Sunday, July 31, 2011

Book Review (#25 of 2011) City of Man

City of Man: Religion and Politics in a New Era by Michael Gerson and Peter Wehner (foreword by Tim Keller).

Since I've been working through various presentations of Christian interaction with society, particularly in the economic sphere, I thought it useful to read some modern takes on Christian involvement in politics. I thought Gerson/Wehner would be a good contrast with Jim Wallis. Gerson is a former speech writer in the G.W. Bush White House and current Washington Post pundit (and occasional NewsHour fill-in for David Brooks) and Wehner was also involved in policy strategy for Bush. Both are professing evangelicals.

As Tim Keller writes in the foreword:
"(A)ny simplistic Christian response to politics—the claim that we shouldn’t be involved in politics, or that we should “take back our country for Jesus”—is inadequate. In each society, time, and place, the form of political involvement has to be worked out differently, with the utmost faithfulness to the Scripture, but also the greatest sensitivity to culture, time, and place."

The authors quickly gloss over a few historical strains of Christian views on politics, comparing the extremes of isolationism and efforts to create theocracy. There is a lot of room between poles on the continuum for a Christians to be.

Engaging in politics as a career can, in the strain of A.W. Tozer, be just as holy an act as sewing a tent, preparing an accounting audit, writing a sermon, or bagging groceries. So long as Christians do the work with a view to glorify God, it is holy, and none of the above are more holy than the other.

The authors look at a proper role of the state that (they hope) all Christians can agree upon while also looking at the proper role of the church within the state. They offer five precepts:
1. Moral duties of individuals and the state are different. Don't confuse Matthew 5 with Romans 13.
2. The Church as a body has different roles and obligations than individual Christians.
3. Scripture doesn't provide a blueprint for government and public policy.
(Emphasis mine):

"(T)he role of the church, at least as we interpret it, is to provide individual Christians with a moral framework through which they can work out their duties as citizens and engage the world in a thoughtful way, even as it resists the temptation to instruct them on how to do their job or on which specific public policies they ought to embrace."


Hence, the church should stand for liberty, justice, and human rights but not endorse specific bills on the floor. As C.S. Lewis believed, it's the role of the layperson and not the clergy to help the Church understand and work through certain issues of expertise. "This is where we want the Christian economist," as Lewis gave as one example that I have posted on my office door.

In stronger language:
"Identification of Christian social ethics with specific partisan proposals that clearly are not the only ones that may be characterized as Christian and as morally acceptable comes close to the original New Testament meaning of heresy."
What is "clearly Christian" is debatable, but I would argue that a pastor endorsing specific budget bills that contain a complex array of complicated items is problematic (more on this tomorrow).


I sent this quote to my congressman:
Yet to govern is to choose—and those in public life have a duty to develop, as best they can, a sound political philosophy, to engage in rigorous moral reasoning, and to make sure they do not become so captive to ideology that they ignore empirical evidence.
4. Political involvement of Christians depends on the context they live in. New Testament Christians accepted their non-democratic governments as given, and submitted to authorities. Through democracy, we have the ability to peacefully pursue changes in our society that they didn't have, and perhaps this obligates us to different action.

5. God doesn't deal with nations as He did with Israel. (America is not Israel. But step into your average Southern Baptist church on a 4th of July service or "God and Country Day," and you might get confused about that).

Gerson and Wehner summarize the emergence of the evangelical Christian Right and the decline of the mainline denominations, for better or worse. They are clearly not fans of Jerry Falwell or Pat Robertson.

They then shift to what they see as the proper role of government:
"There are, we believe, four categories—order, justice, virtue, and prosperity—that can help Christians think through the proper role of government in our lives...A wise government, constructed around a true view of human nature, thus creates the conditions necessary to allow the great mass of the people to live well and to flourish, to enjoy both order and liberty, to live under the protection of the state without being suffocated by it...We count ourselves conservatives in the tradition of Edmund Burke, who averred that God instituted government as a means of human improvement."
Basically, the classical liberal view of man's dignity but supported by a belief in man being created in God's image and undergirded by the ultimate belief in an ultimate source of Truth to provide a basis for our laws. Gerson and Wehner agree that democratic capitalism is the system that best allows man to be free and have the best opportunity to fulfill his God-given potential and creativity. "Judging by its fruit," democratic capitalism has never produced a famine and has provided the highest standard of living in terms of material wealth, liberty, and religious freedom, therefore it makes sense for Christians to promote it as a good way to order society.

The authors conclude the book with a look at rhetoric, how important it is for members of a society to have the freedom to be persuaded:
"(B)ecause human beings are created in God’s image, they are morally autonomous and free to choose. They are capable of reason, and of being reasoned with. What most separates human beings from animals is a moral conscience, the ability to engage in private and public conversations about the human condition."

They conclude with some advice for Christian "persuaders" from the viewpoint of people who were responsible for crafting Bush speeches and op-eds.

There are some real weaknesses in the book, so I give it 3 stars out of 5. It's brief, so they don't contain well-defended arguments of either political or moral philosophy. The sources they draw from are also fairly few. I'm reminded that Christians have been dealing with this for thousands of years, so it'd be better to read something written 1,000 years ago than something written last year. They also ascribe certain economic outcomes to policy they see guided by Christian ethical principles, which I find problematic as economists disagree with them based on the data. Examples: Was it welfare reform that reduced poverty or the 1990s technology boom? Was it Rudy Giuliani's policies that caused crime to decrease in New York, or did he simply benefit from a nation-wide phenomenon of widely debated causes? Economists doubt the effects of policy in these examples, but Gerson and Wehner seem unaware of that. Obviously, the Bush Administration pushing through billions for AIDS-related medicine to Africa had some great outcomes we would not have seen otherwise but other examples they give are not that clean-cut.

Major issues like taxing and redistribution are completely bypassed in this book. They recognize that Christians will debate these issues and that Scripture doesn't give us clear-cut prescriptions.

My biggest disappointment would be that it didn't deal much with the various historical approaches. I look at Christian interaction with society from what I understand to be the Anabaptist perspective (as James Halteman describes it, which differs from how Gerson and Wehner describe it): Our ultimate allegiance as Christians is to God, and not to a country. That doesn't mean that we live as isolationists, but rather that we organize ourselves primarily as a church community that serves as a model for the world and invites others to join. We don't try to force others to adopt our ways and we recognize that we cannot legislate morality, but we argue that God's order is the best order for man to fulfill his God-given potential.

The Christians and Jews of Scripture were living in occupied territories. They understood the Roman Empire both from repeated history and prophecy to be temporary, but the Church would endure forever. So, I think issues of patriotism and nationalism were very familiar to them (particularly Jews) but seen as secondary to the importance of the Church-- among which there is no distinction between race or nationality--"neither Jew nor Greek," as Paul said. As politics inherently involves or results in issues of patriotism and nationalism, it's something that Christians need to be wary about, and something that Gerson and Wehner spend little time discussing.

If the Church isn't our first and primary concern and focus, then we end up engaging in Jim Wallis-like efforts to try and make the government and the entire population do what the church should be doing. We divert Church resources to lobbying Congress instead of working to achieve the same ends they want congressional legislation to do. And we engage in endless useless debate about whether initiatives like welfare reform are biblical or contrary. That's my problem with Gerson and Wehner's ambiguity.

Saturday, July 30, 2011

Book Review (#24 of 2011) The End of Influence

The End of Influence: What Happens When Other Countries Have the Money by Stephen S. Cohen and J. Bradford Delong.
This book would go well with an undergraduate International Macroeconomics course. DeLong and Cohen explain in plain English the national income accounting identity between the U.S. and China -- what Neil Ferguson called "Chimerica." China saves 40% of its national income, the U.S. saves almost nothing. Since China's Savings > Investment, they run a current account surplus, exporting more than they import and purchasing more foreign assets than foreigners purchase of their assets. Investment in the U.S. > Savings so it runs a current account deficit. China lends to the U.S. who in turn buys Chinese products and the process continues.

An estimated 70% of China's $2.5 trillion of reserves is invested in dollar-denominated debt, primarily U.S. Treasuries. China isn't looking to make money on the deal, it loses money, but the accumulation of reserves is necessary to keep its currency and, by extention, goods & services undervalued to a dollar that is steadily depreciating.

The U.S. "enjoys" this position because after World War II, it was the country "with the money," and the dollar has been the world's preferred reserve currency. Since we are the free-market arsenal of democracy, other countries were willing to emulate us and aspire to be like us. But with our affluence came our debt-- developing countries are happy to lend to us and we are happy to import their cheap goods.

The point of the book is that this won't last forever, or much longer:
When you have the money—and “you” are a big, economically and culturally vital nation—you get more than just a higher standard of living for your citizens. You get power and influence, and a much-enhanced ability to act out. When the money drains out, you can maintain the edge in living standards of your citizens for a considerable time (as long as others are willing to hold your growing debt and pile interest payments on top). But you lose power, especially the power to ignore others, quite quickly—though hopefully, in quiet, nonconfrontational ways. And you lose influence—the ability to have your wishes, ideas, and folkways willingly accepted, eagerly copied, and absorbed into daily life by others.

DeLong and Cohen predict the end of neo-liberalism, the worldwide movement of the last 35 years to privatize, deregulate, and loosen barriers to trade and capital movements. The world heeded our neoliberal advice through the 1990s but now watches with cynicism as we practice what we didn't preach:

"When the United States bails out its auto industry, or its banks, or insurers, or airlines—shouldn’t France and Germany do so, too?"

The authors examine the history of the U.S. financial system, in a similar fashion as Johnson and Kwak do in 13 Bankers. From the 1940s to 1970s, we had high income taxes and major restrictions on financial sector activity. Yet, we saw low unemployment and 2.5 percent annual increases in productivity. From the 1970s onward we had lower income taxes and deregulated all sectors of the economy and saw The Great Stagnation-- lower productivity growth. DeLong reminds us that deregulation was championed by those on the Left, like Ted Kennedy and Jimmy Carter:

"Deregulation was, however, a fringe technocratic good-government movement. And it would have in all probability remained a fringe technocratic good-government movement were it not for the macroeconomic breakdown of the 1970s...The failure of the managers of the mixed economy to produce full employment and price stability in the 1970s undermined the whole enterprise—and created the opportunity for the neoliberals to attempt to implement their dream."

The neoliberal enterprise was embraced by those on the center-left as much as those on the far right. The Fed had been soft on inflation in the 1970s, and there were solid arguments for freeing up the private sector from onerous regulation in an increasingly competitive global market. The answer to the central question of whether to make the pie larger or make it more equally distributed became more slanted toward increasing the size of the pie:

"Politicians on the left tended to give a Rawlsian defense that the best way to help the poor was not to punish but to incentivize the rich: Shrinking the regulatory, interventionist, and management role of the states and cutting back on progressive taxes would align the economic incentives of the rich with the social goal of economic growth, and in the end, the relatively poor would wind up better off in a more unequal but much richer society. Politicians on the right tended to regard greater inequality as an absolute virtue: Those at the top of the economic pyramid—because of their smarts, their skills, their enterprise, their industry, their luck, their success at choosing the right parents—deserved a very comfortable life and to be sharply distinguished from their fellow citizens."
The widening income desparities-- the growth in income has been extraordinarily slanted toward upper-incomes has quashed progressive faith in the enterprise.
"The ratio of the top 1 percent (of incomes) to the middle fifth went from 10 to 26 times. What caused the change?"
1. "The top 10 percent (of income) owns 77 percent of all stocks
," and those rose in value. 2. Marginal tax rates on upper-incomes were cut. 3. "Huge, recent waves of unskilled immigrants, legal and illegal, compete for low-wage jobs, pulling down the bottom of the income scale."
4. "Imports and offshoring: The influx of imported goods pushed down employment and pricing power at American manufacturers."
5. The decline of unions.
6. Technology replacing low-skilled workers.
7. Culture: CEO pay, top athlete pay, etc. have grown very disproportionately to everyone else.

The authors then relate the phenomena:
"Is there a connection between rapidly rising inequality, stagnant middle-class earnings, and the collapse of savings in the United States? It is very likely that these trends are all closely linked. Faced with stagnant incomes, seeing themselves falling behind those above them on the income scale, and spending their evenings watching Lifestyles of the Rich and Famous, what did the average American family do?"
The average American family took on debt to keep their lifestyles in line with the increasingly wealthy.
"Between 1966 and 2006, this debt, adjusted for inflation, rose by almost 3,000 percent."

This is the agreed-upon hypothesis for our financial crisis from both DeLong on the Left, and Raghuram Rajan on the Right. The push for homeownership--sponsored by the government--increased the amount of this debt, and the bubble built:
"(T)hough mortgage debt rose from about one-third of GDP in 1990 to over 80 percent now, home equity (the percentage of the house not owed as mortgage debt) fell from two-thirds of GDP in 1990 to one-half of GDP by 2006; it has, infamously, fallen since."
The beneficiary of this movement was the financial sector.
"As manufacturing declined as a percentage of what Americans produced—from 21 percent of GDP in 1980 to 14 percent in 2002, finance grew to fill the gap—exactly! And though just about every think tank and politician issued dire warnings about soaring health-care costs, none came forth with programs, or even warnings, to restrain the growth of finance...Finance was the driving force. It had achieved the cultural dominance that so often goes hand-in-hand with economic dominance: its gigantism and ubiquity, its tonic impact on the entire economy, its fabulous success, the sheer gushing of money, its generous funding of elected politicians, its seconding of its top executives to top posts throughout the regulatory apparatus of government, and its simple and powerful message of “let the market work its magic.” It was so easy."
People with degrees in math, engineering, physics, etc. moved from building stuff to engineering financial instruments-- CDOs, CDS, etc. Hence, most of our recent productivity gains have been in the financial sector alone.

DeLong points out, as I thought about recently, there were always two exceptions to the neoliberal rule: Technocratic central banking and defense spending. Through the space race and winning the Cold War, the U.S. government subsidized the invention of the semi-conductor, microwave oven, the Internet, and other private sector "spin-offs." What we called "defense spending" the rest of the world called "protectionism." What DeLong doesn't point out is the rise of monopolies in the financial sector that, as Hayek preached, threaten the neoliberal order before government does.

The fear that international economists had in the last 15 years was of a sudden collapse of the dollar from, for whatever reason, the international community losing its faith in this system. That didn't happen, as the various countries involved worked to keep the value stable. Instead, the world witnessed the collapse of the U.S. financial system and the problems seemingly created by the neoliberal shift in the last 35 years.

But the other aspect of the global economy that threatens the neoliberal order that DeLong and Cohen highlight is the rise of sovereign wealth funds. It's not just rich private citizens making major investment decisions, it's rich countries-- Russia, Norway, Saudi Arabia, China... over $3.5 trillion dollars held in foreign investments. These countries aren't going to be content holding low-yielding assets like U.S. Treasuries forever, especially if America looks unwilling to deal with its long-term structural deficits (Medicare). Eventually, they will move more and more into ownership of private companies. We've already seen some of that tension recently-- the xenophobic reaction when a Dubai company tried to buy a Houston port. They already have the power to direct investment in their own countries-- to engage in industrial policy.

The authors look at some of the rules proposed for these sovereign wealth funds, but it's quite silly to think that national interests won't rule the day. And the U.S. has now lost its ability to influence or preach.

So, what must happen? The U.S. needs to save more and spend less. China needs to save less and spend more. One hopes this happens gradually, orderly, because it will cause shifts in our productive sectors that will be difficult overnight. We'll be manufacturing and exporting more, and our currency will likely no longer be the world's reserve.

I give this book 3.5 stars out of 5. The authors don't bother giving an exposition of where neoliberalism comes from, or explicitly state that countries that eschew markets do so at their own risk (although DeLong preaches this to his students). They also don't talk about how the U.S. is supposed to start saving more when it has a social safety net unfunded into the future with long-term structural deficits as a result.

But that makes it a short read, easy for a layperson or undergraduate to understand.

The Worst Day in Years

It got overshadowed (as everything has) with the unnecessary debt ceiling debacle, but yesterday was a sad day in the realm of macro. The BEA released revised economic data for the last 3 years along with our advanced estimate for this quarter and told us that the economy has been in much worse shape than we had thought. We have yet to return to our pre-recession level of output.

The gap on the graph above may not look like much, but it makes a big difference. It's quite depressing that we're getting downward revisions in the hundreds of billions of dollars a few years after the fact, and is testimony to how difficult our economy is to measure.

Scott Sumner (emphases mine):
NGDP fell nearly 4% from 2008:2 to 2009:2, and has risen at a tad over 4% a year for the next two years. We are up by only 4.1% in 3 years, that’s a little over 1% per year. In other words, per capita NGDP has barely risen in 3 years! To maintain full employment everyone would have had to go nearly three years without a pay rise. But with soaring minimum wage rates, that wasn’t too likely. I’m sure lots of people in government, health care, education, etc, got raises. I did (even with one year of no raise), as did my wife (a scientist.) So with almost no extra NGDP to go around (per capita), we essentially have a game of musical chairs. The lucky ones get pay increases, the other 9.2% are sitting on the floor.

We already knew that the Fed was behind the curve. There is no way we should have seen unemployment above 9% and inflation expectations falling way below the Fed's implicit target last year, it's the Fed's job to prevent that. Now we know Bernanke's FOMC has allowed NGDP even further below trend since 2007. Reappointing Bernanke now looks to be one of the biggest mistakes of the Obama administration. If he had gone with Larry Summers instead, who would have cracked skulls to get what he wanted, we might be living in a different world.

The data does sorta solve one mystery that I've had to explain in class for the last 2 years: why Okun's Law seems to no longer hold in the U.S. It was a mystery why the "jobless recovery" was so bad, why unemployment had departed so far from the rate of economic growth we were seeing. Now we know that economic growth was not as good as we thought. Claims about a vast increase structural unemployment, rather than cyclical, were therefore misplaced.

There is currently a myth that gets repeated on the political Right-- that the government is currently standing in the way of recovery. That growth today is slow because the increase in government spending is crowding out private spending. But what do the data say? State and local government spending and federal government employment are decreasing. The ARRA stimulus is phasing out, meaning that discretionary spending is already on the downturn. Ryan Avent (The Economist) reminds us that such austerity is contractionary:

Government represented a significant drag in the first quarter, chopping 1.23 percentage points off of growth, 0.41 precentage points of which were due to state and local cuts, and 0.74 percentage points of which can be chalked up to declining defence spending. Indeed, the new report reveals the extent to which government has been an obstacle to recovery. In five of the last seven quarters, government has contributed negatively to growth, again thanks mostly to large state- and local-government cuts that offset the federal government's modest attempts at stimulus.
Private-sector investment has been positive, private sectors of the economy are growing, but the growth in GDP is offset by government retrenchment. This may all be well and good in the long-run (especially if you want to drown the government in the bathtub), but contractionary fiscal policy unaccompanied by expansionary monetary policy creates slower economic growth. This is what makes Congress' current wrangling over the debt ceiling problematic-- the focus is all on discretionary spending and not on entitlements-- where almost 100% of our future deficits will come from. The Tea Party wants to cut minor programs now, thinking that this will boost employment and GDP growth now, tossing 400 years of economic data out the window. (If, as part of their austerity package, Congress wanted to mandate an NGDP level target for the Federal Reserve, I'd be an austerity evangelist).

While Economics21 and others want to claim that it's all government regulation and crowding-out, accompanied by "uncertainty" over government policy, the data don't give them much to stand on. David Beckworth points us to WSJ and NFIB surveys indicating that the main problem is aggregate demand, and not regulation. While I've read articles with CEOs complaining that excess regulation is keeping them from expanding, they never point out a single new regulation that is the culprit. Beckworth notes that problems like regulation seem worse when you're not seeing the sales you're used to. Neil Irwin wrote an article in the Washington Post this week about why companies aren't hiring. While it highlighted frustration with uncertainty over fiscal policy, there was no mention of regulation. I asked Neil via Twitter if any of the CEOs he interviewed mentioned regulation. He said they did in general terms-- they named nothing specific. CEOs seem more fed up with the debt ceiling debate than anything:

The groups that represent businesses in Washington, including the U.S. Chamber of Commerce and the Business Roundtable, have been urging Congress to raise the debt ceiling to avoid the risk of a default or downgrade of the U.S. credit rating, even as many newly elected Republican members of the House — who received support from business interests when running — are reluctant to vote for such a measure. A group of major business groups sent a letter to the president and every member of Congress two weeks ago, imploring them to raise the debt ceiling.

Also on Friday, we saw the biggest 1-day increase in the price of 10-year U.S. Treasury bonds since 2009. Corporations are taking advantage by issuing their own debt as quickly as they can before August 2nd, this is a boon for junk bonds. This is an indication that the bond market--investors--now expect lower inflation and slower economic growth in the next ten years than they did around this time last year.



So, yesterday was a bad day even without the debt ceiling fiasco and the Eurozone implosion. Also, political problems in Turkey mean the markets there could do some interesting things on Monday. (But they have much better monetary policy than we do right now, so I'm not too concerned. )

Friday, July 29, 2011

Book Review (#23 of 2011) 13 Bankers


Johnson and Kwak's blog was essential reading during the financial crisis, and is still quite educational. This book is also required for Money & Banking in the fall. (I'm a bit sad because I went way over the Amazon clipping limit, so 314 of my highlights are invisible via the website.)

Johnson approaches the U.S. financial crisis from the point of view of a former Chief Economist of the IMF. That perspective allows him to see the irony of how the U.S. and the IMF advised East Asian countries through their financial crises in 1997-1998 compared to how the U.S. handled its own.

Related to my previous post, Johnson gives a history of banking and regulation in the U.S., from the first central bank charter of 1791 to Jacksonian populism, to the Panic of 1907 to the Great Recession. All of this is great, concise history.

Johnson comes down on the side of Thomas Jefferson--a distrust of centralized power of bankers as a threat to the Republic. He sees what the U.S. has now-- an oligarchy of a few large politically-influential financial institutions-- as little different from the cronyism of developing nations that the U.S. has been quite critical of. The U.S. advice to Asia in the 1990s was that no bank should be "too big to fail," and the big state-backed monopolies should be broken up. Johnson offers that same advice to the U.S. today-- find a way to break up the banks, just as Republican Teddy Roosevelt did with the Trusts of the early 1900s.

About 1/3 of this book is bibliography-- a treasure trove of sources and references. You always hear of the growth of finance, but it's nice to have specific data. The undeniable fact is that the deregulation of the financial sector in the 1970s and 80s did nothing to boost U.S. productivity and therefore did not result in an obvious better allocation of capital. The financial sector replaced manufacturing 1-for-1, and commercial & investment banking and insurance profits grew to be a much larger portion--almost 50%-- of all U.S. corporate profits by 2007. The amount of leverage taken on by financial sector firms became enormous over this time period:

"in 1978, all commercial banks together held $1.2 trillion of assets, equivalent to 53 percent of U.S. GDP. By the end of 2007, the commercial banking sector had grown to $11.8 trillion in assets, or 84 percent of U.S. GDP. But that was only a small part of the story. Securities broker-dealers (investment banks), including Salomon, grew from $33 billion in assets, or 1.4 percent of GDP, to $3.1 trillion in assets, or 22 percent of GDP. Asset-backed securities such as collateralized debt obligations (CDOs), which hardly existed in 1978, accounted for another $4.5 trillion in assets in 2007, or 32 percent of GDP.* All told, the debt held by the financial sector grew from $2.9 trillion, or 125 percent of GDP, in 1978 to over $36 trillion, or 259 percent of GDP, in 2007...In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the real economy; by 2007, that had grown to $51.14 In other words, for the same amount of borrowing by households and nonfinancial companies, the amount of borrowing by financial institutions quadrupled....by the third quarter of 2009, financial sector profits were over six times their 1980 level, while nonfinancial sector profits were little more than double those of 1980."

The private sector began to wade where only the GSE's had tread before-- securitizing mortgages. Deregulation allowed the lines to blur between banks and non-banks, until the lines were at last removed in 1999. Greenspan and other regulators intentionally decided not to regulate various activities. For example, Greenspan declined to look at the books of mortgage brokers owned by bank holding companies-- even though it was in the Fed's realm to do so. If there were bad practices or "liar loans" piling up, he clearly said the problem would take care of itself (and later regretted his belief in market self-regulation).

The story is that of "bigger and better," following the textbook argument that this was well because insurance conglomerates merging with banking conglomerates merging with investment banks benefited from economies of scope and scale. Johnson, like Hayek, takes issue with this type of argument and offers some good rebuttal using various studies:
"The 2007 Geneva Report, 'International Financial Stability,'... found that the unprecedented consolidation in the financial sector...led to no significant efficiency gains, no economies of scale beyond a low threshold, and no evident economies of scope."
Basically, as banks got bigger they took on even more risk. As commercial banks and investment banks were increasing competition in the securitization game, firms began to engineer products in unique ways to differentiate their products. This caused problems of information asymmetries as very few people--including ratings agencies and the Federal Reserve-- understood the products being created. The banks could manipulate their creations to be rated well by certain risk models when actually they were quite risky. Ultimately, the taxpayer was put on the hook:
"(T)he special inspector general for TARP estimated a total potential support package of $23.7 trillion, or over 150 percent of U.S. GDP (as) theoretical potential liabilities of the government."

Johnson understands the difficulties of regulation, and while he advocated a Consumer Financial Protection Bureau, he understands regulations will do little good if banks know that they are too big to fail. He recommends that a commercial banks' assets be allowed to be no bigger than 2% of GDP, 4% for investment banks.

"Saying that we cannot break up our largest banks is saying that our economic futures depend on these six companies (some of which are in various states of ill health). That thought should frighten us into action."
I give this book 4 stars out of 5. Other reviewers have rightly noted that Wall Street isn't the only place where TBTF rules-- the government has been bailing out the auto industry for years, and various other industries ranging from steel to cotton are heavily subsidized and protected. But the sheer size of the banks, the growing percentage of U.S. GDP generated by finance, and the growing political influence of banks in our "revolving door" government is alarming.

While the book is pretty mistitled, Johnson does make it clear that we've not done much to ensure that a crisis like 2007 doesn't occur again.

Tuesday, July 26, 2011

Conservatives and Monopoly

I'm trying to synthesize a couple strands of thought into one post here, so bear with me.

The main reason that I don't think the U.S. will ever go back to an 1800's "laissez-faire" version of government that Tea Party conservatives might wish for is because economic conservatives (the political right, I mean) can't seem to nail down a consistent position on monopoly. Government and business have become too intertwined in the U.S., and you basically have to go further back than 1776 to resolve that.

Anyone who has read Gordon Wood knows the only Founding Father that would recognize the U.S. today is Alexander Hamilton. Hamilton foresaw Manifest Destiny, American empire with a large standing army, and a federal government promoting the interests of American industry through a central bank coordinating loans and a system of trade protection. Hamilton's way arguably helped America achieve its economic superpower status, and we've been wrestling with Hamiltonian vs. Jeffersonian ideas of democracy and government ever since. One symptom of this is recent polling data that show Tea Party Republicans are more protectionist and skeptical of free trade than even Democrats. (Protectionism is contrary to Classical Liberal/Libertarian principles.) Rupert Murdoch, a monopolist, and the Koch brothers, part of a cartel, have helped give the Tea Party a larger platform to speak from. Hamilton was willing to have monopolies, so long as they were American.

But the monopolist has always been seen as the enemy of free markets. Adam Smith:
"People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices."

Competition is the solution to monopoly, of course, the government should maintain freedom of entry and exit. But classical liberals have always found some regulation necessary-- particularly regulation of monopolies located in the financial sector. There is skepticism about the ability of competition to regulate bank behavior. In Wealth of Nations, Smith recommends a legally mandated cap on interest rates in order to curb what he saw as excesses by lenders.

F.A. Hayek also took a dim view of financial self-regulation. Lawrence White points out in this paper that Hayek didn't support "laissez-faire banking." Hayek believed that competitive commercial banks necessarily engage in a pro-cyclical process of expanding credit due to increased demand, rather than allowing interest rates to rise. He basically argued that as banks compete for customers, there will be an expansion of credit creating a harmful monetary disturbance and a boom/bust cycle. He therefore argued that some central control of monetary policy may be necessary. (White spends much of the paper showing how this contradicts Hayek's other philosophical views.)

Hayek's words remind me of self-professed "lifelong libertarian" Alan Greenspan's recent recantation before Congress in regards to his previous views on financial self-regulation. During the housing boom, Greenspan had repeatedly expressed the view (along with Rubin and Summers) that firms' risk-taking would be curbed by their own self-interest not to go bust, and that assets were priced properly and needed no regulation because the trades were taking place among "professionals."

“All of the sophisticated mathematics and computer wizardry essentially rested on one central premise: that enlightened self interest of owners and managers of financial institutions would lead them to maintain a sufficient buffer against insolvency by actively monitoring and managing their firms’ capital and risk positions,” the Fed chairman said. The premise failed in the summer of 2007, he said, leaving him “deeply dismayed.”

Self-regulation is still a first-line of defense, Mr. Greenspan said. But after the financial collapse of 2007 and 2008, “I see no alternative to a set of heightened federal regulatory rules of behavior for banks and other financial institutions.” He said hoped hoped it would come in the form of tougher capital requirements for banks.


If you read any of the leading Money, Banking, and Financial Markets textbooks you'll find a history of U.S. financial markets as one of increasing consolidation. We have fewer, bigger banks that also now own insurance companies, hedge funds, and other large players in the capital markets. I'm currently reading a book that begins with a historical perspective on U.S. financial markets (not a textbook, emphases mine):
According to historian Thomas McCraw, “in the period 1897–1904 … 4,227 American firms merged into 257 combinations. By 1904, some 318 trusts … were alleged to control two-fifths of the nation’s manufacturing assets.”50 The rise of the trusts depended heavily on investment bankers, who provided the money needed to buy shares and rearrange shareholdings and also offered the social glue necessary to bring disparate industrial interests together. A handful of bankers led by J. P. Morgan played a central role in this rapid transformation...Morgan’s empire handled an extraordinary share of the money flowing into American industry—as high as 40 percent of total capital raised at the beginning of the twentieth century.

After Depression-era regulations on banking activity and consolidation are removed in the 1980s and 1990s, this process continues:

Between 1990 and 1999, the ten largest bank holding companies’ share of all bank assets grew from 26 percent to 45 percent, and their share of all deposits doubled from 17 percent to 34 percent. The largest financial services conglomerate of all (at the time) was put together by Sandy Weill, who began with Commercial Credit, bought Primerica (which owned Smith Barney) in 1988, added Travelers Insurance in 1993, bought Salomon Brothers in 1997, and finally merged his empire with Citicorp in 1998. (this merger was illegal until the Glass-Steagall Act was effectively repealed in 1999.) ...at the end of 2007, Citigroup had $2.2 trillion in assets, not counting $1.1 trillion in off-balance-sheet assets.

Every textbook lays out the premise that the increasing consolidation is inevitable and necessary due to advances in technology. Our economy is better off because the industry exhibits economies of scale and scope. It's interesting that in Road to Serfdom Hayek directly confronts this idea, and sees nothing "inevitable" (his word) about the development of natural monopolies (pgs. 91-94). He sees such arguments as backdoor arguments of monopolists for protection, eventually resulting in state control and socialism. Hayek's recommendation for regulating natural monopoly is simple price controls-- taking away the monopolist's profit and therefore reducing incentive for other monopolies to form:

(W)herever monopoly is really inevitable the plan... of a strong state control over private monopolies, if consistently pursued, offers a better chance of satisfactory results than state management. This would at least seem to be so where the state enforces a stringent price control which leaves no room for extraordinary profits in which others than the monopolists can participate...Only make the position of the monopolist once more that of the whipping boy of economic policy, and you will be surprised how quickly most of the abler entrepreneurs will rediscover their taste for the bracing air of competition!

Hayek goes on to say that he'd rather put up with "a little inefficiency" as a result of government restrictions on monopoly than to have his fate dictated by the monopolists. I can't help but think of Bank of America, the U.S.'s largest bank and wealth manager, active in all 50 states and providing financial services in some way to the majority of Americans. It tried to foreclose on a house that it didn't own, and was even willing to battle in court for it. Is this not the tyranny of monopolists Hayek was talking about?

But there's a knee-jerk reaction on the political right to the word "regulation," it is always and everywhere seen as a bad thing. A stated GOP goal is to repeal Dodd-Frank, or at least not fund regulation for certain aspects. But as Hayek and classical liberals before him have argued, the financial sector is unlike other sectors in its need for regulation.

From the late 1930s to the late 1970s, banking and financial services were heavily regulated. Competition was limited and profits were higher to the banks in business. But the industry was also stable, there were very few bank failures or scandals. The argument for deregulation of the financial sector was essentially that it would increase productivity in the U.S. by better allocating capital. Lower prices and interest rates for the consumers would help foster home ownership and other forms of investment. But the highly regulated banking sector of the 1950s and 60s oversaw 4% annual RGDP growth and one of the greatest booms in productivity in U.S. history. The deregulated banking sector of the 1980s and 1990s oversaw The Great Stagnation-- there were no productivity gains from financial deregulation.

Classical economic theory says that the wages someone earns should be equal to the marginal product of their labor. So, if traders at AIG are earning $165 million bonuses in 2007 and "(Citigroup CEO Jamie) Dimon earned $34 million,( Goldman Sachs') Blankfein $54 million, John Thain of Merrill Lynch $84 million, and John Mack of Morgan Stanley $41 million,"
they must have boosted productivity by that much. But there's no evidence of this, as their firms all took large hits and lost billions in wealth. So, there is a strong case that these CEOs are earning monopoly rents.

And instability has increased, the 1980s S&L crisis, the 1990s failure of LTCM, and the larger debacle of 2007 to today, where banks are still failing every week. The direct result has been the creation of new monopolies.

So, I'm skeptical of Tea Party conservatism because I don't see it attacking the monopoly problem and I see it attacking any government efforts to impose any Classical Liberal regulation on banking monopolies and financial sector activities (regulations now being called for by Randians like Greenspan). I hear anger over government proposing tax increases rather than skepticism over whether the pay of financial sector CEOs and professional athletes match up with their marginal productivity or if it's just monopoly rents that the government might do well to tax. I hear the angry denunciation of "bail-outs," for the financial sector but I don't hear very many (other than Ron Paul) on the political Right calling for the large banks to be broken up to foster competition-- I mainly hear that argument from people on the Left.

(I should note that left-ish economist and sometimes Obama adviser Jeffrey Sachs claims that "It's more accurate to say that the Republicans are for Big Oil while the Democrats are for Big Banks. That has been the case since the modern Democratic Party was re-created by Bill Clinton and Robert Rubin.")

Sunday, July 24, 2011

Friedman-Hayek 2012 T-shirt

I saw a link to this on one of the Google ads on my sidebar here. I like it!


The quote is: "One of the great mistakes is to judge policies and programs by their intentions rather than their results" (Friedman).

I'd love one, but the monopolist price of $27.95 per shirt is out of my budget.

Saturday, July 23, 2011

Book Review (#22 of 2011) The Big Short

I'm catching up on financial crisis history reading since we're a month out from classes starting and a couple classes I teach deal directly with the lessons (hopefully) learned from the event.

The Big Short: Inside the Doomsday Machine by Michael Lewis.
This book is primarily about greed. I would sum up the moral of this book with Proverbs 22:16:
He who oppresses the poor to make more for himself
Or who gives to the rich, will only come to poverty.


Lewis (The Blind Side, Liar's Poker) is one of the best nonfiction writers of our time, a fantastic storyteller. If you've not read his long-form article in Vanity Fair on the Greek debt crisis from last year, it's very much worth your time and you'll see why any efforts to keep Greece on the euro will ultimately fail.

This tells the story of some of the very few people who called the housing bubble correctly, put their money where their mouth was, and made hundreds of millions of dollars.

Michael Burry (this video posted by Bloomberg today tells his story), a former neurosurgeon turned California hedge fund manager who discovers he has Asperger syndrome during the course of his story. His Aspergers explain why he was so successful at consistently being ahead of the market, but also why he burnt out emotionally.

Steve Eisman, a cynical bond trader who also probably has some mental disorder, who often confronted CEOs and other people he saw as villains. He saw shorting the housing market as part of a greater crusade.

A trio of normal guys who start fund called Cornwall Capital, basically betting on "Black Swan" events, even when they didn't know what they were doing.

These guys didn't get famous like John Paulson, but Paulson might not have existed without Burry originating the idea. But these guys pioneered the market for credit default swaps on housing-related CDOs. For Burry and Cornwall, they got to experience the rough treatment that outsiders get from firms like Goldman Sachs-- who basically cheat their customers when they can. (What are you going to do, sue Goldman Sachs?)

The underlying greed of those making money off of housing is the central theme in this book.
"In Bakersfield, California, a Mexican strawberry picker with an income of $14,000 and no English was lent every penny he needed to buy a house for $724,000."

The loan is an adjustable rate loan made by someone-- a bank or a mortgage broker-- who knows the migrant won't be able to repay, but the lender doesn't care. Because he has already sold the loan to an investment bank and gotten paid a nice commission for it. Reproduce this transaction thousands of times over in the U.S. Lenders even start making interest-only loans where the borrower never pays down any principle. A stripper in Vegas somehow gets five home equity loans...The investment bank takes the loans and packages them into asset-backed securities (ABS), a pool of mortgages of varying quality which it convinces Moody's or S&P to rate AAA.

Moody's and S&P get paid fees for doing this, so they have an incentive to rate as many assets as they can, even if they think the underlying loans are junk-- that's not their problem. Next, another investment bank might buy several of the ABS and strip out some of the worst tranches, repackage them into a CDO. Even though the underlying mortgages are of low quality, the ratings agencies again rate the CDO as AAA. Maybe because their models say that the low-quality loans are from various regions of the country, and U.S. home values have never all fallen at once (no one was alive in the 1930s, right?). Or their models were flawed in other ways -- rating a floating-rate mortgage higher than a fixed rate, assuming someone could make payments just as easily at 12% as 8%, etc. Maybe because the fees they're raking in help their bottom lines and boosts their stock price--they are publicly traded companies. Maybe because they're incompetent (the smartest guys on Wall Street don't work at the ratings agencies).

When there are no more loans to be made, CDOs are re-created synthetically, multiplying the amount of people who are basically betting on these assets. But very few people recognized that these assets would go bust when rates adjusted upwards in a couple years. Their trading desks kept billions of dollars worth on their books. Their risk management models only speculated that maybe 5% of the underlying loans would default. Everyone is basically passing the buck-- we collect our fees and commissions now, worry about the rest later.

Guys like Burry and Eisman bought millions of dollars worth of credit default swaps on these CDOs, insurance that would pay out if the assets became worth less. When they finally did, the biggest financial companies in the world paid up and went bust.

At one point in 2006 Eisman is invited to a subprime conference in Vegas organized solely to promote mortgage-backed securities and convince investors to stay in the market. He is basically awestruck by how how dumb everyone is and how "the world has turned upside down." The guys creating the CDOs, the trading desks buying them up, everyone seems to be drinking the kool aid that these are safe bets.
"Something must have come over Eisman, for he stopped looking for a fight and started looking for higher understanding. He walked around the Las Vegas casino incredulous at the spectacle before him: seven thousand people, all of whom seemed delighted with the world as they found it. A society with deep, troubling economic problems had rigged itself to disguise those problems, and the chief beneficiaries of the deceit were its financial middlemen. How could this be?"


There is a lot of profanity in this book, Lewis wants the world to see that Wall Street, where he used to work, is not holy. The "villains" of the story, the mortgage brokers, the CDO sellers, the traders and CEOs who lost their companies billions betting on CDOs, mostly walk away with their bank accounts intact, and keeping the millions in bonuses they earned along the way. The taxpayers took the ultimate fall along with, of course, those who lost their homes.

Despite the profanity, I have made it a required text in Money & Banking. The students will see that they will be confronted with incentives that may conflict with Christian ethics. Would you really care what the adverse consequences for others might be so long as you're making millions of dollars? Would you pass the buck? They will also see that it's not true or that simple to say "everyone knew the housing bubble would burst," or "it was all the government's fault."

I give this book 4 stars out of 5. What I really gleaned from the book is the importance of the ratings agencies in all of this. There are so many accounting rules and laws in our financial system that revolve around capital cushions and the value of assets, and if something is rated AAA and is really BBB-, that causes a lot of problems. It doesn't appear to me that those problems are very easily solvable.

Friday, July 22, 2011

"Missing Milton Friedman"

Will Wilkinson writes a post that repeats sentiments I've been posting here for years (and I've just been echoing several conservative & neoliberal economists' sentiments):

Milton Friedman, classical liberal, champion of libertarian movements everywhere, would blame our current malaise on incompetent Fed policy (just as he blamed Japan's central bank for their malaise). Not that the Fed printed too much money, but that it didn't print enough. Ben Bernanke knows this, agrees with it, but now feels politically constrained to do anything about it.
Because conservatives and libertarians are screaming bloody murder about the Fed "debasing the currency!"

Wilkinson correctly identifies that this is the result of the influence of Rothbardian Austrian economics:

"The influence of this kind of talk has been augmented powerfully by a certain moralising strand of Austrian economics, which is hostile to the very idea of fiat money, and encourages the idea that its entire purpose is to expropriate savings and monetise government debt. This strand of Austrianism also encourages scepticism about the existence of distinctively macro-level economic phenomena...Although sophisticated Austrian-school monetary economists such as George Selgin and Larry White defend rule-based inflation-targeting policies not all that different from Mr Sumner's neo-monetarist nominal GDP-targeting rule, the ghost of Murray Rothbard looms much larger on the free-market right."


What Wilkinson misses in his piece: During the late 1970s, Friedman's University of Chicago pioneered what is now "saltwater" economics, where there is no such thing as aggregate demand and money doesn't matter. A macroeconomic framework that Friedman didn't agree with and that doesn't line up with the data very well. But it (or a politicized version) became the darling of the Right in the 1980s. (Krugman chronicles this in a couple chapters. ) So, when Friedman died, there were very few trained conservative economists who saw the world as he did.

Wilkinson concludes (his quotes are from Rothbard):
I do believe elements of Ron Paul's Rothbardian monetary philosophy enjoy a great deal of currency on the grassroots right, and I believe this exerts a considerable gravitational force on the institutional right, such that arguments for zero or very low inflation are accorded more weight than they would were Milton Friedman still (alive).

If only the free-market right still had such a powerfully persuasive "technician advising the state how to be more efficient", our economy might now be slightly less screwed. Maybe it would help were "advising the state to be more efficient" less widely considered "evil work".

Friedman believed that a gold standard, which Rothbard and Mises promoted, where the government arbitrarily fixes the price of something, was incompatible with liberty. Friedman, like Hayek, instead believed the Fed should follow a simple rule and never depart from it. He varied over the years on what the rule should be. His preferred candidates included growing the monetary base by k% every year, to target expected inflation via TIPS spreads, or (as I've heard, but have never read a piece by him on it) a nominal GDP level target. Friedman (and Hayek) believed such a policy would best promote the free market. (He had other recommendations for monetary policy--like a 100% reserve requirement-- which went hand-in-hand here, I admit.) Such a policy rule-- an explicit target-- would be far superior to the feckless discretionary policy we have now.

Bryan Caplan, an Austrian sympathizer at George Mason puts it:
"In sum, Milton Friedman spoke wisely when he declared that 'there is no Austrian economics - only good economics, and bad economics,' to which I would append: 'Austrians do some good economics, but most good economics is not Austrian.'"

Thursday, July 21, 2011

Using the Cloud to help heal people

My wife's birthday was Wednesday and I want to honor her by posting this story because I think it encapsulates her awesomeness.

One of my pet peeves is email attachments. It's 2011 and we're still filling inboxes with large attachments rather than putting files in the Cloud and then emailing a simple link to view it or work collaboratively on it. Or we're posting paper sign-up sheets and trying to coordinate schedules via email rather than using a rubric in the Cloud (all of which are free).

This week, my wife was able to instantly convert hundreds of people to the power of using Google Docs and help a guy be more efficiently prayed for. That is a Proverbs 31 woman:

It started when a popular blog posted an emergency prayer request for a man named Karl. The author wanted people to pledge to pray at specific times via the comment section, like a sign-up sheet. With dozens of eager prayers, the sign-up sheet became unworkable. So, Joni quickly created a simple Google spreadsheet (here) and posted a link to it. As you can see, Karl was covered (but he still needs prayer). The author was most appreciative, and now all of the readers are connected in a way they've never been before. That's what the Cloud does.

My wife works from home for Roar, a company that designs mobile apps for churches, schools, and other non-profits (they're now the official app maker of Lifeway, of the largest denomination in the U.S.). She writes some good blog posts there too, so check it out.

Tuesday, July 19, 2011

Hayek and the Debt Ceiling

I think one can make a Hayekian argument for raising the debt ceiling.

Ignore for a moment that Hayek would have opposed the policies that created the need to borrow on a massive scale, ie: the government dissaving that drags down our national saving. Hayek's writing in Road to Serfdom and elsewhere tends to look at policy pragmatically--given the government has already enacted a sub-optimal policy, how best to deal with it, particularly without causing instability?

*this part updated for clarity*
Hayek is firm in his belief in what he terms the "Rule of Law." This is not the simple protection of property right and enforcement of law, as Hayek has already laid that out as a foundational role of government a classical liberal order. Hayek's Rule of Law is defined as (emphasis mine):
"(G)overnment in all its actions is bound by rules fixed and announced beforehand-- rules which make it possible to see with fair uncertainty how the authority will use its coercive powers in given circumstances and to plan one's individual affairs based on this knowledge. Though this idea can never be perfectly achieved, since legislators... are fallible men, the essential point, that discretion left to the executive organs wielding power should be reduced as much as possible is clear enough...rules tell people in advance what actions the government will take in certain types of situation, defined in general terms, without reference to time and place and particular people."


For Hayek, government changing a long-standing policy was a big deal because it would adversely affect people who had made individual choices based on the established rules of the game. A rule-based system is fundamental to a functioning market because it anchors expectations (emphases mine):
"(I)t does not matter whether we all drive on the left- or on the right-hand side of the road so long as we all do the same. The important thing is that the rule enables us to predict other people’s behavior correctly, and this requires that it should apply to all cases—even if in a particular instance we feel it to be unjust."

Discretionary macroeconomic policy were therefore anathema. One good example of this comes from Hayek's writings on monetary policy in the early 1930s. As Lawrence White writes,
"Hayek’s monetary policy norm in fact called for the stabilization of nominal income (MV), and thus for central bank action to prevent its contraction."

Monetary policy rules have been in the literature for a long time and Hayek has made his contribution. Given a fiat currency controlled by a central bank, the central bank should follow an announced and specific rule so that there is no deviation from expectations.

Now, the Fed pursuing such a policy in 2008 would still have led to a simple graph of M1 like this that would have bothered a lot of Rothbardian Austrians and Glenn Beck:
But as Scott Sumner and David Beckworth (and others) have spent the last few years arguing, if the Fed had an NGDP growth target, it didn't grow the money supply nearly fast enough to hit it during the financial crisis. Nor did the Fed keep inflation expectations in line with its implicit target of just under 2%-- it allowed them to fall far short. In other words, the Fed didn't live up to the markets' expectations of its behavior, and as a result we're still in a sub-optimal recovery.

So a Hayekian central bank under his Rule of Law definition would announce an explicit target of something and then consistently pursue it. (And pursuing that target in 2007-2008 would have led to policies like QE that would have made a lot of classical liberals uncomfortable.)

Hayek recognized that economic disturbances, if handled badly, caused the public to turn against free market capitalism. Hayek and Keynes were in agreement on this point. During the Depression, Hayek had argued for deflation and liquidation, but later regretted it in part because he saw the much worse political fallout.

While a staunch defender of the price mechanism, Hayek recognized that immediately removing England's wartime price controls would cause chaos and backlash against capitalism:
"(H)owever much one may wish a speedy return to a free economy, this cannot mean the removal at one stroke of most of the wartime restrictions. Nothing would discredit the system of free enterprise more than the acute, though probably short-lived, dislocation and instability such an attempt would produce." (emphasis mine).


Hayekian thought thus seems opposed to neoliberal (Jeffery Sach's) "shock therapy," eliminating any heavy wage/price controls and government interventions in the market immediately for countries that have adopted socialist practices. "Get it over all at once," as Sachs said in an interview. (One can argue that Hayek is vindicated by the observation of populist backlash against such capitalist reforms in countries like Russia after privatization was botched.)

Let's return to the debt ceiling debate. Congress has raised the debt ceiling 89 times since 1939. Judging by the yields on Treasury bonds today, the market expects the debt ceiling to be raised again and for Treasuries to keep their value. Like it or not, raising the debt ceiling is part of the Rule of Law that Hayek would expect the government to continue following. Deviating from those expectations would have consequences.

If the debt ceiling isn't raised, the President has to go through budget items line-by-line to figure out what gets funded and what doesn't. Thousands of jobs and incomes are immediately lost, interest rates rise, and the other economic consequences are quite costly. Given we already have a Federal Reserve that hasn't kept its obligation with the Rule of Law (and its Chairman indicates it's politically impossible for it now to do so), I would quote Hayek again here:

"Nothing would discredit the system of free enterprise more than the acute, though probably short-lived, dislocation and instability such an attempt would produce."


Defaulting on its debt, or meeting its debt obligations and cutting current expenditures dramatically to do so, could be as harmful to the long-run cause of free enterprise as the Great Depression was.

Default isn't being pursued or advocated by Hayekian Classical Liberals. It's being advocated by Conservatives who Hayek was very poignant about not being associated with.

Monday, July 18, 2011

Book Review (#21 of 2011) - Hayek Road to Serfdom

The Road to Serfdom: Text and Documents--The Definitive Edition (The Collected Works of F. A. Hayek, Volume 2) edited by Bruce Caldwell.
(Note, there were some issues with pasting this post from Google Docs, where I originally wrote it. I have re-formatted the below twice to make it easier to read, but on the last edit somehow it got reset. I don't feel like re-formatting it again (namely adding links to external sources).

This new edition of the book features much additional material. The first 20% of the book tells the story of its publishing, explains the context Hayek wrote this book in, and explains the articles Hayek used in compiling the book. It includes the forewords Hayek wrote for the 1956 and 1976 editions, as well as Milton Friedman’s foreward to the 1994 edition and other supplementary documents. Hayek’s notes have been updated to make more sense to a modern reader-- all of which I found essential.

This new edition of the book features much additional material. The first 20% of the book tells the story of its publishing, explains the context Hayek wrote this book in, and explains the articles Hayek used in compiling the book. It includes the forewords Hayek wrote for the 1956 and 1976 editions, as well as Milton Friedman’s foreward to the 1994 edition and other supplementary documents. Hayek’s notes have been updated to make more sense to a modern reader-- all of which I found essential.

Originally published in March 1944, Hayek is responding to some intellectual trends he finds disturbing, primarily the trend of the West moving away from classical liberalism. But he gives caution to those who mischaracterize his words:
“It has frequently been alleged that I have contended that any movement in the direction of socialism is bound to lead to totalitarianism. Even though this danger exists, this is not what the book says.”


Hayek traces the roots of classical liberalism to Christianity, Greek, and Roman thought:
“(T)he essential features of that individualism which, from elements provided by Christianity and the philosophy of classical antiquity, was first fully developed during the Renaissance and has since grown and spread into what we know as Western civilization—are the respect for the individual man qua man, that is, the recognition of his own views and tastes as supreme in his own sphere...”

Hayek spells out the proper role of government under classical liberal tenets:
1. Protection of private property and enforcement of contracts.
2. Provision and enforcement of “the rules of the game.”
3. Provision of pure public goods and correction of negative externalities.
4. Proper regulation of natural monopolies (as opposed to ownership of them).
5. A mild redistribution of income and provision of a social safety net, including catastrophic insurance.

“(T)here can be no doubt that some minimum of food, shelter, and clothing, sufficient to preserve health and the capacity to work, can be assured to everybody. Nor is there any reason why the state should not assist the individuals in providing for those common hazards of life against which, because of their uncertainty, few individuals can make adequate provision. Where, as in the case of sickness and accident, neither the desire to avoid such calamities nor the efforts to overcome their consequences are as a rule weakened by the provision of assistance— where, in short, we deal with genuinely insurable risks—the case for the state’s helping to organize a comprehensive system of social insurance is very strong... Wherever communal action can mitigate disasters against which the individual can neither attempt to guard himself nor make provision for the consequences, such communal action should undoubtedly be taken” (emphases mine).

It’s important to note that in points #3, 4, 5 Hayek differs sharply from the Austrian economists he is usually lumped together with as Bryan Caplan explains:
“Mises and Rothbard clearly rejected many of the key elements of modern neoclassical economics (including #3-5), while Hayek did not.”

Hayek also did not see collective government action in the face of a Depression and high unemployment as opposed to classical liberalism (emphases mine):
Many economists hope, indeed, that the ultimate remedy (to business cycle fluctuations) may be found in the field of monetary policy, which would involve nothing incompatible even with nineteenth-century liberalism. Others, it is true, believe that real success can be expected only from the skillful timing of public works undertaken on a very large scale...But this is neither the only nor, in my opinion, the most promising way of meeting the gravest threat to economic security. In any case, the very necessary efforts to secure protection against these fluctuations do not lead to the kind of planning which constitutes such a threat to our freedom.

Many people mistakenly think that the “laissez-faire” classical economists to which Hayek gives deference were “anarcho-capitalists” opposed to government intervention anywhere. Quite the contrary, Adam Smith, Frederic Bastiat, Jean-Baptiste Say, J.S. Mill, Hayek, and Milton Friedman all unanimously agree on #1-#5 above with only a difference in the details. They also clearly acknowledged that monetary and fiscal policy could be effective during an economic downturn.

But all agreed that these government actions could be used as excuses for other encroachments and proposed a high bar that must be met by the government first.

Hayek understood that the British public were enjoying full-employment under a centrally-planned war economy, and many were advocating that this continue after the war since the Great Depression was such a strong memory. Indeed, Socialists were elected into office immediately after the war and seized much of the “commanding heights” of the economy for the State, in the belief that they were preserving individual freedom by saving the populace from economic hardship, as Keynes had believed possible (without the “commanding heights” bit) in his General Theory:
“(T)he modern classical theory has itself called attention to various conditions in which the free play of economic forces may need to be curbed or guided. But there will still remain a wide field for the exercise of private initiative and responsibility. Within this field the traditional advantages of individualism will still hold good” (Keynes, emphasis mine).

Hayek spends much of the book arguing why this is a fallacy. Economic freedom-- the ability to choose between alternatives, to lose your job, to fail at a business, etc. is intertwined with individual freedom:

“Economic control is not merely control of a sector of human life which can be separated from the rest; it is the control of the means for all our ends. And whoever has sole control of the means must also determine which ends are to be served, which values are to be rated higher and which lower—in short, what men should believe and strive for.”


The Socialists desired to create a Utopia where there would be “full employment,” no poverty, and no perceived unfairness in outcomes. Hayek gives a lucid explanation of why this is incompatible with maintaining individual liberties:
“The choice open to us is not between a system in which everybody will get what he deserves according to some absolute and universal standard of right, and one where the individual shares are determined partly by accident or good or ill chance, but between a system where it is the will of a few persons that decides who is to get what, and one where it depends at least partly on the ability and enterprise of the people concerned and partly on unforeseeable circumstances...”

While a Socialist or Communist regime may eliminate differences in wealth, it doesn’t solve the problem of real poverty and it takes away the most valuable object-- freedom:

“The fact that the opportunities open to the poor in a competitive society are much more restricted than those open to the rich does not make it less true that in such a society the poor are much more free than a person commanding much greater material comfort in a different type of society...in every real sense a badly paid unskilled worker in this country has more freedom to shape his life than many a small entrepreneur in Germany or a much better paid engineer or manager in (Soviet) Russia...It may sound noble to say, “Damn economics, let us build up a decent world”—but it is, in fact, merely irresponsible. With our world as it is, with everyone convinced that the material conditions here or there must be improved, our only chance of building a decent world is that we can continue to improve the general level of wealth.”


Hayek understands the problem that the Soviet propogandists dealt with and we see in North Korea today: Under Socialism, not only do you have to replace freedom and incentives with coercion in order to get labor to produce, but the government has to convince people that its system is “fair,” and eliminate freedom of information to make the people believe they are in the best situation. Because:
“Once government has embarked upon planning for the sake of justice, it cannot refuse responsibility for anybody’s fate or position. In a planned society we shall all know that we are better or worse off than others, not because of circumstances which nobody controls, and which it is impossible to foresee with certainty, but because some authority wills it...Everything which might cause doubt about the wisdom of the government or create discontent will be kept from the people.”
This is why books are burned and banned in every Socialist country. Intellectual freedom is incompatible with a state that has to be believed by the people as making the absolute best decisions.

There were perhaps very few outright Marxists in Hayek’s day, but Hayek spends a good bit of the book explaining that Communism and National Socialism are branches from the same root, and credibly does so from his first-hand Austro-German experience. I appreciated this from the perspective of having celebrated V-E Day modernly in the former Soviet Union with (educated) people there not really able to elucidate what the differences were between Hitler and Stalin.

The weak point of the book deals with how the State or central planner assumes responsibility for defining morality in that society. Defining morality is a problem in any society without an objective standard of Truth.

I piece together Hayek’s thoughts on how a country moves down the road to serfdom:

First, democracy can be frustratingly slow-- as it is designed to be. People hate “gridlock,” and start to clamor for ways to streamline the legislative process. The more tasks the government assumes, the harder it is to find pareto-efficient outcomes. In some cases, technocrats and experts are installed to have control over processes.
Second, monopolies develop and begin to lobby the government for protection. The more protection allowed, the stronger they become. This increases the level of frustration by keeping certain prices high and increasing structural unemployment.
Third, people hate hardships and insecurity. People being laid off by their long-time employer, or losing money in a failed business venture have sad testimonies. Rather than understanding that this is what happens in a world are free to pursue their own economic opportunities, people begin to clamor for a better way, for “economic justice” and “security.” While Hayek agrees with some redistribution for the poor (see above) he points out that some hardship is simply necessary in a free society.
Next, the government begins to intervene in response to the above with “good intentions.” Maybe it’s a tariff to protect an industry, or a price ceiling to “keep things affordable,” or takes over a monopoly, but there are resulting unintended consequences that may exacerbate the problems above or create new ones. People clamor for more relief. Rinse and repeat until eventually the government is trying to direct all economic outcomes.


Hayek does offer some observations that are cause for optimism in 1944-- namely that international socialism is highly unlikely because socialism ultimately collapses in nationalism. Workers in England would object to some world government that redirects capital to, say, Poland:
“That socialism so long as it remains theoretical is internationalist, while as soon as it is put into practice...becomes violently nationalist, is one of the reasons why “liberal socialism” ...is purely theoretical, while the practice of socialism is everywhere totalitarian.”

But Hayek was in favor of something like the League of Nations that could be used to foster the liberal order and help maintain certain international rules-- like trade agreements:
“Federalism is, of course, nothing but the application to international affairs of democracy...a community of nations of free men must be our goal.”

The last few chapters deal with the details of German history, how National Socialism was the natural outcome of the followed philosophies of German philosophers, who Hayek notes were much heralded in the West, particularly in the world of education.

In Hayek’s 1956 foreward, he says that the Socialism and Planning he wrote about in 1944 “in this sense probably came to an end around 1948.” Socialism proved to be inefficient and the loss of individual freedom caused the British public to be alarmed. By 1976, the “Welfare State” with its emphasis on redistribution and soft paternalism had replaced outright central planning on the Left at the same time that many centrally planned economies would begin to free their markets and pursue greater wealth. Even the post-Keynesian attempts by the government to pull levers to achieve “full employment” were widely being abandoned.

Friedman’s 1994 foreward, a re-write of one he wrote in the 1970s, was very lucid. I think Episode I of Friedman’s Free to Choose is much more Hayek than Adam Smith. Highlights:

“What is now described as poverty would have been regarded as plenty when that slogan was first widely used.”
“The free market is the only mechanism that has ever been discovered for achieving participatory democracy.”
“(T)hose of us who were persuaded by Hayek’s analysis saw few signs in 1945 of anything but a steady growth of the state at the expense of the individual, a steady replacement of private initiative and planning by state initiative and planning. Yet in practice that movement did not go much farther—not in Britain or in France or in the United States.”

In all, I give this book 4.5 stars out of 5. It would have meant much more to a European in 1944 than an American today, and parts of the book are very context-relevant. I think Hayek would be concerned that it was being trumpeted by Conservatives, which Hayek was not, to advocate means and ends of which he did not approve in his book.