Last post

Given the readerships statistics for Anti-Dismal, in short bloody awful,there is no point in continuing the blog. Demand does matter, a product with no buyers should be forced out of the market. Thus this is the last post.

What do the new deal and world war II tell us about the prospects for a stimulus package?

This is the title of a guest post by economic historian Price Fishback at Freakonomics. Fishback looks at the issue of whether the New Deal and World War II are good examples of Keynesian stimuli. He makes a simple and compelling case that they are not.

With regard to the New Deal, Fishback writes

Federal spending rose from 4 percent to 8 percent of G.D.P. during the New Deal in the largest peacetime expansion in federal outlays in U.S. history. Yet this was not an example of Keynesian stimulus to the economy. Economists and economic historians have known this for the past 70 years, yet the myth lives on.

Once you take into account the level of taxation, it becomes obvious that the budget deficits of the 1930's were tiny relative to the size of the problems in the 1930s. In fact John Maynard Keynes published an open letter to Franklin Roosevelt arguing that more spending was not enough; the government needed to run larger deficits.

Fishback continues

If not Keynesian policy, what was the New Deal? It was a broad-ranging mix of spending, regulation, lending, taxation, and monetary policies that can best be described as “See a problem and try to fix it.” In many situations the fix for one problem exacerbated other problems. The programs to raise farm prices hurt work relief recipients, while attempts to raise wages and prices contributed to more unemployment, and thus a greater need for relief spending.

Fishback argues that the main New Deal spending programs that might be described as stimulus programs are the relief and public works during the New Deal. With regard to these programs he writes,

How successful were they at stimulating the economy? As yet, the only estimates we have are for the combined effects of the public works and relief programs. Studies that examine their success at the county level suggest that an additional grant dollar per person distributed to a county for public works and relief during the period of 1933 to 1939 contributed to a rise in in-migration and an increase in income per person in the county of about 80 cents in 1939. We should remember, however, that this was during a period when there were huge numbers of unemployed workers available for work. Even during this period, some studies find evidence of crowding out of private employment.

The lesson for today?

Today, with unemployment rates below 7 percent, it is likely that such public-works spending would crowd out a significant amount of private construction.

What about World War II?

It is widely held that World War II was a huge Keynesian stimulus that finally brought us out of the Great Depression. On the surface, the facts seem to fit. The federal government devoted 44 percent of G.D.P. to fighting the war and ran very large deficits. Unemployment rates fell below 2 percent even as large numbers of women entered the work force.

In a series of academic papers, Robert Higgs of the Independent Institute has raised doubts about this rosy picture of Keynesian stimulus. The war economy was a very unusual setting. While running large deficits, the federal government took command over large segments of the economy, allocated a large part of the resources to the war effort, put 15 percent of the working-age population in the military, and established wage and price controls.

He goes on,

One sign that Keynesian budget deficits were not the key to bringing the U.S. out of the Great Depression is what happened after the war. Every Keynesian predicted that the private economy would go into a recession because the large government budget deficits would be eliminated and so many men would be returning from the war jobless. Instead, as government deficits receded, private consumption and investment boomed. Resources were no longer allocated to producing munitions and instead were devoted to production of typical consumer goods and services.

During the 1940s the vast budget deficits that were run by the US government were not a stimulus in the normal sense of the word simply because the US was a command economy devoted to an all-out war effort.

The whole Fishback piece is worth reading.

Quote of the day

Free trade, one of the greatest blessings which a government can confer on a people, is in almost every country unpopular.

Thomas Babington Macaulay, 1824

Homework problem: Explain why.

Behavioural game theory

This audio comes from VoxEU.org. In it Vincent Crawford of the University of California, San Diego talks to Romesh Vaitilingam about the research programme of behavioural game theory, which uses economic theory and lab experiments to make the analysis of strategic behaviour more like the way real people think and therefore potentially more applicable.

Blog type

Kiwiblog's type is here, The visible hand in economics's type is here, Greg Mankiw's blog type is here, Homepaddock's type is here, The Inquiring Mind is here, but the most important one of all is below. According to Typealyzer the personality of Anti-Dismal is ..........

INTJ - The Scientists

The long-range thinking and individualistic type. They are especially good at looking at almost anything and figuring out a way of improving it - often with a highly creative and imaginative touch. They are intellectually curious and daring, but might be pshysically hesitant to try new things.

The Scientists enjoy theoretical work that allows them to use their strong minds and bold creativity. Since they tend to be so abstract and theoretical in their communication they often have a problem communcating their visions to other people and need to learn patience and use conrete examples. Since they are extremly good at concentrating they often have no trouble working alone.

On GenderAnalyzer the blog comes out as having a 91% chance of it being written by a man.

Interesting blog bits

1. The visible hand in economics on A carbon tax?
2. Not PC asks Should we worry about deflation?
3. The Economic Logician asks Are democracies good for peace?
4. Adam Smith's Lost Legacy points out that Smith Knew the Differences Between Self Interest and Selfishness.
5. Gary Becker asks Bail Out the Big Three Auto Producers? Not a Good Idea.
6. Richard Posner comments on Bail Out the Detroit Auto Manufacturers?
7. Stephen J. Dubner asks Would a Market for Organs Punish the Poor More Than They Are Already Punished?

Productivity and wages

Recently there has been discussion on a number of blog about productivity, here at Anti-Dismal I wrote this and this, at tvhe there was this, at Kiwiblog there was this, at The Inquiring Mind there was this and at The Standard there were, unfortunately, this and this. One issue that has risen in this discussion is the relationship between productivity and wages. I quoted Paul Krugman as saying

Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World growth hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)

Following up this, the information below comes from a paper by Martin Feldstein, Professor of Economics, Harvard University and President and CEO of the National Bureau of Economic Research [he has since retied from the NBER post], given to the American Economic Association on January 5, 2008. The paper is entitled "Did Wages Reflect Growth in Productivity?" Feldstein writes,

The level of productivity doubled in the U.S. nonfarm business sector between 1970 and 2006. Wages, or more accurately total compensation per hour, increased at approximately the same annual rate during that period if nominal compensation is adjusted for inflation in the same way as the nominal output measure that is used to calculate productivity.

More specifically, the doubling of productivity represented a 1.9 percent annual rate of increase. Real compensation per hour rose at 1.7 percent per year when nominal compensation is deflated using the same nonfarm business sector output price index.

In the period since 2000, productivity rose much more rapidly (2.9 percent a year) and compensation per hour rose nearly as fast (2.5 percent a year).

and later he says

The relation between wages and productivity is important because it is a key determinant of the standard of living of the employed population as well as of the distribution of income between labor and capital. If wages rise at the same pace as productivity, labor’s share of national income remains essentially unchanged. This paper presents specific evidence that this has happened: the share of national income going to employees is at approximately the same level now as it was in 1970.

So when measured correctly, productivity and wage do roughtly move together over time. For the US at least.

Stephen Gordon at the Worthwhile Canadian Initiative blog provides this graph of productivity and wages in Canada.

In Canada, real wages are tracking productivity fairly closely.

The business of business is business

Here’s video of the November 3rd 2008 Economist Debate on “The Business of Business is Business.”



(HT: Will Wilkinson)

More unproductive comment

Steve Pierson on the Labour Part site The Standard has been talking about productivity again. He writes

It’s exam season for high school students. So, for 10 points explain how the following statement (in the ACT-National agreement and repeated uncritically by the media) can be true,

closing the income gap with Australia by 2025… will require a sustained lift in New Zealand’s productivity growth to 3 per cent a year.

given:
- productivity is just one factor in GDP (production = inputs x productivity, basically the amount produced depends on how much you put in times how much you get out per unit of what you put in)

I'm guessing what he means is something along these lines. Let Y=AF(L,K) where L is labour, K is capital, F() is the production function and A is total factor productivity (TFP). Then think of Y as GDP.

-productivity growth tends to move in the opposite direction to the amount of labour and capital input growth

But growth in total factor productivity is a residual term (often called the Solow residual). TFP is the change in output that cannot be explained by changes in inputs. That is, it is the amount of output growth that remains after we have accounted for the determinants of growth we can measure, ie growth in labour and capital. So I'm really not sure what Peirson means by his statement. A can increase while L and K remain constant. L and K can increase while A remains constant. A could go down when L and K goes up or when K and L go down. Depending on what happens to Y. His statement would be true if Y remains constant. Then if L and K increase, A would have to fall. But why would you increase L and K if Y does also increase? This could not be profit maximising. You get the same output at a higher cost of production because of the increase in inputs.

- ie. productivity actually usually increases faster when GDP growth is slack or after a recession and productivity growth slows when GDP goes through a sustained period of rapid growth

I would love to see his data on this.

- incomes (ie. wages and salaries, the price of labour) is a result of supply and demand for labour, not the productivity of labour.

He is right, incomes are determined by supply and demand but the demand for labour depends on the productivity of labour. A profit maximising firm's demand for labour is determined by P*MPL=W/P where W/P is the real wage and MPL is the marginal product of labour. The MPL schedule is the firm's demand for labour. The MPL will depend on the productivity of labour.

Indeed, wages usually increase fastest when there is a shortage of labour and rising demand while productivity increases fastest when there is an abundance of labour and falling demand (because only the ‘highest quality’ labour is used).

The first part of this statement is true but I don't understand the second part. Why does productivity (and what form of productivity is he talking about) increase fastest when labour is abundant? From what I said above TFP is the residual after accounting for changes in output due to changes in inputs. So I'm not sure what he thinks he is saying.

Or have I missed something?

Nightmare on Main Street

Nicholas Bloom, assistant professor of economics at Stanford University, has an article on VoxEU.org on 2009 will be the nightmare on Main Street. He says

Every economist is predicting a macabre 2009, but no one knows for sure how bad things will get or who will survive. This column, by comparing the current crisis to uncertainty shocks of the last 40 years, predicts GDP growth could be reduced by as much as 4.5%. But, if politicians protect free markets, growth should be back in 2010.

Bloom starts by noting that his academic research has been looking at the impact of large uncertainty shocks on the US economy over the last 40 years. He argues there are bad omens for growth coming from the credit crunch.

In comparison, the credit crunch is a monster of a shock. It has generated an incredible six-fold increase in stock-market volatility and a 30% fall in the stock market level – three times the average impact of the previous uncertainty shocks. Based on these numbers my central prediction is that GDP growth will be reduced by 4.5% in 2009 because of the credit crunch. Since the consensus forecast before the credit crunch for US and UK growth was +1.5%, this reduction in growth leads me to predict a -3% contraction in 2009. Forecasting 2010 is even less accurate, but my central prediction is a return to about +1.5% growth.

He then looks at "the S&P volatility massacre". This guy has seen way too many b-grade horror movies! Bloom looks at the predicted impact of the 30% fall in stock-market levels as a deviation against the prior forecast. The central prediction is that this 30% fall in stock-market levels will reduce growth against prior forecasts by almost 4% by late 2009. But growth will recover to trend by mid 2010.

Then he looks at the predicted impact of the six-fold increase in stock-market volatility since September 2008. The central prediction shows a fall in growth of almost 3% against trend by mid-2009, with a rebound by 2010. The reason for this rapid rebound is that uncertainty leads firms to pause investment and hiring. But once uncertainty falls back to normal levels – which he forecast will happen by the mid 2009 – firms will start to invest and hire again to make up for lost time. Hence, the uncertainty impact of the credit crunch will cause a rapid slow-down in the first-half of 2009 and a recovery by late 2009.

Next he considers the combined effect of the drop in stock-market levels and the rise in uncertainty. The combined impact of this is to reduce output by 4.5% in mid 2009, which given the prior estimate of +1.5% growth in mid-2009, leads to my new forecast of -3% growth for 2009. By late 2009 this contraction will have eased off, with normal rates of growth returning by 2010.

The important upshot of this is Bloom's conclusion,

But as every horror fan knows the monster never dies. Despite being skewered with every sharp object in sight it always manages one final lunge. In the case of the credit-crunch the risk of a final lunge comes from a damaging political response. Politicians around the world are pushing to roll-back free markets, impose greater regulation, restrict trade and provide multi-sector bail-outs. This move away from free-markets towards regulation, protectionism and subsidies risks turning a temporary downturn into protracted recession.

The major lesson from the Great Depression of the 1930s was that terrible policies managed to turn a financial crisis into a disaster. The infamous Smoot-Hawley Tariff Act of 1930 was introduced by US policymakers to block imports in a desperate attempt to protect domestic jobs. But it helped worsen the recession by freezing world trade. At the same time policymakers were encouraging firms to collude and workers to unionise to raise prices and wages.

The current backlash against capitalism risks leading to this repeat. This happened after the Great Depression and it happened after the major recession of 1974/75. Although 2009 will be a year of shrinking rapidly, if politicians protect free markets 2010 should see a return to growth.

Herding cats or governemnt under MMP

Thanks to The Inquiring Mind for this cartoon:

Zimbabwe's inflation rate - update

According to Steve H. Hanke's new Hyperinflation Index (HHIZ) at the Cato Institute, Zimbabwe's annual inflation is 89.7 sextillion percent!

The index was set at 1.00 on the 5th of January 2007. As at the 14th of November 2008 the index is at 853,000,000,000,000,000,000,000 which gives an annual inflation rate of 89,700,000,000,000,000,000,000%.

Here is an article, Zimbabwe hyperinflation 'will set world record within six weeks', from the Telegraph in the UK on the hyperinflation in Zimbabwe and what it means:

There comes a point, though, where the inflation rate makes little practical difference.

"The economy just stops functioning or slows down very much," said Prof Hanke. "A lot of barter takes place. Money is not used as much or if it is, it's all foreign exchange." Supermarkets in Harare are accepting only US dollars and South African rands, leaving those Zimbabweans without access to foreign currency in dire straits.

Reverse Gresham's Law: Good money drives out bad.

EconTalk this week

George Selgin of West Virginia University talks with EconTalk host Russ Roberts about free banking, where government treats banks as no different from other firms in the economy. Rather than rely on government guarantees to protect depositors (coupled with regulation), banks would compete with each other in offering security and return on deposits. Selgin draws on historical episodes of free banking, particularly in Scotland, to show that such a world need not be unduly hazardous or filled with bank runs. He also talks about Gresham's Law and an episode in British history when banks successfully issued their own currency.

Steve Horwitz interview

The St. Lawrence University communications staff recently sat down with their professor of economics, Steve Horwitz, for a podcast interview about his Christian Science Monitor op-ed on the US financial crisis and his "An Open Letter to my Friends on the Left". You can listen here.

Incentives matter: sperm file

Daniel Hamermesh at the Freakonomics blog points out

There’s a shortage of sperm in Britain! Apparently, Britain needs donations for about 4,000 women per year; to reach that number, about 500 sperm donors per year are required, while only 300 are currently registered. Things were fine until 2005, when a law was enacted allowing children of sperm donors the right to discover the identity of their father at age 18

Laws affect incentives and changes to law can have unintended consequences.

Unproductive comment

Steve Pierson over at the Labour Party site, The Standard, has been writing on productivity, and again he is largely wrong. Pierson writes

National/Act agree to close the ‘income gap’ between Australia and NZ by 2025, requiring ‘3% productivity growth per year’. Which is just economic techno-babble. What ‘income gap’ are they talking about? GDP per capita or wages or what? And how would a faster rate of productivity growth close this gap? Anyone who knows what productivity is (the amount of wealth produced in a unit of work) knows that merely increasing productivity doesn’t necessarily boost GDP or wages. GDP = productivity x work done. So, GDP not only depends on productivity it also depends on how many people are in work. And boosting productivity doesn’t lead automatically to higher wages - wages are determined by supply and demand in the labour market, nothing to do with productivity. In fact, productivity grows faster when employment drops because it’s the low quality workers that lose their jobs first and lower quality capital that sits idle first, but wages don’t go up because there is more slack in the labour market.

Fortunately for me over at The visible hand in economics they have taken Pierson to task pointing out his errors. You can see tvhe site for discussion of these issues.

But as to Pierson's claim that

Anyone who knows what productivity is (the amount of wealth produced in a unit of work) knows that merely increasing productivity doesn’t necessarily boost GDP or wages.

I feel I can do no better than to quote, of all people, Paul Krugman

Economic history offers no example of a country that experienced long-term productivity growth without a roughly equal rise in real wages. In the 1950s, when European productivity was typically less than half of U.S. productivity, so were European wages; today average compensation measured in dollars is about the same. As Japan climbed the productivity ladder over the past 30 years, its wages also rose, from 10% to 110% of the U.S. level. South Korea's wages have also risen dramatically over time. ("Does Third World growth hurt First World Prosperity?" Harvard Business Review 72 n4, July-August 1994: 113-21.)

Even Krugman gets it, so why not Pierson?

Let me add that I think tvhe is right when it says

National and Act are right that higher levels of productivity growth would directly help us close the income gap with Australia - a gap that DOES exist (although it may not even be an issue). However, saying that “we will increase productivity” is not useful - it is like saying “we will magically make trade-offs disappear”, as saying that productivity is higher is like saying that we can do more with less! National-Act will need to come out with clear policies about how they will “increase productivity” - then we can discuss those policies. For now it is only empty rhetoric. (Emphasis added)

Putting out some serious policy would be a step in the right direction.

Two very dangerous words

Mark J. Perry blogs at Carpe Diem on Two Very Dangerous Words: "Fair" and "Fairness". He writes,

In "The Armchair Economist," economist Steven E. Landsburg posed the following:

"Suppose that Jack and Jill draw equal amounts of water from a community well. Jack's income is $10,000, of which he is taxed 10%, or $1,000, to support the well. Jill's income is $100,000, of which she is taxed 5%, or $5,000, to support the well. In which direction is the policy unfair?"

An honest person will admit that this question has no indisputably right answer. Prof. Landsburg then asked "If I can't tell what's fair in a world of two people and one well, how can I tell what's fair in a country with 250 million people and tens of thousands of government services?"

HT: Don Boudreaux

The words "fair" and "fairness" are two of the most dangerous words in the English language, for the following reasons:

1. People using those words (e.g. "fair trade," "fair wages") almost always follow with some proposal for government intervention, government regulation, or government force of some kind to correct some perceived "unfairness" and impose their notion of "fairness."

And to paraphrase Thomas Sowell:

2. In most cases, it is hopeless to try to have a rational discussion with those who use the words "fair" and "fairness."

3. "Fair" and "fairness" are two words that can mean virtually anything to anybody.

4. "Fair" and "fairness" are two of the most emotionally powerful words, but at the same time are words that are undefined (see #3).

In many policy discussions the words "fair" and "fairness" appear and it would be nice if the people using them defined exactly what they meant by them before using them. It is impossible to know whether something is "fair" when we don't know what "fair" is.

A friend from Helengrad St Johnnysburg just emailed me to point out that Roger Kerr gave a speech on the uses and misuses of language and the uses of words to mean whatever the user wants them to mean back in 2003. For Kerr the worry was The "We" Word.

But my deeper point is that this ambiguity of 'we' can lead us into collective thinking and coercive action where it isn't necessary. Political rhetoric is full of phrases like 'we as a nation must decide whether we want a national airline/film industry/manufacturing sector/whatever'. This assumes that 'we' have to make a single, collective decision as voters, whereas in reality 'we' as individuals are making that decision every day. If consumers prefer a domestically manufactured product to an imported one, a domestic manufacturing industry or firm will be there to meet the demand; if they prefer the imported product it won't. The demand that 'we as a nation must decide' is to call on people to decide through the political system things that they can readily resolve as individual consumers.

The Obama economic transition team

I have The Inquiring Mind to thank for this link to Willem Buiter's discussion of Barack Obama’s Transition Economic Advisory Board. And in Buiter's view it's not good.

Buiter's points are,

1. They’re old.
2. Too few serious economists.
3. Far too many lawyers.
4. They are protectionist.
5. They are the unalluring faces of past failures.

To summarize,

the members of Obama’s Transition Economic Advisory Board are too old, too uninspiring and too much part of the problem to deliver the change America needs and to keep alive the hope that Obama may have inspired through his election. A wasted opportunity.

Enough said.

National/Act deal

Kiwiblog gives details here. The actual agreement is here in pdf form. Save the Humans comments here. The Standard comments here. No Right Turn comments here. These bits from No Right Turn are particularly good,

ACT's Taxpayer Bill of Rights Bill will be introduced as a government measure "with the aim of passing into law a cap on the growth of core Crown expenses". So, national will kneecap government;

Kneecap government? If only!!!

And

They will also examine "alternative means of achieving [government] objectives" - meaning privatisation and contracting out;

We live in hope.

A few quick comments.

Do we need a Minister for Regulatory Reform? How will this work, via what Ministry? Sounds like creating more red tape to get rid of red tape. Oxymoron?

We will have a "high quality" advisory group to investigate the reasons for the recent decline in New Zealand’s productivity performance. The first thing the "high quality" advisory group would need to do is realise that the decline in New Zealand isn't recent, its a long term issue. Do we need a New Zealand Productivity Commission? The best thing a government can do to increase productivity is stop tying to increase productivity. Government is much of the problem in this area, not the answer. Regime uncertainty is a big problem here so the government should concentrate on the protection of private property rights and leave the rest up to people and businesses. On the good side, at least they have worked out there is a problem with New Zealand's productivity.

We will get a a "high quality" advisory group to recommend short-term amendments to the RMA. But do we want "short-term amendments to the RMA". Should we not be looking at a long term replacement for the RMA?

It is good that they are going forward with the Regulatory Responsibility Bill. Also good is the review of the current Emissions Trading Scheme legislation. The amendment to the ETS legislation delaying its implementation, repealing the thermal generation ban and making any other necessary interim adjustments until the review is completed makes sense.

Establishing a series of Task Forces to undertake fundamental reviews of all base government spending in identified sectors, and to report findings to the cabinet control expenditure committee and relevant ministers. Looks good on the face of it, but what real effects will it have. The Task Forces can report, but can they force ministers and bureaucrats to actually do something?

Overall how many Ministers does the government now have? Many many Task Forces and "high quality" advisory groups are we going to have? How do all of these make government smaller?

There are some good points to the agreement but a lost has to be done to make this government the genuine reforming government we need.

Arnold Kling lectures us

... on macroeconomics.

His lecture can be found on the EconLog bog. Lecture 1 is here, 2 here, 3 here, 4 here, 5 here and 6 here.

Enjoy. If you're into this kind of thing.

Getting out of the depression

Steve Pierson over at the Labour Party site, The Standard, has been writing on the Great Depression. Unfortunately largely wrongly. He writes

Laissez-faire capitalism, whereby the ‘invisible hand of the market’ ruled, had failed ...

Well no. "Laissez-faire capitalism" didn't fail as it had never been tried. Pierson goes on

President Roosevelt termed his economic program to lift the US out of the Great Depression ‘the New Deal’.

and

A new deal was needed to restore the living conditions of workers and, ultimately, to protect capital from revolution. The New Deal replaced hands-off government with active state capitalism - the Government increased participation in the economy by investing in new sectors and job-intensive infrastructure, created better unemployment benefits, and improved regulation of financial markets. It also increased the legal powers of organised labour to put unions on a more equal footing with capital.

While it is true Roosevelt called it a New Deal, it is not true that it lifted the US out of the depression. The New Deal is often seen, in part, as a fiscal driven economic stimulus package. But it is debatable as how much stimulus it actually gave. Also as economic historian Christina Romer has written, see here for more,

This paper examines the role of aggregate demand stimulus in ending the Great Depression. A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion.

Ben Bernanke isn't that enthusiastic about the New Deal's results in dealing with the depression either. He writes, see here for more,

Our [work with Martin Parkinson] own view at present is that the New Deal is better characterized as having "cleared the way" for a natural recovery (e.g., by ending deflation and rehabilitating the financial system), rather than as being the engine of recovery itself.

So monetary policy not fiscal policy got the US out of the depression. Is the US different in this regard? No seems the best answer to that. As Mark Koyama has said of the situation in the UK, for more see here,

In the UK however as in the US expansionary fiscal policy was not used. The 'Treasury view' prevailed and the first 'Keynesian budget' had to wait until 1941 and then it was used to check inflation and not to stimulate demand (readers with access to JSTOR can read Alan's Booth 1983 paper here). Monetary policy drove the recovery by sparking a boom in the construction industry.

What of New Zealand? See here for evidence that changes to New Zealand's monetary regime were behind the recovery from the depression. So all of these cases show monetary policy to be the main driver of the escape from the depression, not New deals.

What then did the New Deal do? Donald J. Boudreaux writes,

Andrew Wilson is right: the New Deal did not end the Great Depression ("Five Myths About the Great Depression," November 4). No less an authority than FDR's Treasury secretary and close friend, Henry Morganthau, conceded this fact to Congressional Democrats in May 1939: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!"*

Indeed, FDR's market-suffocating policies are almost surely what put the "Great" in "Great Depression."

Why did the New Deal put the "Great" in "Great Depression? One reason is the notion of regime uncertainty which is due to the economic historian Robert Higgs. Higgs introduced the idea in a paper Regime Uncertainty: Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War. His purpose was to explain why the depression lasted so long in the US. Higgs writes,

I shall argue here that the economy remained in the depression as late as 1940 because private investment had never recovered sufficiently after its collapse during the Great Contraction. (p.563)

The Great Contraction refers to the macroeconomic collapse that occurred between 1929 and 1933. Higgs goes on to say,

I shall argue further that the insufficiency of private investment from 1935 through 1940 reflected a pervasive uncertainty among investors about the security of their property rights in their capital and its prospective returns. (p.563)

If businesspeople are uncertain as to whether or not they will capture the returns to their investments they will be reluctant to invest. Later Higgs explains,

The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,” and the Second New Deal ravaged the requisite confidence. (p.568)

and

To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. (p.568)

Another reason for the prolonged depression comes from the work UCLA economists Harold L. Cole and Lee E. Ohanian. They conclude in their 2004 study that New Deal policies thwarted economic recovery for seven years. The study, "New Deal Policies and the Persistence of the Great Depression: A General Equilibrium Analysis", appeared in the Journal of Political Economy, 2004, vol. 112, no. 4, p.779-816.

In a news release on the paper Cole is quoted as saying

"President Roosevelt believed that excessive competition was responsible for the Depression by reducing prices and wages, and by extension reducing employment and demand for goods and services," [...] "So he came up with a recovery package that would be unimaginable today, allowing businesses in every industry to collude without the threat of antitrust prosecution and workers to demand salaries about 25 percent above where they ought to have been, given market forces. The economy was poised for a beautiful recovery, but that recovery was stalled by these misguided policies."

Ohanian and Cole use data collected in 1929 by the Conference Board and the Bureau of Labor Statistics. Using this they were able to calculate average prices and wages across a number of industries just prior to the start of the Great Depression. Then they worked out a counter factual of what would have happened if Roosevelt's policies not been put in place. By adjusting for annual increases in productivity, they were able to use the 1929 benchmark to work out what prices and wages would have been during every year of the Depression without Roosevelt's interventions. They then compared those figures with actual prices and wages as reflected in the Conference Board data.

One result they found was that in the three years following the implementation of Roosevelt's policies, wages in 11 key industries averaged 25 percent higher than they otherwise would have done. But unemployment was also 25 percent higher than it should have been, given gains in productivity.

Meanwhile, prices across 19 industries averaged 23 percent above where they should have been, given the state of the economy. With goods and services that much harder for consumers to afford, demand stalled and the gross national product floundered at 27 percent below where it otherwise might have been.

The news release quotes Ohanian as pointing out that

"High wages and high prices in an economic slump run contrary to everything we know about market forces in economic downturns." [...] "As we've seen in the past several years, salaries and prices fall when unemployment is high. By artificially inflating both, the New Deal policies short-circuited the market's self-correcting forces."

An important point noted by Cole and Ohanian is that under the National Industrial Recovery Act (NIRA), industries were exempted from antitrust prosecution if they agreed to enter into collective bargaining agreements that significantly raised wages. Because protection from antitrust prosecution all but ensured higher prices for goods and services, a wide range of industries agreed. In fact by 1934 more than 500 industries, which accounted for nearly 80 percent of private, non-agricultural employment, had entered into the collective bargaining agreements called for under NIRA.

According to Cole and Ohanian the NIRA and its aftermath account for 60 percent of the weak recovery. Without the policies, they contend that the Depression would have ended in 1936 instead of the year when they believe the slump actually ended: 1943.

So we can conclude that the New Deal didn't get the US out of the Great Depression, monetary policy did, and that the New Deal may have extended the depression.

Thus before Pierson calls for a new New Deal, he should understand the old one a little better than he does.

Economic gangsters

At the VoxEU website, Ray Fisman of Columbia University talks to Romesh Vaitilingam about his new book, Economic Gangsters: Corruption, Violence, and the Poverty of Nations, written with Ted Miguel. They discuss witch-killing in Tanzania, parking violations by United Nations diplomats, and the value of political connections in both the developing and developed world.

If GE is the answer, what was the question

That's an interesting question. Or at least one I have been asked - close enough. General equilibrium theory, or for that matter partial equilibrium theory, does seem a bit strange in the sense that it doesn't obviously relate to the the "real world" of markets we see around us. Who has ever seen a market in equilibrium? But this does raise the issue of why then did the model develop the way it did. What was the question that GE was trying to answer.

The thing that the standard GE model tries to model is the price system. As has been pointed out by Demsetz (1982, 1988 and 1995) the fundamental preoccupation of economists, right up until the 1930s and beyond in many cases, was with the price system. The interest in the price system, culminating in the "perfect competition" model, has its intellectual origins in the eighteenth-century debate between free traders and mercantilists. This debate was, at its simplest, about the proper scope of government in an economy, and the model it gave rise to reflects this. The central question of the debate was, Is central planning necessary to avoid the problems of a chaotic economic system? Adam Smith famously answered no.

For Smith, markets are one very prominent mechanism for solving the problems of coordination and motivation that arise with interdependencies of specialisation and the division of labour. Market institutions leave individuals free to pursue self-interested behaviour, but guide their choices by the prices they pay and receive. The 200 hundred years following Smith amounted to a closer examination of the conditions necessary for the price system alone to be able to avoid chaos.

The formal model that arose from this examination is one which abstracts completely from any form of centralised control in the economy. This is an abstraction Smith myself would have argued was going too far. Smith knew of the importance of institutions to the proper functioning of the market economy. But the point of the modelling was to remove those very institutions so that the price system is the only mechanism available to coordinate and control the economy. It is a model delineated by "perfect decentralisation", to use Demsetz's term. Authority, be it in the form of a government or a firm or a household, plays no role in coordinating resources. The only parameters guiding decision making are those given within the model - tastes and technologies - and those determined impersonally on markets -prices. All parameters are outside the control of any of the economic agents and this effectively deprives all forms of authority a role in allocation. This includes, of course, the government, the firm and the household. We are left with a world only controlled by the price system.

The amazing thing is that it can be shown that chaos does not result in such a system. This is what the standard results on the existence, uniqueness and stability of equilibrium in the general equilibrium model tell us. See, for example, Debreu (1959) if you must.

1. Debreu, Gerard (1959). Theory of Value, New York: Wiley.
2. Demsetz, Harold (1982). Economic, Legal, and Political Dimensions of Competition, Amsterdam: North-Holland Publishing Company.
3. Demsetz, Harold (1988). 'The Theory of the Firm Revisited', Journal of Law, Economics, and Organization, 4(1) Spring: 141-61.
4. Demsetz, Harold (1995). The Economics of the Business Firm: Seven Critical Commentaries, Cambridge: Cambridge University Press.

National, Act and the Maori Party.

Eric Crampton wrote recently

Key's hope is that building good relations now with the Maori Party will pay dividends in later elections where the Maori Party may well play kingmaker. Key may also be hoping that moving slowly with a broader coalition is a better recipe for longer-lasting economic reform than moving quickly with fewer allies. Our hope is that he remembers to move at all.

and now Homepaddock tells us

She was referring to the deal negotiated between the party and Prime Minister elect, John Key. Details haven’t been made public yet but it’s thought the party will get two ministerial positions outside cabinet in return for giving confidence and supply to National.

What does this mean? With confidence and supply guaranteed by the Maori Party, National could govern without Act. This weakens Acts ability to force to changes to National's policy, in particular economic policy. For those, like Eric and me, who hoped that National would move down the road of economic reform this is bad news. Act has lost much of its power to push National down that road. Key has the votes he needs to stay in in the centre, to occupy Labour's territory and not move at all. "Labour Lite" could be here to stay and we could see the worst government since Muldoon.

High debt reflects irresponsible government spending

Donald J. Boudreaux writes another letter to the Editor of The Baltimore Sun.

Dear Editor:

Peter Morici alleges that Americans have engaged in "excessive borrowing to finance a huge trade deficit" ("First order of business," Nov. 12). This allegation reflects misunderstanding. First, a higher trade deficit does not necessarily mean higher borrowing. If Mr. Morici pays $25,000 cash for a new Camry and Toyota then squirrels those dollars away in a safe, the U.S. trade deficit rises by $25,000 but Americans' debt hasn't risen by a dime as a result.

Second, the largest portion of the U.S. trade deficit that today BECOMES debt consists of loans by foreigners to Uncle Sam. Contrary to Mr. Morici's claim, this rising American indebtedness does not reflect too much American freedom to trade; instead it reflects too much irresponsible spending by the same agency - Uncle Sam - that Mr. Morici mysteriously trusts to restrict our trade and fix the economy.

A simple but important point.

Interesting blog bits

1. Not PC tells us Let Ford fail. Good advice that.
2. Kiwiblog on Investing on Specials. To do with contracts on iPredict.
3. Michael Bassett on Clark's Career and Achievements. A good read.
4. James Hamilton scoffs at deflation and the liquidity trap.
5. Bryan Caplan asks How Are Stocks Like Bonds?
6. Alex Tabarrok on the Credit Card Crunch?

New Zealand's recovery from the great depression

This piece from Greasley and Oxley (2002) suggests that changes to New Zealand's monetary regime was behind the recovery from the depression here.

New Zealand's recovery from the Great Depression was unusually fast, and was associated with a fundamental shift in monetary regime. The new regime ended the conventional sterling standard, and diminished the influence of the trading banks on monetary conditions in New Zealand. Since the trading banks' operations spanned to Australia, the new monetary regime also decoupled the Dominion's monetary conditions from those across the Tasman. Devaluation and the formation of a reserve bank underpinned the new regime. This article shows that monetary growth in New Zealand was dramatically faster in the 1930s than it would have been had the old regime survived the Great Depression. New Zealand's nominal money stock, measured by M1, fell during the years 1923-9, but almost doubled between 1929 and 1939. The new monetary regime stimulated a recovery from New Zealand's long depression of the 1920s, as well as from the Great Depression. Had the old regime survived, New Zealand's GDP per caput in 1938 would have been around one-third lower.

New Zealand's recovery experience in the 1930s differed sharply from that of other export economies of the periphery, and was based on a new monetary regime that took effect in two stages. In contrast to what happened in Brazil, Mexico, and Australia, devaluation was chosen rather than forced, and eventually associated with a new inflationary regime. Initially, though, devaluation in New Zealand promoted recovery, in 1933, by redistributing income to the hard-pressed farm sector (the 'Copland effect'). Subsequently, during 1934-5, New Zealand's record to some extent mirrors that of the Argentine where the destruction of deflationary sentiments also ameliorated the depression (the 'Mundell effect'). However, New Zealand went much further, by more than doubling money supply between 1932 and 1937, which led to lower real interest rates (the 'Keynes effect').

New Zealand's experience also differed from that of the US, where monetary growth woe initially rapid but was curtailed in 1936 by the Federal Reserve increasing reserve requirements to counter possible inflation. Moreover, the strategy for redistributing income towards farmers in New Zealand did not rest, as it did in the US, on output restrictions, but on monetary manipulation. In concert, the three mutually reinforcing
monetary transmission mechanisms, the 'Copland', 'Keynes', and 'Mundell' effects, stimulated powerfully real economic recovery. The growth potential of New Zealand's economy was strong in the 1920s but constrained by a deflationary regime. The Great Depression destroyed the Dominion's old monetary regime, and the new regime promoted a remarkable recovery.

So again fiscal policy was not the driver of recovery from the Great Depression.

• David Greasley and Les Oxley, "Regime shift and fast recovery on the periphery: New Zealand in the 1930s", Economic History Review, LV, 4 (2002), pp. 697-720.

Fiscal policy and ending the depression

Mark Koyama, at Oxonomics, writes about the effectiveness of fiscal policy in bring about an end to the depression in the UK. Koyama writes,

The UK case may be an interesting point of comparison. The Great Depression in the UK was much shorter and less severe than in the US. In the UK however as in the US expansionary fiscal policy was not used. The 'Treasury view' prevailed and the first 'Keynesian budget' had to wait until 1941 and then it was used to check inflation and not to stimulate demand (readers with access to JSTOR can read Alan's Booth 1983 paper here). Monetary policy drove the recovery by sparking a boom in the construction industry. Private investment in the new industries boomed. The relationship between this housing boom and the interest rate is evident from this diagram from Broadberry and Crafts (1992).This appears to support the view that fiscal policy was not necessary for a quicker recovery than America actually experienced in the 1930s. In comparison note that private investment in America in the 1930s was stagnant as Robert Higgs shows. [...]

Expansionary fiscal policy is actually quite limited in what it can do. If the fiscal expansion is in the form of tax cuts then the multiplier will be quite low due to (weak form) Ricardian equivalence because when a tax cut is funded by borrowing, tax payers consume less out of the cuts because they anticipate future tax rises in order to pay off the debt. If the fiscal expansion is in the form of long run infrastructure projects then the multiplier effects are greater but in order to be effective these projects must be on a large enough scale so as to constitute an intrusion of the state into the private market place. In other words central planning must replace the decentralized price syste in large parts of the economy. This is what occurred in Germany in the 1930s and though it occasioned a swifter initial recovery, it severely impeded the long-run capacity of the economy as Adam Tooze documents.

Crampton on Key

At Forbes.com is this piece, Key Kiwi, on the election outcome by none other than our very own Eric Crampton! Eric opens by saying

After almost a decade of economic under-performance and rising voter anger with an administration viewed as out of touch, power hungry and, in parts, corrupt, voters turned out in numbers to toss out the incumbent and elect a younger man who campaigned on a message of hope.

And so New Zealand's Saturday election brought victory for John Key's National Party.

Eric writes

Key worked hard to pull National to the center, shedding policies viewed as extreme ...

But this was a low cost move. Any voters who stopped voting National because of this would most likely go to Act and thus would indirectly be supporting National. Crampton also says

On other issues, Key largely neutralized policy differences between National and Labour by adopting policies very similar to those already in place, or, in some cases, by overshooting Labour.

When Finance Minister Michael Cullen mused that New Zealand's Superannuation Fund, the laudably independent sovereign wealth fund charged with maximizing returns on investment, might be asked whether it would consider increasing the proportion of its assets held in New Zealand, Key jumped a step further to announce that National would mandate that the fund invest 40% of its assets in New Zealand.

The policy played well with economic populists but was roundly criticized by economists.

As I have argued before, this idea from Key was not a great one. But as I also argued, a number of National's economic policies look far too much like those of Labour and in some cases are worse than Labours.

Eric ends by noting

Key's hope is that building good relations now with the Maori Party will pay dividends in later elections where the Maori Party may well play kingmaker. Key may also be hoping that moving slowly with a broader coalition is a better recipe for longer-lasting economic reform than moving quickly with fewer allies. Our hope is that he remembers to move at all.

Here's hoping he does move, and in the right direction. (bad pun intended)

What ended the great depression?

Tyler Cowen at Marginal Revolution asks this question. One common view is that World War 2 acted like a kind of giant public works project and this ended the Great Depression. But Cowen argues this is not consistent with our best knowledge of the subject. He writes,

To survey the cutting edge of the literature briefly:

Christina Romer writes:

This paper examines the role of aggregate demand stimulus in ending the Great Depression. A simple calculation indicates that nearly all of the observed recovery of the U.S. economy prior to 1942 was due to monetary expansion. Huge gold inflows in the mid- and late-1930s swelled the U.S. money stock and appear to have stimulated the economy by lowering real interest rates and encouraging investment spending and purchases of durable goods. The finding that monetary developments were crucial to the recovery implies that self-correction played little role in the growth of real output between 1933 and 1942.

It would also seem to imply that fiscal policy played little role in the recovery. Cowen goes on to say,

Here is another interesting paper on the topic; it focuses on productivity issues and mean reversion. Here is from a paper by Cullen and Fishback:

We examine whether local economies that were the centers of federal spending on military mobilization experienced more rapid growth in consumer economic activity than other areas. We have combined information from a wide variety of sources into a data set that allows us to estimate a reduced-form relationship between retail sales per capita growth (1939-1948, 1939-1954, 1939-1958) and federal war spending per capita from 1940 through 1945. The results show that the World War II spending had virtually no effect on the growth rates in consumption that we examined.

Robert Higgs has been arguing for years that the standard story of WW2 ending the depression is wrong. In a paper published in 1992 Higgs wrote

Relying on standard measures of macroeconomic performance, historians and economists believe that “war prosperity” prevailed in the United States during World War II. This belief is ill-founded, because it does not recognize that the United States had a command economy during the war. From 1942 to 1946 some macroeconomic performance measures are statistically inaccurate; others are conceptually inappropriate. A better grounded interpretation is that during the war the economy was a huge arsenal in which the well-being of consumers deteriorated. After the war genuine prosperity returned for the first time since 1929.

Higgs end his paper by saying

To sum up, World War II got the economy out of the Great Depression, but not in the manner described by the orthodox story. The war itself did not get the economy out of the Depression. The economy produced neither a “carnival of consumption” nor an investment boom, however successfully it overwhelmed the nation’s enemies with bombs, shells, and bullets. But certain events of the war years—the buildup of financial wealth and especially the transformation of expectations—justify an interpretation that views the war as an event that recreated the possibility of genuine economic recovery. As the war ended, real prosperity returned.

Kukathas on Hayek

From philosophy bites comes this audio interview with professor Chandran Kukathas in which he discusses Hayek's Liberalism

New iPredict stocks

iPredict has new stocks on offer - National's Seats in Official Results: How many seats will National lose when special votes are counted and official results are declared on 22 November? 0,1 or 2?

Five myths about the great depression

Andrew B. Wilson has an interesting piece in the Wall Street Journal on Five Myths About the Great Depression: Herbert Hoover was no proponent of laissez-faire. The five myths:

1. Herbert Hoover, elected president in 1928, was a doctrinaire, laissez-faire, look-the-other way Republican who clung to the idea that markets were basically self-correcting.
2. The stock market crash in October 1929 precipitated the Great Depression.
3. Where the market had failed, the government stepped in to protect ordinary people.
4. Greed caused the stock market to overshoot and then crash.
5. Enlightened government pulled the nation out of the worst downturn in its history and came to the rescue of capitalism through rigorous regulation and government oversight.

On this last point Donald J. Boudreaux writes,

Andrew Wilson is right: the New Deal did not end the Great Depression ("Five Myths About the Great Depression," November 4). No less an authority than FDR's Treasury secretary and close friend, Henry Morganthau, conceded this fact to Congressional Democrats in May 1939: "We have tried spending money. We are spending more than we have ever spent before and it does not work. And I have just one interest, and if I am wrong ... somebody else can have my job. I want to see this country prosperous. I want to see people get a job. I want to see people get enough to eat. We have never made good on our promises ... I say after eight years of this Administration we have just as much unemployment as when we started ... And an enormous debt to boot!"*

Indeed, FDR's market-suffocating policies are almost surely what put the "Great" in "Great Depression."

On the first issue of Hoover's support for "laissez-faire" and free trade in particular Pat Toomey writes

On May 4, 1930, 1,028 economists signed a petition urging Congress and President Herbert Hoover to reject the Smoot-Hawley Tariff Act, arguing that "increased restrictive duties would . . . operate, in general, to increase the prices which domestic consumers would have to pay." Neither Congress nor the president listened, but the stock market certainly did.

Though many associate the Great Depression with the stock market crash on Oct. 29, 1929, the market actually rallied during the six months following Black Tuesday, while the defeat of Smoot-Hawley appeared likely. The market turned south again in April 1930 as those hopes of defeat gradually dimmed.

The Dow Jones Industrial Average sank a full 8%, from 250 to 230, over just two trading days in June 1930, in direct response to the Senate's passage of Smoot-Hawley and Hoover's announcement that he would sign it. Exacerbated by other flawed governmental policies, an international trade war continued to drive the market down until the Dow hit a low of 41 on July 8, 1932, having lost 89% of its value from its September, 1929 high. It would be 25 years before the market recovered its 1929 peak.

On this Bryan Caplan writes

These days a lot of economists blame the Smoot-Hawley Tariff Act for worsening the Great Depression. Herbert Hoover considered this hypothesis back in 1932 - and angrily rejected it.

Note: When Hoover says "our opponents set up the Hawley-Smoot tariff bill," he means that the opponents are blaming the tariff for the depression, not that they voted for it!

In the face of these gigantic, appalling worldwide forces our opponents set up the Hawley-Smoot tariff bill--changing as it did the tariffs on less than one-sixth of our own imports, one one-hundredth of the world's imports, and introduced long after the collapse started-as the cause of all this world catastrophe. What an unspeakable travesty upon reason this explanation is!

Suppose that we had never had the Hawley-Smoot tariff bill. Do you think for one moment that this crushing collapse in the structure of the world, these revolutions, these perils to civilization would not have happened and would not have reached into the United States ?

And yet, in order to make a political campaign by which they can play upon discontent so that they could hope to create a protest vote, they are compelled to set up this travesty of argument.

As to the New Deal in general, even Ben Bernanke isn't that enthusiastic about its results in dealing with the depression,

Our [work with Martin Parkinson] own view at present is that the New Deal is better characterized as having "cleared the way" for a natural recovery (e.g., by ending deflation and rehabilitating the financial system), rather than as being the engine of recovery itself.

(Ben Bernanke and Martin Parkinson, Unemployment, Inflation, and Wages in the American Depression: Are There Lessons for Europe? The American Economic Review, Vol. 79, No. 2, Papers and Proceedings of the Hundred and First Annual Meeting of the American Economic Association (May, 1989), pp. 210-214)

But still the myths survive.

EconTalk this week

Arnold Kling of EconLog and EconTalk host Russ Roberts talk about the role of credit default swaps and counterparty risks in the current financial mess. The conversation opens with the logistics of credit default swaps and counterparty risks and moves on to their role in the financial collapse. The conversation closes with a discussion of the political economy of pending financial regulation.

Incentives matter: mortgage file

The reasons go directly to regulatory differences that should interest Americans. Take nonrecourse mortgage loans. When Australians [and NZers] borrow money to buy a house, they know that if they default and the mortgaged property doesn't cover the debt, they will be responsible for the shortfall. And the lender will chase them for it. It's a neat way of reminding Australians to borrow responsibly.

In America, where populist post-Depression laws in many states have mandated loans be nonrecourse, the opposite is true. Americans can take out a mortgage more or less as a one-way bet. If you can't afford the repayments and can't refinance, you just send the keys back to the bank. Borrowers wipe their hands of liability. So, naturally, an American in financial strife will pay off debts that carry personal liability -- such as credit cards -- before they pay off their mortgage.

(Janet Albrechtsen in the WSJ)

(HT: The visible hand in economics)

Interesting blog bits

1. Frederic Sautet asks Will New Zealand Lead the Way Again?
2. Not PC asks The defining issue of the next political term is ...
3. Out in the Homepaddock they ask, Is the Blue wash bad for democracy?
4. At Save the Humans they have a few Election Thoughts.
5. Liberty Scott points out World weirdly thinks National/ACT is conservative.
6. Kiwiblog tells us about The new MPs and gives his views on the State of the Parties.

Kling on the current state of the US

At EconLog Arnold Kling comments on what should be done about the situation on Wall Street and with the big auto companies,

1. Firms are laying off workers that they probably should have laid off months ago, and they should not hesitate to do so.

2. It is ok for consumers to cut back on their spending; they should not feel they need to go out and spend to "help the economy."

3. Many home buyers are defaulting on their loans, which results in foreclosures, and government should not interfere with that process.

4. In many parts of the country, it makes sense for home builders to curtail activity until excess supplies of houses are absorbed.

5. Auto companies need to renegotiate their obligations to retired workers or go into bankruptcy and let the courts sort it out.

6. State and local governments need to renegotiate their obligations to retired workers or put the matter before legislative bodies and make hard choices.

7. Banks that are definitely insolvent need to be merged with healthy banks or closed by the FDIC.

8. Banks that are possibly insolvent, depending on the value of illiquid securities, need to be placed under close regulatory supervision.

9. New activity by Freddie Mac or Fannie Mae should be frozen. If banks don't want to make mortgage loans, then teenagers don't want to flirt.

10. The Treasury does not know what it is doing with its $700 billion in spending authority, so it should stop doing it.

Once the various excesses have been eliminated from the system and markets are back in balance--especially housing--we'll be fine.

Unfortunately president-elect Obama has been saying things like

The auto industry is the backbone of American manufacturing and a critical part of our attempt to reduce our dependence on foreign oil.

I would like to see the administration do everything it can to accelerate the retooling assistance that Congress has already enacted. In addition, I have made it a high priority for my transition team to work on additional policy options to help the auto industry adjust, weather the financial crisis, and succeed in producing fuel-efficient cars here in the United States of America.

Renegotiating their obligations to retired workers or going into bankruptcy don't look like options for Obama.

And on another note, what has where cars are produced got to do with reducing a country's dependence on foreign oil? Buying less oil would reduce the US's "dependence" on foreign oil, but this has nothing to do with where the cars are produced or which companies produce them. Don't you just want people to drive cars which use less petrol, no matter where those are cars made.

New iPredict stocks

New stocks on iPredict launching today cover a lot of ground,

• Who will replace Helen Clark as leader of Labour?
• Who will replace Michael Cullen as deputy leader of Labour?
• Will interest rates be cut on 4 December?
• Will the Electoral Finance Act be repealed by May?
• Will the economy's negative growth continue in the September quarter?

Happy money making!

The need for governemnt

In a recent post, Think of what politics is, Liberty Scott says the following,

I would like politics to be peripheral. Government is essential. The state provides for law and order, to protect us from those who will do violence to us, who will defraud us. That is a given and the priority.

This is a common view, believed by many from all over the political spectrum. Milton Friedman for example once said

[...] government is essential both as a forum for determining the ‘rules of the game’ and as an umpire to interpret and enforce the rules decided on. (Friedman 1962: 15)

But is this right?

We do have examples of where government enforcement of the "rules of the game" was missing and yet the game went on. Medieval Japan (ca. 1100-1600) was a period of economic growth but growth took place without much of a central government to enforce claims to resources. A recent working paper Property Rights In Medieval Japan: The Role Of Buddhist Temples And Monasteries by Mikael Adolphson and J. Mark Ramseyer argues that with regard to government in medieval Japan,

Emperors it had, along with regents, courtiers, warriors, and eventually shōgun and shōgunal regents. Yet these men seldom offered citizens much stability. Certainly, they seldom offered the security that would have induced citizens to invest scarce resources in easily appropriable investments or to undertake long-distance trade. These were not years of stability or peace. They were centuries of intrigue, murder, predation, and war.

But they also point out that,

... the Japanese economy grew anyway. Despite the chaos, people cleared forests. They lent money. They built elaborate and expensive irrigation facilities. They constructed sake breweries. And they traded their goods over longer and longer distances.

How then were property rights protected? Adolphson and Ramseyer show that temples and monasteries undertook the role of rights enforcer.

To obtain a secure claim to real estate, for example, a local landholder might "commend" his land to a temple (or monastery). Through the process, the temple obtained an equity interest in the land (took a cut of the harvest), and the landholder obtained an exemption from tax. At least as important, the landholder obtained the ability to call upon the temple to (and the temple had an incentive to) protect his land from rival claimants. Artisans and merchants obtained analogous protection by joining temple-sponsored guilds. They paid their dues, and the temple enforced their contracts.

In addition to the tax exemption the temples and monasteries offered a landholder two other sets of valuable services. First, they would adjudicate disputes over trades and property between parties within their jurisdictions. So contracts could be enforced. Second, estates within a temple's or monastery's region of control would be protected against threats and intrusions from outside parties. While it is true that some private landowners has the ability to protect their own property, in many cases the temples and monasteries had under their control the resources necessary to more effectively protect property.

Not only that but the temples and monasteries competed with each other to such services to landholders.

What in effect occurred was that "government services" were provided not by central government but in a competition market by private suppliers. This private provision was effective enough to allow economic growth to take place.

In effect, the temples and monasteries competed with each other to provide landholders with what we usually consider basic government services. In effect, medieval Japan maintained a market in private governments. Imperfectly to be sure, the resulting arrangements gave landholders something close to the protection they needed to improve and maintain their land.

Another case of private law enforcement is Medieval Iceland as discussed by David Friedman in Private Creation and Enforcement of Law: A Historical Case. Friedman argues

[...] medieval Icelandic institutions have several peculiar and interesting characteristics; they might almost have been invented by a mad economist to test the lengths to which market systems could supplant government in its most fundamental functions. Killing was a civil offense resulting in a fine paid to the survivors of the victim. Laws were made by a "parliament," seats in which were a marketable commodity. Enforcement of law was entirely a private affair. And yet these extraordinary institutions survived for over three hundred years, and the society in which they survived appears to have been in many ways an attractive one . Its citizens were, by medieval standards, free; differences in status based on rank or sex were relatively small; and its literary, output in relation to its size has been compared, with some justice, to that of Athens.

[...]

Medieval Iceland, however, presents institutions of private enforcement of law in a purer form than any other well-recorded society of which I am aware. Even early Roman law recognized the existence of crimes, offenses against society rather than against any individual, and dealt with them, in effect, by using the legislature as a special court. Under Anglo-Saxon law killing was an offense against the victim's family, his lord, and the lord of the place whose peace had been broken; wergeld was paid to the family, manbote to the crown, and fightwite to the respective lords. British thief-takers in the eighteenth century were motivated by a public reward of [[sterling]] 40 per thief. All of these systems involved some combination of private and public enforcement. The Icelandic system developed without any central authority comparable to the Anglo-Saxon king; as a result, even where the Icelandic legal system recognized an essentially "public" offense, it dealt with it by giving some individual (in some cases chosen by lot from those affected) the right to pursue the case and collect the resulting fine, thus fitting it into an essentially private system.

The point? At least in the past, government was not essential. But what of today?

There are a number of countries around the world which can be classified as 'weak or failed'. In such countries, the state is so corrupt, fragile or otherwise dysfunctional as to create anarchic - eg Somalia - or 'near anarchic' conditions. Citizens in these places can not rely upon the civil magistrate to uphold contracts or protect individual property rights. In addition, international market activity, which now comprises close to a quarter of world GDP has no overarching supranational authority to interpret or enforce commercial agreements. In these markets as well, government cannot be relied upon to create or enforce the rules of the game required for exchange relationships to thrive. Despite this, markets in both 'weak and failed states' and internationally survive and flourish. The long-standing existence of markets under conditions of real or quasi-statelessness suggests that private 'rules of the game' must be possible without government. How is this possible?

To take the case of commercial law as an example, how can trade continue without the government to enforce contracts, guard against fraud and contractual violations. One reason is that if the interaction between a buyer and seller or a creditor and debtor, for example, is repeated then there are forces to stop people acting opportunistically. If in the case of, say, the creditor and debtor, the debtor or seller wants to enjoy the benefits of contracting with the other party again, he cannot cheat his exchange partner. If he did then clearly the other party would refuse any further deals. Thus, a trading partner's credible threat to terminate future dealing if the other party cheats credibly commits him to cooperation, making the contract self-enforcing without government or any other form of external coercion. But there will be situations where such bilateral punishment may not be enough to ensure contract are honoured. Other mechanisms are need in such cases. One such mechanism is multilateral punishment.

Under multilateral punishment, the punishment is carried out by not just one person but by a group of people. Under this type of strategy, if an agent violates his contract, a whole group of individuals refuses to deal with him again whether any individual group member specifically was the violated party or not. A common example of such a mechanism is the boycott or embargo. In the international trade arena, for example, the way it works is straightforward. Assume that an individual defaults on his contract with another person. In response, the cheated agent communicates this information through his relevant network of other international traders. International commercial associations and arbitration venues, such as the International Chamber of Commerce and the Stockholm Chamber of Commerce facilitate this communication. By sharing the information about the identity of the trader who cheated him, the cheated individual coordinates the responses of his network of other traders, who, not wanting to be cheated themselves, refrain from any commercial dealings with the cheater. This has the effect of cutting off the cheater not only from future dealings with the individual he cheated, but also from this individual's entire trading network. This imposes a much higher cost to creating.

But multilateral punishment is also an effective way of creating reputations for individual traders who are honest. Honest individuals have good reputations and are able to cash in on this through contractual relationships with many others who are willing to contract with them because of their good reputation. Cheating would be very costly for individuals with good reputations because doing so would destroy the value of their histories of good conduct and with it the value of their reputations and thus ability to trade with others in the future. Reputation creation therefore acts as a kind of bond that commits traders to behave honestly. If they do not, they sacrifice the value of their bond.

But such private mechanisms are not useful only in state without government but can also play a role even in states with government enforcement of commercial law. As Peter Lesson writes,

Private mechanisms like reputation are highly important for enforcing contracts even where government is present and functional. The reason for this is straightforward. Even where government exists and is highly functional, state contractual enforcement is costly and imperfect. For many contractual agreements, it is not profitable to seek state enforcement even if a party has certainty he will win the dispute. The value he would receive is lower than the cost of pursuing state enforcement. Given this situation, one might expect that no contracts below this critical threshold would ever be established because, without recourse to state enforcement, defection would be endemic. But this is evidently not the case. Where state enforcement is prohibitively costly and thus cannot provide practical protection, reputation coupled with bilateral or multilateral punishment, discussed above, secures contractual fulfilment. (Lesson 2008: 50)

So, Do markets need government? At the very least, the answer to this question is more ambiguous than you may normally think.

• Friedman, Milton (1962) Capitalism and Freedom, Chicago: The Univeristy of Chicago Press.
  
• Leeson, Peter T. (2008) Do Markets Need Government? In The Legal Foundations of Free Markets edited by Stephen F. Copp, London: IEA.

Richard Ebeling on Greenspan

Earlier I noted a piece by George Selgin in which he argued that the Fed under Greenspan was largely responsible for the US housing crisis. Now Richard Ebeling has a piece on the same topic: The Financial Bubble was Created by Central Bank Policy.

In recent testimony before a congressional committee former Federal Reserve Board Chairman, Alan Greenspan, pointed his finger at various financial insurance schemes and the inescapable uncertainty of the future. “We’re not smart enough as people,” he said. “We just cannot see events that far in advance.”

The one thing he did not admit was that it was his own monetary policy when he was at the helm of America’s central bank that created the boom that has now resulted in a crash.

(HT: The Austrian Economists)

Quote of the day

Classic Rothbard

It is no crime to be ignorant of economics, which is, after all, a specialized discipline and one that most people consider to be a "dismal science." But it is totally irresponsible to have a loud and vociferous opinion on economic subjects while remaining in this state of ignorance.

Murray Rothbard, "Anarcho-Communism", Libertarian Forum, 2(1) January 1, 1970.

If only politicians would take notice.

Is Greenspan guilty as charged? (updated)

Here is a attempt by David Henderson and Jeffrey Hummel to acquit Alan Greenspan's monetary policy from contributing to the now-burst housing bubble. On the other hand, here is George Selgin making the opposite case.

The jury is out.

(HT: Cafe Hayek)

Update: In the comments PC makes the point that opposing views have also been filed by Jeffrey Tucker and Robert Murphy.

Capitalism and the financial crisis

Walter E. Williams writes on Capitalism and the Financial Crisis. Williams makes an excellent point about the regulation of markets. Free markets are regulated, but not by the government, and interference with that regulation can create more problems than it can solve.

It is incorrect to say that laissez-faire or free markets are unregulated. There is ruthless regulation, but it's not by government. Take the mortgage industry. In the absence of government interference, it is unlikely that a lender would extend a mortgage to a person with a poor credit history, making no down payment, and providing no verifiable employment history. But under the pressure of the government's Community Reinvestment Act and Fannie Mae and Freddie Mac buying up or guaranteeing such mortgages, a lender will.

When businesses make unwise decisions that lead to bankruptcy, their assets are sold off to someone else who might be able to put them to wiser use. Government bailouts give businesses a reprieve that the market wouldn't give them. Bailouts have at least two effects. They permit continued unwise use of resources and it creates what economists call moral hazard, the expectation of future bailouts and others hopping on the bailout wagon.

The blame for our current financial mess rests with government, with the major player being the Federal Reserve Board keeping interest rates artificially low and the congressional and White House market interference in the name of more home ownership. In the clamor for more regulation over our financial institutions, has anybody bothered to ask whether people in government know what they're doing?

Free markets are regulated most powerfully by competition and ultimately by takeover and bankruptcy. These are much tougher regulators any any government agency. Within free markets a firm can pay the ultimate price for bad decisions but when the government interferes, that discipline is removed, and as Williams notes the result is the continued unwise use of resources and moral hazard.

PM.National is underpriced

On the iPredict blog Eric Crampton gives us his Morning Update and he's arguing that PM.National is underpriced.

At current prices in the VS markets, and subbing in Ron Mark's chances in his electorate rather than Peters's chances (as either is sufficient for NZ First to return), PM.National is currently substantially underpriced. Only two unlikely potential Parliamentary configurations yield PM.National probabilities under 80%: if NZ First returns and the Maori Party supports Labour, PM.National would be at 75%; if ACT also doesn't return, that probability drops to 19%. The most likely scenario is:
ACT 4
National 60
UF 1
Maori 5
NZ First 0
Labour 41
Green 10
Progressive 1

The above gives us a 122 seat Parliament and a 65 seat Act-National-UF coalition governing handily, with or without Maori Party support.

Unless prices elsewhere in the system are out, and they don't look out to me, National's a strong buy at anything less than 90%. The spreadsheet's telling me 97.5% chance of a National coalition government, but I'm not confident enough in it to go above 90. Full disclosure: I'm current high bidder on PM.National and have substantial position long PM.National and short PM.Labour.

Right now PM.National is trading at around 0.84 so if Eric's spreadsheet is right then it is still underpriced. So there is money to be made. If the iPredict prices are anywhere near right then a change of government is very likely. I should say that I too am long in PM.National.