The Efficient Muffin Hypothesis

During this financial "crisis" and subsequent bailout, some Austrian economists have surprised me with their optimism. Essentially, they argued that the market will pull through. Even if stupidity got us into the mess, and stupidity was going to compound the mess, so long as the market is allowed to chug along we will always ultimately "grow our way out." In the end, these Austrians argued, we would end up better off after the crisis and bailouts are all over (say, a few years hence) than we were before the whole thing started. We might have been even better off had we not passed some of the stupid policies, but we would only lose growth, we would not shrink in real terms.

Austrians also talk a lot about inflationary policy, or other kinds of foolish policies that governments engage in for a short term fix, despite having bad longer term consequences, as being like a drinking binge. They then argue that you can't cure a hangover with more drinking.

Now, if original hedonistic policy is like the binge drinking of a wild night, then the morning is the time for recovery. And if, in fact, if a semblance of protection for private property rights is all it takes to "grow our way out" then we can pretty much use whatever hangover cure we want, and be alright.

We can call this the "efficient muffin hypothesis," because the muffin we eat for breakfast manages, as it breaks down, to metabolize away the worst of the negative effects of our night of drinking. This theory says that we will make it through the hangover and to complete recovery fairly quickly. We can even have a mimosa with the muffin to take the edge off.

The inefficient muffin hypothesis, then, would state that in fact any old hangover cure may not work, the effects of these policies may compound each other, and we may never recover. In this scenario, the muffin cannot purge the poison, nor can time alone, and permanent damage may have been done.

Now, if the efficient muffin hypothesis is true this has significant implications. If, so long as the market is not completely banned, the wee market left can always "grow us out" of any idiocy of government policy, then we might have to take a second look at whether these policies are so bad. A night of drinking ain't a bad thing, sometimes.

Seminar Topic - What Has Economic Science Learned From Socialism?

This is a recurring theme for me, but one which I maintain is very key. I ran into a note I had written up last spring on this topic, and then a post at The Austrian Economists seemed a good place to promote the idea. However, it didn't catch any traction there. I will post in here, so it is not entirely forgotten.

The socialist calculation debate brought to light many fundamental economic issues, and problems of the classical and neo-classical modeling. While classical economists believed strongly in markets, their models could not explain exactly why socialism would not work. But, while the calculation problem provided a lot of insight and generated a lot of profound and interesting investigations, it did not resolve the issue. In fact, Lange's concept of market socialism for some time was considered a refutation of the arguments against socialism. A new set of economic theory rose from the ashes of that debate, focused on beneficial government interventions.

Comparative political economists continued to ask which system worked best, and market failure theorists worked out how government could solve the problems of the market. But then the "other" system fell, and upon cracking open revealed a rotting interior. In fact, the critics appeared to be correct after all. All of the problems they pointed out turned out to be true.

Now what? How has this revelation begun to change the face of economic theory? Is some of the faith in the ability of government to solve market failure on the way out? Do we now consider government failure as often as market failure? Do we now focus on the institutions that make markets possible- what of the old institutions of socialism, can we learn from why they failed? Can we still learn from the calculation debate, by considering why the socialists were wrong and what was wrong with their models and by looking again at the arguments of the opponents of socialism?

If the old models could not prove the problems of socialism, do we now have new models which can? Many of the core problems with the old models concerned their static nature and dependence upon equilibrium. Are we finally moving away from those kind of models, to a more dynamic approach? Should we look to the Austrians, the most adamant critics of socialism, for a better starting point and methodology? How has the science benefited so far, and what more can we learn?

The idea is that economists of all stripes should come together and review the old debates and the models that underlie them, between those who favored socialism and those who were critical, determine what failed in those models that so many fewer economists today would argue for socialism in those same terms, and explore whether we have rid ourselves of those assumptions in the models we use today. Some great work was done right around the collapse which touched on these issues - for example Stiglitz who I posted about a few days ago. But, I am not sure that something like this seminar has occurred, and even if it has perhaps we need more of them.

For example, have we rid ourselves entirely of misuses of equilibrium theory? Static models similar to the perfect competition model? Probably as important as the flaws in the static models are the flaws in aggregation - from Keynes to Solow to DGE models, some of the most highly respected theory and modeling has used fantastic aggregation that would seem ridiculous to a child, and which cannot adequately address institutional structures or behavioral responses to them. Are we still too dependent on aggregation without microfoundations?

Assuming for the moment we have indeed learned our lessons and rid ourselves of these fallacies, it would still be very useful to go over this bit of history, cleanse ourselves of our past and explore the way that these lessons have been incorporated into our current models. It seems to me that any science which believed a falsehood for a long period needs this kind of cleansing, needs to face its own past and take some time to explicitly re-think its models.

Really grasping the mistakes of the past is the best way to ensure they are not repeated. Understanding the way in which the flaws in past models fooled past economists into thinking that socialism could triumph will prevent those today who want to simplify from making the same errors in simplification in new forms. We may think we know the obvious: institutions, institutions, institutions. But what of static models - when can they be used safely? What of aggregation, still used so much in dynamic modeling today, when can it backfire badly? What other lessons can we extract from this long period of darkness in economic science?

Stiglitz on Socialism

I'm flipping through Stiglitz's Whither Socialism, which I've not read before, and finding many interesting thoughts to chew on.

Many of these are of course old news by 1989 when he wrote this, (but not conceded by all economists!), and some are not correct but still interesting. He seems to be a thought provoking guy with some very insightful arguments and connections. He also packs a lot into a short space, and keeps it very readable.

1. Futures Markets: the perfect competition model, which Stiglitz admits is too flawed to inform the choice between markets and socialism, assumes a complete set of markets including the ability for markets to allocate investment efficiently.

But investment into the future requires futures markets, which many sectors don't have. "These futures markets are essential for making the correct investments allocations." He goes on to argue that they must extend infinitely -- of course this would only be in order to be as efficient as a planner with complete and perfect knowledge, so it seems to be a weak argument. p. 16

2. On Austrian methodology:

My concerns are two-fold: First, because Hayek (and his followers) failed to develop formal models of the market process, it is not possible to assess claims concerning the efficiency of that process, and second (and relatedly), in the absence of such modeling, it is not possible to address the central issue of concern here, the mix and design of public and private activities, including alternative forms of regulations (alternative "rules of the game" that the government might establish) and the advantages of alternative policies toward decentralization-centralization.

p. 25

3. Stiglitz does as well as Hayek showing the paradox of perfect competition assumptions, such as complete markets and perfect information (or "informed" markets), see e.g. p. 38

4. Stiglitz points to the incentive/calculation problem of using targets which specify output not according to profit, but according to a single measurement that so plagued socialist economies, calling it the problem of not fully specifying commodity prices. p. 85

He points to this later as a way in which planning failed in precisely the way that the neoclassical model failed, when he invokes the planners inability to specify commodities as creating "an incomplete set of markets" and concludes that it is "one of the reasons that the neoclassical model fails" and "Exactly the same set of factors are at work in explaining why socialism fails." p. 198-99

5. The theory of contests as a replacement for perfect competition-- isn't this very similar to the Austrian concept of competition as a driving force (Kirzner) or a market process (Mises)? Although he finds some areas in which he believes competition can be destructive, he indicates that the active role of the competitive driving force of competition is crucial to its ability to induce innovation, cost minimization, and improving quality. Hence he finds "not only that the ordinary usage of the term competition is not well reflected in the traditional economic paradigm of 'perfect competition' but that the traditional perfect competition model may give us only limited insights into the roles that competition plays." p. 115

And so much more!!

As a side note, he also speaks on such interesting topics as short term incentives when firm managers care about short run stock market valuation (p. 96); rent-seeking to get around patents (p. 129), and lots else not so directly related to comparative systems.

Austrians should look to Stiglitz for good insight, especially, I think, when he looks at socialism.

Not Much Has Changed Since 1949

At least, as far as public opinion about economics goes.

Reason Magazine points out the contradictory responses to changes in prices by the public and the media, who of course consider themselves great economists - otherwise they could not offer such profound arguments as to why the prices are dangerously high or low:

Rising prices are bad, and so are falling prices. As recently as mid-August, we were worried about runaway inflation. In an article headlined "Higher Costs Are Taking a Toll on Business," The New York Times reported that "rising prices have seeped into much of the economy, led by higher costs for food and energy." At the end of last month, under the headline "Fear of Deflation Lurks As Global Demand Drops," the Times warned that reduced consumer demand could lead to "persistently falling prices," "suffocating fresh investment and worsening joblessness for months or even years."

Rising home prices are bad, and so are falling home prices. As home prices rose through 2006, newspapers across the country ran stories bemoaning the lack of "affordable housing." Now that prices are falling, newspapers across the country are running stories about the disaster of negative equity, the loss of what used to be a reliable investment, and the financial havoc caused by the assumption that home values would keep climbing forever.

Rising oil prices are bad, and so are falling oil prices. Last summer, with crude oil going for more than $140 a barrel and gasoline over $4 a gallon, politicians were falling all over each other to do something about rising oil prices, which made food and a wide range of other products more expensive. Now oil is around $60 a barrel, but instead of celebrating we're supposed to worry, because the price reflects fears of a prolonged worldwide recession.

Mises pointed all of this out in 1949. He explained stock market price changes are always vilified, no matter which direction they are going:

Popular opinion finds something objectionable in every possible aspect of stock market transactions. If prices are rising, the speculators are denounced as profiteers who appropriate to themselves what by rights belongs to other people. If prices drop, the speculators are denounced for squandering the nation's wealth.

He also described how different groups want prices and wages to go in different directions. As we all know, interest groups drive politics and public opinion: concentrated benefits and dispersed costs.

So, public opinion and populist policies follow these interest groups, reacting to the price changes as if they are a dire emergency. But this prevents the adjustments which must be made in the free market, in order to reallocate resources as demands change or as ventures are deemed to have failed or as policies by government or by businesses need to adjust because they are simply too costly.

Mises explains:

To the wage earner no wage rates, however high, appear unfair. But the farmer is quick to denounce every drop in the price of wheat as a violation of divine and human laws, and the wage earners rise in rebellion when their wages drop. Yet the market society has no means of adjusting production to changing conditions other than the operation of the market. ... The absurdity of all endeavors to stabilize prices consists precisely in the fact that stabilization would prevent any further improvement and result in rigidity and stagnation. The flexibility of commodity prices and wage rates is the vehicle of adjustment, improvement, and progress.

Both the desire to denounce business and the wealthy, and the rallying cry from interest groups who want government to protect them from competition in labor and product markets drives the conversation. When the price of oil goes up it is evil speculators, when it falls it is a depression. The evil speculator who controlled the price of oil has conveniently disappeared in the fog of fear around the supposed depression.

Though if a crisis has caused the price to drop this must be due to a fall in demand, it is never a rise in demand that has caused the price to go up - it is always greed. The fact that these arguments are entirely inconsistent has never seemed to bother these popular economic scientists of the media and political elite.

It also doesn't bother those who favor antitrust regulation: they have laws against "predatory pricing," setting prices too low, and also against "monopoly pricing," or "price gouging," setting prices too high. These are also relics of the 1930s-era confusion about competition and free market price setting. John Stuart Mill spoke about this problem of seeing only one half of the market, and believing price to be hurting either the worker or the consumer, forgetting about the other half of competition. If competition is seen to drive down prices then it is bad because it hurts the company who can no longer pay high wages (what about competition for wages?) if it is not seen, then it is bad because it hurts the consumer.

Mandatory Service and The Road To Serfdom

(Cross-posted at Heritage)

There has been a small uproar around Obama’s call for a “civilian national security force” especially one “that's just as powerful, just as strong, just as well-funded” as the military. But many have said that these words were taken out of context. If you read the whole speech, they argue, it is clear that he just wants to expand the Peace Corp a little bit*.

Similarly, there was a mild uproar about his call for mandatory service from students, but many said that the programs were never intended to be mandatory. The college program was optional community service in exchange for a larger education credit, and the high-school one was no different from adding an art class or something to the public high-school curriculum. Obama initially called both mandatory on his change.gov website, but after the buzz began he changed the wording and removed several sections of the site.

But now there is new evidence that the critics are right. He does favor mandatory service and it might be worse than we thought. He has chosen Rahm Emanuel as his chief of staff. Rahm Emanuel wrote a book called The Plan in 2006. On page 60-65 of the book Rahm calls for universal conscription of 18-24 year olds for civilian service in order to prepare for a potential terrorist attack.

“All Americans between the ages of eighteen and twenty-five will be asked to serve their country by going through three months of basic training, civil defense preparation and community service.”

In a 2006 radio interview Rahm explains more about the program. He speaks about the dangers of a chemical attack and about the wonderful common experience that all Americans could have by being drafted for 3 months into a civilian national security force training program. He seems to be using the fear of attack to justify drafting all youth into a militaristic civilian security force – something more reminiscent of a dictatorship than a democracy. And all of his calls to unity and common experience only confirm his preference for nationalism or collectivism over individualism and freedom.

That Obama has chosen this man as his chief of staff should give anyone pause. This man has a “Plan” for the country that involves training our youth like soldiers, and calls upon “a new patriotism that brings us together again in a common mission” for his plan which will “unite us in a higher national purpose.”

If this is Obama’s vision, then there is great reason for concern. We are treading very near the Road to Serfdom.

* …and create a Classroom Corps and Health Corps and Energy Corps and Veterans Corp, and a Homeland Security Corp – as one blogger wrote “Here a Corp, there a Corp, everywhere a Corp Corp.”.

The Charmed Circle

(cross-posted at Heritage)

Candidates running for president in recent decades have sounded in their speeches more like they believe they are running for the position “God” rather than the position “President of the United States.” John Stossel pointed this out in his recent special on 20/20.

Politicians claim that they can solve economic crisis, prevent natural disasters, keep the enemy at bay, create millions of jobs, and so on. Gene Healy argues in his book The Cult of the American Presidency that the executive has incredible power outside its original constitutional limits in part because we have fallen for this idea that the president can save us. The candidate we like we think can cure all our ills, while the one we dislike will destroy the country over night. But, he argues, in fact both are probably about equally destructive because the power given to the position and the scope of the government’s role is the core problem, not who sits in the office.

It wasn’t always this way. Although government was a tiny fraction the size it is today, Calvin Coolidge was a proponent of privatizing those concerns where the state had taken control and failed. There are so many time when these words would have been appropriate these past decades, but so few times when this sentiment was aired, and fewer when the action was taken:

If anything were needed to demonstrate the almost utter incapacity of the National Government to deal directly with an industrial and commercial problem, it has been provided by our experience with this property.

In that speech Coolidge mentions the “enormous debt” of $30 per person or $150 per 5-person household. Adjusted for inflation, $30 would be about $352 dollars today. Our per capita national debt today is about $35,000. Yet, he saw the debt as a serious concern, and vowed to reduce it. Just a few years later he was able to make these remarks – just imagine we could say this today:

We have substituted for the vicious circle of increasing expenditures, increasing tax rates, and diminishing profits the charmed circle of diminishing expenditures, diminishing tax rates, and increasing profits.

Four times we have made a drastic revision of our internal revenue system, abolishing many taxes and substantially reducing almost all others. Each time the resulting stimulation to business has so increased taxable incomes and profits that a surplus has been produced. One-third of the national debt has been paid, while much of the other two-thirds has been refunded at lower rates, and these savings of interest and constant economies have enabled us to repeat the satisfying process of more tax reductions. Under this sound and healthful encouragement the national income has increased nearly 50 per cent…

Notice that he spoke of the “national debt” not the deficit being paid off. What America needs today is not a president who promises hope and dreams, and to cure our ills with more spending, but a president that sees how far outside constitutional bounds we have come, and vows to get us on the path of that charmed circle of reducing expenditures, cutting taxes and increasing our private prosperity.

America Serves

(cross-posted at Heritage)

President-elect Barack Obama has quietly changed the meaning of the American Dream and introduced a proposal for American Serfdom. In America, what it means to serve one’s country is very clear. It is voluntary and for the purpose of defending the country during a time of war, or for the purpose of upholding the constitution by serving, for example, as a judge or on a jury.

Obama has reinterpreted the American Dream of “life, liberty and the pursuit of happiness,” as a collectivist ideology. He believes it is a dream about the collective happiness. He connects the notion of “service” to the American Dream, as he interprets it:

When you choose to serve -- whether it's your nation, your community or simply your neighborhood -- you are connected to that fundamental American ideal that we want life, liberty and the pursuit of happiness not just for ourselves, but for all Americans. That's why it's called the American dream.

Obama is wrong. It is called the American Dream because in America the individual is secured rights and liberty, and with those rights protected and liberty ensured anything is possible. The American Dream is an individual dream. It is the dream of each of us, not the dream of a collective hive, or a collective outcome. This is not to say that private charity in un-American. Private charity and civil society are very much part of the American spirit. But this is because they are private and voluntary.

But then Obama goes on to describe what it means to him to serve. He has a list of new “corps” to add to his expansion of the Peace Corps. Then he lists “a plan to require 50 hours of community service in middle school and high school and 100 hours of community service in college every year.” That is, 500 hours of mandatory community service.

Obama says that it is when “you choose to serve” that you are connected to the American Dream. But this quote is used to bolster support for a program which includes mandatory community service for every American child and college student. So, now mandatory community service is the American Dream. Now, it is not an independent pursuit of a better life but performing manual labor for the state that constitutes the American Dream.

Now to serve one’s country in America will have the taste of being a servant to the state, a serf, rather than the proud voluntary service of a free man.

Bureaucrats and Diapers

Recently, I came across this article. I laughed - it was funny. But, I kept thinking about it. It is really an important example of why regulations are dangerous. In this particular case the government just "promoted" the use of cloth diapers, they did not regulate disposable diapers, as far as I know, nor certainly ban them. But, the story illustrates why it is so good that they did not take that step.

It was lucky that they were able to discover their mistaken assumption - that in fact in order for cloth diapers to produce as little a carbon footprint as disposable diapers they must be washed at a moderate temperature and line dried. Typical use of cloth diapers produces a larger carbon footprint than typical use of disposables. If government had taken the "moral and responsible" step that many activists advocated and either banned, regulated or highly taxed the disposable diapers: it would have led to a larger carbon footprint.

The truth came out in this study - the truth about the carbon footprint. But even what this "carbon footprint" means is not entirely clear. We think we know what greenhouses gases do, which are the worst, what is the right way to combat them according to environmental science, etc. But the "truth" we know today is different from the truth we knew 10 or 20 years ago. New studies poke holes every year in things we thought we knew, or produce new information that changes what we think we know today.

Science is a constant evolutionary process. We are always learning. The market too is a constant evolutionary process, always evolving and innovating. The market immediately begins to adapt to every new piece of information, new signal about resources, and new evolving preferences. Fighting to better serve customers, firms make products more efficient - less wasteful. If consumers care about the environment then firms will respond with products with a small footprint. Even if consumers don't care about that, more efficient product innovations may reduce the footprint anyway.

But government commands are not an evolutionary process, they are an intervention into the evolutionary process which diverts resources along another path, interrupting the flow of information, blinding the actors involved in the learning process. Government itself has the wrong incentive structure. Fighting for their own self-interest but in a bureaucracy instead of a competing firm, government officials use rent-seeking to expand their power in the market instead of improving a product to sell to customers.

Anyway, I wrote this to the EPA:

It is noble to want to prevent disaster. Government is clearly trying to pursue a goal - less global warming. But, particularly when scientists cannot come to complete agreement on exactly how different technologies affect this goal, it is extremely dangerous to pursue the end through stringent government regulations that reduce personal and economic freedoms.

Government agencies can often become over-zealous in pursuing their goals, and may do much more harm than good. Recently, after promoting the "green" solution of reusable diapers for years, the Department for Environment, Food and Rural Affairs (Defra) in the UK did a study and discovered that, unless an "extreme" approach was taken to laundering, in fact disposable diapers produced a smaller carbon footprint.

Thankfully disposable diapers had not been banned. However, another lesson came from that incident -- the study was hushed. Embarrassed that they had been promoting the wrong choice for so long, not wanting their so-obviously "green" solution to be blemished, the agency instructed civil servants not to publicize the conclusions.

The bill proposed here would expand the powers of our own green energy agency, but we could make the same kind of mistakes and restrict freedom unnecessarily. We could do a lot of damage in pursuit of a noble goal but with limited information and limited means. The government can only command and ban, it cannot innovate and find creative solutions. And it is often wrong, and often over-zealous.

The private sector came up with efficient disposable diapers to serve a need. Despite the noble will and immense power of the government, the government was wrong about the need to intervene and return to a more primitive replacement, and then it tried to hide its mistake. If the government takes the further step to regulate or ban the product it perceives as harmful and if government does not stumble upon the science that redeems the product, or if it refuses to turn back, the harm could be much greater.

This proposal would give the EPA far too much power to regulate and ban products which may not cause the great harm which the agency perceives. I believe the agency is acting in an over-zealous manner and must be restrained.

Not that I expect self-restraint from bureaucrats. This will have to be decided in the Supreme Court (again) as usual.

Planning Insights from a Non-Austrian

An interesting article in the QJE from 1964 offers some nice non-Austrian insights into the problems of central planning, by looking at problems of large organizations , be they large firms or governments, and their bureaucracy.

The first insight is in this nice paragraph, imagine yourself standing in a central statistical bureau of the government - or maybe the Fed - trying to work out how to save an ailing economy:

Statistics at the center must lose cognizance of individual psychologies, attitudes, and tendencies that are too detailed, amorphous or untactful to put into summary reports, but that can be thoroughly useful in decisions. The central staff live in the midst of aggregates, trends, averages, and over-all generalizations. They are remote from the individual reality behind the words and figures that flow and jumble over their desks. They are dealing with symbols: their input is items on paper, and their output is items on paper. The individual is expendible-- both to the American Telephone and Telegraph and to the Soviet Union.

(my emphasis)

Of course, if AT&T deals with you that way, you, hopefully, can find another phone company (so long as government hasn't given them a monopoly). The point about aggregates goes deeper than is made clear here. In particular, aggregates cannot tell you the micro-level reasons for problems with coordination and growth, and macro-level targets cannot aid individuals in the coordination necessary for growth, to reach those targets.

Another good paragraph is this one. Think of Obama's community service projects and call to the spirit of "public service". Hopefully the insight is well known, if often forgotten:

Conventional wisdom in most communities of the world approves of harnessing the "highest motives," rather than the strongest motives, to achieve social goals. Down-grading the profit motive (discussed above) is only one example. Public exhortation and praise are focused on community service, mutual help traditions, and cooperate ventures. Looking after oneself, and one's own family, earns no special applause. But economic efficiency and progress mainly depend, as Alfred Marshall advises us, on making effective use of the strongest, and not necessarily the highest, motives of mankind.

He then cites Khrushchev who tried to invoke Lenin, when he realized the need for profit motive, and stressed to the people "the exceptional importance of the Leninist principle of material incentives," explaining that "It is completely erroneous to oppose material stimuli to moral ones, material incentives to ideological-education work..." -- Indeed, Adam Smith couldn't have said it better.

The two points come together when the author then goes on to discuss corruption. The author makes the important point that planners can only make decrees, they cannot set up institutions that allow the actors to fulfill the goals by following their own strongest motives. If they did the latter, they would not be planning, but providing an environment for free choice -- a market. Instead the planner must use command, which cannot ensure the target is met, but just direct the actions of the individuals. If the actions won't produce the desired ends of the individual, he may break the law, making the results unreliable. If he follows the law from fear, but knowing it won't achieve the ends, the plan won't be fulfilled.

To the extent a central authority relies on incentives-- income, status, etc-- to get work done, it is trying to make the public interest and private interest coincide. To the extent it relies on regulations or laws -- backed in the case of government by police, courts, and army -- it is forcing people to do, in the purported general interest, what they would otherwise not do. That is, giving incentive to avoidance, evasion and corruption.

On the point of corruption, the author also wins my heart with this footnote about how the more laws imposed, the more are broken, creating a social acceptance of violation of law:

It seems plausible to estimate that the average respectable citizen in the United States breaks at least one law a day (for example, did he come to a complete stop at the last stop sign?), whereas in 1800 it is doubtful whether his predecessor broke one law a year (did he murder or steal last year?).

Thank you-- still respectable even if I get fined for California stopping.