Pope II

Here I wrote about the Freakonomics podcast with Jeffrey Sachs which covered the Pope’s anti-capitalism remarks.

Shortly thereafter, in Taleb’s book, Antifragility, I was surprised to read what I think is a more thoughtful response to the Pope’s remarks and one that supports the Pope’s view.

What surprises me even more is that what Taleb writes about isn’t new to me. It’s a frequent topic of conversation, something that I know well. But, I hadn’t taken it to the logical conclusion.

First, Taleb points out that even the patriarch of capitalism, Adam Smith, was

…extremely chary of the idea of giving someone upside without downside and had doubts about the limited liability of joint-stock companies (the ancestor of the modern limited liability corporation). He did not get the idea of transfer of antifragility, but he came close enough.

And he detected–sort of–the problem that comes with managing other people’s business, the lack of pilot on the plane:

The directors of such companies, however, being the managers rather of other people’s money than of their own, it cannot well be expected, that they should watch over it with the same anxious vigilance with which the partners in a private copartnery frequently watch over their own.

Let me make the point clearer: the version of “capitalism” or whatever economic system you need to have is with the minimum number of people in the left of the Triad.

“The Triad” is Taleb’s classification of systems as (from left to right) fragile, robust and antifragile; and what he means by ‘left of the triad’ is people who get the downside, as well as the upside, or they have skin in the game.

Taleb contiues:

There is a difference between a manager running a company that is not his own and an owner-operated business in which the manager does not need to report numbers to anyone but himself, and for which he has a downside. Corporate managers have incentives without disincentives — something the general public doesn’t quite get, as they have the illusion that managers are properly “incentivized.” Somehow these managers have been given free options by innocent savers and investors.

He provides an example:

…banks have lost more than they ever made in their history, with their managers being paid billions in compensation — taxpayers take the downside, bankers get the upside [Russ Roberts has been saying this for years]. And the policies aiming at correcting the problem are hurting innocent people while bankers are sipping the Rose de Provence brand of summer wine on their yachts in St. Tropez.

To bring this all together:

We are witnessing the rise of a new class of inverse heroes, that is, bureaucrats, bankers, Davos-attending members of I.A.N.D. (International Association of Name Droppers), and academics with too much power and no real downside and/or accountability. They game the system while citizens pay the price.

At no point in history have so many non-risk-takers, that is, those with no personal exposure, exerted so much control.

Now, let’s re-read what the Pope wrote (quoted from the Freakonomics post):

“[S]ome people continue to defend trickle-down theories which assume that economic growth, encouraged by a free market, will inevitably succeed in bringing about greater justice and inclusiveness in the world. This opinion, which has never been confirmed by the facts, expresses a crude and naïve trust in the goodness of those wielding economic power and in the sacralized workings of the prevailing economic system. Meanwhile, the excluded are still waiting. … One cause of this situation is found in our relationship with money, since we calmly accept its dominion over ourselves and our societies. The current financial crisis can make us overlook the fact that it originated in a profound human crisis: the denial of the primacy of the human person! … While the earnings of a minority are growing exponentially, so too is the gap separating the majority from the prosperity enjoyed by those happy few. This imbalance is the result of ideologies which defend the absolute autonomy of the marketplace and financial speculation. Consequently, they reject the right of states, charged with vigilance for the common good, to exercise any form of control. A new tyranny is thus born, invisible and often virtual, which unilaterally and relentlessly imposes its own laws and rules.

To me, this reads like leftist dribble, where their intuition leads them, perhaps, in the right direction for outcome, but the wrong direction for cause.

Maybe the Pope is right that there are some fundamental problems in the mixed markets that have emerged.

But, they’re wrong about the cause of those problems. They blame things like “trickle down theories” (Thomas Sowell challenges us to name one economist who used “trickle down“).

But, the part of the Pope’s passage that reminds me of Taleb’s point is:

…expresses a crude and naïve trust in the goodness of those wielding economic power…

Perhaps that is true. And Taleb tells us why:

At no point in history have so many non-risk-takers, that is, those with no personal exposure, exerted so much control.

They don’t have downside.

This includes politicians, apparatchiks in government agencies, economists and — the one that I am really disappointed that I missed because of my biases — managers of businesses who only have upside and no downside. I’ve even noticed that senior managers often have the same characteristics as politicians, but darn if I haven’t carried that through.

So, as I like to say, all problems can be traced to problems with feedback — I think Taleb exposes a couple of real feedback problems in — not free markets — but our mixed market economy. That feedback problem is that too many people “wielding economic power” don’t have downside. Rather they have incentives to game the system for their upside.

How can this be changed? Taleb gives one example that surprised me:

…in some countries such as Brazil, even today, top bankers are made unconditionally liable to the extent of their own assets.

Think about that. Would bankers act differently if they may have to repay the bonuses they received in what are now apparent as the fraudulently fueled good-times?

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Do you need another can of green beans in your pantry?

English: Cut Green Beans Español: Habichuelas ...

"Creating" Demand

I enjoyed Arnold Kling’s column (econblogger at EconLog), Government Cannot Create Sustainable Jobs, published in the European edition of The Wall Street Journal.

I think the following two paragraphs contain the most concise and understandable contrast of two competing visions on how the economy works (emphasis mine):

For Keynesians, job creation is simple. Entrepreneurs have knowledge of how and what to produce. All that is required is more demand, in order to induce them to undertake more hiring.

n contrast, in our [Adam] Smith-Ricardo story, the knowledge of how and what to produce has to be discovered. Entrepreneurs have to figure out ways to utilize resources that satisfy wants in an efficient way. The market mechanism first must undertake trial and error to create production processes that exploit comparative advantage. Until these new patterns of sustainable specialization and trade are discovered, there are no job slots.

I bolded the key phrases.  Do you believe that progress comes from stimulating evermore demand or from trial and error experimentation?

I believe the latter.  Progress, wealth, improvements in the standard of living, GDP per capita growth — whatever you call it — comes from experimentation and trial and error and a process that allows the valued to survive and multiply and the least valued to die off (i.e. evolution).  This trial-and-error market process is driven by the ultimate democracy of individuals voting with their own value store on the the things they value and vote against those things they don’t value.

The problem for me with the former explanation, creating more demand, is where this new demand comes from.

The theory says that more government spending will put more money into some folks pockets, which they then spend.  So, then the businesses that benefit from that extra spending will spend more too.  And so on.  This is a chained spending effect.  By the time the that extra dollar of government spending has worked its way through the economy, it’s spawned more than a dollar of economic activity.

This seems reasonable on the surface.  But pry deeper.  Where did that extra dollar of government spending come in from in the first place?  It either came from current or future spending.

If it came from current spending, then all we’ve done is take a dollar from someone to get the spending chain started.  That someone may have started their own chain by spending it themselves.

Defenders of this theory will say, yes, but that someone wasn’t going to spend it any time soon so it’s best for everyone that the government took it and spent it.

I believe the miss in this line of thinking is that someone was waiting to discover something of value to spend it on, while spending it now does not help him find that value.

What’s really happened is that demand was pulled forward from the future and we’ve spent it on something that doesn’t add value.

Companies see this when they run ineffective limited time promotion.  The sale will produce a sales spike during the offer period and a lull afterwards.  The sale encouraged people who were going to buy the product anyway to buy it sooner, and buy less later.

But, in the case of the government pulling forward demand, it makes things worse.

That someone with the original dollar was waiting to spend that dollar on something he valued — maybe a new pill that will reduce his sick days and make him more productive.

Instead, the government takes it and spends it on another can of green beans.  So, instead of having four cans of green beans in the pantry (that he’s never going to eat), he has five now — something that doesn’t bring as much value as that new pill.  But, hey, the green bean growers and canners are better off.  Except, we find that since there’s a glut of canned green beans now, green bean makers will sell fewer cans in the coming months.

So, creating demand through government spending is a myth.  There is no creation.  Just moving demand from one place to another or from the future to now — and in either case, we replace careful spending with careless.

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I don’t love greed

It’s not often that I disagree with Walter Williams, but I did this week.  Or, at least I disagree with the title of his column,  I Love GreedThough, I will give him some wiggle room.  Column authors don’t always come up with the titles for their pieces.

I think a better title is I Love Capitalism.

In the column, he explains Adam Smith’s observation that capitalism directs greed (or self-interest) to encourage humans to serve their fellow man.  I like his example (emphasis added):

This winter, Texas ranchers may have to fight the cold of night, perhaps blizzards, to run down, feed and care for stray cattle. They make the personal sacrifice of caring for their animals to ensure that New Yorkers can enjoy beef. Last summer, Idaho potato farmers toiled in blazing sun, in dust and dirt, and maybe being bitten by insects to ensure that New Yorkers had potatoes to go with their beef.

Here’s my question: Do you think that Texas ranchers and Idaho potato farmers make these personal sacrifices because they love or care about the well-being of New Yorkers? The fact is whether they like New Yorkers or not, they make sure that New Yorkers are supplied with beef and potatoes every day of the week. Why? It’s because ranchers and farmers want more for themselves. In a free market system, in order for one to get more for himself, he must serve his fellow man. This is precisely what Adam Smith, the father of economics, meant when he said in his classic “An Inquiry Into the Nature and Causes of the Wealth of Nations” (1776), “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” By the way, how much beef and potatoes do you think New Yorkers would enjoy if it all depended upon the politically correct notions of human love and kindness?

I like that last question.  Adam Smith wrote it this way:

We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages.  Nobody but a beggar chuses to depend chiefly upon the benevolence of his fellow-citizens.

When I read that passage from Adam Smith for the first time, it caused me to see the world differently.

Before that I had not seen as clearly the motivation of all those who supply me with the goods and services that I demand and how well those motivations work.

But, back to the title of Williams’ column.  Later Williams writes:

Free market capitalism is relatively new in human history. Prior to the rise of capitalism, the way people amassed great wealth was by looting, plundering and enslaving their fellow man. Capitalism made it possible to become wealthy by serving one’s fellow man.

That looting, plundering and enslaving was driven by greed also.  What’s there to love about that? Absolutely nothing.  Sorry Walter.

But, there’s a lot to love about a system that directs that greed away from looting, plundering and enslaving and channels it to serving our fellow man.

Greed and self-interest exists.  This is human nature.  I believe coming to grips with this fact moved me along my political path from neo to classical liberal.

Many people are not willing to recognize this fact of human.  They hold romantic hope that human nature can somehow be different because they feel it should be.

And such people often seem oblivious that their very own behavior is guided by self-interest and does not often live up to the romantic hope they hold for everyone else.

The invisible hand is not the free market

Many people say that the housing bubble was caused by a failure of the invisible hand.

When I encounter such folks, I like to make sure they understand what the invisible hand is.  Many believe invisible hand is synonymous with free market.

It’s not.

The invisible hand is how a free market produces socially desirable outcomes.  It is not the free market itself.

So, what is the invisible hand?

It’s the incentives we face when we make the trade-off decisions that we encounter each day and how we respond to those incentives.

Some of the trade-off decisions might be: Do I go to work?  Do I buy a cup of coffee?  Do I refinance my house?  We face many invisible incentives around each of these decisions.  How much work do I have?  How much vacation have I banked?  What am I going to do with my time off?  Is the coffee good? Is it far out of my way?  Will there be a long line? Is the new mortgage rate worth the closing costs?

Others face trade-off decisions too.  Investors hire business managers to generate good returns on their investments.  Business managers, to stay employed, have to decide how to grow sales.  Do we try a new product or open locations in new markets?

The incentives that help guide our decisions is the invisible hand.  It’s invisible because we can’t physically see incentives, but they’re there.

Adam Smith claimed that the incentives in the invisible hand tended to produce socially desirable outcomes in a free market with little government regulation because in a free market we choose when and how to interact with each other.

That choice to interact or not is the key to producing socially desirable outcomes.

Consider the cup of coffee that you bought this morning.  Did you force the coffee shop to sell it to you? No. Did the coffee shop force you to buy it? No.

You and the coffee shop owner both chose to trade because you both felt like you came out ahead by doing so.  You valued the cup of coffee more than the $2 it cost you.  The coffee shop owner valued the $2 more than the cup of coffee he sold you.

That’s called a voluntary, mutually beneficial trade.  Value was created on both sides of the transaction — for you and the coffee shop owner (though most people forget about the value created for the customer, they only see the ‘profit’ for the coffee shop owner).

Smith’s famous quote illustrates the value creation engine of the invisible hand incentives nicely:

It is not from the benevolence of the butcher, the brewer or the baker, that we expect our dinner, but from their regard to their own interest.

We choose to interact with the butcher for the very reason he chooses to interact with us:  self interest.  We both benefit from the interaction, otherwise we would pass it up.

When things don’t appear to produce a desirable outcome, we are quick to blame the invisible hand.  We say it failed.

But, we shouldn’t rush to judgement.  What really happened is that the incentives changed somehow so some people traded even when they did not benefit from doing so.

We should look to identify where this occurred, because that will tell us what went wrong.

Alan Greenspan, for one, told Congress that he overestimated the self-regulation of the free market.  (That self-regulation being that two parties of a transaction prudently seek to come out ahead.)

He was specifically referring to trades where investors bought mortgage-backed securities from banks.  Investors bought these for what would turn out to be much more than they were truly worth.  In fact, these investors had an insatiable appetite for mortgage-backed securities.  So much so, that banks created as much as possible by lending to just about anyone no matter their credit history and ability to pay.

But, Alan Greenspan was wrong.

He didn’t understand why investors bought this stuff.  He thought they were incorrectly overvaluing mortgage-backed securities based solely on the expected payback.  If that’s all investors were buying, Greenspan would have been right.

I doubt any of these investors would have lent money directly to many of the folks who they lent money to through the mortgage-backed securities.

So why did they did they lend money to them through the mortgage-backed securities?

Because politicians in government changed the incentives by signing up taxpayers as unwilling, and unknowing, co-signers.  The taxpayers are the folks that traded in this house of cards when it did not benefit them from doing so. 

As Russ Roberts points out in his 2010 white paper, Gambling With Other People’s Money, mortgage-backed security investors weren’t only lending to folks unlikely to repay.  They were lending to these folks with U.S. taxpayers as co-signers.

Think of it this way, a friend with a bad credit history asks you for a loan.  The payment your friend would need to repay the loan would be more than half of his income.  Do you lend him the money?

Judging the transaction solely on its merits — that is, your chances of receiving the loan  back — you’re not likely to lend him the money.

But, what if your friend’s rich Uncle Sam co-signs the loan?  If your friend stops paying, Uncle Sam will pay what’s owed.  Will you make this loan now?

More likely.  But now, you’re not judging the loan purely on the merits of your friend.  You are factoring in the value of the co-signer.  Having the co-signer changed the incentives for you.

Russ Roberts makes a good case in his paper that’s exactly what investors in mortgage-backed securities did — and they turned out to be right.  And, this is the piece of the incentive structure of subprime mortgage-backed securities that Alan Greenspan missed.

Critics of this argument say that there was no explicit guarantee from U.S. taxpayers.  Roberts argues that the pattern had been established with previous government bailouts.  And, I’d argue that politicians from both sides of the aisle were in such a fervor to “expand the dream of home ownership” that they had been sending strong signals that they wouldn’t let these investors go under (though I think they hoped it wouldn’t come to this).

So, it wasn’t the invisible hand of the free market that failed.  What caused the failure was the introduction into the incentive structure a forced trade with U.S. taxpayers in co-signing the loans of people who would not have been able to get a loan 20 years ago.

Now, I do think there were other factors that contributed.  There was an overconfidence in the ability of statistical models to somehow group bad credit risks in a way that lowered risk.  There was also the fever of rising housing prices, which caused more people to want to buy homes just to be able to sell them a few months or a year later at a higher price.

But, even these things really had the implicit guarantee of the U.S. taxpayer underlying them.  Without this guarantee, the demand for housing would not have increased as rapidly, driving up prices.  Without this guarantee, we may have been more skeptical of those sophisticated risk models.

As Roberts has stated, “Capitalism is a profit and loss system.  Profit encourages risk-taking and losses encourages prudence.”  Having the U.S. taxpayer as co-signer reduced the chance of loss and reduced prudence in just about every decision in the chain.

Government’s weakness: It doesn’t have to add value

In this previous post, I wrote about how government is overhead and that increasing overhead is probably not the way to improve a bad economy.

I compared the economy to a burrito-making business, with the private sector being the burrito-making and selling part of the business and the government being the overhead functions like accounting, legal and IT.

In this post, I’ll explore the limits of that overhead a bit more.

The value creation engine of our society is greatly under appreciated.  Without the burrito making part of the business, the overhead jobs for accountants, lawyers and IT folks at the burrito company would not exist.

The value creation engine in the economy is voluntary mutually beneficial trading.  When two parties trade voluntarily, they do so because they both come out ahead — otherwise, why would they trade?  Since they both come out ahead, value is created.

We each trade with others every day.  It’s hard not to.  We do it so naturally that we take it for granted.

Try this exercise.  The next time you buy something, ask yourself why you bought it.  What benefits did it provide you that made it more valuable than whatever it was that you gave up to buy it?

What was your next best use for your money?  Could you have spent it on something else? Save it? Why did you buy it instead of your next best use for the money?

Why do you show up to work to trade your time and skills for money?  Is that time or skill not worth as much to you as the time you give up?

The reasons you trade (or not) and the value you gain from the trade is Adam Smith’s Invisible Hand.   Your actions or inactions send signals through the price system on how much you value or don’t value things so that other individuals will respond and oblige to provide you more of what you do value.

In that sense, the price system was one of the earliest and best communication networks (although it doesn’t send information on why you value the things you buy, which befuddles many company managers).

Taxes paid to government, unlike voluntary trade, is compulsory trading forced by the government.

That’s not to say that some value isn’t created in that forced trade.  Government does create value for society, just as the overhead functions create value for the burrito business.  Governments provide citizens with security, law enforcement and justice systems, for example, that may benefit all of us.

But, since taxes and government are forced, it does mean that this trade does not have to create value for both sides of the trade.  That’s the important distinction that is glossed over by all sides of the debate on taxes and government.

When debating what government should or shouldn’t do, one side tends to provide examples of where they think government is worth the taxes paid.  The other side provides examples of where they think government is not worth it.

They never settle their dispute because they both can be right.  Neither side sees the full view that government can create value, but it’s not necessary that it does create value since government can force collect on taxes. Government gets money whether it creates value or not.

With voluntary transactions, it is more of a necessary condition that both sides come out ahead.   Voluntary trading that does not result in both sides coming out ahead usually dies out quickly because sooner or later the side that’s not coming out ahead voluntarily decides not to trade.  That’s a natural check on non-value added trades.

There’s not a natural check on what creates value with government and that’s why government can and does tend to grow far beyond where it adds value, which means it destroys value — or makes us poorer.

This also happens at successful companies.  Once a business finds a successful product and reaches a level of sustainable income, its overhead functions tend to grow faster than the value creation side of the business.

Some of this growth is good.  More overhead can make the business function more consistently.  But, it doesn’t have to all be good.  Just like with government, there’s not natural check (like the Invisible Hand) to limit the size of overhead and the “right” size of overhead is not clear cut.  Eventually bureaucrats feed off the flesh and muscle of the business and destroy value.

The overall limit on the size of overhead is the business’s income and many successful businesses have failed because management let overhead grow too large.

The overall limit on the size of governments (all of them — local and federal), is the value created by the private sector.  We are lucky that capitalism has created such a wealthy private sector.  It has allowed us to afford a good sized government.

But we are spending and destroying that wealth faster than the private sector is creating it.  Which means we are dipping far into our “rainy day” fund.  As Margaret Thatcher said,

The problem with socialism is that you eventually run out of other peoples’ money.

I’ll go a step further.  The problem with growing government so large is that you eventually run out of other people.

Don’t mistake this for an argument that essential government functions — especially those listed in the Constitution like defense — should be privatized.

Rather, we should be aware of this weakness of government and understand it has brought us to our current situation.  Further, we should keep this mind when evaluating what spending should be cut and consider private alternatives for the areas of government that are destroying value.

Make Someone Else’s Life Better

Econ Professor David Henderson gives a hat-tip to Bob Murphy for this wisdom from Will Smith:

Henderson likes Will’s wisdom at the 3:30 and 7 minute marks.  Me too.

I also liked what he had to say between 4 minutes and 4:35, especially this:

If you are not making someone else’s life better, then you’re wasting your time. Your life will become better, you know, by making others’ lives better.

As I commented on Henderson’s post, I believe most people will understand this wisdom to mean giving in a charitable way.  However, I also think it captures the meaning of this Adam Smith quote:

It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of their advantages. Nobody but a beggar chuses to depend chiefly upon the benevolence of his fellow-citizens. Even a beggar does not depend upon it entirely.

Perhaps Adam and Will are related.

In this quote, the long-dead Smith explains the positive sum universe of capitalism: voluntary, mutually beneficial exchange. Simply put, we choose to trade with others because we value what we give up in the trade less than what we gain.  Likewise for those trading with us.

Even simpler: capitalism is win-win, not win-lose.

I’m certain Will Smith had a charitable note in his wisdom.  I’m also believe he included family and community responsibility.

But, given that Will has been quite successful in the capitalist realm, I imagine he understands and included Adam Smith’s secret potion that benefits so many people on a daily basis with so few of those people seeming to grasp it.  It’s why I get to eat king crab just about whenever I want.

Why Does Power Corrupt?

Lord Acton famously said that “Power corrupts; absolute power corrupts absolutely.”

Have you ever wondered why?

Like most things, it’s a problem with the feedback. Someone with absolute power faces few consequences for their actions.

We are all self-interested. Adam Smith wrote about this over two hundred years ago in his book, The Wealth of Nations.  Self-interest is not greed, it’s human nature. We need to eat, have a place to sleep and stay warm. We all have our own preferences, needs, wants, luxuries and so forth. Our self-interest keeps us alive.

For most of us, our own self-interest also encourages us to be on our best behavior. If we don’t behave, we face negative consequences. If you insult a friend, they might give you the cold shoulder for a few days. For kids, time out is an effective consequence to teach right from wrong.

I know many people think they are good to others out of the kindness of their hearts. Maybe that’s true. I’d certainly like to believe that. But, more often than you may believe, self-interest keeps us from treating others poorly.

Have you ever gritted your teeth when a boss was mean to you? You did so out of self-interest. You didn’t want to risk losing your job.

Have you ever accidentally cut in line? Those you cut in front of quickly let you know about your infraction and you likely said, “I’m sorry, my mistake,” and then you moved to the back of the line to avoid making a scene or worse. Again, you were guided by self-interest.

Now, think about what happens if you remove those consequences. We’ve all experienced this to some degree.

What happens? For many of us it may have been surprising how quickly things went to our heads.

Maybe we aced a test, so we study less for the next one on the mistaken belief that we are smarter than we thought we were.

Or maybe your favorite sports team beat the pants off of a high-ranked opponent and you brag to your friends about how good they are.

That’s called hubris.

For most of us, it’s short-lived because we end up barely passing that next exam. Or, our sports team disappoints in the next game, because they also over assessed their abilities, discounted the fact that the highly ranked team had an off game, and then went into the next game with too much confidence.

Our friends and family will quickly let us know that we got “too big for our britches”. Those consequences deflates our hubris, quickly.

Now, consider some others that had limited consequences to their actions like superstars from the entertainment world. When people achieve super stardom, many of the natural feedback mechanisms weaken.

Laws seem to become a bit more lenient for you. People around you don’t want to jeopardize missing out on getting a piece of your fame and fortune by telling you the truth.

We all want to believe that we’d be a benevolent king or queen. But, think about how quickly hubris affected our behaviors when we aced the test or when our favorite sports team beat the higher ranked opponent. You didn’t go all the way to absolute corruption, but once you came back to earth, you may have even surprised yourself with how quickly you lost your bearings.

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