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.

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.

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.

The new New Deal

Cross Posted at Heritage

Could the current crisis usher in a new “New Deal”, with a new brand of corporatism to replace the free market system? Certainly European leaders are arguing that case. The current economic “crisis,” may itself have been caused by bad policy. Yet, is provides a great pretext for an expansion of government.

During the 1930s, as part of the New Deal, Franklin D. Roosevelt nationalized banks, set prices, wages and work hours, and promoted public works programs to employ the unemployed. The New Deal, or the National Industrial Recovery Act (NIRA) to be precise, was supported by many industrial leaders, some of whom had helped draft the legislation. Cartels, inflated prices and subsidies were great perks for established business, especially those that would have trouble staying ahead in a free market.

Businesses then, as now, cried to Congress about their need for a bailout, and the disaster which would be wrought by their bankruptcy. NIRA was eventually declared unconstitutional. The decision made the important point that “extraordinary conditions do not create or enlarge constitutional powers.”

Until then these laws were widely supported and considered critical to recovery from the economic crisis of the time. Yet intervention did more to cause and prolong the crisis than to aid recovery.

Although these measures were defended as being necessary during an emergency, and only temporary, many still exist today. For example the emergency farm supports created with the Agricultural Adjustment Act (AAA) have morphed into the current Farm Bill, which still pays farmers not grow food.

Like the New Deal period, we are seeing waves of nationalization, bailouts of unrelated industry, and expansion of central bank power. The nationalization of banks during the New Deal was actually smaller than what we are doing today – as a percentage of GDP it was the equivalent to about $500 billion. Today the state took shares in the largest nine banks and bailouts total well over a trillion dollars.

As John Goldberg points out, the stake that government now holds in these banks is actually greater than the stake it held in Fannie Mae and Freddie Mac, and it is quite likely that this temporary measure might too become the regular state of affairs.

If Obama is the next president, he would like to see a return to union domination and government mediation in wages and hours. Obama also favors public works programs to employ those out of work. He has already proposed at least two kinds of programs like this: his “transitional jobs” program which hires the unemployed, and his National Infrastructure Reinvestment Bank. With the excuse of an ongoing recession, he could easily roll these into New Deal sized public works projects.

But, prior to the New Deal we had small government. Prior to this new “New Deal” we already have enormous government and massive debt. The Deal we sign today would be for European style socialism, with European style unemployment and stagnation.

Causes and Cure for the Credit Crunch

This crisis is often complicated way out of proportion to what is necessary. It is really quite simple. This article makes a nice rundown, and I will give you some basic bullet points. Then I will attempt to convince you that the best medicine is to let the market detox.

Causes

The crisis was triggered by a collapse in housing. There was first a bubble - with housing prices rising and rising and rising and everybody knew it couldn't last - and then it popped. Crash. And then - oops - it took down all related lending, since so many firms had a major portion of their lending wrapped up with mortgages. Hence, credit crisis.

Now, what could have caused the bubble and the pop? Well, before jumping right to culprits, lets remind ourselves what drives prices up and down: supply and demand. So, for prices to rise, there must be greater demand than supply (lots of bids on few houses) and for prices to crash, there must suddenly be greater supply than demand.

OK. So what could have gotten supply and demand out of whack? In normal times, if demand is high and prices rise, more suppliers will come in, prices fall again; but here the supply never caught up with demand. Why?

Supply and Demand

Several policies and programs have been put into place to encourage home ownership, but which drove a wedge between supply and demand. These include:

(1) Fannie and Freddie which ensure cheap mortgages as they buy bad loans back from places like AIG and which dominate at least half of the housing market, drove reasonable lenders out of business, and made poor lending and bad loan packaging possible by being a massive customer (read: subsidy) to places like AIG.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out by Fannie/Freddie except those making loans that gov. buys

(2) The Community Reinvestment Act which forces lenders to offer cheap loans (with quotas) and which, together with Fannie and Freddie, led government to create the securitized secondary mortgage market, and which also drove potentially profitable lenders out of business, expanding Fannie and Freddie's dominance.

Demand: Much more demand by the lower income buyers, demand for bad loans by gov.
Supply: Private market crowded out again, only the few big ones can meet gov. quotas

(3) Fed-induced low interest rates which made mortgages more affordable, tax write offs and personal tax credits for mortgages, etc.

Demand: Much more demand by all buyers
Supply: Supply contingent on interest rates staying low, otherwise defaults


Now, what was the point of Fannie and Freddie? Their charter states that it is to ensure loans to those who cannot normally afford them by buying low-income private loans up on a secondary market. This is not a recipe for profit maximization, it is a recipe for excessive risk. Now, it is non-profit insurance - risk sharing - in theory. If that could work.

But it can't for several reasons. Moral hazard and plain old demand will go up, when rates are this low, so losses grow. Government has actually fed the demand of low income buyers, not only by offering them cheap housing but also by driving interest rates down, offering tax credits, etc. In fact, they kept expanding and expanding further into low-income and sub-prime lending, in the dream of reaching 70% home ownership.

Meanwhile those who would offer low-income loans at rates which would allow profit are all crowded out of the market. The only ones left who can make a profit are those who depend on Fannie and Freddie to buy their risky loan packages. So long as Fannie and Freddie stay in business, they are OK. But Fannie and Freddie can only appear as if they are above water so long as housing prices keep rising, so long as fuel keeps going on the fire of demand.

But they are going deeper and deeper and crowding out everything around them. They are swollen with risk and poised right in the center of the credit market, waiting to explode.

Why did it all come a head now? Because:

Between 2005 and 2008, Fannie purchased or guaranteed at least $270 billion in loans to risky borrowers — more than three times as much as in all its earlier years combined, according to company filings and industry data.

Boom.


Cure

I keep stressing that we understand what caused the problem. The reason for this is that (as the first link above mentions) the cure that we are putting in place is actually more of the same-- more of what caused the crisis. If the crisis was caused and fueled by these policies, why do we expect them now to save us?

Fannie and Freddie caused the crisis by not pursuing profitable business strategies - by risky lending and loss-making pricing - and yet, Paulson promises that to cure our ails he will make sure that Fannie and Freddie stop worrying about being profitable. Put the homeowner first.

Fannie and Freddie caused the crisis by expanding into the sub-prime market, the answer to foreclosures a year ago? Expand Fannie and Freddie's mandate for low-income lending. Today? More of the same.

Fannie and Freddie caused the crisis by subsidizing a risky secondary market for mortgage-back securities. Our initial response a year ago? Buy more bad loans. Our current plan? Buy more mortgage backed securities (bad loans).

The fed fueled the fire with easy money. Answer? Easy money.

This is classing government intervention feeding on itself.

What is the right cure? Leave it be. Let the market restructure. Don't feed the crisis. If you think it will hurt, you may be right. But won't $700 billion in transfer from taxpayer to government also hurt? Won't feeding the loss-making machinery of socialized companies, which will need to be bailed out again and again hurt? Won't subsidizing failing companies which drive out regular business hurt too?

There is no pain-free answer. But there are cures that hurt because they detoxify, and there are cures that feel good right now, like a mamosa over breakfast after a drinking binge, but fail to actually solve the problem. In fact, they make it worse. And the final detox hurts more.

This crisis, the more I learn of it, the more it reminds me of the transition in Russia. We have to cut the strings. We are being made a muppet.