The Soviet growth controversy once again

“In the 1961 edition of his famous textbook of economic principles, Paul Samuelson wrote that GNP in the Soviet Union was about half that in the United States but the Soviet Union was growing faster. As a result, one could comfortably forecast that Soviet GNP would exceed that of the United States by as early as 1984 or perhaps by as late as 1997 and in any event Soviet GNP would greatly catch-up to U.S. GNP. A poor forecast--but it gets worse because in subsequent editions Samuelson presented the same analysis again and again except the overtaking time was always pushed further into the future so by 1980 the dates were 2002 to 2012. In subsequent editions, Samuelson provided no acknowledgment of his past failure to predict and little commentary beyond remarks about "bad weather" in the Soviet Union … .


Among libertarians, this story has long been the subject of much informal amusement. But more recently my colleague David Levy and co-author Sandra Peart have discovered that the story is much more interesting and important than many people, including myself, had ever realized.


First, an even more off-course analysis can also be found in another mega-selling textbook, McConnell's Economics (still a huge seller today). Like Samuelson, McConnell estimated Soviet GNP as half that of the United States in 1963 but he showed that the Soviets were investing a much larger share of GNP and thus growing at rates "two to three times" higher than the U.S. Indeed, through at least ten (!) editions, the Soviets continued to grow faster than the U.S. and yet in McConnell's 1990 edition Soviet GNP was still half that of the United States!


A second case of being blinded by "liberal" ideology? If so, Levy and Peart throw another curve-ball because the very liberal even "leftist" texts of the time, notably those by Lorie Tarshis and Robert Heilbroner did not make the Samuelson-McConnell mistake.


Tarshis and Heilbroner were more liberal than Samuelson and McConnell but offered a more nuanced, descriptive and tentative account of the Soviet economy. Why? Levy and Peart argue that they were saved from error not by skepticism about the Soviet Union per se but rather by skepticism about the power of simple economic theories to fully describe the world in the absence of rich institutional detail.”

Alex Tabarrok, “Soviet Growth and American Textbooks”, Marginal Revolution (4 January 2010).

http://www.marginalrevolution.com/marginalrevolution/2010/01/soviet-growth-american-textbooks.html

Alex Tabarrok is a professor of economics at George Mason University and co-author with Tyler Cowen of the Marginal Revolution blog.


The problem of measuring the rate of growth of an economy is more complex than most people realize.  In any economic system  --  whether capitalist or socialist, centralized or decentralized  --  the necessity of valuing the myriad and uneven streams of different kinds of output produced becomes a central question to be addressed.  Inevitably, it involves the introduction of some sort of coefficient of economic choice stating the relative importance of any one commodity with regard to any other.

How a Mozart string quintet helps explain high health care costs

A recent article (http://prescriptions.blogs.nytimes.com/2010/01/17/an-economist-who-sees-no-way-to-slow-rising-costs/) in the New York Times discusses the problem of high and rising health care costs and traces the problem to what is referred to in economics as “Baumol’s cost disease”. 
 
William Baumol (1922-) was for many years a professor at Princeton and New York universities.  He made contributions in many areas but is best known for the theory of contestable markets, the Baumol-Tobin model of transactions demand for money, and Baumol’s cost disease.  A major influence on Professor Baumol was Joseph Schumpeter, and he claims that the object of his lifetime work was to develop a place in economic theory for Schumpeter’s entrepreneur.
 
In a famous 1967 article, Professor Baumol used the Mozart String Quintet to point out that the productivity of Classical music performers has not increased in 200 years.  He noted it takes the same number of musicians and the same amount of time today to play the quintet as it did in 1787. 
 
Professor Baumol did not directly address the economics of health care but rather looked at the general effects of automation on the U.S. economy.
 
At the time (and continuing today), the U.S. was undergoing a revolution of factory automation where the introduction of new technologies and processes was rapidly raising productivity in many lines of manufacturing production.  Other sectors, however, such as education, health services, and government services, among many others, were more labor-intensive, and there was less scope to automate and substitute new technology-embodying capital for labor.  Consequently, the more labor-intensive sectors did not experience much productivity growth.  As a result, costs and prices (and total income and employment) tended to fall in those activities conducive to technological progress (such as manufacturing) while costs and prices remained relatively high in non-manufacturing sectors (especially services). 
 
While many people who work in sectors experiencing high-productivity growth such as manufacturing lose their jobs to automation, those that remain are paid more and average incomes rise.   The huge and growing output of manufactured goods resulting from the growth in productivity tends to saturate the market for these products and the income elasticity of manufactures --  their responsiveness to increases in income  --  falls with time. 
 
In contrast, in the more service-oriented sectors productivity gains are difficult to realize.  Workers in these sectors nonetheless experience rising wages because they have the option of working in other occupations, and will leave if they are not adequately compensated.  Moreover, many of these workers are also highly educated and would be difficult to replace should they resign.  This also tends to keep their wages high.  The service sector also benefits from a high income elasticity of demand as people choose to spend a growing proportion of their rising incomes on health care, education and other labor-intensive services where productivity gains are difficult to generate. 
 
What this means is health care costs are high and rising because they involve high labor skills and direct personal attention and cannot be easily reduced by automation or spreading the costs over more people.  Like a Mozart string quintet, a certain number of workers must be involved and the time taken to treat a patient, like the time it takes to play the music, is fixed and cannot be reduced.  (But, let me note, that while it costs the same to produce the music from the string quintet, once recorded music it is much cheaper to consume today than it was in 1787, where once heard the music was lost.  Now, the recording can be replayed at almost zero marginal cost.  Unfortunately, this is not the case with health care where each “performance” is tailored to a specific individual and their unique condition.)
 
It is a mistake for Congress and the Administration to imply that public policy can do much to reduce health care costs or the general efficiency of the health care sector.  Compared to other sectors of the economy the potential for productivity advance in health care is low and any expansion in the delivery of health care services will inevitably raise the share of health care in the economy and the expenditures of government to support it.
 
Talk by politicians about lowering health care costs is easy.  Because of the nature of these costs, they will find actually accomplishing this goal is very, very difficult.

The beginning of the end for the euro as Europe's single currency

Greece is in the news and the news is not good, for Greece or for the countries of the eurozone.
 
The state of that nation's finances is terrible, and international ratings agencies have downgraded its credit rating because of a huge burden of public debt and a large budget deficit.  Output declined last year and forecasts indicate another drop is set for this year, with unemployment reaching double-digit levels.  However Greece decides to deal with its mounting economic troubles it faces a prolonged squeeze on its living standards as it addresses unsustainable fiscal imbalances and a current account deficit of more than 10 per cent of its GDP.
 
A major constraint on the ability of the Greek authorities in dealing with their deteriorating economic situation is their inability to change their exchange rate.  Greece is part of the eurozone and its monetary policy by the European Central Bank in Frankfurt, not in Athens,  constraining its policy options when dealing with its problems.  Add to this a fiscal policy in disarray and the stage is set for continuing problems aggravated by a fixed exchange rate increasingly at variance with their domestic economic circumstances and needs.
 
Let me add many economists --  I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures.  But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area.  Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.
 
Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do.  Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher.  If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries.  This is what appears to have happened to Greece. 
 
The smaller and more peripheral countries of the eurozone now have a difficult decision to make.  By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank.  It is no longer available to them as a domestic policy instrument.  Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems.  For these countries, fiscal policy is no longer a domestic policy instrument.  The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries.  They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.
 
In the case of Greece, any attempt to meet the targets of the Maastricht Treaty that  created the European Union and led to the introduction of the euro will only deepen the recession that has taken hold in this country.  Similarly, any attempt to restore the competitiveness of the Greek economy with respect to the other members of the eurozone will mean years and years of at best slow growth and continual pain.  For Greece, a break with the euro seems inevitable.  The sooner Greece leaves the eurozone, the better.
 
Greece is not the only eurozone country struggling to meet the demands of  a fixed exchange rate that is stifling its economy and imposing high costs on its citizens.  In many of these countries the euro was adopted mainly for political reasons, with too little thought given to the costs associated with changing their national currency arrangements.  Some of these countries are accumulating a mountain of external debt that will be very difficult to pay off or even reschedule.  In these circumstances, they should give thought to abandoning the euro and adopting exchange rate arrangements which provide them with more flexibility than the euro.
 
While the euro will not end as the official currency of the European Union and will not be dropped by its major member-states, neither will it be the single and only currency used in the EU.  Perhaps after some time Greece and other countries will be able to adjust their domestic economies to the requirements of a wider economic area and harmonize their domestic policies in a manner consistent with the rest of Europe.  But until they do, pressures on the euro will continue and its will continue to unravel as Europe's most important currency .

Simon Johnson on the financial crisis and Obama’s advisors

LW:  MIT economist Simon Johnson explains that the policies embraced by key members of Obama's economic team are opposite those they supported during the Asian financial crisis of the 1990s. This charge applies in particular to Lawrence Summers, in charge of the White House National Economic Council, Treasury Secretary Timothy F. Geithner, and David A. Lipton, who is now at the National Economic Council and the National Security Council.  All three were heavily involved in preparing a US response to the Asian financial crisis.
 

“In the 1990s, they were opposed to unconditional bailouts — providing money to troubled financial institutions with no strings attached. .... The Treasury philosophy was clear and tough: "a healthy financial system cannot be built on the expectation of bailouts," Mr. Summers said in his American Economic Association speech in 2000. ...

“In the 1990s, the United States — working closely with the I.M.F. — insisted that crisis countries fundamentally restructure their financial systems, which involved forcing out top bank executives. In the United States during 2009, we not only kept our largest and most troubled banks intact (while on life support) but allowed the biggest six financial conglomerates to become larger, both in absolute terms and relative to the economy. ....”

Presumably this time, the Summers-Geithner-Lipton group will argue that the only way to restore confidence was through the kind of unconditional and implicit bailout guarantees they opposed in the 1990s.

If true, this has a terrible implication. The structure of our financial system has not changed in any way that will reduce reckless risk-taking by banks that are large enough to cause significant damage when they threaten to fail.”

 
Simon Johnson, "Lessons Learned but Not Applied", Economix (31 December 2009).
 
http://economix.blogs.nytimes.com/2009/12/31/by-simon-johnson-lessons-lea/
 
DOW:  Simon Johnson is currently the Ronald A. Kurtz Professor of Entrepreneurship at the Sloan School of Management at MIT.  From March 2007 through the end of August 2008 he was Chief Economist of the International Monetary Fund.  Recently Prospect Magazine named Simon Johnson as the "clear winner" out of 25 economists who have made notable contributions to "public conversation" during the current financial crisis.  Also on the list were Martin Wolf of the Financial Times, Paul Krugman of the New York Times, and Columbia University economist Joseph Stiglitz.
 
The issue Professor Johnson has focused on in this post is the one of “Moral Hazard”.  Moral hazard is the tendency of a person or institution that is imperfectly monitored to engage in dishonest or risky behavior.  (“Moral hazard” is another one of those lousy economic terms that makes no sense but is used by everyone anyway.)  In the case of financial institutions, moral hazard is the tendency for financial bailouts by governments and central banks to encourage risky lending in the future, if the bankers come to believe they will be bailed out and not suffer personal loss if things go wrong.
 
Moral hazard has been a concern expressed about the Administration policy since it first took office.  The objection is both that Wall Street has not simply been “saved” from its own stupidities but that the very people that made disastrous decisions have benefited from the very mistakes they made.  This, it is argued, will only encourage them to be even more reckless in the future and, anyway, they should be fired and not benefit from their mistakes. 
 
Nor has the issue of moral hazard been limited to the banks, as the Administration also bailed out auto companies, investors in housing, states and localities, and pension funds, among others.  The fear on the part of the critics is both the unfairness of shifting the costs of all these bailouts to the taxpayer and the precedent it sets for the future. 
 
As Simon Johnson notes, the problem of moral hazard is well understood by President Obama’s economic advisors.  When addressing the question of bailouts at the international level in 2000 Larry Summers had this to say about the problem of moral hazard in his speech to the AEA:
 

“… as in the case of an efficient and incentive-compatible deposit-insurance and safety-net scheme, possible moral-hazard distortions induced by automatic guarantees need to be avoided to ensure that the scheme does not lead to systemic losses and distortions. Thus, it is certain that a healthy financial system cannot be built on the expectation of bailouts.”

American Economic Review, Vol. 90, No. 2 (May 2000).
 
But bailouts are exactly what the Obama Administration’s policy has been.  Wall Street is back in business earning huge profits and its executives are back in their offices receiving the huge bonuses.  Car companies are living off the public dole and their executives are still receiving high salaries.  Fannie and Freddie are still in business, still paying exorbitant salaries to their management, and still near financial collapse.  Yet the rest of the economy remains in the doldrums and employment is still sinking. 
 
It’s hard to understand why bailouts were bad policy during the Asian financial crisis in the 1990s and yet bailouts are wise economic policy for the U.S today.
 
Thanks to Larry Willmore for the pointer.

How successful has the Obama Administration been in achieving its economic goals?

The start of a new year is a good time to look back at what happened the past year and assess the degree to which the President’s has been successful in bringing about the changes he said his Administration wanted to make. 
 
Contrary to the Administration’s hopes, the past year has been one of continued disappointments and setbacks that may be broadly described as follows:  Output and employment fell sharply in at the end of 2008 and through much of 2009 in response to a worsening financial crisis that remains unresolved to this day;  The fall in production was particularly steep, with the GDP dropping by 3 per cent in 2009;  A weak, one might even say anemic, recovery may have been underway at the end of the year but this is uncertain;  The number of unemployed across the country rose rapidly throughout 2009 and continues to rise today, with 15.3 million people out of work this past December and with the unemployment rate at stuck at 10 per cent, far above what the Administration predicted;  While inflationary trends are now muted and deflation can be seen in some sectors, inflationary pressures may be building in response to huge government deficits and large injections of liquidity by the Fed at the Administration’s behest;  Deficits in government accounts at all levels are huge and growing, with several states on the verge of bankruptcy and the Federal government projecting its deficit at almost 10 ½ per cent of GDP in 2010, almost as large as the extraordinary 11 per cent last year;  and Banking systems and financial institutions across the country remain in a precarious state, with lending to businesses and consumers much reduced and the balance sheets of many of firms verging on the insolvent.  The economy remains very ill and despite the Administration’s efforts there is no reason to believe it will get well any time soon.
 
It is difficult not to conclude the Administration has made little or no progress across a broad front of economic concerns in 2009.  In fact, the President has fallen far short of his own major goals.  With regard to employment, as pointed out by James Hamilton at Econbrowser, on 9 February the President stated:
 

“I think my initial measure of success is creating or saving 4 million jobs. That's bottom line No. 1, because if people are working, then they've got enough confidence to make purchases, to make investments. Businesses start seeing that consumers are out there with a little more confidence, and they start making investments, which means they start hiring workers. So step No. 1, job creation.”

 
But instead of creating of saving 4 million jobs, over the past year we have lost over 4 million jobs.  More jobs have been lost in the United States under the Obama Administration than under any 12 month period since before World War II.  Nor does there appear to be any relief in sight to our employment problem, as the Administration itself acknowledges.
 
One reason for this failure is the President has not been concerned with the state of the economy and the creation of jobs.  Instead, he has focused on health care and energy and a host of other measures intended, as he puts it, to “transform” the U.S. economy.  While the President may or may not achieve the health care, energy and education reforms he desires, in transforming the U.S. economy he appears to be succeeding.  Unfortunately, it may be the U.S. economy is being transformed from an engine of rapid economic progress into a low employment, low growth economy with little of the prosperity it has enjoyed in the past.

The United States After a Decade of Disappointment and Setback

At the dawn of the Twenty-first Century the position of the United States and other economically advanced countries in the world seemed unchallengeable.  In the second half of the previous century, the countries of the West had marshaled the economic resources of the world, controlled its oceans and space, and extended their trading relationships not only to the other side of the globe but deeply into every country on every continent.  The West's per capita incomes, already far higher than other areas of the world, had risen markedly as it witnessed a strong renewal of progress following a protracted and deep depression and a devastating full-scale war extending across several continents.  Labor productivity rose rapidly in response to a broadening division of labor, more capital per worker, and innovations in organization, products, techniques and transport.  As a result, living standards in the West far exceeded those of the rest of the world and as the end of the Twentieth Century approached Western countries enjoyed an economic boom.  

Equally important, the development of poor countries that had lagged in the process of world development was spurred by the success of the more economically advanced countries, and prosperity spread, indeed, accelerated with time, across the globe. This was in no small part due to the leadership of the United States in establishing an international monetary and trading system that promoted world development.
 
The global economic landscape of year 2000 reflected the progress made by all countries during the previous half century. In the case of the West, its relatively small proportion of the world’s population, only some 15 per cent of all its inhabitants, produced the vast bulk of its wealth and was the center of scientific and technical advance.  One country, the United States, endowed by its geography and history with the position of leader of the West, comprised  a much smaller five per cent of all people on earth but exercised unchallenged global economic supremacy and political hegemony as its former adversaries either lay prostrate and exhausted from an economic competition that they could not win, as in the case of the states of the old Soviet Union, or were so weak and poor and divided so as to represent no threat to its dominant position.  For Americans, a future of peace and prosperity smiled upon them.
 
But the last decade has not been at all successful for America.  Two recessions, one very deep, growing internal and external imbalances, high unemployment and a financial crisis scorched the economy and left a legacy of tarnished hopes.  It is not surprising that after a half century of progress a decade of setbacks soured Americans on what was a very difficult decade and changed their outlook about the future.  It is not too much to say the experience of the past decade has shaken many Americans to their core.
 
In contrast, for much of the rest of the world the first decade of the Twenty-first Century was a very good one.  Developing countries grew very rapidly most years during the decade and, while affected by the global financial crisis, it appears they are now rebounding strongly from the downturn.  For these countries, and therefore for the vast majority of the world’s population, these have been very good years, even great years and there is promise of more to come.
 
Geopolitically, the first decade of the Twenty-first Century could represent a turning point in the political and economic history of the world.   During the past decade, the United States has been incautious in its economic policies and allowed its economy to fall from being the wonder of the world to become the debtor to the world.  At the same time, other countries, many initially much poorer and backward in their technological sophistication and business acuity, surpassed it in many areas. For them, the decade was truly one of great economic achievement.
 
The world economic landscape of 2010 is therefore very different than that of 2000, and it is different not only because of the success of other countries but because of a failure of the United States to conduct itself with the seriousness and purpose of a great country with great responsibilities.  Americans made serious errors in policy and consequently suffered setbacks and financial panics at their own hands. 
 
The world economic scene of 2020 is now being set.  If the U.S. returns to the theme of limited government and free markets, it will prosper and retain its position in the world.  If it continues down its current road of expansive government and interferences in and controls on the economy, it will find itself falling ever further behind a world economy dominated by the rapidly expanding economies of Asia, Africa and Latin America.

The downside of fixed exchange rates

LW:  Martin Wolf has drafted another superb Wednesday column. He begins with these words:
 

“What would have happened during the financial crisis if the euro had not existed? The short answer is that there would have been currency crises among its members. The currencies of Greece, Ireland, Italy, Portugal and Spain would surely have fallen sharply against the old D-Mark. That is the outcome the creators of the eurozone wished to avoid. They have been successful. But, if the exchange rate cannot adjust, something else must instead. That "something else" is the economies of peripheral eurozone member countries. They are locked into competitive disinflation against Germany, the world's foremost exporter of very high-quality manufactures. I wish them luck.”

 
Martin Wolf, "The eurozone's next decade will be tough", Financial Times (6 January 2010).
 
http://www.ft.com/cms/s/0/19da1d26-fa2f-11de-beed-00144feab49a.html
 
The remainder of the column is just as informative, just as well-written, and should be read in its entirety. Martin ends on a sober note:
 

“When the eurozone was created, a huge literature emerged on whether it was an optimal currency union. We know now it was not. We are about to find out whether this matters.”

 
I've said this before, and will say it again: Martin Wolf's column alone is worth the price of an online subscription to the Financial Times. Non-subscribers, I understand, are allowed to download three articles each week. If you are a non-subscriber, do reserve one of your free weekly downloads for Martin Wolf. Martin rarely disappoints.
 
DOW:  Let me begin by saying I endorse what Larry says above about the wisdom of Martin Wolf and double endorse his recommendation to download Martin’s weekly column. 
 
Let me add that many economists --  I was one of them -- were never a supporter of the euro precisely because we did not think Europe as a whole was sufficiently integrated to allow a single currency to operate across such a varied economic landscape with such diverse policy objectives and different institutional structures.  But I was sympathetic to the need to reduce the transactions costs associated with currency conversions and fluctuating exchange values, and I hoped that the introduction of a single currency would sufficiently discipline economic policy and improve economic performance so as to limit any problems caused by the introduction of a rigid and unchangeable unit to effect transactions and carry out investments over such a wide area.  Opening up Europe as a whole to flows of people and capital was also a good idea that could help a continent overcome a terrible history of nationalistic turmoil.
 
Our fear was the euro would shift the internal balance of payments adjustment process among these countries entirely to changes in the level of income (and hence employment), as fixed exchange rates inevitably do, rather than allowing changes in relative prices to absorb some of the adjustment effects, as more flexible exchange rates tend to do.  Wider swings in growth and more persistent external imbalances would result if a fixed exchange rate were imposed and the unemployment rate would be higher.  If this happened, the economic situation in some of these countries would worsen over the long-run, not improve, at least relative to the other countries.  This is what appears to have happened some of the peripheral countries. 
 
The peripheral countries now have a difficult decision to make.  By accepting the euro they have turned the conduct of their monetary policy over to the European Central Bank.  It is no longer available to them as a domestic policy instrument.  Moreover, now their fiscal policy must be directed at their external concerns rather than their internal problems.  For these countries, fiscal policy is no longer a domestic policy instrument.  The fixed exchange rate of the euro has become the sole concern and focus of economic policy in these countries.  They will either have to discipline their internal policies to the demands of their external monetary relationships or they will have to abandon the euro.
 
As Martin Wolf mentions in his article, the late Charles Kindleberger of MIT argued that an open economy required a hegemon to bring stability to the external environment within which countries conduct their external economic relations.  In the case of the eurozone it is Germany.  But because of the nature of its own structural relationships Germany is not capable (or even willing) of carrying out this role.  Consequently, the peripheral countries of the eurozone are left to fend on their own not only without support from other countries but with the constraints imposed by others tightening on them.  Their immediate outlook is bleak and their adjustment process to deal with their problems is becoming increasing difficult.
 
In the same way for the same reasons as Kindleberger set forth the world economy requires a hegemon to provide it the stability and lend it the time required to adjust domestic productive structures and trading patterns to the incessant changes brought about by technological change and rising incomes.  This hegemon is the United States, whose currency is the main international currency and whose economy is the main absorber and provider of goods and services at the international level.  The U.S. attempted to avoid the role as hegemon at the end of the Second World War, or at least minimize it, through the establishment of a set of international monetary institutions --  the Bretton Woods System  -- to which it transferred many of the operations necessary for the efficient functioning of the world economy.  By doing so, it hoped to release itself from the constraints entailed in managing the world economy.
 
But the United States quickly learned that, in the end, there must be a spender and borrower of last resort in a crisis, and the IMF and other international agencies it created were not up to the task.  Moreover, it quickly learned, to its sad regret, that that a fixed exchange rate system at the world level required domestic policy discipline on the part on the global hegemon and its failure to live within its means and conduct its domestic policy with the goal of international stability in mind would bring down the entire system.  The world (and, equally, the Americans) has lived with the consequences of the inability of the United States to conduct its economic policies in a manner worthy of its responsibilities since the late 1960s and early 1970s.  Nowhere is this clearer than in the sharp deterioration in long-term world and U.S. economic performance since that time and an increasingly chaotic international economy.
 
The upside of fixed exchange rate systems is that they provide the stability required for rapid economic advance and spreading global prosperity.  The downside of fixed exchange rate systems is that they require discipline on the part of governments in the conduct of their monetary and fiscal policies, especially on the part of the hegemon, and a willingness to adjust to changes taking place outside their domestic economies. 
 
As Martin points out, we are about to find out whether the peripheral members of the eurozone can summon the discipline necessary to deal with their deteriorating economic circumstances.  One wonders whether the United States, which is far more important to the world economy and encompasses far more people than the smaller countries of the eurozone, can do the same.
 
Thanks to Larry Willmore for the pointer.

Socialist Bread and Capitalist Bread

In a recently published article, Kevin A. Hassett points out that the groves of academe are filled with Marxists and have been so politicized and so disconnected from the rest of society that ordinary citizens no longer trust anything that emanates from our universities. 
 
One can add to this that the fall of the Soviet Union discredited state Socialism in the eyes of most people and there is also a widespread belief that government is an ineffectual instrument for addressing the country's mounting problems. 
 
In this situation, questioning of the role of government and reliance on it would seem to be in order.
 
Yet we live in an age when the hatred of Capitalism and love of Socialism is so transparent that many people cannot even see it.  Nowhere is this more obvious than in the idea that just because the government provides something, it is seen as somehow fairer and superior to the efforts of the private sector, even if it is an inferior product and providing it collectively bankrupts everybody. As Schumpeter put it, "Socialist bread may well taste sweeter to them [the intellectuals] than capitalist bread simply because it is socialist bread, and it would do so even if they found mice in it."
 
There are plenty of mice in the health care bill but it matters not. Mice and all, the Left will support it and yell for more. And they will see health care as only the beginning of a banquet where they can set the menu and order the cooks about and the waiters to and fro.  When the meal delivered is found to be sour, they will blame everyone but themselves.
 
 One should not think that the trend toward a dirigisme society pushed by the Democrats is simply a matter of ideology, although that is its emanating force. There is also the fact that so much of the economy is effectively “socialized” already, and nothing is as severe an impediment to clear thinking on moral and political issues than the self-interest of the status quo and the rebarbative complexity of making your own way in a difficult world. It is so much easier to let the government worry about meeting our needs and then complain when it things are not as great as one would like.
   
As Schumpeter predicted, the attack on Capitalism and the Law would come from academia and the wider intellectual class. He believed Capitalism creates the productivity on which a modern economy is based and on which all aspects of a modern society feed, especially the intellectual class. Where would Harvard be without its endowment?  But people, especially intellectuals, do not understand the hidden intricacies interwoven into the extensive division of labor upon which their prosperity rests and they become hostile to the very social order which created them and sustains them. Intellectuals increasingly attack Capitalism and the “creative destruction” function of Schumpeter’s hero, the entrepreneur, and as they do so the entire system weakens and declines, intellectuals included.
 
Yes, there is rot in academia. And in the Congress and the other corridors of political power. And in the business community. But not at Regent.
  
Our Faith in the Creator trumps their reliance on Man and Jean Jacques Rousseau and Karl Marx.
 
For as Christians, thankfully our hope and joy do not depend upon who is up and who is down in academe, or Capitol Hill, or the White House, or Wall Street. 
 
Christ’s bread is sweetest of all and our eyes are on it.  1 Peter 1: 3-4.
 
 May it always remain that way.

Why the ‘Oughts will go down as great years

“It may not feel that way right now, but the last 10 years may go down in world history as a big success.

That idea may be hard to accept in the United States. After all, it was the decade of 9/11, the wars in Iraq and Afghanistan, and the financial crisis, all dramatic and painful events. But in economic terms, at least, the decade was a remarkably good one for many people around the globe.

The raging economic growth rates of China and India are well known, though their rise is part of a broader trend in the economic development of poorer countries. Ideals of prosperity, freedom and the rule of law have probably never been more resonant globally than they’ve been over the last 10 years, even if practice often falls short. And for all of the anti-capitalistic rhetoric that has emerged from the financial crisis, national leaders around the world are embracing the commercialization of their economies.

Putting aside the United States, which ranks third, the four most populous countries are China, India, Indonesia and Brazil, accounting for more than 40 percent of the world’s people. And all four have made great strides [this past decade]. …
...
One lesson from all of this is that steady economic growth is an underreported news story — and to our own detriment. As human beings, we are prone to focus on very dramatic, visible events, such as confrontations with political enemies or the personal qualities of leaders, whether good or bad. …

In a given year, an extra percentage point of economic growth may not seem to matter much. But, over time, the difference between annual growth of 1 percent and 2 percent determines whether you can double your standard of living every 35 years or every 70 years. At 5 percent annual economic growth, living standards double about every 14 years.
…
It might be pleasant to boast that America is — or should be — a world leader in every area, but the practical reality is that if some other country solves the problem of green energy, so much the better for us.”

 
Tyler Cowen, "Fruitful Decade for Many in the World", The New York Times (2 January 2010).
               
Tyler Cowen is a professor of economics at George Mason University.
 
 
At the dawn of the Twenty-first Century the position of the United States and other economically advanced countries in the world seemed unchallengeable.  In the second half of the previous century, the countries of the West had marshaled the economic resources of the world, controlled its oceans and space, and extended their trading relationships not only to the other side of the globe but deeply into every country on every continent.  Their per capita incomes, already far higher than other regions of the world, had risen markedly as they witnessed a strong renewal of progress following a protracted and deep depression and a devastating full-scale war extending across several continents.  Labor productivity rose rapidly in response to a broadening division of labor, more capital per worker, and innovations in organization, products, techniques and transport.  As a result, living standards in these countries far exceeded those of the rest of the world and as the end of the Twentieth Century approached these countries enjoyed an economic boom.   Equally important, the development of those countries that had lagged in the process of world development was spurred, and prosperity spread, indeed, with time, accelerated, across the globe.
 
The global economic landscape of year 2000 reflected the progress made by these countries and encouraged the expectation of continued advances.  A relatively small proportion of the world’s population residing in these fortunate countries, only some 15 per cent of the its inhabitants, produced the vast bulk of its wealth and was the center of scientific and technical advance.  One country, the United States, endowed by its geography and history with the position of leader of the West, comprised  a much smaller five per cent of all people on earth but exercised unchallenged global economic supremacy and political hegemony as its former adversaries either lay prostrate and exhausted from an economic competition that they could not win, as in the case of the states former of the old Soviet Union, or were so weak and poor and divided so as to represent no threat to its dominant position.  For Americans, a future of peace and prosperity smiled upon them.
 
America sees itself as a land of economic success.  It regards its economic success as almost foreordained, inevitable in the grand scheme of things, and it always sees itself as the principle source of economic advance in the world.  It has no intention of monopolizing that advance but wants to share it and is welcoming of others economic advance.  It looked to the Twenty-first Century with hope of further success.
 
But the ‘oughts have not been at all successful for America.  Two recessions, one very deep, growing internal and external imbalances, high unemployment and a financial crisis scorched the economy and left a legacy of tarnished hopes.  It is not surprising that after a half century of progress a decade of setbacks soured Americans on what was a very difficult decade.  It is not too much to say the experience of the past decade has shaken many Americans to their core.
 
But as Professor Cowen notes, for the rest of the world the first decade of the Twenty-first Century was a good one.  Developing countries grew very rapidly most years during the decade and, while affected by the global financial crisis, it appears they are now rebounding strongly from the downturn.  For these countries, and for the vast majority of the world’s population, these have been very good years, even great years.
 
Geopolitically, these years could also represent a turning point in the political and economic history of the world.   By its position astride the main shipping routes of both the Atlantic and the Pacific, its large and skilled and educated population, its huge territory of abundant resources, its temperate climate, its highly capital-intensive and technologically-oriented economy, and its commercial culture and extensive network of trading relations, the United States should continue to be the world’s leading country and economy for many decades to come.   No other country has these qualities and no other country could replace it in its role as a world leader. 
 
But it is also fair to say that the United States has been incautious in its economic policies and has allowed its economy to fall from being the wonder of the world to become the debtor to the world.  At the same time, other countries, many initially much poorer and backward in their technological sophistication and business acuity, surpassed it in many areas during the past decade.   They have undertaken the development of their countries not by force of arms or unwelcome intrusion but by hard work and wise policies.  For them, the past decade is truly one of great economic achievement.
 
The world economic landscape of 2010 is very different than that of 2000 and it is different not only because of the success of other countries but because of a failure of the United States to conduct itself with the seriousness and purpose of a Great Country with Great Responsibilities.  Americans made great errors in policy and consequently suffered economic setbacks and financial panics at their own hands. 
 
The world economic scene that will be before us in 2020 is now being set.  If the U.S. returns to the theme of national growth and development and of limited government and free markets, it will prosper and retain its position in the world.  If it continues down its current road of excesses and imbalances and of expansive government and interferences and controls on the economy, it will find itself falling ever behind a roaring world economy dominated by the rapidly expanding economies of Asia, Africa and Latin America.
 
The choice is up to the Americans.

Poverty Progress, Poverty Persevering and Poverty Surmounted by God's Grace

The Census Bureau recently released updated data relating to living conditions in the United States detailed by households classified by age, sex, race and income level. Included are tables relating to the stock of household consumer durables in 2005 for poor families that can be compared with similar data for previous years.

When taken together with statistics relating to cash and non-cash income, the data on household living conditions present a picture of a long-term improvement in the level of living of some of the poorest segments of the U.S. population. According to the latest data, the consumer wealth position of many poor families has improved markedly in recent decades, with the percentage of poor households with washing machines, clothes dryers, dishwashers and other consumer durables rising significantly over the course of the past two decades. Almost half of all poor families now have cell phones and more than 70 per cent have one or more cars.

While the overall poverty rate based on cash income has at times risen during downturns in the economy, there has nonetheless been a longer-term downward drift in the percentage of American families living below the official poverty line, especially among the elderly. This overall improvement does not even consider the effects of the significant expansion in non-cash income maintenance programs not included when assessing poverty status, such as food stamps, housing benefits and health care subsidies. These have contributed significantly to raising the level of resources available to the poor. In longer-term perspective, broad trends in cash income, non-cash benefits and household consumer wealth would indicate that the real income of the poor has risen significantly in recent decades.

All this does not mean the problem of poverty has gone away or is going away. Far too many Americans continue to live in poverty and efforts to reduce it must continue. It must also be recognized that many remaining groups that suffer from poverty and its consequences, such as the elderly, the disabled, and the mentally ill, represent core segments of the population where poverty is not going to be reduced simply by an improved economic environment, a lower unemployment rate, or traditional government programs intended to improve job skills and prepare people for the workplace. It will take special efforts over a very long period of time to reduce the level of poverty in core poverty groups, especially greater efforts by non-governmental organizations such as churches and charities. To this end, each of us should focus more on what we can do to lift others and encourage churches and charities to expand their work of service to people who by their very circumstances cannot work themselves out of poverty and require special help tailored to their individual circumstances.

As Christmas approaches we should pause and give thanks that we live in this country at this time in history and recognize that our bounty comes not from our own hands but from the grace of the God, who placed us here where the little we do is multiplied by His Hand through the efforts of others and the inheritance we received from our forefathers. Had we lived even a century ago in the same place and worked twice as hard as we do today, we would nonetheless live below the poverty line we now use to identify the very poor. Were we living today in one of the least developed countries and worked three times as hard as we do each day, we would nonetheless barely survive with little in the way of food and shelter and clothing and nothing in the way of opportunities, health care and the other services we take for granted. Our efforts, taken alone, count for nothing.

The Bible tells us that it is not of our works that we are saved (Eph. 2: 8-9). It is equally true that it is not by our works that we are materially blessed. It is always His incomprehensible grace that defines this life and the life to come, and we should be grateful and give thanks to He Who gave us life, placed us in the here and now, and blessed us with all we have (Act 17: 26).

Martin Feldstein on the dollar

LW: Harvard economist Martin Feldstein argues that even though the US dollar is losing its status as the world's principal "reserve currency", it has a bright future as an "investment currency". The large foreign exchange holdings held by some central banks, he argues, are not reserves in the traditional sense. In reality they are investment funds, albeit "investment funds that also deter attacks by forex speculators".

“It is prudent for any country with large foreign exchange balances to diversify those funds. It is not surprising then that countries such as China and Korea are diversifying away from dollars, primarily into euros.

That diversification cuts demand for the dollar, putting pressure on its value. Market participants should see this as a natural consequence of the shift of foreign exchange balances from liquid dollar emergency reserves to longer-term multi-currency investment portfolios. But even as countries diversify away from exclusive reliance on dollars, the dollar will continue to be the main form of liquid investment for countries around the world.

As this portfolio rebalancing comes to an end, demand for dollars will stop falling. At the same time, the dollar's reduced value will shrink the US trade deficit, reducing the annual supply of dollars. This stronger demand for dollars and reduced supply can end the dollar's decline. What looks like a crisis of confidence in the dollar as a reserve currency is just part of the evolutionary process that will eventually halt the dollar's decline.”

Martin Feldstein, "The dollar's fall reflects a new role for reserves", Financial Times (10 December 2009).

http://www.ft.com/cms/s/0/0b0ad07c-e50f-11de-9a25-00144feab49a.html

Martin Feldstein (1939-) was from 1972 to 2008 President and CEO of the National Bureau of Economic Research (NBER), except for the period 1982-1984 when he was President Reagan's chief economic adviser. He is currently George F. Baker Professor of Economics at Harvard University, where he has taught for decades.

LW: Nothing can go on forever, certainly not the decline of the dollar, but I am not confident that the process of adjustment will be so easy. The implication of Feldstein's line of reasoning is that central banks will choose to invest only a small amount of their foreign exchange in US treasury bills. What will happen to US interest rates - and the cost of financing the massive US public debt - as Asian central banks dump US treasury bills? Big sums are involved. As Feldstein notes, Thailand holds foreign exchange assets of $100 billion, South Korea $200 billion, Taiwan $300 billion, and China more than $2,000 billion.

DOW: Like Larry, I am not at all confident that the adjustment process will be at all easy. The U.S. (and, indeed, many other countries, most notably, China) have for several decades built their economies on the basis of a set of exchange rates and expenditure patterns that have been and continue to be in a state of fundamental disequilibrium. During these years, patterns of production and employment and consumption and capital formation have adjusted to the prevailing network of trade relationships, including large and on-going financial inflows and outflows from one country to another that are no longer sustainable.

Rebuilding these economies -- and that is what needs to be done -- will take time and involve a large-scale reallocation of productive resources from present patterns of use as some countries expand their exports by increasing the range of products they sell on world markets and other countries shift their production toward their home markets. Employment levels and real incomes will be reduced, at least initially, as workers in some lines of production are transferred to other activities in a process of change fraught with the possibility of permanent loss of livelihood. Changes to exchange rates and terms of trade will affect every individual, and the growth of the world economy is likely to be slower during the adjustment process than it otherwise would have been.

For the U.S. and China very large changes are needed to create patterns of production and spending and exports and imports that are compatible with a rapidly growing world economy. Fortunately, in the case of the U.S. it is a very large economy with a history of great adaptability. Difficult as they may be, the U.S. is likely to weather these changes much better than smaller and less adaptable economies. In the case of China it is difficult to predict how it may fare as the process of adjustment intensifies but there certainly are reasons to believe it can succeed in restructuring its economy.

No one should underestimate the difficulty of the adjustment process that must be undertaken and its importance for the future of the world economy. A changed role for the dollar is only one of them. Feldstein mentions and Larry notes the very large sums involved on the financial side of any adjustment that might take place in portfolios. Equally large adjustments would then be required on the real side to bring about any adjustments on the financial side.

We are only at the beginning of what could be a long and difficult period of adjustment to a very changed world economy.

Thanks to Larry Willmore for the Tdj.

Macaulay on the past, present and future in our eyes

“[I]n spite of evidence, many will still image to themselves the England of the Stuarts as a more pleasant country than the England in which we live [in 1848]. It may at first sight seem strange that society, while constantly moving forward with eager speed, should be constantly looking backward with tender regret. But these two propensities, inconsistent as they may appear, can easily be resolved into the same principle. Both spring from our impatience of the state in which we actually are. That impatience, while it stimulates us to surpass preceding generations, disposes us to overrate their happiness. It is, in some sense, unreasonable and ungrateful in us to be constantly discontented with a condition which is constantly improving. But, in truth, there is constant improvement precisely because there is constant discontent. If we were perfectly satisfied with the present, we should cease to contrive, to labour, and to save with a view to the future. And it is natural that, being dissatisfied with the present, we should form a too favourable estimate of the past.

In truth we are under a deception similar to that which misleads the traveller in the Arabian desert. Beneath the caravan all is dry and bare: but far in advance, and far in the rear, is the semblance of refreshing waters. The pilgrims hasten forward and find nothing but sand where an hour before they had seen a lake. They turn their eyes and see a lake where, an hour before, they were toiling through sand. A similar illusion seems to haunt nations through every stage of the long progress from poverty and barbarism to the highest degrees of opulence and civilisation. But if we resolutely chase the mirage backward, we shall find it recede before us into the regions of fabulous antiquity.

It is now the fashion to place the golden age of England in times when noblemen were destitute of comforts the want of which would be intolerable to a modern footman, when farmers and shopkeepers breakfasted on loaves the very sight of which would raise a riot in a modern workhouse, when to have a clean shirt once a week was a privilege reserved for the higher class of gentry, when men died faster in the purest country air than they now die in the most pestilential lanes of our towns, and when men died faster in the lanes of our towns than they now die on the coast of Guiana. We too shall, in our turn, be outstripped, and in our turn be envied. It may well be, in the twentieth century, that the peasant of Dorsetshire may think himself miserably paid with twenty shillings a week; that the carpenter at Greenwich may receive ten shillings a day; that labouring men may be as little used to dine without meat as they now are to eat rye bread; that sanitary police and medical discoveries may have added several more years to the average length of human life; that numerous comforts and luxuries which are now unknown, or confined to a few, may be within the reach of every diligent and thrifty working man. And yet it may then be the mode to assert that the increase of wealth and the progress of science have benefited the few at the expense of the many, and to talk of the reign of Queen Victoria as the time when England was truly merry England, when all classes were bound together by brotherly sympathy, when the rich did not grind the faces of the poor, and when the poor did not envy the splendour of the rich.”

Thomas Macaulay, History of England (1848), Chapter I, “On the State of England in 1685”.

http://www.margaretmorgan.com/wesley/state.html

Thomas Babington Macaulay, 1st Baron Macaulay PC (1800 – 1859) was a British poet, historian and Whig politician who wrote extensively on British history. Space and time do not permit this man’s accomplishments in support of the Anti-Slavery Society, the widening of the franchise, and his work as an historian.

Two things bring Macaulay to mind. The first is a recently written screed against this fine and good man (Robert E. Sullivan, Macaulay: The Tragedy of Power (Belknap/Harvard)) and the second is the constant whining about the state of the world economy and its prospects for the future.

On the man, Macaulay is accused by Sullivan of being a hypocrite and a liar, at once a man of faith and a skeptic, and a stern moralist in an incestuous relationship with his sisters. Suffice it to say that all the so-called evidence assembled against this man reeks of contemporary judgments imposed on a man who lived in a very different world from today. Macaulay was tolerant and liberal at a time when few were tolerant and liberal, he suffered not from a weakness of faith but from an expansive view of it, and he was imbued with upper-middle-class Victorian sentimentality that showed in a deep love for his family. If the average man today were half as good as Macaulay, the world would be a much better place.

On the world economy, we live at a time when there is almost no understanding of the tremendous progress that has been made over the poverty and squalor that defined earlier times for all people. Only a few centuries ago it is literally true to say that almost every man, woman and child on this earth lived a precarious existence in which every day was fraught with the possibility of starvation and injury leading to death.

The dimensions of the economic progress mankind has made since 1750 are reflected in the enormous gains recorded in population, production and productivity across the entire globe. The Earth can now support a much higher population at a much higher level of living than any previous epoch in human history. Its habitable area has been extended greatly and huge new areas have been opened to the cultivation of food and the extraction of raw materials, of which there seems no limit. The exploration of the moon, planets and stars has begun and, in an answer to dreams from time immemorial, Man walked on this planet’s nearest celestial neighbor. The study of space and contribution it can make to improving human welfare has begun in earnest and promises great benefits to mankind. The deep oceans now contribute greatly to meeting Man’s everyday needs. Most importantly, there is not one area of the world that has not gained from the progress mankind has made during this extraordinary period of world history.

In longer-term perspective, all this progress has taken place without any direction by government and without any single individual person or people coordinating or directing the economic affairs of mankind. For practical purposes, our past economic rise has been spontaneous. All that has been necessary is to leave people free to conduct their own affairs as they wish and they, in their own way and subject to a sensible and equitable rule of law, made the connections one to another that were required to advance their own welfare. In doing so, they advanced the common welfare of all of us by increasing the bounty that comes when each one of us raises his own productivity. That is how free markets work, and it is the lesson learned by the fall of the Soviet Union and the abandonment of central planning by other socialist countries.

Yet right now a meeting takes place in Copenhagen where speeches are given that deny the progress anyone with eyes can see. They challenge the idea that progress can continue when they know a huge swath of the world’s poorest countries continues to grow rapidly in the midst of a deep downturn in the rest of the world economy. Those countries performing best are precisely those that adopted the market mechanism after decades of mounting problems traced to centralized planning.

Here at home there is the insistent cry that some people lag and do without that which there is every indication will become available to all by a continuing prosperity linked to the economic freedoms this country has enjoyed since its founding. Blind to the source of our prosperity and progress, some issue loud and insistent calls for greater concentrations of power Washington and stronger leadership by small groups of people, namely them, who constantly complain they do not have enough power to deal with problems many of us simply do not believe are real problems to be solved by government. If we were to vest them with greater power through government, what reasons do we have that they will perform better than generations of free individuals acting on their own? Why should we believe that government will work selflessly and smartly to improve our lives if we turn over our future to them?

A free people acting through free markets have lifted the stark poverty of the past off our shoulders. As Macaulay tells us, the past was one of great privation and short life. We should not look back upon it with nostalgia. Nor, as we consider the difficulties and challenges of the moment, be it the possibility of global warming or the need for wider access to health care, should we abandon the market-oriented and limited government principles that have served us so well in the past.

John Stuart Mill on growth and distribution

“It is only in the backward countries of the world that increased production is still an important object; in those most advanced, what is economically needed is a better distribution.”

J. S. Mill, Principles of Political Economy (1848).


LW: The new AEA 2010-2011 Economists Calendar, which just arrived, highlights a dead economist each month, with selected quotations from his published works. (Only one of the featured economists - Joan Robinson - is a woman.) The above quote from John Stuart Mill, for May 2011, caught my attention.

Is it not remarkable that more than a century and half ago, Mill saw no reason for economic growth - increased production - to be a priority in economically advanced countries? The compilers of this calendar have done a splendid job, and remind us that Mill's “Principles of Political Economy (1848) was the standard text in economics at Oxford until 1919, when it was replaced by Marshall's Principles". All the selected quotes, due to space constraints, are necessarily brief. It helps to place this one in context, so I provide a longer, more complete quote below.

“It is only in the backward countries of the world that increased production is still an important object: in those most advanced, what is economically needed is a better distribution, of which one indispensable means is a stricter restraint on population. Levelling institutions, either of a just or of an unjust kind, cannot alone accomplish it; they may lower the heights of society, but they cannot, of themselves, permanently raise the depths.

On the other hand, we may suppose this better distribution of property attained, by the joint effect of the prudence and frugality of individuals, and of a system of legislation favouring equality of fortunes, so far as is consistent with the just claim of the individual to the fruits, whether great or small, of his or her own industry. We may suppose, for instance (according to the suggestion thrown out in a former chapter), a limitation of the sum which any one person may acquire by gift or inheritance, to the amount sufficient to constitute a moderate independence.”

John Stuart Mill, Principles of Political Economy (1848), book 4, chapter 6.

http://socserv2.socsci.mcmaster.ca/~econ/ugcm/3ll3/mill/prin/book4/bk4ch06

Mill was an outstanding political economist, and his prose does not seem dated even today. Note the influence of Malthus, however, in his call for restraint on population growth.

DOW: For a quick comparison, according to Angus Maddison, a well-respected economic historian, measured in approximate purchasing power parity the average real GDP per capita of the United Kingdom in 1850 was about 8 to 10 per cent of that of the U.S. today.

I don’t think too many people today would be content to live on a small fraction of their present real income and would want to promote economic growth to raise it.

Having said that, Mill is right that to emphasize the need for a better distribution of income, a problem that remains with us to this day. And in my view he is right to see huge intergenerational transfers of unearned income and wealth as something to limit to improve that distribution.

Thanks to Larry Willmore for this Tdj.

An imaginary award for a forgotten economist

"At the Heavenly Models home for deceased economists, an award is being presented to the resident whose work best explains financial crises, global warming, and other pressing issues of today. The favored candidates include John Maynard Keynes, the patron saint of stimulus programs; Hyman Minsky, an American disciple of Mr. Keynes who warned about the dangers of financial deregulation; and Milton Friedman, the late Chicago economist. (Mr. Friedman's free market principles are out of vogue, but Federal Reserve Chairman Ben Bernanke recently took his advice on how to prevent depressions by pumping money into the economy.)



Arthur Cecil Pigou in 1943.
Ramsey and Muspratt Collection





The winner's name, however, turns out to be much less familiar: Arthur Cecil Pigou. Stepping from the wings, a strapping Englishman with fair, wavy hair and a luxuriant moustache, smiles awkwardly and accepts his prize. A contemporary of Mr. Keynes at Cambridge University, Mr. Pigou was, for a long time, the forgotten man of economics. In the years leading up to his death, in 1959, he was a reclusive figure, rarely venturing from his rooms at King's College. His novel ideas on taxing polluters and making health insurance compulsory were met with indifference: Keynesianism was all the rage.

Today Mr. Pigou's intellectual legacy is being rediscovered, and, unlike those of Messrs. Keynes and Friedman, it enjoys bipartisan appeal. Leading Republican-leaning economists such as Greg Mankiw and Gary Becker have joined Democrats such as Paul Krugman and Amartya Sen in recommending a Pigovian approach to policy. Much of President Barack Obama's agenda—financial regulation, cap and trade, health care reform—is an application of Mr. Pigou's principles. Whether the president knows it or not, he is a Pigovian."

John Cassidy, "An economist's invisible hand", The Wall Street Journal (28 November 2009).

http://online.wsj.com/article/SB10001424052748704204304574545671352424680.html

John Cassidy is a staff writer at the New Yorker.


Arthur Cecil Pigou (1877 – 1959) was a Cambridge University professor and successor to Alfred Marshall. He trained and influenced many Cambridge economists who went on to fill chairs of economics around the world. One of his students was John Maynard Keynes. Pigou and Keynes had great affection and mutual regard for each other and their intellectual differences never put their personal friendship seriously in jeopardy.

Interestingly, in his General Theory of Employment, Interest and Money (1936), which ushered in The Age of Keynesian Economics, Keynes held up Pigou's Theory of Unemployment (1933) as the example of everything that Keynes claimed was wrong with Neoclassical macroeconomics. Pigou responded critically to his student's attack but mainly because he viewed it as an attack on Marshall rather than on him. Pigou later expressed appreciation for Keynes' work and said he failed to appreciate the important points Keynes was trying to say.

As an economist, Pigou made many contributions. Among the most important for which he is remembered today is the concept of "externalities", the uncompensated spillover effects of one person's actions on another. When positive or negative externalities are present prices do not reflect the full costs or benefits associated with production or consumption. Examples of positive externalities are beekeepers whose bees pollinate someone else’s crops or education that results in people who are less likely to engage in violence or crime, benefiting everyone. Negative externalities are pollution of all kinds, overfishing the sea to the point of extinction, or an underfunded pension fund that pushes costs to others. Man-made global warming, assuming it is real, is an negative externality because pollution costs generated by some people weigh on bystanders who did not create the problem.

Pigou remains important today because of his insights on dealing with externalities. Essentially, Pigou wants to tax or subsidize a market activity so as to bring the private cost in line with the social cost. A Pigovian tax (or subsidy) equal to the per unit cost (or benefit) of the negative (or positive) externality is thought to be an efficient way of achieving this. In response to the change in price, a tax would lower the level of production of the polluting product while a subsidy would raise production of a beneficial product.

Pigou's ideas are liked by liberals because they correct problems created by market failures. They are also liked by conservatives because his suggestions are seen as more efficient than direct regulations because they rely on market forces rather than government controls to correct what are acknowledged to be real problems.

When addressing problems of pollution or carbon emissions one alternative to Pigovian taxes is the creation of a market for "pollution rights" such as the "cap and tax" approach to emissions trading now under consideration by the Congress and pushed by international agencies. In general, pollution rights markets are seen as more complex and less efficient than Pigovian taxes. But to politicians pollution rights markets are more appealing than Pigovian taxes because policy makers can give their supporters "rights to pollute" for free or otherwise control their allocation. Pigovian taxes, on the other hand, say any producer can produce the product if it is willing to pay the tax and has the added advantage of providing incentives to reduce pollution and costs of production. Politicians can collect a Pigovian tax but unlike “cap and trade” they cannot favor their friends and supporters over others.

For this reason, no one should be surprised that politicians in Congress and international bureaucrats in New York prefer the "cap and trade" approach over Pigovian taxes. And, unfortunately, despite the recent resurrection of Professor Pigou and his ideas, that would seem to be the direction in which energy policy is headed.

A fable for Copenhagen

“A fox, caught in a trap, escaped by tearing off his bushy tail.

After that, the other animals mocked him, making him feel so ashamed that his life was a burden to him. He therefore worked out a plan to make all the other foxes the same as him, so that in their common loss he might better conceal his own deprivation.

He called a meeting of foxes. A good many came to it, and he gave a speech, advising them all to cut off their tails. He said that they would not only look much better without them, but that they would get rid of the weight of the brush, which was a very great inconvenience.

But one of them interrupted his speech.

“If you had not lost your own tail, my friend,” that fox said, “you would not be giving us this advice.”

Aesop 6th century BC

Let us hope that the alpha-male US fox, at the forthcoming meeting of all the foxes in Copenhagen in December 2009, remembers this fable, and understands its meaning, when listening to the pleas of all those foxes from Continental Europe who have already cut off their own tails, and now beg those that are yet not disfigured to mutilate themselves likewise.

If the big US fox is insufficiently smart to heed the fable, one can rest assured that the smarter foxes from India and the People’s Republic of China will prove to be adept at retaining their brushes so that they can mock and humiliate the now incredibly shrinking, debrushed US fox.”

Charles K. Rowley, “The Fox Who Had Lost His Tail”, Charles Rowley’s Blog (6 December 2009).


Charles K. Rowley is Professor of Economics at George Mason University, Director of the Program in Economics, Politics and the Law at the James M. Buchanan Center for Political Economy and General Director of The Locke Institute. Professor Rowley received his doctorate from the University of Nottingham in 1964.

The United Nations Climate Change Conference is scheduled to begin tomorrow, 7 December, in Copenhagen, Denmark, for two weeks of talks aimed at concluding an agreement that would enter into force after the first phase of the Kyoto Protocol expires in 2012. The meeting will bring together 15,000 delegates and officials, 5,000 journalists and 98 world leaders, 1,200 limos and 140 private jets. The extraordinary carbon footprint of the meeting (roughly, Morocco’s annual carbon emissions) is likely to be its most lasting legacy to the world.

In his most foolish promise, President Obama has said he will pledge the United States to lower its emissions of carbon to a level 85 per cent below those of 2005. This would bring the level of American emissions to those of 1910, which, given the much higher expected level of population in 2050, means the per capita U.S. emissions would be about those of 1875. As Professor Rowley mentions, the U.S., like the fox who lost his tail, is trying to convince other countries to follow its imprudent lead and cut their emissions in like manner. No doubt the President knows it is better to look stupid among a group than all alone.

In their wisest decision, while pledging some cuts, China and India and other developing countries have chosen not to follow the U.S. in draconian cutbacks in their energy use. Even more wisely, they are waiting for Western commitments to boost development aid linked to efforts to reduce greenhouse gas emissions and for specific steps to transfer clean energy technologies to developing countries for free.

The President is pushing hard for an agreement in Copenhagen. Even with his pledge for the U.S. to do the impossible and the sense of urgency he tries to convey about the need for an agreement, a legally binding treaty will not emerge from the talkfest. Too many matters remain in disagreement, not the least of which is how to monitor and enforce any international climate treaty. At best, the President may get a “political agreement” that kicks any attempt to get a real agreement to next year.

Even then, the recent leaking of vast numbers of e-mails and other documents relating to the temperature profile of the earth have now called into question the quality of the data underlying the claims of climate change. Any international agreement on climate change may have to await a much more careful reassessment of the earth’s climate history, and this may well take decades.

If one were to place blame for the failure of the climate change talks, it would be on the United Nations Secretariat. Throughout the many years the problem of climate change has been on the agenda of the international community the work of the Secretariat has been inconsistent with that of an “neutral broker”. It has used its influence to move the debate about climate change in the direction of those with an political agenda to push and a willingness to hide and distort the data on which critically important decisions must be made.

Simply stated: The United Nations is supposed to be a neutral facilitator, not a decision-making body. Serious discussions and important negotiations cannot be carried out when those charged with providing an honest appraisal of facts fail to do so and, worse, set a tone and direction in favor of one side over another. In the case of the climate change discussions, the UN became a cheerleader for man-caused global warming before all the facts were in. Even if in the end it proves to be right in its conclusions, the UN nonetheless failed in its main task of providing an unbiased forum for international discussions of contentious issues.

The policy dilemma before the President

“The problem for the President [when crafting economic policy] is that there are tensions among these problems.

Accelerating GDP and job growth requires big fiscal or monetary stimulus. The Fed has the dial set to 11, so fiscal stimulus is all that’s left. As a policy matter, a big new stimulus program would substantially further increase at least the short-term deficit and take at least a few months to even begin to have an impact. As a political matter, the Administration has poorly managed stimulus implementation and communications to the point that even they are afraid of the word “stimulus.” The President’s communications and political advisors are, I imagine, groaning at the thought of the President’s policy answer to slow job growth being another stimulus. Then again, they’re probably panicked about another year of 9+% unemployment.

Getting serious about budget deficits requires some combination of big spending cuts and/or big tax increases.

• While Congressional Republicans are almost never able to muster the votes for big spending cuts, at least they’re generally willing to talk about them as the preferred solution. (How’s that for faint praise?) I have seen no indication that the President or any of his allies (except House Majority Leader Steny Hoyer) are willing to significantly slow the growth of spending. To have a measurable effect on the long run spending problem, one has to address demographics and health care cost growth in Medicare and Medicaid. But Director [Peter] Orszag routinely ignores demographics in his presentations, arguing the long-run problem is only about health care costs. The President and his allies have lowered their long-term fiscal goal for health care reform to only slight improvements in our deficit picture. Even those small improvements are contingent on wildly optimistic assumptions about future Congressional behavior.

• That leaves tax increases. The Administration already has baked into their projections revenue gains from allowing the top rates and capital tax rates to rise. Getting a lot more revenue (measured in percentage points of GDP) requires either returning to pre-Reagan tax rates or a new source of revenue. Q1: Will the President propose a new value-added tax (VAT), which would raise taxes on all consumers and break the President’s pledge? Q2: Will he instead propose a new business activity tax (BAT) which would have similar effects but which he could claim taxes businesses rather than individuals?

• As worried as the President’s Congressional allies might be about the policy and political impacts of dangerous deficits, it’s hard to imagine them preferring to spend election year 2010 pushing for big spending cuts or big tax increases. I imagine they’ll be looking for ways to punt.

The scheduled automatic tax increases pose another conundrum. On the one hand, they need the revenues to prevent future deficits from being even worse than projected. On the other, if the economy is still soft at the end of 2010, tax increases are counterproductive. …

Within the White House the budget process is almost certainly driving these decisions. In my experience, most big Presidential budget decisions take place in November and December, to be rolled out in the State of the Union address and the release of the President’s Budget in the first week of February.”

Keith Hennessey, “The President’s 2010 challenges: Jobs, deficits, and taxes”, KeithHennssey (3 December 2009).

http://keithhennessey.com/2009/12/03/2010-challenges/

Keith Hennessey was Assistant to the President for Economic Policy and Director of the National Economic Council under President George W. Bush. It is the position now held by Lawrence Summers under President Barack Obama. His blog was recently named by the Wall Street Journal as one of its “Top 25 Economics Blogs”.

The economic situation before the country and the President may be summarized as follows: The real economy remains in a precarious state at what is hoped is the start of at least a weak recovery, with growth forecast by the Administration to reach a pace of 2 to 3 percent next year; Unemployment is at 10 per cent of the labor force and expected to remain above 9 per cent through 2010; Inflation is low, but an upturn in the world economy could spark international commodity price inflation, which could be transmitted to the domestic economy, especially given the excess reserves in the banking system and even a weak upturn at home; Bank failures continue to describe the state of the country’s banking system; The dollar is sinking on foreign exchange markets; and The Administration projects a budget deficit for 2010 equal to almost 10½ of the GDP with an unsustainable average budget deficit exceeding 5 per cent of the GDP for the foreseeable future.

The Administration’s forecasts for a recovery and the deficit are predicated on optimistic assumptions. Those prepared outside the Administration are more pessimistic and while a second deep recession -- a recession within a recession -- is not predicted at this time neither can it be ruled out and it could be triggered at any time by developments in financial markets that remain in turmoil at home and abroad.

Into this mix of troubles can be added the uncertainties and irrationalities of the President’s own policy aspirations. The health care and energy legislation that have been proposed continue -- nay, accelerate -- the policy drift toward unbridled government spending that has described most of the post-World War II period. His policy priorities, like those of his predecessors, only worsen the fiscal and trade imbalances that must be eliminated to restore the possibilities for rapid growth to the U.S. economy and with it the world economy. While wanting to help the economy, his policies only make things worse.

Given the immensity of the crisis that befell not just the U.S. economy but the world economy, one would have thought that policy makers would understand that short-term fixes to a financial calamity in one country, even one as large as the United States, cannot restore the foundations of a worldwide prosperity that have been eroding for decades. The world now requires -- this country especially -- a fundamental adjustment of its patterns of production, spending and international trade that can sustain themselves without causing huge deficits and surpluses in government and external accounts. There is nothing in the policy alternatives summarized by Mr. Hennessey, as he points out, which really address longer-term problems.

Even more incomprehensible is continuing down a policy road of unrestrained spending that is the very cause of the internal and external deficits at the root of the crisis in which we find ourselves.

Mr. Hennessey has set forth the nasty policy choices now before the President. Let me suggest that unless the President and the Congress abandon the policy priorities they have championed since his inauguration, the long-term performance of the economy will continue to deteriorate and the policy dilemmas the country faces in the future will become even more nasty .

Institutions and economic growth

“How do we know that institutions are so central to the wealth and poverty of nations? Start in Nogales, a city cut in half by the Mexican-American border fence. There is no difference in geography between the two halves of Nogales. The weather is the same. The winds are the same, as are the soils. The types of diseases prevalent in the area given its geography and climate are the same, as is the ethnic, cultural, and linguistic background of the residents. By logic, both sides of the city should be identical economically.

And yet they are far from the same.

On one side of the border fence, in Santa Cruz County, Arizona, the median household income is $30,000. A few feet away, it's $10,000. On one side, most of the teenagers are in public high school, and the majority of the adults are high school graduates. On the other side, few of the residents have gone to high school, let alone college. Those in Arizona enjoy relatively good health and Medicare for those over sixty-five, not to mention an efficient road network, electricity, telephone service, and a dependable sewage and public-health system. None of those things are a given across the border. There, the roads are bad, the infant-mortality rate high, electricity and phone service expensive and spotty.

The key difference is that those on the north side of the border enjoy law and order and dependable government services — they can go about their daily activities and jobs without fear for their life or safety or property rights. On the other side, the inhabitants have institutions that perpetuate crime, graft, and insecurity.”

Daron Acemoglu, "What Makes a Nation Rich? One Economist's Big Answer", Esquire, 18 November 2009.

http://www.esquire.com/features/best-and-brightest-2009/world-poverty-map-1209

LW: MIT economist Daron Acemoglu argues that differences in institutions are the reason residents of countries like Canada and Japan enjoy incomes that are much higher than those in countries like North Korea or Ethiopia.

This reasoning is appealing. But institutionalists like Acemoglu, it seems to me, attempt to explain too much. The definition of 'institutions' tends to encompass everything - even schooling and health. The problem is that numerous variables vary by degree of development. Suppose, for example, that I believe that schooling is the key to development. Then, I might argue that income differences between Nogales, Arizona and Nogales, Mexico are due solely - or at least primarily - to differences in educational levels. We could test this hypothesis, by bringing the schooling of all residents of Nogales, Mexico, up to the levels of Nogales, Arizona. But such experiments are not feasible in the social sciences. We would like to explain one variable - per capita income - but we have a wealth of potential explanatory variables. In statistical terms, the model is 'overdetermined': there are more explanatory variables than there are unknowns, and the explanatory variables themselves are correlated.

Bill Easterly argues that the only honest answer to the question "What makes a nation rich?" is "We don't know". I agree.

Thanks to Paul Romer for the pointer. Check out his favourable review at http://chartercities.org/blog/85/daron-acemoglu-on-global-inequality

DOW: I, too, agree with Professor Easterly that we simply do not know what makes a country rich. But let me reverse the question: Do we know what makes a country poor?

I would say we do, more or less, and we can cite reasons why a country is poor, not the least of which is that it lacks good institutions, especially property rights and basic personal security and a way to transmit learning from one generation to the next. But, let us admit, institutions are not enough and there is no single list we can give that would define the essential requirements for growth and development.

More interesting is the question what makes a rich country poor?

In the case of the U.S. the answer to that question may well be an inability to live within one’s means and what would seem to be ever widening internal and external deficits and a never ending accumulation of nation debt.

A tip of the hat to Larry Willmore for this Tdj.

China’s surplus capacity

“In China's current development model, household income is taxed to support corporate profits. Corporations now generate more than half of China's huge savings. Since consumption tends to grow more slowly than GDP, excess capacity can only be used up via yet more investment or exports. This year, economic crisis has made the latter impossible. But China desperately needs to expand its exports once again. The result may well be a crisis in the trading system.

China's trading partners have to engage with the rising giant. They must explain that they cannot – and will not – absorb the surplus capacity its heavily distorted model of development is creating. But they can point out that this pattern also damages the standards of living of ordinary Chinese. China has to shift income from its corporations to its households and spending from investment to consumption. What is needed for that is a massive structural reform. This must start now. Indeed, it may already be too late.”

"The cost of China's excess capacity", Financial Times (30 November 2009).

http://www.ft.com/cms/s/0/a75ade98-dd14-11de-ad60-00144feabdc0.html

LW: China continues to promote savings and investment at the expense of consumption. As a consequence, domestic demand is low and there is unused capacity throughout the economy. This policy is costly for the Chinese people and threatens producers in the rest of the world. Consider steel, for example. At the end of 2008, Chinese plants were capable of producing 660 million tonnes of steel, but demand was only 470 million tonnes. The difference of 190 million tonnes was nearly as large as the entire output of the European Union in 2008. (www.eurofer.org/index.php/eng/Facts-Figures/Figures/EU-Crude-steel-production ) Despite this low 72% rate of capacity utilisation, investments are underway to add an additional 58 million tonnes of capacity.

DOW: As mentioned in a post on the RSG Faculty Blog, and as was discussed earlier at a Regent Forum, huge global imbalances threaten the stability of the world economy, with China and the United States at the center of the problem. It was emphasized that difficult adjustments were required on the part of both countries if patterns of production, consumption, employment, and trade were to be made consistent with a stable foundation for long-term growth in these countries and the wider world. Unfortunately, as indicated here and in the other blog post nothing has been done in the way of an adjustment to more sustainable growth. The Financial Times may well be correct when it says it may already be too late for China to avoid a significant downturn, and if China’s economy turns down the rest of the world will likely follow.

Thanks to Larry Willmore for this Tdj.