More on Saving and Investment

This article is a much better exposition of some of the ideas I was trying to get at in my post titled Bad Investment.

Here's a related post by Eric Falkenstein that discusses how people and businesses behave when their performance on fundamental measures is not well correlated to their earnings.

Bad Investment

I kind of understand the reasons behind the dot-com bubble. The emergence of new, paradigm-shifting technology suggested that untold fortunes might be made by the fearless who got in on the ground floor. The real estate bubble is more mysterious.

Who really thought that housing prices were accurately reflecting a balance between the number of available units (supply) and the ability of consumers to pay (demand), circa January 2006? Or even a year earlier, for that matter. Even casual attention to the loan-making process during this time would suggest a problem with the direction of the investments that were being made. Hindsight is 20/20, but at the time I did decline to take on such a loan myself because it just all seemed so ridiculous (though I should have taken it, had I been a more rational actor). 

I'm clearly no economist, but I think that the bubbles during the last halves of the last two decades must have a common cause. In both cases enormous investment was made on a basis of careless speculation bordering on willful self-injury. Why?

Some people talk about interest rates being artificially low and blame Greenspan and Bernanke. I'm no expert on that one, but I do wonder whether interest rates were low only because of the actions of the Fed. My suspicion is that low interest rates alone didn't cause all that bad investment, but that both the low interest rates and the bad investment were caused by a third factor.

I'm not quite sure how to phrase it, but doesn't it seem like there was an awful lot of capital that needed someplace to go during both of these booms? I've heard the phrase global savings glut bandied about, but I'm not sure exactly how to evaluate that. One thing seems sure: typical due diligence prior to investing was not being practiced in 1996 or in 2006. Is it simply that there were not enough quality investment opportunities available during these periods? Too much money chasing too few opportunities? That story seems to fit the facts, but I can't quite make sense of it.

Under what circumstance is there too much money ready to be invested? It's not the kind of thing I've heard debated, but I can imagine a world where saving is happening at a higher rate than is consumption. In that world, each saved dollar 'wishes' to be put to use producing, but most production is giving slim returns because demand is weak (e.g. most needs are already satisfied, so there's not a strong incentive to buy more). That doesn't sound like the USA we know and love, and whose savings rate has been negative in very recent memory. But it might be a description of the world when evaluated on net. 

Don't look at me like I have data to support that argument, because I don't. But imagine how a world like the one I've described might behave. Because many, many people are choosing to postpone spending until a later date, there are many dollars available for investment. But they can't be profitably put to work building factories to make gadgets to sell to people, because people are saving instead of buying gadgets. So investment dollars are available cheap, chasing every opportunity to earn some kind of return. Consequently, interest rates fall (with or without Bernanke's say so). In such an environment risky investments that pay well look much more attractive than they usually do because investors are desperate. Investment schemes based on the promise of unproven new technology or the faulty hope of perennially rising home values almost make sense. Eventually this kind of bad investment gains a certain amount of respectability and even becomes an indispensable part of every portfolio, because no one wants to be left earning pennies on securities that give Treasury Bill-like returns while the stupid money (other banks, municipalities, and private investors) make relatively good returns and don't seem to be blowing up.

This story is so simple that it must be wrong. Please tell me how it's wrong.

But if we assume that it's right, what policy can fix it? Or should it be fixed?

What if the solution is for governments to tax and spend in order to forcibly lower the savings rate?

What if we believe that taxing and spending is the solution, but it turns out that taxing and spending in the US doesn't fix the problem because we don't save much anyway, and that the real savers are in China and India?

Discouraging Effort and Success

Why do we tax labor? We know that any tax on an activity discourages people from engaging in that activity by reducing the rewards for doing it. So why do we tax hard work, production, and wise investment? Do we really want less of those things?

We need to fund our government (some claim), so we need to tax something. Why not tax behaviors that we want less of? Wouldn't that be killing two birds with one stone?

What would happen if we ditched all income taxes (including capital gains, and corporate income taxes) in favor of taxation levied exclusively against consumption? How would our society change?

I imagine a system wherein my income is not monitored by the government, but the total amount of my consumptive spending is instead. It's easy enough to do - just give up cash and require banks to report the amount of spending. As long as my consumptive spending total for the tax period stays below a legally established minimum, I pay no tax. But when my total rises above that level, I begin to pay tax out of each additional dollar spent. So if I don't spend much beyond the limit, the taxation I experience will be very low.

There are many advantages to such a system. For one, we'd stop punishing smart and hardworking people for being so productive. Every dollar they earn would be theirs to keep. This would include dollars earned for good investments (capital gains). Similarly, we'd stop punishing businesses for competence in producing and selling products and services to people who need them. When a highly successful business has to pay a large amount of income tax while its less successful competitor pays no tax (due to writing off business losses) the playing field is being unfairly tipped to reward poor performance! Not only that, but why tax production at all when production is what gives us the things we need and desire?

Also very important is the fact that taxing consumption, instead of labor, production, and investment, allows individuals to adjust their tax liability to fit their circumstances and desires. If I don't want to pay so much in taxes this year, I can reduce my consumption and pay less. And, I bear no penalty for working extra hard to earn additional money to fund my future, or my children's future.

Under this kind of system saving would be strongly incentivized. For those who wished to avoid taxation, saving and wise investment would be the safest harbor for their money. Everyone would be faced with compelling reasons to defer spending to a later date. Government subsidized retirement could become unnecessary for average Americans.

It's possible to take this idea to a more extreme level and suggest that leisure (time spent not producing or learning) could be taxed when it exceeded a certain minimum amount. This could spur the indolent and chronically unemployed (whether poor or wealthy) to return to productivity, lending their efforts to the improvement of society.

Undoubtedly there are many weaknesses in such a plan, and opportunities for clever gaming of the system. But that is no different from our current system for taxation.

Are there structural problems with this proposition?

Well-Off

Many economists build a case against policies that are aimed at reducing inequality in income and wealth. Their argument rests on two premises:

1. Societies should seek to be maximally productive, because this is the best way to provide for the needs of the members of the society, and
2. There is a trade-off between equality and efficiency - policies that promote equality tend to reduce productivity.

I'm not convinced. 

The first premise invokes Coase: well-defined property rights ensure that any redistribution (of wealth, property, or rights) that will increase societal welfare will happen through the mechanism of the market without the need for the intervention of the government - provided that transaction costs are negligible. 

Transaction costs are rarely negligible, but even if we set that aside there is still a problem. Arnold Kling gives an example that illustrates the problem with Coase. Prof. Kling considers the case of a biker who needs to use a bike path that crosses private land. Here's my retelling: The biker is willing to pay a heavy toll (a large percentage of his total wealth) in order to be allowed to use the path, because he wants to reach the hospital where his father is dying to see his father one last time. If he doesn't use the path then he has to take a much longer route and will not reach the hospital in time. The landowner wants to exclude the biker from using the path because the landowner doesn't like to have strangers on his land. Let's assume essentially zero transaction costs - the biker carries a transponder that automatically computes and pays his toll (with his agreement), according to the rate the landowner has set. The landowner sets the toll at a level that compensates him for the unpleasantness he experiences at having strangers cross his land. 

The problem is that the biker is very poor, and the landowner is very wealthy, and as a result, the price the landowner sets is much higher than what the biker can pay, even though the biker places a very high value on using the path. Under Coase, as long as the biker gets more value out of using the path than the landowner loses when the biker uses the path, then they should be able to agree on a price that compensates the landowner. Why doesn't that work in this case? Clearly, the biker places a very high intrinsic value on using the path - equal to a large percentage of his total wealth!

It doesn't work because the landowner and the biker value money, dollars, differently. Essentially the biker and the landowner are not using a common unit of exchange. You could say that the landowner sets the price in apples, but that the biker is paying in oranges. Or to highlight the difference in value, the landowner is setting the price in coal, but the biker must in diamonds. 

There is a further, even more radical implication to all of this, and that is that when there are differences in wealth among the members of a society, transfers from the wealthy to the poor INCREASE net societal welfare. This is because when a dollar is taken from a wealthy man and given to a poor man, the loss of intrinsic value experienced by the rich man is less than the gain in intrinsic value experienced by the poor man. Prices don't clear the market because prices are not established in units of intrinsic value.

As far as premise number two, I haven't seen any good measures of the magnitude of that trade-off. Is it significant? Is it significant at some degrees of intervention, but not significant at others? If you know where i can see data that describe this relationship I would be very interested.

PostScript: None of this addresses the libertarian arguments against policies that are aimed at reducing inequality. Nor does it address the question of whether governments are needed to effect redistribution (when it is desirable), or whether non-coercive institutions and norms could be a more optimal solution than government.

Social Welfare

I’m puzzled about something, maybe you can help me out.

Economists sometimes talk about a concept that I am going to refer to as the level of social welfare. Basically this is how much utility, or satisfaction, the society is enjoying as a whole. Here’s a simple example: imagine a society that consists of just two people, Bob and Frank. Bob has a banana that he would like to sell to Frank. Bob is willing to sell the banana for any amount greater than $1. Frank is willing to buy the banana for any amount less than $2. Bob is a good negotiator, so they eventually agree on a price of $1.75.

In this example, the sale of the banana increases the wealth of both parties. Bob traded something he valued at $1 for $1.75, so he gained $.75 worth of value.  Frank gave $1.75 for something that he valued at $2.00, so he gained $.25 worth of value. The level of social welfare in Frank and Bob’s society has increased by $1.00, because of the sale of the banana.

So the level of social welfare, as measured by economists, has to do with how much value people place on different items, and on how those items are distributed through the society. Moving goods and services from people who value them less to people who value them more will increase the total level of social welfare in the society. This is basic microeconomics.

The thing that bothers me is this: How much a person is said to value any particular good or service is measured in dollars. That is a relative measure, because it’s really comparing how much the person values the good or service against how much she values dollars.

And how much she values dollars depends on how many dollars she has.

Is this an objective way to measure the level of social welfare in a society? If I am very poor then this measure of social welfare under represents my preferences, needs, desires. Here’s a simple example: two starving men approach a baker who has one loaf of bread left to sell. The baker, having studied microeconomics, knows that the man who values the bread the most will be willing to pay the highest price. One of the starving men has $2 in his pocket, the other has $5. The baker sells the loaf for $5, confident that the man who offered only $2 wasn’t as hungry as the man who offered $5.

Obviously, the prices that the two men are willing to pay do not adequately reflect the value they would receive from the bread.  This is a serious problem. It undermines the legitimacy of calculations of social welfare. It also undermines the legitimacy of the price mechanism as a welfare maximizing means of distributing goods and services.

Is there a legitimate, objective way to separate preferences or utility from ability to pay? Is there some way to put the preferences of the poor on equal footing with the preferences of the wealthy, at least for academic purposes? 

Trade Deficit Bad?

As always, please explain to me where I’m getting it wrong.

The common argument, repeatedly endlessly by reporters and politicians, is that if we import more than we export then that’s bad. It’s bad for American workers because they’re going to lose their jobs if we don’t buy what they make. It’s bad for our long term prosperity because we’re sending all of our money to foreign countries. And it’s bad because it means we’re losing! We’re being outcompeted by our economic and military rivals, e.g. China.

It’s a pretty compelling argument, on the face of it. But there’s something confusing about the whole thing, something that doesn’t quite add up.

When I buy a shiny new Japanese-built car my dollars go to the manufacturer in Japan, and I get the car. But the manufacturer can’t use my dollars to buy things in Japan; the law says you can only use yen to buy things in Japan. So the manufacturer who built my new car has to either spend those dollars in the US, or trade them to someone else who wants to spend them in the US. Those dollars are claims against goods and services in the US – they have to come back to the US in order to be spent.

So every time I spend a dollar buying some imported good, that dollar goes to the foreign company that sold me their product. But eventually that same dollar comes back to the US to be spent on something here. It HAS to, there’s no other place for it to go. So how can we even have a trade deficit? Every dollar spent by Americans on imports eventually comes back as spending on domestic goods, services … or investment.

Investment is the thing that balances the trade deficit. Investment doesn’t show up in imports and exports (when I buy stock in a business, the business stays where it is), so it isn’t counted when computing the trade deficit. So, the reason that America has had a trade deficit with the rest of the world for decades is because Americans have been buying imports while the rest of the world has been buying ownership in America.

What does it mean that the rest of the world is buying ownership in America? Primarily it means two things: 1) Foreign investment in American companies, and 2) Foreign investment in US Federal debt. The rest of the world wants to invest in America because America is a good bet. American companies are enormously productive, and the American government doesn’t default on its loans.

Is it a bad thing that foreigners have been buying ownership in American business? No! American businesses use that investment to innovate and grow. Is it a bad thing that foreigners own US Federal debt? No! The US Treasury sells bonds according to policies that it believes are in the best interests of the US financial system and economy.

The primary effects of the trade deficit have been that Americans have enjoyed low prices for goods and services of all kinds, and have benefited from high levels of direct foreign investment. The real risk is that one day the trade deficit will go away as investment shifts from the increasingly regulation-bound US, to freer markets.

Intuitive Explanation of Who Pays the Tax

Non-intuitive explanation

When a tax is levied against a transaction, both parties to the transaction end up bearing some of the burden of the tax. Whether the buyer or the seller pays more of the tax depends on who has the greater elasticity.

Intuitive explanation

If I want to buy a new boat, but the government just put a new luxury tax on boats, will the boat dealer be able to pass the tax along to me or will he be forced to eat the tax? It depends on who wants to do the deal the most. Of course the seller will do his best to pass the tax on to me, but if he’s desperate to sell boats, and so are his competitors who are also trying to sell me a boat, then he’ll lower his price to get me to buy – effectively eating the tax himself.

It doesn’t matter who officially pays the tax. For example, officially I pay my income tax. But in a tight labor market (when there are lots of jobs and companies are having a hard time finding enough employees), my employer might be the one who is effectively paying the tax. Let’s say that I’m working for a company during a time when employers are desperate to hire people, and the government increases the income tax. My current employer doesn’t automatically raise my salary to compensate me for the increased taxes, so he’s effectively forcing me to eat the tax. However, if another company offers me a position doing the same kind of work for more money, then I can either take the new job, or try to extract a raise out of my current employer. In that kind of market I can effectively force the cost of the tax onto either my old employer or my new employer, because they need me worse than I need them.

Intuitive Explanation of Comparative Advantage

I'm going to try to come up with intuitive explanations for as many important concepts that voters should know about as possible. Maybe you can help me? Here's one:

Comparative Advantage

Non-intuitive explanation

International trade provides big gains to countries by letting them specialize in what they do best. Imagine there are two countries and that they both need paper products and circuit boards. If one country is better at making paper products and the other is better at making circuit boards, then each country should specialize in the product that they are best at producing, and then trade. However, if one country is better than the other at making both paper products AND circuit boards, does that mean that the country with the advantage in both kinds of production should make both kinds of products, and not trade with the other country? No! The country with an advantage in both products should specialize in the higher value product, and then trade with the other country for the lower value product. That way, the country isn't wasting valuable resources making a low-value product when they could be using those resources to make a high-value product. This will actually benefit BOTH countries. Both countries will have more paper products and more circuit boards to consume than if they don't trade.

Intuitive explanation

A successful cosmetic surgeon wants to redesign her kitchen. Not only is she a top surgeon, commanding in excess of $200/hour (on average, with different rates for different services), but she is also a highly skilled interior designer. In fact, she can produce designs that are as good as what her local professional interior designer can do, and she can do it in less time than he can. He charges $75/hr, and it will take him 8 hours to produce a design for her kitchen. She can produce a design of similar quality in 4 hours. The surgeon is very devoted to her family, and is unwilling to use her spare time in a way that takes her away from them, so if she re-designed her kitchen herself, she'd have to take time off work to do it. Should she create the design herself, or pay the professional designer to do it?

If she does the work herself, she will lose $800 worth of time at her practice as a surgeon (4 hours creating the design multiplied by $200 per hour). If she hires the professional designer she will pay him $600 (8 hours creating the design multiplied by $75 per hour). Therefore, she should hire the professional designer and save $200. This option is better for her (she saves $200), it's better for the designer (he gets a commision he wouldn't get otherwise), and it's better for her patients who need surgery (she will be able to serve more patients).

I'm Sorry, Professor Caplan

...but I had to laugh at this line in response to how it must come across to the average guy on the street:

"But think about how fun and enlightening cartoons about price controls and public choice would have been!"


In fairness, I agree with him. I just think you'd better take some pretty good visuals with you when you go into the pitch meeting.

The Future of Labor

In 1850 about 50% of Americans made their living as farmers or farm laborers. In 2000 it was about 1%. Increases in productivity can dramatically decrease the demand for labor in a particular part of the economy. This is all for the best, but it is difficult for the displaced laborers.

I haven't seen data to support it, but the conventional wisdom is that demand for unskilled labor is in steady decline. One story to illustrate this idea is that increased automation in factories eliminates unskilled positions, but may increase the number of skilled positions in the form of an expanded technical staff who develops and maintains the automation equipment. I think that story is at best an oversimplification of reality (e.g. increasing automation may mean that a factory doesn't eliminate jobs but trades skilled labor, like machinists, for unskilled labor in the form of machine operators who only need to push some buttons and measure parts), but even if it's accurate it doesn't tell us what's happening to the number of unskilled labor positions in the overall economy.

Productivity increases in an industry lower the cost of production for that industry, meaning that society can spend less on that industry's products. That's why I spend a smaller percentage of my income on food than did my grandfather, and why fewer people are working on farms today than were in 1850. As we've gotten to be better at producing food we have saturated demand. The US produces more food than it knows how to consume. You can just as easily blame farm worker displacement on the 'low' demand for food as on high farm worker productivity.

Interestingly, increases in farm worker productivity have lowered the costs of non-farm products as well, because all that displaced farm labor was freed up to be used to produce more valuable items like cars and houses. And now we're choking on too much supply of those items as well (due to increasing productivity), and workers are again being displaced.

As Arnold Kling puts it:

"...before you tell me that we are outsourcing to China, you should remember that (a) our manufacturing output has been increasing, even though the number of people working in that sector is declining; and (b) employment in China's manufacturing sector has been shrinking, also."

So what is the future of labor, skilled and unskilled? Continual displacement from one industry to another, and a falling cost of necessities and luxuries. These are near certainties. But what else? Will the unskilled be left behind? The unskilled will always earn less and be less productive than the skilled, but I don't see any evidence that they are simply being left without work. I do see that average, middle class people are spending more of their income on paying someone else to care for their lawns, to service their cars, and to clean and repair their homes.

One day cars will be rolling off of 'lights off' manufacturing lines, with only a handful of humans monitoring entire factories. I don't believe that we'll have high unemployment, or (more to the point) a human welfare crisis when that day arrives.

Practical Economics

I know that several of you are much more knowledgeable than I am on this topic, so consider these to be cries for help rather than pontifications. Even though I'm going to phrase them like pontifications.

It seems like one of the major things that holds Economics back is insufficient data. There are some big schisms in Economics, and I think they could be healed with better data. More to the point, I think that Economics could become MUCH more productive and more helpful in engineering a brighter tomorrow if Economists had enough high quality data.

So why don't we go collect that data?

The argument goes that it would be unethical to perform economic experiments on live populations. Utter nonsense. Our Congress has no such qualms.

Speaking of Congress, you'll notice that legislators do not presume to design aircraft carriers or information systems (though they do weigh in pretty heavily on requirements). So why are they designing our economic system? Wouldn't it be preferable if they farmed that work out to experts?

So what I'm proposing is the establishment of several special economic zones around the country. These would be the labs for economic research, and the schools for economic engineering. The policies in the special economic zones should be set according to the aims of research, but with the limitation of always trying to achieve desirable outcomes in terms of human welfare. I don't think that cramps the science mission too much. It would be desirable to choose economically troubled cities where experimentation has the highest probability of doing good, and where any negative outcomes can be conveniently blamed on the history of the place (sort of kidding about that last point).

The administrators of special economic zones should have wide freedoms to implement policies, without regard to federal or state law, so long as those policies were consistent with the research plan. Results should be carefully collected and reported. Standard measures should be collected and compared for all of the special economic zones, in addition to the data that is collected specifically for the local research plan.

In the interest of human welfare, policies that restrict emigration from the special economic zones should be prohibited. This is a necessary limit on the research objectives. If Keynesville experiences economic implosion, it's not humane to force the residents to suffer through that.

What are the most serious problems with such an idea? Could it ever be possible?

Why Positive Externalities Are Bad

A.K.A. The Tragedy of the Commons

A negative externality is when someone who is doing some activity doesn't bear all of the costs of that activity. Instead, some or all of the costs are imposed on somebody else. This is bad not only because it's unfair, but also because it means that too much of that activity happens, like in the example from yesterday's post where gold mining in California was probably a net economic loss to the state. If the gold miners had to pay for the damage they were doing, they would have only mined the gold that they could get out without causing a lot of damage.

A positive externality is when someone who is doing some activity doesn't capture all of the benefit of that activity, and instead some of the benefit is captured by other people. It sounds like a good thing, like a service to society, right? Actually, positive externalities are also bad, because they mean that too little of that activity will happen.

In the digital age positive externalities are becoming much more noticeable, and having much more powerful effects on society. These effects are good! Google and Wikipedia (just two prominent examples) have provided enormous value to hundreds of millions of people. Though Google has made piles of money for its founders, it is still the case that the the value to society of Google's services is at least many times greater than all of the ad revenues the company has ever collected. How do I know that? Because I've already used Google more than 10 times this morning at no cost to myself, AND I didn't click on, or even notice, any ads. In fact I've hardly ever clicked on any Google ads. I am quite clearly free riding on Google's service, and have done so for years. Google is even subsidizing the wealthy, multinational corporation I work for by allowing my company to do research, for free, with its powerful tools.

So, why are positive externalities a bad thing? Oh right, because where positive externalities exist, not enough of a valuable activity is occurring. Can this be true? Do we really not have enough Google? Has society left money on the table in the form of investment that hasn't been made, but that could be making us all much, much better off?

Yes. Absolutely.

It's a hard thing to prove, because value that hasn't appeared is difficult to visualize, and even harder to quantify. but basic economics tells us that, yes, we are not getting an optimal amount of Google (and similar products/services). In fact, we are over-investing in something, maybe cars or houses or something, and under-investing in other things like information technology where it's hard to capture the benefit, and instead the benefit leaks out to the rest of society.

Just one quick example before this post gets long: Would the internet be what it is today if it hadn't been sponsored by the government? My guess is, no.

Why Externalities Are Bad

Here's another story which, like the one about the hurricane and the ice sellers, belongs in an introductory microeconomics class.

After gold was discovered at Sutter's Mill in Coloma, California, we all know that there was an influx of prospectors to the foothills of the Sierra Nevada mountains. The popular image is of solitary, rough-edged men kneeling in the shallows of mountain streams and panning for gold. There actually were many prospectors who fit this description, especially in the early days of the rush. However, once it became better established that there actually were large quantities of gold dispersed in the alluvium of the rivers, mining companies with the ability to outfit custom excavators and extractors moved into the gold fields. These companies with their mechanized equipment extracted gold much more efficiently than was possible by simpler means.

The equipment they used came in many varieties, but two kinds were particularly prominent due to their power and and effect on the landscape and rivers. The first of these, water cannons, were used to practice a kind of gold extraction know as "hydraulicking" in which sediments were blasted and washed into sluices where the gold would settle out. The second kind, dredgers, were used as platforms for processing large quantities of sediment in the alluvial plains at the base of the hills. Near Sacramento today there are still many places where you can see large fields full of lumpy hills of gravel and stones. These are the remnants of the work done by the dredgers.

All of this activity washed enormous quantities of sediment into the rivers that come down out the the Sierra Nevadas. For those of you not familiar with the physical geography of California, all of the drainage from those mountains comes into California's central valley. There is only one way out for all of that water, and that is through the San Joaquin Delta, into the San Francisco bay, and out to the Pacific. The sediments that were washed down from the hills dramatically impacted these waterways. One of the most noticeable effects was the great flood of 1850 that all but destroyed Sacramento. There is some argument about whether the flood was caused by the plug of sediments working its way through the river system, but it has been cited as a likely contributing factor. Another deleterious effect was the silting up of the San Francisco Bay. A considerable amount of usable area in the east bay was lost to infill from the sediments. Shipping lanes had to be dredged to keep them from becoming impassable. Less well documented, but doubtlessly significant, were the costs to wildlife in the affected wetlands.

It has been estimated that the economic damage to the San Francisco Bay alone was greater than the value of all of the gold that was extracted.

Economists call it an externality when the actions of one group cause consequences that are borne by others. The costs of the damage done downstream by the gold miners was real, but the miners were not held responsible for it. The result was that all of their efforts caused a net loss of wealth for California, even though they created wealth by extracting the gold.

The problem isn't that the miners wanted to extract the gold, or that they didn't care about what happened downstream (they may not have even known). The problem is that because they weren't forced to bear all of the costs associated with extracting the gold, they extracted too much gold, and used processes that were too costly - costly to others. If the miners had borne the costs, as well as the rewards, of their activity, they would have extracted less gold with cleaner processes, and the people of California as a whole would have reaped a net increase, instead of a loss, of wealth.

America's Competitive Edge

How did America become and why does it remain a super power? Here some possible factors:

• Large size - Basic economics tells us that there are huge advantages to be gained from specialization and trade. However, the magnitude of the advantage depends on the size of the market. For example, I can't specialize in making toilets if I live in a small village of population 100 and have no contact with the rest of the world. Why not? Because I won't have a large enough market to be able to sustain myself in that specialty. As a result, when someone does need a new toilet in my small isolated village, they will have to either produce it themselves, or hire someone in the village who has made toilets before to make one. Needless to say, quality will be low, and price will be high. America has at times been somewhat isolated from the rest of the world in trade terms. However, even during those times the US was a relatively large country with a large market for goods and services, and so it captured a large benefit from specialization within the market. I think this is also much of the explanation for the Soviet Union's ability to remain a super power for many decades during which it was economically isolated from the west.

• Free Market Capitalism - There are a couple of important features of free market capitalism that I believe make a big difference to the amount of wealth that is produced within the society. First, the freedom to compete within the marketplace spurs innovation, both for market incumbents and for new entrants to the market. I feel this every day at work (I'm an engineer working for a manufacturing firm) as we are constantly seeking to improve our processes and products in order to remain viable within the market. Everyone in the company knows that standing still means we'll all be out of jobs in a very short time because our competitors will beat us in the market with better products at lower prices. The second part of free market capitalism that is important is that it rewards good ideas and good execution, and punishes bad ideas and bad execution. Inefficient firms die while efficient firms take market share. The image below illustrates how differently capitalism is viewed in much of the rest of the world. If free market capitalism really IS an important part of high productivity and high standard of living, then those who reject it are putting the gun to their own heads.

•  Regime Certainty - This is the opposite of regime uncertainty, where no one is sure if the law will be the same today as it is tomorrow, whether there will be civil war tomorrow, whether property rights will be respected tomorrow, etc. The US has been stable and secure, with mostly predictable application of the law, for decades. This matters! When there is regime uncertainty investment drops because the value of any investment is a value that will mature over time, and uncertainty about the future of something as basic as the law or property rights decreases the value of any and all investment. Look to sub-Saharan Africa for an example of what regime uncertainty does to growth. Of course, the concept of regime certainty also embraces the fact that America was not ravaged by two world wars during the 20th century.

•  Immigration - The US accepts more immigrants than does any other country in the world. The US is characterized by its immigrant population, including those of us whose ancestors came here prior to the 1930s, and now think of ourselves as 'typical' Americans. I think that it is the case that the US has been very successful at attracting the best minds and the most innovative people from around the globe, in part because of the benefits of free market capitalism and regime certainty. Innovative people are drawn to places where they will be free to innovate. Entrepreneurs are drawn to places with regime certainty. I think this is much of the explanation for why the US is such an innovative and entrepreneurial nation. Listen to Paul Graham's comments on immigrants starting businesses to get a better idea of what I mean.

Now I know that this list isn't exhaustive, but these are the main things that come to my mind when I puzzle about the US and its accomplishments and place in the world. What have I left out? Or better yet, what is wrong in my approach altogether to this question?

Pirates of the Gulf of Aden

Imagine you’re the leader of a country, and another country wants to build a pipeline across your soil to get oil to the sea. Do let them do it for free, or do you demand a cut of the oil revenues? I’m betting that most of us would expect to get some piece of the action.

Now imagine that you’re the leader of a non-state entity that has de facto, though tenuous and extralegal, control of a body of water that happens to be an important trade route. If you demand payment for safe passage, are you more morally repugnant than is the government leader in the previous example? If so, why? Both are cases of rent-seeking, where a party tries to extract value without adding any value.

You might say that the leader of the country in the first example is within her legal rights under international law. This is a distinction between the two examples. However, some would argue that international law has a weak claim to legitimacy, since it has been crafted by powerful nations who have sought to codify their own interests.

You might argue that the leader of a country possesses standing to impose limits on regional activity, and that the leader of a pirate coalition does not. But, do the monarchies and dictatorships in the region of the horn of Africa truly have greater legitimacy than do the people who currently provide police and other public services within eastern Somalia?

OK, I’ll admit that the argument that international law legitimizes control of agreed borders, and that the pirate activity in the Gulf of Aden undermines the rule of law, is a compelling one. But how about rent-seeking? Is it any more desirable from a state actor than from pirates, assuming that either way it’s backed up with threat of force?

China is Subsidizing America's Standard of Living

Gary Becker does a good job summarizing the argument against trying to convince China to let the yuan fall against the dollar. Basically it goes like this: We want to buy Chinese goods, but Chinese goods can only be purchased with Chinese currency, so we give dollars to the Chinese central bank in exchange for yuan. But the Chinese government has this policy where they always give us more yuan than our dollars are really worth. So it's a good deal for us, and a bad deal for them. Why do they do that?

Even more relevant to Americans is the question, why is Obama trying to convince the Chinese to STOP doing that?

The comments on Becker's blog aren't working, but here's what I tried to post in reply:

Can it really be sheer foolishness on the parts of both the Chinese and American governments? What can their respective motives be? 

In America there has been a long term advertising campaign against any trade deficit, and many American voters have been persuaded to embrace a cause (make imports more expensive) that is likely not in their own interest. Have unions and export businesses so completely captured trade policy in the US? 

Is there a similar explanation for the Chinese policy?

Arguments For and Against Redistribution

Arguments Against

• It is unfair to take my property and give it to others
• Is a disincentive to be productive due to marginal tax.
• Is a disincentive to be productive due to free riding.
• Hurts productivity by taking resources from the most productive people and giving them to the least productive people.
• Reward merit – hard work, intelligence.

Arguments For

• It's unfair to have so much inequality.
• Increase the total value to society (taking a dollar from a rich person and giving it to a poor person hurts the rich person less than it helps the poor person, and so is a net gain to society).
• Prevent/undo accumulation of wealth and power into the hands of the few.
• Undo the effects of unequal starting points (born into wealth vs. born into poverty).
• Increase market representation of the poor (democracy of capitalism – vote with your dollars for what goods and service should be produced. The rich have more votes.)
• Don’t reward based on chance – birth circumstances, chance opportunity, the genetic lottery.

Cost of Health Care

Why is the cost of health care so high? There are a number of therories.

*Not enough competition in the market for insurance (insurers are taking us for a ride). One explanation for why this might be true is that regulation prevents competition across state boundaries, and that health insurance companies enjoy an exemption from anti-trust policy. This has been the focus of Obama's health care reform argument. Scott Harrington discusses the angle here.

*Not enough competition in the market for care (health care providers are taking us for a ride). The argument here is that health care is an inherently local market, which can result in natural monopolies. This explanation seems to work best for care that is provided through hospitals, and less well for care provided through small clinics. Ezra Klein has some interesting charts to support this argument.

*Medical technology is highly valuable, and highly expensive (the best care doesn't come cheap). This idea can get very complicated very quickly. Patents on drugs and devices, the costs of R&D and FDA evaluation, the relative benefits (if any) of the latest technology over standard technology, the carrying costs of an expensive new machine that will only be used by a small number of patients each year versus the need to provide state of the art care, all play into this argument. Tyler Cowen links to some evidence that the health care system in the US is providing substantial benefits.

*Medical technology companies use monopoly power to inflate prices (drug and medical device companies are taking us for a ride). Similar to above, but with more emphasis on price, and less on value. Robert Reich notes how the whole issue is politically charged. Ira Glass discusses some ways in which drug companies extract inflated profits from insurers in this episode of This American Life.

*The incentive to over-consume health care (patients are taking us for a ride). Because copays are low, the argument goes, too many people visit their doctor for every minor head cold. Arnold Kling makes the argument here, and disambiguates this hypothesis from some of the others. Don Boudreaux makes essentially the same argument in more aggressive terms here.

*Costs of the uninsured (the poor/unemployed/illegal immigrants are taking us for a ride). The argument is that the uninsured are free-riding on the policies of the insured. Whether this is a good thing or a bad thing depends on who you ask. Whose fault it is is also up for debate. (More here.)

*Costs of the underfunding of Medicare (the government is taking us for a ride). That's right! Because the government is the government, it can require hospitals and doctors to treat Medicare patients, but not pay the going rate for their care. So who pays the difference? Well, the story is that health care providers make it up by charging privately insured patients more. So, potentially this practice could cost the health care provider some profit margin, or it could cost the insurer some profit margin, or it could come out of the pockets of privately insured individuals in the form of higher premiums (or some combination of the three). Uwe Reinhardt rebuts this argument, but to my mind his rebuttal lacks nuance on the question of who makes the price in each market. Remember that the market for health care for Medicare recipients is different from the market for health care for privately insured people (because the rules are different for each of these markets), and that the market for health insurance is a separate market still. In each of these three markets different players hold relative market power, and so have differing abilities to make prices. What I'm getting at is that maybe it IS true that the government sets the price in the first market, the hospital sets the price in the second market, and the insurer sets the price in the third market, with the end result being that the costs are shifted from market to another.

*Insufficient supply of doctors/surgeons/specialists (doctors are taking us for a ride). Regulation and licensing of health care professionals creates a barrier to entry to the health care provider market, keeping salaries artificially inflated, and thereby inflating costs of care. So do Doctors earn too much? Doctors say no. Alex Berenson says yes, as does Ezra Klein. In any case, greater utilization of Physician Assistants could help, especially in routine care where all that specialized training may be under used.

So, what do I think? I think costs are the symptom, not the problem. If the symptoms threaten the patient, then please treat the symptoms! But eventually the underlying illness has to be addressed. More on that in a later post.

Survival of the Most Fit

I know that it's not an original observation, but Too Big to Fail and similar policies to protect people and businesses who do a poor job are seriously interfering with the basic premise of a market economy.

James Kwak has written a post about how Citigroup CEO Vikram Pandit seems unable to present a meaningful description of his business strategy.

It's not uncommon to witness top business leadership governing on ego or otherwise failing to understand the limits of their firm's competency, and value in the market. One of my favorite examples is Daimler Benz CEO Jurgen Schrempp's famously bad decision to acquire Chrysler. The evidence suggests that Daimler's management team had no workable strategy for how to make use of their purchase or how to integrate it into their organization. No meaningful synergies were ever anticipated, nor did any emerge - as was practically guaranteed by leadership's policy against platform and technology sharing between Chrysler and Mercedes. In the end Schrempp was fired and Daimler paid Cerberus to take Chrysler off its hands.

This story perfectly illustrates how a competitive market is supposed to function, with severe chastening for incompetence. Interference in this process, even for the best reasons, will introduce pernicious effects.

Moral Hazard - Moral Hazard is a technical term that means that the risks of my actions are borne by others, not by myself. Moral Hazard explains why innovations in automobile safety systems, like airbags and seat belts, has resulted in increasing risk to pedestrians. It also explains why beach homes continue to be built in locations that put them at risk in the event of a hurricane (because the government has historically bailed out the wealthy owners of these sometimes non-insurable properties).

Picking Winners - When an incompetently managed firm shrinks or dies, an opportunity opens for the most efficient competitors to take market share. Bailing out large incumbent firms that perform badly interferes with the success of other, better run companies who are then forced to compete without the benefit of government backing. It also tends to strangle small upstarts who are bringing new value and innovation to the market. How do you think the founders of Tesla feel about GM being propped up by the government?

Regime Uncertainty - Perhaps most pernicious of all is the effect of Regime Uncertainty. This is a reluctance on the part of investors to put their money into markets, industries, or countries where the rules are not clear, or could change at any moment. Why has sub-Saharan Africa failed to develop? Well, one reason is because people are reluctant to build businesses in a region that suffers from frequent civil war and political tumult. If I build a factory in Tanzania today, will it be destroyed or seized by government tomorrow? Similarly, how willing am I to try to operate a business in any market where the government is making up the rules of competition and ownership day by day? Consider how the government chose to take money from GM's bond holders and transfer it to the UAW.

Systemic risk is a matter of incentives. Too Big to Fail is magnifying the wrong incentives.

Sunday Links

California's budget problem results from the uncontrolled growth of government. However, help is on the way! Unfortunately it's coming in the form of a possibly illegal takings (Mother Jones and Cafe Hayek).

You may have already guessed that a rushed and kludgey repair job on the Bay Bridge caused the recent failure. This analysis suggests that guess is correct (Sci-experiments.com).

The University of Utah Genetic Science and Learning Center has created an excellent interactive graphic that helps explain the scale of small things. You'll want to show this one to your kids as you explain to them about germs or molecules (U of U).

The problem with economics is that it hasn't advanced far enough that it can make useful predictions. However, as Nassim Nicholas Taleb would point out, that's OK because there are still plenty of economists who are willing to go out on a limb and suggest untestable hypotheses to explain past events (Amazon.com and Bluematter).

The problem with socialism is that no one knows how much anything costs. Eric Falkenstein uses Amtrack as an example. Funny, but I keep hearing the same thing about health care (Falkenblog).