive sovereign borrowing are common precursors of crises across space and time.  Moreover, bank failures were relatively rare during the Bretton Woods monetary system from the end of World War II to the early 1970s, when governments enacted strict controls on capital movements (Helleiner 1994). This overall finding—that foreign capital opens up a Pandora’s Box of financial distortions—now has the status of conventional wisdom in academic and policy circles.

The potential dangers of capital inflows are real. But existing research has failed to emphasize that foreign capital is not always destabilizing for the banking system. For every instance of a banking crisis preceded by large capital inflows, there are countless examples where inflows are harmlessly—and even productively— channeled throughout the national financial system.  For example, while the U.K. and the U.S. both experienced large current account deficits in the years preceding the Great Recession. Australia and New Zealand also experienced substantial current account deficits, but their banking systems escaped relatively unscathed.

Why do capital inflows lead to banking crises in some cases but not in others? To explain this, we focus on a second variable: national financial market structure. We argue that the substantial variation in the relative prominence of banks versus securities markets (Figure 1) determines whether capital inflows are channeled safely and productively through the national economy, or whether they instead cause banks to take on excessive risks and increase the likelihood of a financial crisis.  Banks often sit alongside other financial institutions, including stock and bond markets, which provide alternative sources of financing for borrowers and alternative investments for savers. When banks are conservative because of the relative absence of competition for financial intermediation, foreign capital can be safely channeled into the system without causing bank instability. On the other hand, when banks sit alongside viable securities markets, capital inflows exacerbate banks’ risk taking and increase the probability of a crisis.

Figure 1: Market/bank ratio, OECD countries, average, 1990-2011

Source: World Bank Global Financial Development Database, calculated as the ratio of stock market trading volume to total bank lending

To test our argument, we analyze data from the 1970s through the early 21st century for most of the world’s developed economies. Figure 2 illustrates the core result of our statistical analysis: capital inflows are only correlated with banking crises under certain conditions – namely, when they flow into a financial system in which commercial banks compete alongside large and highly-developed securities markets.

Figure 2: Average Conditional Marginal Effect of Gross Portfolio Capital Inflows on Probability of a Banking Crisis, by Market/Bank Ratio (World Bank banking crisis classification), 1970-2011

Coefficient on change in gross portfolio inflows (%  of trend GDP, 5-year moving average)

In this book, we not only explore the determinants of banking crises, we also explore how capital inflows and financial market structure interact to affect banks’ risk taking. The conventional wisdom linking capital inflows to crises emphasizes distortions in the allocation of capital as it is channeled through banks and other intermediaries (Portes 2009).  The question is precisely how this plays out and which distortions are most salient.  Some scholars find a clear link between capital inflows and the volume of credit.  For example, Schularick et. al. (2012), in their groundbreaking work on the long-term patterns of financial instability in industrialized countries, find that 1) domestic credit growth is the single most important determinant of banking crises; and 2) capital inflows, as measured by current account deficits, go hand-in-hand with credit booms, especially in the post-Bretton Woods era.  In contrast, other scholars, such as Amri et. al. (2016), find only a weak relationship between capital inflows and domestic credit growth and notes that this connection is diminishing over the last two decades.

If capital inflows lead to banking crises by triggering changes in the volume of domestic lending, then we should find a similar conditional, interactive relationship between capital inflows, financial market structure, and credit growth as we did with banking crises.  However, we find no such relationship – either unconditionally or conditionally – between capital inflows and the growth rate of domestic bank credit.  While capital inflows are conditionally correlated with banking crises, the relationship does not appear to operate through a simple increase in the volume of bank loans.  Rather, credit booms appear to be a separate channel of financial instability from the one we identify in our analysis.

In contrast, we do find evidence that capital inflows influence the propensity of banks to take on greater risk, through a reduction in capital cushions and/or the assumption of greater insolvency risk – and that this varies depending on a country’s domestic financial market structure. In other words, capital inflows – in financial systems where banks complete alongside large securities markets – affect the quality of bank lending and the composition of bank balance sheets.

Figure 3 illustrates this second core result. It shows the conditional relationship between capital inflows, market structure, and national level averages of Tier 1 commercial bank capital.  These results strongly suggest that capital inflows trigger banking crises not because they cause credit booms (surges in the volume of bank lending), but because they lead banks to reduce their capital holdings and lend to more risky customers.  This decline in the quality of banks’ loan portfolios, rather than an increase in the number and amount of loans, appears to be the “smoking gun” linking capital inflows to banking crises in industrialized countries.

 Figure 3: Average Conditional Marginal Effect of Gross Portfolio Inflows (% trend GDP) on Tier 1 Commercial Bank Capital Ratio, by Market/Bank Ratio

Coefficient on change in gross portfolio inflows (%  of trend GDP)

The political roots of financial market structure

While our statistical analysis shows that financial market structure mediates the effects of foreign capital inflows, it cannot explain how such variation in market structure developed in the first place. To resolve this puzzle, we turn to historical analysis, zeroing in on the political decisions that shape the structure of financial markets that make certain countries especially vulnerable to banking crises. Through detailed historical case studies of Canada and Germany, Banks on the Brink shows how seemingly innocuous political decisions about financial rules can accumulate over decades and solidify a country’s financial market structure for generations.

In our case study of Canada, we show that the country’s remarkable history of bank stability has been attributable in part to its equally remarkable fragmented and underdeveloped stock markets. The Canadian Constitution granted the national government the sole authority to regulate the banking industry, but authority over stock markets was relegated to the provinces. During the economic crisis of the early 1930s, while the U.S. government seized the opportunity to create a national securities regulator and to minimize the role of state regulatory agencies, Canada made few changes to its regulatory system. The government took no steps to create a national regulator, instead reaffirming the authority of the provinces to supervise their stock exchanges in accordance with their particular needs. To this day, Canada is the only industrialized country without a national securities regulator. We argue that the country’s underdeveloped securities markets have had a salutary effect on its banks, which have been successful in channeling foreign capital to borrowers over the last four decades without taking on undue risk.

Like Canada, Germany has a long history of bank stability, but it has recently taken a dangerous turn. Our case study highlights how policy decisions in the aftermath of two major financial crises—the Panic of 1873 and the crisis of 1931—arrested the development of German securities markets and solidified a heavily bank-centric financial system. Interest-group and party politics, rising nationalism and anti-Semitism in the late 19th century, and the Nazis’ ascendance to power in the 1930s all conspired to hobble the development of German stock markets prior to World War II, allowing banks to engage in long-term conservative lending with “patient capital” throughout the postwar era until the 1980s. In recent years, however, financial competitors from within and outside Germany have prompted the large German banks to seek alternative sources of revenue. Deutsche Bank, Commerzbank, and other large banks have become champions of Finanzplatz Deutschland, a single large securities market designed to compete with New York and London. As this market has developed, the conservative bias of German banks has eroded, and many required emergency bailouts in the early 21st century.

Key implications

Banks on the Brink shows that politics is the root cause of financial crises, but not in the way that many observers might imagine. Bankers themselves have political preferences and may express them publicly, and some banks lobby for favorable public policies and donate to political campaigns and political action committees. But at a deeper level, banks are embedded in financial markets, which themselves reflect an accumulation of government choices. Banks today operate in an environment shaped by these political choices, some of which make banks more resilient, others of which make them more prone to crisis. This variation, across space and time, explains why some countries find themselves more vulnerable to banking crises and the dangers of foreign capital inflows than others.

These findings have key policy implications for how to minimize the risk of banking crises in the U.S. and elsewhere. In light of the slow-moving nature of financial market structure, any policy proposal to fundamentally alter the shape and depth of financial markets will likely be dead on arrival. Proposals to re-introduce Glass-Steagall-type regulations which separate commercial and investment banking might be episodically popular in countries like the U.S., but as our evidence suggests, they would fail to address the underlying reasons for banks’ excessive risk taking. We also argue against capital controls. Instead, we suggest that regulators should focus their efforts are tightening bank capital requirements, especially in financial systems with prominent or growing securities markets.  Governments are unlikely to be able or willing to fundamentally alter the structure of domestic financial markets in the short- or medium-term. But they can ensure that financial institutions act more prudently, especially when foreign capital inflows flood into the country and the temptation for  banks to engage in more risky behavior is greatest.



This post written by Mark Copelovitch and David Singer.

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Quotation of the Day…



… is this March 21st, 2020, tweet from Thomas Sowell:

It is so easy to be wrong – and to persist in being wrong – when the costs of being wrong are paid by others.

DBx: Indisputably true, both as a matter of logic and as a proposition that consistently succeeds at explaining a great deal of human history.

Note that Sowell’s point is general. Those who are convinced that today’s government-engineered lock-down of much economic activity is appropriate can nod their heads approvingly at the thought that those who are convinced of the opposite fail to account adequately for the costs that would be paid by others were this lock-down less draconian. Ditto the other way ’round: those opposed to this lock-down nod their heads approvingly at what they take to be Sowell’s explanation of why government officials seem now to be so glibly and irresponsibly imposing massive economic costs on hundreds of millions of strangers.

But whatever your position on the lock-down – whether you think it to be worth its gargantuan costs or not worth these costs – you cannot fail to recognize the deep dangers that lurk within any system that allows a handful of people to act in ways that impose massive costs on others.

My own sense is that the benefits of this lock-down are not worth their costs. (And, by the way, I do not reckon as costs only – or even chiefly – financial flows, such as lost profits, and the monetary values of foregone goods and services. Among the many kinds of costs of this lock-down are worse-than-otherwise health in the future, and the innumerable problems inevitably to be created by governments with yet more discretionary powers.) Yet even if I am mistaken – and perhaps I am (I say sincerely) – we should all be deeply suspicious of discretionary power exercised by government officials – power the costs of the exercise of which are borne almost wholly by third parties.

The grade-school fiction – one embraced also by many PhD-sporting intellectuals – is that majority-rule democracy is sufficient to ensure that all decisions made by government officials in democratic nations are without any such negative externalities, that is, without any undue ill-consequences imposed on third-parties. “We the people” make these decisions ourselves through our elected representatives and the assistants that they hire to help them. Problem avoided!

Anyone who believes in this above account of democracy is too naive for words. He or she is wholly ignorant of even the most basic principles of public-choice economics – an ignorance, note, that itself imposes negative consequences on third-parties by encouraging the naive to impose the costs of political superstitions and of the resulting dangerous policy-making regimes on their fellow citizens. Such people should read Buchanan, Tullock, Downs, Olson, SchumpeterArrow, Stigler, Wagner, Niskanen, Higgs, Holcombe, Yandle, Brennan & Lomasky, Caplan, Lee, Simmons, Munger, and Achen & Bartels, among others. Oh, and do read also Sowell’s own great magnum opus.

The post Quotation of the Day… appeared first on Cafe Hayek.

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