An Economic History

The Economist has a review of the upcoming book Grand Pursuit: The Story of Economic Genius. By Sylvia Nasar which included an unfortunate sentence:

And how best to cope with the booms and busts that have been capitalism’s peculiar contribution to human life?

I've heard this statement before - that capitalism is uniquely typified by booms and busts and that it's a feature of the system. There are certainly exceptions. Communism and fascism are typified by unrelenting, grinding poverty for the majority of people under them. But booms and busts did not begin with capitalism. They exist in agriculture, for example, except there the busts are called "famine." The unique advantage of capitalism is that trade and liquid markets means the consequences of busts are not so severe.

The review picks up with this nice passage:

In Marx’s view the capitalist system, for all its ability to unleash productive power, was haunted by a contradiction: the drive to increase profits would immiserate the poor and lead to crises of overproduction. But Marshall demonstrated that capitalism advances not by immiserating the poor, but by boosting productivity. Factory owners make relentless small improvements that allow them to produce both higher wages and lower prices, thereby spreading the gains of material progress throughout society. Schumpeter further expanded the idea of productivity increases. The economy doesn’t simply get bigger and bigger. It goes through a constant process of discombobulation as entrepreneurs invent new products and processes. Marx got it upside down: capitalism’s recurrent crises actually make it stronger.

It's a point worth remembering. In the recent financial crisis many people have resorted to the tired calls of a "crisis of capitalism." In our economy's current absence of hope,we should remember that there have been bad times before and the system has continued, in unexpected ways which have created more wealth than ever before.

The Dissertation

The most distinctive aspect of graduate school, is of course the dissertation. The ordeal of entering the community of scholars by producing your own original research and then defending it against your own hoped-to-be peers. Anyone who has been through it knows how grueling of a process it can be. But unlike law school or medical school, which one can graduate from in a set time simply by taking a series of courses, there are no guarantees with a dissertation. If your experiments don’t happen to work out, or someone publishes your idea before you, then too bad. This uncertainty and doubt can be an emotional killer. No one who’s done it will ever forget it. And no one who’s finished would wish to go back. Therefore, I found it fascinating to hear it described in William Deresiewicz’s semi-autobiographical book A Jane Austen Education. He writes:

     I spent most of my time slaving away at, procrastinating on, whimpering about, and otherwise slogging through my dissertation. There’s nothing quite like writing a dissertation. You’ve gone through almost twenty years of school, including your first few years as a graduate student, and you’ve always had someone there to tell you what to do: take these courses, do this reading, answer these questions. You’ve also always had other people around to share the experience with – sit next to in class, bitch to about your teachers, study with for exams.

     Then, all of a sudden, you’re on your own. It’s like being left in the woods without a map. Good luck, sucker. Drop us a line if you make it out alive. All you know is that you have to go off by yourself for four or five or six years and write what amounts to a book. You’ve never written a book, you have no idea how to write one, and no one, you quickly realize, is going to teach you, because the only way to learn is just to do it. Plus, you have to make up your own topic. And, oh yes, it has to be completely original.

Quality is Always the Best Value

I am a believer in the importance of well-made and beautiful objects. There used to be a belief that exposure to ugliness could itself corrupt the soul and deaden the senses as visitors to the former Soviet Socialist Republics might appreciate. I came across this quote by Stickley and think it is both true and well-put. Something to ponder the next time you are browsing commodity furniture:

"...I felt that the badly-constructed, over-ornate, meaningless furniture that was turned out in such quantities by the factories was not only bad in itself, but that its presence in the homes of the people was an influence that led directly away from sound qualities which make an honest man and a good citizen. It seemed to me that we were getting to be a thoughtless, extravagant people, fond of show and careless of real value, and that one way to counteract this national tendency was to bring about, if possible, a different standard of what was desirable in our homes."

In Which I Discuss A Potential Debt-Limit Solution

This is a cross-post from the blog of the DCYRs. I suggest that revising the accounting of Social Security benefits to reflect actual wage and population growth could be a way for politicians to claim that they've made real cuts, put the system on an actuarially sound footing, and restore faith in the state retirement system.

How to Cut Spending by 25% Without It Costing a Dime

The furious debate in Washington, DC this Summer is over the so-called debt limit, a rule which forbids the treasury from taking on more debt if certain federal accounts exceed a set value.
As a price for increasing this value, Democrat and Republican congressmen are demanding tax increases and spending cuts. But what they won’t admit is that not a dollar of current spending will be reduced – the cuts are all to future projections. This year’s spending was authorized earlier this past Spring and future Congresses can always ignore what this one decides.
The various spending proposals are “scored” or calculated based on best-guess estimates of future revenue and spending based on current law. Those making the estimates are required to assume that future Congresses won’t change the laws mandating taxes or spending. That is one large assumption.
In conversation, most members of the younger generation will admit that they don’t expect to see a dollar back from the money they’ve paid into Social Security. This isn’t strictly true, they will receive something. Social Security’s trustees estimate that they will be able to pay about three-quarters of currently-promised obligations based on employment tax income and redeeming the intra-government IOUs in the trust fund.
And therein lies the problem. Promised obligations due are a legal fiction which have no relation to the actual demographic or economic state of the country – only upon what the laws are written to say.
What we should do is simply change the law. Change the law to have it be honest.
If the law reflected what the system could pay, rather than what politicians think it should pay, we would put Social Security on a sound footing and reduce the notional obligations politicians are arguing about overnight.
Of course there is the issue that only some debt is counted against the limit and this doesn’t include all of Social Security’s obligations. This fact that only some of our legal obligations are counted is another reason why the current argument is so ridiculous. Much of the spending that is being argued about – entitlements such as Medicare, Medicaid, and Social Security – doesn’t get counted against the debt limit until the government adds another IOU to the trust fund.
Changing the accounting of social Security could represent a cut of over $5 trillion to future spending, a figure far larger than the values of $2 to $4 trillion currently being tossed around in negotiations.
Of course opponents would claim that this was a cut from our elderly’s retirement. But this is false. The money is already spent and only held on ledgers in the form of IOUs from one government agency to another. This reform would simply change expectations to line up with reality.
And changing those expectations matters. By knowing what they were actually likely to get from the system, people would have a better idea of how much they would actually need to save for their own retirement. Rather than treating Social Security as a corporate pension, people would view their prospective payouts more like a 401K, whose value can fluctuate over time. By setting an accurate account they may even begin to regain some trust in the system, something that is sorely lacking today.
These savings would be no more fictional than any of the others being debated and because they are going to happen anyway as payments into social security lag, they might even have a chance of becoming real.

Sell in May and Go Away?

Sometime in April I decided that the market chatter had reached the point where it could be assumed that the market had made as many gains as were likely for a while. There were certainly many other hints as well: the presumptive end of QE2, [over]valuations of tech companies, the coming debt-limit showdown, and all sorts of international instability. I decided the time was right to make a move out of equities (I usually support a long-term buy-and-hold strategy with occasionaly reallocations).

Around the same time people were repeating the old saw of technical finance: "Sell in May and Go Away." As a short-term recap, I looked at normalized prices to see the returns for anyone who followed this strategy. So far, it seems to have paid off. This conservative approach seems to echo the feeling of the country as a whole. This is a mood that the country is going to have to be shrug off if the many wilting economic indicators, such as jobs, house prices, and consumption are going to perk up. But that becomes more difficult to do when playing it safe seems to be the profitable strategy.

I repeat this chart below with data since December, 2010 to show how this cycle played out in the first part of 2011 (and to show that I'm not cherry-picking data.) All of the funds are still up for the year but it does seem like our cycle of big gains is temporarily over. The economy seems likely to stay in a holding pattern or sideways market for a while longer yet. This year's data is shown in the chart below with prices normalized to 1 for each fund on April 29th, 2011.

Finally I'll just mention that, at least this year, following an old market saying seems to have paid off and hedge by adding that market timing doesn't work, except when it does.

The Costs of Commitment

A good post by my friend the Prolix Patriot examines Washington's historical streetcar lines and development. One bit of discussion focuses on how fixed services like subways and streetcars are visible commitments by the city to a certain course of action. Bus lines can be rerouted easily and some of Metro's remedies for budget shortfalls involve just that. In contrast, rerouting services with large fixed costs would be inordinately expensive. Thus, the permanence of a service gives others confidence that it will continue.

Being an economist I immediately thought of the similarity with the Asset Substitution problem from corporate finance. In short, an entrepreneur (or agent) goes to investor (or principal) with a profitable project with a certain level of risk. The investor makes a costly investment in the project. The entrepreneur then actually does a different, more risky, project which will give him more benefits if it succeeds and for which the entrepreneur will bear the greater costs if it fails. There are several ways to minimize the problem including insurance contracts and bond covenants. In each case the agent makes a costly decision to signal his commitment to a certain action. Sociologists might point to engagement rings as another example of this theory. Biologists could cite adaptations such as peacock's feathers, although that has more to do with signalling health than any costly commitment. Perhaps those who've watched National Geographic more recently could offer some ideas. For cities, once potential home-buyers see a commitment to providing transit, they might be more willing to buy a house rather than continuing to rent. This can have great benefits for neighborhood stability and quality of life, many of them traditionally promoted as the benefits of homeownership.

It's more evidence that understanding incentives is vital for making good decisions - in many walks of life. Politicians and planners who ignore this fact in search of some Utopian vision do so at their, and their city's, peril.

Happy Easter

While Bach's Christmas Oratorio is well-known, his Easter one is less so. Enjoy!

And let us not forget Handel. Alleluia!

New Print Buttons!

I'm one of those people who prefers reading text as text. I hate having to click through multiple pages to read an article and I often prefer just having simple text without distracting layouts, images, and ads. Occasionally I like to print out articles to read them offline. So through this site I tracked down and added a button which allows you to print posts, email them, or convert them to pdfs. Enjoy.

The American Economic Review's Top 20 Papers

The AER recently posted a list of the top 20 articles published during its first 100 years of existence. I’ve read many of them and presented a few. Modigliani and Miller’s classic 1958 paper on corporate finance is a personal favorite. They also listed Hayek’s Use of Knowledge in Society which was the subject of discussion at a recent conference. All the articles are fascinating, although most require a bit of mathematical facility. These lists are always somewhat arbitrary, but one could certainly find a worse way of learning some of Economics’ great insights over the past century.

Shuffling The Deck Chairs

To hear the comments of some conservative opinion-makers, you would think that Federal Departments are an endangered species. In a recent Op-Ed Matt Kibbe and Dick Armey of FreedomWorks suggested eliminating the Departments of Commerce and Housing And Urban Development. Not to be outdone, former-Speaker of the House and presumptive presidential candidate Newt Gingrich has called for scrapping the Environmental Protection Agency and replacing it with … another agency.
And that’s the problem. While these calls may grab headlines and build a reputation as a cost-cutter they are not real solutions to reduce the scope of government. They are merely fiddling with an org chart.
Ending the Department of Education would not reduce the federal government’s role in education. The executive branch carries out actions which it is required to by law and the source of that law is Congress. Any real reform must begin with Congress taking actions to reduce the tangled web of diktats and mandates that the U.S. Code has grown into.
The only way to cut the size of government is for the government to pass fewer laws.For every law that is passed the executive branch must expand to interpret, define, and enforce it. Real reform would begin with requiring the legislative branch to exercise restraint on its own powers. A positive first step might be ceasing the knee-jerk rush to “solve” every perceived problem with a new bit of legislation. These laws are just added to the accumulated pile which has become increasingly impossible to understand, even for well-meaning Americans. The real test of seriousness for the 112th Congress will be if they understand that reform begins at home.
And commentators might be better served by flipping through their law books and finding ways to streamline and simplify the legal code rather than focusing on what the enforcing agencies are called.