EconTalk http://www.econtalk.org/ Copyright 2010 Mon, 08 Feb 2010 06:30:00 -0500 http://www.movabletype.org/?v=4.21-en http://blogs.law.harvard.edu/tech/rss Roberts on Smith, Ricardo, and Trade Russ Roberts, host of EconTalk, does a monologue this week on the economics of trade and specialization. Economists have focused on David Ricardo's idea of comparative advantage as the source of specialization and wealth creation from trade. Drawing on Adam Smith and the work of James Buchanan, Yong Yoon, and Paul Romer, Roberts argues that we've neglected the role of the size of the market in creating incentives for specialization and wealth creation via trade. Simply put, the more people we trade with, the greater the opportunity to specialize and innovate, even when people are identical. The Ricardian insight masks the power of market size in driving innovation and the transformation of our standard of living over the last few centuries in the developed world.

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0:36Intro. [Recording date: February 4, 2010.] No, guest today. Thoughts on trade. Thanks for request for feedback on experimental Mike Munger podcast. Read all email even if not enough time to respond to all. We are on Twitter at EconTalker. About 15 years ago, wrote book The Choice, in which David Ricardo comes back to life as a ghost to try to convince a television manufacturer that trade is good for Americans even though it will destroy his company and hurt his home town. Central is Ricardo's idea of comparative advantage. A few years ago, essays on Econlib. In last couple of thinking has changed: perhaps an even deeper insight and more important than Ricardo's which is in many classrooms. Ideas on trade have not changed so much as gotten richer. Insights come from conversations with Don Boudreaux; seminar with James Buchanan, podcast with Mike Munger on division of labor; podcast with Paul Romer on growth. Quote from article by Robert Frank, NYTimes: "For example, as a Peace Corps volunteer in Nepal long ago, I hired a cook..." Question is: Why does a spectacularly resourceful and intelligent person in Nepal earn spectacularly less than a lazy untalented American? Daughter, age 17, babysitting for 2-3 years; makes about $10 an hour, a lot more than anybody in Nepal makes who is incredibly talented. Her main talent is her ability to show up on time and not burn the house down. Patience helps; a few other skills, but not like thatching a roof or butchering a goat. Frank points out that relatively unskilled people in America make a lot more than people in Nepal. David Henderson EconLog blog post closer to the truth. Will try to answer why and impart insights.
5:55The one-sentence answer comes from a quote from the book The Choice, and that is that "self-sufficiency is the road to poverty." Self-sufficiency in everyday language is a good thing--standing on your own two feet and not relying on others. In the context of economics and trade, realize quickly that standing on your own two feet if you mean it literally, you are going to be desperately poor and probably will not supply. PBS special, "Frontier House"--try to live in 1880s in Montana. None of the families made it: didn't generate enough output with just their own skills to have made it through the winter. One family that created a still, made liquor and swapped it was viewed as cheating by other families. Modern skills not well suited; but also if you only rely on yourself you are going to be very, very poor. Literally, couldn't use tools others made. Quick answer. Slightly longer answer, coming from David Ricardo, is that specialization and trade make us rich. The more America trades with Nepal, the better off both of us will be; trade is mutually beneficial; trade allows people with diverse skills, even if you are not as good at everything as someone else. Even if Russ is not as good at thatching a roof or butchering a goat, and even if you are better at all those things than Russ, both will be better off if you each specialize in one of those things and trades for the other things we want. The power of specialization in that setting isn't what we normally think of, which is learning by doing. It simply has to do with each devoting himself to what he is relatively good at; more can be produced than otherwise. Opponents of globalization want us to be more like Nepal. But deeper answer as to why Nepal suffers comes from insight by James Buchanan in a paper he wrote with Yong Yoon on increasing returns and Adam Smith. Example they use: You and I and a bunch of fellow human beings are part of a group of hunter-gatherers, close to subsistence living conditions. We get all of our food from hunting; basically one task; meat sustains us. Daughter and wife vegetarian, but in primitive society probably not that common. Primitive society of hunters. Sitting around at the end of a long day of hunting for deer; suppose tired of living on a very small amount of venison; would like to have more meat, more output, higher income. What are your choices? How could we move toward a higher level of prosperity? three options: can bang your neighbor on the head and take his meat; you can develop a technique that allows you to be a more successful hunter for every hour you spend hunting:--improve the knife you use, invent a bow and arrow, invent a gun or net, learn to track deer more successfully--generally called productivity. Theft, plunder; productivity. There is a third option which is trade. Banging people on the head: Walter Williams observation: that first option of banging people on the head has been the historical favorite for a long time. Only in the last few centuries have people done something else. Tend to think of theft as a zero-sum game--if I get richer by taking your venison, I'm better off and you are worse off. But it's important to remember that theft is a negative-sum game. If I know I might get banged on the head, my incentive to accumulate wealth is smaller. And I'll have to devote resources to keeping you from banging me on the head--lock meat up or hide it. Secure property rights are an important part of prosperity. The other two methods, productivity and trade, are not zero-sum; they are positive sum. They certainly make me better off without making someone else worse off--assume lots of deer and no congestion problems. A better way to kill deer or trading for it also makes you better off as well as me, certainly in the trade case. If I make a better knife and you see me coming home with more meat, you are going to wonder how I did that; might follow you around; I might share idea, sell it to you, or you might figure it out on your own.
14:27When we think of trade--third technique--we think of David Ricardo. We think of specializing in some task full time and trading. In the Ricardo story, what drives trade is our differences, the fact that we are not the same. Jonathan Sacks, Chief Rabbi of the United Kingdom: Trade makes diversity a blessing. Often, diversity is a source of conflict and tension; but because of the opportunity to specialize with trade, trade encourages us to cooperate. But what if we are all identical? Ricardian incentive to trade goes away. If you are a teacher, you know that it isn't just a special case where we are literally identical; if you are twice as good as I am at two tasks, our incentive to trade disappears, or three times as good. What really matters is our differential ability in Task A versus Task B. If we are all equally good at all tasks, it looks like there isn't going to be any specialization; certainly isn't going to be Ricardian specialization. But it turns out--this is the Buchanan-Yoon point--that there is a possibility for specialization and trade even when we are all identical. Rather spectacular--didn't appreciate it, hadn't thought about it; important. Back to hunting scenario: only one task, hunting; but there are other tasks as well. We have to keep our tents or lean-to's thatched. Hunting is just the only way of gathering food. One thing we have to do before we go out into the woods is make sandwiches; no restaurants. Each of us takes some time to make a sandwich for breakfast and for lunch; takes away time from hunting. One of us decides to open a business with take-out lunch solution; pre-made sandwiches so the hunters don't have to do it for themselves. At first glance, this takeout solution cannot succeed. What's required for this to succeed is that for my business as the sandwich maker, you have to be willing to pay more for a sandwich than I give up by not being able to hunt. By making the sandwich for you, I'm going to lose time hunting; you're going to free up time. You as the buyer of the sandwich want to pay less than you normally have to spend in time--foregone hunting--to make the sandwich itself. So, if we are all identical, and it takes me just as long to make a sandwich as it takes you and we are equally productive as hunters, my making a sandwich for you is not a viable business opportunity. Cannot be profitable. It seems we need the Ricardian world. But what Buchanan and Yoon point out is that even when we are all identical, it is possible that the sandwich business can thrive. We are leaving out non-monetary factors--you might want to stay home and make sandwiches even if it means giving up meat production, you might want to sell the sandwiches cheaper than your foregone costs of going out into the field, because you hate hunting--it disgusts you or you hate the woods or you love cooking. So there are non-monetary factors which we are putting aside for now. Continuing with the example.
20:30At first glance it appears there is no advantage to specializing and trading if we are all identical. But in fact if there are enough hunters, it can be productive for me to become a sandwich maker and make all of us better off. What it requires is the addition of technology to the sandwich-making process that makes sense when I am making 100 or 500 sandwiches but that doesn't make sense when I am making 1. Economies of scale: suddenly I can now produce a sandwich at a low enough cost to me--I can do it quickly enough--that my foregone time per sandwich is less than it would take you with your production of a single sandwich. Some obvious ways that might happen: facetious examples--if making one loaf of bread, small oven, might knead the dough myself, slice the meat and spread the mustard with my knife, grow the mustard in my mustard field--all those things are technology when making one sandwich. But if I'm making 500, I might have a special oven when baking bread; food processor or mix master for kneading the dough, power electric meat slicer; mustard field that is easier to cultivate enough for 500 sandwiches a day. Shocking--when making 500 sandwiches, the addition of those technologies, of adding capital, those technologies make the sandwich cheaper per sandwich in terms of foregone time, which allows me to make a profit, pricing it at a price that makes you want to buy it. You can't say that as the buyer of that sandwich, and here's what's interesting: 'Oh, I'll just do that myself; I'll get my own slicer.' But if you are making just one sandwich, a meat slicer makes a sandwich more expensive, not cheaper. One sandwich is not enough to amortize the cost of the meat slicer; you have to have a large volume to exploit the advantages of that technology. Puzzle sometimes why in primitive societies: why don't primitive societies today use the most up-to-date technologies available? It's not profitable. It's not productive to use a grain thresher when you have a plot of land that's 20 feet by 30 feet. You have to have a big farm. Important to notice that the scale of the operation has a huge impact on how much capital to employ. This was one of Adam Smith's most fundamental insights in The Wealth of Nations: the division of labor is limited by the extent of the market. Mike Munger podcast: not just that you divide the sandwich-making up into smaller and smaller pieces. That's part of it. Might have one person baking the bread, another person assembling the sandwich, someone who tears the aluminum foil. As volume expands, more and more specialization. But more important insight is the application of capital, technology, suddenly becomes profitable, wise to use. Then have an incentive to improve that technology. Leverage our potential as human beings. If you lift weights, you can be stronger and carry more books around with you. You don't need technology--you can do pushups. But you can add some technology--can add a backpack. But then you can kick it up a notch--you can add a Kindle. Then can have a thousand books. Can leverage your human abilities to carry stuff. If I'm producing enough sandwiches, it can be possible to add technology to make it profitable. A couple of points: First, the technology isn't sitting there. You have an incentive to invent a meat slicer. Somebody has to come up with a way to make the process worthwhile, and that's only sensible when you have lots of people around you. Might take a few million people, or tens of millions around you to make it worthwhile to produce an automobile instead of crafting something in a more artisanal way. Fifty people gathered in the wilderness--let's make them the most skillful Nepalese--they're going to be desperately poor. Self-sufficiency is the road to poverty because even fifty people can't maintain the modern standard of living we've become accustomed to. Have to be able to interact with tens of thousands, millions of people to attain the scale.
30:01Question: Even if we are all identical we can have this potential for specialization. So, which one of us is going to become the sandwich maker? One answer is it doesn't matter. Any one of us could. Better answer, from a student--it's the first person to think of it. It's not obvious that there is the potential for profit from sandwich making. Not obvious that there are two jobs--hunting and sandwich making. Important insight. When we teach trade, we get stuck in this two-by-two matrix. But there aren't two tasks. There are n; and we don't know how big n is. The number of tasks emerges from our insights. There is no book; they have to be figured out by human creativity. In the real world we are not all identical. We are all different. Ricardo's question: If we are all different, which one of us becomes the sandwich maker? Who would do it best, who of our group would be the best person to assign to that task? Said that two different ways, don't really mean the same thing. What we mean by best is not literally the best, because what we are trying to do with that phrasing is to get at comparative advantage. Say it a little better, make the distinction: there is a person who is best at sandwich making and the best person for the job; may not be the same person. That was Ricardo's insight. Who will it be? It's tempting to say that the sandwich maker--could think of this as a competitive process, could be one person starts it and somebody else competes with him and drives him out of business, or a few of them might open up. Could also think about a cooperative process: there's fifty of us sitting around; which of the fifty of us should not be a hunter and should stay home every day? Either could come up with the right answer. Think about what appears to be the obvious answer and why it's wrong. Obvious answer is: let's have a competition. Everybody makes sandwiches; whoever can make sandwiches the quickest should be the sandwich maker. That's not true; will show in a minute. A second obvious but not true answer is: let's just take the worst hunter. The reason those answers are wrong was David Ricardo's great insight--you have to look at opportunity cost. Summary on website, Lauren Landsburg. What you give up is the true cost of making the sandwich. The cost of making a sandwich isn't money but the time you give up and what you can do with that time. Even though you're the best sandwich maker in the competition, you might be so good at hunting that it would be nuts to make you the sandwich maker; the market in a competitive process would never assign sandwich making to you because you give up too much coming out of the field. And even if you are the worst hunter, you could be so awful at sandwich making that you are better off staying a hunter. That was Ricardo's insight, that what you give up to do a particular task is really the determinant of who you assign to do a task.
36:14Another way to think about Ricardo's insight also is that it matters who does what. You don't assign people randomly to tasks. If you want to make the pie of economic activity as large as possible, you don't just assign sandwich making to the best sandwich maker because that can be too costly. It could mean giving up a lot of venison if that guy is an extraordinary hunter. Which people do which thing is not obvious because you want to look at their relative abilities. One of the lessons here is--talking about economic output, maximizing the size of the pie; holding off non-monetary aspects, they do matter; if talking about the true size of the true pie we'd want to talk about those aspects as well. So, one of the lessons of the Ricardian insight and approach is: there are two ways to get venison. Direct way--you go out and be a hunter. Roundabout way--make sandwiches and swap them for venison. True for individuals or for nations. Trade is fundamentally in this Ricardian story--implicit cooperation where we leverage each other's skills. Important point in the Ricardian story: in a world where we are different, the pattern of trade that results is an illusion. The observed pattern of trade can fool us into thinking what the underlying cause of trade is. If you and I are in this primitive society and I become the sandwich maker; and after a few years have added fancy new breads and spices to the venison, improved the sandwiches a lot; an observer could look at it and would say it's obvious why he's the sandwich maker--he's terrible at hunting. And it would be true. After not hunting for five or ten years and running the sandwich shop, my hunting skills would probably atrophy. You in the kitchen would look inept trying to slice the meat or bake the bread. The pattern of skills is endogenous. It emerges. Depends on the technology that evolves. The person in Nepal who has to do all those things for himself, because there aren't enough people around him to specialize--Smith's point. By looking at the exterior, apparent skills, fooled. Self-sufficiency is the road to poverty. Nepal relatively cut off-tariffs, not a lot of good infrastructure. Spence podcast. To answer the question why the Nepalese person is so desperately poor and the American so rich: that Nepalese cook doesn't have as many people to exchange with; goods are more costly. Smithian because the more people you can exchange with, the more you can leverage the economies of scale; Ricardian because the more people you can exchange with, the more diverse they are likely to be and the more you can specialize. Ricardo story that there are differences is a different story in terms of timing than the Smith story. Ricardian story is about a point in time: at this point in time, given our skills and technology, it makes sense to specialize. The Smithian story is about the power of trade to change our technology in a much more dynamic way. Growth of innovation and technology, power of ideas and knowledge--Paul Romer point.
44:28Question: We've said if there are enough people to trade with, and there could be some false starts, even if there are no differences in skills, then specialization and exchange--trade--makes us better off; and even if there is no difference, they make us better off. What is the difference between becoming a better hunter--making a better knife, creating a spear or a net--and having the opportunity to buy a sandwich on the way to the field? The answer is: there is no difference. It doesn't matter to me as a hunter whether I've got a better tool or can buy a sandwich--both allow me to become more productive. Both create time. Time is our most precious resource. That means there are only two ways to improve our standard of living. You can bang your neighbor over the head and take his stuff, or you can figure out ways to make your resources to be more productive. Steal or figure out ways to make your time, energy, skills to yield more. Two ways to be productive: add technology so that spear goes faster--fishing rod, better fishing rod, net, trawler--or specialization with trade, which allows us to use all of our skills. Theft or plunder, or increase our productivity. Two ways to be more productive: either increase our technology to be more productive, or specialize and trade more, taking advantage of technology. fundamentally all about technology, but one is direct and the other is roundabout. Over the last 300 years this has been the story of human enterprise. In the United States in the last century, an increase in our standard of about 10 times. More capital and most productive people based on their opportunity costs. But not everyone is better off every minute. A textile worker in North Carolina can have a lower standard of living today than a few years ago because of economic forces. Example: about 50 years ago, a typical North Carolina textile worker operated about five machines at once. Each capable of running a thread through a loom 100 times a minute. Today's machines are six times as quick--600 times a minute. That's the standard productivity change we think of. In addition, each machine itself is easier to oversee; so instead of overseeing 5 machines, each worker oversees 100 machines. Output per worker way up 20 times over; worker is 120 times more productive in total. Smith's point: maybe you should put the textile mill in China. But person in North Carolina may not find other work right away. The people who wear clothes benefit and have more resources to do other things, but the worker in North Carolina may suffer. Same true of farmers in 1900. This is how our standard of living improves. Overall our standard of living improves even though not everyone's situation improves at the same time. In about 1900, about 40% of our population was on the farm; today about 2% or a little under 3%. A farmer in 1900 told that would happen would assume people would starve to death and there would be riots in the street because people wouldn't have jobs. What happened was that new jobs came along. Economic change; Don Boudreaux podcast--everything we observe around us is the result of an enormous web of specialization and trade. Incredible blessing in United States--large country with open trade. We specialize a lot. Also true that even when economy is humming along there are going to be short-run challenges; but even when struggling they are doing better than people did hundreds of years ago.
55:25More questions. This story about specialization and trade increasing our standard of living--Smith and Ricardo stories--what does that story have to do with borders between nations? If hunter is in Maine, and sandwich maker is a few feet away in Canada, does it change the conclusions about specialization and trade? Not at all. Borders have nothing to do with it. Both sides better off. What's the difference between Toyota figuring out a better way to make cars and Ford figuring that out? between finding ways to make your land more productive through fertilizer or better harvesting techniques and buying cheaper food through foreigners? They are the same. Obviously ups and downs. Question: in the real world we live in, David Ricardo's world, how do we decide who does what? Not just the 2x2 matrix of hunting and fishing. There isn't one. What steers people into different tasks are the wages, sending people into the most productive uses of their time. Suppose you believe you have a God-given obligation to use your skills and talents to serve mankind. How would you decide what to do? What is Roger Federer better at--tennis or fly fishing? Meaningless question. Surprising! Let's have him play tennis for a while and then let's have him fly-fish for a while. Maybe he's not just the best tennis player in the world but the best fly-fisherman in the world. Not obvious. It's the value of his playing tennis that matters, not his absolute aptitude. How good he is at fly fishing doesn't matter. Take Andy Roddick--one of the top 50 tennis players in the world--could be he's the best knot-tier in the world, so that's what he should do. It's the value of what your productivity produces relative to the other values of things you be doing. Enormous matrix; which as Friedrich Hayek pointed out would be an impossible problem to solve. You could never gather that information, much less use it to allocate people. The wages and prices steer people into their activities. Knot-tying doesn't pay. Once you put the value in, Roddick puts his energy into tennis. It could be that Federer is the best golfer in the world, even better than Tiger Woods; but he sticks with tennis because he loves tennis. That's okay too--that's the non-monetary aspect. You don't just take the job that pays the most money. You take the job that's most rewarding based on both the monetary and non-monetary aspects. You take the job that pays the most where the pay isn't just the monetary pay but also the satisfaction you get. Very few of us take the job that pays the most. Few of us take the job that takes the most.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/02/roberts_on_smit.html. http://www.econtalk.org/archives/2010/02/roberts_on_smit.html http://www.econtalk.org/archives/2010/02/roberts_on_smit.html Russ Roberts Mon, 08 Feb 2010 06:30:00 -0500 Larry White on Hayek and Money Larry White of George Mason University talks with EconTalk host Russ Roberts about Hayek's ideas on the business cycle and money. White lays out Hayek's view of business cycles and the role of monetary policy in creating a boom and bust cycle. The conversation also explores the historical context of Hayek's work on business cycle theory--the onset of the Great Depression and the intellectual battle with Keynes and his work. In the second half of the podcast, White turns to alternative ways to provide money, in particular, the possibility of private currency and free banking explored by Hayek late in his career. White then describes his own research on free banking and in particular, the more than a century-long experience Scotland had with free banking. The podcast concludes with the economics rap "Fear the Boom and Bust," recently created by John Papola and Russ Roberts. The song itself can be downloaded at EconStories.tv where viewers can also watch the video, read the lyrics, and find related resources on the web for Keynes and Hayek.

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0:36Intro. [Recording date: January 27, 2010.] Friedrich A. Hayek's view of the business cycle and money. Rap song, John Papola and Russ Roberts, at end of interview; video at EconStories.tv. Business cycle: What did Hayek see as the cause of the business, the booms and busts? Two scenarios. One: Central Bank independently decided to cheapen credit, expand the supply of loanable funds--Wicksellian phrase--ignite and investment boom. Second scenario more subtle: investors become more optimistic, new technology they want to invest in; come to banks and want to borrow more; instead of banks letting that drive the interest rate up, the Central Bank becomes involved by injecting enough credit to keep the interest rate from rising. So, first theory is the supply of loanable funds shifts first; second is that demand shifts first, but then the Central Bank shifts the supply to accommodate the demand. As the "real bills doctrine" used to put it: to supply the needs of trade. In either case, bad idea; drives the market interest rate below the equilibrium or natural rate and creates a disequilibrium between the plans of savers and investors. Investors are trying to invest more resources than are really available in the economy; consumers don't want to delay that much consumption. First scenario: Fed mistakenly or because of political pressure artificially lowers interest rates. That does what in the real economy that causes a problem? Think of investors having lots of investment plans on their shelf with different rates of return; interest rate serves as a rationing device, benchmark that an investment plan has to clear to make it worth it. As the interest rate goes down, more and more investment plans begin to look like they'll pay back enough to cover the cost. Plans come off the shelf, which increases the quantity of money. In particular, Hayek emphasizes: it's the most interest-sensitive plans that are going to take off in a low-interest environment; and those are the ones that involve a lot of time between the investment and the rewards being reaped--basic principle of finance. You discount your cash flows back to the present. If you can borrow just a little more cheaply, long term investment projects become more attractive.
4:42Continue the story: Some projects get undertaken. Sounds good! More investment! What's wrong with that? There are only so many resources in the economy--only so many workers, equipment, raw materials; they get drawn away from more sustainable investment projects into these other projects that aren't appropriate for the state of demand in the economy, the time-preferences of consumers. Economy invests in roundabout production, early stages of long-term projects; other parts start to languish; shorter projects become starved for resources. Misallocation; which would mean that the pie is not as big as it could get. But that's not the end of the story. Projects that need a long time to come to fruition need continual investments; you don't usually investments at once and wait; you have to keep tending the tree. That's where the problem comes. As resources are expended to keep these projects going, they start to bid up the prices of labor, materials, and machines; other businesses find their costs of production going up. Input prices going up; not enough to go around. At some point it becomes clear that there aren't enough savings to bring all these projects to fruition and some have to be terminated--they aren't going to make a profit. Will lead to unemployment in those industries that made the wrong investment. In the last boom and bust, it was the housing industry that took off. Characteristic of the Hayekian process is where you see half-finished investment projects being abandoned because they will not be profitable. Half-built condominium projects on the outskirts of Las Vegas. But those were stopped because the interest rate changed; the funding changed. In the current situation--John Taylor's story--the artificially lower interest rates of the 2002-2004 period encouraged lots of borrowing and construction; but when raised by Greenspan in 2004-2005 they became unprofitable. In the Hayekian story, does it require the rise in interest rates? That's the usual symptom of their being more investment than savings. In the short run or intermediate run if the Federal Reserve is controlling interest rates, it comes through the news as the Central Bank decided that it needs to raise interest rates. They are bowing to the inevitable; scarcity of resources is pushing interest rates back up to equilibrium.
9:35Wouldn't this also happen in any industry where there is innovation? Take the Fed out of it for the moment and talk about creative destruction--Schumpeter's term--the idea that innovation and new ideas come along, new business comes along; draws resources away from other areas. Price system tries to soften the transition; can't do it perfectly, imperfect information. As a new sector springs up--automotive industry at end of 19th century, internet industry at the end of the 20th century--people are drawn to these new opportunities; some will turn out to be failures. Not artificially induced by an artificially low interest rate. Amazon was unprofitable for a long time; profitable now. Took all kinds of resources that made it hard for other businesses to thrive. That's a healthy kind of growth; test is whether projects do become profitable. If because of new technology, economy has a new set of investment projects that promise higher payoffs in the future, people will be willing to save to provide investment for those projects. New demand for investable resources bids up the interest rate if the Central Bank allows it to happen. Hayek referred to this as the interest rate brake, preventing the economy from overinvesting. To bid the resources away from the current users, businesses have to pay a little more. Healthy, brings about economic growth. Problem comes in second scenario; if Central Bank decides interest rate ought not to rise and pumps in enough credit so that you get the new investments and the old investments, then you get the danger. Some will be profitable like amazon, but pet-dot-com didn't make it. Very often, an overinvestment or malinvestment boom piggybacks on an overinvestment boom. It's just allowed to go too far because the Central Bank is over-accommodating. What influence did the Austrian and Hayek theories have on real business cycle theory, the time-to-build work, Prescott, and others? Empirical puzzle for monetary malinvestment theories: Thought experiment: Central Bank changes policy, makes the interest rate low. We should see a burst of new investment starts. Hard thing to explain is why the change in investment persists even after the change becomes evident to everybody. That's what the time-to-build model attempts to explain: you don't just invest all at once; you have to make continuous investments. Mike Montgomery, U. of Maine, has written papers trying to apply the modeling technique of Kydland and Prescott to show that there's more mileage in the Austrian approach. Some have disrespected--not sure of verb looking for. Sometimes hear references to distress borrowing.
16:31Role of expectations. When the Federal Reserve plays with the current interest rate, it goes down if we are talking about the current crisis, 2002-2004; low for an unusually long time, negative in real terms for a couple of years; most people expect those rates to go back up at some point. If I'm planning a long-term investment, say, with this time-to-build, delayed, ongoing investment--not so much building a house, but an amazon--will have to build warehouses, will have to advertise--will be pumping money in continually over a fairly long period of time. Why would I respond to low interest rates if I know they are only temporarily low--forget rational expectations--if I just reasonably expect that that's not going to persist? Wouldn't it be surprising if short-run changes in interest rates generate these long-term projects? Good question; has to be answered to make sense of Hayek's theory. If everybody had perfect expectations, perfect foresight about the path of interest rates, you wouldn't see this cycle. It doesn't require that everybody guess wrong. It just requires that too many people guess wrong about the path of interest rates, in order to get enough malinvestment to cause a problem. Piggybacked on sustainable investments. People are convinced now that it's a new era--This Time is Different, by Rogoff and Reinhart. Reinhart podcast. Sometimes Fed has encouraged this: Greenspan talked about the "new economy" in the midst of the dotcom boom. Supposed to be permanent, ever-higher productivity growth. Can get the problem. There's no doubt there's a wide distribution of savviness; uncertainty. Differences of opinion about how soon and how much; people want to make their money now and get out at the right time; uncertainty about how long the money is going to stay cheap. Political pressure to keep it cheap. Very, very low interest rates now; but artificially low; Fed trying to keep rates low for home-buying. Big spread now between short-term and long-term interest rates. Would avoid getting caught if you locked in for the long-term, but tempting to borrow at the low short-term rate and roll it over--and that's when people get caught out. U.S. Government doing that now. When U.S. Government borrows short-term, they have an incentive to promote inflation; can refinance their debt.
20:54Economic history. Hayek's most important book on this subject--Prices and Production, 1931. Did he have a story to tell for what started the Great Depression? That was his story. His story was that the Federal Reserve and the Bank of England had injected credit during the 1920s and built up a credit bubble. Done it during a genuine period of high growth in the economy in order to keep the price level from falling--they were stabilizationists, inspired by keeping price level stable. Hayek argued said in 1933 that for several years he had been arguing against the stabilizationists. In an environment of growing output, it requires a continual injection of money to keep the price level from falling; and that injection of credit distorts the interest, and that causes the problem. Hayek criticized earlier economists who said that if the price level is flat, everything must be fine--that's not the indicator you want to look at. Argued that you want to look at relative prices, early vs. late stage investment, structure of production. Explanation for why the boom of 1920s couldn't last. Attracted a lot of followers. Something went wrong; by the 1940s, he was out of favor as a macroeconomist. Austrian business cycle theory neglected, almost forgotten by the economics profession. Why? Another guy came along--Keynes. Hayek was not the only guy troubled by Keynes's ascent--Schumpeter also was very resentful. Both are remembered fondly by other economists; but their work on microeconomics is well-respected, but it's their macro stuff that got put on the shelf. What happened? Events kept moving forward. Hayek had, arguably, a good explanation for the downturn. He didn't have such a good explanation for why the economy continued to deteriorate after 1931--continued to go down and stayed down for so long. He actually had a prescription for what to do about it. In Prices and Production--which we did at the time--he said that the Central Bank should try to stabilize the money stream--nominal GDP, or MV, money times the number of times it's turning over, V, velocity of money. If people are hoarding, inject more money. Also Milton Friedman's advice. But Hayek didn't say that based on his own advice, and later apologized for it: had fond wish that a little deflation would help break the rigidity of prices and wages and restore a more flexibly functioning economy--pipe dream. Did not call for Central Banks to do what his own theory called for--keep spending to continue from encouraging downward spiral. Other Austrians offered what advice for what they called a "secondary deflation." Kind of overkill, having economy going through this deflationary cycle. Hayek should have spoken out more against it; didn't do so. Viewed as having nothing useful to say about how to stop the cycle, even if he had been right about how it started. In that kind of environment, as Friedman has said, Hayek's picture of events was regarded as very gloomy--nothing we can do, had to let the economy purge the problems out of the system in the most painful way possible. When Keynes came along, it was regarded as a message of hope. Here's something we can do. We don't have to just sit by and linger in the depression; something active we can do. Same hopeful message a year ago with the stimulus package; hopeful message keeps selling. Idea that fiscal policy--playing around with government spending and taxes--has enjoyed a comeback. Thought it was dead; thought evidence showed it was too little too late or doesn't have any effect because offset by private spending. Reason may be view that the Fed is out of bullets--interest rates can't go any lower so they can't do anything. Think that's wrong. Some economists have rediscovered idea that monetary policy still is the thing that's ruling the behavior of the economy--if we'd prevented the shrinkage in nominal GDP, the recession would have been milder. Scott Sumner argument; podcast. Difficult to know whether that's right. Can't eliminate recessions that way. There were real malinvestments. When those are written down, real income has to decline. Resources are unemployed temporarily till they can find more sustainable uses. But you don't want to exacerbate it by making it hard for people to repay their debts because, say, nominal income is shrinking.
29:06Money; what the Fed has done wrong. What should the Fed to get it right to avoid these booms and busts? What did Hayek say about what the Fed should be doing? Hayek had talked about the issue on various levels. When he took for granted that you should have a Central Bank issuing fiat money and asked what's the most neutral monetary policy they can pursue, what will do the least damage to the economy, he was always a strong opponent of inflation, against the idea that you could stimulate the economy in any useful way by cheap money. But he suggested early on trying to stabilize the spending flow in the economy--nominal GDP. In The Constitution of Liberty he later said that maybe a shorthand way of doing that would be to stabilize an index of wholesale prices. Still didn't want to stabilize consumer prices because of the problem he pointed to in the 1920s--you are injecting more credit when productivity is high, and that can cause a credit bubble. But instead focus on input prices. As the 1970s went on, and inflation got out of hand, he started thinking more fundamentally about the institutional arrangement: not what the Fed should do, but is there some institutional arrangement, some regime change, that would give us better performance than we are getting from Central Banks. Famously published a pamphlet in 1976 called Choice and Currency, where he said to protect ourselves against inflation, people ought to be free to use whatever currency in the world they find more stable. That would put a damper on the inflationary proclivities of any one Central Bank. Then he pushed it a little further and said why don't we let private firms into this competition; published a monograph: The Denationalization of Money--available on the web at IEA at no charge. Argues against the presumption that government has to provide money and imagines what would happen if private firms were providing money, and fiat-type money: money that is not based on gold or silver but based on the promises of these private banks that they would keep the value stable; might be more reliable than central banks have been. Easier to hold private firms to their promises than to hold central banks to their promises. Historical context: for those of us in our fifties living in the United States, the worst inflation of our lifetimes was in the 1970s, when inflation reached 13.3% in 1979. Scared a lot of people. In the last year or two, some question as to whether we've had deflation, if it was mild; but for somebody like Hayek, they had seen hyperinflation, not just in Zimbabwe, which we read about in the paper, but in many of the nations of Europe. In Germany, in the aftermath of WWI, hyperinflation led to political consequences, partly leading to the rise of Hitler. Fear of inflation must have been very different for that generation. Hayek in his correspondence with Keynes was very uneasy about the threat of inflation in the 1940s. Vigilant; this creature had to be contained. Under the institution of the gold standard, which prevailed for the early part of Hayek's life, there is no tendency toward a rising price level; some periods of mild deflation, even periods when output tends to grow a little faster than the price of gold. Anything about 0 in the price level is cause for concern. Hayek: need to look behind the scenes. Concerned about the consumer price index but also what was behind it, excess growth in Central Bank credit. In the 1970s, these inflation and consumer price index inflation in Great Britain was in the 20% range--much higher than the United States, very alarming.
35:37Turn to The Denationalization of Money. If Hayek was proposing a private money supply, what would be the implications for his story of the interest rate as coordinating the plans of savers and investors? What would be the interest rate path, path of inflation, under a denationalized money in Hayek's view? Written about this: in The Denationalization of Money Hayek seems to switch toward favoring stability in the consumer price index, contrary to what he believed his entire career. It was his explanation for the crash of 1929. But in The Denationalization of Money he says private money issuers would most appeal to the public if they promised stable prices. Has a little footnote: Yes, yes, I'm among those who pointed out this could be a problem, but I no longer think it's a problem of much practical relevance. Trouble making sense of that. Think what he's saying is that when you are talking about Central Banks creating problems of 25% inflation, that's a much bigger practical problem than the malinvestment caused by trying to create a stable price level. Go back to 1931-1932 for a minute: talking about why Hayek's ideas fell out of favor. Gloomy story; waiting it out takes a long time. Others have argued that that long time wasn't Hayek's fault: there was regime uncertainty. Bob Higgs has argued that--Roosevelt frantically intervening in a lot of ways in the price system and the rules of the game, so private investment takes horrible tumble in the 1930s; could be for other reasons as well. Add in all these stories: Higgs: regime uncertainty; Friedman: money supply collapsing. Not just uncertainty about Roosevelt was going to do, but what Roosevelt actually did in the National Recovery Act and the Agricultural Adjustment Act. Organized agriculture to restrict output in the name of raising prices, in the name of restoring profits, and thereby prosperity. Non sequitur there: you can make one industry more profitable by cartelizing it and increasing its profits, but you can't do that for everybody because it only works by restricting output. If everybody restricts output, it's even worse. Industries restricting output are not going to be hiring more workers--they will be cutting back on all those things. Strange idea that still has some life of its own.
40:09Piece of Keynes that is fruitfully tied into the story of Hayek: The role of animal spirits, psychology, fear of the future, uncertainty--reference in rap video we are about to hear. Believe Keynes was wrong that that was what causes business cycles, seems there is a part of what makes it difficult to cope with them. For example, equation of exchange, Irving Fisher: MV=PT. Amount of money times the number of times it turns over--that's total spending--equals the amount of economic activity time prices. People are holding onto money because they are anxious. So now people are a little more cautious. That's hard to measure. No handle on that; don't know how severe it is. Offsetting that with M is going to be an inherently difficult thing to do. That's why Milton Friedman said Central Banks have done a bad job of it and shouldn't even try. Should just target M, let it grow at a slow steady rate; fine as long as velocity is relatively stable. One argument would be that V is stable so long as the government doesn't mess around with M, so if M is stable, then V will be responding to whatever people are responding to normally, so pretty stable. Once the government starts messing with M, then V will be relatively unstable. Keynes: could stuck in 1933. Could not have a good answer, either as Hayek or Keynes. The one thing the government needs to do now is create confidence about the future; and that's the one thing that economists, psychologists, and government policy makers know very little about. New plan every week; which tends to undermine. Two problems: One is that people are trying to hang onto their money and not spend it because they don't know what's coming. More generally, investors are going to put off launching new projects until it becomes clear what the environment's going to be. Creating uncertainty in the tax environment just makes it worse. Once the Central Bank and the Treasury and whoever else has made the policy that has dug us into a deep hole, it's not easy to climb out. No magic bullet for doing that. Need to put stable policies in place to allow people to start planning for the future again. Argument for doing nothing; risky politically. Argument for the rule of law. But we have to do something--only if it makes it better--which seems to be the next part of that sentence.
45:38White's ideas, arguments on money and the institutions that might lead to a better world. What do you think we ought to be doing with the money supply, and what is the role of the Fed, if any? What do you advocate? First best idea: not imagining will happen any time soon--monetary systems based on a gold or silver system in which banks compete to issue currency. Traditionally known as a free banking system. No Central Bank. All kinds of money supplied by private institutions. The private institutions discipline each other. Any bank that issues more money than its customers want to hold will find its money returning to it for redemption. It will be losing reserves to the other banks. Tradition based historically on gold and silver that the banks don't issue. Acts as a constraint; constraint made by banking system as a whole. Redemption: Would the redemption process be mandated by law or would it emerge through the competitive process? Part of the contract that banks have with their customers, so part of the competitive process. We have something like that today: your checking account is redeemable in Federal Reserve Notes. Your Federal Reserve Notes are the basic money. You can go to your bank and empty out your bank account. That's your deal with the bank. You wouldn't open a bank account at a bank that didn't promise to let you do that whenever you wanted. In the old days, people did that with bank accounts but the basic money was gold or silver coins, which banks had to promise to deliver whenever people wanted it. Mostly people open accounts so they can pay each other, so they can write checks; so banks have to make good at the clearing house on checks written to people at other banks. Checks come back: we just credited our customer with $50 because your customer said he needed to get it from you. That's the clearinghouse. Banks are always transferring reserves to each other; that's where this constraint is immediately felt. What would be the amount of the reserves that a bank would hold to engender my confidence in this world? The bank has to figure out what reserves it would have to hold in order to meet the redemption demands it has to meet at the end of the business day--at the clearing house. Empirically, banks have to figure this out. It's a practical problem. That's what bankers are good at. Historically banks, in the early days, when reserves were hard to replenish--it was hard to get a shipment of gold from somewhere else--banks would hold 30-40% reserves. As railroads were built, as banks became more sophisticated about managing their assets, gold and silver reserves sometimes went down to 2%. Those weren't the only resources banks had. They had very liquid assets any bank could sell. Any particular bank would have commercial paper or government bonds that it could sell very quickly to replenish its reserves. But banks were very vigilant about meeting all the redemption demands that came to them. But in those days--what period of time are we talking about? Most written about: Scotland, between 1720 and 1845. Very long time, trial. Canada had a fairly free banking system up to the Bank of Canada Act in 1935. Lots of historical experience with these kinds of systems. Kevin Dowd book collected experience in those times. But in those times, there were still runs on banks. What about the stability of the economy as a whole? Competition proponents confronted with "Well, before the Fed, established in 1914, we had all kinds of recessions, depressions, bank runs, problems, so even if you put the current crisis at the Fed's doorstep, and even the 1933, 1929 Great Depression--it wasn't all paradise before that. Free banking more or less stable than the current regime? Bank runs and financial panics were a problem in the United States in the late 19th century. Taken as the number 1 rationale for Central Banking and when Central Banking didn't solve the problem with deposit insurance in the 1930s. If you look around the world, don't just look at the United States, you find that bank runs and financial panics are actually pretty rare. Don't seem to be an inevitable consequence of having a fractional reserve banking system. Much more common in the United States than in Canada, where there are no financial panics; much more common in England than in Scotland. Begin to think: if you want a stable banking system, maybe it has to do with the way banks are regulated. The instability of banking in the United States is due to the peculiar regulations on U.S. banks. In particular, U.S. banks were not allowed to branch out; never across state lines and often not within states. That meant the banks were undercapitalized, under-diversified. Secondly, restrictions on banks' ability to meet shifts in the public's desire to hold currency rather than deposits. Known as the inelasticity of the currency. There was a ceiling on the amount of bank notes a bank could issue, set by the National Banking Acts. Panics have a history. They typically begin in the fall. What happens is farmers come to the bank and say "I need to pay my farm workers." They don't have bank accounts, so can't write checks. Banks would say "We're not allowed to issue more bank notes." Farmer says: but you still have to give me currency, have to let me redeem my deposits, so I'll take silver coins, or I'll take greenbacks--money issued by the government that served as reserves. A problem the banks could have solved by changing the form of their liabilities between deposits and notes turns into a reserve drain. The country banks start pulling reserves out of the cities; the cities then start pulling money out of New York, and then we've got a panic. In countries that didn't have these restrictions on banks, you didn't find those events. Created by our regulation; not a natural weakness.
54:09Why do you think the Fed was created? Fed was created to solve these panic problems. But there was another way to do it. There were people in the United States who said: Hey, look at Canada--they don't have these problems. Why don't we look at Canada? That kind of reform was blocked by the small banking lobby. They said: Canada has nationwide branching of banks. If we allow that, my neighborhood is going to be invaded by banks that are better run than mine; I can't allow that. Of course, small banking lobby is hard to remember. Very powerful. It wasn't until 1995 that banks got to branch across state lines in the United States. In some states you couldn't branch within the state. Unit banking. Russ: graduate student in Chicago [1970s]: you were allowed to have two drive-up windows in Illinois within a certain radius of the main office. Illinoise, strange, anticompetitive. Texas also strange: two-thirds of the banks failed when the because they were not diversified outside Texas. Almost all their loans were oil-related industry or real estate. Part of the political problem: seeming unfairness of losing all your money in one bank. You put all your money in one basket; there's a run on that bank, maybe rare, but effect on you. Most of the time in American history, we let bad decisions yield bad consequences. You make a lousy car, your car company goes out of business. You may a lousy product, you lose your money. If you run your bank badly, normally we'd say you go out of business. But if it imposes a very large cost on a small group of identifiable individuals, the political demand for the Federal Deposit Insurance Corporation (FDIC) must have been part of the story as to why people wanted to get the government into the banking business. Surprising thing is how long it took to get Federal Deposit Insurances; and when it passed, it was by the thinnest of margins. Franklin Roosevelt (FDR) was actually against it--Governor of NY. Almost inevitably went broke, paying out too much money to failed banks. Not popular idea at the Federal level. But the FDIC has the backing of the Federal Reserve, and they can always print money. FDR letter to the Editor he wrote: FDIC, which he opposed, was a moral hazard. Deposits always guaranteed, so it will encourage bad investments. Argument he made and also made by large banks. Proponents of deposit insurance at the time were small banks: people think we are weak, but if we can look just as solid as the larger banks people will stop withdrawing their money from us and putting it into larger banks. Even the playing field. Triumph for the small bank lobby. If a problem arises from bank runs, there is a way for banks to anticipate and build in a a circuit-breaker into their contracts: Notice of withdrawal clause. Trust banks traditionally had this before Federal deposit insurance. What it said was: in the event we need to, you need to give us 60 or 90 days' notice before you withdraw your money. You wouldn't want the bank to invoke that on you; but you would if the alternative was everybody else in the bank empties it before you get there. You'd like them to invoke that clause on the other depositors. The 90 days gives the bank time to sell off some of its other assets, avoiding firesale losses. Historical research on bank runs indicates that the reason people run is run is not fear of people running. People typically ran when the bank was already insolvent. Healthy purpose of closing the bank before the bank lost even more money. True, the losses were unevenly distributed, depending on whether you got on the front of the line or the back of the line. In a way, that provides a useful incentive mechanism: monitor your bank and don't rely on other people to monitor it for you.
1:00:29Just have the government monitor it. That way I can sleep at night. Unless the government monitoring system goes bad. Another contractual mechanism: extended liability for bank shareholders. In the Scottish free banking era, bank shareholders had unlimited liability--if the bank assets declined in value or had bad loans, a letter would go out to the shareholders saying you have to chip in. Banks did fail, but the depositors didn't end up losing any money. It was the shareholders. Scotland: great poetry, great fly-fishing, great single malt scotch, great model for how we ought to organize banking. Adam Smith; ironically now on Britain's 20-pound note. Competitive and innovative, training ground in the 19th century; spread throughout world; modern ideas on banking. Accidentally left haggis off the list of great Scottish contributions; swear on it, swear at it. Free banking politically unlike to be a starter right now. Never been a time in recent American history when people have been more hostile to a Central Bank. Remarkable. Ben Bernanke. Fix the Fed: get the right person in the job. Neglects the incentives the person faces in the job; changed for Bernanke from when he was an academic to when he was a Central Banker. Not going to talk about legislation. But pick the right person or tinker with the institution? Belongia podcast. Any politically viable small step we could make toward a free banking world without having to do it in one swoop? Open the door? Hard sell. Ben Bernanke's survival turns on the fact that he has critics on both the left and the right. Not going to agree on who should replace him; he will emerge as the compromise. Some incremental steps we can take; but don't expect free banking any time soon. Strong version of placing a binding rule on the Fed, path of particular economic policy. Haven't seen much willingness. Strong form--eliminate the Central Bank--unlike. But just as the U.S. postal system has become less relevant as private firms have been allowed to enter the market--overnight letters by UPS or FEDEx do not constitute an entrenchment on the U.S. monopoly on mail--less and less of a problem for consumers. Innovation in payments mechanisms will allow people easier access to other forms of money; might help constrain Central Banks. In the 1990s, Randy Crosner, competition between Central Banks losing market share and competition making them behave more responsibly. Offshore bank accounts, precious metals, more options; if the dollar becomes more iffy. Currently tax disadvantages to putting your money in precious metals--have to pay capital gains taxes if your gold holds its value while the dollar drops. You get taxed on that, even if you haven't made any real profit. Increase in money transfers since 9-11 even though we know the 9-11 hijackers got their money transferred through Western Union. Options we need to keep open. Chip cards, internet transfer. If I want you to build me a house: if I want to write a contract with you to pay you when it is finished, if I specify that payment in gold or Danish kroners or CPI-indexed--it's legal now. If the dollar and inflation got out of hand, the courts would enforce those contracts? Hugh McCulloch AER article said these contracts are now enforceable. Quietly been told that rules against commercial banks in the United States issuing currency have been repealed. Suppose no bank wants to stick its neck out and compete with the Fed.
1:10:42Fear the Boom and Bust: Rap. Mono version. Stereo version available and video available at EconStories.tv
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/02/larry_white_on.html. http://www.econtalk.org/archives/2010/02/larry_white_on.html http://www.econtalk.org/archives/2010/02/larry_white_on.html Lawrence White Mon, 01 Feb 2010 06:30:00 -0500 Spence on Growth Nobel Laureate Michael Spence of Stanford University's Hoover Institution and the Commission on Growth and Development talks with EconTalk host Russ Roberts about the determinants of economic growth. Spence discusses the findings of the Commission's recent report and how it compares to earlier attempts to uncover the sources of growth and the lack of growth such as the Washington Consensus. Spence makes the case for government provision of infrastructure including education and the problems of corruption and governance. The conversation closes with a look at Spence's career and the lessons of that experience.

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0:36Intro. [Recording date: January 18, 2010.] Commission on Growth and Development work, started in 2006. Background on mission and how it's unfolded. Mission had two parts: feeling on part of those who became part of the commission that the importance of growth is that it has been an enabler objectives, poverty reduction. Difficult problems in the developing world without the tailwind of growth. Never meant to be negative with respect to important achievements in health, education, other things. Complementary. Also, Washington Consensus that came together in the late 1980s-1990: experience accumulated in developing world: India, China; growth had turned up after a long hiatus in parts of the world, Africa, South America. Experience plus academic world; goal to assess what we still didn't know. Outlines of the Washington Consensus: put together put together principally by John Williamson with colleagues; attempt to try to understand what the key necessary had to be met in order for a developing country to grow and develop. Put together a list; even to this day sensible; list has been expanded over time. Problem wasn't the idea; it was the way it was interpreted. Interpreted as a set of policy actions by government, or a strategy that if you did that you were pretty much assured to grow. Turned out not to be true. Misuse of the Washington Consensus was that it was a kind of formula, necessary and sufficient conditions for growth. Now, most of us think of them as a close approximation to necessary conditions; sufficient conditions missing. Problem really was in the application; got turned into a prescription for a very limited role for government, including Latin America: the market will take care of most of it and if the government gets beyond a certain size it will start making things worse rather than better. That was not what was intended by the framers of the Washington Consensus. President Obama in inauguration speech: the issue isn't whether the government is big or small but whether it is effective at doing things that require collective action. Washington Consensus was an emphasis on markets, rule of law, private property; but also restraint on government spending because developing countries didn't spend their money wisely. Got interpreted to mean little or no government rather than wiser government. Wiser government tricky. Commissioners mostly policy leaders from the developing world; few exceptions: Bob Rubin--former Secretary of the Treasury--Bob Solow, modern growth theory and Nobel Laureate. Went in thinking it was fairly complex economics; came out thinking this is a lot about government and governance, not thought of as economics. 22 commissioners altogether, most from the "real world." Heads of central banks. Would have predicted in advance that it would be hard for politicians to be brutally honest; hard enough for academics. Was there a lot of political infighting? No. Harder in public forum; not speaking for one's country; output was the Commission's output. Their experience in their own thinking didn't always lead them to agree. Very controversial aspects. Decided to just say they didn't agree when they didn't agree.
8:20Produced report about two years after the Commission was started in 2006. In 2008, Report came out. Sentence startling, might be first of the Overview: "Since 1950, 13 economies have grown at an average rate of 7% a year or more for 25 years or longer." Rule of 72: If you can grow at 7%, you double the size of your economy every decade. If you do that for 20 years, you quadruple the size. What was the secret? Learned two things; don't want to over-generalize from the successes; have to look at the failures and the also-rans if you want to get a complete picture. Understood that; used device to highlight some things. Openness of the global economy, by policy, wise policy on the part of the United States, European Union, advanced countries after WWII was the enabling factor. Two parts: huge markets for developing countries that can find a place in them; and a lot of knowledge they can import: technology, management capability. Increases productive potential much faster than you can do it on a standalone basis, or faster than the advanced countries can do it. Overwhelmingly the dominant factor, more than aid. Then a whole lot of things that go on inside an economy, some political, some economic that take advantage of that favorable environment. On economic side: very high saving and investment levels are critical, including on public sector side: infrastructure, education. Public sector under pressure in a poor country, so investing their 5-8% for the future rather than the present; have to have a supportive population. Takes leadership; people will make those sacrifices if they think their children and grandchildren will be better off than they are. People do that; but they have to believe two things: that it's possible and that their all in it together. Inclusive element that is essential.
12:46Two aspects of public activity. Infrastructure in the United States: bridges, tunnels. In poorer countries, much more basic than that. Can't get the crop to the port; can't bring stuff from the port to the people; can't use a real truck. Educational part harder to understand. Lots of countries pour money into education but get no return; didn't get education but just spent money on it. Ironic for the father of signaling theory, which downplays education for its role in creating human capital and emphasizes its role as a signal to talk about its importance in developing countries. Inputs are more like requirements: if you have one without the other it tends to slow you down. Not surprising that economic development tends to start on the coast or around rivers; historically true, infrastructure already there. True in China case. Paul Collier: a lot of landlocked states in Africa. Infrastructure expensive; in a poor country tends to get pushed aside by immediate problems like disasters, famine. Not trivial things; crowding out effect dramatic on long-term growth. Most of these countries--Japan's an exception--were very poor when they started growing: China, Korea; Singapore was a poor fishing village. Big sacrifice, tough choice; requires inspired leadership. Education: academic studies using data and cross-section studies turn up a huge variety of results. Specification of the model complicated. It is true that there is a tendency to measure education by inputs to it--how much money is spent on it, how many kids are enrolled. When you measure the output, you get surprising and disappointing results; do not get good output in terms of development of young people; ubiquitous. True in the United States also. We often give it away, and people don't treat things they are given with the same care as things they earn. Subsidized education. Data support that. In many developing countries there is family commitment to education including financial commitment, in cases where it seems to be working well. In India, nobody monitors public employees. Resembles political machine from certain American cities; patronage system. In some cases young women don't get to go to school because when the family is under pressure, they are the ones who are pulled out. Complex challenge to up the quality.
19:15Globalization: You don't want to just look at the winners. Any examples of countries that have cut themselves off from the global marketplace and have been successful? No; unable to find any. You can cut yourself off or try to partially cut yourself off and for a while lots of people thought that was a good idea. Runs out of gas; may look like it's working for a decade or so but not going to work for 25 years. You pay an increasing price in terms of cost or efficiency by taking that route. Examples even in advanced countries. Canada, Australia, and New Zealand all had very high tariffs, import substitution policy that developed their industrial sectors; have all abandoned them because the costs got too high. Can measure the costs: amount of protection you require to have an automobile in one of these countries; end up with tariffs that are effectively 80%; too expensive to support this strategy. Lose the economies of scale and lose that competitive edge. Runs out of gas: thinking of the United States and the big three auto makers. In a lot of industries, three competitors is plenty. But in the United States something happened in the 1950s-1970s that made the industry relatively cozy; something then happened in Japan that forced that the big three to work a lot harder and some of them couldn't do it. In a developing country, subtle aspect of policy: want to have the objective of being open and fostering competition, but it is possible to do it too fast. If you had relatively inefficient sectors and then expose them to global competition too fast, the Schumpeterian job destruction instead of job creation can get out ahead. Generally see countries that are succeeding going in the right direction but at a measured pace. Didn't make it easy for the automobile companies; many automobile companies elsewhere operate globally and build cars for countries where the price of gasoline is much higher. Managerial cultural dynamic. Get scale economics: Adam Smith, comparative advantage--what you are relatively good at and can compete in. Advantage you get from the global market. Seeing the potential for an enormously large pin factory that sells to the global market and thereby takes advantage of specialization and application of capital is the road to productivity. Also the road to vulnerability: dependent on the world economy; recent crisis. Lower variance if you are cut off from the global economy, but the mean is not very high.
25:26Corruption. Challenge in these stories: government being the right size, enough to cover infrastructure. What role does governance play in success and failure? Important role. Wholesale corruption--grand theft--is devastating because there are just not that many resources in poorer countries. Banks in Switzerland and the Cayman Islands. Paul Collier. Major issue. When done well, effective leadership. Botswana: president came from the tribe where the diamonds were found, well-developed regional decision-making process at the tribal level; these belong to the country, off in the right direction. The other road is a pitched battle. Natural-resource-wealthy countries: competition to control the resources when cash flow is in a geographically limited place. In developed countries, resources relatively dispersed, in the brains of people. The most you can extract from it is via income tax, not like what people can do to oil and diamonds. Back to the 1950s: where in the developing were things predicted to go pretty well: Africa. Where major problems: they said Asia. Dead wrong. Underestimated the importance attached to human resources when developed. How were they going to make the single asset of people better.
29:46Policy and how we might get more than 13 economies to grow at 7%. Collier and Easterly: Russ pessimistic about the ability of outside influences to do anything in the short run to help. No evidence we can help them; hope but no evidence. Optimism? Have tried aid. Other than opening our borders and trading is there anything the developed West can do for the less developed world? Can do a lot in humanitarian terms. Even countries that are going badly still think it is their business, so external influence, interference, not likely accepted even for poor countries. Humanitarian disaster, manmade or by forces of nature, situation changes. Palliative. Easterly and Spence don't agree on much agree on this; part company on how to think about the role of the state. Effective government, effective leadership an important input; so is the private sector dynamic. When they come together, powerful. Washington Consensus overreaction. Challenge is: selectivity bias. If you look at the successful states, their governments tend to be fairly well run. We don't know much about how to get from A to B. What are we going to do about that? Who is "we?" Not too pessimistic: demonstration effects have enormously large impact; lots of examples in that. China: Deng Hsiao Ping went to Singapore and then New York and it just opened his eyes with respect not only to what was possible but how you'd go about it; why the market was so important. India. A big neighbor, similar in size and population has a big influence. China now starting to have an impact on the developing world both in knowledge transfer and in using their resources. People worry about the international political economy. Nation, identity-building, adapting policies. Reasonable basis to hope we can return to that pattern in the post 2008 financial crisis period. In Brazil, grew rapidly till the mid-1970s, more or less stopped dead in its tracks for 25 years; now is growing very promisingly. Haven't listed those 13 countries. Cultural question: Japan, Korea, Singapore, China, all in Asia; India, close to Asia. How much is a good kind of contagion where the success of your neighbor puts pressure on you or you learn from your neighbors. Not a lot of success in Africa or Latin America to be copied. Any from those areas? Brazil and Botswana. Oman. Majority are in Asia. India and Vietnam about to join the club but haven't been at it long enough. We don't know; but it looks like the demonstration effects are more powerful regionally, so probably a cultural component to it. Hard to reach a definitive conclusion because there are other factors. One of the disadvantages the African countries have is that they are new. Conflict/tribal structure; not a lot of years in building national identity. When push comes to shove, do we all think we are in this together? Still building that identity. United States, China. Deeper questions about the politics and cohesiveness that turn out to be constraints on collective choice, policy, decision-making and investing.
39:17What are the most exciting areas in research on this topic of growth that have the most promise? Work in political economy: incentives created by the economy and the effect of the political system on that and vice versa. Once you put the political system in the model and make it endogenous--rather than thinking of development as having exogenous government policy and the economy reacts, so the model is about the economy. The political economy research agenda is to make the politics part of the model. If you talk to policy-makers, they say it's like you're telling me you've got a model that's going to predict what to do tomorrow. Wonder about where are the levers. What's exogenous with this? Answers will turn out to be interesting. There are constraints on politicians. Creative part in developing country context has to do with sequencing things so you can get things done without too much political resistance. Recipe problem: you might know the ingredients--Washington Consensus--but don't know when to add what to what, don't know the process. Bob Solow used exactly those words. Recipes are country-specific. Nobody thinks that a country with a literacy rate of 40% is going to grow--certain things that everybody agrees on. Nobody thinks that a country where you have to take a horse and buggy to get inland is going to grow at high rates.
42:54Practical aspects of the Commission. Two major reports. First report: requirements for growth, success. What are the prospects that people are going to listen to this? Does the nature of the Commissioners being non-academic help or hinder it? Helps. They are not anti-academic. Highly educated, came to work interactively with the best of the academic world. Conversely, the best of the academics benefit. Because of who the Commissioners are, the Report seems to have a life of its own in the developing world. Public attention. Growth rates of 10% are out of the range of the experience of the developed world. Most popular part of the report: idea of one of the Commissioners: fun, Bad Ideas. Smash hit. Email, newspapers: governments doing 18 of the 25. Good idea to put it in the negative. Anti-demonstration effect.
45:55Haiti. Don't know how horrific it's going to be. Infrastructure: there's nothing there, not about buildings but about government, the normal channels you would go through in a developed country. Part due to so much being destroyed; part due to its not being a good system. Good opportunity to start over? Observation: very difficult to change things when they are not going well; but when they are going horrendously badly or there is a crisis, that's when you have a chance to change things. In a crisis the constraints that normally operate get removed. Lots of examples. Crisis doesn't always produce good results; does produce an opportunity. Make a massive humanitarian effort, and then keep going. Tall order. Have the resources; relatively small country; neighbors in North and South America; lots of relationships: Governor General of Canada is Haitian in origin. Reason to make a supremely large effort. As in every case, they are going to have to take it over. Let the Haitians move to the United States--if we had a different welfare system. Incredible challenge to deliver the aid. Could increase GDP worldwide overnight by 10% practically overnight--meaning in a decade--just by lightening up on immigration. Right, but a tough subject. Natural that some people would be opposed on personal grounds; others opposed on ignorance, assuming it would hurt us; others would be helped by having more folks here. Where young people are coming into job markets and the jobs don't match, enormous matching problem. Lots of countries where even the highest growth rates you can imagine wouldn't have the absorbing capacity for these people. Probably need supervision. In a country like the United States, people move to jobs and jobs move to people. In the global economy, jobs move to people, works pretty well. People are more constrained about moving to jobs. Not letting the pace of creative destruction get too far ahead of the labor market: crude understanding of the labor market. If you make it more expensive to hire and fire people, labor market more dynamic. But also risk, other things we haven't thought about. Right now, with 10% unemployment in the United States right now, it's still a dynamic place to be. In poor countries, creative destruction doesn't work the way it works here. Cultural, infrastructure, legal environment? Different thing. We don't understand it very well. Barriers in incremental employment creation are partially man-made. Relates to the political economy discussion. If you have a formal labor market and a huge informal labor market that is less skilled, less educated, you have a dual economy situation. If you try to work with the formal labor market, may not work very well. End up with barriers to the people who are not in the modern economy entering it.
54:12Wanted to ask about second report; instead will put a link. Deals with financial crisis and global economic crisis. Instead: Spence, unusual career. Standard academic economist, innovative and sophisticated mathematical highest level stuff; became dean of a world-class business school--Dean of faculty of Arts and Sciences at Harvard first--narrow academic economist; academic administrator; changed gears to become dean of a business school, faculty who view themselves as largely self-employed, fund-raising; then win Nobel Prize; then chair international commission. What have you learned? Wiser than at age 25. Which experiences valuable, what relearned? Lucky to have these opportunities. Dean at Harvard and then at Stanford, viewed as leadership. Enjoyed getting to know the people; inside view of management as people were on boards. Commission: leaders in the political and policy area. Came to appreciate not only the people but how many different kinds of skills and capabilities and imaginations and intellects it takes to run a successful society and successful economy. Complex set of things that go into a productive, innovative, rewarding opportunity for society--have a sense of what that means. How can the rest of us understand that without following your career path? Everybody has brushes with this. Nobody ever has the complete picture. Society manages to run where nobody has the whole grasp. People's experience gives them a sense of this: institution they are in or their community gives them a chance to do something different from what they do at work. Young people are very creative; kind of have the advantage of narrowness of focus. Fixated on informational structure of markets and how that worked. As you get older--interview many people, contact with many people, tend to acquire managerial responsibilities--not just the direct experience. Maybe give up the innovative edge and acquire the broader view; sense of how important people and their values are in making things happen. Leadership from values, integrity. Focus: what people say about entrepreneurs; Adam Smith: grotesquely inaccurate assessment of their chances of success--which is a good thing because if they knew their real chances they'd give up. Narrowness of focus: in your 20s and 30s you think you know everything. Handicap, but advantage to it because you focus. Doing this program you learn how little you know. Not a bad system. Spence: Youngest daughter graduated from high school, gave graduation address; you need to understand that you are entering the period when you are most powerful and most creative. Later on you'll be wiser, more balanced. Natural cycle. Understand where you are in that and throw yourself into it. Interview with Commission is not meant to last. What next? Stay involved with things related to the global economy and the developing world; writing, research, teaching. Country level involvement. China, Latin America. Agenda bigger than time available. Indonesia, Commission member from there; switching jobs. Stay involved with the private sector, boards, investment.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/01/spence_on_growt.html. http://www.econtalk.org/archives/2010/01/spence_on_growt.html http://www.econtalk.org/archives/2010/01/spence_on_growt.html Michael Spence Mon, 25 Jan 2010 06:30:00 -0500 Munger on Many Things Mike Munger of Duke University talks with EconTalk host Russ Roberts about many things. Listeners sent in questions for Mike and Russ to talk about and they chose ten of the most interesting questions with the idea of talking about each for six minutes. The topics are the scarcity of clean water, asset bubbles, the role of Fannie and Freddie in the financial crisis, can a business pass a tax on to its customers (or maybe even its workers), compassionate food, the study of economics, how to choose a college, the nature of cooperation in a modern economy, the humanity of non-profits, and the American Dream.

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0:36Intro. [Recording date: January 12, 2010.] Unusual format: solicited questions on Twitter (EconTalker) and Cafe Hayek; picked 10 most interesting, will try to get names right. Will do six minute answers; bell will go off, must finish sentence.
1:44Craig Morgan: Story on National Public Radio about fresh water scarcity threatening mankind. Peak Water. Water is scarce and an important resource. Different from Peak Oil. We don't use up water, just make it temporarily icky or it evaporates. Good desalinization tool called the sun; brings water up out of the ocean and deposits it over land. Scarcity; separate two things: potable drinking water and storm runoff. All cities in the United States and Europe; heavy rain causes runoff and goes directly untreated into rivers. We can't manage all the runoff. We treat water as if it were garbage. Human feces is toxic waste; tiny amount can make a large quantity of water not only unusable but almost a bio-weapon. Take clean potable water and combine it with human feces and then spend billions trying to treat it. Rose George book, analyzes sanitation all over the world. Some cultures are fecal-philic and some are fecal-phobic. China and Southeast Asia use human feces for fertilizer; has a lot of nutrients, though it also contains e-coli and things that are deadly. India and the United States flush it away. Both wrong. The problem is not scarcity of water; the problem is we haven't dealt with the problem of human waste and keeping it separate. Pretty good job in the United States. We pour water into it! Our sanitation system works well, but our water system does not. We have shortages. Richard McKenzie podcast: southern California, not much rain, no shortage of Mercedes and Jaguars but they don't rain either. In poorer societies, struggle to deliver clean water through the public sector. Can the private sector do better? Should focus on sanitary handling of human waste; could deliver clean potable water. A public good would be getting rid of human waste--public sector could deliver that service. Water is a commodity; private systems could deliver that. Rose George book: talk about waste treatment. What mistake? Gold standard is a ceramic toilet inside your house that uses water-born sanitation. We try to approximate that. In China, a number of places are using dry biological systems that also produces a clean methane gas you can cook with. Never touches the water. Bell goes off. No reason to take it away from the house. Want to control odor and contact with germs.
8:12Question 2, from Stephen and TX Sur [sp?]. Bubbles in our current economy. Can we identify bubbles? do something about them? Neoclassical economist. Adam Smith; correction, animal spirits talked about by John Maynard Keynes--group psychology. Used example: investing doesn't have much to do with fundamentals but more like a beauty contest where your objective was not to say which person was the most beautiful but which person everyone else thought was the most beautiful. Nothing about underlying fundamentals; just group psychology. Want to think that's just wrong, but it turns out that Vernon Smith and Charlie Plott, neither of whom would be associated with Keynes, have been able to replicate something like bubbles in laboratory experiments. Thousands of people who didn't know each other at computer terminals all over the world, supposed to buy and sell derivatives on an underlying asset which had a certain value and would fluctuate. They all knew that the value of this asset would go to zero at time 30--a month from now in the experiment. What would happen to the value of the option? For at least 5 or 6 periods after everyone knows the value of the asset has gone to 0, there is still trading in these options. Not surprising that people want to sell them; what's surprising is that people buy them. Why? Thought they could still make money and they were right until they were the last ones holding it. Ponzi scheme, chain letter. But Ponzi scheme seems like a fraud; in this experiment everybody knew the value of the asset was zero. Something like animal spirits might actually count in these kinds of bubbles. They play some role; we don't have a theory of animal spirits, though. For those who want to put bubbles at the center of investing, who want to get rid of the efficient markets hypothesis and bring behavioral economics and bubbles in as the default, pretty empty box. What an Austrian economist might call an asset inflation; wrong signal about the cost of funds, interest rates too low. Taylor Rule, podcast: Fed Funds rates were less than half that suggested by the Taylor Rule, sending a signal to investors that they could make a lot of money in housing; but it was artificial. At least as good an explanation as animal spirits. Way too much money in the housing stock, misallocation of resources. The Fed made it very cheap to borrow. It seems that everybody's really good at identifying a bubble after it's broken; not many people very good at identifying it before. Even the housing bubble--we artificially increased housing prices. Subjectivist with regard to pricing. Keynes's insight--price partly depends on what you think others will pay for it. Prices do seem to return to fundamentals. Bell.
14:25Question 3. Agnostic asks: There has been an explosion in compassionate food--grass fed beef, free range eggs, pastured cows; little stories about treating animals nicely. Bottom up rather than top down regulation by the state. Arguments with vegetarians, who say it's exploitation of the animals. Better if animal had not been born. Cattle and chickens not so great as pets. Montana, mountain meadow, five beautiful cows and one extremely happy looking bull. Cow and bull heaven; somebody was paying for them to be there, designed it, because they want to sell them for profit. People might pay more for happy cattle, taste or health benefits. Or just don't want to be cruel. Peter Singer utilitarian argument--it's not obvious that it really is true that had those cows never been born that they'd be better off. Just the fact that at the end of their life they go into an abattoir--slaughterhouse for the SAT students--when they kill them cows, maybe they do it in a kosher way, allowing people to keep kosher. Paradox: if I am a vegetarian.... Suppose you really value the quality of life of animals, trying to decide whether to be a vegetarian or not. Have to say you favor a capitalist system that delivers meat to consumers because you care about animals. Nice that they are born and live their bovine life for a while. Couldn't live on their own; they would disappear quickly if there were no market for their meat. Strong opinions on this show; defend the vegetarian view: I'm not a utilitarian; all I'm saying is that I as a human being don't have the right to exploit animals. Totally happy with a world with fewer cows. Don't even have the right to bring them into the world to use them as an object for my pleasure. Have converted two utilitarians to eating free range meat. Have to look into the actual conditions; unnecessarily cruel. Why isn't there a middle ground--take cattles' lives with respect and then eat them. Temple Grandin, autistic woman self-described, developed ways to treat animals with more compassion as they enter the abattoir, with little or no increase in cost. Didn't answer the question: top down versus bottom up. Regulations would just raise costs. If what you did was, as an entrepreneur, find a way to appeal to more customers so they would pay more for better treatment. Some people find a difference in the taste because of reduced chemicals released in the frantic final minutes of a cow's life. Bell. Atlantic article about food and about Alice Waters, written by Caitlin Flanagan.
21:27Question 4: Viking Vista [sp.] asks: What is the biggest deficiency in the study of economics today? More and more in a direction where they are studying economics instead of markets; more like a subfield of applied math. Adam Smith, when he wrote the Wealth of Nations, was interested in what causes wealth, but it was a subsidiary question. His earlier book The Theory of Moral Sentiments, was about when is it moral to act in your own self-interest? Under what circumstances can you build a society where people working in their own self-interest make other people better off is an important question; but modern economics doesn't look at either of them. Tends to look at the simplified invisible hand problem: can we show that with what economists call the first and second welfare theorems we actually come up with a competitive market at work. Assumptions we make in order to prove those theorems are absurd. Assumptions about competition, information, nonlinearity--decreasing returns to scale. Adam Smith--pin factory example: if you divide the tasks into 18 different tasks, you get a whole lot of pins; and you get trade and exchange. But that's increasing returns to scale. Economics should be about entrepreneurship, increasing returns to scale, and the way people go over the mountain and find ways to trade with their neighbors. Instead, economics now studies static situations. Old joke: guy comes out of a bar and sees someone on his hands and knees looking for something under a streetlight. Asks to help; guy looking for his keys. Asks where last seen; guy points over into the dark and says over there. So why not look there? The light is better here. Too painful. Economics looks in the place where the light is best, but markets are the place that's dark. Different question: Mike finished grad school, got job--what proportion of understanding gained post-graduate school? Lucky to be at a place that was Chicago-school-oriented. Advertising for eyeglasses and licensing restrictions. Read that literature, Alchian, Demsetz. Learned more, distrustful. First job at Federal Trade Commission; looked at airlines, trains. Like a post-doc. Learned, but because not an economist. For Russ, about 50% or more since grad school at Chicago; couldn't have understood then, not sure how to teach it in an undergraduate education. How do you teach people how to think like an economist, to understand the "and then what?" Mysterious. Bell. Biggest challenge in teaching undergraduates is that we have to give them a grade; hampers education. We only give out questions where we think we know the answers; otherwise hard to grade. Most interesting conversations with economists at lunch: why to sell cars is there such a strange price discrimination? CarMax pops up, different way of doing it. Both exist. We don't know the answer to that.
28:21Question 5: David Williams. To what extent did Fannie Mae and other government-backed debt have in creating the financial crisis? Try to compare different costs. Crisis couldn't have happened without Fannie Mae and Freddie Mac--they were necessary but perhaps not sufficient. Government set a trap baited with three kinds of tasty cheese. We subsidized downpayment, terrible idea, reducing the skin in the game that people had in their own house and takes away the power of the signal about whether the person can manage finances in life. Second, artificially low interest rates. Third, guarantee of permanent price increases. Secretary Paulson in 2006 said that any decline in housing prices was a market failure and government would act--that's what government does--to prevent that. If you think housing prices are always going to go up--first rule of finance is that if anything is known to be going to happen, it's happened already. Fannie Mae and Freddie Mac, created 1938 and 1970 respectively; job called intermediation, find people who want to borrow money and get them together with people who want to loan money. Bigger packages. Problem with mortgages is they are illiquid--don't trade very well as assets. Risky to get the loan too far away from the house, so you have information about it. Big change between 1994 and 1997: definition of a "loan that was conforming." Conforming loan: one with 20% down and a 30-year ceiling on time for mortgage repayments. Dropped both of those: nothing down, 100% of your income could be devoted to your mortgage. Fannie Mae would still buy it at par value. Sisters of Mercy Orphanage could buy it as if it weren't a risky asset--government certified. Reason this happened: Housing and Urban Development (HUD) created mandates for Fannie and Freddie to give something back; they were making a lot of money. Wanted social justice; required them to devote a certain proportion of their business to those with low income. Started to raise that proportion between 1994 and 2006--Clinton administration initiative that the Bush administration embraced. Fannie and Freddie's lobbying effort respected as one of most powerful on Capitol Hill; making a lot of money from loans; government implicitly guaranteed the value of those securities. People kept pouring money into. At one point, $20 billion in new packages every quarter; even more than that. Housing had been a good hedge against inflation; bought a house, stayed in it for 30 years, and after it was paid off it appreciated at about the rate of inflation. American Dream. Once we started pouring all this money in, we destroyed affordable housing because the average price went up, just between 1997 and 2004--up from $150,000 to $250,000 in real terms. Looked like a bubble. Bell. Wasn't animal spirits, though animal spirits played a role because once prices start appreciating like that it can be rational to be exuberant about them; what stoked the fire was bad government policy. Trap. If we can get more people in houses they'll be better off--unless they default.
35:12Question 6: John Strong. It has always seemed to me that a social order with free competition requires a high order of cooperation, much higher than a social order where competition is restricted. Makes you think about what is meant by cooperation. Two different kinds of cooperation. One is that I act in a way that advances your goals because of the way the system is set up. Get used to this tacit coordination or cooperation; still get what we want. Another kind of cooperation is where we have a meeting where we assign people tasks and all go out and do them because we care. Families cooperate that way--sometimes; tell son to mow the lawn and sometimes come back and he'll be gone. Mancur Olson, free rider problem. Two really different kinds of cooperation. Experimental literature: dictator games. Two of us; I go first. $100 on the table; I'll suggest a split--I get $60 and you get $40. You go second; you either veto or you accept. If you veto, we both get $0. If you accept, we get the deal I proposed. Rationally, should accept $40; should even accept $99/$1 rather than $0, and I know that. So the prediction for an economist is that everybody always proposes $99/$1 if they go first and everyone always accepts if they go second because $1 is bigger than $0. Lo and behold, that's not what you find. People will pay a price for fairness. Second person: will I pay $1 because the first person's being such a jerk? Will I pay $2? In Western Europe, United States, Canada, where people are used to markets--if you put them in an anonymous setting they propose 60-40 or 50-50, something close or an even split. If you go to a society that depends on that second sense of cooperation, families, clans, they always propose 99-1 and the other guy will always say no. Weird thing is, sometimes you see that three or four times. They both get zero and stay there because they are not used to impersonal cooperation. Impersonal cooperation is what markets are. Difficult to get into people's minds, but once it's there you get more cooperation. Other factors that may cause those results to differ. Digress: if you go to countries that did not have market-based systems like the former Soviet Union, hear a lot of stories of semi-market behavior where people don't have much trust. Guy plans conference in Soviet Union and right before it's about to start he's told he doesn't have as many rooms as promised. But I had a contract! So, sue me. In America that doesn't happen very often; people would feel like a jerk to be that opportunistic. In societies that are top down or corrupt, they struggle with that level of trust. Worry it's disappearing, especially in light of the bailouts. Play by the rules of the game and end up a sucker. Fragile. Rule of law isn't what sustains capitalism. Bell. Legal system is for last resorts.
41:42Basic economics question, Question 7: Dave. Can you tax a business, or is it passed on to consumers? Complete answer was done by Alfred Marshall in his Principles of Economics. Simple answer: Depends on two things. If it's a tax on income--suppose we tax the profits of the business. Looks like it shouldn't have many distorting effects, like an excess profits tax. After the fact, we are just going to take a little slice. The more you make the more you take. You don't really deserve it; but you have enough incentives. But it encourages overcapitalized production in the sense that instead of declaring profits, the company is going to plow all its money back into robots, conference chairs for its executives, maybe overpaying its executives. So one of the reasons we have robots instead of workers is that the United States has relatively high taxes on corporations. So, who pays the tax on corporate income? Workers! It increases the wages of a few skilled workers, but it reduces employment. It drives companies overseas. Doesn't it make the workers who remain more productive? Yes; the few people who remain are better off, making higher wages; relatively skilled. Corporate income taxes hurt unskilled workers. Second kind of tax: ad valorem, or per unit, tax on the sale of products. Marshall: If a tax impinges on anything used by one set of persons in the production of goods, to be disposed of to other persons, the tax tends to check production--you can get less of it. Shifts a large part of the tax to consumers and a small part back to production. So, unless what is called perfectly competitive--for example, wheat. A tax on wheat would be entirely on consumers. If you put a tax on cigarettes, which is not perfectly elastic, some of that is going to be passed on to consumers. It's only the ones in between where the producer pays any of the tax at all. The distinction is between who pays the tax, who writes the check--the business writes the check--and who pays the check. Generally, it's paid by consumers or by labor. The incidence--the impact of the check--is rarely on business. Technically, it depends on the shapes of the supply and demand curves. One of the values of a formal education in economics. Russ's notes. Cheat and skip off this question: Russ has never seen American Idol; has seen the you-tube of Susan Boyle on the British version; has seen Simon Cowell; leaving the show, rumored that he makes $36 million. Wife thought he made about $600,000. Fascinating--no one seems outraged about that, but people are outraged about Wall Street bonuses, which are enjoying our taxpayer money. He's also enjoying our money--people who watch the show buy the products, which results in his higher income. Market process versus one that is rigged. Incidence question: we don't actually pay Cowell anything. We pay the producers of products, who buy advertising from television companies who buy shows from people like Cowell. The actual incidence of income is different from who pays. Just like for taxes: the person who writes the check--you don't really care who writes the check. Bell.
47:56Question 8: Russell Wood. How would a free market economist advise his own child about the value of attending college? Mike: older son a sophomore, younger son a senior in high school. Three aspects: value added--education; signaling--this is the sort of person I am, I'm college educated; and the kind of college you go to sends a signal about that; third is connections--the people who are in your dorm that you are listening to, meet important people from your state at Harvard. Another thing in parentheses: people go to college to learn how not to become a jerk. Mike took longer than most people--went to college and then got Masters and Ph.D. Why people go to graduate school--takes them longer; nothing productive to give society. Germany has figured out it's cheaper to pay people to study than to pay them to go back to work. As long as they are in school, they are not unemployed; cheaper for the state. Colleges offer different mixes: do you care about the education, the signal, or the connections, and in what mix? There are a lot of ways to cut costs if you look at private colleges, very expensive; a lot of value as signals, lots of connections, people you want your son or daughter to hang out with. No single answer. Which is better, chocolate or vanilla? Part of it depends on taste, on objective. A free market economist would advise his child to think about what I want to get out of this; and how much do I want to pay for it? If you are constrained on money then taking AP courses or courses during the summer makes a huge difference. Can go to a top college; can get in and not spend very much money by trying to economize on the time spent there. Russ at George Mason, state school; Mike at Duke, private school. Russ attended North Carolina as an undergrad, public; Chicago as graduate school, private. Two things to add to list: more important what you study than where you go, some places really good for a particular subject, most okay for most things. Deeply important is the ability to write. Advice: communicating, written, verbally; even PowerPoint. Resume: being at a State school it's really easy to say it doesn't matter where you go; but true based on other experiences. Both compromised in answering this question. Paper: how little time students spend studying today compared to 40-50 years ago. Many better ways to spend your time if your goal is education? People are emphasizing the signaling and connections part. High school where you could take the equivalent of three years of college calculus. Bell. Guidance counselor then said to son: You don't have to take any math in college; you can do other things. Called and said he had pretty clear talents for math; why would you tell him that? Guidance counselor said I didn't take any math and I turned out okay. A lot of the people we have advising our students are not focused on engineering, science, creating new things; view of college as a finishing school, learn to play the piano and sing. Component called "fun"--does take up most of what has been liberated by the reduction in studying habits. Nature abhors a vacuum.
55:21Question 9: Marina. Thoughtful email, gist of it was: There are many charities that collect money from donors to fund cures for diseases, problems, etc. They tend to focus on a particular strategy for curing a particular disease. If a maverick comes along who has a different approach--long shot, mavericks usually wrong, but occasionally right. Ulcers, originally thought to be caused by anxiety and worry; turns out there is a bacteria. Ridiculed, mocked--could be wrong, but could be a threat. Charities care about power and money like everybody else. Ironic: they are humans. One of the first insights of public choice: there is no moral transubstantiation just because someone leaves a market firm and goes to work for the government or a nonprofit. Says they care about people in their mission. Thomas Kuhn, Structure of Scientific Revolution--there's going to be a lot of resistance to new ideas. Some might just be that the existing ideology is a sunk cost, an asset. Human beings going to say they are not so sure about that. Marina in her question gives examples of people not just objecting but going on the attack, spreading rumors. Competing fund-raising source. New entry, private firm may have to be stuck with a competitor. Any relevance to University of East Anglia trove, that suggested that perhaps scientists involved in global warming studies were attacked--people who disagreed with the idea of global warming? Might be just from science, truthiness, truth that transcends mere science; they know that what they want is right; might be a little inconvenient for now. Big harm in public relations' sense; need to suppress facts. Difficult to explain why when the temperature should be going up, it is actually going down. Noted economist on you-tube video: his model suggested there wouldn't be a global crisis if the housing market tanked, not ready to give up on that yet. Digression: strange how cynical we have become. Culture so focused on cynicism, irony. Watch old newsreels and ads; changed. Parts of citizen that haven't grown yet. Cynical about government, but not their Senator. Cynical about business, but not science because romantic illusion about scientists. Have to have some inherent naive trust in some class of human beings. President Obama. Want to trust people. Interesting that we don't make more mistakes than we do. Bell.
1:01:56Question 10: Russ asks Mike. Economy is not doing very well. Ten percent unemployment, falling labor false, so drop from 10.2% to 10% was because some people gave up and stopped looking. Lots of challenges on horizon--massive deficit, growing debt, promises for government entitlement programs, apparently dysfunctional political system, list goes on. Yet optimistic about the future. Will your children have a better life than you will, have a better standard of life than you? Is our future dark or bright? One thing that has made America successful is: what is the American Dream? Central creation myth, not the political one but the economic and family one: if I work hard and provide an education and a house for my children, they will be better off than I was. So the reason I am going to work hard and sacrifice, give time and read to them, is that they will be better off. The world over time gets better. Immigrants certainly believe in it. Do Americans believe in it? Many native-born Americans believe it, sacrifice, work two jobs, send kids to school, whereas they couldn't in their home countries. Evidence on social mobility: less upward social mobility than there was even 20-30 years ago. People are born to a particular class-income percentile; more than used to be stay in or fall from that same percentile. Change in education--people don't work as hard because they don't see the benefits. Suppose you live in Detroit, jobs you depended on either aren't there or disappeared when someone is 56. Shaking that optimism. Russ: data on mobility tricky. Relative versus absolute: may be stuck within same quartile, decile, or quintile, but all moving up. Russ: Shocked at how hard children work in high school relative to how hard I worked. Dumbing downs, but lots of homework. American Dream easier than ever if you graduate from high school and go on to something serious, you will thrive. Immigrants who do that move way up. Most of the mechanisms are still there. Interesting distinctions: in some ways easier than ever before to achieve something like the American Dream; if you work hard, so many opportunities. Computers, cars cheaper; better off than parents if you just work for it. But many young people don't work for it. Divide into two cultures.
1:08:25Close with a different point. Email us if you like or don't like this format. What makes America special is not its success, but the extraordinary opportunity it gives people to pursue their dreams, whatever those dreams are, vegetarian, musical, entrepreneurial, loud, adventurous, quiet. Give people the opportunity to choose their path in life. Book, Price of Everything: there is no weaver of dreams. No one whose responsibility it is in a capitalist system to make sure everything fits together; yet in America it fits together harmoniously. Dreaming and creating. Rising role of government in deciding who wins and who loses; in America till recently much less privilege. Worry. Blame not government, but voters. Rule of law. Interesting: informal institutions, market, educational. We want to mess with it; that gets rid of its genius. Claim on other side is we have to mess with it because only the elites get their chance. Data suggest otherwise. The more regulation, the more likely to shunt people into positions they have already occupied. How do we get voters to be more interested?
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/01/munger_on_many.html. http://www.econtalk.org/archives/2010/01/munger_on_many.html http://www.econtalk.org/archives/2010/01/munger_on_many.html Mike Munger Mon, 18 Jan 2010 06:30:00 -0500 Belongia on the Fed Michael Belongia of the University of Mississippi and former economist at the St. Louis Federal Reserve talks with EconTalk host Russ Roberts about the inner workings, politics, and economics of the Federal Reserve. Belongia talks about the role that power and politics play in Federal Reserve decision-making and how various Fed chairs used their power to suppress dissent within the Fed that was critical of Fed policy. He argues that the Fed faces an unresolvable dilemma when asked to achieve the multiple goals of full employment and price stability using only the federal funds rate as a policy lever. The discussion concludes with Belongia's indictment of the monetary data that the Fed produces.

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0:36Intro. [Recording date: January 6, 2010.] Federal Reserve: What does the Fed do now? What is the range of activities. Responsibilities in three broad areas. Most attention given to its responsibility for monetary policy. Greater scrutiny now for its responsibilities for bank regulation and supervision. Least to third area: provision of bank services--check clearing and cash distribution. Twelve regional banks with oversight by Board in Washington. When we read about the Fed deciding to change or leave the Federal Funds range unchanged, what do the regional banks have to do with that? Input in policy meetings from the local offices; variety of opinions coming from the regional bank presidents, ease or tighten. To outside world, some difference of opinion. In practice, it depends on the strength of the Chairman and what the individual presidents wish to do. Chairman and Board staff tend to run the show. Appearances aside, regional bank presidents do not have all that much input into the making of policy. Two reasons for that: one: If the Chairman cannot get his way in policy, he doesn't stand as Chairman very long. True often in the Volker era--much scrutiny of key policy votes; speculation that the Chairman was not in charge and might be time to be replaced. Strange. In essay, observed when Greenspan was Chairman, at Federal Reserve Open Market Committee (FOMC) meetings, exercised control in duplicitous way. At FOMC meetings each of the 12 regional bank presidents and other 6 governors would take turns going around the table summarizing their idea of where the economy stood and whether current policy should be maintained or perhaps a move should be made on the funds rate. After everyone had spoken, Greenspan could get an idea, say, if he wanted to move on the funds rate, if he had the votes to make that move. If he didn't have the votes, he wouldn't propose a policy change. Committee would vote and announcement would be made. FOMC meeting on Tuesday. On Friday morning, the Board of Governors of the Federal Reserve--the 6 members--meets with the Chairman. Noted macroeconomists, bankers, appointed as political payoff: backgrounds vary. Greenspan comes into the room with a recommendation from one or two of the regional banks to change the discount rate and call for a vote--not the Federal Funds rate. Federal Funds rate is the rate banks charge each other for overnight loans; Fed intervenes to affect that rate by either injecting or taking out money to get that rate to move to the Federal Funds target. It's a competitive, market rate. What's the discount rate? Set administratively by the Fed--it's the rate at which member banks can borrow from the Fed's discount window. If a bank's reserves drop below its required reserves, it can get money from the Fed itself--direct borrowing from the Fed. Supposed to be used as a lender of last resort occasion, when member banks are solvent but temporarily illiquid. Not a market rate--Fed just sets it. At the time we're talking about it was below the Federal Funds rate. So, Greenspan would propose a change to the discount rate on Friday morning. To do that he has to have a proposal from one of the 12 regional banks; typically would be one bank. Vote would be in favor of changing the discount rate. Unanimous or one dissent; if no big majority, Chairman's authority would be brought into question. Board would vote with the Chairman.
10:41What's the impact of that? When the discount rate would change, there would be wider spread between the discount rate and the Federal Funds rate--assuming goal is to ease policy without the consent of the FOMC. For "technical reasons" would do a corresponding pass-through change in the Federal Funds rate--so if moved 25 basis points on the discount rate, would instruct the desk that for technical reasons they should move the Federal Funds rate in the same direction and by the same amount. What you've done is divert the will of the FOMC. So Greenspan lowers the discount rate and then says to the open market desk that they'll want to move the Federal Funds rate by that amount, too. Not well known. None of the regional presidents every spoke up. Two bank presidents who were strong allies of Greenspan, would go along with anything he wanted; but this had gone on for a number of years. Trying to draw Greenspan out of the bushes--will we be sandbagged again? Nobody said anything. Now back at U. of Mississippi, but Belongia was there at the time. Information content of this ruse: the Press reports on the Federal Funds target that comes out of the Tuesday meeting; Greenspan made sure that was supported by the people in the room; but on Friday maneuvered differently. Is that reported? Can look at the record--about a half dozen or maybe more over a three-year period, between about 1989 and 1981. Not particularly sinister--not covered up. Wall Street Journal, NY Times would report it on the Friday.
16:19In essay, suggestion that we don't need the regional banks, or we don't need as many. Begs the question of what you want the regional banks to do. In essay, point out that when Volker was Chairman, he vetoed the choices of two local Boards of Directors of who was to be the local bank president. Vetoed jerry Jordan at Atlanta and Lee Hoskins at St. Louis. Both well-known monetarists; both had well-established records of what they believed in. Reported in the press that Volker wanted the strongest dissenting voice to be silenced. Volker wanted research department shut down. Arthur Burns--more sinister way. Jordan had been director of research briefly at St. Louis, track record of monetarist tendencies. Could make the case that Volker didn't want people like that as regional bank papers. Either you want strong independent points of view, or get rid of them. Strange assessment of Volker's motivation: most of us think of Volker as a monetarist. He wrung inflation out of the system in the early 1980s, late 1970s; recognized role of money supply in creating inflation; raised the Federal Fund rate through open market operations. Interesting alternative: Alton Gilbert, long-time member of the St. Louis staff, had a paper censored by Volker around 1980 or 1981 that was subsequently published in the St. Louis Review about 1985. Used confidential data from the NY Fed's trading desk to demonstrate that at the time the Fed was allegedly doing monetary targeting, it was doing anything but that. Was set to give this paper at Karl Brunner's monetary conference when he was sent a memo ordering him to destroy all copies of the paper. Argument Volker gave was interesting. The paper only included means and variances of the data; but argument was that someone could possibly construct the individual trades from a table of means and variances. Two people walk into a room and average height is six feet tall; presumably from that you can construct their individual heights. The expressed reason is not really credible. What was the worry? The Fed was still fooling around with interest rates. Didn't they say that was what they were doing? Allegedly, after Oct. 6, 1979 famous Saturday emergency meeting they were adopting a policy of targeting the aggregates. Presumably continued that policy until October of 1982, when the misbehaving aggregates caused them to switch to something else. Fears of losing credibility or something else; paper was feared as being critical of what they'd done.
22:58As a grad student, Russ was taught that the Fed controlled the money supply; as time passed, the Fed became focuser on the Federal Funds rate. In 2006 Friedman podcast, he said the Fed says they are targeting interest rates but what they really do is target the aggregates; if they do that the economy does well and if they don't the economy doesn't do well. What's your take on that? Paper in the 2007 issue of Public Choice--old argument, Allan Meltzer, Brunner, and Friedman have made it. Source of confusion about how the Fed falls into mistakes. The Fed has a single tool, open market operations, where it injects or removes reserves from the banking system. With that, it can try to hit an intermediate target--an interest rate or the quantity of money. What information do you glean from that intermediate target? For most of its history, the intermediate target the Fed has pursued has been an interest rate--precisely how they get into trouble. Why do they get in trouble? As a market-determined price, it can change because of changes in the supply of reserves or the demand for reserves, independently of the Fed's open market operations. The Fed believes every change is a result of their actions; do not make allowances for the possibility it can change because of a change in the public's demand for loans, which will in turn affect bank reserves. Consider what happens if we go into an economic downturn. The demand for loans will fall. In turn, the demand for bank reserves will fall, because reserves are an input to bank lending. The Fed will see a decline in the Federal Funds rate and mistakenly assume they have been overly expansionary in their provision of reserves to the banking system, and will tighten up, give an instruction to the desk: we've been too accommodative, so let's drain reserves, exacerbating the economy's decline. In the summer of 2008, everybody has been saying the Fed's been really easy; look how low the Funds rate was. Op ed piece, not accepted by the Wall Street Journal, pointing out that the 5-year growth rate of bank reserves had been slightly negative; Fed had been restrictive for a 5-year period. No wonder the economy was on the verge of a recession. Funds rate: signal was Fed had been easy. In reverse, get the same thing during an upturn; demand for loans rises, so demand for reserves rises, which pushes the Funds rate up; the Fed looks at it and thinks they have been too restrictive and start to loosen precisely as the economy is expanding. Scott Sumner podcast: we often mistakenly look at the funds rate. The Fed itself gets confused--confuses its proxy for the money supply, the target it wants to be manipulating. What a regional bank can do if it gets involved in the process. In 1976, Journal of Monetary Economics had a series of essays in honor of Homer Jones, director of St. Louis Fed between 1957-1971. He introduced many things that the modern Federal Reserve accepts as given, such as hiring economists to write scientific articles and holding conferences and publishing data. One of the essays, written by Jim Meigs, worked at St. Louis Fed while finishing his U. of Chicago dissertation, traces a number of things in the policy record, things the 1959-1961 St. Louis president was trying to introduce--ways that the Fed was operating, confusing being tight for being loose. Not much difference now from what was going on back then. How little things have changed in the way the Fed does policy, not operating as an academic research department trying to impress its professional colleagues but focusing on making a difference in the monetary process. Theme: The different regional Feds have economists who write on all kinds of things, like different economics departments at universities. Suggesting that they should write on monetary policy. They write on all kinds of things. It has become strange. Pressure from interest groups, pressure from boards of directors, vision of individual bank presidents, and also pressure from the Board of Governors. The Board of Governors would like nothing better than to have the 12 regional banks work on ice fishing--anything other than monetary policy. Economists who would like to write about ice fishing like it that they are pushed that way, but that's a small group. Other areas the Feds write on. People who work at the Fed enjoy the freedom to write on their topics of interest and don't want to just write on assessing the Fed, so they like that. Power.
33:38Recommendations: makeover for the Fed. Making the Fed more accountable. Essay recommendations: shrink the regional banks since they are not doing the role of helping critique and measure the Fed's policy but merely cheerleading or doing something else with taxpayer money. Fewer? What else do you recommend to make the Fed more effective? The reason for shrinking the number of districts from 12 to 5 is motivated by a number of things. The price services function, check clearing and other things the Fed does has declined enormously. No reason today to have the volume of services that needs to be done. Fed's supervisory and regulatory function, advocated by Volker and possibly Greenspan: if you are going to provide a stable and sound payments mechanism, the Fed only needs to supervise the 100 largest holding companies. How many does it supervise now? It supervises Federal Reserve member banks--a lot of institutions, many small and don't have an integral role in the payments system. Could reduce, focus regulatory function on a small number of large institutions to keep the payments system sound. If you are going to keep bank presidents as voting members of the FOMC, some bank presidents now get a vote only every third year. Hard to take things seriously. Permanent voting members. Political economy weird: whatever incentive the Chair would have to pick those regional bank heads now, would really try to co-opt those folks if they could vote every time. Begs the question of who appoints them. Currently appointed by the Boards of Directors of those regional banks. Under the current structure, the Chairman has the option to veto. Prefer to see them appointed by the President and confirmed by the Senate as the Board of Governors are, to take that veto power away from the Chairman. Far too much meddling.
38:11Going to more philosophical issue: as a body politic, comforting to voters to think there is a maestro at the Fed. Alan Greenspan Times Man of the Year in 2001--not quite as popular today or as respected. Today, new maestro--Ben Bernanke! He understands, pulled us back from the brink. Idea that there might be five independent, thoughtful folks who might disagree would pull the curtain back from this charade that the Fed is led by this all-seeing wizard of monetary policy. Hard to do. Not always clear what is the "right" Federal Funds rate. Problem, essay: things have been made a mess by Congress's insistence on a dual mandate for the Fed, which is something we know is impossible from basic economic theory. Tinbergen gave us the mathematical result: the Fed has one instrument--one lever--and with one instrument you can at most pursue one independent objective. Congress tells the Fed to pursue full employment--which you can couch in terms of full output--and price stability. Built into the system an impossible mandate for monetary policy. Mostly the bank presidents run around embracing this dual mandate like little schoolgirls: We have this dual mandate! Instead of saying to Congress, we can't do this; tell us to pursue something we can achieve, such as price stability. Most schoolboys. Embarrassing. Want to keep their jobs. Social mission, community development, distractions, politically what they have to do to stay in office. Jobs not that threatened. Don't know that any regional bank president has ever lost his job for saying this; haven't said it very often. Would at least serve one term, not in danger of being unemployable. Responsible to go out the promote the idea that this mandate can be embraced when it is something that cannot be achieved.
42:48Taylor Rule? Two inputs: size of the economy and the change in inflation. Two goals; feedback loop. John Taylor argues that when the Fed is doing its job well, they can handle these two things; need to keep the economy on an even keel. Assessment? Don't buy any of that. Which Taylor rule? Brad deLong's site: John Taylor's rule or Glenn Rudebusch and others--completely different Taylor Rule. Two give wildly different answers. Can add to this mess the Taylor Rule as interpreted by the St. Louis Fed, plotted on p. 10 of Monetary Trends and show what it implies for different assumptions about the Fed's value for target inflation. We know how quickly the economics profession discarded the monetary aggregates in the 1980s when they so-called started to misbehave--M1, M2. If the profession started to apply the same impatience that they applied to the monetary aggregates to the Taylor Rule we'd have stopped talking about it a long time ago. Why so attached to the Taylor Rule? If you look at, in Monetary Trends, Fed was targeting very high inflation rates in the recent past; but does anyone believe that? No. But people are attached to it. Take on trying to achieve two goals; Scott Sumner. Nominal GDP targeting was popular in the early 1990s; Bob Perry president of the San Francisco Fed at the time; wanted to give his take. Sumner podcast: GDP rising in current dollars, want money supply to fall; if falling, be more loose. Change Federal Funds rate accordingly. Gets at notion of looking at prices and real output simultaneously. Bob Perry wanted to talk about nominal GDP targeting at the time and thought that a 6% growth in nominal GDP would make sense. Inflation at 3%, real output growth at 3%, so nominal growth would be 6%. Small meeting of Fed economists; San Francisco Fed; Milton Friedman at luncheon and said: "This is all nice, Bob, but tell me what you would do if you are at your nominal target of 6% but you have 7% on prices and -1% on real?" Awkward. Stagflation. High inflation, economy is growing negatively, recession. Doesn't take a great deal of imagination to envision we could be there a year from now--low employment, prices start to take off; housing overhang but real economy still not in good shape. What does Fed do--nip inflation or handle real economy? That's why Congress has given them two targets--Congress doesn't want them to focus on inflation in that world; they want them to get those people back to work. Right? Ignore one. Can't solve both at once. What most people have in mind is two goals, sometimes one is more important than the other, so focus on the important one. Dynamic inconsistency of optimal plan. Changes in tax rates; the only thing monetary policy can deal with is price stability.
49:54How would you get there? Not the Taylor rule. How should the Fed achieve that goal of price stability? Fed get back to its business of constructing monetary data, which it is not currently doing. Indict the Fed on failing to collect and publish accurate data on money. Isn't that what the Fed does? What's wrong? They are publishing data on money, none of which is scientifically valid. The data it publishes comply with no economic or statistical standards that would be recognized by economists or the Bureau of Labor Statistics (BLS). Meaningless data. They publish M1, M2--why not statistically reliable? and what should they be collecting? Problems complicated by Sweeps programs. When you begin to pay interest on deposits--checking accounts, banking system--things should not be added together, but weighted differently, just as components of the CPI. Not just p_1 + p_2 +p_3. Don't want to weight sardine prices with heavy equipment. What happened within the Board of Governors' special studies section in the late 1970s was that work was done to figure out how you would create expenditure share weights for currency, checkable deposits that didn't pay interest, checkable deposits that did pay interest, as well as where you would draw the dividing lines. Not clear that M1--current definition--is the dividing line. Might be M1 plus some other things. Some work stalled; should be going on at the Board of Governors: weighted measure of money. Don't think that much of the consumer price index (CPI), so that's not so exciting as might be hoped. Casual, not technical. Weighted measure by expenditure shares, weighted by expenditures on monetary services. International data on this don't behave anything like the official accounting data; give you different inferences about testable hypotheses about future course of inflation, course of money in the cycle, etc. Fed reconstructed their index of industrial production in this manner; but have done nothing with money. Hide the truth or other things? If we had a good monetary series, what goal for the Chair of the Fed to do with those data? People advocate, small group at least: keeping the supply of reserves on a stable path that would keep the inflation rate low and stable so that people can make long-term planning decisions. Monetary policy can't influence real variables in the long run; can't fine-tune the business cycle; no evidence to support idea that monetary policy can do much more. By pretending it can do other things it introduces uncertainty into the world. Politics of the Fed, seems kind of dysfunctional. Get rid of it and have private money? Would impose lots of information costs. Chairman of Fed instead of being elected man of the year might simply be the most boring person in Washington. Ought to put him in the basement of a building with stereo system and food and not let him come out for a year, not talk to the Press. Bill Belichick school of monetary policy. Fed Chair gets praised for his crypticness, so put him in the basement and don't even let him be cryptic. Just let him be boring. Counterpoint: Greenspan running out and saying things about irrational exuberance, Fed's responsible. How does he know what the right value for the DOW is, and all of a sudden you have all of these ancillary targets that have absolutely nothing to do with anything. Should have been fired after that speech. Define a bubble; when was last time anyone was able to predict one in advance? And if you want to deflate one, what are the costs to other things going on in the economy? Exchange rate target--now up to four targets: keep dollar stable, inflation stable, employment stable, and no asset exuberance of the wrong kind.
1:00:15Transparency and accountability. The Fed needs to be more accountable. The Fed now has more than $1 trillion in housing loans on its books. Bizarre: launched into this whole new area. Whole new area--got to keep mortgage rates stable and have everyone able to buy a house. What should be the political influence on the Fed? He's a political animal. Hard to hold him accountable right now when you have a dual mandate that is impossible. First thing you need to reconcile is by giving the Fed a mandate that is in fact achievable. Example: Central Bank of New Zealand reformed more than a decade ago: if you don't achieve, we will reduce your salary or remove you from office. First, set a mandate that makes sense: price level, rate of change for the price level that is very specific. Independence and accountability are at opposite ends of a continuum. The only way that the Fed should be independent is that once you give it a mandate, the Fed is free to pursue that mandate any way that it chooses. If the Fed's responsible for keeping the inflation rate between 0-2% it can do that by targeting the money supply, the Taylor Rule, or following a Ouija board. If they fail to achieve the result, penalties; accountability. Transparency: Fed now announces after each meeting what the new Fed Funds rate is--another censored Fed paper, topic for another day--no idea how they are arriving at anything that they do. Talk that they are following the Taylor Rule. Bear Sterns episode: abrogation of democracy. Where is the accountability? Why were they allowed to do that? What weight attached to employment versus inflation at any one point in time? No idea what they might attach to one objective versus another. None of this is transparent. Any ex post justification? No. As a practical matter, not much transparency at all. Would come forth if backed up by a practical mandate, explicit statement of how you would achieve it. Price stability: achieve by 2% reserve growth, with intermediate target for this variable and provide data the public could monitor to see if you are on that path, that would be transparency the public could monitor.
1:06:03Thirst that people want the comfort that people want someone at the top of the economy running it. President; Chairman of the Fed. Why does it persist? Thirst; Ignorance; Inherent advantages that accrue to economists about what the Fed can do. Mission creep. Fed steering the economy; every once in a while disastrous mis-step. Who should be fired? Well, it was complicated. Without any data, how would have any accountability. Bootlegger and baptists story--we like the idea that the Fed can steer the economy. People at the top reap the benefits. Comment? Doctors or scientists or economists: all professions and individuals get into trouble when you oversell what you can do. The worst thing you can do when take your first job is over promise what you can do. Fed's problems self-inflicted. Retrench: this is what you can reasonably expect from us. Refine what it can do in bank regulation so that it has faith in the regulatory function; get back to monetary policy, what it can deliver. Wizard of Oz role--can't help but disappoint. "It needs to"--no "it" there. Next Chairman of the Fed has no incentive to say it should have a smaller role. Time Magazine from Roosevelt Administration in waiting room. Memorial for Tony Snow: so refreshing as the White House spokesman because he would say, "I don't know." Individuals who take office. Can't make Paul Volker or Alan Greenspan behave in a certain way; but can make rules. Ben Bernanke was first rate economist; now a first rate bureaucrat. Different incentives. Political pressure about who is in the job. From the inside, sometimes individuals do make a difference; heroic people do sometimes do heroic things. At the margins we can change incentives a little bit.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/01/belongia_on_the.html. http://www.econtalk.org/archives/2010/01/belongia_on_the.html http://www.econtalk.org/archives/2010/01/belongia_on_the.html Michael Belongia Mon, 11 Jan 2010 06:30:00 -0500 Rustici on Smoot-Hawley and the Great Depression Thomas Rustici of George Mason University and author of Lessons from the Great Depression talks with EconTalk host Russ Roberts about the impact of the Smoot-Hawley Act on the economy. The standard view is that the decrease in trade that followed Smoot-Hawley was not big enough to be a significant contributor to the Great Depression. Rustici argues that this Keynesian approach that looks at aggregate spending misses a crucial mechanism for understanding the impact of Smoot-Hawley. Rustici focuses on the impact of Smoot Hawley on bank closings and the money supply. Smoot-Hawley launched an international trade war that reduced world trade dramatically. This had large concentrated regional effects in the United States and around the world in areas that depended on trade. Those were the areas where the first banks collapsed, contracting the money supply via the fractional reserve banking system. Rustici argues that the Keynesian indictment of the price system ignores the policy failures that destroyed the institutions that make the price system work.

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0:36Intro. [Recording date: December 30, 2009.] Smoot-Hawley tariff as cause of the Great Depression. First, Keynesian theory of business cycle and economic growth. In the Keynesian model, what is the cause of recessions and depressions? Lack of aggregate demand--total spending--usually arises from an increase in the demand to hold money. People start hoarding cash, don't spend; and in that model, spending is what creates income. Size of the real economy is determined by total demand from investors, consumers, government spending. Demand-driven model, often called an over-production, under-consumption model; Mercantilistic model. Pre-classical view of the world with more sophistication and algebra. Output of the economy is given; it's demand that is the defining limit for how big the economy is. Aggregate supply is just there. If we produce but don't consume it, then we enter a downturn. Everything in the Keynesian model is a spending model--spending is what drives the actual size of the real economy. Keynesian policy advocates that--stimulate consumers to spend, the government to spend. Making up the gap. In that hoarding of money, anxiety on the part of consumers, does Keynes or his followers talk about that? Keynes uses the phrase "animal spirits" to capture the uncertainty of people's feelings about the future. Is that just exogenous? Yes; the volatility of money demand drives the Keynesian system. People just become fearful, expectational fears of the future, fearful they might lose their job--they do lose their job--therefore they start holding back. Money accumulates and doesn't circulate in exchange. Price level in the Keynesian model is given, parametric. If prices don't adapt to this shift to aggregate demand then quantities have to adapt. Keynesian system is about quantities adapting, not prices adapting. Justified historically by Keynesians by prices or wages being sticky downwards; unemployment in labor market is a result. Important point: Keynesians have a view of money supply itself as an endogenous variable--money supply adapts to money demand.
5:13Paradox of thrift. They Keynesian argument, brought up in The General Theory of Employment, Interest and Money: if people save, in the aggregate, that people are poorer. Classicals'--pre-Keynesians, up to around 1930--view was that if people save, and did not spend for current consumption, the money went into the banks, the banks loaned it out for productive investment, capital accumulation; this increased productivity and real wages; higher standard of living. Straightforward; savings beneficial to productivity; better off if we consumed less in the present and more in the future. Keynes turned the world on its end. Paradox of thrift: he argued that if we all try to save more, savings will leave the flow of spending; the money goes in the bank but the bank doesn't lend it back out. Like in a mattress--it leaves the circuit of transactions. Think of savings in the Keynesian model like a black hole--goes in and nothing comes back out. Puts pressure to contract the whole real economy. If people save it doesn't lead to capital accumulation; it leads to lower income because people are not spending. Real economy shrinks to that level of spending that is left. If we all save more, we are all poorer. The General Theory came out in 1936, a time when there wasn't a lot of investing. We are in a time right now when people put money in the bank and the banks are not so anxious to lend, and there aren't so many willing to take risks and borrow. So the standard classical model would say if there is this increase in savings, for whatever reason, interest rates will fall, which will make some investments more attractive that once were unattractive. That should cause equilibrating effect; more productive stuff. In the middle of a downturn, though, there are times when the money just sits in the bank; there are times when that Keynesian worry about savings could be correct? Can understand the logic of the Keynesian model if the price system is broken; and that's exactly what Keynes is doing, macro with no micro, no price system. Reality is that money going into the banks and consumers not spending it, investors spending it, is just shifting around who is doing the spending. The black hole argument that the money goes in and becomes excess reserves of the banks, borrowers not borrowing because they are fearful they can't repay it, is an empirical question. Interest rate emerges between borrowers and lenders, investors and savers--if we are arguing that that doesn't function, we have to ask the question why.
9:55Intermediation: just a fancy word for the fact that when people are willing to postpone consumption--which we call savings--and there are other people who want to invest, and have access to more money--borrow--there is an information problem. Lender needs to find the folks who want to borrow. Munger podcast on middlemen--a bank is just a middleman, middle thing, intermediary that links the lenders to the borrowers, takes a cut for its comparative advantage in this brokering activity and for the risk it is taking. If someone says aren't doing their job, something might be wrong with the banking system, then that's what we ought to look at. Banks are the brokers, middlemen, coordinate savers and borrowers. Problem with the Keynesian model, the original way it is written, is that what Keynes is observing is institutional collapse, and not giving proper weight and criticism on the policies that structured those institutions. The price system doesn't have inherent flaws that make it fail. The laws of supply and demand and the competitive process--short of public goods and negative externality arguments--price system based on incentives, respond unless you are in institutional collapse. At higher rates of interest, savers are willing to save more. At higher interest rates, borrowers do not want to borrow as much; at lower interest rates they are encouraged to. If supply-demand for loanable funds through the bank are not responding in the way that incentives in a normally-functioning institution would operate under competitive forces, then we have to ask what are the policy questions. Keynes never does this; not an empiricist in this regard; pure theory without much evidence. Why do you call that institutional collapse? Taping end up 2009, to air the first week of 2010. If great idea for new business, this wouldn't be the week or month to want to borrow a lot and risk family's future; would wait. Totally rational. Wouldn't require institutional collapse. Don't care how cheap money is; just nervous. Real empirical question is the volatility of money demand under normal and abnormal circumstances. Keynes will think the abnormal circumstances are the normal conditions of life. Current monetary crisis we are in--financial institutional crisis; at the edge of institutional collapse. Public policy has encouraged them to lock up by absorbing enormous volumes of risk.
15:14The Great Depression. Close parallels. Institutional collapse of the 1930s and Smoot-Hawley. Standard view of Smoot Hawley--a tariff act passed in 1930 which set off a round of reciprocal tariff increases by our trading partners. Discouraged economic trade between the United States and the rest of the world. On the surface it had an attractiveness to the general citizen--let's keep out their stuff and that way people will buy more of our stuff; and through a Keynesian argument of aggregate demand people this will keep our factories going. Standard view of Smoot Hawley: In 1930 trade wasn't nearly as important in percentage terms in the U.S. economy--about 5-7% of U.S. economy. If you pass a tariff and that number fell, it can't have the magnitude necessary to explain the contraction we saw in the 1930s--a 36% decline in the economy from 1930-1933. So, Smoot-Hawley has been dismissed as an important contributor to the Great Depression. Why argue with that? Many problems with the way we model that tariff today, partly because of that Keynesian influence. We model the as C+I+G+X-M (Consumption Spending + Investment Spending + Government Spending + Exports - Imports); when you add that up, that's 100% of total spending. Can take total spending and parse it amongst consumers, investors, government and net exports. Most modern economists basically argue that it was a negative policy, reduced the economy, but not near the magnitudes, sideshow; and they argue that free marketers have exaggerated the argument. The time it was passing, most of the world's economists argued it was vastly destructive. Why did the economics profession at the time have such a unified and loud voice to this, that it was central to the Great Depression; yet economists today with econometrics and modeling techniques argue it was a sideshow? We're smarter now. Or: in pre-Keynesian times, economists saw these things as more integrated, more effects than can be quantitatively measured in any macro model. Keynesians and New Classicals, e.g., Robert Lucas, alike argued it was not the main story. The main story today is predominantly the monetary story, which comes from Milton Friedman and Anna Schwartz. Most economic historians accept the monetary hypothesis: institutional collapse of 10,421 banks--40% of the banks--in three years; the money supply declined catastrophically. Don't dispute that. Tendency today to do one of two mistakes: macro dissipation effect or micro trivialization effect. If you look at the water in the Panama Canal, it's a very small amount of water compared to the Atlantic and Pacific Oceans. If you look at a broad map of the oceans, one might infer that the volume of world trade that occurs in the Panama Canal has to be small, because it's a relatively small amount of water. But we know that's not true--it's very critical water there. We are tempted with Smoot-Hawley to dissipate it into the background and say this is just a little small thing relative to all this other stuff. Conversely, when we do micro modeling of it and look at the Harberger triangles, deadweight losses for tariffs--losses of people artificially induced to buy the more expensive products and use more resources for steel than it needs to because of the tariff--we get into compartmentalization, where we hermetically seal off the effects of that tariff to other institutions. Hypothesis came from two monetary economists--Larry White and also Alan Meltzer, who in his article in 1976 Journal of Monetary Economics pointed out that Smoot Hawley may have had a very significant monetary effect.
24:21Non-obvious channel. We usually think of trade as being a micro phenomenon or aggregate macro. Why would it have monetary implications? Book: monetary implosion, collapse of the banking system, financial disintermediation, etc. is the main culprit in why it was a catastrophic rather than normal downturn. But what caused that collapse? Authorities to cite: Friedman and Schwartz, in their Monetary History of the United States, were the first to point out that the proximate cause was the Federal Reserve and allowing a series of bank runs over four years. Fractional reserve system; only a fraction of the deposits are ever in the bank at any one time. Credit structure is based on that. Base money changes have massive effects throughout the entire economy. If the Fed behaves properly and wisely, shouldn't be a problem. Can have runaway inflation or deflation. People don't trust the banks and pull money out. Where were the first bank runs? We had the stock market crash in October 1929--precedes Smoot-Hawley. The legislative history of Smoot-Hawley: Herbert Hoover was elected on a promise to impose tariffs--to protect the farmers in America. But America at this time--about half of its export income came from the farm sector. We were the world's largest exporter of agricultural goods--as we still are today. So tariffs would hurt farmers, not help them. In March and April of 1929, right after inaugurated, tariff went through the House of Representatives; passed the House in fall of 1929. House very protectionist at this time; expanded tariff to virtually everything, very high rates. Senate at this time was more free trade; 16 free trade Senators blocking Smoot-Hawley in the Senate. On October 21, 1929, the 16 free trade Senators log-rolled; said they'd join in if you give tariffs for the industries in our states. The Senate then supported the Smoot Hawley bill. Tariff increases from 38%-60%--almost a doubling. Immediate ramifications. The day the 16 Senators switched, on October 21, is when the market began its slide; lost 1/3 of its value before the Crash on October 29, 1929. When you read the financial papers--Wall Street Journal, New York Times--they have front page stories on one side with markets decline and other side Smoot-Hawley passes; nobody connecting the dots. The reason they have something to do with each other--speculators are acquiring and processing information about the future. Hugely protectionist stand; traders around the world are seeing this and can anticipate; train coming right at them. Expect it to hit not only our export companies--automotive, radios--expect their prices to collapse; and expect commodities market, grains, also to collapse. Why? We put up tariffs to the rest of the world's goods. Any goods that come into the United States will have to have a higher price to absorb this tax that has to be paid by the importer. Foreign governments retaliated; in early 1929 when Smoot-Hawley was going through the House and the Senate, a lot of countries started preemptive strikes on us, e.g., Spain, and raised tariffs to American goods. Speculators around the world saw the impending tariff war; tariff wars have a tendency to proliferate, so not just Spain against America, but Spain against France, Britain, etc. Exactly what ended up unfolding. Foreign buyers that were buying about 30% of our wheat, corn, cotton, put up tariffs to our goods; buying corn, wheat, cotton from other places, like Canada. Farmers dependent on the export market were also hit. Not only get the capital market on all of our foreign products, electronics, steel, automotive industry to take a severe hit, stock market slide. But more important is the quantity side--less production. A lot less corn, cotton sold to the rest of the world. More available here, pushing price down; but total amount will shrink.
33:29Interesting what happened after the stock market crash. Smoot-Hawley, Federal Reserve in fall of 1929 raised interest rates dramatically, started earlier, deliberately trying to squelch what they called stock market speculation--but market was not overvalued by any financial criteria. Same thing happening today. Monetary contraction in late 1928, early 1929, slows economy down. Depression actually started in July-August 1929. What happened after the stock market crash: Senate and House bills for Smoot-Hawley were different bills. Tried to reconcile them in November and December. Couldn't agree; looked like the bill was dead. NY Times even declared it was dead. Stock market, which had lost more than a third of its value gradually started to come back. Wasn't finally passed until June of 1930. Congress meets in January 1929 and starts on reconciliation; changes made in schedules to get the tariff to pass. Got back to 8% of where it had been at the beginning of 1929; but in spring of 1930, 36 countries lodged 59 formal protests with the State Department, start to get retaliation by countries. On May 5, 1930, 1,028 professors of economics, professional economists signed a petition to Hoover saying not to sign this bill. Made the point in that letter that it would have monetary effects. Today there are maybe 10,000-20,000 economists; back then many fewer, and they all agreed enough to sign the petition. In June the final bill went to Hoover, June 14; on the following Monday he signed the bill to keep his campaign promise. Stock market took a big hit. In first two weeks of June, stock market lost 20% of its value. Second-biggest drop in the history of the stock market. Stock market is just a barometer. People tend to think it has its own causal effects, and it has some; but this was as a barometer. Not just American stock markets. In 10 different countries, all of our trading partners, also massive collapse in their stock markets. England, Germany, Italy. Something worldwide going on. Economists at this time realized that trade had monetary effects.
40:05Will be less efficient as an economy, less trade, everyone dealing with it, but 2-3% less. Missing something. If you have a 2% lose of Gross National Product, it sounds like everything moves down 2%. Reality is that if you have a 2% loss in your real economy but it's showing up in 5 or 10 states, that is catastrophic for those states. Modern modeling, tend to think everything is in unison, but everything is not in unison. There are distributional effects. When you take $2 or 3 billion out of 5 or 10 states at this time, catastrophic--10-15% drops in those states. What are those states? Where did those bank failures start to occur? Went back to Friedman and Schwartz, and they make the point that the first bank runs occur in November and December of 1930, and they occur in 6 Midwest farm states--agricultural export markets. Massive drop in farm income. Total of 600 banks failed in two months. Not 600/50, rounding number of states, which was 48 at the time--it was concentrated in those 6 states. One big bank that went down was the Bank of the United States in New York, sixth largest bank in America, own unique significance; all the rest of these banks started to fail in the Midwest. In the years 1920-1929 we had an average of 600 banks per year nationwide close their doors, small farm banks spread all across America. Now you get 600 in two months, plus one huge bank in NY. In 1931, more bank runs in spring, summer, and fall; hundreds more banks go down. 1300 banks go down in 1931. Primarily starting with the agricultural regions. 1931 catastrophic worldwide--a lot of bank failures in Europe. In the U.S. the bank runs start in the South and Midwest, migrate north and east; go from rural to cities. In Europe, same pattern. Domino effect. In 1929 in Austria, largest farm credit bank--government had been subsidizing farmers; in 1930, forced it to merge with the largest commercial bank; combined was bankrupt when it reopened its doors. Hungary general credit bank, Germany's 3rd largest bank went down; bank runs over this period moving from country to country. All tied to subsidies given to specific sectors on the world export market. The world tariff war--the loans made to special interest groups were not sustainable when the tariffs started to escalate. The farmers who had borrowed the money on the expectations of future profits--those profits disappeared when world trade collapsed; as a result they couldn't repay their loans in those regions; and as a result of that the banks didn't have the cash flow they expected; loss of confidence. Banks that had loans to businesses in the world export market failed when the world export market went down.
48:34Question is: if those banks fail, what's the proper response? If those failures lead to contagion or general fear of the bank system collapsing--none of the European banks had deposit insurance; we didn't have deposit insurance. Most of the Europeans created central banks after 1920--after WWI. So, now, what does a central bank to do? Supposed to support the base money and the inverted credit pyramid. If people are pulling their money out of the banks out of fear they will lose their principal, then you have to inject liquidity to keep those banks open. If you don't, those banks come down, and that's what they did. European and our central banks both derelict in this. Flawed institutional financial structure; and the tariff, via international retaliation, put enormous pressure on the banking institutions. Why aren't the central banks responding? Discussion in free banking literature; they didn't see it coming. Right in the middle of the collapse they thought they had an easy money policy--at the same time the money supply is contracting. They didn't have the data we have today. Can think of this as a fleshing out of the Friedman and Schwartz story, to uncover the mechanism that led to the collapse of the banking system; and the subsequent contraction of the money supply. Inverted pyramid--small amount of base money held by the banks, supporting to the fractional reserve system and lots of loans. If loans fail, create an insolvency problem for those banks. Difference between illiquidity and insolvency. Illiquidity is what the Fed can prevent by having elastic currency, open market operations, being the lender of last resort. The problem was there wasn't a lender of last resort. In a central banking system on a fractional reserve, you absolutely have to have a lender of last resort. Entire concept of central banking structurally flawed. Nevertheless that's one of the institutions we have; but during the Great Depression, the Federal Reserve did everything wrong. In 1931 during the height of the bank runs, banks had gone down, money supply had already contracted in double digits, the Fed was selling assets through open market operations, pulling reserves out of the system. Alan Meltzer argues it was because they were wedded to the Real Bills Doctrine--credit should go along with the needs of trade. Very pro-cyclical: if the economy is in a downturn, there is less trade going on; therefore you need to supply less currency. Would magnify the downturn. Or: if the economy is picking up, you have more trade, you need more money; print more money--procyclical view of the world. Some truth to that. At the time the Federal Reserve Board--now the Board of Governors--you didn't have to be an economist or have any credentials in economics. Three had no training in economics--one a farmer, another a politician, another a "used-car salesman--I don't know what he was." No background. Didn't have the data. We still have that problem today--lags now, and the lags then were worse.
53:45Full circle: implications. Two examples. Want to get back to opening question of institutional collapse. When you are in a world where banks are failing because of expectations of profit not being realized as the tariff rug is being pulled out from under them, you are going to have inability of these institutions to perform helping lenders and borrowers get together. Will get to that. Two examples. Farm and industrial activity. In the tariff war following Smoot-Hawley, we had a retaliation from Canada, our largest trading partner. Canada had a very different monetary system, much more free banking: no limits on branch banking. No bank failures during the Great Depression even though 1/3 of their GDP came from foreign trade. Took massive tariff hit but the monetary system didn't dive. It absorbed that hit. Their money supply only dropped 13% vs. ours dropping 29%. They had no bank failures; we had 10,421 bank failures. Their financial system didn't become an aggravating factor. Their downturn in real output was much smaller than ours. Lessons to be learned. We put up tariffs to a lot of Canadian goods. After 1930 they deliberately went after our iron and steel exports to Canada. We were exporting about $200 million a year in iron and steel to Canada. After Smoot-Hawley when the Canadian government retaliated--specifically iron and steel but also other items--our exports to Canada dropped to $29 million a year--an 85% drop. Looking at the 17 months between the tariff retaliation by Canada and the decline in exports of iron and steel to Canada, in first 17 months, $359 million less exports. Why 17 months? Seventeen months after Smoot-Hawley, something happens in a particular city: Pittsburgh, city of iron and steel. Eleven of Pittsburgh's banks go insolvent and have to shut their doors. Depositor losses of $69 million, main structure of the entire banking system. If we are going to take most of the iron and steel out of the Pittsburgh economy, this is a good reason why you might have so many losses in the banks that were shut down. Furthermore, if you look at the interregnum period between Roosevelt being elected in November 1932 and being inaugurated in March 1933 (when we did inaugurations at the time), what we find is the big collapse occurred--4000 banks went down in those four months--while Hoover was still President, but lame duck. The Detroit banks, the main banks the Reconstruction Finance Corporation was worried about--in February, the Reconstruction Finance Corporation examined the banks in Detroit directly tied to the auto industry and came up with a rescue plan, which would have required about $12 million to save all of the banks tied directly to the auto industry. They went to Henry Ford and asked for $7.5 million of his money to be subordinated deposits he wouldn't withdraw to give the cash to the banks; and then went to the other companies--Hudson Motors, Chrysler, General Motors, to come up with $4.5 million. For about $12 million they argued they could stabilize the banking system in Detroit. Look back at the auto industry following Smoot-Hawley, in book, auto industry our largest export, along with iron and steel--like planes today--and what we find is the three-year cumulative loss from the time of Smoot-Hawley's passage to the time of the Detroit banking crisis in January-February 1933, cumulative volume in dollars of auto exports declined $1.5 billion. Had we not had those tariffs and maintained our world exports, Detroit would have seen a billion and a half dollars flow right into it. They needed $12 million to save those banks. The entire Detroit system decimated by this law. Henry Ford backed out and withdrew $25 million of his own cash when the other companies wouldn't agree, and put it in his own personal vault; precipitates whole collapse. Notion that Smoot-Hawley was a little trivial sideshow is misleading. Have to start disaggregating, looking at the micro connections. All this inefficiency ultimately shows up in the financial system. All mistakes in investments, all investments that are not going to fulfill expectations, all end up in the insolvency of those banks. We did not have leaders of central banks that responded correctly, even though it was an insolvency problem that could have prevented the contagion.
1:02:26Not surprisingly, people don't want to use that intermediary at that point in time. Keynes argument about savings. Keynes, in The General Theory, when he argues that people save not according to interest rates, but tradition: we have notions of tradition and inertia, we save because our fathers and mothers saved, not responding to price incentives--and we invest based on animal spirits, psychological factors, overconfidence or fear, nothing to do with that price or incentives--before 1933 and there's no deposit insurance, and the central bank is not acting like a lender of last resort, which would stabilize those bank runs; and you are on a fractional reserve and have a massive exogenous hit to regional economies: If I put $100 in the bank and the interest rate on my savings in 3% and someone says put it over in this bank at 7%, I have an incentive to put it there, but if I am worried about losing my principal there, the 7% doesn't matter to me. It's a matter of getting my principal back because there was no deposit insurance. Is the bank safe? Movie: It's a Wonderful Life--bank runs like that happened worldwide. "Your money's not here." Keynes's "broken joint" between savers and investors might make sense of a world of institutional collapse. Instead of Keynes's blaming government policy, he blames the price system. But prices are not just floating abstractions--they are connected to property, connected to ownership, connected to institutions. Keynes has no clue about institutions. Blames price system for the failings of government--the tariff, the central banking system; fractional reserves per se are not necessarily unstable but a monopoly on that is. But we had bank runs before the Federal Reserve system. How can you claim that the bank runs in the late 1920s and early 1930s were a function of the Federal Reserve? What's different here is we did have bank runs in the 1920s. Fed policy different. State banks, not part of the Federal Reserve system. Bank failures from 1929 tend to be small unit banks, farm banks; when you look at total depositor losses through the decade of the 1920s, yearly loss for depositors was $62 million per year on average nationwide. Failure of the Bank of the United States took down $200 million by itself. By the time you get to 1929--about 5000 bank failures in ten years; don't get the major runs. Last run before the creation of the Fed, 1907, was Knickerbocker Trust in NY, and JP Morgan saved that system. Created the Fed because we said we don't have to privately save the banking system. In the 1920s, main person at Fed was Benjamin Strong, never let the contagion happen. Money supply steadily growing about 5-6% a year; though there was deposit insurance at the state level and every deposit insurance system failed. Trying to challenge argument that Keynes blames the wrong culprit: failure of the bank as coordinator of savings and lending collapses during the Great Depression. Keynes blames that on animal spirits, the price system, etc. You are suggesting the bank system failed because the Fed--per Friedman and Schwartz--could have averted it. Deeper point: if we didn't have fractional reserve banking and monopoly supply money from the Federal Government, that that more competitive world would be a more stable world and wouldn't have to rely on these lender of last resort arguments. Challenge: in pre-Fed days, you still had instability in the banking system. In the 1920s understandable; but before the Fed we had all this instability. Difference between asking about the interest rate versus the institutional structure. In America, we only had one era close to free banking--end of the Second Bank of the United States up to the Civil War. Roughly 1827 for 30 years. Look at that era--not totally free banking. From Civil War onwards, two tracks--national banks under Federal regulation, State banks under State regulation. Most of those crises that we like to attribute to the banking system, can look at the policies. Not as if you had laissez faire. Wildcat era of free banking, but not free banking because of branching laws. Also have states that will put up unit banking laws--can't have a second one within a state. California unique--didn't have branching laws, survived better. Rolnick, Weber, Rockoff, and others. Era of free banking more stable, no major inflation, no catastrophic downturns. Huge spread of financial services. Small empirical window--could say that about the Great Moderation of the post WWII period. Difference: in American history, we had this experience. Look at depositor losses; 80% came in a handful of states, which had a requirement for anyone who opened a "free bank" that they had to have a certain percentage of their assets in State Bonds. Indiana, Michigan. You can open a bank, but part of your capital has to be that you have to purchase our bonds. Not a free bank. Those states defaulted on their bonds. In percentage terms, not even a fraction of a percent. Then you look at the Federal Reserve system, from its inception through 1933, vastly higher relative to deposits. Free banking vastly superior even with the distortions even then. Canada, other countries. Free trade matters; free banking matters; money matters. Brittle, rigid system with all the wrong incentives--deposit insurance, moral hazard, previous branching restrictions, unit banks, dual-track regulatory system with some banks in and others out of the Fed.
11:15:44It's one thing to say Smoot Hawley's magnitude can't be important because its magnitude isn't important; can't just look at the volume of trade, have to look at the impact on the monetary system. Still a question of magnitude. In Pittsburgh, 17 months, Detroit 3 years. Confident that those banks' contraction can be pinned on Smoot Hawley? How about the contraction in the money supply? Agriculture for starting point--but not just Detroit or Pittsburgh. Nevada, minerals, copper. We know how much the state lost in income. Twelve banks, a fourth of the banks in the state went down. Boise, Toledo, Chicago; look around the world. A lot of banks failed. Interesting research question. Insolvency problem hits these banks. Insolvency crisis in agricultural and city banks--Smoot-Hawley has a big thing to play with. Insolvency creates illiquidity. Can't solve an insolvency problem with a liquidity solution--Anna Schwartz. Caldwell and Company Bank System--140 banks, Tennessee and Arkansas. What kind of reactions to your research? Boring book--detailed book. Review from John Allison--banker but not economic historian. Monetarists or any economic historians in the past who have been skeptical of Smoot-Hawley? Elgar criticism: not sure the tariff could have had that much effect; maybe worse than we can econometrically measure, have to dig in further. Maybe those 1028 economists who signed that petition saw something on the ground that we are not seeing here. Pattern, no one has disputed that pattern. Sure, there are other factors. Douglas Irwin made point that 2% job but tariff might have had monetary effects.
]]> Posted by Russell Roberts at http://www.econtalk.org/archives/2010/01/rustici_on_smoo.html. http://www.econtalk.org/archives/2010/01/rustici_on_smoo.html http://www.econtalk.org/archives/2010/01/rustici_on_smoo.html Thomas Rustici Mon, 04 Jan 2010 06:30:00 -0500