DRI-191 for week of 3-15-15: More Ghastly than Beheadings! More Dangerous than Nuclear Proliferation! Its…Cheap Foreign Steel!

An Access Advertising EconBrief:

More Ghastly than Beheadings! More Dangerous than Nuclear Proliferation! Its…Cheap Foreign Steel!

The economic way to view news is as a product called information. Its value is enhanced by adding qualities that make it more desirable. One of these is danger. Humans react to threats and instinctively weigh the threat-potential of any problematic situation. That is why headlines of print newspapers, radio-news updates, TV evening-news broadcasts and Internet websites and blogs all focus disproportionately on dangers.

This obsession with danger does not jibe with the fact that human life expectancy had doubled over the last century and that violence has never been less threatening to mankind than today. Why do we suffer this cognitive dissonance? Our advanced state of knowledge allows us to identify and categorize threats that passed unrecognized for centuries. Today’s degraded journalistic product, more poorly written, edited and produced than formerly, plays on our neuroscientific weaknesses.

Economists are acutely sensitive to this phenomenon. Our profession made its bones by exposing the bogey of “the evil other” – foreign trade, foreign goods, foreign labor and foreign investment as ipso facto evil and threatening. Yet in spite of the best efforts of economists from Adam Smith to Milton Friedman, there is no more dependable pejorative than “foreign” in public discourse. (The word “racist” is a contender for the title, but overuse has triggered a backlash among the public.)

Thus, we shouldn’t be surprised by this headline in The Wall Street Journal: “Ire Rises at China Over Glut of Steel” (03/16/2015, By Biman Mukerji in Hong Kong, John W. Miller in Pittsburgh and Chuin-Wei Yap in Beijing). Surprised, no; outraged, yes.

The Big Scare 

The alleged facts of the article seem deceptively straightforward. “China produces as much steel as the rest of the world combined – more than four times as much as the peak U.S. production in the 1970s.” Well, inasmuch as (a) the purpose of all economic activity is to produce goods for consumption; and (b) steel is a key input in producing countless consumption goods and capital goods, ranging from vehicles to buildings to weapons to cutlery to parts, this would seem to be cause for celebration rather than condemnation. Unfortunately…

“China’s massive steel-making engine, determined to keep humming as growth cools at home, is flooding the world with exports, spurring steel producers around the globe to seek government protection from falling prices. From the European Union to Korea and India, China’s excess metal supply is upending trade patterns and heating up turf battles among local steelmakers. In the U.S., the world’s second-biggest steel consumer, a fresh wave of layoffs is fueling appeals for tariffs. U.S. steel producers such as U.S. Steel Corp. and Nucor Corp. are starting to seek political support for trade action.”

Hmmm. Since this article occupies the place of honor on the world’s foremost financial publication, we expect it to be authoritative. China has a “massive steel-making engine” – well, that stands to reason, since it’s turning out as much steel as everybody else put together. It is “determined to keep humming.” The article’s three (!) authors characterize the Chinese steelmaking establishment as a machine, which seems apropos. They then endow the metaphoric machine with the human quality of determination – bad writing comes naturally to poor journalists.

This determination is linked with “cooling” growth. Well, the only cooling growth that Journal readers can be expected to infer at this point is the slowing of the Chinese government’s official rate of annual GDP growth from 7.5% to 7%. Leaving aside the fact that the rest of the industrialized world is pining for growth of this magnitude, the authors are not only mixing their metaphors but mixing their markets as well. The only growth directly relevant to the points raised here – exports by the Chinese and imports by the rest of the world – is growth in the steel market specifically. The status of the Chinese steel market is hardly common knowledge to the general public. (Later, the authors eventually get around to the steel market itself.)

So the determined machine is reacting to cooling growth by “flooding the world with exports,” throwing said world into turmoil. The authors don’t treat this as any sort of anomaly, so we’re apparently expected to nod our heads grimly at this unfolding danger. But why? What is credible about this story? And what is dangerous about it?

Those of us who remember the 1980s recall that the monster threatening the world economy then was Japan, the unstoppable industrial machine that was “flooding the world” with imports. (Yes, that’s right – the same Japan whose economy has been lying comatose for twenty years.) The term of art was “export-led growth.” Now these authors are telling us that massive exports are a reaction to weakness rather than a symptom of growth.

“Unstoppable” Japan suddenly stopped in its tracks. No country has ever ascended an economic throne based on its ability to subsidize the consumption of other nations. Nor has the world ever died of economic indigestion caused by too many imports produced by one country. The story told at the beginning of this article lacks any vestige of economic sense or credibility. It is pure journalistic scare-mongering. Nowhere do the authors employ the basic tools of international economic analysis. Instead, they employ the basic tools of scarifying yellow journalism.

The Oxymoron of “Dumping” 

The authors have set up their readers with a menacing specter described in threatening language. A menace must have victims. So the authors identify the victims. Victims must be saved, so the authors bring the savior into their story. Naturally, the savior is government.

The victims are “steel producers around the globe.” They are victimized by “falling prices.” The authors are well aware that they have a credibility problem here, since their readers are bound to wonder why they should view falling steel prices as a threat to them. As consumers, they see falling prices as a good thing. As prices fall, their real incomes rise. Falling prices allow consumers to buy more goods and services with their money incomes. Businesses buy steel. Falling steel prices allow businesses to buy more steel. So why are falling steel prices a threat?

Well, it turns out that falling steel prices are a threat to “chief executives of leading American steel producers,” who will “testify later this month at a Congressional Steel Caucus hearing.” This is “the prelude to launching at least one anti-dumping complaint with the International Trade Commission.” And what is “dumping?” “‘Dumping,’ or selling abroad below the cost of production to gain market share, is illegal under World Trade Organization law and is punishable with tariffs.”

After this operatic buildup, it turns out that the foreign threat to America spearheaded by a gigantic, menacing foreign power is… low prices. Really low prices. Visualize buying steel at Costco or Wal Mart.

Oh, no! Not that. Head for the bomb shelters! Break out the bug-out bags! Get ready to live off the grid!

The inherent implication of dumping is oxymoronic because the end-in-view behind all economic activity is consumption. A seller who sells for an abnormally low price is enhancing the buyer’s capability to consume, not damaging it. If anybody is “damaged” here, it is the seller, not the buyer. And that begs the question, why would a seller do something so foolish?

More often than not, proponents of the dumping thesis don’t take their case beyond the point of claiming damage to domestic import-competing firms. (The three Journal reporters make no attempt whatsoever to prove that the Chinese are selling below cost; they rely entirely on the allegation to pull their story’s freight.) Proponents rely on the economic ignorance of their audience. They paint an emotive picture of an economic world that functions like a giant Olympics. Each country is like a great big economic team, with its firms being the players. We are supposed to root for “our” firms, just as we root for our athletes in the Summer and Winter Olympics. After all, don’t those menacing firms threaten the jobs of “our” firms? Aren’t those jobs “ours?” Won’t that threaten “our” incomes, too?

This sports motif is way off base. U.S. producers and foreign producers have one thing in common – they both produce goods and services that we can consume, either now or in the future. And that gives them equal economic status as far as we are concerned. The ones “on our team” are the ones that produce the best products for our needs – period.

Wait a minute – what if the producers facing those low prices happen to be the ones employing us? Doesn’t that change the picture?

Yes, it does. In that case, we would be better off if our particular employer faced no foreign competition. But that doesn’t make a case for restricting or preventing foreign competition in general. Even people who lose their jobs owing to foreign competition faced by their employer may still gain more income from the lower prices brought by foreign competition in general than they lose by having to take another job at a lower income.

There’s another pertinent reason for not treating foreign firms as antagonistic to consumer interests. Foreign firms can, and do, locate in America and employ Americans to produce their products here. Years ago, Toyota was viewed as an interloper for daring to compete successfully with the “Big 3” U.S. automakers. Now the majority of Toyota automobiles sold in the U.S. are assembled on America soil in Toyota plants located here.

Predatory Pricing in International Markets

Dumping proponents have a last-ditch argument that they haul out when pressed with the behavioral contradictions stressed above. Sure, those foreign prices may be low now, import-competing producers warn darkly, but just wait until those devious foreigners succeed in driving all their competitors out of business. Then watch those prices zoom sky-high! The foreigners will have us in their monopoly clutches.

That loud groan you heard from the sidelines came from veteran economists, who would no sooner believe this than ask a zookeeper where to find the unicorns. The thesis summarized in the preceding paragraph is known as the “predatory pricing” hypothesis. The behavior was notoriously ascribed to John D. Rockefeller by the muckraking journalist Ida Tarbell. It was famously disproved by the research of economist John McGee. And ever since, economists have stopped taking the concept seriously even in the limited market context of a single country.

But when propounded in the global context of international trade, the whole idea becomes truly laughable. Steel is a worldwide industry because its uses are so varied and numerous. A firm that employed this strategy would have to sacrifice trillions of dollars in order to reduce all its global rivals to insolvency. This would take years. These staggering losses would be accounted in current outflows. They would be weighed against putative gains that would begin sometime in the uncertain future – a fact that would make any lender blanch at the prospect of financing the venture.

As if the concept weren’t already absurd, what makes it completely ridiculous is the fact that even if it succeeded, it would still fail. The assets of all those firms wouldn’t vaporize; they could be bought up cheaply and held against the day when prices rose again. Firms like the American steel company Nucor have demonstrated the possibility of compact and efficient production, so competition would be sure to emerge whenever monopoly became a real prospect.

The likelihood of any commercial steel firm undertaking a global predatory-pricing scheme is nil. At this point, opponents of foreign trade are, in poker parlance, reduced to “a chip and a chair” in the debate. So they go all in on their last hand of cards.

How Do We Defend Against Government-Subsidized Foreign Trade?

Jiming Zou, analyst at Moody’s Investor Service, is the designated spokesman of last resort in the article. “Many Chinese steelmakers are government-owned or closely linked to local governments [and] major state-owned steelmakers continue to have their loans rolled over or refinanced.”

Ordinary commercial firms might cavil at the prospect of predatory pricing, but a government can’t go broke. After all, it can always print money. Or, in the case of the Chinese government, it can always “manipulate the currency” – another charge leveled against the Chinese with tiresome frequency. “The weakening renminbi was also a factor in encouraging exports,” contributed another Chinese analyst quoted by the Journal.

One would think that a government with the awesome powers attributed to China’s wouldn’t have to retrench in all the ways mentioned in the article – reduce spending, lower interest rates, and cut subsidies to state-owned firms including steel producers. Zou is doubtless correct that “given their important role as employers and providers of tax revenue, the mills are unlikely to close or cut production even if running losses,” but that cuts both ways. How can mills “provide tax revenue” if they’re running huge losses indefinitely?

There is no actual evidence that the Chinese government is behaving in the manner alleged; the evidence is all the other way. Indeed, the only actual recipients of long-term government subsidies to firms operating internationally are creatures of government like Airbus and Boeing – firms that produce most or all of their output for purchase by government and are quasi-public in nature, anyway. But that doesn’t silence the protectionist chorus. Government-subsidized foreign competition is their hole card and they’re playing it for all it’s worth.

The ultimate answer to the question “how do we defend against government-subsidized foreign trade?” is: We don’t. There’s no need to. If a foreign government is dead set on subsidizing American consumption, the only thing to do is let them.

If the Chinese government is enabling below-cost production and sale by its firms, it must be doing it with money. There are only three ways it can get money: taxation, borrowing or money creation. Taxation bleeds Chinese consumers directly; money creation does it indirectly via inflation. Borrowing does it, too, when the bill comes due at repayment time. So foreign exports to America subsidized by the foreign government benefit American consumers at the expense of foreign consumers. No government in the world can subsidize the world’s largest consumer nation for long. But the only thing more foolish than doing it is wasting money trying to prevent it.

What Does “Trade Protection” Accomplish?

Textbooks in international economics spell out in meticulous detail – using either carefully drawn diagrams or differential and integral calculus – the adverse effects of tariffs and quotas on consumers. Generally speaking, tariffs have the same effects on consumers as taxes in general – they drive a wedge between the price paid by the consumer and received by the seller, provide revenue to the government and create a “deadweight loss” of value that accrues to nobody. Quotas are, if anything, even more deleterious. (The relative harm depends on circumstances too complex to enumerate.)

This leads to a painfully obvious question: If tariffs hurt consumers in the import-competing country, why in the world do we penalize alleged misbehavior by exporters by imposing tariffs? This is analogous to imposing a fine on a convicted burglar along with a permanent tax on the victimized homeowner.

Viewed in this light, trade protection seems downright crazy. And in purely economic terms, it is. But in terms of political economy, we have left a crucial factor out of our reckoning. What about the import-competing producers? In the Wall Street Journal article, these are the complainants at the bar of the International Trade Commission. They are also the people economists have been observing ever since the days of Adam Smith in the late 18th century, bellied up at the government-subsidy bar.

In Smith’s day, the economic philosophy of Mercantilism reigned supreme. Specie – that is, gold and silver – was considered the repository of real wealth. By sending more goods abroad via export than returned in the form of imports, a nation could produce a net inflow of specie payments – or so the conventional thinking ran. This philosophy made it natural to favor local producers and inconvenience foreigners.

Today, the raison d’etre of the modern state is to take money from people in general and give it to particular blocs to create voting constituencies. This creates a ready-made case for trade protection. So what if it reduces the real wealth of the country – the goods and services available for consumption? It increases electoral prospects of the politicians responsible and appears to increase the real wealth of the beneficiary blocs, which is sufficient to for legislative purposes.

This is corruption, pure and simple. The authors of the Journal article present this corrupt process with a straight face because their aim is to present cheap Chinese steel as a danger to the American people. Thus, their aims dovetail perfectly with the corrupt aims of government.

And this explains the front-page article on the 03/16/2015 Wall Street Journal. It reflects the news value of posing a danger where none exists – that is, the corruption of journalism – combined with the corruption of the political process.

The “Effective Rate of Protection”

No doubt the more temperate readers will object to the harshness of this language. Surely “corruption” is too harsh a word to apply to the actions of legislators. They have a great big government to run. They must try to be fair to everybody. If everybody is not happy with their efforts, that is only to be expected, isn’t it? That doesn’t mean that legislators aren’t trying to be fair, does it?

Consider the economic concept known as the effective rate of protection. It is unknown to the general public, but is appears in every textbook on international economics. It arises from the conjunction of two facts: first, that a majority of goods and services are composed of raw materials, intermediate goods and final-stage (consumer) goods; and second, that governments have an irresistible impulse to levy taxes on goods that travel across international borders.

To keep things starkly simple and promote basic understanding, take the simplest kind of numerical example. Assume the existence of a fictional textile company. It takes a raw material, cotton, and spin, weaves and processes that cotton into a cloth that it sells commercially to its final consumers. This consumer cloth competes with the product of domestic producers as well as with cotton cloth produced by foreign textile producers. We assume that the prevailing world price of each unit of cloth is $1.00. We assume further that domestic producers obtain one textile unit’s worth of cotton for $.50 and add a further $.50 worth of value to the cloth by spinning, weaving and processing it into the cloth.

We have a basic commodity being produced globally by multiple firms, indicated the presence of competitive conditions. But legislators, perhaps possessing some exalted concept of fairness denied to the rabble, decide to impose a tariff on the importation of cotton. Not wishing to appear excessive or injudicious, the solons set this ad valorem tariff at 15%. Given the competitive nature of the industry, this will soon elevate the domestic price of textiles above the world price by the amount of the tariff; e.g., by $.15, to $1.15. Meanwhile, there is no tariff levied on cotton, the raw material. (Perhaps cotton is grown domestically and not imported into the country or, alternatively, perhaps cotton growers lack the political clout enjoyed by textile producers.)

The insight gained from the effective rate of protection begins with the realization that the net income of producers in general derives from the value they add to any raw materials and/or intermediate products they utilize in the production process. Initially, textile producers added $.50 worth of value for every unit of cotton cloth they produced. Imposition of the tariff allows the domestic textile price to rise from $1.00 to $1.15, which causes textile producers’ value added to rise from $.50 to $.65.

Legislators judiciously and benevolently decided that the proper amount of “protection” to give domestic textile producers from foreign competition was 15%. They announced this finding amid fanfare and solemnity. But it is wrong. The tariff has the explicit purpose of “protecting” the domestic industry, of giving it leeway it would not otherwise get under the supposedly harsh and unrelenting regime of global competition. But this tariff does not give domestic producers 15% worth of protection. $15 divided by $.50 – that is, the increase in value added divided by the original value added – is .30, or 30%. The effective rate of protection is double the size of the “nominal” (statutory) level of protection. In general, think of the statutory tariff rate as the surface appearance and the effective rate as the underlying truth.

Like oh-so-many economic principles, the effective rate of protection is a relatively simple concept that can be illustrated with simple examples, but that rapidly becomes complex in reality. Two complications need mention. When tariffs are also levied on raw materials and/or intermediate products, this affects the relationship between the effective and nominal rate of protection. The rule of thumb is that higher tariff rates on raw materials and intermediate goods relative to tariffs on final goods tend to lower effective rates of protection on the final goods – and vice-versa.

The other complication is the percentage of total value added comprised by the raw materials and intermediate goods prior to, and subsequent to, imposition of the tariff. This is a particularly knotty problem because tariffs affect prices faced by buyers, which in turn affect purchases, which in turn can change that percentage. When tariffs on final products exceed those on raw materials and intermediate goods – and this has usually been the case in American history – an increase in this percentage will increase the effective rate.

But for our immediate purposes, it is sufficient to realize that appearance does not equal reality where tariff rates are concerned. And this is the smoking gun in our indictment of the motives of legislators who promote tariffs and restrictive foreign-trade legislation.

 

Corrupt Legislators and Self-Interested Reporting are the Real Danger to America

In the U.S., the Commercial Code includes thousands of tariffs of widely varying sizes. These not only allow legislators to pose as saviors of numerous business constituent classes. They also allow them to lie about the degree of protection being provided, the real locus of the benefits and the reasons behind them.

Legislators claim that the size of tariff protection being provided is modest, both in absolute and relative terms. This is a lie. Effective rates of protection are higher than they appear for the reasons explained above. They unceasingly claim that foreign competitors behave “unfairly.” This is also a lie, because there is no objective standard by which to judge fairness in this context – there is only the economic standard of efficiency. Legislators deliberately create bogus standards of fairness to give themselves the excuse to provide benefits to constituent blocs – benefits that take money from the rest of us. International trade bodies are created to further the ends of domestic governments in this ongoing deception.

Readers should ask themselves how many times they have read the term “effective rate of protection” in The Wall Street Journal, The Financial Times of London, Barron’s, Forbes or any of the major financial publications. That is an index of the honesty and reputability of financial journalism today. The term was nowhere to be found in the Journal piece of 03/16/2015.

Instead, the three Journal authors busied themselves flacking for a few American steel companies. They showed bar graphs of increasing Chinese steel production and steel exports. They criticized the Chinese because the country’s steel production has “yet to slow in lockstep” with growth in demand for steel. They quoted self-styled experts on China’s supposed “problem [with] hold[ing] down exports” – without every explaining what rule or standard or economic principle of logic would require a nation to withhold exports from willing buyers. They cited year-over-year increases in exports between January, 2013, 2014 and 2015 as evidence of China’s guilt, along with the fact that the Chinese were on pace to export more steel than any other country “in this century.”

The reporters quoted the whining of a U.S. steel vice-president that demonstrating damage from Chinese exports is just “too difficult” to satisfy trade commissioners. Not content with this, they threw in complaints by an Indian steel executive and South Koreans as well. They neglect to tell their readers that Chinese, Indian and South Korean steels tend to be lower grades – a datum that helps to explain their lower prices. U.S. and Japanese steels tend to be higher grade, and that helps to explain why companies like Nucor have been able to keep prices and profit margins high for years. The authors cite one layoff at U.S. steel but forget to cite the recent article in their own Wall Street Journal lauding the history of Nucor, which has never laid off an employee despite the pressure of Chinese competition.

That same article quoted complaints by steel buyers in this country about the “competitive disadvantage” imposed by the higher-priced U.S. steel. Why are the complaints about cheap Chinese exports front-page news while the complaints about high-priced American steel buried in back pages – and not even mentioned by a subsequent banner article boasting input by no fewer than three Journal reporters? Why did the reporters forget to cite the benefits accruing to American steel users from low prices for steel imports? Don’t these reporters read their own newspaper? Or do they report only what comports with their own agenda?

DRI-135 for week of 1-4-15: Flexible Wages and Prices: Economic Shock Absorbers

An Access Advertising EconBrief:

Flexible Wages and Prices: Economic Shock Absorbers

At the same times that free markets are becoming an endangered species in our daily lives, they enjoy a lively literary existence. The latest stimulating exercise in free-market thought is The Forgotten Depression: 1921 – The Crash That Cured Itself. The author is James Grant, well-known in financial circles as editor/publisher of “Grant’s Interest Rate Observer.” For over thirty years, Grant has cast a skeptical eye on the monetary manipulations of governments and central banks. Now he casts his gimlet gaze backward on economic history. The result is electrifying.

The Recession/Depression of 1920-1921

The U.S. recession of 1920-1921 is familiar to students of business cycles and few others. It was a legacy of World War I. Back then, governments tended to finance wars through money creation. Invariably this led to inflation. In the U.S., the last days of the war and its immediate aftermath were boom times. As usual – when the boom was the artifact of money creation – the boom went bust.

Grant recounts the bust in harrowing detail.  In 1921, industrial production fell by 31.6%, a staggering datum when we recall that the U.S. was becoming the world’s leading manufacturer. (The President’s Conference on Unemployment reported in 1929 that 1921 was the only year after 1899 in which industrial production had declined.) Gross national product (today we would cite gross domestic product; neither statistic was actually calculated at that time) fell about 24% in between 1920 and 1921 in nominal dollars, or 9% when account is taken of price changes. (Grant compares this to the figures for the “Great Recession” of 2007-2009, which were 2.4% and 4.3%, respectively.) Corporate profits nosedived commensurately. Stocks plummeted; the Dow Jones Industrial average fell by 46.6% between the cyclical peak of November, 1919 and trough of August, 1921. According to Grant, “the U.S. suffered the steepest plunge in wholesale prices in its history (not even eclipsed by the Great Depression),” over 36% within 12 months. Unemployment rose dramatically to a level of some 4,270,000 in 1921 – and included even the President of General Motors, Billy Durant. (As the price of GM’s shares fell, he augmented his already-sizable shareholdings by buying on margin – ending up flat broke and out of a job.) Although the Department of Labor did not calculate an “unemployment rate” at that time, Grant estimates the nonfarm labor force at 27,989,000, which would have made the simplest measure of the unemployment rate 15.3%. (That is, it would have undoubtedly included labor-force dropouts and part-time workers who preferred full-time employment.)

A telling indicator of the dark mood enveloping the nation was passage of the Quota Act, the first step on the road to systematic federal limitation of foreign immigration into the U.S. The quota was fixed at 3% of foreign nationals present in each of the 48 states as of 1910. That year evidently reflected nostalgia for pre-war conditions since the then-popular agricultural agitation for farm-price “parity” sought to peg prices to levels at that same time.

In the Great Recession and accompanying financial panic of 2008 and subsequently, we had global warming and tsunamis in Japan and Indonesia to distract us. In 1920-1921, Prohibition had already shut down the legal liquor business, shuttering bars and nightclubs. A worldwide flu pandemic had killed hundreds of thousands. The Black Sox had thrown the 1919 World Series at the behest of gamblers.

The foregoing seems to make a strong prima facie case that the recession of 1920 turned into the depression of 1921. That was the judgment of the general public and contemporary commentators. Herbert Hoover, Secretary of Commerce under Republican President Warren G. Harding, who followed wartime President Woodrow Wilson in 1920, compiled many of the statistics Grant cites while chairman of the President’s Conference on Unemployment. He concurred with that judgment. So did the founder of the study of business cycles, the famous institutional economist Wesley C. Mitchell, who influenced colleagues as various and eminent as Thorstein Veblen, Milton Friedman, F. A. Hayek and John Kenneth Galbraith. Mitchell referred to “…the boom of 1919, the crisis of 1920 and the depression of 1921 [that] followed the patterns of earlier cycles.”

By today’s lights, the stage was set for a gigantic wave of federal-government intervention, a gargantuan stimulus program. Failing that, economists would have us believe, the economy would sink like a stone into a pit of economic depression from which it would likely never emerge.

What actually happened in 1921, however, was entirely different.

The Depression That Didn’t Materialize

We may well wonder what might have happened if the Democrats had retained control of the White House and Congress. Woodrow Wilson and his advisors (notably his personal secretary, Joseph Tumulty) had greatly advanced the project of big government begun by Progressive Republicans Theodore Roosevelt and William Howard Taft. During World War I, the Wilson administration seized control of the railroads, the telephone companies and the telegraph companies. It levied wage and price controls. The spirit of the Wilson administration’s efforts is best characterized by the statement of the Chief Price Controller of the War Industries Board, Robert Brookings. “I would rather pay a dollar a pound for [gun]powder for the United States in a state of war if there was no profit in it than pay the DuPont Company 50 cents a pound if they had 10 cents profit in it.” Of course, Mr. Brookings was not actually himself buying the gunpowder; the government was only representing the taxpayers (of whom Mr. Brookings was presumably one). And their attitude toward taxpayers was displayed by the administration’s transformation of an income tax initiated at insignificant levels in 1913 and to a marginal rate of 77% (!!) on incomes exceeding $1 million.

But Wilson’s obsession with the League of Nations and his 14 points for international governance had not only ruined his health, it had ruined his party’s standing with the electorate. In 1920, Republican Warren G. Harding was elected President. (The Republicans had already gained substantial Congressional majorities in the off-year elections of 1918.) Except for Hoover, the Harding circle of advisors was comprised largely of policy skeptics – people who felt there was nothing to be done in the face of an economic downturn but wait it out. After all, the U.S. had endured exactly this same phenomenon of economic boom, financial panic and economic bust before in 1812, 1818, 1825, 1837, 1847, 1857, 1873, 1884, 1890, 1893, 1903, 1907, 1910 and 1913. The U.S. economy had not remained mired in depression; it had emerged from all these recessions – or, in the case of 1873, a depression. If the 19th-century system of free markets were to be faulted, it would not be for failure to lift itself out of recession or depression, but for repeatedly re-entering the cycle of boom and bust.

There was no Federal Reserve to flood the economy with liquidity or peg interest rates at artificially low levels or institute a “zero interest-rate policy.” Indeed, the rules of the gold-standard “game” called for the Federal Reserve to raise interest rates to stem the inflation that still raged in the aftermath of World War I. Had it not done so, a gold outflow might theoretically have drained the U.S. dry.  The Fed did just that, and interest rates hovered around 8% for the duration. Deliberate deficit spending as an economic corrective would have been viewed as madness. As Grant put it, “laissez faire had its last hurrah in 1921.”

What was the result?

In the various individual industries, prices and wages and output fell like a stone. Auto production fell by 23%. General Motors, as previously noted, was particularly hard hit. It went from selling 52,000 vehicles per month to selling 13,000 to 6,150 in the space of seven months. Some $85 million in inventory was eventually written off in losses.

Hourly manufacturing wages fell by 22%. Average disposable income in agriculture, which comprised just under 20% of the economy, fell by over 55%. Bankruptcies overall tripled to nearly 20,000 over the two years ending in 1921. In Kansas City, MO, a haberdashery shop run by Harry Truman and Eddie Jacobson held out through 1920 before finally folding in 1921. The resulting personal bankruptcy and debt plagued the partners for years. Truman evaded it by taking a job as judge of the Jackson County Court, where his salary was secure against liens. But his bank accounts were periodically raided by bill collectors for years until 1935, when he was able to buy up the remaining debt at a devalued price.

In late 1920, Ford Motor Co. cut the price of its Model T by 25%. GM at first resisted price cuts but eventually followed suit. Farmers, who as individuals had no control over the price of their products, had little choice but to cut costs and increase productivity – increasing output was an individual’s only way to increase income. When all or most farmers succeeded, this produced lower prices. How much lower? Grant: “In the second half of [1920], the average price of 10 leading crops fell by 57 percent.” But how much more food can humans eat; how many more clothes can they wear? Since the price- and income-elasticities of demand for agricultural goods were less than one, this meant that agricultural revenue and incomes fell.

As noted by Wesley Mitchell, the U.S. slump was not unique but rather part of a global depression that began as a series of commodity-price crashes in Japan, the U.K., France, Italy, Germany, India, Canada, Sweden, the Netherlands and Australia. It encompassed commodities including pig iron, beef, hemlock, Portland cement, bricks, coal, crude oil and cotton.

Banks that had speculative commodity positions were caught short. Among these was the largest bank in the U.S., National City Bank, which had loaned extensively to finance the sugar industry in Cuba. Sugar prices were brought down in the commodity crash and brought the bank down with them. That is, the bank would have failed had it not received sweetheart loans from the Federal Reserve.

Today, the crash of prices would be called “deflation.” So it was called then and with much more precision. Today, deflation can mean anything from the kind of nosediving general price level seen in 1920-1921 to relatively stable prices to mild inflation – in short, any general level of prices that does not rise fast enough to suit a commentator.

But there was apparently general acknowledgment that deflation was occurring in the depression of 1921. Yet few people apart from economists found that ominous. And for good reason. Because after some 18 months of panic, recession and depression – the U.S. economy recovered. Just as it had done 14 times previously.

 

It didn’t merely recover. It roared back to life. President Harding died suddenly in 1923, but under President Coolidge the U.S. economy experienced the “Roaring 20s.” This was an economic boom fueled by low tax rates and high productivity, the likes of which would not be seen again until the 1980s. It was characterized by innovation and investment. Unfortunately, in the latter stages, the Federal Reserve forgot the lessons of 1921 and increases the money supply to “keep the price level stable” and prevent deflation in the face of the wave of innovation and productivity increases. This helped to usher in the Great Depression, along with numerous policy errors by the Hoover and Roosevelt administrations.

Economists like Keynes, Irving Fisher and Gustav Cassel were dumbfounded. They had expected deflation to flatten the U.S. economy like a pancake, increasing the real value of debts owed by debtor classes and discouraging consumers from spending in the expectation that prices would fall in the future. Not.

There was no economic stimulus. No TARP, no ZIRP, no QE. No wartime controls. No meddlesome regulation a la Theodore Roosevelt, Taft and Wilson. The Harding administration and the Fed left the economy alone to readjust and – mirabile dictu – it readjusted. In spite of the massive deflation or, much more likely, because of it.

The (Forgotten) Classical Theory of Flexible Wages and Prices

James Grant wants us to believe that this outcome was no accident. The book jacket for the Forgotten Depression bills it as “a free-market rejoinder to Bush’s and Obama’s Keynesian stimulus applied to the 2007-9 recession,” which “proposes ‘less is more’ with respect to federal intervention.”

His argument is almost entirely empirical and very heavily oriented to the 1920-1921 depression. That is deliberate; he cites the 14 previous cyclical contractions but focuses on this one for obvious reasons. It was the last time that free markets were given the opportunity to cure a depression; both Herbert Hoover and Franklin Roosevelt supervised heavy, continual interference with markets from 1929 through 1941. We have much better data on the 1920-21 episode than, say, the 1873 depression.

Readers may wonder, though, whether there is underlying logical support for the result achieved by the deflation of 1921. Can the chorus of economists advocating stimulative policy today really be wrong?

Prior to 1936, the policy chorus was even louder. Amazing as it now seems, it advocated the stance taken by Harding et al. Classical economists propounded the theory of flexible wages and prices as an antidote to recession and depression. And, without stating it in rigorous fashion, that is the theory that Grant is following in his book.

Using the language of modern macroeconomics, the problems posed by cyclical downturns are unemployment due to a sudden decline in aggregate (effective) demand for goods and services. The decline in aggregate demand causes declines in demand for all or most goods; the decline in demand for goods causes declines in demand for all or most types of labor. As a first approximation, this produces surpluses of goods and labor. The surplus of labor is defined as unemployment.

The classical economists pointed out that, while the shock of a decline in aggregate demand could cause temporary dislocations such as unsold goods and unemployment, this was not a permanent condition. Flexible wages and prices could, like the shock absorbers on an automobile, absorb the shock of the decline in aggregate demand and return the economy to stability.

Any surplus creates an incentive for sellers to lower price and buyers to increase purchases. As long as the surplus persists, the downward pressure on price will remain. And as the price (or wage) falls toward the new market-clearing point, the amount produced and sold (or the amount of labor offered and purchases) will increase once more.

Flexibility of wages and prices is really a two-part process. Part one works to clear the surpluses created by the initial decline in aggregate demand. In labor markets, this serves to preserve the incomes of workers who remain willing to work at the now-lower market wage. If they were unemployed, they would have no wage, but working at a lower wage gives them a lower nominal income than before. That is only part of this initial process, though. Prices in product markets are decreasing alongside the declining wages. In principle, fully flexible prices and wages would mean that even though the nominal incomes of workers would decline, their real incomes would be restored by the decline of all prices in equal proportion. If your wage falls by (say) 20%, declines in all prices by 20% should leave you able to purchase the same quantities of goods and services as before.

The emphasis on real magnitudes rather than nominal magnitudes gives rise to the name given to the second part of this process. It is called the real-balance effect. It was named by the classical economist A. C. Pigou and refined by later macroeconomist Don Patinkin.

When John Maynard Keynes wrote his General Theory of Employment Interest and Income in 1936, he attacked classical economists by attacking the concepts of flexible wages and prices. First, he attacked their feasibility. Then, he attacked their desirability.

Flexible wages were not observed in reality because workers would not consent to downward revisions in wages, Keynes maintained. Did Keynes really believe that workers preferred to be unemployed and earn zero wages at a relatively high market wage rather than work and earn a lower market wage? Well, he said that workers oriented their thinking toward the nominal wage rather than the real wage and thus did not perceive that they had regained their former position with lower prices and a lower wage. (This became known as the fallacy of money illusion.) His followers spent decades trying to explain what he really meant or revising his words or simply ignoring his actual words. (It should be noted, however, that Keynes was English and trade unions exerted vastly greater influence on prevailing wage levels in England that they did in the U.S. for at least the first three-quarters of the 20th century. This may well have biased Keynes’ thinking.)

Keynes also decried the assumption of flexible prices for various reasons, some of which continue to sway economists today. The upshot is that macroeconomics has lost touch with the principles of price flexibility. Even though Keynes’ criticisms of the classical economists and the price system were discredited in strict theory, they were accepted de facto by macroeconomists because it was felt that flexible wages and prices would take too long to work, while macroeconomic policy could be formulated and deployed relatively quickly. Why make people undergo the misery of unemployment and insolvency when we can relieve their anxiety quickly and compassionately by passing laws drafted by macroeconomists on the President’s Council of Economic Advisors?

Let’s Compare

Thanks to James Grant, we now have an empirical basis for comparison between policy regimes. In 1920-1921, the old-fashioned classical medicine of deflation, flexible wages and prices and the real-balance effect took 18 months to turn a panic, recession and depression into a rip-roaring recovery that lasted 8 years.

Fast forward to December, 2007. The recession has begun. Unfortunately, it is not detected until September, 2008, when the financial panic begins. The stimulus package is not passed until January, 2009 – barely in time for the official end of the recession in June, 2009. Whoops – unemployment is still around 10% and remains stubbornly high until 2013. Moreover, it only declines because Americans have left the labor force in numbers not seen for over thirty years. The recovery, such as it is, is so anemic as to hardly merit the name – and it is now over 7 years since the onset of recession in December, 2007.

 

It is no good complaining that the stimulus package was not large enough because we are comparing it with a case in which the authorities did nothing – or rather, did nothing stimulative, since their interest-rate increase should properly be termed contractionary. That is exactly what macroeconomists call it when referring to Federal Reserve policy in the 1930s, during the Great Depression, when they blame Fed policy and high interest rates for prolonging the Depression. Shouldn’t they instead be blaming the continual series of government interventions by the Fed and the federal government under Herbert Hoover and Franklin Roosevelt? And we didn’t even count the stimulus package introduced by the Bush administration, which came and went without making a ripple in term of economic effect.

Economists Are Lousy Accident Investigators 

For nearly a century, the economics profession has accused free markets of possessing faulty shock absorbers; namely, inflexible wages and prices. When it comes to economic history, economists are obviously lousy accident investigators. They have never developed a theory of business cycles but have instead assumed a decline in aggregate demand without asking why it occurred. In figurative terms, they have assumed the cause of the “accident” (the recession or the depression). Then they have made a further assumption that the failure of the “vehicle’s” (the economy’s) automatic guidance system to prevent (or mitigate) the accident was due to “faulty shock absorbers” (inflexible wages and prices).

Would an accident investigator fail to visit the scene of the accident? The economics profession has largely failed to investigate the flexibility of wages and prices even in the Great Depression, let alone the thirty-odd other economic contractions chronicled by the National Bureau of Economic Research. The work of researchers like Murray Rothbard, Vedder and Galloway, Benjamin Anderson and Harris Warren overturns the mainstream presumption of free-market failure.

The biggest empirical failure of all is one ignored by Grant; namely, the failure to demonstrate policy success. If macroeconomic policy worked as advertised, then we would not have recessions in the first place and could reliably end them once they began. In fact, we still have cyclical downturns and cannot use policy to end them and macroeconomists can point to no policy successes to bolster their case.

Now we have this case study by James Grant that provides meticulous proof that deflation – full-blooded, deep-throated, hell-for-leather deflation in no uncertain terms – put a prompt, efficacious end to what must be called an economic depression.

Combine this with the 40-year-long research project conducted on Keynesian theory, culminating in its final discrediting by the early 1980s. Throw in the existence of the Austrian Business Cycle Theory, which combines the monetary theory of Ludwig von Mises and interest-rate theory of Knut Wicksell with the dynamic synthesis developed by F. A. Hayek. This theory cannot be called complete because it lacks a fully worked out capital theory to complete the integration of monetary and value theory. (We might think of this as the economic version of the Unified Field Theory in the natural sciences.) But an incomplete valid theory beats a discredited theory every time.

In other words, free-market economics has an explanation for why the accident repeatedly happens and why its effects can be mitigated by the economy’s automatic guidance mechanism without the need for policy action by government. It also explains why the policy actions are ineffective at both remedial and preventive action in the field of accidents.

James Grant’s book will take its place in the pantheon of economic history as the outstanding case study to date of a self-curing depression.

DRI-183 for week of 12-7-14: Immigration and Economic Principles

An Access Advertising EconBrief:

Immigration and Economic Principles

1776 marked the founding of a new nation and a new intellectual discipline. The Declaration of Independence announced the creation of a United States of America and proclaimed the individual’s right to life, liberty and the pursuit of happiness. The Founders – specifically, the Declaration’s author – relied heavily on Adam Smith for the intellectual underpinnings of their document.

Smith’s Wealth of Nations, published in 1776, identified the purpose of all economic activity as consumption. Today, economists view consumption as the source of happiness. But in 1776, that notion was radical indeed. The reigning philosophy of government was mercantilism, which taught that government should accumulate gold (or specie generally) as a store of wealth by promoting the export of goods and discouraging imports. The resulting net inflow of gold would enrich the nation. Of course, even mercantilists knew that food was necessary to human survival – they coexisted with a primitive school of economists known as the physiocrats, who believed that land was the only source of economic value and agriculture the only productive economic activity.

Smith’s work began the tradition of modern economics by overturning both his fallacious predecessors. The mercantilists were wrong on two counts: they were wrong to stress exports at the expense of imports and wrong to imply that a “favorable” export surplus was a stable outcome. Imports are the beneficial part of international trade because they enhance consumption; exports are the cost of international trade because they connote a sacrifice of goods sent abroad to obtain imported goods for consumption. Even if an export surplus were to prevail temporarily, it could not persist. Building on the work of his contemporary David Hume, who developed the famous “price-specie flow model,” Smith pointed out that the net inflow of money (either gold or silver) resulting from the export surplus would raise domestic prices, causing exports to become less desirable to domestic residents and foreign imports to become more desirable.

Smith also pointed out that human labor created goods for consumption not only by working the land but in factories as well. His discussion of a pin factory is still studied today as a pioneering analysis of productivity.

Thus did the modern study of economics and international trade begin life together. International economics has stayed in the spotlight ever since. Currently immigration occupies center stage; President Obama has seized the political initiative from the Republicans by proposing to temporarily suspend enforcement of immigration laws against large numbers of undocumented immigrants.

Unfortunately, the accidental historical precedence given to international economics has contributed to the misapprehension that this field of economics is sui generis. The truth is that international economics is subordinate to general economic theory. The truths of basic economics apply internationally as well as intranationally. In fact, most international issues would be clearer if they were reconfigured in intranational form. This applies just as strongly to immigration as it does to every other aspect of international economic theory.

Migration and Marginal Productivity

When students take their first economics course, the principle of marginal productivity is one of the first lessons they learn. But first things first. In the beginning, there is scarcity – and it is pervasive. The “economic problem” is the outgrowth of scarce resources and infinite wants. There is no end to the number of good things that the human imagination can dream up. Unfortunately, virtually all of those good things are created using “inputs” – human labor, natural resources and produced goods. Inputs are available in limited quantities; they are “scarce.” Consequently, the good things – “output” – are also scarce. The science of economics has devised a pure logic of choice enabling us to make the best use of scarce inputs in producing scarce output to satisfy unlimited human wants.

The principle of marginal productivity deals with input allocation. It says to allocate inputs so that all marginal productivities are equal. That sounds mind-blowingly simple, and it is. In practice, what it boils down to is that business managers – indeed, all of us, if you want to view each individual as their own manufacturer of happiness – are on the lookout for situations in which some inputs are highly productive. For example, we are all looking for jobs in which our own labor specialties are highly valued. If we are teachers, we keep a weather eye peeled for highly paid teaching vacancies. Movie actors flock to auditions for desirable parts. Computer programmers look for programming jobs that offer the highest salaries.

Input prices, such as the wages paid for human labor, reflect the productivity of the input at the margin. The more productive the input, the greater the demand by managers and the higher the price they are willing to pay it. The more people supply the input, the more sellers compete to offer input services and the lower the price will be, all other things equal.

Input supply and demand determine the market prices for all inputs, from human labor to land to capital goods. The principle of marginal productivity governs the productive allocation of inputs – it tells us whether it makes sense to use more or less of each input in producing the various outputs. It also tells us whether it is efficient to shift inputs between different outputs by using more labor to produce one good and less labor to produce another one.

When we talk about changing input amounts and shifting inputs, we are talking not just about one particular place and one particular point in time. We are also talking about different places at the same time and about different points in time as well. That is, it may also make sense to shift labor from one place to a different place. The same is true of natural resources and capital goods. We also shift input use from today into the future and vice-versa. Differences in input prices and productivities are the keys to these shifts, too.

Migration is one of the most fundamental examples of all economic adaptive response. Differences in input price and productivity between geographic regions create an opportunity for gain by input reallocation. Let us assume that low-skilled human labor is more productive in Kansas than in Missouri. This will tend to make wages for unskilled labor in Kansas above those in Missouri. The most practical response to this discrepancy is for unskilled labor to migrate from Missouri to Kansas. This will tend to lower wages of unskilled labor in Kansas and raise them in Missouri, thereby reducing the wage discrepancy in the two states. The migration will also tend to reduce the marginal productivity discrepancy in the two states by lowering marginal productivity for unskilled labor in Kansas and raising it in Missouri.

Migrations of this kind happen throughout the U.S. on a daily basis. Nobody thinks much about them, let alone takes measures to prevent them. But if I were to replace the word “Kansas” with the word “Texas” and the word “Missouri” with the word “Mexico,” the whole passage would suddenly become controversial and subject to debate. While intranational migration has occurred throughout American history without attracting unfavorable comment, international immigration has been heatedly debated since at least the 1920s.

Our discussion is the tipoff to the falsity of most of the debate. There is little economic difference between intranational migration and international immigration. The mere fact that the migratory movement crosses an international boundary does not invalidate it. It does not rob it of its economic value. Of course, it does change its superficial character. But that is all; the change is superficial only. The gain from immigration is the same as that from migration – more efficient use of scarce resources. It is one of the most basic, bedrock principles in economics.

Opportunity Cost and Comparative Advantage

The very first subject undertaken in the very first course in economics taken by college students is the subject of economic cost. What is special about economic cost, as opposed to (say) accounting cost? Economists view cost in a special way. Because all of us live our lives exchanging goods for money and vice versa, we are completely habituated to denominating prices and costs in monetary units. And that’s good, because it gives us a common denominator for valuing thousands of things whose heterogeneity would otherwise make comparative valuation a nightmare. Can you imagine a life in which we had to trade goods and services directly for other goods and services, without a medium of exchange to intermediate each transaction?

The thought sends shivers up and down your spine. But economists conceptually do just that when they explain microeconomic theory or, as it is sometimes called, price theory. That theory treats money prices only in relative or real form. A relative price reveals the implied sacrifice of one good involved in the purchase of one unit of another. For example, if the Px = $10 and the Py = $5, then the relative price of X (its real price) is the ratio of X’s price to Y’s price. That is, the purchase of one unit of good X implies the sacrifice of 2Y. While the money price of X is $10, its real price is 2Y. In a two-good world, this relative price is the opportunity cost of consuming X.

Why do economists go to all the trouble of jolting students out of their comfortable familiarity with monetary valuation and into the retrograde world of direct barter exchange? Not because barter trade has much practical application, certainly, although it does arise occasionally in special contexts. No, the purpose is expressed in an aphorism by the great 19th-century English economist John Stuart Mill, who characterized money as a veil that obscures but does not completely hide the underlying reality. That reality is that indirect monetary exchange substitutes for direct barter exchange, and this accounts for the concept of a relative or “real” price. When we pay money for goods we are really trading alternative consumption – specifically, the highest-valued alternative consumption purchase equal in monetary amount. This is a tipoff to the fact that the real value we derive from goods and services is the happiness they bring; money is merely a placeholder (or unit of account) that facilitates comparison and exchange.

We penetrate the monetary veil because it’s the only way to learn the underlying truths about opportunity cost and comparative advantage. In 1815, an English stockbroker named David Ricardo assumed Adam Smith’s mantel as the world’s leading economist by developing a revolutionary model of international trade. Ricardo’s model stipulated two hypothetical countries. He could just as well have called them “A” and “B,” but with an eye to the headlines of his day he called them “England” and “Portugal.” He specified two produced goods, wine and cloth, both produced using human labor. (He treated all labor hours as equivalent.) No chauvinist, he assumed that Portugal was capable of producing both goods using fewer labor hours than was England. He began by assuming a condition of autarky; that is, no international trade between the two countries. He also stipulated (arbitrary) price and production levels for both goods in each country.

Up to this point, Ricardo had done nothing remarkable by contemporary standards. But now he hit his audience with a thunderbolt. He asserted that opening up the two countries to international trade would benefit both of them by allowing them to consume more than each country could produce and consume in the absence of international trade.

First, Ricardo pointed out that the true economic cost of production for wine and cloth in each country was not the (unspecified) monetary cost of employing labor. It was not even the amount of labor hours used to produce each good. (Up to this point, classical economists such as Adam Smith had favored a ‘labor theory of value”; the value of any good was determined by the amount of labor required to produce it.) No, the true economic cost was the opportunity cost of production – except that Ricardo called it the “comparative cost.” Based on the labor coefficients of each good in each country, Ricardo calculated the opportunity cost of one unit of wine and cloth production in both England and Portugal.

And lo! The results shocked the world. In fact, they still do. Even though Portugal appeared to be the more efficient producer of both goods, it had a lower opportunity-cost of production for one good only – wine. Portugal was the more efficient wine producer because its opportunity-cost of production was lower than England’s.

The implications of this finding were – and are – world-shaking. England should specialize in its most efficient good, cloth, by producing more cloth than it did under autarky. Portugal should produce more wine than it did under autarky. (Actually, Ricardo’s model prescribed complete production specialization by each country, an artifact of the super-simplified assumptions built into his model.) Then the two countries should trade internationally – England should export cloth to Portugal in exchange for wine produced by Portugal, thus allowing both countries to consume both goods. The terms of trade should represent a ratio of prices intermediate to that existing under autarky.

Sure enough – Ricardo’s model generated a result in which both England and Portugal achieved consumption levels for wine and cloth that exceeded the possibilities open to them under autarky. At the time, this seemed to the general public like a magic trick. To some people today, it still does. Some people have never learned it and others refuse to believe what they learned. Then there are those who insist that Ricardo’s conclusions apply only in textbooks and not in reality, for a host of reasons.

There are two key insights behind Ricardo’s theory. The first is his notion of comparative cost. Modern economists have broken this term in two. They have modified the term “comparative cost” to “opportunity cost” in order to stress its alternative element. To bring out the comparative or relative element, they have devised the term “comparative advantage” to encompass situations like England’s in Ricardo’s theory. Despite being less productively efficient in both goods in the absolute sense, England nevertheless had a comparative production advantage in cloth because its opportunity-cost of production was lower.

But merely identifying the locus of comparative advantage is purely academic unless we act on it by specializing in production, which creates the extra output that allows us all to consume more by engaging in international trade. Thus, specialization and trade is the second key element in Ricardo’s theory.

Thus far in this section, we have said nothing whatever about immigration. But immigration is the proverbial elephant in the room. For thousands of years, civilization has been following this principle of specialization and trade according to comparative advantage. That is what we do when we grow up, go to school, get a job, work and earn money – then use the money to support our lifestyles. We did it for millennia without realizing what we were doing or why, like the character in Moliere’s play who had been speaking prose all his life without realizing it.

David Ricardo developed his theory in terms of international trade for the same reason that Adam Smith began the modern study of economics by focusing on international trade: that was where the action was in terms of money, public interest and government activity.

It is only very recently that economic textbooks have tentatively begun to point out that the same insight they have been flogging for centuries while teaching the theory of international trade is valid in intranational trade. In fact, this is exactly the insight that has accounted for human productivity since the days when human beings left their hunter-gatherer bands and formed individual families residing in villages, towns and cities.

And how does immigration fit into this implicit theory of everyday production, you ask? The answer would be too mundane to need mention were it not for the fact that so many people ferociously resist it even now. In order for specialization and trade according to comparative advantage and trade to work, people have to specialize in their comparative-advantage line of production, just as England and Portugal had to specialize in Ricardo’s model for those countries to realize the gains from international trade.

And they can’t very well specialize when they aren’t allowed to work at what they do best, can they? Yet Mexicans who are five times more productive working in Texas than in Mexico are nevertheless barred from working legally in the U.S.! The basic fundamental principles of markets are designed to achieve maximum productivity by assigning all of us to our highest-valued uses, where our marginal productivity is highest. And U.S. immigration laws allow people to move across international borders only according to their national origin, which has as much to do with their marginal productivity as the color of their eyes does.

Is this any way to run a railroad? Is it any wonder that the greatest economists, like Milton Friedman, constantly stress fundamental principles rather than niggling about esoteric mathematics or econometric models?

Cost Minimization

The standard microeconomic theory taught in college courses is divided into three subject areas: the theory of consumer demand, the theory of cost and production and the theory of marginal input productivity. The theory of cost and production is sometimes called “the theory of the firm” because its usual application is to business firms. That theory explains the optimal logic behind the production and sale of output to consumers by businesses.

A key principle of this theory is cost minimization. The theory of the firm assumes that the firm’s goal is profit maximization. (“Profit” might be viewed in instantaneous terms as the residual of total revenue from the sale of output minus all costs of production, including the opportunity cost of capital and/or the owner’s labor time, or it might be viewed intertemporally as the discounted present value of expected future net revenue.) The firm’s manager(s) will choose the rate of output that maximizes profit and will select the combination of inputs that minimizes the cost of producing that rate of output.

It goes without saying that the firm will purchase any quantity of (homogeneous) input at the lowest possible price. Alternatively, the firm will purchase the highest quality of any heterogeneous input at a given price.

Well, it’s supposed to go without saying, anyway. But when it comes to immigration, suddenly it’s a crime even to say it out loud. When employers want to hire foreign workers because they can pay lower wages than they are paying to domestic workers for the same work, that turns out to be illegal, or immoral, or fattening or otherwise verboten. But if this is not only allowable but even downright de rigeur in an intranational context, why should it be unthinkable in an international context?

Of course, the answer is that it shouldn’t. It is just as beneficial to minimize costs by hiring cheap foreign labor as it is to hire cheap domestic labor. It is just as beneficial to hire cheap labor from any source as it is to purchase cheap raw materials or cheap land or cheap machinery.

Did a reader respond by inquiring “beneficial for whom?” Well, the answer is “beneficial in the first instance for business owners, but beneficial in the long run for everybody, because lower costs ultimately are reflected in lower prices and everybody is a consumer – including all the owners of inputs who are paid the lowest prices.” We can’t always guarantee that every single person benefits from every efficient economic activity – such as immigration – more than they suffer from it. But that has to be true for most people – otherwise, how did civilization advance as it has over the millennia? How did the U.S. become the U.S.?

What About “Fiscal Cost” or “Net Job Creation” or …

We now know that the concept of free and open migration – whether inside the boundaries of a nation or across national boundaries – is fundamental to the efficiency of markets. It is inextricably interwoven into the fabric of our everyday lives, so much so that we take it completely for granted. Thus, when we protest against immigration by foreigners into our country we are engaging in the most blatant contradiction.

How many times have readers of this EconBrief previously seen this issue framed in these clear, straightforward terms? Chances are, the answer is: Zero. Instead, we are presented with a variety of alternative arguments against immigration.

For example, a fairly recent anti-immigration tactic is the “fiscal cost” scam. We are urged to restrict immigration – or ban it altogether – because it is unaffordable. Supposedly, immigrants cost the government more in various forms of transfer payments (welfare, Social Security, emergency medical and more) than they generate in receipts (various tax payments). Thus, on net balance they flunk the criterion of “fiscal cost.”

The non-economist might suppose that this is a key test of economic worthiness, perhaps tabulated quarterly or annually on every American by a government bureau and kept on file. What a laugh. Fiscal cost is a term made up by anti-immigrationists in order to discredit immigrants. The easiest way to appreciate this is to recall that half of the American population now pays no income tax. It has recently come to light that most Americans stack up even worse by the fiscal cost standard than do immigrants! This is hardly surprising; immigrants are not eligible for most forms of welfare and tend to be younger than the average American, so get less medical treatment than average as well. They are more entrepreneurial and tend to work harder, so are more productive as well. This follows because, far from being the tired, dispossessed, tempest-tossed, ragged poor of the Emma Lazarus poem, immigrants tend to have more initiative and smarts than the average person. They have to be better than average in order to contemplate traveling to another land, speaking a foreign language, coping with another culture and starting another life. The anti-immigration stereotype of a lazy bum who somehow runs the border gauntlet in order to live off the fat of the U.S. welfare state is a particularly egregious myth.

Calculating fiscal cost is no easy task. Why would a researcher engage in laborious calculations to produce estimates of aggregate effects whose meaning is so obscure? Actually, complexity and obscurity are what make concepts like fiscal cost attractive to anti-immigrationists. The last thing they want to do is join a debate on fundamental economic principles, where the issues are so straightforward and clear-cut. Why start a fight they are destined to lose? Instead, they want to pick a fight they can pretend to win because the public will not know how to judge it. We are so used to hearing economic issues outlined in complicated terms, so accustomed to watching with glazed eyes and hearing without comprehending that we fall back on our emotions rather than our reason.

Now the anti-immigrationists have us where they want us. The immigration debate takes us back to the days of pre-history, when mankind first began to break up the ancient bands and form families. Outsiders were looked upon with suspicion. Trade and specialization were forbidden; economic activity was geared to benefit the band, not the individual household. Today, the nation state has taken the place of the ancient hunter-gatherer band as the extended family. The state dispenses welfare benefits and rules over us with an iron fist. It wants to control economic activity for its benefit and the benefit of its acolytes. It inflames those ancient, instinctive antagonisms toward outsiders that still reside within the citizenry.

We can revert to the savage, instinctive atavism of mankind’s primitive past. Or we can embrace the reasoned productivity of freedom and free markets. The choice should be easy, for the record of history shows that markets have lifted mankind out of the muck and mire to the prosperity of today.

The last thing we should do is judge immigration by perusing the latest pseudo-study by a think-tank dedicating to obfuscating clear thought. The simplest, clearest, most basic of all economic principles tell us that immigration is vital to freedom and prosperity.

DRI-291 for week of 7-27-14: How to Debate Bill Moyers

An Access Advertising EconBrief:

How to Debate Bill Moyers

In the course of memorializing a fellow economist who died young, Milton Friedman observed that “we are all of us teachers.” He meant the word in more than the academic sense. Even those economists who live and work outside the academy are still required to inculcate economic fundamentals in their audience. The general public knows less about economics than a pig knows about Sunday – a metaphor justly borrowed from Harry Truman, whose opinion of economists was famously low.

Successful teachers quickly sense that they have entered their persuasive skills into a rhetorical contest with the students’ inborn resistance to learning. Economists face the added handicap that most people overrate their own understanding of the subject matter and are reluctant to jettison the emotional baggage that hinders their absorption of economic logic.

All this puts an economist behind the eight-ball as educator. But in public debate, economists usually find themselves frozen against the rail as well (to continue the analogy with pocket billiards). The most recent case of this competitive disadvantage was the appearance by Arthur C. Brooks, titular head of the conservative American Enterprise Institute (AEI), on the PBS interview program hosted by longtime network fixture Bill Moyers.

Brooks vs. Moyers: An Unequal Contest

At first blush, one might consider the pairing of Brooks, seasoned academic, Ph D. and author of ten books, with Moyers, onetime divinity student and ordained minister who left the ministry for life in politics and journalism, to be an unequal contest. And so it was. Brooks spent the program figuratively groping for a handhold on his opponent while Moyers railed against Brooks with abandon. It seemed clear that each had different objectives. Moyers was insistent on painting conservatives (directly) and Brooks (indirectly) as insensitive, unfeeling and uncaring, while Brooks seemed content that he understood the defensive counterarguments he made in his behalf, even if nobody else did.

Moyers never lost sight of the fact that he was performing to an audience whose emotional buttons he knew from memory and long experience. Brooks was speaking to a critic in his own head rather than playing to an alien house whose sympathies were presumptively hostile.

To watch with a rooting interest in Brooks’ side of the debate was to risk death from utter frustration. In this case, the only balm of Gilead lies in restaging Brooks’ reactions to Moyers’ sallies. This should amount to a debater’s handbook for economists in dealing with the populists of the hard political left wing.

Who is Bill Moyers?

It is important for any debater to know his opponent going into the debate. Moyers is careful to put up a front as an honest broker in ideas. Brooks’ appearance on Moyers’ show is headlined as “Arthur C. Brooks: The Conscience of a Compassionate Conservative,” as if to suggest that Moyers is giving equal time in good faith to an ideological opponent.

This is sham and pretense. Bill Moyers is a professional hack who has spent his whole life in the service of the political left wing. While in his teens, he became a political intern to Texas Senator Lyndon Johnson. After acquiring a B.A. degree in journalism from the University of Texas at Austin, Moyers got an M.A. from the Southwest Baptist Theological Seminary in Fort Worth, Texas. After ordination, he forsook the ministry for a career in journalism and left-wing politics, two careers that have proved largely indistinguishable for over the last few decades. He served in the Peace Corps from 1961-63 before joining the Johnson Administration, serving as LBJ’s Press Secretary from 1965-67. He performed various dirty tricks under Johnson’s direction, including spearheading an FBI investigation of Goldwater campaign aides to uncover usable dirt for the 1964 Presidential campaign. (Apparently, only one traffic violation and one illicit love affair were unearthed among the fifteen staffers.) A personal rift with Johnson led to his resignation in 1967. Moyers edited the Long Island publication Newsday for three years and he alternated between broadcast journalism (PBS, CBS, back to PBS) and documentary-film production thereafter until his elevation to the presidency of the SchumanCenter for Media and Democracy in 1990. Now 80 years old, he occupies a position best described as “political-hack emeritus.”

With this resume under his belt, Moyers cannot maintain any pretense as an honest broker in ideas, his many awards and honorary degrees notwithstanding. After all, the work of America’s leading investigative reporters, James Steele and Donald Barlett, has been exposed in this space as shockingly inept and politically tendentious. Journalists are little more than political advocates and Bill Moyers has thrived in this climate.

In the 1954 movie Night People, Army military intelligence officer Gregory Peck enlightens American politician Broderick Crawford about the true nature of the East German Communists who have kidnapped Crawford’s son. “These are cannibals…bloodthirsty cannibals who are trying to eat us up,” Peck insists. That describes Bill Moyers and his ilk, who are among those aptly characterized by F.A. Hayek as the “totalitarians in our midst.”

This is the light in which Arthur Brooks should have viewed his debate with Bill Moyers. Unfortunately, Brooks seemed stuck in defensive mode. His emphasis on “conscience” and “compassion” seemed designed to stress that he had a conscience – why leave the inference that this was in doubt? – and that he was a compassionate conservative – as opposed to what other kind, exactly? Thus, he began by giving hostages to the enemy before even sitting down to debate.

Brooks spent the interview crouched in this posture of defense, thereby guaranteeing that he would lose the debate even if he won the argument.

Moyers’ Talking Points – and What Brooks Should Have Said

Moyers’ overall position can be summarized in terms of what the great black Thomas Sowell has called “volitional economics.” The people Moyers disapproves of – that is, right-wingers and owners of corporations – have bad intentions and are, ipso facto, responsible for the ills and bad outcomes of the world.

Moyers: “Workers at Target, McDonald’s and Wal-Mart need food stamps to survive…Wal-Mart pays their workers so little that their average worker depends on $4,000 per year in government subsidies.”

Brooks: “Well, we could pay them a higher minimum wage – then they would be unemployed and be completely on the public dole…”

Moyers: “Because the owners of Wal Mart would not want to pay them that higher minimum wage [emphasis added].

 

WHAT BROOKS SHOULD HAVE SAID: “Wait a minute. Did you just say that the minimum wage causes higher unemployment because business owners don’t want to pay it? Is that right? [Don’t go on until he agrees.] So if the business owners just went ahead and paid all their low-skilled employees the higher minimum wage instead of laying off some of them, everything would be fine, right? That’s what your position is? [Make him agree.]

Well, then – WHY DON’T YOU DO IT? WHY DON’T YOU – BILL MOYERS – GO BUY A MCDONALD’S FRANCHISE AND PAY EVERY LOW-SKILLED EMPLOYEE CURRENTLY MAKING THE MINIMUM WAGE AND EVERY NEW HIRE THE HIGHER MINIMUM WAGE YOU ADVOCATE. SHOW US ALL HOW IT’S DONE. DON’T JUST CLAIM THAT I’M WRONG – PROVE IT FOR ALL THE WORLD TO SEE. THEN YOU CAN HAVE THE LAUGH ON ME AND ALL MY RIGHT-WING FRIENDS.

[When he finishes sputtering:] You aren’t going to do it, are you? You certainly can’t claim that Bill Moyers doesn’t have the money to buy a franchise and hire a manager to run it. And you certainly can’t claim that the left-wing millionaires and billionaires of the world don’t have the money -not with Tom Steyer spending a hundred million dollars advertising climate change. The minimum wage has been in force since the 1930s and the left-wing has been singing its praises for my whole life – but when push comes to shove the left-wing businessmen pay the same wages as the right-wing businessmen. Why? Because they don’t want to go broke, that’s why.

WHY IT IS IMPORTANT TO SAY THIS: The audience for Bill Moyers’ program consists mainly of people who agree with Bill Moyers; that is, of economic illiterates who do their reasoning with their gall bladders. It is useless to use formal economic logic on them because they are impervious to it. It is futile to cite studies on the minimum wage because the only studies they care about are the recent ones – dubious in the extreme – that claim to prove the minimum wage has only small adverse effects on employment.

The objective with these people is roughly the same as with Moyers himself: take them out of their comfort zone. There is no way they can fail to understand the idea of doing what Moyers himself advocates because it is what they themselves claim to want. All Brooks would be saying is: Put your money where your mouth is. This is the great all-purpose American rebuttal. And he would be challenging people known to have money, not the poor and downtrodden.

This is the most straightforward, concrete, down-to-earth argument. There is no way to counter it or reply to it. Instead of leaving Brooks at best even with Moyers in a “he-said, he-said” sort of swearing contest, it would have left him on top of the argument with his foot on Moyers’ throat, looking down. At most, Moyers could have limply responded with, “Well, I might just do that,” or some such evasion.

Moyers: “Just pay your workers more… [But] instead of paying a living wage… [owners] do stock buy-backs…”

Brooks: [ignores the opportunity].

WHAT BROOKS SHOULD HAVE SAID: “Did you just use the phrase ‘LIVING WAGE,’ Mr. Moyers? Would you please explain just exactly what a LIVING WAGE is? [From here on, the precise language will depend on the exact nature of his response, but the general rebuttal will follow the same pattern as below.] Is this LIVING WAGE a BIOLOGICAL LIVING WAGE? I mean, will workers DIE if they don’t receive it? But they don’t have it NOW, right? And they’re NOT dying, right? So the term as you use it HAS NOTHING TO DO WITH LIVING OR DYING, does it? It’s just a colorful term that you use because you hope it will persuade people to agree with you by getting them to feel sorry for workers, isn’t it?

There are over 170 countries in the world, Mr. Moyers. In almost all of those countries, low-skilled workers work for lower wages than they do here in the United States. Did you know that? In many countries, low-skilled workers earn the equivalent of less than $1,000 per year in U.S. dollars. In a few countries, they earn just a few hundred dollars worth of dollar-equivalent wages per year. PER YEAR, Mr. Moyers. For you to sit here and use the term “LIVING WAGE” for a wage THIRTY TO FIFTY TIMES HIGHER THAN THE WAGE THEY EARN IS POSITIVELY OBSCENE. Don’t you agree, MR. MOYERS? They don’t die either – BUT I BET THEY GET PRETTY HUNGRY SOMETIMES. What do you bet – MR. MOYERS?

WHY IT IS IMPORTANT TO SAY THIS: The phrase “living wage” has been a left-wing catch-phrase longer than most people today have been alive. Its use is “free” because users are never challenged to explain or defend it. It sounds good because it has a nice ring of urgency and necessity to it. But upon close examination it disintegrates like toilet tissue in a bowl. There is no such wage as a wage necessary to sustain life in the biological sense. For one thing, it would vary across a fairly wide range depending on various factors ranging from climate to gender to race to nutrition to prices to wealth to…well, the factors are numerous. It would also be a function of time. Occasionally, classical economists like David Ricardo and Karl Marx would broach the issue, but they never answered any of the basic questions; they just assumed them away in the time-honored manner of economists everywhere. For them, any concept of a living wage was pure theoretical or algebraic, not concrete or numerical. Today, for the left wing, the living wage is purely a polemical concept with zero concreteness. It is merely a club to beat the right wing with. It is without real-world significance or content.

Given this, it is madness to allow your debate opponent the use of this club. Take the club away from him and use it against him.

Bill Moyers: “Wal Mart, which earned $17 billion in profit last year…”

Arthur Brooks: [gives no sign of noticing or caring].

WHAT ARTHUR BROOKS SHOULD HAVE SAID: “You just said that Wal Mart earned $17 billion in profit last year. You did say that, didn’t you – I don’t want to be accused of misquoting you. Does that seem like a lot of money to you? [He will respond affirmatively.] Why? Is it a record of some kind? Did somebody tell you it was a lot of money? Or does it just sort of sound like a lot? I’m asking this because you seem to think that sum of money has a lot of significance, as though it were a crime, or a sin, or special in some way. You seem to think it justifies special notice on your part. You seem to think it justifies your demanding that Wal Mart pay higher wages to their workers than they’re doing now. And my question is: WHY? Unless my ears deceive me, you seem to be making these claims on the basis of the PURE SIZE of the amount. You think Wal Mart should “give” some of this money to its low-skilled workers – is that right? [He will agree enthusiastically.]

OK then. Here’s what I think: WHY DON’T YOU, MR. MOYERS? [He will pretend not to understand.] I MEAN EXACTLY WHAT I SAID. WHY DON’T YOU DO IT, MR. MOYERS, IF THAT’S WHAT YOU BELIEVE? [He will smile or laugh: “Because I’m not Wal Mart, that’s why.] BUT YOU ARE, MR. MOYERS. OR YOU CAN BE. ANYBODY CAN BE. FOR THAT MATTER, THOSE WAL-MART WORKERS WHOSE WELFARE YOU CLAIM TO CARE FOR SO MUCH CAN BE, TOO. ALL YOU HAVE TO DO IS BUY WAL-MART STOCK. IT TRADES PUBLICLY, YOU KNOW.

IF YOU THINK WAL- MART SHOULD GIVE ITS MONEY AWAY, THEN BUY WAL-MART STOCK, TAKE THE IVIDENDS YOU PAY YOU AND GIVE THE MONEY AWAY TO WHEREEVER YOU THINK IT SHOULD GO. AFTER ALL, ONCE YOU BUY WAL MART STOCK…NOW YOU’RE WAL-MART. YOU OWN THE COMPANY. AT LEAST, YOU OWN A FRACTION OF IT, JUST LIKE ALL THE OTHER OWNERS OF WAL-MART DO. YOU WANT WAL MART TO GIVE ITS PROFITS AWAY? OK, GIVE THEM AWAY YOURSELF. WHY SHOLD THE GOVERNMENT WASTE MILLIONS OF DOLLARS IN BUREAUCRATIC OVERHEAD IN ACCOMPLISHING SOMETHING THAT YOU CAN ACCOMPLISH CHEAP FOR THE COST OF A DISCOUNT BROKERAGE COMMISSION?

And you can deduct it from your income tax as a charitable contribution…MR. MOYERS.

As far as that’s concerned, as a matter of logic, if Wal-Mart’s workers really agree with you that Wal-Mart is scrooging away in profits the money that should go to them in wages, then the workers could do the same thing, couldn’t they? They could buy Wal-Mart’s stock and earn that share of the profit that you want the company to give them. It’s no good claiming they don’t have the money to do it because they’d not only be getting a share of these profits you say are so fabulous, they’d also be owning the company that you’re claiming is such a super profit machine that it’s got profits to burn – or give away. If what you say is really true, you should be screaming at Wal-Mart’s workers to buy shares instead of wasting time trying to get the government to take money away from Wal-Mart so some of it can trickle down to the workers.

Of course, that’s the catch. I don’t even know if YOU YOURSELF BELIEVE THE BALONEY YOU’VE BEEN SPREADING AROUND IN THIS INTERVIEW. I don’t think you even know the truth about all three of those companies that you claim are so flush with profits. To varying degrees, they’re actually in trouble, MR. MOYERS. It’s all in the financial press, MR MOYERS – which you apparently haven’t read and don’t care to read. McDonald’s has had to reinvent itself to recover its sales. Wal-Mart is floundering. Target has lost touch with its core customers. And the $17 billion that seems like so much profit to you doesn’t constitute such a great rate of return when you spread it over the hundreds of thousands of individual Wal Mart shareholders – as you’re about to find out when you take my advice to put your money where you great big mouth is – MR. MOYERS.

WHY IT IS IMPORTANT TO SAY THIS: The mainstream press has been minting headlines out of absolute corporate profits for decades. The most prominent victim of this has been the oil companies because they have been the biggest private companies in the world. Any competent economist knows that it is the rate of return that reveals true profitability, not the absolute size of profits. Incredibly, this fact has not permeated to the public consciousness despite the popularity of 401k retirement-investment accounts.

Buying Wal-Mart stock is just another way of implementing the “put your money where your mouth is” strategy discussed earlier. If Bill Moyers’ view of the company were correct – which it isn’t, of course – it would make much more sense than redistributing money via other forms of government coercion.

The Goal of Debate

If you play poker and nobody ever calls your bluff, it will pay you to bluff on the slightest excuse. In debate, you have to call your debate opponent’s bluffs; otherwise, you will be bluffed down to your underwear even when your opponent isn’t holding any cards. Arthur Brooks was just as conservative in his debating style as in his ideology – he refused to call even Moyers’ most ridiculous bluffs. This guaranteed that the best outcome he could hope for was a draw even if his performance was otherwise flawless. It wasn’t, so he came off poorly.

Of course, he was never going to “win” the debate in the sense of persuading hard-core leftists to convert to a right-wing position. His job was to leave them shaken and uncomfortable by denying Bill Moyers the ease and comfort of taking his usual polemical stances without fear of challenge or rebuttal. This would have delighted the few right-wingers tuned in and put the left on notice that they were going to be bloodied when they tried their customary tactics in the future. In order to accomplish this, it was necessary to do two things. First, take the battle to Bill Moyers on his own level by forcing him to take his own advice, figuratively speaking. Second, clearly indicate by your contemptuous manner that you do not respect him and are not treating him as an intellectual equal and an honest broker of ideas. People react not only to what you say but to how you say it. If you respect your opponent, they will sense it and accord him that same respect. If you despise him, this will come through – as it should in this case. That is just as important as the intellectual part of the debate.

In a life-and-death struggle with cannibals, not getting eaten alive can pass for victory.

DRI-275 for week of 6-1-14: The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

An Access Advertising EconBrief:

The Triumph of Economics in Sports: Economics Takes the Field to Build Winning Teams

In the previous two EconBriefs, we spoke of a popular attitude towards sports. It looks nostalgically to a hazy past, when men played a boys’ game with joyous abandon. Today, alas, sports are “just a business,” which is “all about the money.” As elsewhere, “greed” – a mysterious force no more explicable than a plague of locusts – has overtaken the men and robbed them of their childlike innocence.

This emotional theory of human behavior owes nothing to reason. It is the view now commonly bruited by those who describe the financial crisis of 2008 and the Great Recession as the outcome of free markets run rampant. People are irrational, so the result of “unfettered capitalism” must naturally be chaotic disaster.

Economics is the rational theory of human choice. For a half-century, it has opposed the irrationalists from two directions. Its free-market adherents have been led by the Chicago School of Frank Knight, Milton Friedman and George Stigler. That school embraced a theory of perfect rationality: perfect knowledge held by all market participants (later modified somewhat by a theory of information only slightly less heroic in its assumptions), perfectly competitive markets and (where necessary) perfectly benevolent government regulators and/or economist advisors.

The neo-Keynesian opponents of Chicago accepted individual rationality but asserted that individually rational actions produced perverse results in the aggregate, leading to involuntary unemployment and stagnant economies. Only counteracting measures by far-seeing government policymakers and regulators – following the advice of economist philosopher-kings – could rescue us from the depredations of free markets.

The debate, then, has largely been defined by people who saw market participants moved either by utter irrationality or complete rationality. But our analysis has revealed instead an evolutionary climate in which participants in professional sports pursued their own ends rationally within the limits imposed by their own knowledge and capabilities. The great free-market economist F.A. Hayek observed that capitalism does not demand that its practitioners be rational. Instead, the practice of capitalism itself makes people more rational than otherwise by continually providing the incentive to learn, adapt and adopt the most efficient means toward any end. Professional sports has exemplified Hayek’s dictum.

Early on, in its first century, the pursuit of individual self-interest left baseball owners, players and fans at loggerheads. The first owner to address himself to the task of improving the product provided to sports fans was Bill Veeck, Jr., who introduced a host of business, financial and marketing innovations that not only enhanced his own personal wealth but also treated his fans as customers whose patronage was vital. The attitude of ownership toward fans prior to Veeck can be gleaned from the dismissal by New York Yankees’ general manager George Weiss of a proposed marketing plan to distribute Yankee caps to young fans. “Do you think I want every youngster in New York City walking around wearing a Yankees’ cap?” snorted Weiss. Veeck made owners and administrators realize that this was exactly what they should want.

Although few people seemed to realize it, economics had yet to play its trump card in the game of professional sports. Economics is the study of giving people what they want the most in the most efficient way. What sports fans want the most is a winning team – and that is exactly what economics had failed to give them. It failed because it had never been deployed toward that end. Even Bill Veeck, despite his success in improving the on-field performance of his teams, had not unlocked the secret to using economic principles per se to win pennants and World Series.

As sometimes happens in human endeavor, baseball had to traverse a Dark Age before this secret was finally revealed.

The Dark Age: Municipal Subsidies and the Growth of Revenue Potential

During Bill Veeck’s swan song as baseball owner in 1975-1981, baseball had entered the period of free agency. The reserve clause tying players to a single team had been drastically modified, allowing players to eventually migrate to teams offering them the best financial terms. As we indicated earlier, this development – viewed in isolation – tilted the division of sports revenue from ownership to players.

This created the pretext by which owners were able to extract subsidies from municipalities throughout the nation. Owners could truthfully claim that they were earning less money as a result of free agency. What they left out was that they were earning more money for a host of other reasons. The obscure nature of player depreciation hid the true financial gains of sports-team ownership from the public. Moreover, the early years of free agency coincided with the advent of massive new revenue sources for owners. Television had brought baseball to millions of people who otherwise saw few games or none; broadcast rights were becoming a valuable asset of team ownership. Radio-broadcast rights increased in value as the increased visibility of teams and players enhanced their popularity. These increases were just gaining speed when the vogue of sports-team subsidies became a national pastime of its own.

The movement of baseball teams had long been viewed as analogous to the movement of businesses. Even the loss of popular teams like the Brooklyn Dodgers and New York Giants to westward expansion of baseball in Los Angeles and San Francisco was grudgingly accepted, since baseball still remained in New York City and the Mets were added as an expansion franchise in 1962. But when the Athletics moved from Kansas City to Oakland in 1967, Missouri Senator Stuart Symington decided that the federal government could not countenance “unfettered capitalism” in the baseball business. He demanded that major-league baseball replace Kansas City’s lost franchise. This opened the floodgates to the intrusion of politics in baseball.

If it was fair for politicians to dictate where major-league baseball should operate, then franchises should be able to demand favors from local governments – or so reasoned baseball owners. And demand them they did.

Owners demanded that teams build new, larger, better-appointed stadiums for their sports teams. Cities should fund construction, own the stadiums, operate them, maintain them and lease them to the sports teams for peanuts – otherwise, owners would pack up and move to a city that would meet their demands.

What was in it for the host city? After all, not everybody is a sports fan. Owners sensed that they needed something to offer the city at large. Thus was born one of the great con games of the 20th century: the notion of sports as economic-development engine of growth. Owners seized on the same thinking that animated the dominant neo-Keynesian economic model. They sponsored “economic-impact studies” of the effect sports teams had on the local economy. In these studies, spending on sports took on a magical, mystical quality, as if jet-propelled by a multiplier ordained to send it rocketing through the local economy. And everybody “knew” that the more spending took place, the better off we all were.

It is hard to say what was worse, the economic logic of these studies or their statistical probity. It was not unusual to find that a study would add (say) the money spent on gasoline purchases at stations adjacent to the stadium to the “benefits” of sports team presence. Of course, this implies that locating the team as far as possible from the fans would increase the “benefits” dramatically; it is a case of cost/benefit analysis in which the costs are counted as benefits. This novel technique inevitably produces a finding of vast benefits.

As time went on, sale of team artifacts and memorabilia was added to the list of supplemental revenue. Larger stadiums, lucrative TV, radio and cable rights, team product sales – all these drove revenues to owners through the roof as the 20th century approached its close. With municipalities subsidizing the ownership, maintenance and improvement of stadiums, it is no wonder that the capital gains available to owners of sports teams were phenomenal. Ewing Kauffman bought the Kansas City Royals’ franchise for $1 million in 1968. At his death in 1993, the team’s value was estimated at well over $100 million.

One might have expected the usual left-wing suspects to recoil in horror from the income redistribution from ordinary taxpayers to rich owners and rich ballplayers – but no. Newspaper editorialists threw up their hands. The economists who supported free agency said that the major-market teams would get the best players, didn’t they? And hadn’t things worked out just that way, before free agency as well as after? If small-market taxpayers want to win – or even have a team at all – they’ll just have to ante up and face the fact that “this is how the game is played in today’s world.” Besides, doesn’t economic research show the economic-development benefits of sports teams?

Heretofore, economics had operated beneficially, albeit in a gradual, piecemeal way. Now the distortion of economics by the owners and their political allies meant that it was serving the ends of injustice.

Economics – and baseball fans – needed a hero. They got one – several, actually – from a pretty unlikely place.

Middle American Ingenuity to the Rescue

Bill James was born in tiny Holton, KS, in 1947. From childhood, he was a devoted sports fan. Like countless others before him, he was fascinated by the quantitative features of baseball and studied them obsessively. He was unique, though, in refusing to take on faith the value of conventional measures of baseball worth such as batting average, fielding average and runs batted in. James developed his own theories of baseball productivity and the statistical measures to back them up.

In 1977, he published the first edition of his Baseball Abstract, which subsequently became the Bible for his disciples and imitators. James was suspicious of batting average because it deliberately omitted credit for walks. (Ironically, walks were originally granted equivalent status with hits in computing batting average; “Tip” O’Neill’s famous top-ranking average of .485 in 1887 was accrued on this basis. The change to the modern treatment took place shortly thereafter.) While it may be technically true that a walk does not represent a “batting” accomplishment, it is certainly the functional equivalent of a single from the standpoint of run-producing productivity. (Veterans of youth baseball will recall their teammates urging them to wait out the opposing pitcher by chanting, “A walk’s as good as a hit, baby!”) Moreover, walks have many ancillary advantages. Putting the ball in play risks making an out. A walk forces the opposing pitcher to throw more pitches, thereby decreasing his effectiveness on net balance. Waiting longer in the count increases the chances that a hitter will get a more hittable pitch to hit, one that may be driven with power. For all these reasons, James made a convincing case that on-base percentage (OBP)is superior to batting average as a measure of a hitter’s run-producing productivity.

Rather than the familiar totals of home runs and runs batted in, James argued in favor of a more comprehensive measure of power production in hitting called slugging percentage (SP), defined as total bases divided by at bats. This includes all base hits, not just home runs. Instead of runs batted in, James created the category of runs created (RC), defined as hits plus walks times total bases, divided by plate appearances. James also sought a substitute for the concept of “fielding average,” which stresses the absence of errors committed on fielding chances actually handled but says nothing about the fielder’s ability or willingness to reach balls and execute difficult plays that other players may not even attempt. Moreover, fielding must be evaluated on the same level with offensive production since it must be just as valuable to prevent run production by the opposing team as to create runs for the home team.

These measures and maxims formed the core of Bill James’ theory of baseball productivity. His Baseball Abstract computed his measures for the major-league rosters each year and analyzed the play and management of the teams each year. Gradually, James became a cult hero. Others adopted his methods and measures. The Society for American Baseball Research (SABR) sprang up. The intensive study of quantitative baseball – eventually, sports in general – came to be known as “sabermetrics.” Even with all this attention, it still took decades for Bill James himself to be embraced by organized baseball itself. That, too, happened eventually, but not before sabermetrics left the realm of theory and invaded the pressbox, the front office and the very baseball diamond itself.

Moneyball Takes the Field

Billy Beane was a high-school “phenom” (short for phenomenal), a term denoting a player whose all-round potential is so patent that he “can’t miss” succeeding at the major-league level. Like a disconcerting number of others, though, Beane did miss. He played only minimally at the major-league level for a few years before quitting to become a scout. He rose to the front office and was named general manager of the Oakland Athletics in 1997. Beane’s mentor, general-manager Sandy Alderson, taught him the fundamentals of Bill James’ theories of baseball productivity. To them, Beane added his own observations about player development – notably, that baseball scouts cannot accurately evaluate the future prospects of players at the high-school level because their physical, emotional and mental development is still too limited to permit it. Thus, major-league teams should concentrate on drafting prospects out of college in order to improve their draft-success quotient.

Beane hired a young college graduate from HarvardUniversity – not as a player but as an administrative assistant. Paul DiPodesta was an economics major who was familiar with the logic of marginal productivity theory. The theory of the firm declares that managers should equalize the marginal productivity per dollar (that is, the ratio of output each unit of input produces at the margin to the input’s price) between inputs by continually adding more of any input with a higher ratio until the optimal output is reached. Of course, the problem in applying this or any other economic principle to baseball had always been that the principles were non-operational unless a meaningful measure of “output” could be found and the inputs contributing to that output could be identified. That was where Bill James and sabermetrics came in.

In 2001, the Oakland team had won the Western Division of the American League. But their star player, Jason Giambi, has been wooed away by a seven-year, $120-million dollar contract offered by the New York Yankees. It was the age-old story, the “Curse of the Bambino” all over again in microcosm. Oakland’s success had ramped up the value of its players on the open market; replacing those players with comparable talent at market rates would bust the payroll budget. Various other Oakland players were lost to injury or disaffection or free agency. Throughout baseball, opinion was unanimous that the Athletics were in for hard times until the team’s talent base could be rebuilt through player development.

Beane and DiPodesta used the most basic sabermetric concepts, such as ONB, SP and RC, as their measures of productivity. Using publicly available information about player salaries, they calculated player productivities per dollar and discovered the startling number of players whose true productivity was undervalued by their current salaries. Methodically, they set out to rebuild the Oakland Athletics “on the cheap” by acquiring the best players their budget could afford through trade or purchase of contracts. They substantially remade the team using this approach. Despite a slow start, their rebuilt club eventually tied the all-time major-league baseball record by winning 21 straight games and successfully defended the Western Division championship in 2002 and 2003. Author Michael Lewis outlined their story and the rise of sabermetrics in baseball in his 2003 best-selling book Moneyball, which later became a 2011 movie starring Brad Pitt that received six Academy Award nominations.

For the first time, baseball management had explicitly used an economic production function – marginal productivity theory with an operational definition of product or output – to maximize a meaningful object function – namely, “wins” by the team. And they succeeded brilliantly.

Money See, Money Do

In 2003, new Boston Red Sox owner John Henry hired Bill James as a consultant to management, to put the theories of sabermetrics into practice in Boston. During 2001 and 2002, the team had lugged the second-highest payroll in major-league baseball to disappointing results. But in 2003, with a lower- (6th-) ranked payroll, the Boston Red Sox laid the ghost of Babe Ruth by winning their first World Series since 1918. Over the succeeding decade, the Red Sox became the success story of baseball, winning the World Series three more times.

Was this a case of what Rocky’s manager Mickey would call “freak luck?” Not hardly. Thanks to the success of Oakland and Boston and Michael Lewis’s book, the tale of Bill James and sabermetrics traveled. Throughout baseball, sabermetrics ran wild and economics reigned triumphant. In 2003, the Detroit Tigers lost an American-League-record 119 games. In 2006, with only the 14th-highest payroll out of 30 major-league teams, the Tigers won the American League championship. In 2008 and 2009, the Washington Nationals were the worst team in baseball. In 2012, with baseball’s 20th-highest payroll, they had baseball’s best record. In 2010, the Pittsburgh Pirates lost 105 games. In 2013, with baseball’s 20th-highest payroll, they made the post-season playoffs. The Cleveland Indians rebounded from sub-.500 seasons to playoff finishes twice between 2006 and 2014, despite never ranking higher than 15th in the size of their payroll; usually, they ranked between 20th and 26th.

The crowning achievement was that of the perennial cellar-dwelling Tampa Bay Devil Rays. Cellar-dwelling, that is, in the size of their payroll, but not necessarily in the season standings. After years of dismal finishes, the 2008 TampaBay team became American League champs despite ranking 29th (next to last!) in the size of their payroll. They have made the playoffs in four of the six subsequent years, but their payroll continues to languish at the bottom of the major-league rankings.

The New Frontier

Does this mean that the generalization about large-market teams getting the better players and enjoying the better results was and is a lie? No, it was and still is true. But like all economic propositions it is subject to qualification and careful statement.

First, it is a ceteris paribus proposition. It is true that “you can’t beat the stock market (averages)” but every year some people (particularly professional investors) do it. You can’t do it systematically by trading on the basis of publicly available information. The few people who succeed do it on the basis of (unsystematic) luck or by uncovering new information (legally) before it becomes generally known. The market for professional sports is not nearly this efficient; techniques of sports productivity evaluation are not nearly as refined and efficient as those of stock evaluation and trading, which leaves much more room for systematic exploitation by techniques like those of sabermetrics.

Second, the term “large market” is no longer limited by geography as it has been during the first century and a half of U.S. professional sports. Ted Turner’s promotion of the Atlanta Braves using his cable-TV stations blazed the trail for turning a local team into a national one, thereby increasing the value of the team’s broadcasting and product rights. Today, there is no inherent geographic limitation of the size of the market for any team – no reason, for example, why the Kansas City Royals or Chiefs could not become “the world’s team” and sit atop the largest market of all.

The Evolutionary Approach to Free Markets

The correct approach to economics is not the irrationalist view that has clouded our understanding of professional sports. Neither is it the perfectionist view of the ChicagoSchool, which has oversold the virtues of free markets and damaged their credibility. It is certainly not the remedial view of the neo-Keynesian school, which has failed whenever and wherever tried and is now undergoing its latest serial failure.

The evolutionary approach of the true free-market school, so nobly outlined by Hayek and his disciples, fits the history of baseball like a batting glove. It is now in full flower. Taxpayers need no longer be violated by owners who promote false economic benefits of sports and hide the real ones. Fans no longer need languish in a limbo of psychological unfulfillment. Economics – not politicians, regulators or academic scribblers – has come to the rescue at last.

DRI-303 for week of 5-11-14: The Real ‘Stress Test’ is Still to Come

An Access Advertising EconBrief:

The Real ‘Stress Test’ is Still to Come

Timothy Geithner, former Treasury Secretary and former head of the New York Federal Reserve, is in the news. Like virtually every former policymaker, he has written a book about his experiences. He is currently flogging that book on the publicity circuit. Unlike many other such books, Geithner’s holds uncommon interest – not because he is a skillful writer or a keen analyst. Just the opposite.

Geithner is a man desperate to rationalize his past actions. Those actions have put us on a path to disaster. When that disaster strikes, we will be too stunned and too busy to think clearly about the past. Now is the time to view history coolly and rationally. We must see Geithner’s statements in their true light.

Power and the Need for Self-Justification

In his Wall Street Journal book review of Geithner’s book, Stress Test, James Freeman states that “Geithner makes a persuasive case that he is the man most responsible for the federal bailouts of 2008.” Mr. Freeman finds this claim surprising, but as we will see, it is integral to what Geithner sees as his legacy.

This issue of policy authorship is important to historians, whose job is getting the details right. But it is trivial to us. We want the policies to be right, regardless of their source. That is why we should be worried by Geithner’s need to secure his place in history.

Geithner and his colleagues, Federal Reserve Chairman Ben Bernanke and then-Treasury Secretary Henry Paulson, possessed powers whose exercise would have been unthinkable not that long ago. Nobody seems to have considered how the possession of such vast powers would distort their exercise.

Prior to assumption of the Federal Reserve Chairmanship, Ben Bernanke wrote his dissertation on the causes of the Great Depression. Later, his academic reputation was built on his assessment of mistakes committed by Fed Board members during the 1920s and 30s. When he joined the Board and became Chairman, he vowed not to repeat those mistakes. Thus, we should not have been surprised when he treated a financial crisis on his watch as though it were another Great Depression in the making. Bernanke was the living embodiment of the old saying, “Give a small boy a hammer and he will find that everything he encounters needs pounding.” His academic training had given him a hammer and he proceeded to use it to pound the first crisis he met.

In an interview with “Bloomberg News,” Geithner used the phrase “Great Depression” three times. First, he likened the financial crisis of 2008 to the Great Depression, calling it “classic” and comparing it to the bank runs of the Great Depression. Later, he claimed that we had avoided another Great Depression by following his policies. For Geithner, the Great Depression isn’t so much an actual historical episode or an analytical benchmark as it is an emotional button he presses whenever he needs justification for his actions.

When we give vast power to individuals, we virtually guarantee that they will view events through the lens of their own ego rather than objectively. Bernanke was bound to view his decisions in this light: either apply principles he himself had espoused and built his career upon or run the risk of going down in history as exactly the kind of man he had made his name criticizing – the man who stood by and allowed the Great Depression to happen. Faced with those alternatives, policy activism was the inevitable choice.

Geithner had tremendous power in his advisory capacity as President of the New York Federal Reserve. His choices were: use it or not. Not using it ran the risk of being Hooverized by future generations; that is, being labeled as unwitting, uncaring or worse. Using it at least showed that he cared, even if he failed. The only people who would criticize him would be some far-out, laissez-faire types. Thus, he had everything to gain and little to lose by advising policy activism.

Now, after the fact, the incentive to seek the truth is even weaker than it is in the moment. Now Bernanke, Geithner et al are stuck with their decisions. They cannot change their actions, but they can change anything else – their motivations, those of others, even the truths of history and analysis. If they can achieve by lying or dissembling what they could not achieve with their actions at the time, then dishonesty is a small price to pay. Being honest with yourself can be difficult under the best of circumstances. When somebody is on the borderline between being considered the nation’s savior and its scourge, it is well-nigh impossible.

And a person who begins by lying to himself cannot end up being truthful with the world. No, memoirs like Stress Test are not the place to look for a documentary account of the financial crisis told by an insider. The pressures of power do not shape men like Paulson, Bernanke and Geithner into diamonds, but rather into gargoyles.

We cannot take their words at face value. We must put them under the fluoroscope.

“We Were Three Days Away From Americans Not Being Able to Get Money from ATMs”

Not only are Geithner’s actions under scrutiny, but his timing is also criticized. Many people, perhaps most prominently David Stockman, have insisted that the actual situation faced by the U.S. economy wasn’t nearly dire enough to justify the drastic actions urged by Geithner, et al.

Geithner’s stock reply, found in his book and repeated in numerous interviews, is that the emergency facing the nation left no time for observance of legal niceties or economic precedent. He resuscitates the old quote: “We were three days away from Americans not being able to get money from their ATMs.”

There is an effective reply because its psychological shock value tends to stun the listener into submission. But meek silence is the wrong posture with which to receive a response like this from a self-interested party like Paulson, Bernanke or Geithner. Instead, it demands minute examination.

First, ask ourselves this: Is this a figure of speech or literal truth? That is, what precise significance attaches to the words “three days?”

Recall that Bernanke and Paulson have told us that they realized the magnitude of the emergency facing the country and determined that they must (a) violate protocol by going directly to Congress; and (b) act in secret to prevent public panic. Remember also that Paulson told Congress that if they did not pass bailout legislation by the weekend, Armageddon would ensue. And remember also that, typically, Congress did not act within the deadline specified. It waited  ten days before passing the bailout deal. And the prophesied disaster did not unfold.

In other words, Paulson, Bernanke, et al were exaggerating for effect. How much they were exaggerating can be debated.

That leads to the next logical point. What about the ATM reference itself? Was it specific, meaningful? Or was it just hooey? To paraphrase the line used in courtroom interrogation by litigators (“Are you lying now or were you lying then?”), is Geithner exaggerating now just as Paulson and Bernanke exaggerated then?

Well, Geithner is apparently serious in using this reference. In the same interviews, Geithner calls the financial crisis “a classic financial panic, similar to the bank runs in the Great Depression.” In the 1930s, U.S. banks faced “runs” by depositors who withdrew deposits in cash when they questioned the solvency of banks. Under fractional-reserve banking, banks then (as now) kept only a tiny ratio of deposit liabilities on hand in the form of cash and liquid assets. The runs produced a rash of bank failures, leading to widespread closures and the eventual “bank holiday” proclaimed by newly elected President Franklin Delano Roosevelt. So Geithner’s borrowing of the ATM comment as an index of our distress seems to be clearly intended to suggest an impending crisis of bank liquidity.

There is an obvious problem with this interpretation, the problem being that it is obvious nonsense. Virtually every commentator and reviewer has treated Geithner’s backwards predictions of a “Great Depression” with some throat-clearing version of “well, as we all know, we can’t know what would have happened, we’ll never know, we can’t replay history, history only happens once,” and so forth. But that clearly doesn’t apply to the ATM case. We know – as incontrovertibly as we can know anything in life – what would have happened had bank runs and bank illiquidity a la 1930s so much as threatened in 2008.

Somebody would have stepped to a computer at the Federal Reserve and started creating money. We know this because that’s exactly what did happen in 2010 when the Fed initiated its “Quantitative Easing” program of monetary increase. The overwhelming bulk of the QE money found its way to bank reserve accounts at the Fed where it has been quietly drawing interest ever since. We also know that the usual formalities and intermediaries involving money creation by the Fed could and would have been dispensed with in that sort of emergency. As Fed Chairman, Ben Bernanke was known as “Helicopter Ben” because he was fond of quoting Milton Friedman’s remark that the Fed could get money in public hands by dropping it from helicopters in an emergency, if necessary. Bernanke would not have stood on ceremony in the case of a general bank run; he would have funneled money directly to banks by the speediest means.

In other words, the ATM comment was and is the purest hooey. It has no substantive significance or meaning. It was made, and revived by Geithner, for shock effect only. This is very revealing. It implies a man desperate to achieve his effect, which means his words should be received with utmost caution.

“The Paradox of Financial Crises”

Geithner’s flagship appearance on the promotion circuit was his op-ed in The Wall Street Journal (5/13/2014), “The Paradox of Financial Crises.” The thesis of this op-ed – the “paradox” of the title – is that “the more aggressive the government is in designing a rescue plan, the easier it is to force more restructuring in the financial sector, and the better the chances of leaving the surviving system stronger and less dependent on the taxpayer.” Alas, Geithner complains, “Americans don’t give their presidents much in the way of emergency authority to fight” financial crises. As evidence of the need for this emergency authority, Geithner cites the loss of 16% of U.S. household net worth in 2008, “several times as large as the losses at the start of the Great Depression.”

No doubt eyebrows were raised throughout the U.S. when Geithner bemoaned the lack of emergency authority for a President who has appointed dozens of economic and regulatory “czars,” single-handedly suspended execution of legislation and generally behaved high-handedly. Geithner’s thesis – a generous description of what might reasonably be called a desperate attempt at self-justification – apparently consists of three components: (1) the presumption that financial crises are uniquely powerful and destructive; (2) the claim that, nevertheless, a financial crisis can be counteracted by sufficiently forceful action, taken with sufficient dispatch; and (3) the further claim that he knows what actions to take.

The power of financial crises is a trendy idea given currency by a popular scholarly work by two economists named Rogoff and Reinhart, who surveyed recessions featuring financial panics going back several centuries and ostensibly discovered that their recoveries tended to be slow. How much merit their ideas have is really irrelevant to Geithner’s thesis because Geithner’s interest in financial crises is entirely opportunistic. It began in 2008 with Geithner’s improvisations when faced with the impending failure of Bear Stearns, Lehman Brothers, et al. It perseveres only because Geithner’s legacy is now tied to the success of those machinations – which, unlikely as it might have seemed six years ago, is still in dispute.

Geithner’s theory of financial crises is not the Rogoff/Reinhart theory. It is the Geithner theory, which is: financial crises are uniquely powerful because Geithner needs them to be uniquely powerful in order to justify his unprecedented recommendations for unilateral executive actions. In his book and interviews, Geithner peddles various vague, vacuous generalities about financial crises. In order to these to make sense, they must be based on historical observation and/or statistical regularities. But they cannot jibe with the sentiments expressed above in the Journal. Geithner claims to be enunciating a general theory of financial crisis and rescue. But he is really telling a story of what he did to this particular financial system in the particular financial crisis of 2008.

And no wonder, since the financial system existing in the U.S. in 2008 was and still is like no financial system that existed previously. Instead of “banks” as we previously knew them, the failing financial institutions in 2008 were diversified financial institutions – nominally investment banks, although that activity had by then assumed a minor part of their work – some of whose liabilities would once have been called “near monies.” Meanwhile, the true banks were also diversified into securities and investment banking, and the larger ones controlled the overwhelming bulk of deposit liabilities in the U.S. This historically unprecedented configuration accounted for the determination of Paulson, Bernanke, and Geithner to bail them out at all costs. But they weren’t drawing upon a general theory of crises, because no previous society ever had a financial structure like ours.

Geithner stresses the need to “force more restructuring in the financial sector,” as though every financial crisis was caused by corporate elephantiasis and cured by astute government pruning back of financial firms. This is not only historically wrong but logically deficient, since the past government pruning couldn’t have been very astute if crises kept recurring. Indeed, that is the obvious shortcoming of the second component. There are no precedents – none, zero, nada – for the idea that government policy can either forestall or cure recessions, whether financial or otherwise. This is not for want of trying. If there is one thing governments love to do, it is spend money. If there is another thing governments love to do, it is throw their weight around. Neither has solved the problem of recession so far.

What leads us to believe that Timothy Geithner was and is well qualified to pronounce on the subject of financial crises? Only one thing – his claims that “we did do the essential thing, which was to prevent another Great Depression, with its decade of shantytowns and bread lines. We put out the financial fire…because we wanted to prevent mass unemployment.”

Incredible as it seems now, Timothy Geithner had even fewer economic credentials for his post as Chairman of the New York Federal Reserve than Ben Bernanke had for his as Chairman of the Federal Reserve Board of Governors. Geithner had only one economics course as a Dartmouth undergraduate (he found it “dreary”). His master’s degree at John’s Hopkins was split between international economics and Far Eastern studies. (He speaks Japanese, among other foreign languages.) He put in a three-year stint as a consultant with Henry Kissinger’s consulting firm before graduating to the Treasury, where he spent 13 years before moving to the International Monetary Fund, then becoming Chairman of the New York Fed at age 42. As Freeman observed in his book review, Geithner “never worked in finance or in any type of business” save Kissinger’s consulting firm.

This isn’t exactly a resume of recommendation for a man taking the tiller during a financial typhoon. Maybe it explains what Freeman called Geithner’s “difficulty in understanding the health of large financial firms.”

When asked by interviewers if he had any regrets about his tenure, Geithner regrets not foreseeing the crisis in time to act sooner. This certainly contradicts his theory of crises and his claim of special knowledge – if he was the man with a plan and the man of the moment, why did he fail to foresee the crisis and have to go begging for emergency authorization for Presidential action at the 11th hour? Why should we now eagerly devour the words of a man who claims responsibility for saving the nation while simultaneously admitting that he “didn’t see the crisis coming and didn’t grasp the severity of the problems when it appeared?” He now boasts a special understanding of financial crises, but “didn’t require the banks he was overseeing to raise more capital” at the time of the crisis. In fact, as Freeman discloses, the minutes of the Federal Reserve show that Geithner denies that the banking system in general was undercapitalized even while other Fed governors were proposing that banks meet a capital call.

Geithner offers no particular reason why we should believe anything he says and ample reasons for doubt.

“The Government and the Central Bank Have to Step In and Take Risks”

Geithner’s book and publicity tour are a public-relations exercise designed to change his image. Ironically, this involves a tradeoff. He had image problems with both the right wing and the left wing, so gains on one side rate to lose him support on the other side. The Wall Street Journal piece shows that he wants to burnish his left profile. He closes by lamenting that “we were not able to do all that was important or desirable.  …Long-term unemployment remains alarmingly high. There are very high levels of poverty and appalling inequality, not just in income and wealth, but in the opportunities Americans have for a quality education or economic mobility.” Having spent the bulk of the op-ed apologizing for not allowing undeserving Wall Street bankers to go broke, he now nods frantically to every left-wing preoccupation. None of this has anything to do with a financial crisis or emergency authorizations or stress tests, of course – it is just Geithner stroking his left-wing critics.

The real sign that Geithner’s allegiance is with the left is his renunciation of the concept of “moral hazard.” Oh, he gives lip service to the fact that when the government bails out business and subsidizes failure, this will encourage subsequent businessmen to take excessive risks on a “heads I win, tails the government bails me out” expectation. But he savagely criticizes the moral hazard approach as “Old Testament” thinking. (The fact that “Old Testament” is now a pejorative is significant in itself; one wonders what significance “New Testament” would have.) “What one has to do in a panic is the opposite of what seems fair and just. In a financial crisis, the natural instinct is to let creditors suffer losses, let firms fail, and protect taxpayers from any risk of loss. But in a financial panic, a strategy based on those instincts will lead to depression-level unemployment. Instead, the government and the central bank have to step in and take risks on a scale that the private sector can’t and won’t… reduce the incentive for investors, lenders and depositors to run…raise the confidence of businesses and individuals… breaking a vicious cycle in which the fear of a financial-system collapse and a deep recession feed on each other and become self-fulfilling.”

This is surely the clearest sign that Geithner is engaging in ex post rationalization and improvisation. For centuries, economists have debated the question of whether recessions are real or monetary in origin and substance. Now Geithner emerges with the secret: they are psychological. Keynes, it seems, was the second-most momentous thinker of the 1930s, behind Sigmund Freud. All we have to do is overcome our “natural instinct” and rid ourselves of those awful “Old Testament” morals and bail out the right people – creditors – instead of the wrong people – taxpayers.

Once again, commentators have glossed over the most striking contradictions in this tale. For five years, we have listened ad nauseum to scathing denunciations of bankers, real-estate brokers, developers, investment bankers, house flippers and plain old home buyers who went wild and crazy, taking risks right and left with reckless abandon. But now Geithner is telling us that the problem is that “the private sector can’t and won’t …take risks on a scale” sufficient to save us from depression! So government and the central bank (!) must gird their loins, step in and do the job.

But this is a tale left unfinished.  Geithner says plainly that his actions saved us from a Great Depression. He also says that salvation occurred because government and the Fed assumed risks on a massive scale. What happened to those risks? Did they vanish somewhere in a puff of smoke or cloud of dust? If not, they must still be borne. And if the risks are still active, that means that we have not, after all, been saved from the Great Depression; it has merely been postponed.

It is not too hard to figure out what Geithner is saying between the lines. He wants to justify massive Federal Reserve purchases of toxic bank assets and the greatest splurge of money creation in U.S. history – without having to mention that these put us all on a hook where we remain to this day.

In this sense, Timothy Geithner’s book was well titled. Unfortunately, he omitted to mention that the most stressful test is yet to come.

DRI-315 for week of 4-20-14: Is GDP NDG in the Digital Age?

An Access Advertising EconBrief:

Is GDP NDG in the Digital Age?

For years, we have heard the story of stagnant American wages, of the supposed stasis in which the real incomes of the middle and lower class are locked while the rich get richer. Various sophisticated refutations of this hypothesis have appeared. Households have been getting smaller, so the fact that “household income” is falling reflects mainly the fact that fewer people are earning the income that comprise it. “Wages” do not include the (largely untaxed) benefits that have made up a steadily larger share of workers’ real incomes ever since World War II.

But there is something else going on, something more visceral than statistics that leads us

to reject this declinism. It is the evidence of our own senses, our eyes and ears. As we go about our daily lives, each of us and the people around us do not exhibit the symptoms of a people getting materially worse off as we go.

For over thirty years, we have been forsaking the old broadcast trinity of network television stations, at first in favor of cable television and recently for a broadening array of alternative media. For over twenty years, our work and home lives have been dominated by desktop computers that have revolutionized our working and personal lives. For over ten years, an amazing profusion of digital products have taken over the way we live. Cell phones, smart phones, tablets, pads and other space-age electronic wonders have shot us out of a consumer cannon into a new world.

Can it really, truly be that we are worse off than we were before all this happened? As the late John Wayne would say if he were here to witness this phenomenon: “Not hardly.”

The pace of this technological revolution has not only been too fast for most of us to stay abreast of it. It has left many of our 20th century institutions blinking in the dust and gasping for breath. Mainstream economic theory and national income accounting, in particular, are trying to gauge the impact of a 21st-century revolution using the logic and measurement tools they developed in the first half of the 20th century.

The Case Study of Music

Music was one of the great consumer success stories of the 20th century. Thomas Edison’s invention of the phonograph paved the way for the recording of everything from live artistic performances to studio recordings of musicians and singers to the use of recorded sound tracks for motion pictures. The recordings themselves were contained on physical media that ranged from metal discs to vinyl to plastic. At first, these “records” were sold to consumers and played on the phonographs. Sales were in the hundreds of millions. Artists included some of the century’s most visible and talented individuals. The monetary value of these sales grew into billions of dollars.

Since recordings were consumer goods rather than capital goods, sales of records were recorded in the national income and product accounts. Or rather, the value added in the final, or retail, transaction was included. The value-added style of accounting was developed with the inauguration of the accounts in the late 1930s and early 40s in order to do three things: (1) show activity at various stages of production, but (2) highlight the new production of consumption goods each year to reflect the fact that the end-in-view behind all economic activity is consumption (3) by including only the additional value created at each stage to avoid double-counting.

As the 20th century came to a close, however, record albums were replaced by small audio discs that could be played on more compact devices. And these were soon supplanted by computers – that is, the playing medium became a computer and the music itself was housed within a computer file rather than a substantial physical object. As technology advanced, in other words, the media grew smaller and less substantial. But the message itself was unaffected; indeed, it was even improved.

How do we know that the value people derive from music has not been adversely affected by this transition to digitization? In The Second Machine Age, authors Erik Brynjolfsson and Andrew McAfee consider the question at length. In terms of physical units, sales of music have fallen off the table. Just in the years 2004-2008, they fell from roughly 800 million units to less than 400 million units – a decline of over 50% in four years! And the total revenue from sales of music fell 40% from $12.3 billion to $7.4 billion over the same period. By the standards we usually apply to business, this sounds like an industry in freefall.

In this case, though, those standards are misleading. During that same time span, the total unit-volume of music purchased still grew when purchases of digitized music where factored in. And acquisitions of music free of charge by various means swelled the total much, much larger. One of the things economists are best at is analyzing non-traditional markets, which is why Joel Waldfogel of the University of Minnesota was able to infer that the quality of music available to consumers has actually increased in the digital era. Today, anybody with a smartphone can access some 20 million songs via services like Spotify and Rhapsody. For those of us who recall the days of LPs and phonograph needles, the transition to today has been dizzying.

But the economics of the digital age have driven prices through the floor. As Brynjolfsson and McAfee observe, it is the same process that has driven the newspaper business to the wall and its readers online; the same one that has driven classified-advertising from newspapers to Craigslist; the same one that impels us to share photos on Facebook rather than buying prints for friends and family. “Analog dollars,” they conclude, “are becoming digital pennies.”

This creates an unprecedented marketplace anomaly. Measured by the value it creates for human beings, which is how economists want to measure it, the music industry is booming. But measured in dollars’ worth of marketplace transactions, which is how economists are currently able to measure it, the music industry is declining rapidly.

GDP RIP?

If the music industry were a singularity, we might treat it as a mere curiosity. It is not, of course; the gap between price/quantity product and value created yawns wide across the spectrum of industry. “By now, the number of pages and digital text and images on the Web is estimated to exceed one trillion…children with smartphones today have access to more information in real time via the mobile web than the President of the United States had twenty years ago. [!] Wikipedia alone claims to have over fifty times as much information as Encyclopedia Britannica, the premier compilation of knowledge for most of the twentieth century.”

“…Bits are created at virtually zero cost and transmitted almost instantaneously worldwide. What’s more, a copy of a digital good is exactly identical to the original… Because they have zero price, these services are virtually invisible in the official statistics. They add value to the economy, but not dollars to GDP… When a business traveler calls home to talk to her children via Skype, that may add zero to GDP, but it’s hardly worthless. Even the wealthiest robber baron would have been unable to buy this service [in the 19th century]. How do we measure the benefits of free goods or services that were unavailable at any price in previous eras?”

This understates the case. As Brynjolfsson and McAfee acknowledge, most of the new digital services substitute for existing services whose sales contribute to GDP. Thus, the digital bonanza actually lowers measured GDP at the same time that our well-being rises. In economic jargon, the effect on GDP’s function as index of national welfare is perverse.

This leads many people, including these authors, to the conclusion that GDP is no longer an adequate measure of national output. If this is true, it makes our monthly, quarterly and annual preoccupations with the growth rate of GDP seem pretty silly. The government agency whose task is the compilation of economic statistics is the U.S. Bureau of Economic Analysis. Its definition of the economy’s “information sector” aggregates sales of software, publishing, movies, audio recordings, broadcasting, telecommunications, and data processing and information services. These sales account for about 4% of measured GDP today. Yet we are commonly understood to be chest-deep in a new “economy of information” that is replacing the economy of tangible goods and services. Either this perception or that 4% metric is wrong; the latter seems vastly more probable.

What’s more, the irrelevance of GDP increases by the nanosecond.

New Products

Of course, not all digital products and services are substitutes for existing counterparts. Some of them are genuinely new. If these are similarly hard to incorporate in GDP, the distortion may be only half as great as that described above. But the digital revolution has displayed a propensity for creating things that were unknown heretofore but that soon became necessary accoutrements of daily life.

Longtime macroeconomist and textbook author Robert Gordon estimated the value of new goods and services added but missed by GDP at about 0.4% of GDP. That may not sound like much, but since the long-term average annual rate of productivity growth is around 2%, it would mean that we are overlooking 20% of annual productivity.

GDP and Investment: The Bad News Gets Worse

GDP is failing because it neglects to measure the tremendous increases in consumption and well-being conferred by the digital age. But GDP also measures investment, or purports to. Are its failings on the consumption side mitigated by its performance with investment?

No, they are magnified. The production of digital goods and services is heavily dependent on intangible assets rather than the familiar plant and equipment that are the focus of traditional investment. Brynjolfsson and McAfee identify four categories of these intangibles: intellectual property, organizational capital, user-generated content and human capital. It comes as no surprise to find that the measurement of these assets largely eludes GDP as well.

Intellectual property encompasses any creation of the human mind to which legal ownership can be attached. Patents and copyrights form the backbone of this category. A great deal of spending on research and development (R&D) constitutes investment in intellectual property.

Yet R&D has long been recognized as almost impossible to accurately measure because only its cost is transparent, while the value (e.g., capital) it creates often escapes measurement.

Organizational capital is an even broader concept intended to capture the value inhering in brands, processes, techniques and conceptual structures owned by particular businesses. This category long predates the digital age but is idealized by companies like Apple, whose brand and unique corporate style complement its portfolio of intellectual property to create perhaps the world’s most productive company. Accountants have long sought to put a price tab on things like “good will” and “brand name.” We have observed that the transition to a computer-savvy work force has necessitated investment in procedures and processes far greater than the initial spending on the computer hardware and software – spending that doesn’t show up in the national income accounts as investment.

User-generated content is a true digital innovation. Facebook, Twitter, YouTube, Pinterest, Instagram, Yelp and countless other websites are largely created by their users. The value of this approach is both undeniable and subjective, as anybody who has every previewed a restaurant on Yelp or planned a vacation with TripAdvisor can testify. The feedback generated these sites provides an object lesson in the generation of information – the kind of information that economists had to assume that people already knew because we didn’t know how markets could make it available to them. Now we do.

Human capital was a concept invented and popularized by economists Theodore Schultz and Gary Becker decades before the Internet existed. The talents, skills and training that we receive make us better productive “machines,” which inspired the analogy with physical capital.

How important are these intangible assets in the modern economy? Nobody knows with certainty, but – as always – economists have made educated guesses. Brynjolfsson and McAfee estimate the value of organizational assets as some $2 trillion. The preeminent theorist of investment, Dale Jorgenson, estimated that human capital is worth 5-10 times as much as the stock of all physical capital in the U.S. Investment in R&D has been estimated at roughly 3% of GDP in recent decades.

The degree of distortion in GDP numbers – specifically in measures of productivity, which compares growth in inputs and output – is harder to gauge in this case than in the consumption example. Some intangible assets, like R&D and human capital, are longtime thorns in the sides of statisticians; their measurement has always been bad and may be no worse now than before. In some cases, the distortions in investment may offset those in consumption, so that the measure of productivity may be accurate even though the numerator and denominator of the ratio are inaccurate. But the elements most closely associated with the digital revolution, such as user-generated content, impart a huge downward bias to measured productivity in the national income accounts.

A New, Improved GDP?

Economists and other commentators have done a good job of diagnosing the havoc wreaked on GDP by the digital revolution. Alas, they have rested on those laurels. In the “solutions and policy proposals” section of their work, they have fallen back on the tried and trite. GDP was a sibling of macroeconomics; the economic logic underlying the two is the same, with the operative word being “lying.” Macroeconomists are loathe to repudiate their birthright, so their reflex is to cast about for ways to mend the measurement holes in GDP rather than abandon it as a bad job. Hence the rosy glow cast by Brynjolfsson and McAfee over nebulous concoctions like the “Social Progress Index” and the “Gallup-Healthways Well-Being Index.” As for the touted “Gross National Index” of Bhutan, the less said about this laughable fantasy (treated in a previous EconBrief), the better.

The authors cite the comments of Joseph Stiglitz, whom they call “Joe” to profit by the implied familiarity with a Nobel laureate: “…Changes in society and the economy may have heightened the problems at the same time that advances in economics and statistical techniques may have provided opportunities to improve our metrics.” The “improvements” don’t seem to have included the ability to stop the scandalous misuse of the concept of “statistical significance” that has plagued the profession for many decades.

In fact, GDP has been known to be a failure almost since inception. Introductory economics textbooks routinely inculcate students in the shortcomings of GDP as a “welfare index” by listing a roster of flaws that predate the digital age, the Internet and computers. It has ignored the value of household services (predominantly provided by women), ignored the value created by secondary transactions of all kinds of used goods, undervalued services and thrown up its figurative hands when confronted by non-market transactions of all kinds. Its continued use has been a grim tribute to Lord Kelvin’s dubious dictum that “science is measurement,” the implication being that measuring badly must be better than not measuring at all.

What’s more, the blame cannot be laid at the feet of economic theory. It is certainly true that the digital age has brought with it a veritable flood of “free” goods – seemingly in contradiction with Milton Friedman’s famous aphorism that “there is no such thing as a free lunch.” Hearken back to Brynjolfsson and McAfee’s words that “bits are created at virtually zero cost.” A fundamental principle – perhaps the fundamental principle – of neoclassical microeconomics is that price should equal marginal cost, so that the value placed on an additional unit of something by consumers should equal its (opportunity) cost of production. When marginal cost equals zero, there is nothing inherently perverse about a price approaching zero. No, the laws of economics have not been suspended on the Internet.

Careful comparison of the age-old flaws of GDP and its current failure to cope with the challenges posed by digital innovation reveal a common denominator. Both evince a neglect of real factors for lack of a monetary nexus. The source of this insistence upon monetary provenance is the Keynesian economic theory to which the national income accounts owe their origin. Keynesian theory dropped the classical theory of interest in favor of a superficial monetary theory of liquidity preference. That is now proving bogus, as witness the failure of Federal Reserve interest-rate policies since the 1960s. Keynesian theory gives spending the pride of place among economic activity and relegates saving and assets to a subordinate role. Indeed, the so-called “paradox of thrift” declares saving bad and spending good. No wonder, then, that the national income accounts fail to account for assets and capital formation in a satisfactory manner.

Instead of tinkering around the margins with new statistical techniques and gimmicks when they have not even mastered basic statistical inference, economists should instead rip out the rotting growth root and branch. Reform of macroeconomics and reform of the national income accounts go hand in hand.

End the Reign of GDP

The digital age has merely exposed the inherent flaws of GDP and widened its internal contradictions to the breaking point. It is time to dump it. The next measure of national output must avoid making the same mistakes as did the founders of the national income accounts nearly 80 years ago.

The next EconBrief will outline one new proposal for reform of the national income accounts and explain both its improvements and shortcomings.

DRI-304 for week of 3-2-14: Subjugating Florists: Power, Freedom and the Rule of Law

An Access Advertising EconBrief:

Subjugating Florists: Power, Freedom and the Rule of Law

A momentous struggle for human freedom is playing out in a mundane setting. Two people in Washington state are planning to wed. They want their florist, Arlene’s Flowers and Gifts, to supply flowers for the wedding. The owner, Barronelle Stutzman, refuses the job. The couple wants her to be compelled by law to provide service to them.

Even without knowing that particular facts distinguish this situation, we might suspect it. In this case, the couple consists of two homosexual men, Robert Ingersoll and Curt Freed. Ms. Stutzman’s refusal stems from an unwillingness to participate in – and thus implicitly sanction – a ceremony of which she disapproves on religious grounds.

The points at issue are two: First, does existing law forbid Ms. Stutzman’s refusal on the grounds that it is an illegal “discrimination” against the couple? Second, is that interpretation the proper one, regardless of its legality?

The first point is a matter for lawyers. (Washington’s Attorney General has filed suit against Ms. Stutzman.) The second point is a matter for all of us. On it may hinge the survival of freedom in the United States of America.

The Facts of the Case

The prospective married couple, Messrs. Ingersoll and Freed, has granted numerous interviews to publicize their side of the case. To the Christian Broadcasting Network (CBN), they described themselves as “loyal customers for a decade” of Arlene’s.

“It [Stutzman’s refusal] really hurt because it was somebody I knew,” Ingersoll confided. “We stayed awake all night Saturday. It was eating at our souls.”

For her part, Ms. Stutzman declared that “you have to make a stand somewhere in your life on what you believe….” The unspoken implication was that she had faced repeated challenges to her convictions, culminating in this decision to stand fast. “In America, the government is supposed to protect freedom, not… intimidate citizens into acting contrary to their faith convictions.”

The attitude displayed by major media outlets reflects the Zeitgeist, which decrees: Ms. Stutzman is guilty of illegal discrimination on grounds of sexual orientation. It is significant that this verdict crosses political boundaries. On the Sunday morning discussion program Face the Nation, longtime conservative columnist and commentator George Will claimed that “public-accommodations law” had long ago “settled” the relevant legal point regarding the requirement of a business owner to provide service to all comers once doors have been opened to the public at large. But Mr. Will nonetheless expressed dissatisfaction with the apparent victory of the homosexual couple over the florist. “They [homosexuals in general] have been winning…this makes them look like bad winners.” Mr. Will seemed to suggest that the couple should forego their legal right and let Ms. Stutzman off the hook as a matter of good manners.

Legal, Yes; Proper, No

The fact that the subjugation of the florist is legal does not make it right. For decades, the Zeitgeist has been growing ever more totalitarian. Today, the United States of America approaches a form of authoritarian polity called an absolute democracy. In an absolute monarchy, one person rules. In an absolute democracy, the government is democratically elected but it holds absolute power over the citizens.

The inherent definition of freedom is the absence of external constraint. In this case, that would imply that Messrs. Ingersoll and Freed would be free to engage or refuse the services of Ms. Stutzman and Ms. Stutzman would be free to provide or refuse service to Messrs. Ingersoll and Freed – on any basis whatsoever. That is what freedom means. A concise way of describing the operation of the Rule of Law would be that all (adult) citizens enjoy freedom of contract.

But in our current unfree country, Messrs. Ingersoll and Freed are free to patronize Arlene’s or not but Ms. Stutzman is not free. She is required to serve Messrs. Ingersoll and Freed, like it or not. The couple’s sexual orientation has earned them the status of a privileged class. They have the privilege of compelling service. This is a privilege enjoyed by a comparative few.

George Will and company may pontificate about settled law, but the truth is that refusals of service happen daily in American business. Businesses often refuse other businesses as a courtesy, typically as an acknowledgement of their own shortcomings or lack of specialized knowledge or expertise. Sometimes a business will frankly admit that a would-be customer falls outside their target customer class. This sort of refusal rarely, if ever, leads to recriminations. After all, who really wants to pay for a product or service unwillingly supplied? The only exception comes when the customer falls within one of the government-protected categories covered by the anti-discrimination laws. Then the fear of litigation, financial and criminal penalties and adverse publicity kicks in.

This may be the clearest sign that the Rule of Law no longer prevails in America. The Rule of Law does not mean scrupulous adherence to statutory law. It means the absence of privilege. In America today, privilege is alive and growing like a cancer. In the past, we associated the term with wealth and social position. That is no longer true. Now it connotes special treatment by government.

The Role of Competition Under the Rule of Law

Under the Rule of Law, Messrs. Ingersoll and Freed would not be able to compel Ms. Stutzman to provide flowers to their wedding. But this would not leave them without resource. The Rule of Law supports the existence of free competitive markets. The couple could simply call up another florist. True, they would be denied the service of their longtime acquaintance and supplier. But nobody is entitled to a lifetime guarantee of the best of everything. What if Ms. Stutzman was ill on their wedding day, or called out of town, or struck down by a beer truck? What if she went bankrupt or retired? The Rule of Law simply protects a free, competitive market from which Messrs. Ingersoll and Freed can pick and choose a florist.

That is not the only benefit the couple get from the Rule of Law and competition. In a competitive market, any seller who refuses service to a willing buyer must pay a penalty or cost in the form of foregone revenue. In strict, formal theory, a competitive market produces an equilibrium result in which the amount of output produced at the equilibrium price is exactly equal to the ex ante amount desired by consumers. A seller who turns away a buyer is throwing money down the drain. This is not something sellers will do lightly. Anybody who doubts this has never run a business and met a payroll. Thus, free competitive markets offer strong disincentives to discrimination.

Of course, that does not mean that businesses will never refuse a customer; the instant case proves that. But refusals of conscience like the one made by Ms. Stutzman will be comparatively rare, because it will be unusual for the owner to value the moral issue more than the revenue foregone.

The existence of competition under the Rule of Law is the safeguard that makes freedom and democracy possible. Without it, we would have to fear the tyranny of the majority over minorities. With it, we can safely rely on markets to protect the rights and welfare of minorities.

The Rule of Law and Limited Government

Free choice by both buyers and sellers is not the enemy of minority rights. The real danger to minorities is government itself – the very government that is today advertised as the champion of minorities.

After the Civil War, newly freed and enfranchised blacks entered the free economy in the South. They began to compete with unskilled and skilled white labor. This competition was successful, both because blacks were willing to work for lower wages and because some blacks had mastered valuable skills while slaves. For example, professional baseball originated in the 1860s and increased steadily in popularity; blacks participated in this embryonic period.

White laborers resented this labor-market competition. In order to artificially increase the wages of their members, labor unions had to restrict the supply of labor. Denying union membership to blacks was a common means of catering to member desires while furthering wage objectives. But the competition provided by blacks was difficult to suppress because employers had a clear incentive to hire low-wage labor that was also productive and skillful. Businesses had a strong monetary incentive not to refuse service to blacks because the money offered by blacks was just as green as anybody else’s money.

The solution found by the anti-black forces was the so-called “Jim Crow” laws. These forbade the hiring of blacks on equal terms and denied blacks equal rights to public accommodations and service. In effect, the Jim Crow laws cartelized labor and product markets in a way that would not otherwise have occurred. Governments also handed out special privileges to labor unions that enabled them to compel membership and deny it at will. Historically, labor unions excluded blacks from membership for the bulk of the 20th century. Blacks were banned from organized baseball and most other professional sports until the 1940s, when sports became the first wedge driven into the Jim Crow laws.

The apartheid law passed in southern Africa in the early 20th century also arose in order to thwart successful competition offered by white labor by black labor. Left alone, competitive labor markets were enabling black South Africans to enjoy rising wages and employment. South African labor unions agitated for government protection against black workers. The result was the “pass laws” or “color bar” or apartheid system, not unlike the Jim Crow laws prevailing in America. Once again, the purpose was to cartelize labor markets in order to erect barriers to competition offered to white labor by black workers.

The rationale behind public utilities was ostensibly to limit the pricing power and profits enjoyed by firms that would otherwise have been “natural monopolies.” In actual practice, by guaranteeing public utilities a “normal profit,” government removed the specter of a loss of revenue and profit associated with discrimination against black customers and employees. Sure enough, public utilities were among the chief practitioners of discrimination against blacks – along with government itself, which also did not fear a loss of profit resulting from its actions.

A recurring effect of government regulation of business in all its forms has been the erosion of competition. Sometimes that has been caused by costly compliance with regulation, driving businesses bankrupt and reducing market competition through attrition. Sometimes this has come from direct government cartelization of competitive markets, resulting from measures like marketing orders and quotas in milk and citrus fruit. Sometimes that has come from price supports, target prices and acreage allotments that have reduced agricultural output and raised prices or, alternatively, raised prices while creating costly surpluses for which taxpayers must pay. Sometimes the reduction in competition results from anti-trust laws like the Robinson Patman Act, deliberately designed to raise prices and restrict competition in retail business.

There is no formal, coherent theory of regulation. Instead, regulatory legislation is accompanied by vague protestations of good will and good intentions that have no unambiguous translation into policy. The typical result is that regulators either take over the role of controlling business decisions from market participants or they become the patrons and protectors of businesses within the industries they regulate. The latter attitude has evolved within the financial sector, where regulators have gradually taken the view that the biggest competitors are “too big to fail.” That is, the effects of failure would spill over onto too many other firms, causing widespread adverse effects. This, in turn, precludes discipline imposed by competitive markets, which force businesses to serve consumers well or go out of business.

The enemy of minorities is government, not free competitive markets. Government harms minorities directly by passing discriminatory laws against them or indirectly by foreclosing or lessening competition.

The Two-Edged Sword of Government Power

Many people find it difficult to perceive government as the threat because government vocally broadcasts its beneficence and cloaks its intentions in the vocabulary of good intentions. It bestows noble and high-sounding names on its legislative enactments. It endows them with historic significance. Like Edmund Rostand’s protagonist Chanticleer, government pretends that its will causes the sun to rise and set and only its benevolence stands between us and disaster.

But the blessings of government are a two-edged sword. “A government powerful enough to give us everything we want is powerful enough to take from us everything we have.” One by one, the beneficiaries of arbitrary government power have been also been stung by the exercise of that same power.

In 1954, government insisted that “separate was inherently unequal” and that the segregated education received by blacks must be inferior to that enjoyed by whites. Instead of introducing competition to schools, government intruded into education more than ever before. Now, six decades later, blacks still struggle for educational parity. And today, it is government that stands in the schoolhouse door to thwart blacks – not through segregation, but by resolutely opposing the educational competition introduced by charter schools in New York City. The overwhelming majority of charter patrons are black, who embrace the charter concept wholeheartedly. But Mayor Bill de Blasio has vowed to fight charter schools tooth and claw. The state and federal governments can be relied upon to sit on their hands, since teacher unions – diehard enemies of charter schools – are a leading constituency of the Democrat Party.

For over a century, blacks have lived and died by government and the Democrat Party. Now they are cut by the other edge of the government sword.

The print and broadcast news media have been cheerleaders for big government and the Democrat Party throughout the 20th century and beyond. First-Amendment absolutism has been a staple of left-wing thought. Recently, FCC regulators in the Obama administration hatched a plan to study journalists and their employers with a view towards tighter regulation. The pretext for the FCC’s Multi-Market Study of Critical Information Needs was that FCC broadcast licenses come with an obligation to serve the public – and how can government determine whether licensees are serving the public without thoroughly studying them? All hell has suddenly broken loose at the prospect that journalists themselves might be subjected to the same stifling regulation as other industries.

Of course, in a competitive market it is quite unnecessary to regulators to “study” the market to gauge whether it is working. Consumers make that judgment themselves. If businesses don’t serve consumers, consumers desert them and the businesses fold. Other businesses take their place and provide better service – or they join their predecessors on the scrap heap. But the presumption of government is that regulation must be necessary to promote competition – otherwise “market failure” will strand consumers up the creek without locomotion.

For decades, the knee-jerk reflex of journalists to any perceived problem has been that “no government regulation exists” to solve it. Now journalists tremble as they test the opposite edge of the government sword.

Now homosexuals are the latest group to successively experience both blades of the government sword. After years of life spent in the shadow of criminal prosecution, homosexuals have witnessed the gradual dismantling of state anti-sodomy laws. State-level bans on marriage by couples of the same gender have been invalidated by the U.S. Supreme Court. Not satisfied with their newly won freedom, homosexuals strive to wield power over their fellow citizens through coercion.

This is the only sense in which George Will was correct. His characterization of homosexuals as “bad winners” was infantile; it portrayed a serious issue of human freedom as a schoolboy exercise in bad manners. But he correctly sensed that homosexuals were winning something – even if he wasn’t quite sure what – and that this latest shift toward subjugating florists was a disastrous change in direction.

What Do Homosexuals Want? What Are They Owed Under the Rule of Law?

The holistic fallacy treats homosexuals as an organic unity with homogeneous wants and goals. In reality, they are individuals with diverse personalities and political orientations. But the homosexual movement follows a clearly discernible left-wing agenda, just as Hispanic activist organizations like La Raza hew to a left-wing line not representative of most Hispanics.

The homosexual political agenda strives to normalize and legitimize homosexual behavior by winning the imprimatur of government and the backing of government force. This movement feeds off the angst of people like Ingersoll and Freed – “It really hurt…it was eating at our souls” – who ache from the sting of rejection. The movement is selling government approval as a psychological substitute for parental and societal approval and economic rents as revenge for rejection. Homosexuals have observed the success of blacks, women and other protected classes in pursuing gains via this route.

There was a time, not so long ago when measured by the relative standard of history, when male homosexuals were not merely criminals but were subjected to a kind of informal “Jim Crow” persecution. They were routinely beaten and rolled not only by ordinary citizens but even by police. It is worth noting that these attitudes began to change decades ago, even before the advent of so-called “affirmative action” programs ostensibly designed to redress the grievances of other victim classes.

The Rule of Law demands that homosexuals receive the same rights and due-process protections as other people. It applies the same standards of consent to all sexual relationships between consenting adults. It grants the same freedom of contract – marital and otherwise – to all.

By the same token, the Rule of Law abhors privilege. It rejects the chimerical notion that the past harms suffered by individual members of groups can be compensated somehow by committing present harms that grant privilege and real income to different members of those same victimized groups.

The Rule of Law and Social Harmony

Sociologists and political scientists used to marvel as the comparative social harmony of American society – achieved despite the astonishing ethnic, racial, religious and political diversity of the citizenry. The consensus assigned credit to the American “melting pot.” The problem with this explanation is that a culture must first exist before new entrants can assimilate within it – and what mechanism achieved the original reconciliation of diverse elements?

Adherence to the Rule of Law within competitive markets made social harmony possible. It allowed the daily exchange of goods and services among individuals in relative anonymity, without disclosure of the multitudinous conflicts that might have otherwise produced stalemate and rejection. Milton Friedman observed astutely that free markets permit us to transact with the butcher, baker and candlestick maker without inquiring into their political or religious convictions. We need agree only on price and quantity. The need for broader consensus would bring ordinary life as we know it to a grinding halt; government would have to step in with coercive power in order to break the stalemate.

When everybody wears their politics, religion and sexual orientation on their sleeves, it makes life unpleasant, worrisome and exhausting. Shouldering chips weighs us down and invites conflict. This is the real source of the “polarization” complained of far and wide, not the relatively trivial differences between Republicans and Democrats. (The two parties are in firm agreement on the desirability of big government; they disagree vehemently only on who will run the show.)

Intellectuals wrongly assumed that the anonymity fostered by the Rule of Law reflected irreconcilable contradictions within society that would eventually cause violence like the Stonewall riots in 1969. The truth was that the Rule of Law reconciled contradictory views of individuals and allowed peaceful social change to occur gradually. Homosexuals were able to live, work and achieve outside of the glare of the public spotlight. It slowly dawned on the American public, at first subliminally and then consciously, that homosexuals were successfully contributing to every segment of American life. The achievements pointed to with pride today by homosexual activists were possible only because the Rule of Law facilitated this gradual, peaceful process. They were not caused by self-righteous activists and an all-powerful government bitch-slapping an ignorant, recalcitrant public into submission.

Subjugating Florists: A Pyrrhic Victory

Free competitive markets cash the checks written by the Rule of Law. Homosexuals have lived and prospered within those free-market boundaries, mirroring the tradition of Jews, blacks and other stigmatized minority groups. For centuries, homosexuals have faced ostracism and even death in various societies around the world. That remains true in certain countries even now. While it is true that homosexuals were formerly treated cruelly in America, it is also true that their cultural, economic and political gains here have been remarkably rapid by historical standards. Historical memory, rather than etiquette, should counsel against trashing the free-market institutions that have midwived that progress.

Violating the Rule of Law in exchange for the power to compel service by businesses would be far worse than a display of bad manners. It would be the worst kind of tradeoff for homosexuals, gaining a temporary political and public-relations triumph at the expense of long-run economic stability.

Of course, homosexual activists are hardly the first or the only ones grasping at the levers of government power. The history of 20th-century America is dominated by such attempts, emanating at first from the political Left but now from the Right as well. It is grimly amusing to recall that early efforts along these lines were hailed by political scientists as encouraging examples of “pluralism” and “inclusiveness” – they were supposed to be signs that the downtrodden and marginalized were now participating in the political process. Today, everybody and his brother-in-law are trying to work local, state or federal government for an edge or a subsidy. Nobody can pretend now that this is anything but the unmistakable indicator of societal disintegration and decay.

Heretofore, the visible traits of democracy – representative government, elections, checks and balances – have been considered both necessary and sufficient to guarantee freedom. The falsity of that presumption is now dawning upon us with the appreciation of democratic absolutism as an impending reality. Subjugating florists may provide the homosexual movement with the thrills of political blood sport but any victories won will prove Pyrrhic.

DRI-270 for week of 2-9-14: Can We Make Economic Sense of First Wives’ ‘Joining Forces’ Initiative?

An Access Advertising EconBrief:

Can We Make Economic Sense of First Wives’ ‘Joining Forces’ Initiative?

In 2011, the wives of President Obama and Vice-President Biden, Michelle Obama and Dr. Jill Biden, announced formation of a public-service initiative called “Joining Forces.” The action is ostensibly intended to “honor and support our veterans, troops and military families.” What sort of “honor” and “support” is provided? A fair idea can be gleaned from the op-ed appearing under Ms. Obama’s byline in the Monday, February 10, 2014,

Wall Street Journal. It is entitled “Construction Companies Step Up to Hire Veterans.”

It contains the sort of prose that adult Americans have been bombarded with since birth. Still, inquiring economists want to know: What sense can we make of this sort of appeal?

Why Should Construction Companies Hire Veterans?

Ms. Obama uses the lead paragraph of her op-ed to announce an announcement. On publication day, “more than 100 construction companies – many of whom are direct competitors – are coming together to announce that they plan to hire more than 100,000 veterans within the next five years. They made this commitment not just because it’s the patriotic thing to do, and not just because they want to repay our veterans for their service to our country, but because these companies know that it’s the smart thing to do for their businesses.”

“As one construction-industry executive put it, ‘Veterans are invaluable to the construction industry. Men and women who serve in the military often have the traits that are so critical to our success: agility, discipline, integrity and the drive to get the job done right.” Ms. Obama records her approval of this “sentiment” and reiterates the guiding challenge of Joining Forces: “Hire as many of these American heroes as you can.”

Joining Forces originated in 2011. “Since then,” Ms. Obama reports, “we have been overwhelmed by the response… The CEOs we have spoken to have been consistently impressed with their hires…veterans are some of the highest-skilled, hardest-working employees they’ve ever had… resilient, adept at building and leading teams, comfortable with diversity, and able to handle uncertainty.” This is attributable to veterans’ “training and experience,” including “some of the most advanced information, medical and communications technologies in the world.” To bolster her argument, she offers an anecdotal case of an Air Force manpower specialist whose service job was estimating the troop strength and specialties needed for missions. Like many veterans whose “qualifications aren’t always obvious from their resumes,” he would have been “easy to overlook” if not for the Disney Company’s human-resources specialists, who are “trained…to translate military experience into civilian qualifications.” They realized that his military background ideally qualified him to plan meals by specifying exact kinds and quantities of ingredients.

Ms. Obama earnestly implores us to consider the multitude of possible employment conversions. Military medics would make such good paramedics and EMTs. Tank crew members would make dandy truck drivers. The military employs “engineers, welders [and] technicians.” Small wonder, then, that “American businesses have hired nearly 400,000 veterans and military spouses” since Joining Forces opened up.

Why Do Construction Company Managers – or Employers

Generally – Need Advice on Whom to Hire?

The first question that occurs to the inquiring economist is: Why do construction company managers need advice on whom to hire? Indeed, why would any employer need that sort of advice?

Running a business can get complicated. But few decisions are as fundamental as qualifications for new hires. If owners and managers don’t know what they’re looking for in a job applicant, how can they ever hope to succeed?

It is true that we recently underwent a financial crisis, the trigger of which was a housing bubble. Undoubtedly many unwise decisions were made in housing sale and finance, and quite a few in housing construction. But nobody has suggested that the crisis was caused by construction companies hiring the wrong people.

In her op-ed, Ms. Obama didn’t actually

say that employers are boobs who are incapable of hiring the right candidates without the help of the federal government – more specifically, without the help of the wives of the President and Vice-President of the U.S. (Of course, her actions tacitly encourage this belief on the political Left, where it has always flourished.) In fact, what she actually said was that “CEOs …have been consistently impressed with their hires.” She even quoted “one construction industry executive” to the effect that “veterans are invaluable to the construction industry. Men and women who serve in the military often have the traits that are so critical to our success.” (The executive cannot be speaking from experience gained from working with Joining Forces, since that partnership is only now being announced.) If construction-industry executives

already knew

that veterans are “invaluable” – a plausible conjecture for reasons adduced above – why was the intervention of Joining Forces needed?

The clincher comes from Ms. Obama herself, referring to the commitment made by the consortium of construction companies. “They made this commitment not just because it’s the patriotic thing to do…but because these companies know that it’s the smart thing to do for their businesses.” If they

already knew that it was in their interest, in

advance

of this agreement, why was jawboning by Joining Forces required?

In her op-ed, Ms. Obama offers no hint as to why the employers she is urging need advice on hiring. She actually vitiates her own argument by providing persuasive evidence that they do

not

need her gratuitous advice.

If Employers Did Need Advice on Hiring, Why Would They Seek it from the First Wives?

When people need advice, they generally seek out experts. The hiring decisions of business owners and managers affect their livelihoods and the wealth of investors – all the more reason to obtain qualified opinions when in doubt. Why would a manager base hiring decisions on advice offered informally by two people whose fame and expertise lie outside the industry – and who have no experience in management or personnel?

Taking the advice of a lawyer and an English professor on hiring because their husbands happen to be the President and Vice-President would be tantamount to acting on the basis of a celebrity endorsement. We might heed a celebrity endorser on a question of taste – a choice of beer, say, or candy bar – but not on a matter demanding specialized or expert knowledge.

In her op-ed, Ms. Obama makes one reference to “current research,” but cites no original research attributable to her, Ms. Biden or Joining Forces. In other words, her initiative adds nothing not already available to employers, who already have the strongest possible incentive to seek out and act upon pertinent information about employment candidates.

It is clear that the First Wives would ordinarily not be people whom executives, managers and business owners would solicit for advice on hiring.

Is Ms. Obama Asking for Charity, Demanding an Entitlement or Offering Advice on Efficient Hiring?

Ms. Obama’s plea for hiring of veterans is a mixture of mutually exclusive messages. In the opening paragraph of her op-ed, she declares that construction companies made the commitment to hire over 100,000 veterans in the next five years “because it’s the patriotic thing to do…because they want to repay our veterans for their service to our country [and] because it’s the smart thing to do for their businesses.” Each of these motives is distinct from, and inconsistent with, the others.

In a free-market economy, the purpose of business is to produce as many goods and services as efficiently as possible. This requires hiring workers solely on the basis of their productivity. While business owners are not barred from having ulterior motives and acting upon them, they will suffer a penalty for indulging any prejudices or whims not consonant with the goal of maximum efficiency and profit. And when businesses depart from the straight and narrow, consumers suffer as well.

If the veteran is indeed the best employee for the job, everybody – the veteran, the company and consumers – wins if the vet is hired. But in that case, the intercession of Ms. Obama, Dr. Biden and Joining Forces is utterly superfluous. If the vet is not the best candidate, then the efforts of some outside agency might well be decisive. But that is hardly a victory for truth, justice and the American way. How is patriotism served by making the company and consumers worse off? For that matter, what is patriotic about sticking a veteran in a job in which he or she is inferior to somebody else?

The notion of “repay[ing] our veterans for their service to their country” is at best an anachronism, a throwback to the days before the all-volunteer military. The draft was viewed – erroneously – as a means of assembling a fighting force without having to pay the full economic costs that would be demanded by willing workers. In that context, it might have made a semblance of sense to provide extra compensation to surviving soldiers after demobilization. But today’s fighting force is composed of volunteers. They are professionals who are paid for their work and equipped with physical, mental and emotional skills that pay dividends after their service ends. It is patronizing and insulting as well as flagrantly inaccurate to treat them as naïve conscripts who need looking after. They are not “our boys.” They are men – and women. Apart from medical treatment for injuries suffered on duty, the only further payment they require is respect.

Why is it Desirable for Construction Companies to Collude in Hiring Veterans?

Ms. Obama went to great pains to announce that over 100 construction companies were “coming together” to “plan” their hiring of veterans. To alleviate potential ambiguity on the point, she noted that “many of [them] are direct competitors.” The term economists and lawyers use to characterize collective hiring decisions made by direct competitors is “collusion.” It is presumptively illegal, on the theory that it allows firms to set wages lower than would be the case were the companies to compete independently in the same labor market. Collusion allows the firms to replicate, or at least approach, the outcome attained by a single

monopsony buyer of labor – just as collusion by a cartel of sellers in a market for output strives to replicate the

monopoly

result attained by a single seller.

When owners of major-league baseball teams were adjudged guilty of collusion in bargaining with players, they were subject to legal penalties. Why is it wrong for baseball-team owners to collude in hiring players but praiseworthy for construction companies to collude in hiring veterans? Does the approval of Madams Obama and Biden sanctify the practice?

It seems axiomatic that when two people whose primary basis for association is political cooperate to achieve an outcome, their motives are presumed to be political. A political motivation does not sanctify collusion – just the opposite, in fact. A political motivation suggests that the collusion will benefit one political interest or party at the expense of the other or others. Moreover, it also suggests that the gains of the gainers will be less than the losses felt by the losers. That is one way of defining the difference between economic change and political change.

Will Madams Obama and Biden personally supervise the hiring to prevent the monopsony outcome described above? Ms. Obama made no mention of it. There is no reason to expect that, since we have no reason to think that either Ms Obama or Ms. Biden have advanced training in economic theory and no reason to think they could effectively supervise the hiring of thousands of people even if they did. It is competition that precludes the possibility of monopoly, not minute scrutiny of each economic transaction by government authorities.

How Do We Explain the History of Joining Forces?

We have cast overwhelming doubt on the public rationale behind Joining Forces, the initiative promoted by the First Wives. What, then, is its likely purpose? The late Milton Friedman likened the actions of politicians to those of the lead duck in a flying V-formation. Periodically, the leader glances back, only to discover that the formation has deserted him and is flying off in a different direction. The leader must scramble to find the formation and resume his place at the head. The point is that this form of leadership is purely ceremonial; the formation leads and the apparent leader is really following.

It was clear even in 2011 that the Obama administration’s economic stimulus package had failed to stimulate. The Federal Reserve had embarked on an unprecedented program of monetary expansion that was being sold as stimulus but was really designed to prop up the financial system. The Obama administration needed something it could point to as a success and claim credit for.

Presidential spouses since Mamie Eisenhower have been publicly active. Mostly their activities have been innocuous; i.e., non-political. The most conspicuous exception was Hillary Clinton’s leadership of her husband’s health-care program – a choice that turned out to be notably unsuccessful. This time, Mrs. Obama’s involvement was shrewdly chosen.

Politically, her support for veterans was designed to appeal to both friend and foe. It would satisfy Democrats who had become accustomed to a party line of supporting soldiers but not war and whose nostrils quivered at the scent of a victimized interest group. The President

was thought to be particularly unpopular with the military community and pro-military Republicans, so Ms. Obama’s stand couldn’t help but improve matters there.

Economically, Ms. Obama would be betting on a sure thing. The President’s wind-down of wars in Iraq and Afghanistan, coupled with Defense Department budget cuts, would gradually feed veterans into the civilian work force. Mrs. Obama’s strategy would portray them as if they were draftees coping with a painful readjustment amidst civilian indifference or even hostility,

a la the World War II vets in the movie

The Best Years of Our Life or the Vietnam vets of

Coming Home

.

Of course, nothing could be further from the truth than this pretense. The volunteer military has been working well for decades. In order to attract recruits, the military has had to offer not only wages and salaries sufficient to compensate soldiers for the opportunity costs of service, but also training in the skills and technological savvy necessary to run a modern military. To employers starved for job applicants with just those skills and training and the emotional maturity gained from military service, skilled vets are like raw meat to hungry lions. And even unskilled vets offer physically trained bodies coupled with mental self-discipline – two more attributes that are highly attractive to sectors like the construction industry.

What about the publicity given to returning vets suffering from forms of emotional trauma such as delayed stress? Could this have given rise to a bias adversely affecting the employment prospects of all returning veterans? Could Joining Forces play a role in overcoming this bias?

We will never know because Ms. Obama’s op-ed says nothing on the subject. We cannot very well grant Joining Forces the credit for overcoming a bias that may or may not exist and that the initiative has ignored. It is easy to understand why the First Wives might skirt the issue. They have no expertise in this area either and do not want to introduce an issue that can only detract from their otherwise favorable publicity.

So what role have the First Wives and Joining Forces played in the absorption of vets into the civilian work force? None whatsoever. They are the leader ducks scrambling to get in front of the formation. They are desperate to take credit for veterans’ inevitable success. No wonder, since this has been the only bona-fide economic success that the Obama administration has rubbed up against in recent years.

Why Has Business Cooperated in this Sham Initiative?

Ms. Obama’s op-ed makes it clear that businesses throughout the country have cooperated with the First Wives in professing solidarity with their initiative and making sympathetic noises toward veterans in general.

Our analysis shows that Joining Forces is a sham. Its motives are purely political. In economic terms, it is superfluous. The internal logic behind the project is so contradictory that the more contemplation it receives, the more ludicrous is becomes.

Why, then, have businesses been so cooperative with the First Wives? The obvious answers would seem to be: fear and prudence. Businesses have watched the conduct of the Obama administration. They have seen auto-company shareholders expropriated for the benefit of unionized employees. They have seen one regulatory agency after another launch assaults on industries in the form of new rules, regulations and policies. They have observed an entire Presidential campaign built around attacks on business success and a candidate who epitomized it. They saw the President’s approval rating remain consistently high throughout, suggesting that his actions resonated with a majority of the general public – not just the proverbial 47% that are supposedly dependent on government. Thus, they have every reason to fear the wrath of this administration and to avoid displeasing it if possible.

In this case, business leaders almost certainly reason that playing along with the sham of Joining Forces is a form of cheap insurance. They can make effusive public statements supporting the goals of the First Wives – talk is the cheapest form of political payoff. And they don’t even have to lie – at least not much. They can sign declarations of support and even make public “plans,” “announcements” and “commitments” – none of which contractually obligate them to anything and which the public will have forgotten about within days. The Obama administration has no intention of later holding their feet to the fire and checking to see if they follow through on that “commitment” to hire 100,000 veterans. (Follow-through would have everything to lose and nothing to gain, since the administration only cares about

seeming to cause veterans to be hired, not about actually

doing

it.) Businesses will certainly hire veterans, who constitute an attractive employment option. No economic archaeologist is going to later paw through the data to calculate whether veteran hires reached the promised total. As political blackmail goes, this is probably the cheapest form of protection these businesses will ever pay.

What’s the Harm?

Readers might wonder where the harm lies in allowing the First Wives their little deception. They aren’t altering the course of economic activity much by their actions. Perhaps this forestalls them from pursuing some more destructive pastime.

Willful deception practiced by government cannot be beneficial. Its effects will harm us both directly and indirectly. Waste and misdirection of resources are bad enough. But the misleading impression of an omniscient and confident government compensating for the ham-handed, ineffectual efforts of a short-sighted private sector establishes a precedent for future interventions. Each new intervention sets the stage for the one that follows. The success of a protection racket like this one emboldens and empowers politicians to attempt bigger and more expensive scams.

There is no conceivable rationale or defense for Joining Forces, the job-placement initiative for veterans begun by Madams Obama and Biden. Its economic benefits are entirely illusory. Its aims are purely political. It is big-government bunkum at its most cynical and demagogic. And this conclusion derives not from political animus, but rather from the straightforward logical implications of Ms. Obama’s own words.

DRI-201 for week of 1-12-14: No Bravos for Bernanke

An Access Advertising EconBrief:

No Bravos for Bernanke

Last weekend’s Wall Street Journal featured an op-ed by the former Chairman of President Obama’s Council of Economic Advisors, Austan Goolsbee. Goolsbee’s tenure obviously familiarized him with the chief requirement for policymaking success in a Democrat regime; namely, the ability to define success down. His op-ed, “Brave for Bernanke and the QE Era,” is a spectacular example of the art.

Goolsbee contrasts the enthusiastic reception given to Federal Reserve Chairman Bernanke’s farewell address to the American Economic Association convention with the wide-ranging criticism directed at Bernanke from across the political spectrum. He briefly summarizes the Fed’s policies under Bernanke, confining himself to the last 3 ½ years of the so-called QE (quantitative easing) Era. Bernanke’s imminent departure and the start of the “exit-strategy countdown” signaled by QE tapering mean that “it is time to take stock of the QE Era – and time for the critics to admit they were wrong.”

Partisan divisions being what they are, it is a foregone conclusion that Goolsbee’s call will not resonate with many on both sides of the political spectrum. But it is not necessary to invoke partisan politics to criticize it. Bernanke’s policies – and Goolsbee’s – are anathema to free-market economists. But one need not espouse laissez faire in order to gaze askance at Goolsbee’s case for Bernanke’s actions. Bernanke’s tenure should be viewed as a disaster regardless of one’s political preference or economic philosophy.

Indeed, the propriety of Bernanke’s policy choices is not up for debate at this point. They are what economists would call a sunk cost; their costs have been incurred (or are unavoidable) and can’t be changed or escaped. No doubt Bernanke should have chosen differently and we would be better off if he had done so. But the question before the house is: What were the actual results of his choices? Goolsbee finds those results to be very good and purports to explain why. We can and should quarrel with his verdict and his explanations.

Bernanke and Stimulus

“…Looking back…it is clear that the Fed was right to try to help improve the [economy] and the critics were wrong [about inflation].” Goolsbee assigns Bernanke’s policies a grade of A for activism.  The implication is that it is better for a Federal Reserve Chairman to do something rather than nothing, even if activism requires a program of unprecedented scope and unknown impact.

“Think back to the days before the 2008 crisis or recession. If confronted with the scenario that would follow – five years of GDP growth of only around 2% a year, five years of unemployment rates around or above 7%, core inflation consistently below 2% – the near-universal response of economists would have been for the Fed to cut interest rates.” But would economists have reacted that way knowing that all of these effects accompanied a policy of zero interest rates? It’s one thing to say “we should have cut interest rates and all these bad things wouldn’t have happened,” but quite another to say “all these bad things happened anyway in spite of our interest rate cuts.” An objective observer would have to consider the possibility that the interest rate cuts were the wrong medicine. Of course, Goolsbee pretends that this is unthinkable; that the only possible action in the face of adversity is cutting rates. But if that were really true, his review of Bernanke’s reign is a mere formality; Bernanke’s decisions were right by definition, regardless of result. In reality, of course, the zero-interest-rate policy was not a foregone conclusion but rather an evaluative action subject to serious question. And its results do not constitute a ringing endorsement.

To appreciate the truth of this, ponder the wildly varying conclusions reached by Keynesian economists who are not ideologically hostile to Bernanke and Goolsbee. Larry Summers considers macroeconomic policy under Obama a failure because the U.S. suffers from “secular stagnation.” He prescribes a cure of massive public spending to replace the structural collapse of private investment and private over-saving. While Bernanke cannot take the blame for the failings of fiscal policy, Summers criticizes him for not doing more to provide liquidity and increase (!) inflation. Summers’ colleague Paul Krugman is even more emphatic. Bernanke should crank up the printing press to create bubbles because wasteful spending by government and the private sector is necessary to create employment. Without waste and profligacy, unemployment will persist or even rise. Alan Blinder has the temerity to point out what free-market economists noticed years ago – that the money created by Bernanke was mostly sitting idle in excess bank reserves because the Fed had chosen to pay interest on excess reserves. But Blinder is too gentlemanly to ask the obvious question: If the money creation is supposed to be “economic stimulus,” why has Bernanke prevented the money from actually stimulating?

These Keynesian economists are the farthest thing from free-market, laissez faire doctrinaires. But they are not about to give Ben Bernanke a passing grade merely for showing up, trying hard and looking very busy.

To be sure, Goolsbee does make a case that Bernanke actually succeeded in stimulating the U.S. economy. He names two of his colleagues, fellow attendees at the AEA convention, whose “research indicates that [Bernanke’s] Fed policies have helped the economy, albeit modestly… they lowered long-term Treasury rates by about 30 basis points and a bit more for mortgage spreads and corporate bond yields…Americans were able to refinance their homes at more affordable rates, and the drop led to an increase in consumer spending on automobiles and other durables.” Fifty years ago, John Maynard Keynes’ picture appeared on the cover of Time Magazine as an avatar of the end of the business cycle. Now, our Fed prosecutes a policy characterized by a leading English central banker as “the greatest government-bond bubble in history,” and economists have to do research in order to dig up “modest benefits” of the policy that would otherwise go unnoticed. And Goolsbee offers them up with a straight face as the blessings that justify our gratitude to Ben Bernanke.

Bernanke and Inflation

“The QE Era did not create inflation. Not even close. The people who said it would were looking only at the growth in the monetary base… the people arguing that QE means simply printing money (it doesn’t, really) didn’t recognize that the policy was simply offsetting the reverse printing of money resulting from the tight credit channels in the damaged financial system.” Milton Friedman devoted the bulk of his career to refuting the claims of this type of thinking; it would require a lengthy article to review his insights and a book-length analysis to review the economics issues raised by Goolsbee’s nonchalant assertions. But one sentiment popularized by Friedman suffices to convey the concern of “the people” Goolsbee dismisses so condescendingly: “Inflation is always and everywhere a monetary phenomenon.”

At no point in human history has a monetary expansion like Bernanke’s occurred without leading to hyperinflation. So Bernanke’s critics are not a gaggle of tinfoil-hat-sporting, tennis-shoe-wearing conspiracy theorists. They have history on their side. Goolsbee’s confident assurance that Bernanke leaves office with inflation under control is based on a planted axiom the size of an iceberg; namely, that Bernanke’s successor(s) can somehow corral the several trillion dollars of excess reserves still loitering around the financial system before they emerge into circulation in the form of expenditures chasing a limited stock of goods and services. But that’s only the beginning; the Fed must also conduct this money wrangling in such a way as to keep interest rates from rising too greatly and thereby dealing the economy a one-two death blow of overwhelming government debt service and private-sector constriction of economic activity. It is not immediately obvious how this might be accomplished.

Friedman made a case that the Great Depression began in the early 1930s with bank failures that had a multiple contractionary effect on the U.S. money supply. Like generals always fighting the last war, the Fed has since been grimly determined not to be hung for monetary tightness. As F.A. Hayek pointed out, a central bank that always errs on the side of loose money and inflation and never on the side of tight money or deflation will inevitably bias its policy toward inflation. That is the status quo today. Japan’s longtime low inflation is miscalled “deflation,” thereby providing a rhetorical justification for revving up the inflationary printing press. A similar boomlet is building here in the U.S.

Presumably, this explains Goolsbee’s reference to QE credit creation as an offset to credit destruction. But whether you accept Friedman’s analysis or not, Goolsbee’s rationale doesn’t hold water. The bank bailouts of 2008-09 – which were forced on sound banks and shaky ones alike by the Fed and the Treasury – were explicitly sold as a means of guaranteeing financial liquidity. QE did not come along until mid-2010. By then, banks had already repaid or were repaying TARP loans. Thus, Goolsbee cannot sell the QE Era as the solution to a problem that had already been solved. Instead, the evidence favors QE as the palliative for the financial problems of the U.S. Treasury and the spending addiction of the U.S. Congress – matters that Goolsbee delicately overlooks.

Bernanke and Greenspan: The Perils of Premature Congratulation

When Alan Greenspan left office, he had presided over nearly two decades of economic prosperity. The news media had dubbed him “The Maestro.” It is not hard to understand why he was showered with accolades upon retirement. Yet within a few short years his reputation was in tatters. Bernanke gave us an industrial-strength version of Greenspan loose-money policies. But the economy spent most of Bernanke’s tenure in the tank. And Bernanke leaves office having bequeathed us a monetary sword of Damocles whose swing leaves our hair blowing in its breeze.

With the example of Greenspan still fresh in mind, we can justifiably withhold judgment on Bernanke without being accused of rank political prejudice.

Bernanke as Savior

“…We should all be able to agree that fashion standards during a polar vortex shouldn’t be the same as in normal times.” Goolsbee is suggesting that Bernanke has adopted the stern measures called for by the hard times thrust upon him. This is indeed the leitmotiv for economic policy throughout the Obama Administration, not merely monetary policy – hey, just imagine how much worse things could have been, would have been, had we not done what we did. In order for this alibi to stand up, there must be general agreement about the nature and size of the problem(s) and the remedy(ies). Without that agreement, we cannot be sure that Bernanke hasn’t worsened the situation rather than helping it – by addressing non-existent problems and/or applying inappropriate solutions.

In this case, we have had only the word of Chairman Bernanke and Treasury Secretary O’Neill (under President Bush) that economic collapse was threatened in 2008. Despite the wild talk of imminent “meltdown,” none occurred. Indeed, there is no theoretical event or sequence that would meet that description in economics. General economic activity worsened markedly – after the bailout measures were authorized by Congress. The emergency stimulus program did not affect this worsening, nor did it effect the official recovery in June 2009; stimulus funds were so slow to reach the economy that the recovery was well underway by the time they arrived.

The QE program itself has been advertised as “economic stimulus” but is notable for not living up to this billing. (To be sure, this is misleading advertising for the reasons cited above.) If anybody feels grateful to Bernanke for launching it, it is presumably officials of the Treasury and Congress – the former because QE prevented interest rates from rising to normal levels that would have swamped the federal budget in a debt-service tsunami, the latter because the precious spending programs beloved of both parties were spared. But Goolsbee comes nowhere within sight or shouting distance of these financial truths.

It makes sense to hail a savior only when you have reached safety. We haven’t even crossed the icy waters yet, because we’ve had the benefits – tenuous though they’ve been – of QE without having to bear the costs. In other words, the worst is yet to come. Bernanke has made all of us protagonists in an old joke. A man jumps out of a skyscraper. As he falls toward earth, the inhabitants of the building on each successive lower floor hear him mutter, “Well – so far, so good.”

The Politicization of Economics

Why make so much of Austan Goolsbee’s valedictory salute to Ben Bernanke? If the quality of Bernanke’s economic policy is a sunk cost at this point, doesn’t that also moot our assessment of his job performance? If Austan Goolsbee has badly misjudged that performance, that doesn’t say much for Goolsbee, but why should we care? After all, Goolsbee is no longer employed by the Obama Administration; he is now safety ensconced back in academia.

Goolsbee’s judgments matter because they are clearly motivated by politics. They are part of a disturbing pattern in which liberal economists provide a thin veneer of economics – or sometimes no economics at all – to cover their espousal of left-wing causes. Goolsbee pooh-poohs the claim that QE was both dangerous and unnecessary, claiming that the rise in the stock market is not a bubble because it has “tracked increases in corporate earnings.” But earlier in the same article, Goolsbee claimed that QE lowered long-term interest rates on Treasuries and corporate bonds (thus reducing costs of corporate finance) and increased spending on consumer durables. So QE induced increases in corporate earnings that wouldn’t otherwise have occurred, causing increased stock prices – but is absolved from charges of creating a stock bubble because the stock prices were caused by autonomous increases in corporate earnings? Goolsbee claims credit for QE on Bernanke’s behalf at one stage, and then disclaims QE’s influence on exactly the same point at another. This is the type of circular contradiction masquerading as economics that Goolsbee and other Keynesians use to sell their politics.

“Forgoing the Fed’s unconventional monetary policies – inviting real and quantifiable damage to the economy – just to prevent the possibility of a potentially dangerous bubble forming somewhere in the economy would have been cruel and unnecessary,” Goolsbee concludes. Foregoing the “modest benefits” that Goolsbee’s pals managed to dig up merely because the Fed had to create “the greatest government-bond bubble in history” in order to generate them would have been “cruel and unnecessary.” Oh, wait – what about the loss of interest income suffered by hundreds of millions of Americans – many of them retirees, the disabled and other fixed-income investors – thanks to the zero-interest-rate policy ushered in by the QE Era? Was this cruel and/or unnecessary? Goolsbee delicately avoids the subject.

But Goolsbee’s fellow Keynesian, Paul Krugman, is not so circumspect. Krugman comes right out and says that nobody has the right to expect a positive interest return on safe assets while the economy was in a depression; they can either make do with an infinitesimal interest return or lose the value of their money to inflation. (In the same blog post, Krugman had previously accused his critics of callous indifference to the pain caused by business liquidations in a depression.)

This is not economics. It is half-baked value judgment hiding behind the mask of social science. Similarly, Austan Goolsbee’s evaluation of Ben Bernanke’s term as Federal Reserve Chairman may have the imprimatur of economics, but it lacks any of the substance.