Capitalism, Socialism and other terms to be avoided

Capitalism is a term coined, or at least popularised, by the enemies of the system they labelled capitalism. It was understood from the start to have a pejorative connotation and the term’s use is still dominated by that pejorative connotation. Despite the efforts of supporters of capitalism-so-labelled to reclaim capitalism as a positive, or at least neutral, label; particularly based on historical experience.

One should always be wary of any term where the pejorative element built in. Even if you somehow do not let the pejorative element infect your own thought, it is going to be there in the mind of many, often most, readers.

Socialism is a term coined, or at least popularised, by the proponents of the system they labelled socialism. It was understood from the start to have a positive, indeed overwhelmingly positive, connotation and its use is still dominated in many quarters by that positive connotation. This despite the efforts of the opponents of “socialism” to give it thoroughly negative connotations, particularly based on historical experience.

Capitalism has at least has some vague consensus on what the term means. Socialism does not even have that, as recent American politics has demonstrated, thanks to the attempts of Sen. Bernie Sanders, self-proclaimed socialist, to win the Democratic Party nomination for President of the United States.

Capitalism has some vague consensus regarding what the term means because almost everyone agrees that there is currently, and has been, a lot of it. Apart from some labelling of command economies as state capitalism, there is a general consensus that we more or less know capitalism when we see it.

There is no such consensus around socialism, mainly because socialists typically want to dissociate the term from every command economy that has ever operated, or patent embarrassments such as Venezuela. Conversely, the enemies of socialism what to hang every command economy that has ever operated, and embarrassments such as Venezuela, on any use of socialism.

If socialism has never been “really” tried, then it can never have failed. Or if there is this new form or conception of socialism that has never been tried, then clearly it has nothing to do with any command economy that has ever operated, or any embarrassment such as Venezuela.

Of course, one might suspect that this attempt to constantly separate socialism from history might be a bit of a warning sign. Especially if folk want to play the game of comparing the ideal of socialism (carefully separated from history) with the practice of capitalism (often using carefully edited, selected or re-construed bits of history).

For me, there is a simple solution. Avoid, as much as possible, using either term. Then you can at least aspire to some analytical rigour.

Other possibilities

That does not remotely foreclose considering new social possibilities. It just means trying to do so with some analytical precision without dragging along the deadweight of fraught ideological conflicts.

Moreover, contemplating the social possibilities that do not seem to be much explored can be a very useful exercise. To consider the dogs that don’t bark in the night.

If not separating workers from the product of their labour, or simply having the workers in charge, is such a fine thing, one might think that would be entirely possible to set up worker-controlled companies. Then the non-alienated, self-controlled workers might be expected to produce so well that they can outcompete capital-owned firms in the market place.

Of course, if your notion of alienation covers any attempt to produce for exchange, then even in a worker-controlled firm workers will be alienated from their labour. Of course, not producing for exchange then reduces Homo sapiens to the economic level of every other species on the planet. One might consider the possibility that producing for exchange permits the scaling up of production and consumption far more extensively or efficiently than any other way of dealing with the issues of subsistence and surplus. So, perhaps giving up an advantage that may predate our emergence as a species is not a good move.

Let’s assume that something we have been doing for maybe 320,000 years or so (and certainly for 200,000 years), exchanging things we have produced, is not some alienating disaster, and go with worker control is good. Worker-controlled firms is still an entirely possible option. So, why don’t we see far more of such?

What is a firm? A firm is a mechanism for lowering transaction costs and dealing with risk. Do we want to dump risk on to labour or on to capital? Surely, on to capital. So, a labour-controlled firm is going to make the decisions, and is going to need capital, but will also want to dump the risk onto the holders of capital.

So, which firms are going to operate better? Those where control ultimately rests with those who have to deal with the risks or those where control ultimately rests with those who get to systematically dump risk on to others?

Clearly the former. The owners of a capital-owned firm get the residual income from the firm because they also cover the residual losses from the firms.

Moreover, when we say “worker controlled”, which workers? The original workers presumably. But what if you want to hire new staff, do they get the same control rights? Suppose the firm has too many workers, it needs to lay off staff, how do you decide that? What are the dynamics of a group of workers who every so often may have to vote on who gets to be ejected from the firm?

Capital-owned firms solve these problems by essentially having a market in control. The more you are willing to buy in, the more control you have. If you want to leave, you sell your control rights. Decisions about hiring and firing are left with those who are managing the firm. (And firms with mechanisms for workers to become shareholders are still capital-owned firms.)

What about coordination issues as a worker-controlled firm gets bigger?

At this point, we can see why the somewhat Darwinian selection processes of markets select for capital-owned firms and not worker-controlled ones. It is not that worker-controlled firms are illegal, it is that they represent a risk-and-decision profile that no one (including workers) are likely to invest in. The closest we get are partnerships, and they represent human-capital firms, not worker-control.

And about the state

Consider again the question: which firms are going to operate better? Those where control ultimately rests with those who have to deal with the risks or those where control ultimately rests with those who get to dump the risk on to others? Here’s something to conjure with. Is not: a structure where control ultimately rests with those who get to dump the risk on to others, a pretty good description of the state?

People (often with good reason) complain about the socialisation of losses and the privatisation of profits. But that is precisely what an awful lot of state politics is about. Shifting benefits to one group and costs, including risks, to another because the coercive power of the state makes that a game that can be played (and is obviously one with significant potential pay-offs). When one sees risks being shifted from capital to labour, there is generally some state action underlying it.

This is why the term state capitalism has a little bit of purchase behind it. If you squint just right.

In a command economy, the state owns all (or almost all) the capital. So, in a command economy, risk regularly gets dumped by the capital-owning state on to labour. Including risks of mass starvation or environmental degradation. But that is not because capital owns the state, but because the state owns the capital.

Lenin, Stalin, Mao, etc. did not control the state due to their ownership of capital, they controlled the creation and use of capital due to their control of the state. To call such capitalist or capitalism is to get the causal drivers entirely the wrong way around.

So, yes, it is significant that state owns the capital in a command economy. It affects its patterns of behaviour and means there is no significant non-state control of surplus, so no significant basis of institutional resistance to the power of (those who control) the state. But the capital is entirely subordinate to the state. So, the society is not capitalist.

And we are back with avoiding the use of terms so weighed down with emotionally-laden connotations. Because, without those connotations, there would be no incentive to so badly mis-characterise the relevant social, political and economic dynamics.

Firms, Cities, States: who has open borders and why?

This is based on a comment I made here.

Econblogger Robin Hanson notes that firms and cities have open borders and argues that:

So if nations act differently from firms and cities, that should be because either:
1) there are big important effects that are quite different at the national level, than at firm and city levels, or
2) nations are failing to adopt policies that competition would induce, if they faced more competition.
My bet is on the latter.

This comparison is more complicated than it at first appears, but still (it turns out) revealing, if you consider how state behaviour has changed over time.

Firms (at least as employment entities) have highly controlled borders--they have to hire you, you can be fired. They also have expansionary tendencies and can operate across jurisdictions. That is not really open borders as such. Indeed, the harder it is to fire people, the more cautious they tend to be about who they hire (i.e. "let in"). You can buy your way in to a firm as a shareholder, but then you become a risk guarantor. It is a particular form of commercial exchange to which you commit capital.

Cities are ambiguous between jurisdictional entities, which are generally not allowed to control movement of people across their borders, or as some (territorially contiguous) level of density of population, in which case it is not clear exactly what one means by "borders" and who would "control" them.

Source.

City governments do tend to control land use, often in considerable detail, and that has sometimes been used to block the residence of certain groups (pdf). Politicians such as James Michael Curley and Coleman Young have used city policies to drive away folk in order to make their own ethnicity dominant, what economists Edward Glaeser and Andrei Shleifer called the Curley Effect (pdf). The returns to controlling land use are much higher than any returns to controlling population movement as such, so there seems no reason for cities to demand the right to their own border control from states that are not likely to grant it.

States are the only one of the three (firms, cities and states) with hard territorial borders. That is, borders that are policed, that separate entire legal systems, that have no overlapping political authority. (Obviously, some arrangements, such as the European Union, pool a certain amount of sovereignty, but they are exceptional to the normal pattern.)

Leaving aside labour bondage systems (serfdom, slavery, Communism) which, by their nature, have to control exit-movement, states have historically not sought to control inward movement. Indeed, attracting more people meant more tax payers. 

What states have had strong controls over is who gets to control the state. Historically, that has been bitterly defended. It is conspicuous that border controls over inward movement start happening when states start acquiring broad electorates. In particular, working class voters have tended to be strong supporters of various forms of border control. Indeed, generally they still are.

Ceuta border fence.

So, the question is not "why do states control borders?" in the sense of movement across borders, because historically many have not, but "why do working class voters support border control?". That is not a hard question to answer. Especially when the vote is their only significant political leverage and they are the group (unlike migrants and holders of land and capital) who do not gain significantly from migration, indeed, can be net losers from migration, and who are much more reliant than more educated voters on local networks for support and risk management that can easily be disrupted by migration.

So, once we have worked through the what do you mean by borders? question, yes it is about competition pressures and how much capacity working class voters have to push back. But it is the comparison with state behaviour over the long run that is the most revealing, not the comparison with firms and cities.


[Cross posted at Skepticlawyer.]

Thoughts on wage stickiness

Based on a comment I made here.



Nominal wage stickiness is about contracts being written in nominal terms. But, given heterogeneous consumption/investment bundles/preferences, how else could contracts plausibly be written?  Money is not only a (largely "the") transaction good, it is, in effect, the common language of transaction and so of contract -- hence a sort of "network" effect of being the unit, indeed medium, of account where your income contract is tied into your expenditure contracts.

Given utilities and debt contracts are also in the same "language", and given we are social beings very concerned with status and standing (our notions of fairness are often about status while a strong element in bargaining is not losing "standing" for future interactions), there are powerful reasons for wage stickiness. Even when one hires new workers.

Possibly, in earlier times, when many industrial workers were ex-agrarian workers and used to rising and lowering prices for products across seasons, wage flexibility was more acceptable.  But once we got plugged into debt, utilities, etc; not nearly so much.

Broken by the fix

What do the goldzone Great Depression (1929-3?) and the Eurozone Great Recession (2008-?) have in common? They were both created by European central banks with the US Federal Reserve (the Fed) as accessory during and after the fact. (Yes, the monetary shock which set off the Great Recession started in Europe though the responsibility of the European Central Bank [ECB] in that initial shock was a bit more indirect than that of the Bank of France in the Depression; the ECB was much more directly culpable in the subsequent monetary contraction.)

When Nobel laureate Thomas Sargent described the euro as an artificial gold standard he was zeroing in on common features--the goldzone and the Eurozone both being fixed exchange rate systems operating over institutionally divergent countries with limited labour flows, no fiscal union (so no significant fiscal transfers) nor common risk pool otherwise (in the case of the eurozone, no lender of last resort). Having the Eurozone include Mediterranean economies was not (pdf) a monetary union that conventional Optimum Currency Area (OCA) theory supported. While economist Charles Goodhart is quite correct when he points out that OCA theory cannot explain the boundaries of existing currency realms--that being a result of the operation of state power--if OCA theory is seen as providing an analysis of whether currency realms should amalgamate, it turns out to be very powerful, as the travails of the Eurozone are proceeding to demonstrate.

This surprised-by-American-scepticism paper [pdf] by European economists--scepticism largely driven by OCA theory--reads rather differently now. Though labour mobility is supposed to be one of the key differences between the US and the Eurozone, yet land-rationing in the richer US cities is seriously reducing labour mobility, making the US more like the Eurozone and undermining its macroeconomic resilience.

Inflation phobia
Milton Friedman was famously an advocate of (pdf) floating exchange rates, Frederich Hayek an advocate of (pdf) fixed exchange rates. The latter seems an odd position for a free market thinker to take. Especially when Hayek was also an advocate for the gold standard, if one was going to keep the state money monopoly. A series of fixed prices (fixed exchange rates, fixed gold price) erected on monopoly provision seems a very odd position for a free market thinker to take.

The explanation is simple: fear of inflation. A fixed price of money in gold means--given gold's scarcity--that the possibilities of inflation are greatly reduced. A fixed exchange rate means giving up the ability to domestically inflate (as Greece, Italy, Portugal and Spain are currently discovering). A monetary authority can control price stability or it can control the exchange rate, it cannot do both. Being in the goldzone means inflation will only occur if the price of gold is falling, which it is unlikely to do by much, given that stocks greatly outweigh new production.[i]

The experience of inflation is another feature in common between the goldzone Great Depression and the eurozone Great Recession. Both the great deflation of the former and the disinflation of the latter occurred after dramatic periods of inflation. In the case of the interwar goldzone; the wartime inflations, the German and Austrian hyperinflations, the French early 1920s inflation. Fear of inflation dominated the thinking of monetary authorities--indeed, paralysed their thinking. To the extent that the Fed is paying people not to spend money.
In our own time, the Great Inflation from the late 1960s to the early 1980s has profoundly affected the thinking of monetary authorities; indeed, paralysed it. The success of inflation targeting in squeezing inflation out of Western economies has made it a policy fetish that central bankers cannot see beyond, just as the gold standard was a policy fetish monetary authorities in the early 1930s could not see beyond. Not even to make adjustments necessary to save it. It has been a continuing pattern for central bank policy to respond more to the traumas of the past than the dilemmas of the present.

Been there, done that
It is a sad reflection on the ability of policy makers to find new ways of making old mistakes that if one reads either version of the paper (pdf) by Barry Eichengreen and Peter Temin, The Gold Standard and the Great Depression, and replaces 'gold standard' with 'inflation targeting', one gets an almost perfect description of the current failures of central banks and the mentality behind such. Particularly when the Eichengreen and Temin say (p.19 of the NBER paper):

policies were perverse because they were designed to preserve the gold standard, not employment.

Replace 'gold standard' with 'inflation target' and that is exactly what has been happening in our own time.[ii] Indeed, it was worse than that, as the the Fed and the Bank of France were not even "doing" the gold standard properly (pdf). Just as the European Central Bank and the Fed are now not even doing inflation targeting properly. (To the extent that the IMF is now reporting a significant risk of deflation [pdf] in Mediterranean Eurozone countries.) Just to increase the similarities between the Great Depression and Great Recession, inflation targeting that implicitly or explicitly incorporates "headline" inflation which includes oil and commodity price shocks turns into a de facto commodity standard (since a rise in commodity prices leads to monetary tightening; so the value of money is tied to commodity prices).

As for the authors' comment:

Central bankers continued to kick the world economy while it was down until it lost consciousness (p.2)

that is a fair description of the role of the ECB in the Eurozone crisis. With the added proviso that many think some beating is warranted: alas for such righteous monetary Calvinists, the policy of the beatings continuing until performance improves has long since degenerated into pointless and destructive monetary sadism.

Which makes Greece an enormously useful scapegoat for the ECB.  While people are pointing at its obvious policy dysfunctions (a country rated by the World Bank as 100 out of 183 in difficulty of doing business has considerable capacity to improve its economic performance through its state simply stopping spending money and effort getting in the way of people transacting[iii]), and the undoubted economic rigidities in other Mediterranean Eurozone countries (Italy is rated 87, Spain 44 and Portugal 30 in difficulty of doing business compared to Germany at 19), the ECB is avoiding any accountability for its actions. (Which would make it the ultimate EU creation; the EU being a construction where power without accountability is not a bug, it's a feature.)

Conversely, the worst thing for the Eurozone would be for Greece, or any other country, to leave--and promptly start to do better. Moreover, economic rigidity hardly explains the level of economic pain in the Great Recession—the UK is ranked 7, Ireland 10, USA 4 in difficulty of doing business. Nor does public debt on its own--even within the Eurozone, Spain has a lower level of public debt than Germany (pdf).

Compared to the ECB's destructive monetary austerity, the Fed is more in the situation of having belted the US economy into a TKO,[iv] then helped it sit back up a bit, and offered some water, but resolutely refuses to help the punch-drunk economy stand, proclaiming that if it cannot stand up on its own, it is not fit to, while promising that it won't let it fall to the matt again. Monetary policy matters.

Contractionary blindness
The great blindness involved in this inflationphobia is to think that inflation is the only significant monetary danger. Firstly, serious monetary-contraction deflation is worse than monetary-expansion inflation, even hyperinflation. Both undermine economic calculation, but inflation tends to promote transactions (as people spend before their money loses value), deflation to restrict them (as people defer using money that will buy more later, leading to falling spending and thus falling income). Generally, falling transactions, falling economic activity, is worse than rising.

[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

The mystery of the human and the trade-offs of control

What is the biggest difference in decision-making between buying equipment and hiring a person?  The characteristics of the equipment are much easier to discern.

Sure, there can be hidden flaws in machinery and buildings. You may have to take the equipment for a test run, you may need some expert to have a look at it, but, in a very important sense, what you see is what you get. And, once you are used to one example of a piece of equipment, the next item of the same thing is likely to have the same characteristics. Indeed, the higher quality the provider, the more reliable this sameness is.

People are so not like that. They vary greatly in ways which matter to an employer (or, indeed, anyone else seeking to interact with them) but which are not easy to discern. The only reliable way to find out about a particular person is to interact with them. (Nobel Laureate James Heckman has co-written a study on how "soft skills" matter [pdf] [via], on how personality traits affect life outcomes yet can be hard to assess.)

Who is telling me
Much of how labour markets work is dominated by the opacity of relevant personal characteristics. For example, the biggest labour market intermediary (way people get jobs) is generally "friends, relatives, acquaintances, etc"--someone they know told them about the job and/or the employer about them.

You can spread information about a job much more easily by posting a job vacancy.  But that will tell you almost nothing about the applicants. Personal networks provide much richer information; even if it is just "I don't know Bob, but Kate recommended him and Kate wouldn't steer me wrong" and/or "I have a high regard for Kate's judgement". You can judge the recommendation on the reliability of the recommender and to what extent the recommender is, in effect, acting as a guarantor (so as to avoid harming your existing connection).

Recommendation through existing networks thus becomes a proxy for judging the personal characteristics you cannot directly discern.

It tells me what
Such proxies abound. Has someone else taken the risk of hiring you? If yes, have they persisted in that choice for any length of time?  Hence the best place from which to get a job is being already in one. Does your education suggest that you have application and persistence? Hence the value of education qualifications is surprisingly weakly connected to the alleged content of that education. And so forth.

This is where making it hard to sack someone (in Australia "unfair dismissals" legislation) tends to so retard the operation of labour markets, for it greatly increases the risk in hiring someone precisely because of the opacity of personal characteristics. If the minimum cost of getting rid of a complete dud is, say, $3,000 in legal fees, employer time and "go away" money, then that adds a $3,000 risk premium to every hire. This is then offset by not hiring if it pushes the risk too high for expected benefits or relying even more heavily on other filtering mechanisms. Both responses hit the most marginal would-be labour market entrants hardest. But, like much labour market regulation (indeed, much regulation generally), job-protection legislation is about protecting incumbents.

It also weakens the signal of simply being in a job, as the employer's persistence in keeping you becomes a weakened recommendation.

What can I tell?
Given the difficulty in discerning the relevant characteristics, the harder it seems to "read" someone, the less attractive they are as employees. Language and cultural differences--to the extent they seem to make it harder to discern characteristics, communicate information and predict behaviour--become an employment negative. Effects which can be hard to distinguish from actual ethnic antipathy.

So, if you are a young Muslim male in a Western European country with strong "job protection" legislation, your chances of employment are not good. Or even just being young; there are reasons why France exports young people to Britain (while Britain exports retirees to France), as these job emigres in London (helping to make London France's sixth biggest city) can attest:

[Read the rest at Skepticlawyer.]

The slow adaptation of US wages to the fall in money income

This is based on a comment I made here.


George Selgin posted a challenge to market monetarist analysis which he has also attempted to answer and to which Scott Sumner has responded to particularly thoughtfully. Both the last two posts included this graph:

NGDP (US nominal GDP) fell in a heap, yet average hourly earnings kept growing, albeit at a slower rate. Both George Selgin and Scott Sumner have very sensible suggestions about possible reasons. Further factors which occur to me include that one consequences of persistent unemployment is that what might be called "competitive" supply narrows, as the insider-outsider gap grows, as Evan Soltas has pointed out nicely. That takes time to kick in, but it does mean the "natural rate" of unemployment increases just from having unemployment.

Secondly, the public sector is not so affected (i.e. it has a higher rate of earnings growth than the private sector).

Also, it is mainly hirings which change over the business cycle. While private sector earnings growth does seem to be tracking roughly CPI.  So, it seems employers are paying to keep the employees they have and they're not leaving so much.  Nominal wage stickiness is surely to a significant degree about preserving relationships with existing workers, so if those relationships are being "stretched out" that would slow down adjustment.

Finally, one way to adjust is to cut back hours worked, which would not show up in the average hourly earnings.

The law tells it as it was

One of the more irritating historical memes is the preposterous notion that the American Civil War was not "really" about slavery, it was about tariffs and states rights. Fortunately, it is easy to demolish this claim for the historical canard it is.

All one has to do is to read the Constitution of the Confederate States of America. In particular, since it was an amended version of the Constitution of the United States of America, read it in clause-by-clause comparison.

There are some changes which arguably made for better governance. In the words of the commentator providing the aforementioned comparison:

The President's term limit and line-item veto, along with the various fiscal restraints, and the ability of cabinet members to answer questions on the floor of Congress are all innovative, neutral ideals whose merits may still be worth pondering today.

Then there are the shifts in the power of the states. Confederate States actually lost more powers than they gained:

At least three states rights are explicitly taken away--the freedom of states to grant voting rights to non-citizens, the freedom of states to outlaw slavery within their borders, and the freedom of states to trade freely with each other.
States only gain four minor rights under the Confederate system- the power to enter into treaties with other states to regulate waterways, the power to tax foreign and domestic ships that use their waterways, the power to impeach federally-appointed state officials, and the power to distribute "bills of credit."

The Constitution did not even change those sections which were particularly controversial regarding the powers of the States at the time:

the CSA constitution does not modify many of the most controversial (from a states' rights perspective) clauses of the American constitution, including the "Supremacy" clause (6-1-3), the "Commerce" clause (1-8-3) and the "Necessary and Proper" clause (1-8-18). Nor does the CSA take away the federal government's right to suspend habeus corpus or "suppress insurrections."

As for tariffs and trade policy mattering so much, not only did the Confederate government retain all its powers to tax foreign trade, the Confederate States were given more power over trade, including trade with other Confederate States. So, free trade hardly seems a cause dear to the hearts of the Confederate Founding Fathers.

What was very dear to their hearts, however, was slavery:

As far as slave-owning rights go, however, the document is much more effective. Indeed, CSA constitution seems to barely stop short of making owning slaves mandatory. Four different clauses entrench the legality of slavery in a number of different ways, and together they virtually guarantee that any sort of future anti-slave law or policy will be unconstitutional. People can claim the Civil War was "not about slavery" until the cows come home, but the fact remains that anyone who fought for the Confederacy was fighting for a country in which a universal right to own slaves was one of the most entrenched laws of the land.

The suggestion that tariffs mattered so much that they were worth fighting to break the country up over is frankly risible. It being nonsense is particularly obvious to an historically aware Australian, because Free Trade versus Protection was THE great political divide in the late C19th and early C20th in the Australiancolonies. And what did those same colonies do while being bitterly divided in the aforementioned way? They federated together to form the Commonwealth of Australia.

In the antebellum years, the South had dominated the Presidency essentially until the election of Lincoln in 1860. The South had lost control of the House of Representatives years before and had recently lost control of the Senate. Their own political domination the Southern political class regarded as acceptable, Northern political domination not so.

Why this mattered is because there was a strong Northern push to abolish slavery: part humanitarian, part political calculation to redirect Northern worker anti-immigration angst away from the political dead-end of nativism, and part claim over Western resources. Slaves represented about one-third of the total capital of the South. Anything that put that at risk was worth fighting over. Especially as the abolition of slavery would have also massively devalued the votes of white Southerners generally and undermined their incomes (due to direct labour and other competition). In other words, slavery was also deeply in the political and economic interests of Southern whites who were not slaveowners. That was also worth fighting over. The go-to book on this is Nobel Laureate Robert Fogel's Without Consent of Contract: The Rise and Fall of American Slavery.

Trade policy merely represented a point of argument over much larger differences.

Fighting and losing the Civil War did devastate the South: even apart from direct war damage. First, because a third of its capital was liquidated overnight, in the only mass property confiscation from whites in US history. Second, it was forced to pay for Northern war pensions. Third, because keeping the whites on top meant resources were expended keeping the blacks down and use or development of their skills was minimised. As Thomas Sowell has pointed out, it hardly seems accidental that the economic renaissance of the South took off just as the Civil Rights Acts were passed and resources were no longer being doubly wasted in that way.

Slavery had been the great contradiction in the United States, a country created in a Revolution which supported both property rights and general liberty but incorporating property rights based on the most absolute denial of liberty. (Hence anti-slave Tory Dr Johnson’s comment “How is it that we hear the loudest yelps for liberty among the drivers of negroes?”)

The American Revolution was also a reaction to the British Crown’s insistence on keeping its treaties with the Amerindians (much to the frustration of land-hungry settlers). While Somersett’s Case—declaring slavery to be unrecognised by common law—was another sharp reminder that Americans had no say in British decisions.

One of the revealing questions for American history is: why did the Canadian colonies not revolt? After all, they also suffered the problem of "taxation without representation". What we now call "Canada" was originally just those British North American colonies which did not revolt against the British Crown. (Just like what we now call "Belgium" was the bit of the Low Countries that the Habsburgs managed to hold onto.)

The answer is--the Canadian colonies were not populous enough that land-hunger was serious issue, slavery was unimportant and they still needed the British Crown to arbitrate between English and French settlers. In other words, the Imperial trade-off still worked for them. It was not merely the lack of say in British decisions which was important to the colonies that did revolt--an issue which was brilliantly expressed in the slogan "no taxation without representation". It was that there were key issues which really mattered to them: in the Northern colonies, expanding into Amerindian land. In the Southern colonies, keeping slavery.

And those same issues mattered in the Civil War. The Northern States wanted to elbow out Southern interests in seizing Amerindian land (a key reason why Amerindians supported the Confederate cause, just as they had supported the Crown cause in the American Revolution, and ended up big losers yet again from the Northern victory) and the South wanted to preserve slavery. But now those issues drove them to war with each other, rather than a shared war against the British Crown.

There is a great deal to admire in American political history. But that is way not the same as not being realistic about it.

The American Civil War was about slavery (and seizing Amerindian land). But so was the American Revolution. The saving grace for both that was not all they were, or came to be, about.

The rhetoric used to inspire and persuade for the first Revolt and against the Second had much greater resonances. The US Declaration of Independence, the writings of Thomas Paine, Patrick Henry's Give me liberty or give me death speech, the Gettysburg Address, Lincoln's Second Inaugural Address, are all key documents in the formulation of modern political democracy. As are The Federalist Papers and the effort to create an enduring republican order. That the American Republic was able to fight a long and bitter civil war and survive as an electoral republic rebutted the common C19th view that history proved that democracies were unstable and short-lived, unable to survive great crises.

Nevertheless, the American Civil War was triggered by secession which itself was motivated by the defence of slavery. The American Civil War simply would not have happened without slavery. It was the Confederate cause, and the Southern political class expressed their attachment to it (but not free trade) in the Constitution they wrote for their new country.

[Cross-posted at Skepticlawyer and at Critical Thinking Applied.]

Don't mention the A-word

The Eurozone, the US, Japan and the UK are all suffering prolonged economic stagnation. [You can see how serious it is in the US here.] It is sensible to suggest that they are doing something (or perhaps many things) wrong and need to change policy. 

What is not sensible is ignoring a developed world economy that has conspicuously not suffered any of the economic stagnation problems that have hit the major developed economies. Indeed, has not had a recession (in the sense of two quarters of economic contraction) since 1991. That sailed through the Great Recession and Global Financial Crisis (aka GFC) with barely a ripple. Whose current problems are not of economic stagnation but of maintaining economic balance when one part of the economy is doing much better than another.

That country is Australia. Yes, it is true that the surge in commodity demand (centred on China) has been a boon to the Australian economy (well, to the commodity exporting States; the resultant surge in the value of the $A has been a problem for the tourism-and-goods exporting States—the commodity boom has been a distinctly mixed blessing). But Australia had also managed to avoid recession even when its terms of trade (the ratio of the price of what it sells to the price of what it buys) were in long-term decline and when commodity prices dropped dramatically at the onset of the Great Recession. Indeed, the fall in Australia’s exports as a % of GDP was worse than the US’s.

Yet the Australian success gets mostly ignored. A classic example is Raghuram Rajan’s recent piece in Foreign Affairs. (Non-gated version here [pdf].) Much of what he has to say about the desirability for supply-side reforms is sensible. Indeed, much of what he advocates Australia has already done; which makes the failure to mention what should be the poster-polity for what he is advocating all the more of a glaring failure.

The problem with mentioning Australia is that it does not conform to the stories that Rajan and others want to tell about what went wrong. Rajan essentially ignores monetary policy, both in the commonly offered solutions to economic stagnation (fiscal stimulus and even-lower interest rates: interest rates are a very limited way of looking at monetary policy) and in diagnosing why the economic stagnation descended. So Rajan writes:

today’s economic troubles are not simply the result of inadequate demand but the result, equally, of a distorted supply side.

Australia has done a lot of supply-side reforms, so perhaps it can be ignored. Except Rajan goes on to say:

For decades before the financial crisis in 2008, advanced economies were losing their ability to grow by making useful things. But they needed to somehow replace the jobs that had been lost to technology and foreign competition and to pay for the pensions and health care of their aging populations. So in an effort to pump up growth, governments spent more than they could afford and promoted easy credit to get households to do the same. The growth that these countries engineered, with its dependence on borrowing, proved unsustainable.

Does anyone really think Australia just magically averted such structural problems, that its economy is somehow profoundly different from other developed countries? Given its per capita GDP growth has been respectable but not outstanding. In particular, while its public finances were much sounder, with public debt reduced to very low levels, enthusiastic embrace of private debt meant that the total level of indebtedness was and is comparable to other developed countries.

 The story that Rajan wants to tell is that:

the common thread was that debt-fueled growth was unsustainable.

Except, apparently, in Australia. Australia ran a mildly higher inflation rate than the US during the “Great Moderation”, so its monetary policy was more “lax” than “easy money-easy credit” US.


[Read the rest at Skepticlawyer or at Critical Thinking Applied.]

Unemployment and labour surplus

Daniel Kuehn makes a point that is often overlooked in discussions of labour markets and unemployment:

To be in a labor surplus, you must (1.) have a reservation wage that is equal to or lower than the market wage, and you (2.) have to be jobless. Only the second criterion is involved in your classification as being "unemployed" - the phenomenon we allegedly care about and the data which we look at. We don't know how many people satisfy (1.) and (2.) - we don't know how many people comprise a labor surplus in this country. Nobody seems to have cared enough to even think about how to collect that data. We don't know if that number is cyclical or not. We don't even know if our unemployed uncle or unemployed friend is in that labor surplus or not. And we don't seem to care about that. The social fact we seem to care about is unemployment, not labor surplus. To be unemployed, it's perfectly possible to have a reservation wage above the market wage (and it's not even clear exactly what this means, since one person's labor can be sold in multiple labor markets). Nobody associated with the Current Population Survey will ever issue a survey to you asking you what your reservation wage is. It has nothing whatsoever to do with the phenomenon of unemployment. Unemployment is not the same as labor surplus.

It is possible to have a reservation wage below the market wage and be unemployed if you are not permitted to offer your labour at rate at or below the rate at which you could get a job. This is the basis for the standard criticism of minimum wages.

Labour markets are generally not spot markets: that is, jobs are for varying lengths of time (including being indefinite in duration). This matters for both sides of the exchange. An employer typically not only wants someone productive, they want someone who will stick around for a reasonable time. This is where that dreaded phrase “over-qualified” comes in. An employer is not going to invest effort assessing and training an employee who is fairly clearly going to be off as soon as something better comes along (and has a significant range and degree of “better”).*

When discussing labour markets, it is never sensible to consider only one side of the employment transaction.

Labour is highly heterogeneous: people vary considerably. An employer takes risks employing someone; the smaller the employer, the greater the risks. If you raise the risk of employing people without increasing the benefits, you lower the level of employment. This is the problem with “unfair dismissal” laws: they greatly increase the risks of hiring people so discourage employment, particularly the employment of the marginal. Meanwhile, well-connected folk with good credentials and a solid employment history become even more favoured by such laws. Naturally, such folk think “unfair dismissal” laws are a great idea, a mark of a “compassionate” society.

Actually, it is using ostentatious compassion to put the boot into the underprivileged, a common modern game which particularly common in Europe, which is why their labour markets are typically so disastrous for young folk (particularly young members of out-groups).

That people vary so much is also why the most important labour market intermediary is “friends, relatives, acquaintances”. The employer may not know anything about the offered person directly but they can consider the recommender, and the relationship they have with them, and judge matters accordingly: in effect, the recommending intermediary becomes a proxy “guarantor” of the prospective employee.

So much of commercial activity is about techniques to deal with risk, and labour markets are no exception.

* It has also been pointed out to me that it makes a great cover phrase for an employer who does not want to hire someone for another reason.

Forms of employment, unions and wages

Loath as I am to disagree with an economic historian as eminent of Peter Temin, his paper The Great Recession in Historial Context (pdf) has a claim about wage stickiness and its source I disagree with.

In explaining the development of stickiness of wages and the rise of unions. Temin writes:

As the size of production units, whether mines or factories, became larger, the ability of labor markets to be optimally competitive also diminished. Large employers yielded little bargaining power to workers to negotiate wages and working conditions. If a factory, for example, was the only large employer in town, the options for workers were even more limited and the market power of the employer more obvious. Workers formed unions to countervail the market power of employers, and wage bargaining and strikes supplanted the individual wage negotiations implicit in Hume’s and Smith’s analyses.

This is a wonderful (indeed popular) “just so” story. The trouble is, it is clearly wrong. Large employers tend to pay more than small employers, just as large supermarkets tend to be cheaper than corner stores. Size does not equal market power and does not determine comparative wages or prices.

There is a much simpler reason why unions arose in response to large employers. The workforces of large employers are easier to organize. The rate of unionization increases with the size of the employer (hence the public sector is far more unionised than the private sector) because the bigger the employer, the easier its to organize the employees—they are easier to identify, collectively talk to and have more commonality of interests. Moreover, the power of unions comes from their ability to exclude competing workers. The true enemy of a union is not the company, it is the “scab”, the non-unionised competing worker. The more centralised the workplace, the easier to exclude.

Similarly, wages are “sticky” outside unionised workplaces and across employers regardless of size. The “stickiness” comes from the labour relations being across time periods and asymmetric information. Reliable workers who understand how the firm operates are worth keeping, are valuable. Massively undermining their status as bargaining agents—and your own reliability as a bargaining agent—by unilaterally cutting wages is not the way to have a good relationship with your employees. Particularly given they have obligations set in money terms, so cutting their money income makes their situation worse regardless of what money prices are doing generally. Nevertheless, that money is how contracts “keep score”—so go directly to employee status as bargaining agent and employer reliability as bargaining agent—is even more important.

Moreover, with the development of extensive regional, national and global markets, and increased complexity of products, it becomes harder to workers to judge employer claims. A medieval peasant could see how good the harvest was, and could observe grain prices, so variability in income was much more manageable because far less trust was involved. A modern employee has far less information to directly observe about inputs and outputs in what they produce. That leads to more emphasis on what workers can judge as “proxies” for what they cannot. The reliability of employer behaviour, the respect (or lack) of employee status as bargaining agents has to be increasingly relied upon in an ongoing interaction (a repeated game, if you like).

It is not the size of the company that determines “stickiness”, but the form of the employment contract. “Spot” markets in labour allow much more flexibility in wages since there is no ongoing relationship. It also provides an example where unionisation provided large gains to (some) workers—the unionisation of the waterfront. But that is a case where unionisation changed the form of the labour contract. It is also a case where exclusion of competing labour is particularly intense—employment on the Australian waterfront, for example, has practically become hereditary.

It was not unionisation, but changes in the forms of labour contracts, in the structure of labour relations so that labour became much more an across-time interaction with increased information asymmetries, which increased the “stickiness” of labour. Unions are a symptom of that change far more than they are a source of wage “stickiness”.

Contemporary unions confront a range of problems. First, with the growth of two-income households, variation in income became rather less of an issue for many households, so workers become more willing to shift to forms of labour provision not susceptible to unionisation. Second, the increase in incomes and growth of regulation and other government interventions has meant that legal mechanisms (lawyers) and political ones (politicians and media) became increasingly competitive to unions as bargaining mechanisms. Third, the interests of unions is to make employment remuneration as complex as possible—both because that increases the need for a bargaining agent and because that provides various “victories” for unions to trumpet. The problem is that such a strategy increasingly generates wasted resources that can be harvested by moving to different forms of labour provision or contractual arrangements. Just as it was not employer market power which drove the rise of unions, nor is it driving their decline.

As to why large corporations tend to pay more than small employers, consider why large supermarkets have lower prices than the corner shop. The corner shop is, indeed, the corner, that is local, shop. A large supermarket has to make it worth your while to go that extra distance. Once you have decided to travel further (typically drive) to shop, then it is competing with all the providers in reasonable driving distance. It offers range and low prices to compensate for more travel time and less personalised service.

A large corporation finds it easier to spread/manage risk than a small employer but harder to tie worker effort to productive outcome. So, it pays a “hostage premium”—more than the employee can get elsewhere so that they police themselves more, as they have more to lose. This “hostage premium” is not merely basic salary; it includes a range of benefits and common activities to try and encourage self-policing. So, even in the absence of a unionised labour-exclusion premium, wherever the corporation finds it hard to tie employee effort to productive outcome, we can expect a “hostage premium” to encourage self-policing.

This does not explain what we observe of CEO pay, however. Tying the pay of CEOs to performance should be a lot clearer than executives further down the corporate hierarchy. Yet, what we observe is pay rates that seem unconnected to performance. A (very high) premium that is apparently often not hostage to productive behaviour.

So, consider the mechanism that selects pays for CEOs. In political science terms it is like rigged election autocracies. What we get is an "insider's game": insiders agree that you should be rewarded for being an insider, a game they all hope to benefit from so seek to maximise the return for being an insider. Benchmarking just increases the “gaming” (pdf), since it just increases information to insiders without increasing effective accountability since it does not breach the insider dominance of such decisions: the problem is not information asymmetries, it is insider privilege. The real puzzle is not why CEOs are paid so much, it is why their compensation can be notoriously unconnected to actual performance.

Forms of employment (including expected length of interactions), degree of centralisation of workplaces, information assymetries, insider privilege/outsider exclusion: they explain a lot more of how labour markets work than alleged employer market power. Including wage stickiness and the rise and decline of unions.

A seriously bad idea

This expands significantly on a comment I made here.


The Obama Administration's American Jobs Act has a seriously bad idea of the type that one might expect from an Administration headed by a Chicago corporatist who was a humanities academic and "community organiser". The notion is to allow unemployed people to sue employers who fail to hire them for discrimination. This despite the fact that very few US job ads say unemployed need not apply. Econblogger Tyler Cowen has already suggested it may be one of the worst (economic policy) ideas ever.

Let us apply some elementary economic reasoning. The more unemployment there is, the lower the cost of discrimination. So, if you wish to lessen discrimination, aim for full employment. Since the "allow suits for discrimination" proposal will increase risks in, and costs of, hiring, it will discourage hiring, meaning unemployment will be higher than it otherwise would be. So, the net effect is likely to be to increase the overall level of discrimination.

It will also encourage more hiring to be "within networks", as they provide implicit "guarantors" and more sources of information. Marginal workers are less likely to be plugged into such networks.

So, a bad idea even in terms of lessening discrimination and improving the position of marginal workers.

But it sadly fits in with the Obama Administration's track record: we are suffering from serious economic stagnation, so let's stuff up the supply-side of the economy even more! Alas, the evidence is mounting that President Obama seriously does not understand economics.

Why do the poor remain with us?

Norman Geras raises a point that recurs in his commentary in his excellent blog:

but what a mark against the world's wealthiest countries that there remains in them such a category of people - the poor - who can be spoken about in this way. These are societies fat, bulging, overflowing, with stuff; oozing personal wealth, economic crisis notwithstanding; and they are yet to provide all their citizens with a standard of material well-being such that no one would any longer need to be referred to as the poor but might enjoy, even as unequals, the advantage both of a more comfortable state and a more dignified style of description.

An obvious response is that, by the standards of history and of much of the globe, the people referred to as ‘the poor’ in developed democracies are not poor. [This point is made very powerfully via a graph here.] They have life expectancies, security of food and shelter and rates of possession of consumer durables that mark them out as among the blessed of history. Indeed, as Michael Cox and Richard Alm point out in their Myths Of Rich And Poor: Why We're Better Off Than We Think, poor people in the US in the mid-90s had an average level of possession of consumer durables that would have marked them off as middle class in the early 1970s. [This point is expressed graphically here.]

But, by the standards of their own societies, they are poor, even if poor means “middle class two or so decades ago”. So, why do we have a persistent category of people who lag behind the general prosperity?

Well, for no single reason. As Norman Geras intimates, it is not a matter of how productive the society is, as used to be the case when poverty was the general human condition. There have been sharp drops in the general level of poverty in Western societies over time. Which is another way of saying that developed societies have been great engines of mass prosperity: that is what makes them “developed societies”. But these drops in poverty rates slowed and then stopped: for example, the proportion of people in poverty in the US dropped steadily, even dramatically, during the postwar boom until the mid 1960s and has been stubbornly persistent ever since. Rather discouragingly, the apparent ending of mass exit from poverty coincided with increased government effort against war on poverty: the US “war on poverty” has been about as successful as the “war on drugs”. But similar patterns can be discerned in other developed societies.

Indeed, one way to put the question is “why has poverty persisted despite massive expansions in the welfare state?” The question is not often put like this, but it is a very reasonable question to ask, on the evidence. After all, the welfare state is a century or more old: the failure of eliminate poverty is a reasonable criteria to evaluate it by, particularly given its massive expansion from the 1960s onwards. (It can hardly be the fault of “capitalism”, as its success in generating unprecedented and steadily increasing mass prosperity is what has made the elimination of poverty a remotely plausible goal in the first place. Indeed, the first post-classical public welfare measures – Venetian public health measures, English poor law provisions – grew up in the most commercial societies in part precisely because they were the richest societies.)

One answer to the persistence of poverty might be: because of the expansion of the welfare state. After all, the great mass exits from poverty clearly were not products of the welfare state: they were the result of massive expansion in productive capacities. The welfare state needs clients: if there are no poor people, then there are no poor people to be clients. Milton Friedman pointed out that, if one took the entire expenditure on anti-poverty programs and divided it by the number of poor Americans, there would be no poor Americans. Clearly, employing people in secure jobs with good pensions in welfare bureaucracies, and the transferring of funds to people who are not poor, take up a considerable amount of welfare resources and generate a considerable number of beneficiaries: beneficiaries who might be of some risk of losing said benefits if poverty was abolished.

So, waste and failure in welfare might be one reason for the persistence of poverty. Particularly if such retards economic growth – given why the mass exits from poverty have occurred – by, for example, reducing the level of productive investment.

Or it might be due to welfare subsidising unfortunate patterns of behaviour. The richer the society, the less absolute the penalties for destructive behaviour patterns tend to be, but they still exist. One of the effects of welfare can be to soften the effects of folly (or, to be less blunt, lessen the penalty for patterns of behaviour not conducive to increased income). People can get away more with clinging to leisure preferences, instant gratification preferences or familiar attitudes and patterns of behaviour which are not conducive to good incomes. (And the behaviour of parents may well have effects on the prospects of their children.) If there is a bell-curve of income-producing behaviour, then there will always be a tail end. The richer the society, the better off the tail-end will tend to be. But they will still be the tail-end.

In the US, if one completes high school, get and stays married, get and stays employed (even starting at a minimum wage job) and avoids becoming involved in crime, one’s chances of staying poor are small.

We also get into some stubborn persistences here. Consider that, in the US, students of Asian ethnic backgrounds do far more homework, on average, than do black students. If lifetime income prospects are connected to educational achievement (as they are) and educational achievement is connected to student effort (as it is) then we can reasonably predict that poverty will be more common among black Americans than Asian-Americans on that one indicator alone (as it is).
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So, what can we do about this? If doing less homework leads to higher rates of poverty, does poverty lead to doing less homework? No, but the patterns of behaviour and outlooks which lead to poverty (for example, by discouraging scholastic effort) may do so. A society where human capital is important, and increasingly important, has limited ability to get specific groups to value the acquisition of human capital. But, if they fail to do so, they will have higher rates of poverty. So poverty will persist due to a failure to take advantages of the opportunities available (with some depressive effect on the general productivity of the society, since the level of human capital will be lower than it otherwise would be).

Moreover, how good is the welfare system likely to be at putting itself out of business by encouraging patterns of behaviour that lead to exiting from poverty? Noting that, to the extent that a social system can be said to have “an interest”, poverty is not in the interest of “capitalism” – there is far more profit to be made from selling to rich consumers than poor ones. More precisely, the logic of capitalism has clearly been to generate mass prosperity, since capitalism is the best system ever developed for creating and using capital (the produced means of production) and the more capital, the more production, the more prosperity, the less poverty.

The welfare system can also create barriers to exit from it. Public housing can “trap” people in high unemployment areas, as to move is to lose one’s eligibility. The very high effective marginal tax rates that beneficiaries face (from their benefits reducing, and taxes increasing, as they earn more money) also constitute a barrier to exiting from poverty. But such are expensive to fix and tend to keep the level of clients for the welfare system higher, so there is little incentive from within the system to push for reform.

There are also some forms of poverty that simply are not much of a concern. That university students have low incomes in their 20s is not a concern if they end up being high-earning professionals in their 40s. Indeed, as Cox and Alm point out, the increased participation in higher education is a major reason for increased income inequality – we can tell this, because the slope of “life cycle” income changes (i.e. average income by age group) has become much steeper than it used to be.

So, given the increased participation in higher education, something that also took off in the 1960s, some of the persistence in poverty is a life-cycle effect.

Some of the persistence of poverty is a “recent entry” effect. New migrants, lacking skills and entre into various networks, will tend to start off with low incomes. Increased low-skill migration will also tend to lead to persistence in poverty rates, particularly if there is an increase in the importance of human capital in an economy. It is likely that the children and grandchildren of new migrants will not live in poverty, but if the flow-in is constantly replenished, then the poor are being replenished.

And, of course, if migration to a developed democracy becomes a guarantee that one will not be poor, the incentive to migrate will be greatly increased. Milton Friedman famously argued that the welfare state was incompatible with open borders: certainly the welfare state is likely to increase the resentment of migrants if people believe they are paying for people whose arrival they had no say in.

The low-skill migrant point interconnects with the educational point. It is clear that the Anglosphere is better at attracting productive migrants than much of Europe (and, apparently, my own country of Australia is the very best at cherry-picking its migrants).

But that second-generation male Muslim migrants in Europe are “going backwards” in their economic participation points to another difficulty – barriers to economic participation. Some of these can arise from the behaviour of those with lower levels of economic participation (e.g. the lower levels of homework among black American students). Others can flow from regulation or other institutional factors.

Regulation has a persistent tendency to protect the interest of incumbents: this is particularly true in land use regulation and labour regulation: unfair dismissal laws, for example, protect incumbents against new entrants to labour markets (since they raise the risk of employing new people, particularly for small businesses). Faced with increased risks in employing new staff created by such regulations which is not compensated for by increased productivity, businesses respond by cutting back on hiring, relying more on certification and on “vouching for” networks, became more reluctant to deal with differences that might get in the way of communication (i.e. the transaction costs of cultural differences) and so on. If migrant Muslim males put less effort into school and so are less certificated, are more likely to “have attitude” (or are believed to be so), are less plugged into networks, have less skills then they will be disproportionately excluded by such regulation. Though young people generally suffer from such “protect incumbent” laws.

The problem of persistence of attitudes not conducive to exit from poverty are not only a matter for the poor, they can be attitudes among the better connected as well. Labour market regulation penalising the more marginal in the labour market, land use regulation driving up rents and housing prices by restricting the supply of land for housing are not created or justified by the poor, and certainly do not benefit them, but do disproportionately penalise them.

The capacity for “progressives” (or, as former Labor Senator John Black puts it [pdf] the inner city rich, the code word for which is apparently, ‘progressive’) to romanticise green fields (which are every bit as much human creations as any suburb, and may well have less biodiversity), thereby driving up the value of their inner city properties by restricting the supply of land able to be used for housing, and to frame labour market regulation as “protecting workers” (as, indeed it does: it protects incumbent workers against competition from marginal workers) does its bit to increase barriers to economic participation and so to the persistence of poverty.

Add all these factors together and the elimination of poverty – that is, of a category of “middle class minus two or so decades” – becomes difficult, to say the least.

So, is it a “mark against the world’s wealthiest countries”? Well yes, though not as much as it may seem at first blush and those who are most likely to hold it so are often very much part of the problem.

Or, to put it another way, the sort of mushy, self-satisfied reasoning that Norman Geras likes to berate Guardianistas for in international affairs has its domestic equivalents. There is even some suggestive social science research (pdf) that implies that conservatives signal competence while progressives signal trust: hence the importance to the latter of policy positions which allow one to signal one’s good intentions (and conservative contempt for any disastrous consequences, which the liberals deride as being unfeeling or otherwise lacking in virtue).

Indeed, we observe people who not that many years ago would have been nodding along to descriptions of science as a “patriarchal Western discourse”, not worthy of any privileging, now holding the results of climate science as absolutely authoritative: attitudes to science clearly being subordinated to the commitment to signalling virtuous intentions. But embracing of such serial, or even concurrent, contradiction actually improves the capacity to signal that one’s priority is membership of the club of the ostentatiously virtuous.

If we allow actions to have income consequences (since that promotes productive behaviour) but not negative ones (since that can lead to poverty), stop low-skill migration, ensure that the welfare system promotes independence and not dependence (even at the risk of losing its client base) but otherwise pays those who cannot be independent enough not to be poor, only permit students in higher education who won’t be on low incomes while they are studying and eliminate regulations and other institutional factors that are barriers to economic participation (which will require neutering the “progressive” intelligentsia having any effective capacity to frame public debate so as to block such changes), we in developed countries can have “tail ends” which are not poor by the standards of our societies.

Good luck with that.

Still, the good news is that we could do better: the bad news is that we probably won’t (beyond general increases in productivity).

Thinking rationally about unemployment

This (greatly) extends a comment I made here.


One of the dispiriting things about observing the US's economic problems from afar (specifically, a country that managed to avoid both the Global Financial Crisis and the Great Recession) is watching old and tired debates about unemployment getting another whirl. This piece from Salon provides examples of people blaming the unemployed for unemployment.

This all so "old" for me. My first job was in the (since abolished) Commonwealth Employment Service dealing with unemployed people in the 1982-3 recession. (I had never had a job before, so naturally the Australian Public Service thought the best use of my talents was advising folk on their job prospects.) I later worked in various labour market economics/stats areas. I am so familiar with all these arguments, and I find the “blaming unemployment on the unemployed” approach utterly tedious.

The basic three operating principles are:

(1) Unemployment shifts dramatically because of changes in economic conditions.

(2) Long-term trends in unemployment occur because of institutional (particularly regulatory) factors.

(3) There are sorting processes about who gets and stays unemployed, but this does not change (1) and (2).

Really, it is not so hard.

Unemployment in Australia is much lower than in the US or UK. (In my local suburb, most of the fast food places and cafes have "help wanted" ads in the window.) This is not because suddenly Australians are harder working than Yanks or Poms. It is because:

(1) our central bank, the Reserve Bank, handled monetary policy better than the Bank of England and (especially) the US Federal Reserve;

(2) our prudential regulation of our financial sector worked a lot better (and did not have to deal with a collapsing housing price bubble); and

(3) the Australian public debt position is much stronger [which improved both confidence generally and policy flexibility in particular].

This, added to a much more flexible economy due to almost three decades of economic liberalisation meant that we even manage to weather a dramatic drop in commodity prices.

Just as Europe needs to face the fact that its entrenched unemployment is largely due to the way it regulates its labour markets, the US needs to face the fact that bad decisions by the Federal Reserve is the most important reason for its massive levels of unemployment. Not any change in behaviour by the unemployed.

For if wage contracts are set according to certain expected trends in the value of money (e.g. around the 2% inflation the US has had for a couple of decades) and there is a sudden, unexpected increase in the value of money (i.e. the scarcity of money increases because the Fed suddenly adopts a tight monetary policy to get even lower, possibly zero, inflation) then there are suddenly a whole of labour contracts where the real cost of labour increases unexpectedly. Hiring plummets, firings surge, economic activity drops and you have a dramatic economic downturn and a massive increase in unemployment. (Now think what a sudden increase in the scarcity of money would do to highly leveraged financial institutions: Irving Fisher described this scenario back in 1933 [pdf] in his debt-deflation theory of the Great Depression of the 1930s.)

Which is not remotely the fault of the unemployed. Yes, of course interventions (such as extending unemployment insurance) affect trend levels of unemployment. Yes, of course there is a sorting process about who gets and stays unemployed. But that sorting process does not affect the level of unemployment: it occurs within a given level of unemployment. Which is a product of economic conditions (including public policy, especially monetary policy) and institutional structures (particularly labour market regulation and other interventions). Moralistic nonsense blaming the unemployed is precisely that.

Blame the Fed, they did it. Again:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.

Spoke too soon. But really, really the consequence of greatly increased unemployment is not the fault of the unemployed.

ADDENDA: On the US unemployment situation, this graph is deeply depressing. It comes from this highly informative post on the diabolical state of much of the US housing and housing finance market. Though this is not a good sign regarding Australian housing finance.

The destruction of prudence: understanding the global financial crisis

Prof. Russ Roberts of George Mason University has produced the best single analysis (pdf) (via) of the global financial crisis (GFC) I have read: empirically grounded, with careful, perceptive analysis leavened with moral outrage. (And if you do not have some level of moral outrage, you do not know what went on.)

Over the last 15 years or so, I have had various conversations with people about how the IMF has been injecting moral hazard into the international financial system by acting as “welfare for Wall St” and bailing out banks who loan to developing countries: bailouts which have usually involved major costs to the taxpayers of said countries.

This turns out to be a more general problem. President Bush put it nicely in conversation with the Chairman of the Federal Reserve and his Treasury Secretary:

Someday you guys are going to have to tell me how we ended up with a system like this. I know this is not the time to test them and put them through failure, but we’re not doing something right if we’re stuck with these miserable choices.

(I wonder if he did ever get a good answer.)

Roberts is about finding underlying causes:

Yes, deregulation and misregulation contributed to the crisis, but mainly because public policy over the last three decades has distorted the natural feedback loops of profit and loss. As Milton Friedman liked to point out, capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. When taxpayers absorb the losses, the distorted result is reckless and imprudent risk taking.

In other words, a system not merely suffering from moral hazard, but increasingly built on it:

The most culpable policy has been the systematic encouragement of imprudent borrowing and lending. That encouragement came not from capitalism or markets, but from crony capitalism, the mutual aid society where Washington takes care of Wall Street and Wall Street returns the favor. Over the last three decades, public policy has systematically reduced the risk of making bad loans to risky investors. Over the last three decades, when large financial institutions have gotten into trouble, the government has almost always rescued their bondholders and creditors. These policies have created incentives both to borrow and to lend recklessly.

At the level of social systems, there is a very large difference between reducing risk and suppressing risk. Reducing risk means one is lowering the level of risk in the general system. One can see that happening over time with the downward historical trends in interest rates, for example.

Suppressing risk
Suppressing risk shifts the risk from certain actions (and thus particular agents) to somewhere else: generally into more concentrated forms in the future. From the beginning of Federation until the early 1980s, Australia was under the Deakinite policy regime of industry protection, wage arbitration, state paternalism, white Australia and imperial benevolence.

Each part of the Deakinite regime was intended to be about reducing risk. Industry protection blocked foreign competition, wage arbitration blocked (low) wage competition, state paternalism reduced risks of aging and ill-health, white Australia blocked competition from “tropical zone” migrants and imperial benevolence sought the protection of friendly Great Power (first Britain, then the US). White Australia was the first part of the policy regime to disappear, being abandoned in the 1966-72 period. It arose because, during the nineteenth and first part of the twentieth century, there were two global labour flows. “Temperate zone labour” from Europe to North America and the Antipodes and “tropical zone labour”, particularly from China and India to various European colonies. It was an urgent demand of the North American and Antipodean working class that it be shielded from competition from “tropical zone labour”, often using the available prop of racial ideology.

As a policy regime, the Deakinite policy regime suppressed risk rather than reducing it in any systemic sense. And it suppressed risk by building a lot of rigidities into the economy. Consequently, the Australian economy handled external economic shocks badly because it lacked flexibility. The greatest achievement in the dismantling of most of the Deakinite policy regime has to been create a much more flexible Australian economy, which has handled both the 1997 Asian Crisis and the more recent GFC and Great Recession not merely well, but better than comparable countries.

[Under the Deakinite regime, regulation and other government intervention blocked the flow of information by blocking action: which inhibited the development of better ways of doing things and effective action in response to sudden changes. The latter in particular led to the Australian economy tending to deal poorly with economic shocks in the period.]

What the history of bailouts and implicit government guarantees that Roberts sets out did is suppressed risk by reducing risk for individual actors thereby massively increasing the level of risk in the financial system as a whole. Suppressing risks for individual acts, which therefore discouraged attention to risk, massively increased the level of systemic risk. [The pattern of action did not reflect the risks inherent in particular investments, as it suppressed seeking such information and acting upon it. What it actually reflected was the implicit government guarantees. Taxpayers were the "backstops" for the actions of others.]

Destroying prudence
Roberts sets out the perverse incentives created:

The punishment of equity holders is usually thought to reduce the moral hazard created by the rescue of creditors. But it does not. It merely masks the role of creditor rescues in creating perverse incentives for risk taking.

These perverse incentives became pervasive, which is precisely the problem:

Because of the large amounts of leverage—the use of debt rather than equity—executives can more easily generate short-term profits that justify large compensation. While executives endure some of the pain if short-term gains become losses in the long run, the downside risk to the decision-makers turns out to be surprisingly small, while the upside gains can be enormous. Taxpayers ultimately bear much of the downside risk. Until we recognize the pernicious incentives created by the persistent rescue of creditors, no regulatory reform is likely to succeed.
Almost all of the lenders who financed bad bets in the housing market paid little or no cost for their recklessness. Their expectations of rescue were confirmed.

Hence:

And what we do is make it easy to gamble with other people’s money—particularly borrowed money—by making sure that almost everybody who makes bad loans gets his money back anyway. The financial crisis of 2008 was a natural result of these perverse incentives.

Roberts uses the analogy of a poker game with Uncle Sam watching (sometimes changing the rules, sometimes guaranteeing players) to illustrate the problems very effectively.

What was going on was not “managing” the market system, it was a profound subverting of it:

Capitalism is a profit and loss system. The profits encourage risk taking. The losses encourage prudence. Eliminate losses or even raise the chance that there will be no losses and you get less prudence. So when public decisions reduce losses, it isn’t surprising that people are more reckless.

Read More...There is also another factor which is implicit in Roberts’ analysis, but he does not bring out. If access to decision-makers increases one’s returns, that will advantage firms with access to decision-makers. The flooding of funds into the financial system and financial markets is hardly surprising in the circumstances. An expansion particularly driven via the underpinning of massive levels of leveraging. Thus:

Without extreme leverage, the housing meltdown would have been like the meltdown in high-tech stocks in 2001—a bad set of events in one corner of a very large and diversified economy.

This was a crisis building for a long time:

The [1984] rescue of Continental Illinois and the subsequent congressional testimony sent a signal to the poker players and those that lend to them that lenders might be rescued.

A signal that was reinforced again and again by subsequent government action:

Continental Illinois was just the largest and most dramatic example of a bank failure in which creditors were spared any pain. Irvine Sprague, in his 1986 book:

“Of the fifty largest bank failures in history, forty-six—including the top twenty—were handled either through a pure bailout or an FDIC assisted transaction where no depositor or creditor, insured or uninsured, lost a penny.”

The 50 largest failures up to that time all took place in the 1970s and 1980s. As the savings and loan (S&L) crisis unfolded during the 1980s, government repeatedly sent the same message: lenders and creditors would get all of their money back. Between 1979 and 1989, 1,100 commercial banks failed. Out of all of their deposits, 99.7 percent, insured or uninsured, were reimbursed by policy decisions.

This had utterly predictable effects on the attention of actors in the financial system to levels of risk:

… all profit and no loss make Jack a dull boy.

[The information role of markets and prices were systematically distorted.] It was the systematic destruction, by government policy, of prudence in the financial system:

Each case seems different. But there is a pattern. Each time, the stockholders in these firms are either wiped out or see their investments reduced to a trivial fraction of what they were before. The bondholders and lenders are left untouched.

Tracing the effects of this does have some evidentiary problems. No one is likely to say “yes, I was reckless!” But:

While direct evidence is unlikely, the indirect evidence relies on how people generally behave in situations of uncertainty. When expected costs are lowered, people behave more recklessly.

This was a problem not only in the US. The UK authorities were playing the same game:

The only difference between this scenario in the United Kingdom and the one in the United States is that in the U.S. the Fed came to the rescue and the executives, for the most part, kept their bonuses.

That equity was not guaranteed made much less of a difference than one would imagine. As Roberts points out, equity investors tend to diversify and could use bonds to reduce downside risk.
Read More...
Roberts cites a study on the perverse incentives facing executives and concludes that:

This kind of looting and corruption of incentives is only possible when you can borrow to finance highly leveraged positions. This in turn is only possible if lenders and bondholders are fools—or if they are very smart and are willing to finance highly leveraged bets because they anticipate government rescue.

He then considers the case of a couple of the CEOs whose firms were rescued by the government (i.e. the taxpayer):

When we look at Cayne and Fuld, it is easy to focus on the lost billions and overlook the hundreds of millions they kept. It is also easy to forget that the outcome was not preordained. They didn’t plan on destroying their firms. They didn’t intend to. They took a chance. Maybe housing prices plateau instead of plummet. Then you get your $1.5 billion. It was a roll of the dice. They lost.
When Cayne and Fuld were playing with other people’s money, they doubled down, the ultimate gamblers. When they were playing with their own money, they were prudent. They acted like bankers. (Or the way bankers once acted when their own money or the money of their partnership was at stake.)

In other words, behaviour was different in the realms were public policy was not systematically destroying prudence.

Roberts examines various explanations offered for the GFC, concluding that:

These explanations all have some truth in them. But the undeniable fact is that these allegedly myopic and overconfident people didn’t endure any economic hardship because of their decisions. The executives never paid the price. Market forces didn’t punish them, because the expectation of future rescue inhibited market forces. The “loser” lenders became fabulously rich by having enormous amounts of leverage, leverage often provided by another lender, implicitly backed with taxpayer money that did in fact ultimately take care of the lenders.

The systematic destruction of prudence as moral outrage.

Perverse incentives
Roberts then examines the (largely regulation driven) perverse incentives in housing finance and purchase in various markets before examining Fannie Mae and Freddie Mac:

But between 1998 and 2003, Fannie and Freddie played an important role in pushing up the demand for housing at the low end of the market. That in turn made subprime loans increasingly attractive to other financial institutions as the prices of houses rose steadily.

Fannie and Freddie had particular value for policy makers:

… one other group sitting at the table playing with other people’s money: politicians. Politicians are always eager to spend other people’s money. It’s what they do for a living. But it’s an even better deal for politicians if they can hide the fact that they’re spending other people’s money or delay when the bill comes due. That’s what they did with Fannie and Freddie.

We can see clearly from Roberts’s analysis that the suppression of risk actually massively increased the total level of risk in the system. In the housing market, there were massive increases in riskier housing loans.

The story Roberts tells is one of consistent rationality creating perverse incentives, rather than having to posit various levels of irrationality. In particular, he asks the excellent question of why specific types of assets were invested in and not others.

Roberts shows quite clearly that the issue is not merely problems with computer models used in assessing risks, it is the incentives driving the creation and use of models.

How was prudence destroyed? By making the taxpayers the backstop, the guarantors of what wealthy, powerful and connected people were doing:

As in the Fannie and Freddie story, the firms aren’t the real financers of the salaries associated with picking up nickels. The taxpayers ultimately fund picking up of nickels, and the taxpayers get flattened.

In Yoram Barzel’s property rights analysis of firms, the boundary of the firm is the boundary the guarantee offered by the equity capital. The owner of the risk exposure in lending is whoever provides the debt guarantee. That turned out to be the taxpayers. The system systematically nationalised risk, and operated as chaotically as any command economy does. [For it had the same underlying structure: those making the decisions about capital did not have to bear the costs of what they did while information was being systematically blocked or distorted.]

In particular, it destroyed prudence.

Bloating perversity
Part of what went on was the creation of complex financial instruments whose attributes were not clear to the “owners” of said instruments. But, if someone else is providing the ultimate guarantee, how hard are you going to bother to look (or even worry)?

Roberts’ analysis leads him to a very scary place:

An unpleasant but unavoidable conclusion of this paper is that Wall Street was (and remains) a giant government-sanctioned Ponzi scheme.

But, if one wants to know how the financial system became so huge, then this analysis explains why. The advantages of access to policy makers both causing, and combining with, the implicit (and increasingly explicit) taxpayer guarantee. As Roberts notes:

There is an old saying in poker: If you don’t know who the sucker is at the table, it’s probably you. We are the suckers. And most of us didn’t even know we were sitting at the table.

This is not a good place for democracy to be:

Rescuing rich people from the consequences of their decisions with money coming from average Americans is bad for democracy.

Just as the IMF has been bad for global governance because it has been doing the same thing, only more so, and gouging taxpayers a lot poorer than the average American taxpayer.

The consequences for democracy are indirect, the consequences for the economy much more direct:

Rescuing people from the consequences of their decisions is bad for capitalism.

What we do not need is replacing “bad” people with “good” ones. We need better ideas and much better public policy incentives.

Maybe it is as simple, as the cases of Canada and Australia suggest, of just having good prudential regulation in the first place. (A model, which does not, alas, work for the IMF.)

The massive destruction of prudence, and the subsequent creation of high levels of systemic risk (including sovereign debt issues—themselves an issue of a lack of fiscal prudence—which Canada and Australia have also managed to avoid), perhaps explain the fearfulness of monetary and banking authorities, such as the Bank for International Sentiments recently endorsing fiscal and monetary tightening in a situation of serious deflationary pressures. (Since one would have to be something of an obsessive idiot to be worrying about inflation in the current situation: though (re)fighting the last war you won has notoriously held a certain attraction.)

Roberts quotes Milton Friedman putting the point well about not just hankering for the “right” people:

The way you solve things is to make it politically profitable for the wrong people to do the right things.

That is, after all, the way Madison designed the constitutional structure of the American Republic. What is needed is ways of discouraging politicians from continuing to systematically destroy prudence in the financial system.

ADDENDA: Roberts' analysis can be taken as something of a case study for Jeffrey Friedman's argument (pdf) (via) for the cognitive superiority of markets over politics.

FURTHER ADDENDA: Having now read Hayek's The Meaning of 'Competition' (which, Jeffrey Friedman is completely correct, should be read in conjunction with Hayek's The Uses of Knowledge in Society), I have extended the post somewhat by the sections in [square brackets].