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.

The Point Of This Blog

"Without new technologies, an economy might grow slowly. But without decent rules, an economy cannot even make use of the technologies that already exist."


-Sebastian Mallaby

Roots of Government

Government is coercive. Concentrated application of force is what government is for.

I imagine two stories for how government arises. The first is government as the embodiment of the social contract, where the contract in question is not figurative or proverbial, but literal. According to this story, government is chartered through an agreement among parties to defer power to an enforcer. This is the process by which townships of the old west incorporated, and hired a mayor to attend to administer the activities of government and a sheriff to physically enforce law and order. The people of the town authorized the government explicitly, and explicitly agreed to be subject to the law and to the officers who carried it out. They further participated in government through town hall meetings and by bearing arms in the defense of the law as deputies.

This same kind of government can be found in clubs and private organizations, and in businesses. The fact that in this story government originates in an agreement among the parties to be governed should not obscure the fact that the government is adopted specifically for the purpose of exercising coercion over the governed. Consider the freelance labor crew who wishes to maximize their profit. They may choose to hire a foreman who is brutally forceful, in order to ensure that every member of the crew works hard and no one is allowed to free ride.

In the second story of the origin of government, government is imposed on local people from outside of their own community, and without their consent. This is the feudalistic story of government, where small farming villages are robbed repeatedly by regional bandits. Eventually the theft becomes routine, and competent leadership among the bandits leads to a sustainable level of pillaging that doesn't destroy the farmer's ability to continue producing each year. Full-fledged feudalism is justified as protection of the serf class by the bandits, who claim that the bandits of the next fiefdom over are far more brutal than they are. So, a social contract-like mantle legitimizes the theft and coercion.

In both of these stories, government exists for the purpose of exercising force.More particularly, it is for the purpose of imposing the will of a powerful coalition, who may be a majority or may simply be a sufficiently powerful elite, upon the rest of the society. The townsfolk impose law and morality upon the lawless and the eccentric, the crew of laborers impose hard work upon the lazy, and the bandits impose taxation upon the serfs. The difference is in what fraction of the population is represented by the government, and what fraction is victimized by it.

Business Cycle

Systems with feedback loops can have complicated, difficult to predict behavior. However, there are three basic varieties of simple feedback loop, and understanding these three types can lend insight into the behavior of more complicated loops.

The first type is positive reinforcing. These loops runaway in one direction forever, until something in the system changes and the dynamic is allowed to breakdown. The classic example is the runaway population growth of bacteria in a petri dish.

The second type is balancing. This kind of loop is characterized by equilibrium among opposing forces. It takes effort to push these systems away from their natural equilibrium point, and they tend to fall back again once the effort stops. However, they can be complicated by having multiple points of equilibrium.

The third type of feedback loop is oscillating. This is essentially a special version of the balancing type of feedback loop. As with the balancing type there is a force and an opposing force, but in this case the opposing force has a delayed response. As a result the system swings from one extreme to another, like a pendulum, as the system is dominated first by one force and then by the other. Aviators may refer to this behavior as PIO - Pilot Induced Oscillation. If there is a delay between when the pilot gives an input to the control surfaces and when the aircraft responds then the pilot will tend to give too much input and then over-correct, sending the plane into a potentially fatal oscillation. In a way, the PIO acronym puts too much blame on the pilot as this problem is really a result of the system dynamics.

I think the business cycle is the result of an oscillating feedback loop in the economy. Not much of an insight really, except that it implies that there is something structurally wrong with the economic system. Left to its own devices, the system will keep exhibiting this behavior.

The story I was taught in high school economics was that the Fed had been established to interrupt this oscillating behavior, by anticipating it and correcting for it. I was told that the Fed had been enormously successful in that role. I'm not sure that was true.

Can there be a market solution for bubbles and the Business Cycle?

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.

Creeping Anarchy

I think it was my good friend Justin who recently pointed out to me that one Anarchist viewpoint is that societies are largely self-organizing -- and government is a sham. There's something interesting in this argument, though I am not yet ready to accept it in total. It's an empirical statement, and as such it's either right or wrong.

I DO think that our would be overlords are generally helpless to impose unpopular policies, thanks to our democratic institutions. And no matter how you poll it, healthcare reform is hugely unpopular.This recent AP News blurb documents the likely shedding of still more features from the planned healthcare legislation package. Correct me if I'm wrong, but doesn't that mean there is no meaningful healthcare reform left in either of the bills? Sure there's that thing about how the states should maybe do something about the lack of competition in the market for health insurance, but that doesn't count, especially compared against what was planned but has since gone missing: the public option, a requirement that large companies provide health insurance, regulation of insurance, elimination of the tax break on employer provided plans, meaningful provision of aid for the poor, any means for containing costs, and funding.

I think this all has to do with the fact that,

"...rules are hard to change (because they) reflect the values that are embedded in a culture."

Sound wisdom.

Citizens of the World

This is something I've wanted to blog about for a long time but haven't been able to put my thoughts in order. I might still not be there, but I'm going to give it a shot.

I love America. I'm proud to be part of this nation of immigrants and freedom, innovation and individuality, community and law. I'm an American. But I'm a human first.

I'm not a constitutional scholar so I can't speak to the intentions of the framers, but it seems inconsistent with the ideals that they encoded into the first law of the nation that the Constitution should apply to American government only within the boundaries of the States. Whatever the precedents may be, I believe that serving representatives of our government should be bound by the law of this land, wherever they are.

Here on American soil we don't believe in diluted ideals. We believe in and practice the freedom of discourse in a way that is not replicated in other western nations. We do not proscribe the wearing of the burkha in public universities. We protect the right of the Klan and of neo-Nazis to argue their misguided and hateful views, because we believe that no ideas are so dangerous that they can't be talked about. We applaud criticisms of our government, of our bigotries, and even of our traditions and culture, when such criticisms are levied with honest intent. And even when they aren't, we protect them.

On American soil we defend the right of all people, even non-citizens who are here illegally, to due process and equal access to the rule of law. We welcome far more immigrants than any other nation. We believe that YOU should reap the rewards of your hard work, and your creative ideas. We believe that every person, and especially every child, should have access to the best health care, and to a high quality education.

On American soil we hold our representatives in Congress to these ideals stubbornly, fiercely, and even foolishly at times. We believe in these ideals.

But outside the borders of the States we tolerate evil and cruel acts against humans, committed by our agents. We permit an abridgment of the rule of law. We condone the use of propaganda and misinformation, and the suppression of free discourse. We allow our tax dollars to support corrupt regimes. We lend our support to barbarous tyrants.

We do these things in our strategic interest. And in so doing we reveal a shallowness in our ideals that permits us to refuse to admit the humanity of persons who live far from us, and who are strangers to us. Yet they are the same people we welcome into our neighborhoods and our workplaces, our churches and schools, when they apply for the right to immigrate to the United States.

I don't propose a radical change to the law. I only propose that we extend the rightness of our laws to all of our actions, and to the actions of our government, wherever it is operating. I am an American, but I am a human first. What is right for the best and worst Americans is surely right for the best and worst of our neighbors abroad.

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?

Freedom

Scott Adams, in one of his weaker posts, claims that freedom is a zero sum game. OK, since it's Scott Adams, he might just be playing a joke on me (not me exactly, just incautious, literally-minded people). It's happened before.

In case he's serious though, I've prepared a short rebuttal: B.S.

In my opinion. the whole point of government, law, etc. is to EXPAND my usable freedom by limiting the freedoms to do things that have net deleterious effects on freedom.

Quick example: making murder illegal is a limit on freedom, but successfully preventing murder expands freedom far more than freedom has been limited by murder being illegal.

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?

Picking Winners

In an earlier post I asked "How do you think the founders of Tesla feel about GM being propped up by the government?" Well, it turns out that Tesla can't complain too much. I guess I should have known.


I'm worried about the government funding companies, whether startups or established players, because government investment drives out private investment, and because the companies who receive support have a competitive advantage over the ones that don't. Why is this an important problem? Because the government doesn't know which companies are going to be enormously productive, and which ones won't. Just as an example, what if the government had propped up Ask Jeeves at the expense of Google? Of course I don't actually know what would have happened, but it's possible and maybe likely that Google would have been crushed or absorbed before it had a chance to bring so much value to so many people.


Econtalk has a great interview with Y-combinator partner Paul Graham. Graham says that government attempts to 'create the next Google' are doomed to failure because no one knows what the next Google is going to be like. By definition, the next big innovation is going to be something that is not currently understood well enough for the value to be obvious. It's ludicrous to me to think that government bureaucrats, no matter how competent, are going to be able to predict which companies are the future sources of important innovation, and which aren't.

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?

The Hurricane and the Ice Sellers

If you haven't already started listening, Russ Roberts has an excellent podcast called Econtalk. It features guests who discuss issues related to economics and policy from a variety of viewpoints.

In one podcast Russ and Mike Munger discuss price gouging, and illustrate the subject with a true story.

When Hurricane Fran came aground in the Carolinas more than 10 years ago, power and other services were knocked out in Raleigh, and transportation through the city was halted by fallen trees. The damage was so widespread that it was simply impossible to restore services to all residents of the city in the first few days after the storm.

A couple of entrepreneurial young men who lived outside the affected area realized that without power in the city, many people would be in need of ice. So they decided to take the day off work, rent a truck and some chain saws, loaded the truck full of ice and headed for Raleigh intent on cutting their way through the fallen trees until they reached the city center where the ice would command the highest price. The morning that they headed into Raleigh, emergency services still had not reached many residents of the city. The National Guard, the Red Cross, and others simply were not yet present.

It took several hours, but the men were able to clear a path into the city and when they found what seemed to them to be a likely spot, they started selling bags of ice at an elevated price. Many customers lined up.

But they weren't all happy customers, and someone called the police. Price gouging is illegal. The people who had been waiting in line to buy ice clapped as the men were handcuffed and taken to jail. Maybe they clapped because they assumed they would now be able to have access to the truck full of ice for free, but the truck and the ice were impounded, and the ice melted away uselessly.

Remember, this is happening in a city bereft of electricity. At the same time that these ice sellers are being arrested, local officials are making an impassioned plea to the federal government to PLEASE SEND ICE, as much as possible as SOON as possible.

Nobody wants to be taken advantage of, especially not in an emergency. That's why there are laws against price gouging. But do these laws make any sense?

Consider: During an emergency, valuable commodities are in short supply in the affected area. However, these same commodities are still available outside that area. What is needed is for people to transport the needed goods from the areas where they are plentiful to the area where people are suffering. We could rely on the good natures of our neighbors to do this for us, or we could rely on the government. OR we could rely on the profit motive, and this just might marshal more resources, more quickly than will the other options. Who made it to downtown Raleigh that day with a truck full of ice?

Don't forget, there are real costs associated with providing a good or service during an emergency. Maybe I care about the people who are stranded without services, but I can't just leave work and spend my own money on a truck, chainsaws, and ice. I've got responsibilities at home that may trump my desire to help.

And what IS price gouging anyway? Who can say what a fair price is for ice in a city without electricity? it cost something to get the ice there, so the price of the ice must be something higher than what it would normally be. The high price is what motivates someone to rent a truck and chainsaws and take the day off work. If enough people do that, the price of ice in Raleigh will come down because the supply will go up!

Isn't that the desired outcome?

Growth of Govt.

Just a few quick graphs that illustrate how things have changed in a hundred years or so. How did we ever get by back then?

More info here.

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?