Thoughts on energy, economics, history

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Consider this question: Is your family better off if everyone pitches in and helps? I hear my mother giving an answer to that question clear back in my childhood. Is it better if everyone does each task together or if some do one thing while others do something else? For example, Sally vacuums while Sammy does the dishes. In our house that will work much better than having to clean up the mess if two children try to work in the sink at the same time. If the goal is to teach the children about cooperation then perhaps working together may be an efficient means to that end. However, if the goal is a clean house then some amount of specialization can improve your outcome.

Now consider this question: You just adopted the neighbors on both sides, do the answers to our first two questions change? I wouldn’t think so. Will you all be better off if some of your new family members specialize in particular house cleaning tasks? Clearly yes. Now you can have vacuuming, dishwashing, dusting, and picking up all happening at the same time – your house will be spotless in no time and you will have more time to play a wonderful game together!

Is there a dark side to this happy story? Is something terrible happening because of all this cooperating? The longer you cooperate and specialize the more you will come to depend on each other. That increases your vulnerability while increasing your welfare. If your neighbors aren’t trustworthy then you may want some assurance that they will hold up their side of the bargain. But if you can achieve that you will be better off cooperating with your neighbor.

Now expand your family even farther. Does the same logic of specialization and cooperation apply to a larger family? One of the most interesting differences between us and all other animals is that we evolved to cooperate with strangers to achieve mutual ends. No other animal does that – they cooperate with relatives, but not with strangers. It seems to me that this fact tells us that cooperating between larger groups does indeed produce some advantage, at least from an evolutionary point of view.

Why then do some people get so bent out of shape by international trade? Why should we consider trade with China to be any less good than trade with our adopted neighbors? We will certainly want to establish some rules and enforcement mechanisms to ensure contracts are honored since it is harder to walk next door and demand payment, but the volume of international trade tells me that we have perfectly adequate solutions to this issue. If specialization and cooperation – trade by another name – with our neighbors helps make life better, why wouldn’t we want to open up to a wider range of options and trade with anyone and anywhere? The logic of those opposed to international trade and globalization and suspicious of trade with China escapes me.

The meaning of the word ‘liberal’ in politics used to be aligned with notions of personal and business freedom, along the lines of the meaning of ‘libertarian’. However its meaning changed over time to now mean “Lets have the government mess with people’s lives and with what business does, for we know better how everything should run.” Over time, with the help of “conservative” invective, the term liberal was tainted. Now it seems people are trying to adopt the term ‘progressive’ which seems to mean “Lets have the government mess with people’s lives and with what business does, for we know better how everything should run, only this time we know how to do that better.” So it seems that modern day liberals are trying to escape the label without changing their positions.

However, at least they are consistent (for the most part). People who adopt the label ‘Conservative’ seem to take some positions that are diametrically opposed to each other from a philosophical perspective, e.g., ‘Lets have the government tell people how to live their lives but it should stay out of business affairs.’

Don Boudreaux has a short but eloquent discussion of a similar issue on CafeHayek.com at
http://cafehayek.com/2010/11/from-free-to-choose-to-choose-to-obey.html

For a slightly different take on the issue, Walter Russell Mead describes how the environmental movement has lost the connection it used to have with people from the early days of the environmental movement – it used to be that environmentalists were suspicious of government-provided solutions but now seem to think that only the government can save us. The Greening of Godzilla – Walter Russell Mead’s Blog That fits with my default thought: we ought to be seriously suspicious of any claims that government solutions will be the best approach to our problems – see my series on Unintended Consequences for more along those lines.

[This is part of a series, which is introduced in the posting titled "Unintended Consequences" here.]

There are plenty of options for pointing to government policies and behavior that brought about the Great Depression, deepened it, and helped it to last much longer.

The Gold Standard and France against the World.

I owe most of the following to an EconTalk podcast with Douglas Irwin, a professor at Dartmouth College (October 11, 2010. http://www.econtalk.org/archives/2010/10/irwin_on_the_gr.html)

Before the Great Depression most of the world was on the gold standard. French leaders were very afraid of inflation and so wanted to keep the value of their currency low relative to the rest of the developed world. By following this policy, they gradually accumulated more and more foreign exchange reserves. In 1927 they held 7% of the world’s gold reserves and by 1932 they held 27% of the world’s gold reserves. Given the structure of and support for the gold standard taken by the other major economies this created a shortage of money in the rest of the world, which hampered economic activity. Irwin said “If the country is losing gold reserves, it has to raise interest rates, tighten monetary policy to prevent that outflow, and pursue more contractionary policies.”

Irwin reported that “countries not on the gold standard managed to avoid the Great Depression almost entirely, while countries on the gold standard did not begin to recover until after they left it.” The US left the gold standard in 1933 and according to Irwin, that action alone may deserve the lion’s share of the credit for the U.S.’s eventual recovery.

Sources:

EconTalk podcast. With Douglas Irwin of Dartmouth College
http://www.econtalk.org/archives/2010/10/irwin_on_the_gr.html

Douglas Irwin has a paper entitled “Did France Cause the Great Depression?”, see the link http://www.dartmouth.edu/~dirwin/ (Direct link: to the paper (pdf).

Monetary policy was restrictive instead of expansionary

It is fairly common in the economic story of the Great Depression to point fingers at monetary policy authorities in the United States for maintaining a contractionary monetary position during the depression, which restricts economic activity exactly at the time they should have been striving to promote economic activity. Prices fell dramatically during the depression, so inflation shouldn’t have been a worry leading them to proceed cautiously. I’d like to know more about the link between this contractionary economic policy and France’s accumulation of gold reserves. Irwin’s argument would imply that the monetary authorities in the U.S. did not have much of a choice in the matter. I’d welcome any suggestions for information on this topic.

Minimum Wage

The minimum wage was established in 1938 at 25 cents an hour. (source) This reduced the incentive to hire workers, raised the cost of business, reduced the incentive to grow businesses – all while the Great Depression was dragging on. The minimum wage gave a windfall to those who already had low-paying jobs but at the cost of leaving more people unemployed and raising costs for everyone. It seems hard to see how this could not have helped but worsen the general economic conditions.

I’ll expand more on this another day.

Restrictions on Free Trade

It is also fairly common in the economic story of the Great Depression to point fingers at congress and the president for creating tariffs and lowering import quotas during the depression. This brought a lot of economic activity to a halt and raised prices. This rewarded domestic industries in protected areas but moved the costs on to everyone else in the country.

I’ll expand more on this another day.

[This is part of a series, which is introduced in the posting titled "Unintended Consequences" here.]

There is a lot of blame to spread around for the housing crisis we are still experiencing and the accompanying financial crisis. The main stream stories mostly point at rapacious rich bankers. I don’t doubt that greed played a large role – but we always have the potential for greed to interfere with the efficient flow of the economy. What enabled greed to cause so much trouble this time? I have heard of some options and will expand on these as time goes along:

U.S. government policies were explicitly designed to encourage home ownership. At first this supported standard loans to generally credit-worthy buyers – but in the form of 30 year fixed rate mortgages with no pre-payment penalty. That put all the risk on the bank’s shoulders and little on the homeowners’. Then the government began pushing for more and more loans to ever more marginal buyers – those the market would not serve because they were too risky. If you increase the risk of your portfolio of loans, lending to ever more risky borrowers, it only should be expected that more and more loans would default.

US v Canada – Canada did not have the magnitude of housing crisis the United States did, by a long shot – why? Possible answers: no government guarantees (check on that), no 30 year loans, pre-payment penalties were allowed. 10 or 20% down was the norm. Presto, no housing crisis! A coincidence? I think not.

The next thing I’d like to research is the rules that encouraged credit default swaps. This is a dense topic so I’d welcome any pointers anyone has to offer.

Well doesn’t that just fill you with confidence about the plans the federal government has for dealing with the deficit. The first big headlines they make after the Republican resurgence is three things guaranteed to fix the deficit: cut income tax, cut social security tax, and extend unemployment insurance. Wonderful. At least they had two in favor of higher employment vs one that will work to keep unemployment high.

Even if we grant that the drafters of legislation and regulations have the country’s best interests in mind (which I believe is a reasonable assumption, at least most of the time) it is not a rare event that the unintended consequences of policies are so bad as to call into question the overall benefit of the policies. I have heard of such cases over and over again and thought it would be interesting and perhaps helpful to document some examples. I will edit this post over time to provide examples as I come across them. Please add a comment if you know of other examples that would help demonstrate the point.

This approach cannot be a proof that all legislation is hopelessly misguided and doomed to failure but I hope it will provide support for the notion that the burden of proof should be on the side of any drafter of legislation to prove that their effort will not make the world worse rather than better off. I also hope it will help provide a broader perspective when considering what the government can or should do – and that anyone contemplating government action should not just assume away or ignore unintended consequences.

Topics in this series include:

• The Great Depression

• The Housing Crisis

I am sometimes amazed at the tortured logic people can use to defend a position. I’m going to start chronicling them here for fun. The first was, of course, intended to be fun:

William Shakespeare: As You Like It

TOUCHSTONE. Such a one is a natural philosopher. Wast ever in court, shepherd?
CORIN. No, truly.
TOUCHSTONE. Then thou art damn’d.
CORIN. Nay, I hope.
TOUCHSTONE. Truly, thou art damn’d, like an ill-roasted egg, all on one side.
CORIN. For not being at court? Your reason.
TOUCHSTONE. Why, if thou never wast at court thou never saw’st good manners;
if thou never saw’st good manners, then thy manners must be wicked;
and wickedness is sin, and sin is damnation. Thou art in a parlous state, shepherd.
http://www.gutenberg.org/cache/epub/1121/pg1121.html

Arguments that espouse taking from the rich and giving to the poor act as if this is a zero sum game being played. Under this frame of mind you can take surplus from the rich and give it to the poor and the total income of the population will not change. However, we know that at some point increasing taxes will reduce the incentive to work and thus decrease output. On the other side of this math giving more of the tax taken from the rich will not increase the poor’s output. Thus the more you tax the rich to give to the poor the lower will be aggregate income.

This argument also can illuminate potential positive effects on society: pure supply and demand theory tells us that the less you tax work, the more of it you will get. More work will produce more aggregate income. Thus reducing taxes on the rich may be a better way to improve aggregate income than the opposite. Increased demand for goods and services created by this increased aggregate income should increase the demand for, and thus the pay to, the working poor. Any argument that favors direct transfers from rich to poor should consider this relationship before concluding that we all will be better off.

I have been reading Henry Hazlitt’s “Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics”. It was first published in 1942 and most recently edited in 1979. It is an insightful book with many lessons for the modern day. Hazlitt saw the coming of the current financial crisis long ago. Too bad his advice wasn’t taken by the powers that be. He said:

“Government-guaranteed home mortgages, especially when a negligible down payment or no down payment whatever is required, inevitably mean more bad loans than otherwise. They force the general taxpayer to subsidize the bad risks and to defray the losses. They encourage people to “buy” houses that they cannot really afford. They tend eventually to bring about an oversupply of houses as compared with other things. They temporarily overstimulate building, raise the cost of building for everybody (including the buyers of the homes with the guaranteed mortgages), and may mislead the building industry into an eventually costly overexpansion. In brief in the long run they do not increase overall national production but encourage malinvestment.”

Henry Hazlitt. Economics in One Lesson: The Shortest and Surest Way to Understand Basic Economics. Page 47. Three Rivers Press, New York. 1979.