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Monday, July 28, 2008

Ten Economic Fundamentals and their Consequences

The City Journal has interesting piece today about ten economic principles that the article says have become settled economic matters. Now, the piece uses so called experts to make the case that these are settled matters. I am always weary of unspecified "experts" that are used to make a point. That said, I think these ten principles should be the basis for any economic plan. Let's look at each of them.

1)The market economy is the most efficient of all economic systems.

This means that all those that are touting universal health care or socialized medicine as the way to go to fix the health care system are NOT founded in any economic principles. The tragic irony is that in my opinion our health care problems come largely from a lack of market activity. Because most folks receive their health insurance from their employer, the population doesn't perform the same market functions they would with most goods or services. There are those now using our economic malaise to push the idea that free market is not the way to go. Their perspective is simply wrong. (Here is how I countered one such argument)

2) Free trade helps economic development.

Free trade has become the whipping boy for much of the economic problems throughout the heartland. The reality is that free trade became the scapegoat for many other problems. The concept behind free trade is very simple. Everyone has things they are good at and things that are in short supply. We trade those things that we are good at, and important those things that are in short supply. This bit of economic common sense won't stop those opportunists from using free trade as some sort of source of demonization. They just won't have economics on their side.

3) Good institutions help development.

As I mentioned earlier, free markets are the key to any successful economic system. Good institutions are key to making sure that any free market doesn't get corrupted. In fact, good instutitions are key to making sure any economy doesn't get corrupted. Good institutions make sure there is fair play. Even here we hav a long way to go to make sure that good institutions overlook the market.

4) The best measure of a good economy is its growth.

This one has plenty of consequences to partisans everywhere. The best measure of growth is Gross Domestic Product. GDP has been growing nearly non stop since the beginning of 2002. It had outstanding three percent plus growth from 2003-2007 and even continues to show some growth, though barely. In other words, based on this principle, the Bush economy was a good economy.

5) Creative destruction is the engine of economic growth.

Capitalism is based on the principle of survival of the fittest. That means whoever is number one had better always watch their backs. This constant struggle to be number is what spawns innovation and innovation spawns growth. The engine to innovation is capital investment and thus anyone that punishes capital investment by raising taxes on capital is stunting growth.

6) Monetary stability, too, is necessary for growth; inflation is always harmful.

Let's call this the Steve Forbes principle. Sacrificing inflation for growth will always wind up slowing down the economy in the end. Once prices rise it stunts growth.

7)Unemployment among unskilled workers is largely determined by how much labor costs.

As our economy gets more and more globalized, unskilled labor becomes more and more obselete. The lesson here is that in the 21st century it is even more vital to be educated. It is the unskilled workers that are more at risk of free trade. Gaining education and skills is the most vital asset in the 21st century.

8) While the welfare state is necessary in some form, it isn’t always effective

Don't tell folks like Hillary Clinton but welfare almost never works. We want an economy short on entitlements only unfortunately we have seen an explosion of entitlements over the last half century. It is due strictly to politics though not to economics.

9) The creation of complex financial markets has brought about economic progress
Remember this the next time someone condemns too many mergers, derivatives, or other sophisticated economic tool. Tools like this get demonized all the time and used to contrast what the working stiff has with what the fat cat has. Yet, it is these tools that help drive our economy. Beware of anyone that demonizes any sophisticated tool.

10) Competition is usually desirable

This goes without saying. It should also mean that the answer to any economic problem is more competition. If more problems were solved by increasing competition we would see more sensible solutions. This principle should be a warning to all those that vehemently defend the oil companies. Six companies dominating the so called market is NOT competition.


Anonymous said...

Hi Mike,

Re: #9. I agree that complex financial vehicles have contributed to growth. The ability to construct them depends on cheap computational power and the consequent ability to develop things like Monte Carlo simulation.

But here's the catch. Very few people actually understand how some of these vehicles work. And even with something as simple as those subprime mortgages that got sold into derivative SIVs? Well, guess what? The computer models used by the rating agencies for those SIVs never anticipated that when faced with upside down mortgages, people would just walk away from the houses.

This is not an argument against - just a caveat that all vehicles and transactions that trade them involve risk and that risk was never correctly priced. Without a reliable price signal, complex vehicles actually undermine growth - as we are seeing now.



mike volpe said...

I agree with your sentiment though I would totally disagree that it had any contribution to the sub prime crisis. That was due solely to recklessness and greed. It wasn't faulty computer models that made banks and wall street create and market loans that were extreme.

That said, I agree that these are complicated beings and open to mistakes. That is the nature of the economy. My point is that we should always be weary of those that attempt to demonize sophisticated financial vehicles for populist political purposes.

Anonymous said...

That was due solely to recklessness and greed. It wasn't faulty computer models that made banks and wall street create and market loans that were extreme.

In some cases I would agree with you. But the closest I can come to the 'original sin' in my reading is Congress' passage of the Community Reinvestment Act, which required banks to lend to people who could not qualify for 'conforming' mortgages. Yes, there certainly were agencies that played fast and loose with income figures, etc. That was possible because the incentives were distorted. The loan originating institution never intended to hold that paper and so never assumed the risk. That was the first step in losing the pricing signal.

Also, of course, you can't go wrong betting on people being just plain dumb.

I like the stuff you post on LGFs spinoff links. Thanks.


mike volpe said...

It wasn't merely folks playing fast and loose with income. That drove it no doubt. It was much worse than that. Loans were opened to folks with marginal credit, where no income was documented, no assets were documented, and no money was put down.

What really happened in a nutshell was an entire industry that worked and flawed belief that real estate prices would go up forever. These ridiculous programs were created with that faulty premise in mind. It sounds just plain ridiculous now, but it really was the going belief at the time. Here is my detailed account of how we got here...

Anonymous said...

Oooo, nicely done! bookmarked. Now what exactly does HR 3915 say?

If anyone reading this would like to know more about how this nonsense percolated throughout the financial system, I highly recommend a book "The Trillion Dollar Meltdown". Even I understood it.


mike volpe said...

H.R. 3915 said all sorts of nonsense. The reason I got deeply involved in the debate is because it attempted to eliminate Yield Spread Premium. That is a tool for mortgage brokers to make money. Essentially embedded in the rate is the amount the bank is willing to pay the broker, me, to take it off my hands. H.R. 3915 would have eliminated that tool entirely. It was in every way an unmitigated disaster but this was the most pernicious.

Ironically enough, H.R. 3915 had no chance of becoming law. While it moved through the House, Chris Dodd had no intention of ever moving on it himself in the Senate. As soon as it passed the House, it was immediately tabled in the Senate. Of course, as it turns out, Dodd had his own plans for mortgages, which I wrote about here...

Anonymous said...

Nice post, Mike. On #10, however, I disagree with your choice of "6 oil companies dominating the market". Those 6 are the PUBLICLY traded oil companies. The largest oil companies in the world are all nationalized entities that do not report any public earnings but pump and produce far more oil than any publicly-traded oil company. These companies also have far more say in the price of oil. The top three are all nationalized: those companies owned by Saudi Arabia, Mexico, and Venezuela.

Other than that minor quibble, great post. Thanks, Jim