Posts Tagged ‘Economics’

The assumptions and logic of neoliberalism

November 14, 2015

There is no such thing as society.  There are only individuals, and their families.      ==Margaret Thatcher


Neoliberalism is the philosophy that economic freedom is the primary freedom, economic growth is society’s primary goal and the for-profit corporation is the ideal form of organization.

It is the justification for privatization, deregulation and the economic austerity being imposed on governments by lending institutions.

What follows is my attempt to understand the thinking behind neoliberalism.  I welcome comments, especially from those who think I am wrong or unfair.

17149339-Abstract-word-cloud-for-Neoliberalism-with-related-tags-and-terms-Stock-PhotoGovernment is by definition coercive.  All governmental authority is ultimately backed by armed force.  The role of government should be limited to protection of life and property and enforcement of contracts.   

Private enterprise is by definition free choice.  Privatization by definition increases freedom.  All income deriving from the private sector, and not involving force or fraud, is earned income.

Most people are good judges of their individual self-interest and bad judges of the common good.   People generally make good decisions as consumers and poor decisions as voters.  Consumer choice is more meaningful than the right to vote.

Free markets, though the law of supply and demand, coordinate individual choices without the direction of any particular people or group of people.  The free market is more impartial and just than any system of planning or regulation could be.

A capitalist dictatorship that protects property rights is better than a socialist democracy that attacks property rights.

Economic growth is the key to increasing economic well-being.  Growth is produced by capital—that is, by investment in machines, factories and other human-made goods that generate new wealth.  

In a free enterprise economy, capital is invested by private individuals based on the law of supply and demand.  Whatever diminishes the ability of individuals to accumulate wealth or respond to the signals of the free market diminishes capital and retards economic growth.

Money spent on welfare and charity may temporarily alleviate distress, but it will not cure poverty.  Only capital investment and economic growth will do that. 

Capital investment and economic growth should take precedence over public education, public health, the environment and other so-called pubic goods, because they are the means of generating the wealth that pays for the public goods.

Banks, investment firms and financial markets are the key institutions of society.  They must be preserved in order to support investment and economic growth.

Monetary obligations are absolute.  Any person, organization or government that borrows money has an absolute obligation to pay it back, no matter what the sacrifice.  People who don’t repay their debts or fulfill their contracts are parasites on the system.

Inequality is a good thing.  To break up accumulations of wealth that have been acquired by legitimate means is not only unjust because it destroys the just reward for achievement.  It destroys the capital by which new jobs and wealth are created.


My economic philosophy in a nutshell

October 6, 2015

When, lo, these many years ago, I studied economics in college, I learned that capital was the most important factor in a prosperous economy.

I still think this is true.  But that doesn’t mean that owners of financial assets are the most valuable members of society.

Standard economics teaches that three  are factors of production—land, labor and capital.  “Land” means all natural resources—everything of value not created by human beings.  “Labor” means all human effort, physical or mental.

 “Capital” is the most important of the three.  It means everything that increases the productivity of land and labor—railroads, machine tools, computers.  It is the force multiplier for land and labor.  It is what makes economic growth possible.

The problem is that “capital” also means also the financial resources available (but not necessarily used) to create these tangible resources.

Landlords who receive rents contribute nothing to the wealth of nations.  Laborers who earn wages contribute a fixed amount.  Capitalists who make profits have—so I was taught—an incentive to direct their capital in a way that created the most value, and thus increase the total wealth of society.

Late in life I have come to read Karl Marx’s rebuttal.  Physical and intellectual capital is not created by capitalists, he noted.  Every railroad, every machine tool, every computer was created not by money, but by the mental and physical effort of human beings.

The increase in human wealth that physical capital generates does not go to those who created it.  It goes to those who own it.

Marx denied that the owners of capital are job creators.  He asserted that workers are capital creators.


The economic argument against the paranormal

June 16, 2015

Source: xkcd.

What worked and what didn’t

July 17, 2014

The passing scene: Links & comments 7/16/14

July 16, 2014

The case for shutting down Stuyvesant High School, the best public high school in New York by Reihan Salam for Slate.

Stuyvesant High School in New York City is a highly selective public school which admits fewer than 1 in 100 applicants, based solely on test scores.  The newest class is 71 percent of Asian origin and less than 3 percent black and Latino, even though blacks and Latinos are the overwhelming majority of New York City’s eighth graders.

Reihan Salam, a graduate of Stuyvesant, does not believe that blacks and Latinos will be helped by changing admissions policies.  Even in its glory days, he said, not every Stuyvesant student flourished in its highly competitive, sink-or-swim environment.

Because of differences in background, gifted black and Latino students are likely to need more backup and support from the school system than gifted Asia students did, Salam wrote.  He said the best thing would be to have a diverse range of high schools that serve the differing needs of students.

Piketty is the Anti-Marx by Noah Millman for The American Conservative.

Thomas Piketty’s Capital in the Twenty-First Century deals with the same subject as Karl Marx’s Capital more than a century before, but his approach and conclusions are the opposite.

Marx wrote about how capitalism was revolutionizing everything, and concluded that humanity was on the verge of a new stage of development.  Piketty wrote about how, despite revolutionary changes, the concentration of wealth and income remains the same.

Marx was a revolutionary.  Piketty wants the minimum change necessary.  Marx was a bold and original theorist.  Piketty is a cautious researcher, whose great merits are his compilation of new data and his reluctance to go beyond what the data show.

Israel’s bombing of Gaza is morally justified—and eminently stupid by Damon Linker for The Week.

Gaza War: Tunnels, Targets and Rockets | IJ Strategy and Tactics by Ahmed Hadi for Al Akhbar English.   Hat tip to Informed Comment.

The rocket attacks on Israel by Hamas and Islamic Jihad do not threaten Israeli power.  All they do is provoke retaliation.   The Israeli bombardment of Gaza does not threaten the power of Hamas and Islamic Jihad.  Their leaders are hidden in underground tunnels.  Nothing will change except that many civilians will be dead and peace will be even more unlikely.


The logic of modern monetary theory

July 10, 2014

Modern monetary theory seems wacky to me.

But try as I might, I can’t find any logical flaw in the basic idea.

Governments create money.  Why, then, do governments ever have to borrow money?  Why can’t they simply print the money they need to cover deficits.

One answer:  It would be inflationary.   But inflation is too much money chasing too few goods and services.   To the extent that government spending would generate goods and services that otherwise would not exist, new fiat money would not be inflationary.  And to the extent that there was a danger of inflation, the excess money could be soaked up through taxation.

MMT supporters said last year’s debt crisis and government shutdown were unnecessary.   The government should simply have created a trillion-dollar platinum coin (which is supposedly authorized by an obscure law), deposited the coin in a Federal Reserve Bank and used the new money to buy up the excess government bonds.

Again, I can’t see any logical flaw.  If the Federal Reserve has authority to create money to buy up bonds, why can’t it buy up Treasury bonds, liquidate them and reduce the national debt?

But the whole idea makes me uneasy.  I do think the U.S. government ought to be spending more money than it is for infrastructure, education, scientific research and other things needed to the nation’s future.   That’s not the same thing as thinking there should be no limits at all.

I fear MMT would remove a sense of limits.   I willingly pay taxes to support police, firefighters, schools, public roads, water and sewerage service and so on.  I’m not so sure I would willingly pay taxes just to reduce the money supply.

Why the rich will probably get richer

April 2, 2014


CAPITAL IN THE TWENTY-FIRST CENTURY by Thomas Piketty (2013) translated by Arthur Goldhammer (2014)

Thomas Piketty of the University of Paris is the world’s foremost authority on income distribution and the super-rich. All the charts you see how income is being redistributed upward to the top 1 percent of income owners are based on work by him and his collaborators. In this new book, based on 20 years’ work, he concluded that it is not an aberration that ever-greater shares of income go to a tiny elite. Piketty said this is the natural working of a market system.

According to Piketty, the higher you go on the income scale, the larger the amount of income comes from investments rather than work. When the economic grows at a higher percentage rate than the average rate of return on investment, income becomes more widely distributed. When the average rate of return on investment is greater than the rate of economic growth, the owners of economic assets gain at the expense of everybody else.

His research is based on 200 years of data on income and wealth distribution in France, the UK, the USA and other countries, which now can be analyzed and processed with computer technology. His book would be a good supplement to David Graeber’s Debt: the First 5,000 Years, whichi is sketchy on precisely the past two centuries.

Piketty concluded that the average rate of economic growth since 1800 is about 1 percent a year for the countries he studied, and the average rate of return on investment is about 4 to 5 percent a year. Unless something happens to change one or the other figures, a wealthy elite will grow richer and richer at the expense of everyone else, until there is nothing left to invest in.

pikettybookcover00Piketty defines “capital” as anything you can own that will generate income. In the late 18th and early 19th centuries, capital (by his definition) consisted mainly of agricultural land and government bonds. Now it consists mainly of housing, industrial machinery and stocks and bonds of private corporations. Few economists would define “capital” in so broad a way, but if all you’re interested in is income distribution, it doesn’t matter what form “capital” takes.

If you read English and French novels set in the early 19th century, the characters consist mainly of members of what Piketty calls the “dominant” class, which are the 1 percent of the population who receive 30 to 60 times the average income, and the “well-to-do”, who consist of the next 9 percent. Characters in Balzac and Jane Austen seek wealth through inheritance, marriage and patronage of wealthier and more powerful people. Nobody in those novels thinks that wealth is acquired through hard work and superior talents. Piketty said there is nothing to prevent a reversion to this kind of world, although the difference between wealth and poverty wouldn’t be quite so extreme.

The reason the history of the 20th century was different, he wrote, is the great destruction of capital during the two world wars and the Great Depression. This cleared the deck for the great surge in prosperity of 1945-1975, which benefited all segments of the population. Since then, according to Piketty, the growth in income has been sucked up by the dominant and well-to-do classes.

Now I don’t think that someone born in 1900 would have thought the prosperity of 1945-1975 justified the catastrophes of 1915-1945. This points to an important limitation of Piketty’s book. It is full of fascinating information, drawn from a wide variety of sources, ranging from centuries of income and property tax records to social history, economic theory, literature and financial journalism.

Thomas Piketty

Thomas Piketty

But when you get right down to it, he deals with only one subject, the income share of the super-rich. He doesn’t have theories on how to eliminate poverty, promote economic growth, set priorities for public investment or any other important objective. This is not a criticism. It is just a description of what the book is and isn’t about.

His one subject – which is important – is the economic elite and how, short of violent revolution, to prevent from sucking up an undue share of society’s wealth and income. But as the experience of 1915-1945 shows, destroying the power of capital does not, in and of itself, make things better for everyone.

Piketty focuses on data from France and the UK because the United States is, in good and bad ways, exceptional compared to the rest of the world. During the past 200 years, the boundaries of France remained roughly the same and population grew from 30 million to 60 million. During the same period, the United States expanded from a narrow strip along the Atlantic to the Pacific coast, and its population grew from 5 million to 300 million.

Income distribution in the United States historically has been more equal than in Europe, he noted, at least for white men in the Northern states. The chief form of capital in the early United States was agricultural land, and this was very cheap compared to Europe. Early settlers and immigrants brought little wealth with them. What they created was the fruit of their labor. A great deal of the capital for building U.S. factories and railroads came from European investors. The great American hereditary fortunes did not emerge until the dawn of the 20th century.

The South was different from the North because the economic elite possessed enormous capital in the form of enslaved human beings. Piketty estimated that in the 1770-1810 period, the economic value of slaves in the South exceeded the value of all land, housing and other forms of wealth, and also exceeded the total wealth of the North. The result was a high concentration of wealth, and a large gap between rich and poor white people, which persists to this day.

Differences in earned income, while great in all countries, have seldom been as important as differences in income from wealth. The exception is the surge in corporate compensation in the United States and other English-speaking countries in the last generation. Piketty showed, by means of international comparisons, that the current size of executive compensation cannot be justified on the basis of merit or results. It is the result of executives being able to influence their own pay, and the lack of standards as to how much is enough.

The disturbing fact about investment income is that the more you have of it, the higher your rate of return. Piketty compared the returns on endowment funds of American universities, which are a public record, by size categories. The larger the fund category, the higher the percentage return, with Harvard by far outpacing all the rest.

This is because the larger the fund, the more the owner can afford to get expert investment advice, and the better able the owner is to invest small amounts in high risk, high return investments. Also, unlike an individual who has saved for retirement, the super-wealthy person or institution does not have to take out a significant percentage to live on.

The implication is that once you reach a certain level of wealth, your wealth becomes self-sustaining.  A Bill Gates or a Steve Jobs can simply coast. He not longer needs the entrepreneurial drive that brought him success in the first place. Piketty’s analysis of the Forbes 400 list indicates that inherited wealth is at least as important as entrepreneurial wealth, and he thinks Forbes vastly underestimates income from passive investments because of lack of access to tax havens.

Piketty’s solution is a tax on capital – which, remember, is by his definition any form of income-producing property – sufficient to bring the average return on investments down to the expected rate of economic growth. He pointed out that some forms of wealth, such as real estate and buildings, already are taxed. In principle, taxing stock portfolios is no different.

Since the average rate of return is greater for greater wealth, his proposed tax would be graduated, with a zero or 0.1 percent rate for fortunes below 1 million euros and perhaps rising as high as 2 percent above 5 million. These don’t seem high, but they are high compared to expected rates of return. He also favors continuation of the graduated income tax and inheritance taxes. His purpose is not to prevent people from getting rich. It is to prevent the rich as a group from getting richer at a faster rate than the economy is growing.

The revenue from the wealth tax should be spent in reducing government debt, which Piketty sees as a transfer of income from taxpayers to wealthy holders of government bonds. It is better to tax the rich than borrow from them, he said.

Piketty’s proposals require much better information about wealth and income than we have now. The first step would be for the international community to require reporting of financial information from places such as Switzerland and the Cayman Islands that act as tax havens.

The 577-page book and the 76 pages of notes are crammed with information of interest even to those who don’t accept his basic argument. It is not written in technical language, which is part of the reason it is so long; Piketty, like the late Isaac Asimov, explains everything from the groun up.  If you don’t have time to read the whole book, his core argument can be found in the Introduction or Conclusion.  Or click on some of the links below.


Supply, demand and minimum wage

February 24, 2014

One of the big arguments against raising the minimum wage is based on an over-simple understanding of the law of supply and demand  — that if employers have to pay higher wages, they’ll hire fewer workers.

If that were true, then the long-term decline in the minimum wage and in median workers’ wages (adjusted for inflation, which you should always do) would have resulted in full employment.  Obviously this hasn’t happened.

A rational employer will hire as many workers as necessary for the profitable operation of the business, and no more.  The law of supply and demand sets limits.  The employer will not pay so much that he can’t operate profitably, nor so little that nobody will work for him.  But, as is shown by the difference between Costco and Walmart, there is a broad range between those two limits.

Suppose I have a franchise to operate a McDonald’s restaurant.  I would not raise wages to the point where higher costs forced me to charge more for a hamburger than the Burger King restaurant across the street.  But if the minimum wage was raised for both of us, we could pay higher wages and still be on a level playing field.

In theory, minimum wage could be raised to the point where I charged more for hamburger than people were willing to pay.  But there is no evidence that this has ever happened with minimum wage in the United States.

One economist, for example, compared employment in adjoining counties of adjoining states with different state minimum wages.  There was no evidence of any difference in unemployment rates or job availability.

A higher minimum wage could have a positive effect on employment.  If low-wage workers have more money to spend, there is a greater demand for goods and services, and could result in new hiring.


Economic incentives are no substitute for ethics

October 20, 2013

“Yves Smith” wrote an important post on her naked capitalism web log about the claim that economic incentives can be a substitute for ethics and morals.

Economics as it usually is taught considers moral values only as one of the factors that influence free choice.   A few make a specialty of writing books and articles purporting to show that acting on moral intuition always does harm, and that self-interest always works to the greater good.

It is true enough that good intentions can backfire if there is no reality check.  That does not mean simplistic economic goals such as “maximize shareholder value” are a substitute for a moral code.   In our complex economy and big organizations, actions and decisions are so far removed from their consequences that it is impossible to design a set of economic incentives that will automatically generate the common good—especially when the structure of economic incentives is rigged to benefit those who already have economic and political power.

As Yves Smith wrote:

Over the course of my life, one of the side effects of the increased infiltration of economic-style thinking into more and more walks of life has been a decline in a sense of social responsibility among what passes for our elites.

Yves Smith

Yves Smith

To the extent that anyone is tasked to see that outcomes are fair, it appears to default to government (food stamps, early childhood education programs, prohibitions against workplace discrimination, etc).

But at the same time, we’ve also been on the receiving end of a forty-year campaign to discredit, co-opt and shrink government. One proof of this pudding is that formerly competent regulators like the SEC and FDA are shadows of their former selves.

The reason the lack of concern with ethics is a focus is that ethics are an important, perhaps the most important, guide for managing complex systems.

One of the points that John Kay argues persuasively in his book Obliquity is that most systems are so complex that we cannot map an efficient path through them. He’s taken pairs of companies in the same industry, similarly endowed, one of which focused on maximizing shareholder value, the other which set a richer set of goals which seldom included making shareholders wealthy. The ones with the loftier aspirations also did better for stockholders.


Highly complex societies don’t simply have rising energy costs, they also have increasingly high information and communication burdens. Those larger spans of control and the difficulties of monitoring make it hard to get incentives right.

It’s brutally hard to define rewards and checks well when you have to manage from afar, through reports, infrequent meetings, and results that depend on environmental and competitive conditions, not just skill and effort.

There just aren’t good substitutes to the owner who grew up in a business, knows the industry well, knows his people and their job requirements intimately, and can reprimand bad behavior and give rewards based on direct observation.

The U.S. Constitution establishes the principle of separation of church and state, which means the government should be neutral between one religion and another.  But this does not mean individuals should be ethically and morally neutral.

One mistake we liberals make is that we try to reduce all issues to procedural questions, rather than frankly stating our moral principles and making a case for them.  This disarms us morally against those who want to bring the values of for-profit corporations into all walks of life.  We make arguments on grounds of procedure or economic efficiency rather than stating our real reasons.

Click on Ethics and Complex Systems to read Yves Smith’s whole post.

A David Graeber reader: links to articles

September 9, 2013


David Graeber’s Debt: the First 5,000 Years is a brilliant work that reinterprets history in a new way and shows how payment of interest-bearing debt has come to be regarded as the obligation that overrides all moral obligations.

Here is a set of links to articles that explain what Graeber is all about.  The first is an article in the New Yorker about who Graeber is.

David Graeber and the Anarchist Revival by Kalefa Sanneh for the New Yorker.

Next some links to Graeber explaining his ideas in his own words.

What Is Debt?: an Interview with Economic Anthropologist David Graeber

Debt: the First Five Thousand Years by David Graeber.  This is his outline of the basic idea of the book for the Anarchist Library.

And some links to critiques and reviews.

The Debt We Shouldn’t Pay by Robert Kuttner for the New York Review of Books.

David Graeber’s Debt: My First 5,000 Words by Aaron Bady for The New Inquirer.

The Very Last David Graeber Post by Brad DeLong.  A scathing critique of the concluding chapter of Debt by a professor of economics.

Debt: the First 500 Pages by Mike Beggs for Jacobin magazine.  Why he found Graeber’s main arguments “wholly unconvincing.”

In Defense of David Graeber’s Debt by J.W. Mason for Jacobin magazine.

And the full text of the book.

Full text of ‘Debt: The First 5,000 Years’  [added 4/29/2015]

An economics lesson from a kangaroo

August 19, 2013


This is true, although in terms of purchasing power, the Australian minimum wage for fast-food workers is more like $12 in the United States. Click on Australia minimum wage for details from the Real News Network.

Many economists say, without any empirical evidence, that an increase in the minimum wage will automatically result in increased unemployment.  This is because it is a basic principle of economics that if you increase the price of something, people will buy less of it, and so it is with wages.

Under certain conditions, that would be true.  Fewer people would be hired for minimum wage jobs if, say, the U.S. minimum wage was raised to $72.50 an hour.  But there is no evidence that any of the actual increases in the minimum wage have had any adverse measurable effect on U.S. employment.  Indeed, the number of minimum wage and near-minimum wage jobs has increased dramatically since 2007-2009, when the minimum wage was increased from $5.15 to $7.25 an hour.

The basic concept of economics—that the law of supply and demand describes how people respond to economic incentives—is true as far as it goes.  This concept has such beauty and explanatory power that it is easy to forget the other dimensions of human behavior.   Economists who forget this wind up like the physicist in the joke, who could infallibly predict the outcome of horse races, provided there were spherical horses racing in a vacuum.

Why wages are falling (British version)

June 21, 2013
Rising profits, declining wages in Great Britain

Rising profits share, declining wages share in Great Britain

A British blogger reports that the same thing is going on in Britain as in the USA.

Back in the 70s and 80s, bosses could often not efficiently monitor their workers. To keep pilfering and skiving within tolerable limits they therefore had to pay better than market-clearing wages, to buy goodwill.  The upshot was that wages rose even during downturns, because bosses feared that real wage cuts would create discontent and thus increase thieving, insubordination and malingering.

This led to a huge literature in economics on efficiency wages, gift exchange and insider-outsiders, which tried to explain high and sticky real wages.

However, as Frederick Guy and Peter Skott have shown, socio-technical change since the 80s such as CCTV, containerization and computerized stock control has made it easier for bosses to monitor workers.  Direct oversight means they don’t need to worry about buying workers’ goodwill.  They are instead using the Charles Colson strategy: “When you’ve got ’em by the balls, their hearts and minds will follow.”

Years ago, firms wanted smaller but motivated workforces.  Now they can control workers directly, they don’t need to worry so much about motivation except, of course for top-level managers who cannot be directly monitored – hence their rising incomes.

All this has three implications:

1. Talk of “wage rage” misses an important point.  At the point of production – to use a quaint Marxian phrase – there is little meaningful rage, because workers can do little to fight falling real wages.  (This poses the danger that such rage will find perhaps misdirected political expression, such as in antipathy towards immigrants.)

2. Issues of industrial organization – how firms are organized – have important macroeconomic effects. Macroeconomics cannot be easily studied separately from industrial organization.   Economists need to look inside the “black box” of industrial structure.

3. You cannot understand economics without understanding power.  The fact is that bosses’ power has risen and (many) workers’ power has declined. In this sense, the rising incomes of the 1% and the fall in real wages for the average worker are two manifestations of the same process.

Click on Stumbling and Mumbling for the original.  Hat tip to Avedon’s Sideshow.

Click on The Market Oracle for the source of the chart.

As inequality rises, opportunity declines

June 13, 2013


Some Americans like to say that while we are less equal in income and wealth than some of the western European countries, we have greater opportunity to rise on the economic scale.   If everybody has a reasonably fair chance to acquire wealth, based on talent and hard work, then we should not complain about inequality of wealth, or so the argument goes.

The chart above shows the problem with that argument.   Among 10 industrial nations, the United States had the greatest concentration of income at the top, measured by the Gini coefficient, and the second least equality of opportunity, based on correlation of your income with your parents’ income.

This stands to reason.   The steeper and higher the slope, the hardest it would be to climb up.

The chart is based on figures for 1985, which was nearly 30 years ago.   Income inequality has grown since then, and there is a dot on the chart extrapolating the decline in economic mobility for 2010 based on the Gini coefficient of wealth concentration for that year.

Click on The Great Gatsby Curve for an animated GIF of the chart, which makes it easier to understand.


‘I regard the moral environment as pathological’

April 22, 2013

Jeffrey Sachs is a well-regarded American economist, who is director of the Earth Institute at Columbia University.  Last week he took part in a conference sponsored by the Drexel University at the Federal Reserve Bank of Philadelphia on how to fix the banking system.  This is part of what he had to say.


Jeffrey Sachs

I regard the moral environment as pathological.  And I’m talking about the human interactions that I have.  I’ve not seen anything like this, not felt it so palpably.  These people are out to make billions of dollars and nothing should stop them from that.  They have no responsibility to pay taxes.  They have no responsibility to their clients.  They have no responsibility to people, counterparties in transactions.  They are tough, greedy, aggressive, and feel absolutely out of control, you know, in a quite literal sense.  And they have gamed the system to a remarkable extent, and they have a docile president, a docile White House, and a docile regulatory system that absolutely can’t find its voice.  It’s terrified of these companies.

If you look at the campaign contributions … … the financial markets are the number one campaign contributors in the U.S. system now.  We have a corrupt politics to the core, I’m afraid to say, and no party is—I mean there’s—if not both parties are up to their necks in this.  This has nothing to do with Democrats or Republicans.  It really doesn’t have anything to do with right wing or left wing, by the way.  The corruption is, as far as I can see, everywhere.  But what it’s led to is this sense of impunity that is really stunning, and you feel it on the individual level right now, and it’s very, very unhealthy.

I have waited for four years, five years now, to see one figure on Wall Street speak in a moral language, and I’ve not seen it once.  And that is shocking to me.  And if they won’t, I’ve waited for a judge,  for our president,  for somebody, and it hasn’t happened.  And by the way it’s not going to happen anytime soon it seems.

The significance is not so much the content of what he is saying, which has been obvious for some time, as that he as a member of the American economics establishment is saying it.


Those loaded words, “free markets”

October 25, 2012

The free exchange of goods and services is necessary for the functioning of a modern industrial economy.  It is not just because freedom is good in itself, although it is.  It is not just because free competition spurs companies to produce better goods at lower prices, although it does.

It is that in order to makes decisions within a modern economy, it is necessary to compare relative values.  You can’t do that unless you know the prices of things, and the only non-arbitrary way to set prices is through agreement of a willing buyer and a willing seller.

So the economics profession is perfectly right to start with the concept of free markets as a premise.  The problem is when that concept is taken to a self-defeating extreme.  Free markets are not the same thing as the absence of rules and regulations.  If that were so, Lebanon under the warlords or Haiti after the earthquake would be the greatest free market countries in the world.  The New York Stock Exchange draws investors from all over the world because they have confidence that a listed company’s financial report bears some semblance to reality, and that a broker is not trying to rip them off.

To say that rules and regulations as such are inconsistent with the free market is like saying traffic lights and speed limits are inconsistent with free driving.  You could make the argument that individual drivers are better able than traffic police to decide when to stop and start and how fast to go, but that is not a freedom that would be meaningful to me.

The test of a proposed law are regulation is (1) whether it is consistent with basic Constitutional rights, (2) whether it promotes the common good and (3) whether it can be enforced impartially.

For insight into what happens when decision-makers decide that “free markets” can function without law and regulation, I recommend Yves Smith’s book, ECONned: How Unenlightened Self-Interest Undermined Democracy and Corrupted Capitalism and her web log, naked capitalism.

A reality checker for economic illusion

October 25, 2012

I recently read a number of books during the past couple of years about Wall Street and the events leading up to the 2008 financial crash.  The latest is ECONned: How Unenlighted Self-Interest Undermined Democracy and Corrupted Capitalism.  It was published two years ago, but unfortunately is still as relevant as it was then.

What this book offers that the previous ones didn’t is an analysis of how bad policies were based on unproved but widely accepted economic theories, and how these theories continued to be accepted even though evidence had proved them wrong.

One example is the Arrow-Debreu Theorem, a mathematical proof that for any commodity at any given time, there will be a price that will clear the market—that is, leave no sellers with unsold goods or buyers with unsold orders.

econnedThe Arrow-Debreu Theorem assumes perfectly competitive markets, buyers and sellers with equal information, no buyer or seller big enough to influence the market, separate markets for different locations and a futures market with no limits on time or place.

In other words, it assumes conditions that never were and never will be.  It is like the joke about the physicists who came up with a formula for predicting the outcome of horse races, based on the assumption of spherical horses racing in a vacuum.

Nevertheless many economists decided that the Arrow-Debreu Theorem proved that you should work for unconstrained markets, especially unconstrained futures markets, with the idea that this would bring you closer the ideal of the market-clearing equilibrium price.  They persisted in advocating this even after the Lipsey-Lancaster Theorem, which showed that unless every single one of the Arrow-Debreu conditions were met, partial fulfillment would be useless or even harmful.

Some of Smith’s other examples are:

  • The Capital Asset Pricing Model, which says that risky investments can be made relatively safe through diversification.  The fact is that in a market crash, the prices of all securities fall, because investors sell their better investments to cover their losses.  I found this was true in 2007 when my diversified mutual funds all collapsed in price at the same time.
  • The Black-Scholes pricing model, which says that you can figure out what’s a good price on an option to buy a stock or bond based on the stock or bond’s “beta” (the history of its variability).  But this ignores all the outside factors that could affect the price of a security—the effect of a bad tomato harvest on the stock of a ketchup company, for example.

Even more fundamental economic concepts aren’t always true, Smith pointed out.  Economics is the study of how people respond to material incentives, but that is a narrow and inadequate way of looking at human behavior.  The typical human being is not trying to maximize utility in isolation from everything and everyone else.  Sometimes raising the price of something means you get less of it, rather than more, because somebody may have a target amount of money they’re trying to make, and quit when they reach it.

The economics profession has sought to distinguish itself from the other social sciences by greater reliance on mathematical rigor.   The equations don’t necessarily reflect reality, but they enhance the intellectual authority of economists in the eyes of those who are mathematically unsophisticated.

Yves Smith does not say that fundamental economic concepts or mathematical economics are completely wrong or completely useless, only that they are not the whole truth and should be subject to a reality check.

Yves Smith

About half the book is devoted to the claims of financial economists to understand and hedge against risk.  The financial crash of 2007 was partly due to financiers who didn’t understand risk.  They didn’t understand that if a larger enough number of people are hedging against the same risk, there is nobody left to bail them out.  That is why Long-Term Capital Management Company, a hedge fund headed by two Nobel economists, collapsed in 1998 and would have brought down a large part of the U.S. banking and finance industry along with it, if it hadn’t been bailed out by the Federal Reserve System.

There also were many financiers who understood the risk very well, but were nimble enough to push it off onto those who didn’t.   They were given free rein because of a more fundamental fallacy—the belief that individual pursuit of material self-interest always works for the general good.

I think Smith is too harsh in her judgment of the economics profession.   As she noted, many economists saw that an economic crash was coming, and issued warnings, but they were disregarded.  Economists are developing new tools, such a behavioral economics, which overcome some of the limitations of past theory, but they do not influence policy.   But it is the economists who were wrong, not the ones who were right, who guide the U.S. government’s policy.

Yves Smith is the pen name and Internet handle of Susan Webber, a graduate of Harvard Business School, who formerly worked in corporate finance for Goldman Sachs and headed the mergers and acquisitions division of Sumitomo Bank, and now has a consulting firm called Aurora Advisers Inc.  She knows whereof she speaks.

Click on naked capitalism for her web log.  She and her contributors produce outstanding investigative financial journalism and commentary on conventional economic thinking.

Click on the following three links for a good summary of her book

ECONned Part I: The Theory Behind the Great Recession,

ECONned Part II: Shadows of a Crash and

ECONned Part III: Insuring Financial Stability.

I don’t see how this can possibly end well

September 28, 2012

The Federal Reserve System has the power to create money, which it puts into the U.S. economy by buying Treasury bonds or other financial assets.   The chart above, which comes from the Federal Reserve Bank of St. Louis, shows how the money supply has more than tripled since Barack Obama was sworn in as President.

Recently Ben Bernanke, the chair of the Federal Reserve Board, announced that the Fed will spend $40 billion a month to buy mortgage-backed securities (aka toxic assets) until employment is back to normal.

The theory behind this is that putting more money into circulation will stimulate economic activity, because banks will increase their lending to American small businesses and consumers.  As economist Michael Hudson (shown in the video in my previous post) pointed out, this hasn’t happened.  The big Wall Street banks have more profitable things to do with their money.  What the Fed’s action does is to relieve the big Wall Street banks of the consequences of the 2001-2007 house price bubble and set the stage for a new bubble.

Another of the Fed’s policies has been to hold down interest rates to virtually zero.  The theory behind this is that Americans will borrow more and this will stimulate economic activity.  The actual result has been to artificially stimulate the stock market by driving money out of bank savings accounts.

Taking myself as an example, I get virtually no interest on my bank account.  This means that as a result of inflation, which is low but not zero, my savings are worth less in real terms than they were at the beginning.  This creates an incentive to venture out into the financial markets.  But since stock prices are being lifted by something other than the perceived value of the companies issuing the stock, there is bound to be a fall.

One cause (or definition) of inflation is too much money chasing too few goods.  During the past three years, the Federal Reserve System has more than tripled the amount of U.S. dollars, but this has not gone into increased production of U.S. goods.  Inflation is low in historic terms, but there is no guarantee this will continue.  I don’t see how this can possibly end well.

Click on QE Forever for analysis by Robert P. Murphy in The American Conservative.

Click on QE3: Another Fed Giveaway to the Banks for analysis on the naked capitalism web log.

The “monetary base” is spendable money, including cash and coins, bank accounts and money market funds.  There are other measures of the money supply, which include bank savings certificates, Treasury bonds and certain other kinds of financial assets.

“Rent-seeking” and the American 1 percent

September 5, 2012

Over the Labor Day weekend, I read another good book about the U.S. economy.  It is THE PRICE OF INEQUALITY: How Today’s Divided Society Endangers Our Future by Joseph Stiglitz, a Nobel economist and former chief economist for the World Bank.

Stiglitz argued that most American economic problems are due to excessive economic inequality, and to the “rent-seeking” behavior that, according to him, brought this inequality about.

Rent-seeking is a pejorative term used by economists for people who try to get income not by creating value, but by extracting wealth from others.  Conservative and libertarian economists apply the term to high-level government bureaucrats and recipients of government subsidies.  Stiglitz said the worst rent-seekers are Wall Street financiers and some of today’s corporate CEOs.

Stiglitz won his Nobel for his work on “asymmetric information,” which is about how, in the marketplace, insiders can take advantage of outsiders.  The mortgage crisis is an example of this.  My friend Marie said once told me that she assumed a banker would not lend you money unless he had good reason to think you could pay him back.  The average borrower prior to the crash had no way of knowing that this was no longer necessarily so.

Banks knowingly lent money to people they knew couldn’t pay them back, and then securitized the loans and sold them to people who didn’t understand the risk. The mortgage securitizers were rent-seekers.  They did not create value; they exploited their positions of trust and access to inside information.

The bank bailout took rent-seeking a step further.  The heads of the big Wall Street firms expected and got help from the government, both because of their influence in Washington and because of the argument that they were too big to fail without bringing down the whole U.S. economy.  Again, they weren’t creating value.  They were exploiting their positions.  Then, too, even if the banks had failed, the bankers responsible for the failure would not have suffered much.  By virtue of their positions, they would have collected enough in salaries and bonuses to walk away from the collapse and live very comfortably.

Some other examples of rent-seeking.

  • Excessive compensation of CEOs.  When CEOs of failing corporations get a performance bonus, this is completely different from the success of an entreprenuer, who has created something valuable and new.
  • Buying up public resources at bargain rates.  Typically rights to oil, gas and timber on U.S. public lands are granted at a fraction of their market value.  Privatizing of public services in Russia allowed insiders to acquire valuable assets for little or nothing; I wouldn’t be surprised (this is my example, not Stiglitz’s) if the same thing happened when and if the U.S. Postal Service is shut down.
  • Deregulation.  This may not seem like a form of rent-seeking, so let me explain.  Suppose you are the head of an oil company drilling in the Gulf of Mexico.  If there are no regulations requiring you to adopt the best practices of industry, and a disaster happens because of your negligence, neither you nor your stockholders will have to pay the full cost.  The cost will be imposed on fishermen and property-owners in the vicinity.

If Stiglitz is right, and I think he is, the first step toward making the American economy more productive would be to change the rules so that people are rewarded for their work and their achievements, not their ability to milk the system.  Like all good ideas, this can be taken to an extreme.  The limited-liability corporation could be regarded as a form of rent-seeking, because stockholders have no responsibility for the debts and liabilities of a company beyond what they put in.  But there definitely is a need to improve corporate governance and make corporate executives more accountable.

Inequality to the degree that it currently exists in the United States is an important social problem, Stiglitz wrote.  It wouldn’t be such a problem if it were due to successful entrepreneurship  like that of Henry Ford or George Eastman in the past.  These tycoons acquired vast wealth, but they also created new wealth.  The current crop of CEOs and financiers—not all of them, but many—have enriched themselves by transfer of wealth from others to themselves.

Joseph Stiglitz

Extreme economic inequality disconnects the lives of the elite from the mass of their fellow citizens, Stiglitz wrote.  They live in gated communities, send their children to private schools and associate with each other.  They have no reason to care—at least, not in the short run—about unemployment, education or public services.   To the extent that they are in a position to influence government policy, these concerns will be neglected.

Upward redistribution of wealth made the recession worse and the recovery slower, Stiglitz wrote.  The true job creators are consumers.  Nobody will produce goods and services unless someone will buy them, and mass prosperity depends on working people and the middle-class having enough income to create a mass market.  When the mass of the public are able to buy the products of industry, everybody does well, including the upper 1 percent.

Stiglitz outlined a program for reducing inequality and curbing rent-seeking.  He thinks it is possible to reduce inequality and stimulate the economy through the tax system and still balance the budget; this would be done by shifting the tax burden upward and the benefits of government programs downward, so as to increase consumer spending.   Maybe that would work, but I doubt it.   The most valuable part of the book is his definition of rent-seeking, and how it applies to the U.S. economy.

If you don’t have time to read the entire book, I recommend you check it out of a public library and read Chapter Two.

Click on From The Price of Inequality: Joseph Stiglitz on the 1 Percent Problem for an excerpt from the book.

Click on The Price of Inequality: Interview With Joseph Stiglitz by Jared Bernstein for Rolling Stone.

Adam Smith on financial incentives

August 17, 2012

What can be added to the happiness of a man who is in health, out of debt and has a clear conscience?

This quote is from Adam Smith’s The Theory of Moral Sentiments.

Adam Smith (1723-1790) is the founder of the modern discipline of economics.  Being an old retired guy with time on his hands, I once sat down and read The Wealth of Nations and The Theory of Moral Sentiments the whole way through.  As with most great classics, I found them different from how they had been described.

Although a strong advocate of the idea of a free market, Adam Smith was not a defender of corporations or the wealthy, nor was he an opponent of public works or a social safety net for the poor.  In his day, most corporations were government-sponsored monopolies that were chartered for a specific purpose.  Smith saw free enterprise and economic competition as a way to limit profit to a reasonable amount and force businesses to respond to what the public wanted.

I do not know what Adam Smith would think of the economic controversies of today, because our government, economy and society are so different from his.  But he most certainly was not a social Darwinist who looked on economic competition as a way of weeding out the unfit, nor did he think of maximizing wealth as a worthy goal.  Rather he saw the free market as an alternative to economic privilege and as a way strangers could establish relationships to their mutual benefit.

Click on Adam Smith’s Lost Legacy for a blog devoted to reinterpreting Adam Smith’s thought.

Click on Adam Smith’s Theory of Happiness for thoughts about Smith’s moral philosophy.

Paul vs. Paul on banking and debt

May 8, 2012

Last week Bloomberg News hosted this interesting debate between libertarian Rep. Ron Paul of Texas, currently seeking the Republican nomination for President, and liberal Paul Krugman, the Nobel Prize-winning economist and New York Times columnist, on central banking, deficit spending and inflation.  You could watch two important public figures, both independent thinkers who are beholden to nobody, debate what they honestly think about an important public issue.  That is something I fear will be a rarity in this Presidential election year.

Ron Paul wants to phase out the Federal Reserve System.   He correctly pointed out that without the existence of a semi-government agency with authority to buy government bonds and create money, it would be very difficult and maybe impossible for the government to finance either the current endless wars or the welfare state, which he is equally against.

The problem is that without a Federal Reserve, decisions about interest rates and money supply would be made not by an impersonal mechanism, but by powerful individuals such as J. Pierpont Morgan, who would not be accountable to the public.  Or you would have a chaotic system, like that which existed in the United States during the decades leading up to the Civil War, when wave of bank failures were frequent, and depositors lost their money.   Ron Paul would like to go back to that era or, alternatively, to return to the gold standard.  The problem is that impersonal mechanisms are just as fallible as individual people.   There is no magic of the market, or magic anything else–just a choice among imperfect systems.

While Ron Paul focused on deficit spending, debt and inflation, Paul Krugman focused on employment and economic growth.  I think Krugman had the right priority.  The U.S. government dealt with the enormous debt left over from World War Two, not by paying down the debt but by generating strong economic growth so that the debt became proportionately less in relation to the overall economy.

Krugman is a Keynesian, which means that while he favors a balanced budget and tight money in normal times, he thinks that deficit spending and easy money are warranted in a serious recession, as a means of getting money into circulation so that people will start spending and investing again.   The problem with that is that it doesn’t seem to be working.  I think the reason is that the current recession is more than part of the normal economic cycle.  It is a crisis resulting from decades of running the U.S. economy on debt rather than production.  When people have more money in their pockets, they don’t necessarily spend it, they use it to pay off their mortgages, installment loans and credit card balances.  And the big banks, as Ron Paul said, are content to borrow money from the Federal Reserve at 1 percent interest and lend it back to the government at 3 percent interest.   That does nothing to help the real economy.

I don’t believe in spending money for the sake of getting money into circulation, but I think the government should refrain from cutting back on basic services and that this is a good time to invest in infrastructure repairs, scientific research, job training and other measures to maintain our country’s productivity.  Ron Paul said, perhaps in jest, that it would have been better for the Federal Reserve to give relief to mortgage-holders (perhaps by refinancing their loans?) than to relieve the banks.  Certaintly this would have done more for economic recovery.

Click on Economics Throw-Down! Krugman vs. Ron Paul on Bloomberg TV — Helicopters, Gold and More for highlights.

Click on David Henderson on Paul vs. Paul for a conservative economist’s summary of the debate.

Click on Ron Paul Flunks History for comment on David Frum’s Daily Beast web log.

Click on Ron Paul vs. Paul Krugman: the Bloody Aftermath for discussion of the issues by Reason magazine’s Brian Doherty.

Click on Krugman Says Fed ‘Reckless’ to Allow High Jobless Rate for a Bloomberg News followup to the debate.

Hat tip to Joshua Chacon.