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-287 for week of 8-31-14: The Hollywood Blacklist as an Economic Phenomenon

An Access Advertising EconBrief:

The Hollywood Blacklist as an Economic Phenomenon

Very few people will ever develop an econometric model. Even fewer will use abstruse mathematics to formulate economic theory. A larger subset of the population is called upon to interpret the output of these economic tools, but this group is still microscopically small. To pinpoint the practical value of an economic education, we will have to look elsewhere.

Economics should enable us to understand the “blooming, buzzing confusion” of our daily life, to borrow the characterization of a 19th-century historian. Indeed, the great historical questions of yesterday should yield their mysteries to basic economic logic.

No economic exercise is as deeply satisfying as the parsing of a great historical dispute or debate using economics. When this exercise overturns the conventional thinking, it is one of life’s most exhilarating moments.

The famous Hollywood Blacklist is a ripe subject for this economic treatment.

The Blacklist as Portrayed by the Political Left

The stylized portrayal of the Blacklist by the political Left begins in the 1930s, when numerous actors, actresses, screenwriters and other rank-and-file motion-picture personnel were strongly attracted by the tenets of socialism and Communism. Indeed, for many Communism was the practical embodiment of socialism. This attraction led them to participate in rallies, join organizations and make contributions in kind and in cash to the socialist and Communist movements. Some even joined the Communist Party, but these were mere flirtations, more emotional than intellectual. Almost all of these Party memberships were short, transitory affairs that, however, would later come back to haunt the participant.

Even the biggest movie stars were contractual employees of the big movie studios. The operational heads of the studios, moguls like Louis B. Mayer of Metro Goldwyn Mayer, Darryl F. Zanuck of Twentieth Century Fox and Harry Cohn of Columbia Pictures, were fanatically dedicated to the profits returned by their movies. This led them to take an unseemly interest in the private lives of their actors and actresses, even to the point of influencing the stars’ marital, pre-marital and extra-marital pursuits. The moguls feared that unfavorable publicity about a star would destroy his or her box-office value.

After World War II, American attitudes toward the Soviet Union underwent a reversal. The public became inordinately fearful of Russia and of Communism. This wave of emotion was typical of a country that was governed by a chaotic, competitive spirit rather than by a tightly regulated bureaucracy run by left-wing intellectuals, or what the radical economist Thorstein Veblen had called a “Soviet of engineers.” The same spirit had made America society racist (anti-black, anti-immigrant) and sexist (anti-woman). Now it had become “anti-Communist,” which was the same thing as anti-intellectual, anti-democratic and fascist. After all, the Fascists and Communists had opposed each other in the Spanish Civil War prior to World War II, hadn’t they?

This inordinate fear was exploited by Senator Joseph McCarthy of Wisconsin, who used his government investigative committee as a tool to further his political career by pretending to expose Communists operating in government and virtually every other nook and cranny of institutional America. The Left originated the term “McCarthyism” and used it as shorthand for the Cold War anti-Communist mentality and all its representations.

The moguls were less interested in anti-Communism as a political project than for its financial implications on their industry. They feared that the public would associate the left-wing sympathies of their actors, actresses and screenwriters with Russian Communism. This potential linkage threatened studio profits.

Thus was born the Blacklist. The moguls commissioned their sycophantic underlings and outside organizations, such as the newsletter Red Channels, to provide lists of Hollywood artists who were current or former Communist Party members. Those on the list were blacklisted – they could no longer work. The lists were compiled partly by offering an inducement: Those “naming names” of other current or former Party members would be spared punishment. The question “Are you now or have you ever been a member of the Communist Party?” became associated with the House Committee on Un-American Activities and McCarthyism in general.

The Left saw the dilemma faced by witnesses testifying before security hearings as a Catch 22. A witness admitting current or former Communist Party membership would subsequently be blacklisted. A witness refusing to “inform” on his friends and/or colleagues would also be blacklisted. A witness citing his or her Fifth Amendment right against self-incrimination as justification for a refusal to testify would be blacklisted. But a witness who testified and named names could work only at the cost of eternal damnation – by universal understanding, the most despised and despicable of all human beings is an Informer.

Thus, the Blacklist is pictured as an intellectual Dark Age, a dark night of the American soul. Some blacklistees (John Garfield, J. Edward Bromberg) were so traumatized by their plight that they died from the stress. Others (Larry Parks) suffered permanent destruction of their careers. Most (Lee Grant, Dalton Trumbo, Carl Foreman, Marsha Hunt, Michael Wilson, Jules Dassin) lived in literal or figurative exile for one or two decades, suffering financial reverses and emotional isolation. A few (Edward G. Robinson) coped with a quasi-blacklist (“greylist”) that produced similar but less severe effects.

The Blacklist hovered like a great plague over the land for many years until it finally ended suddenly in the early 1960s. The heroic Kirk Douglas (or, in some retellings, the heroic Otto Preminger) openly hired long-blacklisted screenwriter Dalton Trumbo, thus breaking the back of the Blacklist.

The Blacklist as Seen Through the Lens of Economics

If the left-wing tale of the Blacklist has a fairy-tale quality, that is apt. Despite the acceptance and even reverence with which it is treated, it makes little sense. The principals behave in unreal ways, unlike actual human beings impelled by rational motives. The portions of the story that are correct are woefully incomplete. The rest is inaccurate. Most misleading of all is the complete absence of economic logic from the tale.

America’s “inordinate” fear of Communism. To be sure, fear is a prime mover of human action. But fear is conditioned and shaped by our rational understanding of the world around us. After World War II, the Soviet Union’s public face was rapidly transformed. Russia blockaded Berlin. It invaded or formally occupied Eastern Europe. After a few years, it acquired nuclear weapons that it pointed at the U.S. It aided its client states in the export of Communism throughout the world and indirectly fought the U.S. by aiding North Korea against South Korea. Eventually, the confluence of all these actions resulted in the term “Cold War.”

We know now what we strongly suspected then – that the Soviet Union had unleashed the worst campaign of mass murder in human history during the 20th-century’s first half. Joseph Stalin supervised the killing of more Jews than did Adolf Hitler and killed more of his own citizens than did the Nazis in wartime. We also know that the America Communist Party was the Soviet espionage apparatus in the U.S.

Given all this, the fear of Soviet Russia does not seem “inordinate.” Moreover, the actions of the Communist Chinese subsequent to the fall of Nationalist China in the late 1940s validate the fear of Communism generally. Red China did not export terror and death to the extent that Soviet Russia did. But their murderous reign within China itself surpassed even Stalin’s butchery.

In this light, the American reaction against Communism seems mild and tentative. And indeed we know that prior to the accession of Ronald Reagan to the Presidency in 1980, the Cold War was all but lost. While the American public displayed a well-founded a prophetic fear of Communism, our intellectual elites showed a shocking indifference to it. This began with the attempts by the Truman administration to cover up the discovery of high-level Communist penetration of the U.S. State Department and continued with the friendliness shown to Communist dictators by the American intelligentsia and to Marxist ideology by the American academy. Marxist economics has long exceeded free-market economics in popularity at American universities. Mainstream economics textbooks, notably the best-selling Economics by Nobel laureate Paul Samuelson, touted the superiority of Communist central planning to American free markets in promoting economic growth right up to the day when the Soviet Union collapsed.

Time after time, the American public’s fear of Communism was validated while the American elites’ acceptance of it was not.

The Moguls and the Blacklist. The Left portrays the Hollywood Moguls as craven cowards because they were profit-motivated. Of course, when those same moguls occasionally dabbled in politics without a business rationale, the Left excoriated them for that as well. This leads us to suspect that the Left simply approved of the Communist sympathies of the blacklistees.

Left-wing intellectuals criticized corporations in the 1930s for putting the interests of executives ahead of shareholder and consumer interests. Yet here the moguls are criticized for doing just the opposite. Using the Left’s own premise – but applying it within the model of economic logic – the moguls were safeguarding the interests of consumers and shareholders when they instituted the Blacklist.

The movie moguls developed – or, more accurately, stumbled upon – the “star system” of moviemaking as a way of stimulating movie attendance by focusing their attention on movie stars. This system worked so well that in the 1930s and 40s, average weekly movie-theater attendance approached the population of the entire country. (Today it languishes at 10-15% of U.S. population.) The leading actors and actresses may have been salaried employees, but they were the best-paid people in the nation – behind only the moguls themselves.

The appeal of the stars rested on the image they projected. Of course, audiences knew that Clark Gable was not really a reporter or a British naval officer and Errol Flynn was not really a pirate or a medieval aristocrat-turned-rebel-bandit. But they believed that the roles were extensions of the stars’ true personalities – Gable’s as a straightforward, aggressive male and Flynn’s as an irresistible cavalier. Ditto for Gary Cooper as a man of few words and James Stewart as hesitant and bashful.

In order to keep their profit machine humming, the moguls inserted morals clauses in studio contracts allowing termination for “moral turpitude” or anything that would destroy the good will vested in those personalities. From the standpoint of consumers – and therefore from the standpoint of shareholders and the moguls as well – a movie star was a product consisting not wholly but largely of image. A mogul that ignored the image projected by a star would have been derelict in professional duty.

Communism was a label that threatened a studio’s brand just as (for example) genetic modifications affect the brand of certain foods today. The comparison is apt. Communism was a genuine threat, regardless of whether or not any actor or actress really ever espoused Communist doctrine. Genetic modification, on the other hand, is a bogeyman whose dangers are illusory. But in both cases, the relevant consideration was and is what consumers think rather than objective truth. Consumer beliefs, truth aside, will govern their actions and the marketplace outcome. Consequently, moguls must act on their perception of what consumers perceive.

The moguls accurately judged that any actor or actress linked to Communism would be box-office poison, as would any writer whose words were being spoken on screen. Therefore, they had to purge their industry of Communists and suspected Communists – and do so in the most visible way possible. After all, any executive could, and presumably would, say that there were no Communists working for him. But the Blacklist was an exercise in product labeling – just the sort of thing that the political Left likes and even demands from corporations. The moguls were trying to obtain independent certification that their motion-picture product was “Communist -free.” Audiences could safely admire the actors and actresses appearing in it; they could safely consume the spoken and visual content contained within it. If the moguls had been selling apples, the Left would surely have admired the energy and determination devoted to preserving the purity and wholesomeness of the product.

But since we were talking movies, the Left was outraged by the Blacklist.

The Blacklist helped usher in an undemocratic reign of terror in America. Nothing prevented the dozens of competing movie studios and independent movie producers from advertising their movies by saying “we employ Communists and former Communists” or “we cast Fifth-Amendment-takers in our productions.” If the public was indifferent to this or even pleased by the idea, they could have flocked to these competing movies and enriched the maverick studios and producers. Of course, that didn’t happen because the public held no such beliefs. The moguls were neither craven cowards nor undemocratic tyrants. They were doing exactly what producers are supposed to do in a free market and what the Left criticizes producers for not doing: catering to consumers by insuring the quality of their product, thereby catering to shareholders by safeguarding profits.

The Blacklist was undemocratic and unfair because it denied blacklistees the means of earning a living. This is completely untrue. At worst, blacklistees were denied the ability to work in Hollywood productions. That is, they were denied the same thing that actors and actresses are denied when they are not cast and writers are denied when their scripts are rejected – which is the fate of the overwhelming majority of all actors, actresses and writers. In this case, the denial was figuratively stamped “unsuitable due to Communism.” This was a subjective evaluation, just as all rejections are subjective. Of course, the particular artist involved will take the blow hard and view it as unfair – just as all rejects do when consumers prefer the work of somebody else.

At all events, the so-called “victims” of the Blacklist were not denied the “right to work.” Movie actors went abroad and worked. Michael Wilson and Dalton Trumbo wrote Oscar-winning scripts submitted under false names while working and earning income abroad. Other blacklistees worked on Broadway or on television. And of course, nothing prevented them from – hold on to your seats here – getting an ordinary job and earning an ordinary living instead of earning thousands of dollars per week in Hollywood while the average American wage was less than five thousand dollars per year. Indeed, from among the few hundred documented Blacklist cases, it is often difficult to sort out those people whose Hollywood careers were ended by the Blacklist from those whose careers petered out naturally. In Hollywood as in professional sports, the average career is short though often sweet.

Among the victims of the so-called “greylist,” Edward G. Robinson made 13 movies during the short time period when he was allegedly greylisted. All but one of these was for American studios, mostly major ones. Of course, his roles were not necessarily plum ones, but that was certainly because his career was declining both before and after the Blacklist. For those whose career proved disappointing, claiming victimization by the Blacklist has provided compensation for the recognition fate denied them and an excuse for failing to justify their own expectations of success.

The Blacklist was evil because McCarthyism itself was evil and threatened America with dictatorship. We have shown that, far from being evil, the Blacklist was a product of free-market economics at work. The Left excoriates free-market economics when it fails – or supposedly fails – then turns around and excoriates it for succeeding while correcting its supposed errors. But even more ridiculous is the fact that the Hollywood Blacklist – today almost always linked with McCarthy and McCarthyism even by those caught in its toils – had nothing whatever to do with Joe McCarthy.

Senator Joseph McCarthy was elected to the Senate from Wisconsin in 1946. But he was virtually unknown to most of America until he made a speech in Wheeling, West Virginia in 1950. The speech concerned Communists that McCarthy alleged to reside in the U.S. State Department, not in Hollywood. And throughout McCarthy’s subsequent career, Communists in Hollywood were not an issue raised by McCarthy. McCarthy’s Senate Committee was Government Operations, not too surprisingly in view of his preoccupation with Communists in government. The government committee most often concerned with Communists in Hollywood was not even in the Senate – it was the notorious House Committee on Un-American Activities (HUAC).

Hollywood Communism made national headlines in 1947 when the so-called Hollywood Ten were called to testify before HUAC. These were a group of actors, writers and directors who were known to be current or former members of the Communist Party. They included now-famous names like writer Dalton Trumbo and director Edward Dmytryk. In his memoir Odd Man Out, Dmytryk confirms that all of the Hollywood Ten were indeed current or former Party members. He recounts how the appearance of the Ten before Congress was orchestrated by the Party and how non-Communist Hollywood liberals like Humphrey Bogart, Lauren Bacall, Gene Kelly and Danny Kaye were duped into supporting the Ten. The Party line was that the Ten were exercising their First Amendment rights of free speech and free association. After all, Communist Party membership was legal.

But when the hearings began, Dmytryk was astonished to find that the Ten uniformly pleaded their Fifth Amendment right against self-incrimination to avoid answering questions and having to name names. Their testimony consisted of diatribes against the Committee in a Communist-Party vein. This episode reinforced Dmytryk’s resolve to quit the Party and sever his ties with his Leftist colleagues. His refusal to name names led to a prison sentence for contempt of Congress, after which Dmytryk emerged one year later to testify again and salvage his career by naming the names of his Party colleagues.

In 1947, McCarthy sat in Congress but was uninvolved in the Hollywood Ten episode. He played no part in the Hollywood Blacklist. By the time McCarthy delivered his Wheeling speech, the Blacklist had already been established. McCarthy played no part in it; he was concerned with security risks in government (the State Department) and the military (the Army). McCarthyism, whatever it was or meant, was a phenomenon of the 1950s, while the Blacklist was the outgrowth of the Cold War security debates that began in the 1940s.

McCarthy is notorious today for claiming that large numbers of Communists were employed in government without naming any names. (“He never produced a single Communist.”) As is usually the case, the Left is wrong. McCarthy did name names and was usually right about those he named, such as Owen Lattimore. He also named numbers, but the numbers did not refer to those currently employed but rather Communists known to have operated within government. We know now that substantial numbers of Communist agents operated within the State Department, for example, and the exact number is not of paramount importance today because we are still uncovering more. All this is irrelevant to the Hollywood Blacklist.

The Blacklist was evil because (a) the blacklistees were never Communists (b )the blacklistees had every right to be Communists and still remain employed in Hollywood (c)anti-Communism was evil by definition (d) choose any one or all of the above. Perhaps the most amazing facet of the Left’s portrayal is its fuzziness. When discussing blacklistees like Larry Parks, the Left implies that all blacklistees were innocent victims who were selected at random by Red Channels or victimized by John Wayne, Ward Bond or an anonymous grudgeholder. It is true that fellow actors at the Motion Picture Alliance, including stars like Wayne, were involved in the interviews prepatory to blacklisting. By blacklisting a fellow performer, MPA officials might leave themselves open to a charge of thinning the ranks of their competition. But every blacklistee was a potential employee of the studio; this was the opportunity cost incurred by the moguls. They had no incentive to be randomly vicious or inaccurate, since they were cutting their own throats by doing so – and the object of the exercise was to preserve their profits, not squander them. Presumably, this is why prospective blacklistees were always given an out, either by naming names or by pleading innocence with sufficient eloquence. This latter course was taken by various stars, including Lucille Ball and James Cagney.

The Left has gotten a lot of mileage out of the implication that the blacklistees were all, or mostly, innocent. But the problem is that this does not imply that the investigations of Communist infiltration of Hollywood were wrong; it implies that there was not enough investigation. Even if the moguls had done nothing, if Red Channels and the MPAA had never existed, the American public’s well-founded fear of Communism would have remained. The investigations did not convict innocent people of being Communists; they gave people under suspicion the opportunity to absolve themselves. Those who seized the opportunity – e.g., most people involved – emerged better for the process.

When the subject changes to avowed Communists like Dalton Trumbo, the Left abruptly changes its tune to focus on the unfairness of denying the writer his right to write, to earn income, support his family, etc. But what the Left is defending is not a right but rather Trumbo’s power to force people to hire him when his qualifications for hire no longer pass muster. While Trumbo would have protested that he was still the same writer he always was, the truth was that his qualifications did not consist solely of his writing talent. He also had to be free of moral taint. Would the Left defend O. J. Simpson’s “right” to work as an actor today even after a civil conviction for murder? Would they have defended Lord Haw Haw’s right to remain employed as an announcer after he worked for the Nazis in World War II?

Indeed, suppose the word “Communist” in the entire Blacklist controversy were to be replaced by the word “Nazi” – would the Left still take the same anti-blacklist position? Of course, we all know that the answer to that question is “no.” Right-wing writers like Ayn Rand and Morrie Ryskind were subjected to the Left’s own Blacklist after they objected to the Communist penetration of Hollywood. In the ensuing years, nobody on the Left has come to their defense.

The Blacklist killed blacklistees. The few blacklistees who died, including John Garfield and J. Edward Bromberg, had pre-existing medical conditions. (Garfield’s heart condition exempted him from military service in World War II.) Medical science lacks the capability of assigning causation to an external event like the Blacklist, which is one of many potential stressful events that might or might not contribute to death.

The overarching question, though, is why any moral opprobrium should attach to the Blacklist. The moguls had no incentive to kill Garfield or Bromberg. If nobody intended to cause the deaths, then the Blacklist is like any other stressful event. All kinds of morally innocuous actions might conceivably result in a death without adversely transforming the character of the action.

The Blacklist was an anti-competitive cartel. Intriguingly, this argument was advanced not by the Left but by free-market economist Milton Friedman in his book Capitalism and Freedom. Its problem is that it fails to distinguish between actions taken simultaneously and those taken in concert. To use the O.J. Simpson case again, it is obvious that Simpson became unemployable the moment he killed Nicole Simpson. Hollywood moguls did not need to collude to achieve that outcome. The same is true of the Hollywood Blacklist. If simultaneous actions taken to insure product quality are “collusion,” then the word has been distorted beyond all semblance of meaning.

The Blacklist was not destroyed by the heroic actions of Kirk Douglas or Otto Preminger in hiring Dalton Trumbo (to write Spartacus or Exodus, respectively). The Blacklist was already a dead letter by 1960, then these movies were produced. It was killed by the death of anti-Communism, which died when Joe McCarthy was discredited during the Army-McCarthy hearings in 1956. If Douglas or Preminger had hired Trumbo in 1953, that would have been courageous. But they didn’t because – at that point – it would also have been suicidal.

Forcing witnesses to inform to keep their jobs is immoral. The injunction against informing is the heart of the criminal code. (It is even the title of a cult-movie classic from 1931, Howard Hawks’ The Criminal Code.) Without informing, police would be unable to solve most criminal cases; even with the sophisticated technology aired on television shows like CSI, the solution of most crimes depends on confession and prying information out of witnesses. The technique of threatening knowledgeable parties with sanctions in order to induce testimony is perhaps the most venerable – and successful – of all police techniques.

The position taken by the Left aligns it perfectly with the criminal element, which tries to preserve collusion between criminals against the substantial inducements for confession. It is those economic incentives that persuaded Dmytryk and others, such as director Elia Kazan and actor Lee J. Cobb, to relent and name names.

It is unfair that people should be held accountable for past actions that led to unforeseeable consequences such as blacklisting. When people publish embarrassing photos or posts about themselves on the Internet, they give hostages to fortune. Yet the prevailing sentiment today seems to be that they should have known better. If anybody should have known better, it was Hollywood actors with morals clauses in their lucrative contracts. Communism was both controversial and popular in the 1920s and 30s. During World War I, the “Palmer Raids” had set a precedent for government interference with the exercise of a right to practice Communism. Yet an illusion of invulnerability and messianic notions of social responsibility persuaded countless Hollywood figures that their moral duty lay in following the red star of Communism.

If people choose to offer sympathy for former Communists, that is their business. Most of the original editors of the conservative magazine National Review were former Communists. They rebuilt their lives despite this youthful misstep by forcefully changing direction and repudiating their past. That is exactly what too many Hollywood Communists were unwilling to doand that is why we owe them no sympathy, just as we owe their arguments no respect.

DRI-284 for week of 7-13-14: Why Big Government is Rotten to the Core: The Tale of the Taxpayers’ Defender Inside Federal Housing

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Why Big Government is Rotten to the Core: The Tale of the Taxpayers’ Defender Inside Federal Housing

Today the trajectory of our economic lives is pointed steeply downward. This space has been disproportionately devoted to explaining both how and why. That explanation has often cited the theory of government failure, in which the purported objects of government action are subordinated to the desires of politicians, bureaucrats, government employees and consultants. Economists have been excoriated for sins of commission and omission. The resulting loss of personal freedom and marketplace efficiency has been decried. The progressive march toward a totalitarian state has been chronicled.

A recent column in The Wall Street Journal ties these themes together neatly. Mary Kissel’s “Weekend Interview” column of Saturday/Sunday, July 12/13, 2014, is entitled “The Man Who Took On Fannie Mae.” It describes the working life of “career bureaucrat” and economist, Edward DeMarco, whose most recent post was acting director of the Federal Housing Finance Agency. Ms. Kissel portrays him as the man “who fought to protect American taxpayers” and “championed fiscal responsibility” in government. As we shall see, however, he is really integral to the malfunctioning of big government in general and economics in particular.

The Career of Edward DeMarco

Edward DeMarco is that contradictory combination, a career government bureaucrat who is also a trained economist. He received a PhD. in economics from the University of Maryland in the late 1980s and went to work for the General Accounting Office (GAO). As “low man on the totem pole,” he was handed the job of evaluating Fannie Mae and Freddie Mac. They had been around since the 1930s but were known to few and understood by fewer in Congress. The decade-long-drawn-out, painful series of savings-and-loan bailouts had scalded the sensibilities of representatives and regulators alike. DeMarco’s job was to determine if Fannie and Freddie were another bailout landmine lying in wait for detonation.

His answer was: yes. The implicit taxpayer backstop provided to these two institutions – not written into their charter but tacitly acknowledged by everybody in financial markets – allowed them to borrow at lower interest rates than competitors. This meant that they attracted riskier borrowers, which set taxpayers up to take a fall. And the Congressional “oversight” supposedly placing the two under a stern, watchful eye was actually doing the opposite – acting in cahoots with them to expand their empire in exchange for a cut of the proceeds.

DeMarco sounded the alarm in his report. And sure enough, Congress acted. In 1992, it established the Office of Federal Housing Oversight (OFHO). A triumph for government regulation! A vindication of the role of economics in government! A victory for truth, justice and the American way!

Yeah, right.

DeMarco pinned the tail on this donkey right smack on the hindquarters. “‘The Fannie and Freddie Growth Act,'” he called it, “because it told the market ‘Hey, we really care about these guys, and we’re concerned about them because they’re really important.'” In other words, the fix was in: Congress would never allow Fannie and Freddie to fail, and their implicit taxpayer guarantee was good as gold.

This was the first test of DeMarco’s mettle. In that sense, it was the key test, because the result jibed with the old vaudeville punchline, “we’ve already agreed on what you are; now we’re just haggling about the price.” As soon as the ineffectual nature of OFHO crystallized, DeMarco should have screamed bloody murder. But the “low man on the totem pole” in a government bureaucracy can’t do that and still hope for a career; DeMarco would have had to say sayonara to the security of government employment in order to retain his integrity. Instead, he kept his mouth shut.

Kissel discreetly overlooks this because it doesn’t jibe with her picture of DeMarco as heroic whistleblower. She is acting as advocate rather than journalist, as editor rather than reporter.

Any doubts about the fairness of this judgment are dispelled by Kissel’s narrative. “After stints at the Treasury and Social Security Administration, DeMarco found himself working at the very oversight office that his reports to Congress had helped create.” Oh, he “found himself” working there, did he? At the very office that had doublecrossed and betrayed him? “It was 2006, when Fannie and Freddie’s growth had been turbocharged by the government’s mortgages-for-all mania. Mr. DeMarco recalls that during his ‘first couple of weeks’ at the agency, he attended a conference for supervision staffers organized to tell them ‘about great, new mortgage instruments’ – subprime loans, he says, with a sardonic chuckle.” But what exactly did he do about all this while it was in progress, other than chuckling sardonically?

The first twenty years of Edward DeMarco’s career illustrate the workings of big government to a T. They depict the “invisible handshake” between orthodox, mainstream economics and the welfare state that has replaced the “invisible hand” of the marketplace that economics used to celebrate.

The Mainstream Economist as Patsy for Politicians and Bureaucrats

Mainstream economists are trained to see themselves as “social engineers.” Like engineers, they are trained in advanced mathematics. Like engineers, they are trained as generalists in a wide-ranging discipline, but specialize in sub-disciplines – civil, mechanical and chemical engineering for the engineer, macroeconomics and microeconomics for the economist. Like engineers, economists hone their specialties even more finely into sub-categories like monetary economics, international economics, industrial organization, labor economics, financial economics and energy economics. Economists are trained to think of themselves are high theoreticians applying optimizing solutions to correct the failures of human society in general and markets in particular. They take it for granted that they will command both respect and power.

This training sets economists up to be exploited by practical men of power and influence. Lawyers utilize the services of economists as expert witnesses because economists can give quantitative answers to questions that are otherwise little more than blind guesses. Of course, the precision of those quantitative answers is itself suspect. If economists really could provide answers to real-world questions that are as self-assured and precise as they pretend on the witness stand, why would they be wasting their lives earning upper-middle-class money as expert witnesses? Why are they not fabulously rich from – let us say – plying those talents as traders in commodity or financial markets? Still, economists can fall back on the justified defense that nobody else can provide better estimates of (say) wages foregone by an injured worker or business profits lost due to tortious interference. The point is, though, that economists owe their status as experts to default; their claim on expertise is what the late Thorstein Veblen would call “ceremonial.”

When economists enter the realm of politics, they are the veriest babes in the savage wood. Politicians want to take other people’s money and use it for their own – almost always nefarious – purposes. They must present a pretense of legitimacy, competence and virtue. They will use anybody and everybody who is useful to them. Economists hold doctorates; they teach at universities and occupy positions of respect. Therefore, they are ideal fronts for the devices of politicians.

Politicians use economists. They hire them or consult with them or conspicuously call them to testify in Congress. This satisfies the politicians’ debt to competence legitimacy, competence, virtue and conscience (if they have one). Have they not conferred with the best available authority? And having done so, politicians go on to do whatever they intended to do all along. They either ignore the economist or twist his advice to suit their intentions.

That is exactly what happened to Edward DeMarco. His superiors gave him an assignment. Like a dutiful economist, he fulfilled it and sat back waiting for them to act on his advice. They acted, all right – by creating an oversight body that perverted DeMarco’s every word.

Deep down, mainstream economists envision themselves as philosopher kings – either as (eventual) authority figures or as Talleyrands, the men behind the throne who act as ventriloquists to power. When brought face-to-face with the bitter disillusion of political reality, they react either by retreating into academia in a funk or by retreating into their bureaucratic shell. There is a third alternative: occupational prostitution. Some economists abandon their economic principles and become willing mouthpieces for politicians. They are paid in money and/or prestige.

It is clear that DeMarco took the path of bureaucratic compliance. Despite the attempt of WSJ’s Kissel to glamorize his role, his career has obviously been that of follower rather than either leader or whistleblower. His current comments show that he harbors great resentment over being forced to betray his principles in order to make the kind of secure living he craved.

For our purposes, we should see him as the wrong man for the job of taxpayers’ defender. That job required an extraordinary man, not a bureaucrat.

DeMarco, DeMartyr

The second career of Edward DeMarco – that of “DeMarco, DeMartyr” to the cause of fiscal responsibility and taxpayer interests, began after the housing collapse and financial panic of 2008. After bailout out Fannie and Freddie, Congress had to decide whether to close them down or reorganize them. They fell back on an old reliable default option – create a new agency, the Federal Housing Finance Agency, whose job it was to ride herd on the “toxic twins.” When FHFA’s director, James Lockhart, left in August, 2009, Treasury Secretary Timothy Geithner appointed DeMarco as acting director.

DeMarco began by raising executive salaries to stem the exodus of senior management. This got him bad press and hostility from both sides of the Congressional aisle. DeMarco set out to reintroduce the private sector to the mortgage market by reducing loan limits and shrinking the mortgage portfolios of Fannie and Freddie. But we shouldn’t get the wrong idea here – DeMarco wasn’t actually trying to recreate a free market in housing. “I wasn’t trying to price Fannie and Freddie out of the market so much as get the price closer so that the taxpayer capital is getting an appropriate rate of return and that, more important, we start selling off this risk,” DeMarco insists. He was just a meliorist, trying to fine-tune a more efficient economic outcome by the lights of the academic mainstream. Why, he even had the President and the Financial Stability Oversight Council (FSOV) on his side.

Ms. Kissel depicts DeMarco as a staunch reformer who was on his way to turning the housing market around. “Mr. DeMarco’s efforts started show results. Housing prices recovered, both [Fannie and Freddie] started to make money – lots of it – and private insurance eyed getting back into the market. Then in August 2012 the Obama administration decided to ‘sweep’ Fannie and Freddie’s profits, now and in the future, into the government’s coffers. The move left the companies unable to build up capital reserves, and shareholders sued.”

That was just the beginning. DeMarco was pressured by Congress and the administration to write down principal on the loans of borrowers whose homes were “underwater;” e.g., worth less at current market value than the value remaining on the mortgage. He also opposed creation of a proposed housing trust fund (or “slush fund,” as Kissel aptly characterizes it). Apart from the obvious moral hazard involved in systematically redrawing contracts to favor one side of the transaction, DeMarco noted the hazard to taxpayers in giving mortgagees – 80% of whom were still making timely payments – an incentive to default or plead hardship in order to benefit financially. How could mortgage markets attract investment and survive in the face of this attitude?

This intelligent evaluation won him the undying hatred of “members of Congress [and] President Obama’s liberal allies [including] White House adviser Van Jones [who] told the Huffington Post “you could have the biggest stimulus program in America by getting rid of one person;” namely, DeMarco. “Realtors, home builders, the Mortgage Bankers Association, insured depositories and credit unions” fronted for the White House by pressuring DeMarco to “degrade lending standards” to the least creditworthy borrowers – a practice that epitomized the housing bubble at its frothiest. “Protestors organized by progressive groups showed up more than once outside [DeMarco’s] house in Silver Spring, MD, demanding his ouster. A demonstration in April last year brought out 500 picketers with ‘Dump DeMarco’ signs and 15-foot puppets fashioned to look like him. ‘My first reaction was of course one of safety,’ [said DeMarco]. ‘When I first saw them, I was standing a few feet from the window of a ground-level family room and they’re less than 10 feet way through this pane of glass, and it was a crowd of people so big I couldn’t tell how many people were out there. And then all the chanting and yelling started.’ His wife had gone to pick up their youngest daughter…’so I had to get on the phone and tell her ‘Don’t come.’ Then he called the police, who eventually cleared the scene. ‘It was unsettling,’ he says. ‘I think it was meant to be unsettling… They wanted me to start forgiving debt on mortgages.'” This is what Ms. Kissel calls “the multibillion-dollar do-over,” to which “Mr. DeMarco’s resistance made him unpopular in an administration that was anxious to refire the housing market.” Ms. KIssel’s metaphor of government as arsonist is the most gripping writing in the article.

Epilogue at FHFA

Edward DeMarco was the “acting” director at FHFA. The Senate capitulated to pressure for his removal by approving Mel Watt, Majority Leader Harry Reid’s pick, as permanent director. Watt immediately began implementing the agenda DeMarco had resisted. DeMarco had successfully scheduled a series on increases in loan-guarantee fees as one of a series of measures to entice private insurers back into the market. Watt delayed them. He refused to lower loan limits for Fannie and Freddie from their $625,000 level. He directed the two companies to seek out “underserved, creditworthy borrowers;” i.e., people who can’t afford houses. He assured the various constituencies clamoring for DeMarco’s ouster that “government will remain firmly in control of the mortgage market.”

DeMarco’s valedictory on all this is eye-opening in more ways than one. Reviewing what Ms. Kissel primly calls “government efforts to promote affordable housing,” DeMarco dryly observes, “‘Let’s say it was a failed effort…To me, if you go through a 50-year period, and you do all these things to promote housing, and the homeownership rate is [the same as it was 50 years ago], I think the market’s telling you we’re at an equilibrium.’ If we assume “that only government can foster homeownership among people ‘below median income,’ that ‘suggests a troubling view of markets themselves.'”

And now the whole process is starting all over again. “If we have another [sic] recession, if there’s some foreign crisis that …affects our economy, it doesn’t matter whatever the instigating event is, the point is that if we have another round of house-price declines like we’ve had, we’re going erode most of that remaining capital support.” Characteristically, he refuses to forthrightly state the full implications of his words, which are: We are tottering on the brink of full-scale financial collapse.

Edward DeMarco: Blackboard Economist

The late Nobel laureate Ronald Coase derided what he called “blackboard economists” – the sort who pretended to solve practical problems by proposing a theoretical solution that assumed they possessed information they didn’t and couldn’t have. (Usually the solution came in the form of either mathematical equations or graphical geometry depicted on a classroom blackboard, hence the term.)

Was Coase accusing his fellow economists of laziness? Yes and no. Coase believed that transactions costs were a key determinant of economic outcomes. Instead of investigating transactions costs of action in particular cases, economists were all too prone to assume those costs were either zero (allowing markets to work perfectly) or prohibitive (guaranteeing market failure). Coase insisted that this was pure laziness on the part of the profession.

But information isn’t just lying around in the open waiting for economists to discover it. One of Coase’s instructors at the London School of Economics, future Nobel laureate F.A. Hayek, pointed out that orthodox economic theory assumed that everybody already knew all the information needed to make optimal decisions. In reality, the relevant information was dispersed in fragmentary form inside the minds of billions of people rather than concentrated in easily accessible form. The market process was not a mere formality of optimization using given data. Instead, it was markets that created the incentives and opportunities for the generation and collation of this fragmented, dispersed information into usable form.

Blackboard economists were not merely lazy. They were unforgivably presumptuous. They assumed that they had the power to effectuate what could only be done by markets, if at all.

That lends a tragic note to Ms. Kissel’s assurance that “Mr. DeMarco isn’t against government support for housing – if done properly.” After spending his career as “the loneliest man in government” while fighting to stem the tide of the housing bubble, Edward DeMarco now confesses that he doesn’t oppose government interference in the housing market after all! The problem is that the government didn’t ask him how to go about it – they didn’t apply just the right optimizing formula, didn’t copy his equations off the blackboard.

And when President Obama and Treasury Secretary Geithner and the housing lobbyists and the realtors and builders and mortgage bankers and lenders and progressive ideologues hear this explanation, what is their reaction? Do they smack their foreheads and cry out in dismay? Do they plead, “Save us from ourselves, Professor DeMarco?”

Not hardly. The mounted barbarians run roughshod over Mr. DeMarco waving his blackboard formula and leave him rolling in the dust. They then park their horses outside Congress and testify that “See? He’s in favor of government intervention, just as we are – we’re just haggling about the price.” Politicians with a self-interested agenda correctly view any attempt at compromise as a sign of weakness, an invitation to “let’s make a deal.” It invokes contempt rather than respect.

That is exactly what happened to Edward DeMarco. He is left licking the wounds of 25 years of government service and whining about the fact that the fact that politicians are self-interested, that government regulators do not really regulate but in fact serve the interests of the regulated, that the political left wing will stop at nothing, including physical intimidation and force.

No spit, Spurlock. We are supposed to stand up and cheer for a man who is only now learning this after spending 25 years in the belly of the savage beast? Whose valiant efforts at reform consisted of recommending optimizing nips and tucks in the outrageous government programs he supervised? Whose courageous farewell speech upon being run out of office, a la Douglas MacArthur, is “I’m not against government support for housing if done properly?”

Valedictory for Edward DeMarco

The sad story of Edward DeMarco is surely one more valuable piece of evidence confirming the theory of big government as outlined in this space. Those who insist that government is really full of honest, hard-working, well-meaning people full of idealistic good intentions doing a dirty job the best they can will now have an even harder time saying it with a straight face. It is one thing when big government opposes exponents of laissez faire; we expect bank robbers to shoot at the police. But gunning down an innocent bystander for shaking his fist in reproof shows that the robber is a hardened killer rather than a starving family man. When the welfare state steamrolls over an Edward DeMarco’s efforts to reform it at the margins, it should be clear to one and all that big government is rotten to the core.

Even so, the fact that Edward DeMarco was and is an honest man who thought he was doing good does not make him a hero. Edward DeMarco is not a martyr. He is a cautionary example. The only way to counteract big government is to oppose it openly and completely by embracing free markets. Anything less fails while giving aid and comfort to the enemy. Failure coupled with career suicide can only be redeemed by service to the clearest and noblest of principles.

DRI-305 for week of 3-17-13: What is Behind the New ‘Sharing Economy?’

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What is Behind the New ‘Sharing Economy?’

The once-distinguished British weekly The Economist highlights a new Web-based economic phenomenon in a recent (03/9-15/2013) issue. The name assigned by the magazine to this activity is the “sharing economy” – a dreadful misnomer that conjures up images of 60s counterculture and communes. But however misnamed, the transactions it denotes are a sign that cannot be ignored.

In his Wealth of Nations, Adam Smith explained the growth of markets by citing man’s innate “propensity to truck, barter and exchange.” Ever since, these words have received both veneration and ridicule. Smith’s admirers saw in them a beautifully realized portrait of human nature. Opponents of free markets have scoffed. They long since rejected whatever validity Smith’s “higgling and haggling of the marketplace” might have had in favor of Thorstein Veblen’s picture of “shadowy figures moving in the background;” they see corporate power, not voluntary exchange, as the dominant motif in the market. Since 2008, the Left has pooh-poohed the notion of rational choice by citing the financial collapse as proof of the irrationality of crowds and the infeasibility of deregulated markets.

But now comes The Economist to point out that even as world financial markets were imploding, unregulated private markets were springing up to enrich the daily lives of billions of the world’s citizens. Alas, the magazine itself misses the significance of its own reporting.

The “Peer-to-Peer” Rental Market

Every night some 40,000 people around the world rent rooms from a service that operates throughout the world – 192 countries, 250,000 rooms in 30,000 cities. The customers choose their rooms and pay online. But the provider is not a commercial business chain like Hilton, Marriott or even Motel 6. Instead, a San Francisco-based firm called Airbnb matches up customers with rooms in homes owned by private individuals. The company has operated since 2008, attracting roughly 4 million customers. Room renters choose and pay for their rooms online.

This is perhaps the largest business in the “peer to peer” rental market. Individual consumers rent assets like beds, boats, and cars directly from other individuals rather than from businesses. The rationale for these practices is quite straightforward. You may wish to cut your automotive transportation costs by earning income from giving rides to people whose destinations coincide with yours. Or, viewing the same situation from the other side of the market, you may wish to cut your costs by paying a peer to chauffeur you to a common destination rather than calling a taxi or riding the bus.

Boat ownership is commonly likened to owning a hole in the water into which you pour money. One way to offset this outflow is to rent the use of the boat to peers. The intermediary and clearinghouse for all this activity is the World Wide Web.

Observing and noting this market is easier than pinning a descriptive label on it. The Economist calls it “the sharing economy.” This is surely wrongheaded, if only because we do not associate “sharing” with commercial transactions. Carpooling arrangements, for example, involve a spatial arrangement for the pooling of transportation services. Participants “share” a common space inside a single vehicle for the purpose of reducing joint transportation expenses. But each vehicle’s owner is commonly responsible for fuel purchases. Pooling equalizes travel responsibilities and costs among participants; the net exposure should be zero. The benefits are symmetrical, both in quantity and kind. This is sharing in a true, meaningful sense; the benefits are objectively equal and depend on the shared use.

Charity is another conventional form of benefit sharing. The owner of income or assets shares it (them) with others with no reciprocation except, perhaps, a “thank you.” The mutuality derives from the satisfaction gained through helping.

But the peer-to-peer market is simple commerce, unlike the genuine sharing examples just cited. There is an exchange of money for goods-or-services. The buyer gains the usual consumer surplus – the excess of the maximum price he or she would have been willing to pay over the price actually paid. The seller gains better utilization of existing capacity, whether the capital good is a personal automobile, spare bedroom or pleasure boat. Sellers are no more “sharing” than are taxi drivers, motel owners or charter-boat skippers. Indeed, a better descriptor would be the “utilization” or “capital-utilization” economy. Of course, this clinical language lacks the warm and fuzzy feel of “sharing” but it compensates in accuracy.

The Economist also tosses out the term “collaborative consumption,” which is just as inapropo as “sharing.” Fairness and full disclosure require noting that the terms “sharing economy” and “collaborative consumption” date back several years. They are particularly associated with left-wing authors like Rachel Botsman, whose communitarian views are hostile to capitalism and private property. But The Economist, of all publications, should know that private ownership is essential to the preservation and maintenance of capital goods, without which the peer-to-peer market would vanish into thin air.

Come to think of it, why not follow current buzzword practice and adopt digital vernacular, using The Economist‘s own phrasing? Call it the P2P market.

The Key Role of the Internet

Where has this new economy been all our lives? Did it take over a century for people to wake up to the possibility of using their cars as taxis or rental cars? Was there an epiphany, a la Bell and Watson, when a restaurant habitué decided he could pay his bill by ferrying his fellow diners back and forth for a fee?

Actually, P2P has been operating in the background all along. It ran on word-of-mouth or classified advertising, using referrals as its primary security. This guaranteed that its importance would remain marginal. It took the Internet to turn it into a $26 billion annual, growing enterprise.

First, the Internet gave P2P the reach it lacked heretofore, allowing sellers to reach an unlimited audience at extremely low cost. Second, the Internet provided the security necessary to both sides of the market. For example, taxi drivers lead a notoriously precarious existence at the mercy of their passengers. But insecurity runs in both directions when the driver is not a business owner or employee, operating a highly visible vehicle. On the Web, though, the platform fulfills the role otherwise played by the business in vouching for its representatives. Follow-up reviews and ratings ensure that bad trips are not repeated.

The surest sign that P2P really works is that commercial businesses want a piece of the action. The Economist reports that Avis, GM and Daimler have all acquired their own piece of P2P; e.g., acquired P2P assets or entered the market de novo. The magazine speculates that the acquisition may enable the parent to list its excess capacity-assets on the P2P firm’s website. This looks like a clear case of evolutionary adaptation rather than creative destruction; P2P does not rate to destroy its competing industries but rather to modify their operations for the better.

Last April, The Wall Street Journal reported on the hottest extension of P2P in the financial realm – P2P lending. For roughly a decade, at least two P2P firms – Prosper Loans and Lenders Club – have offered individuals a chance to lend directly to their peers. The loans are extended versions of the payday/high risk loan that has long been a staple of the low-income and pawn-loan credit market. These P2P loans have terms of up to five years and principal amounts ranging up to $25-35,000. They are unsecured and assigned a risk rating based on the borrower’s creditworthiness.

The success of these P2P firms has now attracted the attention of Wall Street. Fund managers have started funds organized along similar lines, offering investors the chance to pool investment capital into funds offering the same types of high-risk, unsecured loans. Risk spreading and high returns make these funds an attractive alternative to current low-yield, fixed-income investments. The high risk means that their fraction of the total portfolio should be low. Naturally, the increase in lending activity will improve terms and outcomes for borrowers.

Lessons Learned

Even if we accept that P2P is an adaptive rather than a disruptive force, this should not obscure the powerful message it conveys. The rise of P2P overturns the conventional thinking that had prevailed since the financial crisis of 2008 and the ensuing global recession. That dominant view has been that market participants do not act rationally. They act emotionally, even hysterically. They are stampeded by mob psychology and incapable of gauging their own interests. Without the wise guiding hand of government regulation, free markets will inevitably devolve into chaos.

To be sure, this view is itself hysterical. It offers no clue as to why or how regulators themselves escape the emotional distractions that sway market participants. It doesn’t explain how regulators regulate markets without actually substituting their own decisions for those of markets. It also doesn’t tell us how regulators are able to perceive the interests of market participants who (supposedly) cannot discern their own interests. Nonetheless, this regulatory view won out (essentially by default) in 2008-2009.

Every major regulatory agency in Washington – OSHA, EPA, FDA, SEC, FTC, DOT, DOE, FMCSA, et al – has presided over a reign of terror for the last four years. If federal-government regulation were the key to safety, America would now be the safest nation on Earth by far. There is no logical or empirical case for this regulatory full-court press, other than the fact that the Democrats won the last two Presidential elections and the Republicans did not. Still, asking Democrats not to regulate is like asking a horse not to eat hay.

P2P offers the perfect test case for the new conventional thinking. Here we have both supply and demand sides essentially pioneering a new market all by themselves. According to today’s party line, this is a sure-fire recipe for disaster. After all, taxi regulators in New York
City have spent decades warning consumers to beware of “gypsy [unregulated] taxicabs.” Riders might be placing themselves in the hands of robbers, rapists or even worse. Unfortunately, New York City hasn’t approved the issue of a single new taxi license (they are issued in the form of medallions) since World War II, so its citizens have conditioned themselves to ignore these admonitions. They actually want to get somewhere without waiting for a bus or walking. Well, if an unregulated commercial vehicle is this unsafe, just imagine how risky P2P must be!

No, according to The Economist, “the remarkable thing is how well the system usually works.” Then again, P2P “is a little like online shopping,” where “15 years ago…people were worried about security. But having made a successful purchase from, say, Amazon, they felt safe buying elsewhere.” And there was eBay, which began essentially as P2P and morphed into a vehicle for professional sellers.

Well, gol-l-l-l-l-e-e, Sgt. Carter, could it be that old Adam Smith was right – not just about mankind’s inherent affinity for trade but also about the self-adjusting character of mutually beneficial voluntary exchange? So it would seem.

Yet The Economist‘s liberal knee cannot help jerking towards regulation. “The main worry,” they declare gravely, “is regulatory uncertainty.” Yes, politicians in America have cast lascivious glances at Internet trade for years, longing to tax it under a guise of benevolent regulation. Since The Economist sails under the banner of …er, economics – where a tax discourages the taxed activity, creates a welfare burden and reduces the well-being of the taxed – it should come out forthrightly against Internet taxation, right?

Wrong. “People who rent out rooms should pay tax, of course [of course!], but they should not be regulated like a Ritz-Carlton hotel. The lighter rules that typically govern bed-and-breakfasts are more than adequate.” Mere readers – being only consumers, humble recipients of The Economist‘s sunbursts of illumination – needn’t expect any illuminating insight on why tighter regulation of Ritz-Carltons is either necessary or beneficial, because none is forthcoming. The editorial’s anonymous author has the wit to notice that incumbent taxi firms are even now mobilizing the forces of regulation to protect their monopoly position. But the magazine’s leftist editorial stance is so ossified that it cannot permit that admission without an accompanying qualification that “some rules need to be updated to protect consumers from harm.” Taxicab regulation is probably the most notorious textbook example of regulatory harm to consumers in the history of economics, but The Economist is bowing its knee to it. (Elsewhere, the magazine laments the absence of even more Keynesian stimulus spending policies to create jobs.)

This is an old story. A precursor to P2P sprang up in black communities throughout the U.S. during the early and mid-20th century. Taxicab service was often sparse in these areas, not merely because of racial discrimination but also because high crime posed serious risks to drivers. Taxi regulation typically prevented black taxicab companies from entering the market or expanding to meet demand. It became common practice for private individuals to frequent grocery stores, barber shops and other high-traffic areas in order to provide “car service.” This service consisted of informal, unmetered charges (sometimes on a flat-rate basis) in return for carriage to and from shoppers’ homes. Carrying of bags and escort duties were usually included in the service.

Researchers have applied the term “jitneys” to the unregistered, unlicensed vehicles used to provide this service. Research is conclusive on two points: Consumers benefitted unambiguously from the service, and jitneys were legally hounded by taxi and bus companies in their jurisdictions. They were made illegal because taxi and bus owners feared and resented the competition and loss of income that this low-cost alternative form of transportation inflicted on them. Amazingly, jitneys still survive today in inner-city America; they are the “missing link” connecting modern P2P with its ancestral forebears.

When the worst that The Economist can cite is that “an Airbnb user had her apartment trashed in 2011,” you can rest assured that today’s P2P system is working extraordinarily well. It is a measure of our times that even a single complaint instantly triggers the demand for more regulation. When abuses occur despite the presence of tight, heavy regulation – as in financial markets – it should be clear that regulation is the problem rather than the solution. When complaints are rare, it hardly suggests a need for regulation.

The word “regulation” itself has become a rhetorical refuge of first resort precisely because its meaning is so vague. There is no clear-cut theory of regulation to explain why it is necessary, exactly what it does or how it does it. To a bureaucrat, this may constitute a highly desirable sort of flexibility. But it is not conducive to favorable outcomes.

All the News That’s Fit to Decode

Readers of The Economist should probably be grateful that the magazine deigned to notice P2P at all. The fact that we have to hack our way through the magazine’s ideological bias and occupational ineptitude to glean any value from the article is a journalistic scandal. Still, these days students of economics have to take our good news where we find it and our sources as we find them.