Occupy Wall Street

A friend asked what I thought about Occupy Wall Street.  I directed him to John Stossel’s latest column, Wall Street Protesters Half Right, because Stossel does a great job of summing up my views.

I hope that the OWS protesters learn to better distinguish between the free market and the rent-seeking profits that seem to bug them.  Right now, they confuse those concepts.

Here’s another post on this distinction.

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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.

“Your Teacher Said What!?” Review

I’ve been looking forward to reading Joe and Blake Kernan’s book, Your Teacher Said What?! Defending Our Kids from the Liberal Assault on Capitalism.

I highly recommend it. It exceeded my expectations.  I found it well-written, easy-to-read, entertaining, critical, well researched and fair.

In the book, Kernan describes how he handled presenting ideas of about liberty, free markets, business and the government to his daughter.  We can all benefit from it.

For those unfamiliar, Joe Kernan is the morning host of CNBC’s market and business program Squawk Box and an unabashed capitalist.  His daughter is (or was) ten-years-old and attends public schools.

Despite the title, the book doesn’t focus a great deal on what Blake’s teachers say.  Though, in the book he gives credit to her teachers for doing a fine job of teaching everything other than liberty, markets and business (an example of where he is fair).

Here’s another example of his fairness (p. 3).

When Barack Hussein Obama took the oath of office, I admit I understood the proud cheers of the hundreds of thousands of people lining the parade route in Washington that day.  I didn’t vote for the guy, but I’m not a complete dolt, and I could see how his election said something pretty positive about America.

The hangover didn’t take long coming.  My hangover isn’t the result of concerns about the president’s birth certificate. Or worries that he is some kind of Manchurian candidate in the pay of a foreign power.  I don’t think he’s Muslim, or racist, or anticolonialist, or un-American.

No, my problems with the president are on an entirely different plane: I hate what he’s doing to my children’s future, and I don’t have to think that Barack Obama is the devil to know that he has a very different idea than I do about what America should look like when Blake and Scott are adults.

It’s a belief thing.  Penelope (Kernan’s wife) and I believe in free markets–that the best economic decisions are made by the largest number of individuals acting in what they believe to be their own interests.  President Obama and most of his administration believe in an economy that depends on the cleverest people acting in what they believe to be the interests of everyone else.  We believe in voluntary associations.  They prefer compulsory ones, at least when it comes to health insurance or union organizing.

This sets the stage.  Kernan is not out to make unsubstantiated personal attacks.  Rather, he presents why he thinks his beliefs are right.

In one chapter, Kernan dives into anti-business portrayals and caricatured markets in movies like WALL-E and Avatar.   He concludes:

…I still don’t understand the reflexive hostility of the entertainment business to free markets and capitalism.  Maybe the best explanation is that the writers, directors, and actors who produce our filmed entertainment are allowed (maybe even encouraged) to retain a child’s view of the world.  Like ten-year-olds, they retain a belief in obvious heroes and villians, in perfection as a place where things don’t change (especially as the result of human action), and in happy endings.

A little later, Kernan defines Progressivism (p. 127):

The desire to regulate economic life might be the defining characteristic of Pregressive philosophy.  It combines a mistrust of the free market in allocating resources; an appeal to a vague and indefinable virtue (“fairness”); a desire to achieve perfection in economic outcomes; a deference to experts over the judgement of ordinary folks; and, best of all, a chance to tell other people what to do.  Oh, heck, let’s just say it: Regulation is progressivism.

It is also the perfect way to illustrate just how much Progessive thinking depends on treating adults like kids.  Because kids love regulation.

“Blake?”

“Yes, Dad?”

“You know cigarettes are bad for you, right?”

Eyes roll upward.

“And you know that people aren’t allowed to smoke in restaurants or lots of other places, right?”

“They shouldn’t be allowed to smoke anywhere.”

“Why not?”

“Because it’s bad.”

These two previous passages spurred the idea that many people form their sense of how government, business, markets and the economy work when they are about 10-years-old.  And, they don’t reconcile these views with the real world often, even against compelling evidence.

This brings to mind folks I know who haven’t realized that markets have made available, even to folks with modest income, a standard of living unmatched on this planet, ever.

Or folks who haven’t yet realized that all politicians should be considered narcissists only interested in their own political gain.  I admit, this one took me some time.  I spent too many of my younger days defending “my” politicians for their disappointing behavior before I realized that was a waste.  Assuming all politicians are in it for themselves dispels with the vacuous “I really like that guy” vote and helps you focus on whether or not you agree with the politician’s positions.

If it’s true that many folks think of government using their 10-year-old logic, this may make Kernan’s book one of the most important of the year because it provides nice advice on how to deal with this.

Beware combo fallacies

Hypocrisy is a common criticism leveled at free market advocates.

The criticism is that since free market advocates use and benefit from various forms of government programs like roads, Social Security, fire protection, Medicare, public education, libraries (I threw that one in there) and so on they are hypocrites for suggesting that such programs could be carried privately.

The implication is that unless free market advocates refuse to use these programs as a matter of principle they are not credible.

A couple examples from the last week stick out in my mind.  In one, a commenter on a local blog pointed out that Ayn Rand, libertarian heroine, relied on Medicare near the end of her life.

Below is another example from the comment section at Cafe Hayek, where a commenter charges Don Boudreaux with this hypocrisy:

I take it you (and your blog buddies) vehemently oppose support of any kind of “welfare state;” though, I’m betting you have no problem with the many and various forms of corporate welfare that abound, or the state university systems which apparently provide for your education and career, or the Internet (still regulated by the GAC) which provides a very public platform for your right-wing ideology…and I could go on, but you get my point.

Don responded: “I oppose ALL government programs, including support for higher education.”  Great.  But, I think Don’s response is unnecessary.  He took the commenter’s fallacious bait.

The hypocrisy criticism is a combo fallacy.  It combines a red herring (aka ‘changing the subject’) fallacy with an ad hominem (aka ‘name calling’).

Whether Don is a hypocrite, or not, has no bearing on whether he is correct.

The roots of this combo fallacy tactic can be traced to Kindergarten recess. It should not be so becoming for supposedly well-educated and bright folks to use as adults.

The ad hominem part of this combo fallacy is a personal attack (“hypocrite”) meant to put the accused on the defensive and respond to the red herring.

If you change the topic of conversation away the merits and demerits of free market vs. government to defend yourself against the hypocrite charge, the red herring fallacy succeeds and little productive discussion will take place about the original subject.

When faced with this combo fallacy, I think it’s best to keep to the topic at hand.  Here’s an example of a response that could do that:

Whether or not I’m a hypocrite has no bearing on the correctness of my point.  Would you like to discuss my point?

If they can send a man to the moon…

I started the draft for this post before reading Steven Landsburg’s The Big Questions.  Only now, as I get back to completing it do I realize that he provided the perfect words to back up this point, and I’ve already posted those words.

The fact that “we (I certainly didn’t have anything to do with it) sent a man to the moon” has been used in many debates over what the government is capable of achieving.  Maybe you’ve heard it.  It usually goes something like this:

“If we can send a man to the moon, then we can…

…end poverty

…make sure everyone has health care

…ensure everyone has a good standard of living

…give everyone a vacation?” (This one surfaced recently in the UK.  While they didn’t send a man to the moon, this shows where this logic can lead.)

Sending men to the moon was hard, no doubt.

But, the fallacy is generalizing what it takes to send a man to the moon is similar to what it takes to end poverty or give everyone health care.

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The market in action

One of the disadvantages the “market” has is that few people understand what it is and how it works.

What: A market is nothing more than the interactions that take place between people.

How: Contained in the those interactions are signals and feedback that help us respond better to each other.

Yesterday a colleague and I were responsible for providing birthday treats for our work group. We went to the grocery store across the street from the office.  I decided I was going to buy Hostess cupcakes.  My colleague wanted to buy Ding-Dongs.  We happened to come across the Hostess vendor as he was restocking his shelf.

I picked up the box that contained nine cupcakes for $2.99.  My colleague asked the vendor for the big box of Ding-Dongs.  The vendor replied that he only stocks the snack size of Ding-Dongs on this rack, because the bigger size just doesn’t sell well enough here.

There it is.  The market in action.  The people who frequented that grocery store, for whatever reason, didn’t buy very many big boxes of Ding-Dongs.  Not buying was a signal from the customers telling the vendor that they didn’t prefer the big box of Ding-Dongs.  He had tried it out. The response was poor.  His employer encourages him to maximize sales, which means he would be stocking the mix of products and sizes that customers are most willing to buy.  The vendor uses the feedback he receives from what sells and what doesn’t to try different things out and to make his customers and his employers as happy as possible.  That’s a win-win situation and that’s a great example of how the market works.

Obviously, it’s not perfect.  My colleague didn’t get his big box of Ding-Dongs (though he could have bought 6 snack sizes), but he chose an acceptable substitute – Twinkies.

What’s the Comparison?

In the latest Econtalk podcast, Don Boudreaux on Public Choice , Boudreaux of Cafe Hayek and George Mason University points out a common error by critics of free markets.  The error is in comparing the functioning of the free market to an idealized perfection:

…compared to what? It’s not the merits of the market compared to some ideally-performing government, or ideally-performing dictator–it’s compared to government as it is likely to perform as the alternative to the market.  Also wrong to hypothesize a perfectly working market and assume that’s what’s happening in reality.

I hear this all too often.  The reasoning usually goes something like, if a market does not work exactly how I want, then we must rely on government instead — as if the government is perfect or can someday be.

Markets are not perfect, but neither is government.  Government has proven to be much less perfect because of the feedback loops and incentives.  Markets are self-healing, governments keep pumping in blood without attending to the wounds.

The next time someone suggests government as a means to achieve perfection, ask them which government program is the model on which such perfection should be based.