Looking back at 2009

Looking back at Year 2009, I think the biggest question that Americans grappled with was what kind of economic system would be best. Whatever system prevailed through 2008 (see below for my characterization) was obviously flawed. Just as in the Great Depression, this opened the door to considerations of alternatives.

What’s on the table right now?

Option 1: Planned Economy or “Trying to cheat our way out of recession”. If the housing market is soft, the government will guarantee all of the mortgages that are being issued to people who buy houses. If the housing market is still soft, the government will lower interest rates on those mortgages. If the housing market still won’t obey, the government will give outright tax credits to people who buy houses. If companies don’t think that they can afford to hire additional Americans given current wages, regulations, and taxes, we will first have the President cajole them into doing so. If that doesn’t work, we’ll have tax credits for companies that hire Americans. If people don’t want to buy GM and Chrysler cars, we’ll give them a $4,000 credit toward the purchase. When that isn’t sufficient, we’ll have the taxpayers buy GM and Chrysler. Obama and Congress will successively turn their attention to each sagging square of the American economic quilt and sew in $100 bills as reinforcements. When the market gives you an answer that you don’t like (e.g., that a house on the outskirts of Las Vegas isn’t worth much), declare that the market has failed and send in the government.

Option 2: 1970s-style regulation. Prior to the Ford Administration, the U.S. economy was heavily regulated, mostly for the benefit of incumbent companies. You’d need Department of Transportation approval to offer trucking or airline services, for example, and you’d have to do it at prices set by government regulators. Folks believe that they’ve seen the destructive effects of a free market and therefore that the government needs to step in with a heavier foot, starting with Wall Street.

Option 3: Faith in a charismatic leader. “Obama is so smart, I have faith in anything that he does,” is how one of my Cambridge neighbors described her feelings recently.

Option 4: Parliamentarianism. Give one party control of both legislature and executive and let them make major changes. This is how things work in most other Western countries, but the American system has been to keep power fragmented. Oftentimes we vote different parties into executive and legislative branches. Even when one party controls both Congress and the White House, parochial concerns have typically kept anything significant from being changed. We have elected a Representative or Senator not to push forward a grand Party agenda, but rather to bring a pork barrel project home to our town. The big push to pass a 2000-page $1 trillion health care bill that nobody had read or understood was an example of parliamentarianism at work and it was a shocking and surprising process to many.

As in the Great Depression, one thing that very few Americans seem to have faith in is market economics. The system that prevailed prior to 2009 was supposedly “free market capitalism” and we now know that it doesn’t work. Limiting ourselves to just those things that directly relate to the Crash of 2008-?, let’s consider what we actually had:

  • laws and regulations preventing shareholders from nominating board members for public companies (enabling the CEO and other managers to pack the board with golfing buddies and then work together to loot from the shareholders); recall that nearly all of the Wall Street firms that blew up were public companies rather than the traditional partnerships
  • laws and regulations giving an oligopoly to a handful of ratings agencies such as Moody’s (the guys who were paid by bond issuers to rate their sub-prime mortgage collections as AAA)
  • policies encouraging banks to issue mortgages to people who were poor credit risks (Fannie Mae relaxed its own credit standards in 1999, on the Clinton Adminstration’s theory that it would help minorities and the poor; banks collected big fees for issuing mortgages to people who would never make payments and then stuck Fannie Mae with all of the risk (and then Fannie Mae blew up and the taxpayers were stuck with the losses (after Fannie Mae executives had taken billions of dollars home in salary))

People close to or favored by the government were able to make enormous amounts of money without taking any personal risk. That’s not a classical free market (in which investors can expect no more than a normal return on investment, after adjusting for risk). That is crony capitalism.

Where can we see a free market operating in order to evaluate whether it was a workable economic system? Due to the enormous size and power of governments worldwide, it seems almost impossible to find a truly free economy. In almost any country one could make a better return on investment by cozying up to a government official or collecting subsidies than by taking risks. The free market, however, does operate internationally. If you are sailing around in a freighter and want to buy sugar, you’ll buy it wherever it is cheapest without any incentives from or intervention by the U.N. If you’re sailing around in a freighter full of cash and want to invest it, there is no international tax system encouraging you to put the money in a particular place or industry. Does the free market work? Commodities by and large seem to be pretty cheap and efficiently produced. Capital flows to support rapid growth in China, Brazil, India, and other countries whose mix of education, costs, stability, and regulation are attractive. Why wouldn’t this free market system work domestically for the U.S.?

Perhaps when government grows beyond a certain percentage of the economy it is no longer possible to have a market economy. Federal spending in the U.S. right now is more than $3 trillion annually. A handful of senators on a single committee can direct a healthy slice of that $3 trillion wherever they choose. It shouldn’t therefore be a surprise that economists found political lobbying to yield the highest return on investment of anything that American companies did. (Lobbying need not result in direct government payments to be profitable; consider the Detroit automakers getting one line inserted into federal regulations, a 25 percent tariff on light trucks starting back in 1963.)

When federal, state, and local government constitute 40 percent of GDP, and the political system is open to lobbying, perhaps pretending that we can have anything resembling a free market is a mistake. Those of us who took Econ 101 are prejudiced against planned economies, but perhaps a Soviet-style planned economy is more efficient than a crony capitalist system.

In my opinion, this is the big question that we’re going to be working out as a society during the coming decade.

16 Comments

  1. Stephen

    December 31, 2009 @ 3:30 pm

    1

    Agreed that it’s hard to have a “free market” when the government participates in the economy to the degree it does in modern Western states, but on the other hand didn’t the demise of the Soviet Union show that a planned economy is not viable in the long run? (The old story about the nail factory: when the quota was weight, it made a few huge, heavy nails; when the quota was number, it made millions of tiny, useless ones.)

    The thing is, because America is not yet as far down the road as the European economies, you can still have companies like Google and Apple making a global impact and creating staggering amounts of new wealth; what will happen when America is just another European economy? What was the last Europe-based company that radically changed any industry on a global level?

    Taleb says that capitalism just allows for more experimentation; the more crazy ideas people try, the more likely one of them will become a Black Swan and change everything. In America, this experimentation is encouraged, by and large, and there is an independent culture of starting out on your own and trying something new. This culture is antithetical to statist thinking, which likes everything to be planned out and for everyone to do predictable things. So in Europe, in its advanced statist straitjacket, everyone is encouraged to support the status quo by joining existing large companies (or the govt itself), with predictable results.

  2. Yossi Kreinin

    December 31, 2009 @ 4:32 pm

    2

    Didn’t the USSR settle this question experimentally by producing surplus woolen socks people bought up to make sweaters of which there was a shortage? As entertaining as the process of reducing a woolen sock to a single long thread used to be, I’d hate to see the US working this out during the coming decade.

  3. BobC

    December 31, 2009 @ 7:21 pm

    3

    If the Obama administration continues down it’s
    current path, you’re liable to get your wish regarding
    having a Soviet-style “planned economy”.
    Personally, I don’t understand what all the hand wringing
    is over. Our country is still functioning at high levels
    thoughout, much better than any other country that am aware of.
    Clever prople can make a man walking out his front door
    newsworthy. I think much of what the U.S. has experienced
    in the last twenty-four months has been a perfect example
    of that sort of cleverness.
    We didn’t have anyone lose their savings that was in
    a bank. We didn’t have bread lines, and we didn’t have
    bankers jumping out of windows.
    If you disagree, tell me where this supposed cliff is that
    the U.S. is about to drive off of.

  4. philg

    January 1, 2010 @ 1:11 am

    4

    Stephen, Yossi: Agreed that the old Soviet Union was not a great advertisement for a planned economy. However, the current Chinese economy has significant elements of central planning and seems to be doing very well indeed. For example, ten years ago the Chinese decided to make big investments in renewable energy and they are now leaders in wind and solar power.

    BobC: http://www.time.com/time/magazine/article/0,9171,1946924,00.html shows that the rate of employment for American men aged 25-54 is the lowest that it has been since the BLS began keeping statistics in 1948. If you’re one of the 80 percent of these guys who has a job, the economy is pretty good. If you’re one of the 20 percent who does not have a job, the economic situation could be rather dire. For at least those 20 percent, alternative economic systems may have a substantial appeal.

  5. Stephen

    January 1, 2010 @ 6:16 am

    5

    Good point about China. I’m not certain I fully understand the differences between Chinese and Soviet economic planning, but I have a vague idea that there is something closer to state capitalism in China, ie party officials use state money to run enterprises for their own personal profit, at least in certain areas; this might disguise the ill-effects of centralised planning to some extent.

    Regarding the investment in renewables; this is a classic example of government picking winners in the technology race. I am very skeptical of wind ever being a significant source of energy; due to its extreme variability, you need conventional backup of at least 90% of capacity, and running conventional as backup has major efficiency problems. So the Chinese government may have built up a lead in a useless technology. In a free market situation you can be a lot more certain that the leading technology is economically viable.

    Political interference works the other way as well; the environmental lobby has destroyed the viability of nuclear, despite the fact that it is the obvious choice for reducing carbon emissions. We are only messing around with wind because nuclear has been placed off-limits. You really do start to wonder if the goal of some environmentalists isn’t to stop economic growth altogether.

  6. Matt Henderson

    January 1, 2010 @ 5:48 pm

    6

    My understanding is that, throughout history, governments have tended to grow, and that this is due primarily to the tendency of society to want to increasingly rely on government to solve its problems, and therefore willing to promote/accept leaders that promise such.

    It’s also my understanding that as government grows, a country’s prosperity (and freedoms) tend to decline, due to many reasons, including the type of people that central power tends to attracts, and the lack of effectiveness/efficiency of government operated programs absent of competitive forces.

    If it is true that the best system we know to organize a society is characterized by small government and markets that are largely free, then it seems that our only hope of achieving that is to achieve widespread belief that, in the long run, personal responsibility leads to a more prosperous society for all, and that, on principle, we should be strongly against the expansion of government’s role, regardless of how beneficial such expansion might seem on the surface.

    What can we possibly do to achieve such widespread belief? Everyone I talk to seems to agree with this idea in general, but then takes a big step back at the suggestion of reducing (or removing) some benefit that *they* receive from government.

    (Aside: As someone working in software, this seems to be similar to the observation that feature-creep, while apparently beneficial in the short-run, often spells the end of software in the long-run.)

  7. Rellag

    January 2, 2010 @ 3:27 am

    7

    Matt:

    From an engineering perspective, government is the ultimate open-loop system.

    In software, there are hard budget constraints. If your project or product doesn’t generate enough packets of ramen to feed the staff, the project ends and the staff [hopefully] gets reassigned to higher-value tasks.

    A government entity or program doesn’t work that way. The amount of resources it consumes is unrelated to the amount of value, if any, it produces.

    Standards for measuring such value would be at best vague, at worst purposely unmeasurable.

    Historically, the only form of negative feedback an incompetent gov’t faces is when the barbarians/Russians/Vandals show up outside the capital city with cavalry or tanks to put an end to the idiocy.

    That’s why if you get the choice between limited government and democracy, pick limited government.

  8. Sean O.

    January 2, 2010 @ 12:52 pm

    8

    Phil, you mentioned an economic study that found that lobbying produced the highest ROI of all business activities. I’d like to refer to that in the future. Do you have a source?

  9. BobC

    January 2, 2010 @ 5:18 pm

    9

    Phil,
    You stated that free market capitalism doesn’t work. I assume you are at least partially an engineer at heart so I understand why you state that (although I believe you’re very mistaken).
    The free markets have and still do work. It’s the human emotions that tend to throw it out of whack every decade or so.
    Unadultered greed is what damaged our market system over the last few years and not much else. You may say that is an over-simplification of the problem, but I don’t think so.
    We have not had a financial collapse of anywhere near the magnitude that the U.S. experienced in the “Great Depression” and there are too many (sorry for the misnomer) systems in place now for the U.S. to ever have something of those proportions occur again.
    The auto industry and the greedy bankers on Wall Street simply experienced (firsthand) the old saying:
    “All good things must come to an end.”

  10. philg

    January 3, 2010 @ 12:28 am

    10

    Sean: I’m traveling now but will try to dig up the source. I think it was covered in mass market newspapers a couple of years ago, so it is not obscure.

    BobC: I hope that I didn’t say that free market capitalism does not work. I thought that I said it was not possible with our current political system and size of government. The potential rewards to lobbying are too great and the ability of the government to intervene in markets is too powerful. As for “greed” damaging our “market system”, I don’t think the assertion makes any sense. The whole point of a free market system is that all participants can be greedy and the results are still fair (and the benefits widespread). Setting up Wall Street firms so that employees can place bets and take home the winnings as bonus, but stick shareholders with any losses, and then prevent shareholders from exercising any control over the firms, is not something contemplated by Adam Smith.

    As for your assertion that we have not had a financial collapse comparable to what we experienced in the Great Depression, keep in mind that we are only about one year into this. A lot of Americans were optimistic in October 1930, a year after the Crash of ’29. We are a much richer society and we have more mechanisms for redistributing income, which means that we’re unlikely to see bread lines. However, it is hubris to say that we can’t stagnate economically for decades, the way that Britain did after World War II or the way that Argentina did during many parts of the 20th Century.

  11. Yossi Kreinin

    January 3, 2010 @ 7:58 am

    11

    So we have:

    China – socialism corrupted by capitalistic reformers under slogans such as “true socialism is the elimination of poverty rather than shared poverty” in order to free up the economy to an extent sufficient to at least sustain life.

    US – capitalism corrupted by socialistic reformers under slogans such as “true equality of opportunity is when everyone has an opportunity to buy a house” in order to gain votes/lobbyist money/self-congratulation/all of the above.

    You suggest that corrupted socialism outperforms corrupted capitalism; if you are right, more thought must be given to the likely corruption of ideas than to the ideas themselves (religions advocating celibacy, turning the other cheek, etc. exemplify ideas looking completely unworkable in their pure form but practiced in corrupted forms which are very enduring).

  12. zhenre

    January 3, 2010 @ 11:29 am

    12

    I take issue with your freighter example. International trade is certainly not a free market. You have many exporting countries (china) manipulating their currencies to make their goods artificially cheap then passing laws flow of currency in and out of the country to attempt to control inflation. This has the net effect of causing people in those countries work at below free market wages. Then you have western countries which are uncompetitive both due to this manipulation, poor labor agreements, and laziness, with tariffs preventing its companies from adapting. Along with strange bi- and multi-lateral trade agreements which tend to benefit whoever holds more leverage when the deal is negotiated.

    My feeling btw is that the western countries should treat the subsidies as a windfall gift and use it to invest in physical and human infrastructure. If someone is willing to do work for you at half price you’d be a fool to not take them up on it. Of course like most windfalls this one has mostly been spent poorly. Though the housing boom has led to some urban renewals that seem to be outlasting the bubble (lowest crime rate in recent history in new york city etc.)

    As to comments about planned vs. free market economy. It is premature to look at China’s recent ascent using a planned economy as anything but a so far ok way of transitioning from a true communist economy to a capatilistic one. It is (relatively) easy and efficient to have a planned economy when your “plan” is to replicate the last 50 years of western technological and economic innovation. Your plan is to just replicate what has worked so far and you will grow enormously. This has happened before in Japan and S. Korea both with economies that were planned much more tightly than the US. Like those countries china will surely have trouble transitioning from copying to innovating. Certainly those examples have made the transition but I would not say that they have overtaken us. China may or may not but if it does so I doubt highly that it will be with the same type of planned economy that they have now.

  13. philg

    January 3, 2010 @ 11:59 am

    13

    Yossi: I didn’t mean to suggest that the current Chinese system was necessarily superior or would continue to outperform the U.S., just that its recent strong performance will have an appeal to Americans who have lost faith in the U.S. system of crony capitalism.

    zhenre: Thanks for that interesting analysis of why China might be doing so exceptionally well. It should be a cautionary note for those folks who have invested heavily in an inflated Chinese stock market! I think that their stocks must have many years of 10 percent GDP growth already priced-in.

  14. Friedrich

    January 4, 2010 @ 4:12 am

    14

    Sorry for the follow-up. I have seen you commented on “free” markets. And there you mentioned the problem with a too big “state” So it’s clear every thing has to be done to make the “state” smaller. But as you wrote it’s more profitable to be good friends with Washington and that’s the biggest problem currently. Why spend time on science if you can spend your time much more profitable with advocates? Law-makers etc. Why spend time on production if you can steal with the help of the governement?

    However it all goes back to “unsound fiat-money”, so the biggest chance everyone can have is disallow the governement to mess around with your money. So follow Ron Paul on “ending the fed” and you’ll be fine with a big governement also.

  15. Friedrich

    January 4, 2010 @ 4:20 am

    15

    Oh I’m getting old. Check the prosperity of countries with different “liberal levels”. E.g http://en.wikipedia.org/wiki/List_of_countries_by_economic_freedom

    And see how well they do in prosperity of their inhabitants. The figures will be interesting.

  16. Fazal Majid

    January 4, 2010 @ 6:18 pm

    16

    Phil, your protestations that the US is not in fact a free market capitalist system but in fact crony capitalism, are probably true but insufficient as a way out.

    They remind me of trotskyists who explain away the manifest failure of communism by saying no communist regime was ever “true” or “pure” communist but in fact represented “state capitalism”.

    If capitalism is not robust to rent-seeking by the politically well connected, just as communism was not to basic facts of human nature (selfishness), it’s a big design flaw that needs to be explicitly addressed. The free market does not operate in a vaccum. It presupposes government or some other mechanism to muster force to enforce contracts and property rights. That such a government is susceptible to influence-peddling and cronyism is a historical rule, not an exception.

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