Economics of Safety and Security

Economic globalisation

Free trade, free movement of capital, free movement of labour

Neoliberalism

Deregulation, privatisation, and the elimination of tariffs, capital controls, etc

Multilateralism

Cooperation through international organizations like the UN, IMF, etc

American hegemony

System revolves around US dollar and US security guarantees → US dollar is the world’s reserve currency

Microeconomics

Contemporary sub-field of economics primarily concerned about how individuals behave and make decisions → behavioural assumptions (= requires making psychological assumptions about humans) → eg Why does someone buy one product rather than another? How do humans make consumption decisions under budget constraints?

Macroeconomics

Contemporary sub-field of economics primarily concerned with national, regional, or international economic processes; study broader topics but are ultimately based on (sometimes unspoken) behavioural assumptions → eg What causes economic growth? How do interest rates impact employment rates?

Utilitarianism

[fill in later from the slides]

Rational Choice Model

view that humans are perfectly rational,

self-interested, and seek to maximize their utility

Perfect information

Humans have complete information about all possible alternatives when making a decision (+ information accessibility)

Utility function

Mathematical representation of a rational actor’s preference over options

Indifference curve

Mathematical representation of a utility function over different bundles of options

Expected utility theory

When making choices, individuals weigh the utilities of expected outcomes by their probabilities and choose the option with the highest weighted sum (so instead of choosing the option that has the highest financial gain, they will calculate what has the optimal utility based on the combination between chance and profit)

• Example: guaranteed $500 VS 50/50 chance of $1000 VS $0 → $500 VS $1000×0.5=$500 → equal, so the average person should be indifferent, but it depends on their risk profile (risk averse, risk neutral, risk seeking)

Rationality

Decision-making based on self-interest and utility-maximising

4 key dimensions of change (Schwarzer, 2020)

Rational Choicel Model (preference axioms)

1. Perfect information

2. Completeness

3. Transitivity

4. Context independence

5. Choice determination

(First) Law of Deterrence

IF punishment go UP, THEN crime go DOWN

Elasticity

Informs about the change in quantity demanded of a good due to a change in price

Discount rate / discount factor

A measure of impatience. The higher it is, the more impatient someone is

Deterrence theory

In criminality: Expected Punishment (EP) = severity of sanction × probability (of apprehension and/or conviction) × discount rate

In IR: The prevention of action by the existence of a credible threat of unacceptable counteraction and/or belief that the cost of action outweighs the perceived benefits

4 phases / bodies of thought of the debate on the “rationality“ of political actors

1. Liberal Internationalism (1800s-present)

2. Classical realism (mid-20th century)

3. Rational Actor Synthesis (1950s-present)

4. Behavioral International Security (1970s-present)

Liberal Internationalism

Belief that rational humans could tame their irrational temptations through rules-based order and economic interdependence (incentives to avoid conflict)

Behavioral Assumption: Optimistic that states can be induced to act rationally

Optimistic about capacity of reason to triumph over passions

Classical Realism

Theory of international politics characterized, in part, by its pessimistic view of human nature

Behavioral assumption: treat human “reason” as subservient to their “passions”

Pessimistic about capacity of reason to triumph over passions

Rational Actor Model (RAM)

Treats nation-states as unitary actors which make consistent, value-maximizing choices under external constraints

Key organizing concepts:

• Unitary Actor Assumption: A nation or government (or perhaps even a region!) can be treated as a single unitary actor with definable preferences over some set of options

• Problem-focused: Model seeks to understand how states solve specific problems when various external constraints are present

• Rational-choice: States rationally assess some set of options and choose whichever option maximizes value (equivalent to maximizing ‘utility’

Sunk Cost Fallacy

Theory that paying for some good or service increases the likelihood it will be used, all things equal (effect occurs even if using that good or service does not maximize utility (eg Doja Cat concert))

Prospect Theory

Contends that humans weigh the expected utility of options against a relative reference point (thus utility is relative rather than absolute)

Loss Aversion

A type of cognitive bias in which losses are weighed more heavily than gains (losses ‘hurt’ more than gains ‘satisfy’)

• Gains increase utility while losses decrease utility, but the rate at which gains and losses impact utility is not the same

Endowment Effect

Cognitive bias in which humans often demand much more to give up an object than they would be willing to pay to acquire it (we really hate losing what we already have)

• Humans assign more weight to out-of-pocket costs (part of pre-existing endowment) than opportunity costs when making decisions

• Examples: Wine Fable, Mug Experiment

Opportunity costs

Foregone benefits of one option incurred by choosing another option (eg the money you would have made working is an _______________ of pursuing a Bachelor’s in Security Studies)

Out-of-pocket Costs

Actual costs/loss incurred by choosing one option over another (eg the tuition fees you pay to pursue your Bachelor’s in Security Studies; selling something)

Efficient Market Hypothesis

Asset prices (including stock prices) fully reflect all available information

• 2 key implications: the price is always right + no free lunch (high risk high reward)

Herd Mentality / Group Bias

Tendency of peoples’ beliefs to conform to the group (if everyone around you thinks a stock’s price will go up, you may be more inclined to agree

Appeals to Authority

If ‘important’ people (or just people on TV) voice an opinion on the future movement of stock prices, people may be inclined to follow their lead

Anchoring Bias

Tendency to anchor our beliefs on an initial piece of information – a reference point (prospect theory) – and downplay information obtained afterwards

Nudge / Nudging

Any aspect of the choice architecture that alters behaviour in a predictable way without forbidding any options or significantly changing their economic incentives (NOT taxes, fines, subsidies, bans, or mandates) → influence, but do not constrain, individuals’ freedom of choice (soft paternalism)

Common types:

1. Default rules

2. Simplification

3. Social norms

4. Ease / convenience

5. Disclosure

6. Warnings

7. Precommitment strategies

8. Reminders

9. Eliciting implementation intensions

10. Informing about past choices

Choice Architecture

The institutional / environmental factors that impact decision-making

Critiques of behavioural economics:

• Nanny State: Some criticize nudging as a manipulative form of state paternalism

• Limits of Experimentation: To what extent can we generalize from unique experiments? Varied results?

• Lack of Unified Theory: Behavioral Economics is a collection of insights but, arguably, does not provide a unified theory which facilitates generalizable micro- and macroeconomic models

Rational Criminals

Deterrence theory assumes criminals are perfectly rational and respond to the cost of punishment

Multilateral Development Banks (MBDs)

Type of international organization that facilities low-cost loans for economic development (created by sovereign states (contributing countries and borrowing countries)) → How it works: leverage the credit rating (usually AAA) of contributing states to borrow money at low rates and pass on to developing countries (eg the World Bank)

Game Theory

A technique used to analyze situations where for two or more actors (individuals, institutions, politicians, AI agents) the outcome of an action by one of them depends not only on the particular actions taken by that actor but also on the actions taken by other actor(s)

• Studies what happens when self-interested agents interact

• Players are rational and aim to maximize their own payoffs (utility)

• Components: players, actions, payoffs

• Different types:

  • Simultaneous-move or static games

  • Sequential-move or dynamic games

• Games can be one-shot or repeated.

• Games can be competitive, cooperative, or mixed-motive

• Games can be symmetrical or asymmetrical (?)

Static Games (simultaneous-move)

The players make moves at the same time (or their moves are unseen by the other players) (eg rock paper scissors, penalty kicks)

Dynamic Games (sequential-move)

The players make moves in some sort of order (one player moves first and the other player or players see the first player’s move and can respond to it) (eg chess, sanctions, trade wars)

North Sea

Major source of fish for Belgium, Netherlands, Germany, Denmark, Norway, and United Kingdom

• 4 key traits:

  • Common: It is a common resource shared by multiple actors

  • Non-Excludable: It is not possible (or would be prohibitively expensive) to exclude any actor from using the resource

  • Finite: The North Sea is not infinite; there are limits to the number of fish and the ecosystem needed for fish growth

  • Rival: Extracting fish from the North Sea reduces the quantity of fish available to other actors using the resource

Excludability

Whether actors can be excluded from using the good

Rivalry

Whether consuming the good decreases the total available supply

Private Goods

Goods that are excludable and rival (eg your phone)

Club Goods

Goods that are excludable and non-rival

Common Goods

Goods that are non-excludable and rival (eg North Sea)

Public Goods

Goods that are non-excludable and non-rival (eg streetlights)

Tragedy of the Commons

Social problem in which the pursuit of individual self-interest leads to the depletion of common goods

How can we “solve” the tragedy of the commons in the environmental sphere?

4 (non-exhaustive) social-psychological strategy categories

• Information

• Identity

• Institutions

• Incentives

Externality

Indirect costs or benefits experienced by one party which arise because of actions taken by another unrelated party

Negative Externality

Indirect costs experienced by one party which arise because of actions taken by another unrelated party

(Examples: environmental pollution; noise pollution; systemic risk posed by collapse of financial institutions; non-vaccination)

Positive Externality

Indirect benefits experienced by one party which arise because of actions taken by another unrelated party

(Examples: open-source software; publicly-available research; voluntary blood drive programs; vaccination)

Pigouvian Tax

Tax which seeks to correct negative externalities by raising costs to induce a reduction in supply (eg carbon tax)

Social Equilibrium

Represents the predicted level of production based on both producer and social costs

Private Equilibrium

Represents the predicted level of production based only on producer costs

Deadweight Welfare Loss

Space represents indirect social costs of overproduction (on graph of slide 18 of lecture 4)

Carbon Tax

Tax that emitters must pay for each tonne of greenhouse gas emissions they produce

Cap and Trade System

Seeks to reduce climate change by creating a market with limited allowances for emissions (rewards sustainable companies by allowing them to sell unused allowance, and punishes unsustainable companies by making them buy expensive allowance)

Two-Level Games

Metaphor for simultaneous strategic games played at domestic and international levels (eg climate negotiations, north sea fishing, etc)

Win-set

Set of outcomes which is acceptable to two or more parties (“set” which will “win”)

• In the context of two-level games, this refers to international outcomes (Level 1) acceptable at the domestic level (Level 2) for each actor

Nash Equilibrium

In a prisoner’s dilemma type of scenario, it’s the suboptimal outcome where both players default to the self defensive action (eg both snitching on each other → both go to jail for 5 years), even though there would have been a better outcome for everyone if everyone chose the selfless option (no one snitches → both go free). This is done to prevent a greater potential loss (eg if A snitches and B doesn’t, A goes free and B goes to jail for 10 years)

Revenue

The total amount of money a business earns from the sale of its goods and services before any expenses are deducted

Money laundering

Processing of criminal proceeds to disguise their illegal origins

• Three traditional stages:

  • Placement: Introduction of illicit funds into the legitimate financial system (e.g., by depositing cash from cocaine sales into a bank account)

  • Layering: Undertaking transactions to disguise the origin of criminal funds (e.g., by moving criminal proceeds through shell companies)

  • Integration: Reintroduction of laundered funds into the legitimate economy to provide a plausible explanation for their existence (e.g., using laundered funds to purchase real estate)

• Example of the 3 stages with a barbershop:

  • Placement: Easy to inject cash into barbershops and falsify business numbers

  • Layering: Profits can be reinvested into other assets like real estate (flat in East London)

  • Integration: The real estate can then be sold, producing seemingly legitimate profits that can be taxed and spent freely

Historical timeline of money laundering

• ~??? - 1986: Pre-Money Laundering Era

• 1986: Money Laundering Becomes Criminal

• 1989 - present: International Adoption of AML

• 2010 - present: AML System Under Increasing Scrutiny

Anti-Money Laundering (AML) Regime

System of laws that imposes regulatory obligations on banks (and other financial institutions) to prevent money laundering and terrorist financing → Effectively outsources surveillance to the private sector (at no small cost)

• Key components of AML programs:

  • Know-your-customer (KYC)

  • Risk Classification (Low, Medium, High)

  • Surveillance of Customer Activity

  • Reporting of Suspicious Activity to Regulator

• Problem on this system: Private banks and financial institutions have no interest in

  policing their clients (conflict of interest)

Financial Action Task Force (FATF)

Established in 1989 by small group of developed states to help win “the war on drugs → FATF’s objective is to encourage states to adopt common rules and practices (FATF Recommendations) to tackle global illicit finance.

• FATF Mechanism: Unofficial Market Enforcement

  • 1. Recommendations: FATF first publishes recommendations for all member states to adopt (e.g., “States should criminalize terrorist financing”)

  • 2. Blacklist: FATF shames countries who fail to adopt its recommendations by adding them to the “blacklist” (e.g., North Korea) or “grey list” (e.g., Nepal)

  • 3. Market enforcement: AML regulations encourage banks to avoid clients associated with blacklisted countries (creating economic pressure to comply with FATF recommendations)

Concerns about the effectiveness of the AML system

• Abysmal detection rates: It is often stated that less than 1% of global money laundering is detected (caveat: substantial measurement problems)

• Private sector costs: It has been estimated that financial institutions spend $200 billion per year to comply with their AML obligations → Those costs are often passed on to consumers in the form of higher banking fees (ABN AMRO has publicly acknowledged this)

• Debanking: practice of financial institutions terminating or restricting business relationships with clients, or entire categories of customers, to avoid rather than manage perceived money laundering risks

• AML rules also encourage banks to engage in arguably discriminatory practices: EU High-risk third-countries: The EU has established its own FATF-style blacklist → EU financial institutions are obligated to perform enhanced due diligence on clients associated with high-risk third countries → Numerous clients from predominantly Muslim countries have found themselves subject to enhanced checks

Debanking

Practice of financial institutions terminating or restricting business relationships with clients, or entire categories of customers, to avoid rather than manage perceived money laundering risks

Shell Company

Legal entity that has no independent operations, significant assets, ongoing business activities, or employees → exploit difference between legal and beneficial ownership:

• Legal owner: individual listed on corporate registries maintained by national or regional governments

• Ultimate beneficial owner (UBO): individual who controls and is entitled to assets

• Nominee: UBOs can nominate an entity or individual to serve as legal owner of the shell company on their behalf → This arrangement is governed through a separate private contract (e.g., a trust) to keep the UBO’s identity secret

Corporate Service Provider (CSP)

Entities who establish, sell, and maintain shell companies (important to note: they also have AML requirements)

• Formation: Complete paperwork necessary to create shell companies

• Domicile: Provide a registered address for a shell company

• Nominee: Act as (or arrange for others to act as) nominee shareholder for actual UBO

Corporate monitor

Individuals assigned to supervise improvements to a company’s internal controls (supported by teams of analysts performing onsite inspections of compliance controls in different country offices)

Gatekeeper model

States around the world have outsourced front-line detection of money laundering, market manipulation, and other financial crimes to private firms → very expensive, but very poor results (because conflict of interest: private firms have little interest in policing their own customers)

The Detection Trilemma

The currently available surveillance systems each only have two of the desirable elements of surveillance systems (Data Access, Positive Incentives, Privacy Protection) and none has all 3

• Gatekeeper surveillance → has DA & PP but NO PI

• Government surveillance → has DA & PI but NO PP

• Corporate monitorships → has PI & PP but NO DA

Licensed Detection Agent (LDA) Program

The solution to the detection trilemma: by offering financial incentives to detect suspicious transactional activity, would create a new class of third-party private firms who are:

• Licensed: pre-approved by regulators and subject to their oversight

• Empowered: to directly monitor transactional data

• Rewarded: for reporting suspicious activity to regulatory agencies

→ would create a competitive market for detection of financial crime

Operational details: licensing (PP), data access (DA), reward structure (PI)

Risks of LDAs

• Overreporting: Perverse incentive for LDAs to report spurious activity for short-term rewards (Mitigated by: strict provisions on reports, enforcement)

• LDA Concentration: Monopolistic LDAs may produce lower quality submissions or leverage exclusivity to force gains on regulators (Mitigated by: entrant-friendly reward structure, anti-trust)

• State competition: States could offer unequal rewards to incentivize LDAs to focus on their own markets (Mitigated by: international agreement)

Scarcity

Extent to which the total supply of some resource is limited

Range of Peaceful Alternative Bargains

Both sides will prefer a peaceful settlement if the expected value exceeds those of war → total bargaining range can be calculated

Blattman’s 5 key sources of conflict

• Unchecked Leaders

• Uncertainty

• Commitment Problems

• Intangible Incentives

• Misperceptions

Unchecked Leaders

Situation in which leaders of a state (or other social group) possess private incentives for war and face few checks on their power → Considering this problem requires that we relax the Unitary Actor Assumption

• private expected utility > social expected utility (leader has an interest in war)

Uncertainty

Lack of certainty about the intensions of others may lead states to strike first (causing war)

• Overwhelming expected costs may override this calculation (eg Cuban Missile Crisis)

Commitment Problems

Arise when some aspect of peaceful negotiation is non-credible (what if the other side won’t honor a peaceful bargain?)

Intangible Incentives

Arise when there are non-material incentives for war/conflict (e.g., status, emotion, principle, desire for violence for its own sake, ego, etc)

Misperceptions

Incorrect estimations of success may lead states to irrationally engage in war (eg What if the UK over-estimates its chances of victory at 65% (because it doesn’t know the Dutch have a secret laser weapon)?)

The Guns vs Butter Trade-off

In order to increase the supply of guns (= military spending), you must sacrifice butter (social spending, tax relief, public or private goods)

Production Possibility Frontier (PPF) / feasible frontier

A curve made of points that defines the maximum feasible quantity of one good for a given quantity of the other

• If actors are rational, they will not choose a combination below the line

• They are constrained and CANNOT choose a combination above the line

2 main options for states to avoid the guns VS butter constraint:

• Borrowing = pay for guns now to (maybe) pay later with interest (requires creditor)

• Alliances = sharing military capacity with other states (requires credible partners)

Borrowing

Allows us to buy more now, at the cost of buying less later

Interest rate (r)

The price of bringing some buying power forward in time

Benefits of borrowing:

• More $$ to finance arms

• Tax Smoothing

• Political Benefit (“hide” the cost of current security from the public)

Borrowing helps governments grow in the long run by avoiding distortionary taxes and spending cuts

Sovereign Default Risk

The likelihood that a government will default (= miss a payment on a debt or repudiate a debt) on its sovereign loans

• The higher the ____________, the larger the interest rate you have to pay and the less money creditors are willing to lend you

Alliances

States can rely on other states to provide security (States can benefit from joint production of security → can Benefit from specialization + Exchange non-security goods (policy concessions) for security) (The idea: Sum of security is greater than the parts) → can mean less guns and more butter

Costs of alliances:

• Collective action problem (states may free ride on others’ contributions → less security it generated)

• Risk of abandonment (allies may not hold agreements in a crisis)

• Risk of entrapment (alliances may embolden states to start conflicts others don’t want to fight)

Behavioral Economics

“Combines elements of economics and psychology to understand how and why people behave the way they do in the real world“, is concerned with “abnormalities“ that don’t adhere to “rational“ behavior

• Aims at detecting consistent patterns of deviations from the rational choice assumptions, which are put forward by neoclassical economists

Dual-use goods

Goods, software, and technology with both civilian and military applications

History of economic globalization:

• ~1860 - 1914: First Wave of Globalization

• 1914 - 1945: World Wars and Interwar

• 1945 - 1971: Bretton Woods

• 1971 - present: Second Wave of Globalization

Classical Gold Standard

System in which countries tied the value of their currencies to gold → Exchange rates were “fixed” because each country based their currency on gold

Bretton Woods Conference

All nations settle international balances in USD, which was pegged to gold at $35/ounce → created a new Gold Standard centred around the USD as the world’s reserve currency

Eurodollars

US dollars held by banks outside America

Floating exchange rates

Rates are determined by market fluctuations