If You Can't Explain It, It Probably Isn't Right

I spoke to a non-economist today about the housing crisis, credit crunch, financial crisis, bailouts and recession. She had some basic insights about supply and demand, listened and agreed with me that the policies were likely to blame (regulations pushing low-income loans, interest rates, subsidies and so on), and we agreed that expanding these policies would make it difficult for entrepreneurs to spur recovery. My explanation was consistent with - in fact was pretty much exactly - the Austrian position.

Could a Keynesian explanation and solution have been as easily explained? The person I spoke to was not predisposed toward a free market solution or a government answer. I wonder if some of the credit crunch explanations that get into all the complexities are necessary, and with their confusing intricate details and delicate cures, whether they are able to get at the essence of something so big and far-reaching.

Of course, some simple explanations - especially ones that blame some minority group - are a distraction, scapegoat. So, perhaps if the explanation is complicated, it is unlikely to be right, but if it is simple it could be right or wrong. Then it just comes down to common sense. Since anyone is able to understand it, it comes down to being rational and honest in examining the logic. What do you think?

A Taste of the Control Inherent in Planning

Hayek said "Economic control is not merely control of a sector of human life which can be separated from the rest; it is the control of the means for all our ends."

This is very true, and key to understanding why the experiments with socialism have inevitably led to totalitarian dictatorships. It is also critical to remember when we little by little feed government power, the power to control our economic lives, and hence our lives in toto.

A fascinating reminder of what economic control truly means comes from the excellent - truly golden - book The Soviet Economic System: A Legal Analysis. Especially those of you who enjoy law and economics both, and "libertarian theory" on Leviathan and freedom, should check it out.

So, here Ioffe and Maggs here are discussing ownership in the Soviet Union, and describing the rights of the state firms, who possess "operative administration" rights, but are not owners. The state is the legal owner, and they investigate whether it can also be considered the de facto owner. They also consider what it means that "the state" is the owner -- of course, it turns out to mean that the Politburo and Secretary are the real owners. In any case, here they are describing the actual rights of the firm. It turns out that some of the restrictions on "possession, use and disposition" which apply to those holding only "operative administration" include strict limitations to use the property for planned purposes only and not to "sell postcards if you are a pharmacy," and that all money must reside in "funds" to be used for specific activities - investment, purchases, wages, depreciation, etc. The state bank which holds the funds ensures that the seller and buyer in any exchange both have the appropriate rights and use the appropriate funds, etc. And then here is the golden paragraph:

An examination of the legal provisions established for goods produced, goods which are the result of production rather than a fund for production, is useful for a full comprehension of the operative administration exercised by a producing entity. In this case, the rightholder has the rights of possession and disposition, but not the right of use. To use its own product, the economic entity must transfer the requisite portion of it from goods produced to production or other funds. If the goods produced are subject to planned distribution, then, in order to acquire its own product, the producer must be included in the plan of distribution issued by the planning agencies. Violations of this rule lead to legal sanctions. If the goods produced are excluded from planned distribution, then, in order to acquire its own product, the producer must have adequate resources in a monetary fund that may be employed for such an acquisition, and when part of the entity's product becomes a part of its fund of physical goods, the price of the product thus obtained must be deducted from the appropriate monetary fund and added to the amount of gain resulting from the sale of the product.

Yes. If you want to use some of the paper that your paper factory makes, you must be part of the planned distribution. Even if the distribution of paper is not being planned out - miraculously - this year, then you must sell the paper to yourself within the guidelines of the use of your monetary funds and adjust your balance sheet to reflect that you fulfilled output and simply sold to yourself some amount of the paper, which you were able to pay for out of your budget for purchases.

Now, I suppose that many firms do this kind of accounting anyway - to ensure that they are not being wasteful. However, the key thing to note here is who is in charge of all of this: the state. And "violations are subject to legal sanctions." This is entirely another kind of "accounting" when this is taken to heart.

The Real Danger of World Government

(Cross-posted at Heritage)

Even more than rent-seeking and government expansion here at home, the greatest danger of a left-leaning Obama administration may be the danger of capitulation to a new world government.

In the past, “One World Government” has been seen as a rallying cry of a fringe group, not something that many in the mainstream would either fear or desire. But, suddenly today it is on the lips of world leaders. The recent financial crisis is being blamed on a lack of world government.

The Financial Times reports:

Jacques Attali, an adviser to President Nicolas Sarkozy of France, argues that: “Global governance is just a euphemism for global government.” As far as he is concerned, some form of global government cannot come too soon. Mr Attali believes that the “core of the international financial crisis is that we have global financial markets and no global rule of law”.

But, the financial crisis was not caused by a lack of international regulation. Financial crises in the past have tended to occur more due to intervention than due to lack of regulation, and each of the banks that failed in this crisis was regulated by at least one country. Monetary policy was a major cause of the 1929 stock market crash and is implicated in just about every other crash.

In addition to dangerous monetary policy, one of the underlying causes of the Asian financial crisis of the late 1990s was government industrial policy, “As part of their industrial policy, governments have directed funds toward favored industries at low rates of interest… This leads to excess lending to the companies that are well-connected and who may have bought influence with government officials.”

This is the same kind of corruption and rent-seeking we’ve been seeing back here at home, with Fannie Mae and Freddie Mac, and in other areas of government. Extensive government reach into markets is what causes crashes and recessions – not a lack of even more expansive government reach.

These leaders want not only to abandon capitalism as we know it, but they want to force these ideas upon all countries by regulating companies at the international level. This kind of anti-market world governance would not make peace more likely, nor would it make free trade more possible or financial crises less frequent.

It Will Never Be Enough

(Cross-posted at Heritage)

A Christian Science Monitor article this morning argues that Roosevelt didn’t spend enough to jolt economy into recovery. Only when spending skyrocketed for World War Two did the economy recover (unemployment finally dropped, of course this was because everyone was mobilized either as soldier or to support the war effort – creating things which were then destroyed in fighting the war). The Article claims that “One big reason is that President Roosevelt didn’t spend enough to really boost the economy, historians say.”

Notice, that it isn’t economists that argued that the programs should have been bigger in order to boost the economy, but historians. This is like getting a philosopher’s opinion on astrophysics. It’s nice, but it shouldn’t be taken as expert.

The article goes on to point out that many economists do think that government spending can stimulate an economy. So, let’s examine this argument a little more closely. After 1929 and before World War Two, federal expenditures tripled as a percent of Gross Domestic Product. If we tripled federal expenditures as a percentage of GDP today, that would mean an additional 8.2 trillion dollars in government spending each year. That is because federal expenditures are already 20 percent of GDP.

Perhaps we don’t have to also triple the government’s role to have the same “stimulus” as Roosevelt. One might argue it is the amount of spending as a percentage of the economy that matters. Roosevelt added about seven percentage points overall of additional annual federal spending (bringing spending from about 3 percent of GDP to about 10 percent).

An additional seven percentage points of GDP today constitutes an additional $1 trillion per year. This is a lot less than 8.2 trillion, but it is still nothing to sneeze at. Yet, are we not already pouring in this much to the financial bailouts? This is the same amount of additional government spending already – hence the need for journalists to argue that FDR’s additional spending wasn’t enough.

The problem is that government spending will never be enough to stimulate the economy. Just think about it this way. We have GDP of about $42,000 per capita. The federal government spends about 20% of GDP. In England, government spends about 45 percent of GDP and GDP per capita is about $33,000. In Sweden, the government spends about 50 percent of GDP and GDP is only $32,000 per capita. In France, it is 53% and $30,000. As we all know, in countries where government spends approximately 100 percent of GDP hardly any output or value is created. This insight formed the basis for such respected indices as the Index of Economic Freedom.

So, the idea that injecting a jolt into the economy by having government spend more as a percent of GDP is highly suspect. If what Roosevelt spent was not enough – despite tripling the government expenditures at the time – we should wonder whether any amount will ever be enough.

Using the Lessons from Socialism

As part of something I recently wrote, I made the following argument about the potential uses for studying comparative economic systems. I wonder how many readers will agree:

I am particularly drawn to the study of more extreme and pure systems. I believe these offer the best chance to draw out universal laws. Careful study of systems which avoid mixing of different incentive structures may present the best opportunity to view a single behavioral or systemic result, as if isolating it in a laboratory. Some of the results of this kind of analysis confirm basic economic laws and theory, such as the importance of the profit motive for keeping costs low and quality high. Even analysis illuminating such well known theory can be an effective learning tool, highlighting economic insights important for theoretical models.

Often economists begin with the simplest form of a model, and then begin to add to the model the complexities of reality. Similarly, the model which is the pure economic structure may be such an extreme example as to simplify the lesson. Yet, the economist can then adjust the simple lesson with the modifications seen in less extreme examples of the policy. The advantage of the pure economic system is that its implementation of the policy is the pure form and may represent the noise-free truth underlying other implementations.

One example is the socialist policy of eliminating unemployment which parallels less extreme policies undertaken in market economies. The lessons from the Soviet attempt to eliminate unemployment are interesting. Planning labor entirely was too difficult; for most periods most labor was free. Working was mandatory and extreme measures were taken to keep all workers employed, including forcing the manager to personally find a new job for each worker laid off. Yet, unemployment remained at about the “natural rate” for the duration of the Soviet socialist experiment. The negative effects of the labor policy included incredible labor inefficiency, underemployment, and a rigidity across the whole economy as firms could not adjust to changes introduced because they could not attract the necessary specialized skilled labor.

Similar lessons can be found with regard to investment and interest rates, monetary policy, and the need for marketing and middlemen among other areas. In the pure socialist economy, the extreme results can be seen across the whole economy, and are easy to study. The lessons can then help to inform or confirm theoretical models, or be combined with them in order to better describe potential policy consequences.

My original argument was going to make a slightly different case, which I ended up not feeling able to defend well. I originally argued not just that a lesson could be extracted, but that a pure isolated truth could be extracted and put into a model, which then could be modified to reflect the differences seen in less extreme policy manifestations. I believe that, but I am not sure I can defend it as of yet. Then again, it isn't really much different than what I say above - it is just that I reduced the claim to "lesson" instead of "model". I am curious what others think about this: are we not learning enough from economic systems such as socialism, which in many cases offer the most pure version of policies which we also pass in market countries?

A Collective Delusion

Pete Boettke, over at AE, posted about the Keynesian legacy. I have some thoughts on that, in particular, I agree that belief in those models represent the economists' collective delusion. I question why we have fallen for them - for private joy or public purse - and I fear that our policies are still colored by them.

I fear that economists have a herding mentality that grasps onto popular figures and then economists cling to the models of these "brilliant" chosen ones. But those who are chosen are not brilliant, they are only popular -- they generally have, like Keynes or Marx, gotten the ear of government. They come up with simplistic models that are easily used to churn numbers or explain phenomena, even though a child could see right through them.

When I took intermediate macro we used Mankiw's book. It was filled with Solow, Keynesian AS/AD, phillips curve, and on and on. I could barely believe that it was for real. None of it made any sense, none of it had any microfoundations (read: basis in reality).

I spent class time with a horrified gawking stare frozen on my face, wondering about the future of mankind if these were our leading economists, and asking the most basic of questions ("If savings is what drives growth according to the Solow model, then wouldn't communism work just as well or better than capitalism? Where are policies and institutions in this model?") and get answers such as "Well, this is just to simplify and explain the basics. Those details can be added later."

And I would be left wondering, about Solow and Keynes: who decided that the aggregate level of saving is more important than whether an individual, or a collective or government owns that savings? Who decided that aggregate investment is more important than whether it is private investment or investment by government in make-work programs? Doesn't it matter if the economy is split 90/10 private or 50/50 private or 10/90? When these models were being made economies spanned that whole spectrum, and yet these guys did not seem to think it mattered who was consuming resources - government or private consumer - who was investing or saving, just so long as the aggregate totals fit into the equations and made them balance nicely.

There were other problems - contradictions about what was better, savings or consumption? and so on - but the idea that private and public spending could be considered equal after the experiment with socialism and the interventionist state was well under way was just crazy. How could anyone think these models were useful at all? These seemed like child's play, fantasy, mind candy maybe. But not important, not something economists or policymakers should be using.

Why would economists fall for these models? And perhaps even worse: why do so many economists still cherish them, and hold them in esteem? What is this collective delusion? Is it that they love the "logic game" of it? Or is it the political clout they love? If they feed politicians with what they want to hear, they will be famous and win a Nobel -- isn't that better than being a no-name who sticks to reality? Isn't it more fun to make convoluted logic games, and be out in the public square?

Clearly for personal gain it is better for economists to engage the delusion. But this kind of absurd modeling still finds voice, and still drives our policies: "President-elect Obama's economic team is counting on investment in America's wind energy infrastructure to create thousands of jobs in a wide range of industries and help preserve existing jobs in other areas, particularly manufacturing."

Our government officials must "create jobs" by subsidizing or publicly providing work in specific targeted sectors. This will spur consumption (aggregate demand) and prevent collapse. This is all based on aggregate factors, and entirely devoid of microeconomic factors. We're also planning on propping up sectors despite their paying 3x normal salaries, by taxing regular workers, without concern over the need for the industry or the company to fail if it isn't profitable. We prevent jobs from "going overseas" as if trade is a bad thing.

Have we learned nothing about the failure of these models? Is this all political, is it useless to appeal to common sense?