04.15.08
Posted in Uncategorized, Book Reviews - Non-Fiction at 7:36 pm by steve
Reflections on Adam Smith’s Wealth of Nations (Prometheus Books, 1991)
Many arguments about theology have a color-wheel sensibility to them. Red is like scarlet. Scarlet is like vermilion. Vermilion is like orange. Orange is like gold. Gold is like yellow. Yellow is like chartreuse. And chartreuse is green. Therefore red is green. It is useful to keep this idea in mind when trying to justify what “free-marketeers” say about Adam Smith’s economic ideas against Smith’s own words printed in The Wealth of Nations. The religious faithful make claims about Smith’s work that range from being not quite accurate to being completely inconsistent with Smith’s ideas. And the reason for the difference has less to do with good reasoning, perhaps, than it has to do with religious tradition, with a long history of theological analysis of the subject.
We are not so interested in how we got here as we are in comparing Smith’s concept of economic theory with the ideas sold to the American public by the free-marketeers. We wish to learn about ideas that Smith had that are materially more interesting and robust than the ideas represented by the free marketeers. We wish to take themes Smith developed, and develop them in a contemporary light. And we wish to show how various modern conceptions of Smith’s ideas are incomplete or wrong and to show whether the problem is in the original conception or in its contemporary interpretation.
Smith’s work is sometimes treated with a kind of holy reverence by economists. And the general principles he establishes as if they were true as, say, the law of gravitation or the fact that prime numbers are divisible only by one and themselves. The former is a natural law the latter a definitional fact. The idea of the invisible hand that Smth proposes in Wealth of Nations is neither of these. It is an argument, a body of reasoning that applies resonably well to some kinds of economic situations and fails quite miserably in others. Failure to make the right distinctions leads to great mischief and a considerable amount of misery.
If one were to view Wealth of Nations solely in terms of the rather difficult to locate “invisible hand,” one would have to accept the rest of the content of the book as framing that idea. And one would have to grapple with all the unstated governing assumptions, the stated governning assumptions, and the range of limitations Smith argues for. Our own criticism of the “Market Libertarians,” or “free-marketeers” or “American Orthodox Economists” - as we will call them from time to time - is that they have completely failed to do any of this. At least they have failed to do it in public.
They have made economics a kind of religion governed by a single unquestionable orthodox rule, namely “No rules.” It is a rule that deserves a considerable amount of attention; but it is also rule that is demonstrably false for a significant portion of human economic and non-economic activity.
Here are some of the assumptions that underlie Smith’s work. Most of them are given too little consideration by the rabid free-marketeers.
1) People behave in a moral way - ( enlightened self-interest and so on … )
This was pretty much taken as a given for the first century and a half. But after WWII people began to imagine that Smith’s Wealth of Nations was inconsistent with his treatise on morals. But even hidden with the pages of Wealth of Nations Smith shows great distain for morally questionable acts. He hates collusion, for instance. It is not just that he sees it as being economically inefficient; he reacts to it as if he believes it to be morally depraved. There are other hints that he believes that people act morally or that his analysis is built on such an idea. So Wealth of Nations is built on the western idea that liberty in economic practices derives from responsible behavior, just as the American Republic iis built on the western idea that liberty in political practices derives from responsible behavior.
2) All economic goods are available from a great many multiple competing sources. This argument applies to almost no real good. Ironically, returns of scale have brought greater benefits than the idea of perfect competition, manufactured goods have grown differentiated by brand. The result is that the ideas of specialization and returns to scale have meant that the fundamental assumption of perfect competition is not meaningful for most goods.
Manufactured goods, most of them, are quite highly differentiated. If one wants any car, there exist competing sources. If one wants an exceptionally reliable car there are two or three viable sources. In most product areas, each good is differentiated from each other good. Each brand of tomato soup is different. Each potato on the shelf is subtly different from the rest. It is possible, in an economic sense, to treat all apples of a type that might be good for baking as an undiffferentiated product and to purchase these apples from one source or another. There is a kind of practical sense in which some goods easily substitute for other goods.
And at another level entirely it is possible to view food as nothing but a source of nutrients, in which case a potato is pretty much the same as a tomato, a pepper, or an orange. It might be so in a nutritional sense; but it is certainly not true in a culinary sense.
I have tried to think of goods that have multiple competing sources and It seems that there are a few commodities that fit the bill. Corn, the kind fed to cattle. And most other grains. Oil is a possibility. Now that most refineries are equipped to treat “sour” crude oil it is probably so. Sand might be. But sand is expensive to ship. So local suppliers can reasonably differentiate their good locally by price or availability. It seems, therefore, that even among a number of commodities, the notion of perfect competition is a very loose approximation of the real situration.
The notion of perfect competition happens to be a convenient place to start the study of microecomic theory. In this respect it is a powerful concept. But it applies to almost no real good. The factors that lead to this departure and the way it is exploited account for why an unconstrained market economy can sometimes be much less efficient than a wisely constrained one.
3) There exists no collusion among suppliers of like goods. This issue is one Smith talks about. In his own day a great many goods were produced by tradesmen in local towns. The fact of local supply meant there were no multiple sources; but it also meant collusion was difficult. The issue of collusion has profound implications in industries with few suppliers; for it does not take a great deal of effort to get firms to collude. Market shares change slowly; but if one can gain an extra twenty percent in price by collusion, it’s all pure profit. In an industry with slim margins this is a huge windfall.
4) Specialization brings efficiency in production. A skilled production worker might be capable of working two, four, eight, or even ten times as fast as an unskilled one. And she might be capable of using the same raw materials more efficiently. Specialization is intimately linked to returns of scale, for the high level of skill make a worker particularly productive. And if this skill is trasferrable to other means of production that employ more capital and are more productive still, then the scale of production can be increased all the more. This is a topic of discussion for Smith and it is closely tied to his thesis.
5) Natural goods are in finite supply; land for instance. Goods that derive directly from it, are similarly in short supply. This idea was painfully clear to Southern Europeans in Smith’s day. It was painfully clear to Greeks in Plato’s day. And as soon as the great biofuels scam is in full swing it will be painfully clear to most Americans. It is already painfully clear to Mexicans and Haitians. The fragile Haitian government has already collapsed over rising food prices. Mexicans are just short of rioting in the streets over corn prices. Governments of India and a few other rice-producing nations have outlawed the export of rice. And last year saw a lentil shortage. Economists who argue that if one has too little of a vital commodity simply means one must raise the price until there is enough are explicitly arguing to starve the poor.
Some free marketeers imagine that if the price goes high enough it will be easy to get more of anything. Let us suppose that we discover an important economic use for the dodo bird. How would I secure a supply of say, a hundred thousand. How much would I have to pay? I have an idea for an agricultural enterprise that requires 100,000 acres of agricultural land on the island of Manhattan. How would I go about securing this? Is it simply a matter of price?
6) That all economic players know everything there is to know that might affect the outcome of a freely made market exchange. For exchanges to work pretty well most of the time this condition is not so absolute. What is required is that the seller reasonably imagines that the buyer knows much about the good, its utility, its like goods, and competing sources of supply. And that most buyers actually have some good information about most of these issues. It also requires that vital information about what the good is and how much it costs be fully disclosed before the transaction starts. Still, there are a number of times when even the minimum requirements are not met. And, if one is an American in Italy, it means getting cheated.
7) That goods are traded primarily on the basis of their utility, not on the basis of their future price. Economic theory is derived from an underlying idea that the world is a sensible, rational place, and that people make sensible rational decisions. It requires that one not trade speculatively.
The act of speculation is sensible and rational only if one makes two assumptions.
a) that one is going to make excess profits exploiting a speculative trend.
b) that there is no harm in selling a speculatively priced good to another person, knowing that if the good were rationally priced it would fetch a much lower price.
But the secont provision denies the moral actor provision. So Smith’s thesis does not apply to speculative markets. One can derive different kind of economic theory for speculative bubbles; but most of the body of economic theory assumes a kind of quasi-equilibrium based on rational choices.
8) That wealth is not fundamentally about money. Rather, it is about the goods that money can buy. The rather remarkable ability of currency to be used to attain any sort of good or service has frequently been a source of confusion to people not careful in their examination of ecomomic ideas. One does not attempt to get money for ets own end. Rather, money is merely a medium of exchange. It represents other goods and services. A person who knows that an iPod costs $150 and who wants such an object will have some sense about the value of an iPod. And if they can wait on tables and get $50 a night in tips, then an iPod is equivalent to three night’s work of waiting tables. The currency only provides a means of equating the one with the other.
Currency and other financial instruments have frequently been confused for wealth. It turns out that a considerable amount of Smith’s book is concerned with refuting this idea. And it would serve Americans’ joint and seperate interests well if economists and politicians could catch up with Adam Smith in their understanding of the fact. Fundamentally, it is the act of transforming relatively useless raw materials into finished goods that have utility that creates real value in the economy. Other activities are derivative. They either increase the effectiveness of these activities, or they exist for an essential cultural reason adding intangible value - as is true of the fields of entertainment and religion and free-marketeering.
9) The creation of goods is the creation of wealth. Thus, the wealth of nations rests squarely on an ability to manufacture goods efficiently. Labor, capital, and raw materials being the relevant inputs whose finite supply leads to a similarly finite supply of finished goods.
10) Governmental laws, practices, treaties, policies, and other acts that promote local wealth-generating enterprises tend to make nations more wealthy. Practices that degrade the conditions for such enterprises tend to make nations less wealthy. One can judge all tax law, all trade treaties, etc. on the basis of how burdensome or helpful they are in the pursuit of the creation of wealth.
Smith argues explicitly that there is nothing a government can or should do but to work to lower foreign trade barriers to a nation’s goods. We expect that this frequently a good point of departure for discussons on governmental role in the local economy; but it is rarely the best place to end up. Most good solutions will not be profoundly different; but many good ones will be materially different.
11) Because wealth is fundamentally about goods and because it is funamentally about such goods being rationally priced, measures of wealth are a good proxy for the measures of material well-being of a society.
Smith or at least those who follow in his footsteps make a number of false assumptions in their arguments for an unrestrained free market system.
1) That it was principally the commercial freedoms of Holland and England that kept its merchants there. Smith argues that the commercial strength of England and Holland over the several preceding centuries owed, in great measure to the presence of a body of merchant families, which was probably true. It is also true that there were commercial freedoms there. But what caused many of these families to move there in the first place was the Spanish Inquisition. And what caused them not to leave was that there was not a compelling reason to do so. There were not so many better places to go.
It certainly was religious freedom that borught them and may have been religious freedom more than it was commercial freedom that kept the most successful merchants in England and Holland. One can see it as kind of a quibble. In an economic sense it is. But not all important questions are economic questions. And sometimes it is important in the study of economics to remember that there exist rational explanations for behaviors that otherwise do not make a great deal of economic sense.
2) That it was entirely due to the “invisible hand” that England owed her ascent. We have argued elsewhere that England and Holland cultivated a materially different kind of relationship with colonies than did Spain and, perhaps, Portugal. The Latin model was extractive, exploitative, and patriarchical. The foreign lands were given no political autonomy, the enterprises focussed most on mining.
Slaves were imported to work the mines. Holland’s trade was with the Orient. It did not colonize quite so intensively as the British except, perhaps, in South Africa. But the Dutch were very interested in commerce as were the British. In North America, English colonialists came not for the gold but for the farmlands and the religious freedom. And they had a considerable amout of autonomy, with the authority to create their own bodies of law, and so on. So in these respects England’s ascent owes much to the invisible hand.
But England had other endowments. It had a rather remarkable educational system that taught the classics, arts, and sciences. It produced a number of bright, well-rounded, thoughtful graduates each year of whom Smith was one. And because the British saw good government too important to leave to the stupid, or slavish, they established a civil service system that placed the best and bnrightest in relatively h igh government positions. So one strength that is purposefully overlooked by the “free-marketeers” is Britain’s insistence on being governed well by highly trained, intelligent people.
A third endowment consistently overlooked is England’s proximity to the New World. This accident of geography gave England a small but material advantage in accessing North America.
A fourth endowment England had was a weak mornarchy, a lively Parliamentary system, and a tradition of “rule of law.” This meant that the monarch was obliged to obey the law; and not even the least important citizen was beneath its protections, at least in theory. And sometimes practice was not far removed from this. By some measure, England’s best monarchs were her queens whose understanding of their tenuous positions led to extraordinary, almost unprecedented levels of attention to the task of ruling well.
This list is merely a short list of some of the important advantages that England had that help explain her ascendency. The invisible hand was not the only one.
The Big Picture
The question implicit to the title of the book and one that informs much of its material is “What causes differences in nations’ wealths?” If one nation is poor and another is rich, why is this? Indeed, what do we mean when we say poor or rich?
Throughout the book Smith argues that wealth is not currency. Currency is simply a medium of exchange, a way of keeping accounts. Wealth consists of lands, resources found on lands improvements to land, and things derived from land, namely, foodstuffs, and manufactured goods. To the extent that gold, currency, or other financial instruments can be traded for these goods - specifically, to the extent that a nation can export gold and by so doing expand its stock of the aforementioned goods, gold and currency may be considered, if not wealth itself, assets useful in obtaining wealth.
Smith does not try to argue that currency and other fungible assets do not constitute wealth but he does make a forceful argument that wealth does not lie in these instruments alone. Later authors would make the argument that currency itself is but a medium of trade and has no intrinsic value. It is an argument that works a little better for paper money than it does for gold coinage. But perhaps not much.
Smith’s idea of wealth puts him far ahead of a huge portion of the free-marketeer crowd who pretend in public that wealth is primarily about getting more currency or about eliminating laws that regulate how institution A, entrusted with the safe keeping and investment of person B’s money may not use that money in a way that would tend to lead to the ruination of A and B alike. Smith understands that financial manipulations may sometimes make the manipulator wealthy; but they do not actually create wealth. Rather, wealth is created when land is employed to grow food. Or when raw materials are transformed into manufactured goods. Activities that make these more robust and efficient augment the wealth creation process.
Wealth of Nations
Wealth of Nations is structurally divided into two parts. The first part concerns itself with the generation of wealth within a nation and with how this wealth is distributed among its inhabitants. The second part concerns itself with the way a nation interacts with other nations, specifically, the legal instruments it uses to build, redeploy, or be destructive of wealth. These legal instruments include taxes, treaties, special trade agreements, and so on. We note here that this division is not accidental; for Smith wants us to understand that the kinds of arguments he makes about how individuals interact in society can equally well be made for how nations interact.
The first several chapters talk about specialization and its relationship to returns to scale. The term returns to scale is never discussed by Smith, partly because there were so few examples of it in his own day. Arguably, it existed in the textile industry in his day; but otherwise, most goods were made one at a time by skilled craftsmen. And the level of skill proved to be the primary component in the cost of production of many undifferentiated goods. A skilled worker could turn out two, five, or even ten times as many units of a good as could an unskilled worker in the same amount of time using the same tools of production. And since the primary cost of a good has a lower bound that relates to the total amount of labor involved in its creation, skill created by specialization tends to drive down production costs very effectively.
Division of Labor
Smith starts the treatise with what turns out to be a rather important proposition to his thesis; but is so in an unexpected way.
The greatest improvement in the productive powers of labor .. seem to have been the effects of the division of labor.
Smith is writing at the very dawn of the industrial revolution. In his day a large portion of the manufactured goods were constructed by hand using standard tools of the trade. But there were some enterprises that had moved on to more modern manufacturing practices. There existed large, water driven cloth production mills that operated at a level of efficiency that far outsripped that of the old hand- looming days, and did so perhaps by orders of magnitude. So Smith is ignoring the employment of capital at this point in the book.
Actually, specialization spurred capital formation because those skilled in the looming arts would be the people who would make the large-scale mechanized looms work. And specialists in the smithing arts would make larger scale iron-making work. Occasionally, perhaps, the working capital of a very successful proprietor of one of these trades was also used to transform the productive capacities by expanding the stock of capital. But Smith’s purpose in this chapter is to talk about specialization; he will talk about capital later on.
The division of labor alone, Smith argues, improves the productive power of labor. This is the reason for specialization. And it explains the extent to which specialization may proceed in any society. In a society in which eighty percent of the population works as agricultural labor, only twenty percent of the society may be employed in other areas of specialization. In many western societies agricultural labor ranges from perhaps six percent in France to something like two percent in the US - at least if one does not count migrant workers. The remaining people specialize in other productive (or non-productive) arts. They produce other goods or services.
This division of labor, this specialization, assumes another activity with which it is intimately tied, namely commerce. A person skilled in making nails, no matter how skilled, must either cease making nails and tend his garden, or he must trade his nails for parsnips, rutabagas, cabbages, or whatever. Specialization, therefore, depends on commerce. Commerce must precede or arise simultaneously with specialization, else the people who do not tend fields do not eat. And this never happens.
There do exist cultures that are almost totally lacking commerce. And in those cultures, establishing specialized businesses is very difficult. In British Colonial Africa, for instance, the British Colonists typically owned and farmed vast tracts of land. They brought in Indian and Pakistani merchants to run all the commercial enterprises in cities and large towns. Trading was not a valued skill among the indigenous people. Nor was the capacity to read and write widely distributed.
In chapter 3 Smith discusses some limitations on commerce. In his day the transportation of goods was highly costly; therefore it put a severe limit on the extent of trade. For that reason trade early on was frequently confined to finished goods; for the costs of distributing a good would then be small in comparison to the costs associated with its manufacture. This, by the way, is a relatively good measure of efficiency of a distribution system. As a child I learned that the rule of thumb in retailing was to get a 100 percent markup; half the retail price of the good would go to the retailer for the cost of transporting it and for assuming the risk associated with keeping it in stock. Today, Costco works on a 15% markup and Wal Mart chargesl only a little more than that. Commerce, by this measure, is considerably more efficient than it was several decades ago.
Of Cost and Price
In chapter 3 Smith distinguishes between the cost of production for a good and its price. He then goes on to discuss how goods are priced in the marketplace. If one strips all the profit and taxes from all the exchanges involved in making and distributing the good, one can trace the remainder to the cost of labor. Near the end there is the direct cost of assembly, finishing, and distributing the good. Before that there are the costs of making the component parts and raw materials. And, of course, there is the cost of making the capital equipment that help make the good. So in an ultimate way, the cost of a good can go no lower than the cost of the labor involved in making it. If one is a hunter-gatherer and the deer are three miles from camp, one cannot harvest a deer by going only two miles; one has to go, get the deer, and bring it back. But in most cases the cost of labor is a little more difficult to figure out than this.
In general, once one has totalled up the price of all the labor that goes into a good, one has set its minimum stable market price. If this is more than the market will bear, the good is doomed not to be produced. If it is very much less than the market price, profits are likely to be very high. And this will tempt a large number of competitors to enter the business.
One can set a price for a good that is lower than the cost of producing it. This sometimes happens by accident with certain agricultural products when good land is very plentiful. It sometimes happens with certain commodities when they are very plentiful. But it can also happen with manufactured goods - and not just as artifacts of bad retailing operations.
Roughly a century ago a few American industrialists realized that large manufacturing plants had great advantages in efficiency over small ones. They saw this to be especially true in the steel and oil refining industries. And they worked to consolidate business. This meant buying up tiny competitors and simply shutting them down. But bigger competitors required other treatment. So they would sell their goods at a price that was below the cost of production. And in a short period of time, the competitor would be driven out of business.
At first blush it seems like an insane strategy to sell goods below cost, for in the short term it reduces return on investment. But if one has driven all one’s competitors out of business, one can set prices at an artificially high level. Profits can far exceed the levels they would in cases where many suppliers compete for the same customers. And if the business is one such as steel or refining, a huge amount of capital is required to compete. In economc terms, the barriers to entry are high. They are especially high when one realizes that the practices that allowed the monopolies in the first place could be used against any new entrant.
This is an eventuality that Smith, evidently, did not forsee. Companies sold at a loss here and there to drive competitors out of business, then they jacked up the price. The excess profits of the oil and steel cartels of early twentieth century US ultimately motivated action by the government to break up cartels and to pass laws that limited this kind of behavior. Some of these laws are still in place; but the era of deregulation that came in the wake of the Reagan Presidency has seen rather dramatic changes in laws that govern the level of concentration in a number of businesses.
A number of the protections against monopolistic and speculative abuses that were put in place in the first few decades of the twentieth century have been overturned. It has already led to some abuses. One such set of abuses has led to the current banking crisis. And in the next several decades there is likely to be a backlash against the kind and extent of deregulation that has been advocated by the Market Libertarians. Firms in certain industries will be judged to be earning profits that are not useful in tems of motivating the firms to act in the public interest. And some practices will have effects obviously in conflict with the general public interest.
It is here where there exists the greatest gap between the spirit of Adam Smith and the language of those zealots who lay claim to his free-market mantel. Smith was interested in an economc system that delivered the goods. The free-market heretics who invoke his name, however, are only interested in the easy money that arises from the cartels that can be arranged when people can be convinced that economic anarchy is superior to economic liberty. Smith was interested in how liberties in economic practice led to good economic practice. The free marketeers are interested in how the abolishion of regulatory laws can be exploited for financial gain. They are hardly at all interested in the matter of the creation of wealth but highly interested in the matter of transfer of wealth. The liberties Smith advocated for were targeted to increase the efficiency of the activities that create wealth and he judged them in these terms. The freedoms that the free traders seek amount to the dismantling of safeguards that keep the system for blowing up and they are not judged in terms of creating wealth but in terms of conformance to a theological ideal. Smith’s motivation was substantially constructive. the free-marketer’s motivation is substantially destructive.
Returns on Investment
By the time he gets to chapter 9 Smith is talking about returns on investment. Mostly he says what has since then become the usual stuff. He does make a few interesting observations that merit further thought.
He uses interest rates as a proxy for returns, He observes that in large cities returns tend to be high, whereas in small, rural towns they tend to be lower. High returns, he argues, tend to make for a shortage of labor, so people who live in cities are compensated with a higher labor rate. He might link this argument back to returns of scale and specialization, but does not do so. He notes, with some interst that both labor rates and returns on invesment are higher in the colonies. (p97)
Smith is onto the trail of something that few economists have since followed, namely, the importance of frontier. What was materially different about the colonies is that they hold a vast array of unexploited resources. And these resources were, by English measures, underexploited. The lands were covered with timber which could be turned into furniture or fuel. And the cleared lands were fertile and suitable for agriculture. It was this property that created excess returns on investment in the New World in Smith’s time. And it is this property that continues to create excess returns on investment in parts of North America today, namely the relative under-population of the land in comparison to its natural endowments.
Smith stops short of making this argument, but he leads us to the brink on multple occasions. In one place he talks about the clearing of Europe. As the ice age ended and the glaciers receded from Northern Europe ten thousand years ago, forests grew. For several thousand years the humans who inhabited the regions were primarily hunters. But as agricultural methods spread westward out of the fertile crescent, the trees were cut down and land was given over to agriculture. It was at this cusp in time when a culture would reach its apex. It was easy to see why.
Long before this point agriculture was rare and food was relatively scarce. But since farmland can produce perhaps a hundred times as much food per acre as woodland, the transformation of woodland to farmland increased the stock of food and supported a growing population. So long as more trees could be cut down to expose new fertile farmland, the population could continue growing. But as soon as there were no more good plots of land to be had by deforestation, the expansion of the food supply would cease. Simultaneously, the supply of wood would then be depleted and people would be prone to freezing in cold winters. Nor could they build new homes or create the kinds of wood and iron tools required for agricultural practices.
It was in reading Wealth of Natons that I realized this argument. And if one has read Jared Diamond’s Guns, Germs Steel and his Collapse, one will see how Diamond has written the first and third books in a trilogy. The first sets up the story of the ascent of Europe. Smith explains the role frontier fist its own and and then frontiers over seas under colonialism. It does not quite go so far as to systematicaly explore the role of trade and the exploitation of imported resources; but it argues for the importance of this.. Finally, Collapse suggests what happens when all the special resources of frontiers have been played out and the population has reached a level that fully exploits the arable land. By reading these three books in the suggested sequence and fulling in the blank space, one can almost fully explain the arc of western history from the point that agricultural practice stabilized in Greece almost 3000 years ago to the point at which resource wars tear civilization to shreds within the next two centuries ( or not, depending on how far the free-marketeers push things.)
Smith’s work actually comes pretty close to arguing the same thing (p202):
In a country which has acquired its full complement of riches, where in every particular branch of business there is the greatest quantity of stock that could be employed in it, as the rate of clear profit would be very small, so the usual market rate of interest which could be afforded out of it …
Mature industries see few opportunities for improvements and therefore the returns tend to dwindle away to not much more than nothing. Only when something comes along to change the matter, either a new and less expensive source of raw materials, or a materially more efficient way of deploying resources, or a more efficient way of creating finished products, is there hope of gaining a higher return. Higher returns require the identification of unexploited opportunities. Should the system get so advanced that these become too difficult to identify, returns will dwindle to almost nothing.
Furthermore, if the industry depends on resources that can be depleted such as is the case with mining, oil extraction, and some agriculture, industry can collapse for lack of inputs. Any industry that has operated for some time on thin margins is in a tenuous position already. In this sense, Wealth of Nations not only does much to help us understand how nations become rich and successful; it can help us understand why they become poor and fail after having been rich.
Pay
Smith turns next to the payment of workers. Smith’s arguments about pay are not incconsistent with traditional arguments about supply and demand; but Smith does not use this particular abstraction. If one views his arguments in terms of supply and demand, they provide reasons for increases or decreases in supply of labor . He accounts for a great deal of the variation in labor rates by free market mechanisms. But he also talks about how guilds and other kinds of licensing and cartel agreements sanctioned by the government artificially raise the price of labor.
Instead of talking of supply and demand Smith describes factors that might reasonably change the suppy of workers in a field. He notes, for instance, that coal miners make more than most other unskilled workers, and suggests that the reason is that their working conditions are most hazardous and unpleasant. The level of physical hazard, presumably, limits the entry into the field, driving up the cost of labor. If people found risking their lives to dig coal more desirable, more attractive than setting type in a printing house, and if both took the same level of training, coal miners would be paid less than typesetters. It suggests why, in an industrial society machismo is a dangerous word.
But in Smith’s day typesetters had a long and expensive education while coal miners had none. This made the pool of applicants for typesetting considerably smaller. And it may have kept the price of labor in the field higher than it was for coal mining. The level of skill required for a job, then, was one of the considerations in judging level of pay. This is kind of a tautological argument, however, because we have argued that specialization leads to productive advantages and that productive advantages lead to excess profit and that excess profit leads to higher pay. It may be that in many cases these are two ways of explaining the same thing. But sometimes, maybe, they are different.
Smith notes that in cases where labor is highly seasonal, it can command a higher rate. One can pay a productive migrant worker ten dollars an hour at the peak of harvest season, or planting season perhaps. But for the same level of skill under other circumstances, similar labor might command a small fraction of this price. The same might hold for construction work
Finally, notes Smith, the level of trust one can place in a worker and the level independence they display in their work sets a limit on what they can be paid. Untrustworthy workers can only be employed in labors so unimportant that the consequences of failure go virtually unnoticed and can be easily ameliorated. One might employ them at the Weekly Standard or the National Review. In a pinch, one might consider them for the job of cleaning latrines; but one would not have them piloting commercial airliners or running great nations.
Smith notes that the normal rate of profit rises and falls with risk (p 117) Riskier enterprises often are not undertaken because of the perceived risks. The perception of risk acts as a barrier to entry. A firm will only be induced to operate in a risky area if it perceives a chance to make a greater profit than normal. So the hope of excess profits lure firms into risky areas. When firms enter risky areas and make better than normal profits it is customary to imagine that these profits are a kind of just reward for creating economic opportunity where before there was none. And this is probably a good way to look at it.
Labor Cartels
Once he has explained the normal free-market issues that bear on differences in wages Smith turns to the issue of cartels - agreements which have the effect of limiting the availability of certain goods or services and thereby driving up the price.
Smith recognizes what few contemporary free-market heretics acknowledge, that in a large portion of cases labor rates are negotiated. There can be a number of case in which such an arrangement is seen by society as being just. One circumstance is when an emplyee works for a firm that earns excess profits, especially where such profits are achieved by means of a cartel or enforced by law or threat of force. We think first of monopolistic corporations; but we might also think of feudal lords in the middle ages. In both cases special pricing powers arise from an imbalance of economic power.
In such cases, the excess returns derived from systematically bilking the customer are divvied up not only among those who own the business but also among who actually do the work. It is somewhat less satisfactory than not bilking the customer in the first place, but it does spread the economic advantages farther. It serves the end of having a large middle class. And the breadth of a middle class is a traditional measure of how stable and happy a society is. Labor cartels provide laborers with the negotiating strength to succeed in negotiating labor rates higher than the normal market rate.
The first sort of cartel Smith takes on is the cartel of the skilled workman or craftsman. The people who might be members of the population under consideration would include carpenters, masons, plumbers, painters, tailors, glaziers, machinists, butchers, bakers, and candlestick makers. Smith is inclined to see them all as knaves. He argues that they don’t have any real skills, that they don’t receive any real training, and that the fact that they belong to guilds elevates their pay without providing a corresponding elevation in the level of services rendered. The guilds, he argues produce no economic benefits and a considerable amount of harm.
Smith employs a little motif. In the firs occurance he claims that a person trained in a particular field could learn all there is to know in eight weeks. He repeats this claim some pages later about another craft, but with a shorter time period. He does it several more times, each time shortening the amount of time. At first we are inclined to take him seriously. But on each successive occasion we take him less seriously. Eventually the argument tempts the rebuttal “ Speaking of cartels, it is clear that any idiot with about three hours training could write a book economic theory exactly like yours, so why should you own the copyrights to Wealth of Nations?”
A more serious rebuttal might be made by examining the context of the social arrangement. The guild arrangement arose in continental Europe during the feudal ages. A landlord or a very small group of them would live on estates not far from a little town. Such a town would have a butcher, a baker, a storekeeper, and a handful of other tradesmen. It was not unusual for a town to be associated with but a single estate. From that estate most of the local staples of grain and meat were derived. So the estate would command a considerable amount of local economic power.
Tradesmen would sell there skilled services where they could; but the biggest employer was likely to be the estate. This general arrangement of things meant that the estate owner had a great deal more economic power than the rest of the locals. So, under a free market system, if a skilled tradesman seemed too expensive to the estate, tthe estate could simply go somewhere else. This would be a good deal for the estate, but it might mean the local tradesman was out of business. That, in turn, could be bad for the town. And it would prove short-sighted for the estate; eventually, the estate itself would suffer.
So the arrangement of guilds was set up to provide a steady supply of people with defined skills. And in return for this, guilds were able to control membership levels and gain artificial pricing advantages. Guilds, by employing means of collusion could offset the negotiating power fo the local estate. The estate owner lived a kind of parasitic life by virtue of receiving rent on land that he himself did not work. But this largesse found its way back into the community through elevated costs of skilled services.
Of Guilds and Classes
The guild system got much farther on the continent than it did in England. We speculate that it was because estates in Europe tended to be bigger. Thus estates had more pricing power. In order to offset this power, guilds needed to be stronger. There might be other arguments. It might be true that the artisans who descended from the Latin tradition really did then or at some earlier point in time require the level of training suggested by the length of time in apprenticeships. And it may be that tradesmen in England were less skilled. In any case, Smith argues that guilds are bad.
There must surely be some truth in what Smith is arguing here. It is certainly true that self-governing guild organizations when their status is not in question too often tend to work less toward the goal of providing a steady and reliable supply of the skilled labor through training, licensing, and monitoring the guild’s members than it works to extend the political and economic powers of the institution. It strives to gain more political power and takes its eyes off the business of creating guild members who are good at the trade. It is true that they can be abusive of their members and of the people who pay them. And all of these behaviors are destructive.
But these facts do not negate the fact that the guilds exist to counterbalance ( or to exploit ) abusive practices by a guild members’ employers. And it is sometimes true that this counterbalancing force provides greater benefit to guild members and to society at large than the costs associated with the abuses. It might also be true that the English sense of noblesse oblige tended to make English estates, in general, somewhat less abusive of skilled workers than were their continental counterparts. So it may be that guilds were less necessary in England.
Finally, we might argue that the guild system might have saved continental Europe from the ravages of communism because it spread the gains of capitalism more generously to those who labored in factories. Marx might have expected this; but he wrote early enough in the industrial revolution to be forgiven for not understanding that its productive capacity might have the power to materally change the standard of living of workers who labored within it, provided that the gains were equitably shared with workers. For some reason Smith, who wrote eighty years earlier seems to be ahead of Marx on this count.
If one can see the logic of communist revolution occurring first where there was the least developed middle class, namely Russia. And one can explain why it followed in China. And why it tempted most peoples in the poorest lands. Germany never really got very close. France had already had its revolution and was disinclined to have any more. And England had Queen Victoria and Dickens who both worked hard to make the British aristocracy a socially responsible class. Finally, England’s substantial commercial class both wanted to emulate the aristocracy and had no real reason to overthrow it. The nobs might have been twits and dimwits sometimes; but the most dangerous ones were out in Afghanistan shooting Sikhs or something.
The question of how England got a middle class with a weak guild system and whether the English model can be copied broadly or whether it depends of creating a vast system of vassal states is a question deserving lively debate. It seems reasonable, however, to argue that the British model was only sustainable while she could sustain her empire, exporting her poor and criminal classes to the boondox to thrive or starve, sending her aristocrats on great military expeditions, and exporting her petty bourgoisie to India to rule, play cricket, and slowly rot in the sun.
Not every nation wishing to do as well can follow the same model. But they can, sometimes provide rich educational opportunities and support the efforts of its nationals to establish new and more profitable commercial enterprises abroad. Be vigorous in the fields of education, industry, and commerce and success will follow. It’s a message the Chinese have learned from the west and in the narcotic sleep induced by the free-marketeers’ magic potion it is one the west has nearly forgotten.
Rent on Land
Smith turns next to the question fo rent on land. Rent, here, is an amount of money paid to the person who owns a plot of land by a person who uses it for some purpose. Smith starts by observing
As men, like animals naturally multiply in proportion to the means of their subsistence, food is always in demand
This snippet gave rise to the controversial Malthusian idea of population which essentially states that population will expand until most people live lives of subsistence, existing mostly on thin gruel and shivering in damp ruins. Malthus dark view of population dynamics has been used to justify such odd policies as not importing wheat into England during a famine during the mid ninteenth century. The point of debate was whether England should import grain from the US. Membes of the British aristocracy invoked Malthus, suggesting that imported food would simply cause the rabble to over-multiply and things would just get worse. This would have been a mean-spirited argument at best. But these same aristocrats stood to gain the most from elevated food prices during the dearth. The longer the poorest of their countrymen starved, the higher their net profit on the situation.
There is a lesson in this that applies to how we evaluate the claims of the free-marketeer.
The consequence of this abuse is that Malthus has been widely discredited by liberals ever since. But Malthus was probably close to the factual truth. And if one denies Malthus, one can make no sense of the economic problems that plague a number of the poorest nations. The day most people choose not to have sex because they are too poor will be the day we can legitimately claim that Malthus was wrong. But until then, it is reasonable to believe he was right. And Smith, too.
But what we do in light of the fact is a difficult matter. One might believe that if the aristocracy did not actually stand to gain from food shortages, if they were pinched at least a little bit by them as well, they might work toward develomental strategies that improved food production efficiency and helped people do what they could to manage fertility intelligently.
(It is striking that the free-marketeers today are striving for the same kinds of policies that tend to cheapen the lives of all but the richest one in ten thousand. It is almost as if they have read a book about how to create a poor, feudal society in which most people barely subsist and they are just checking things off the to-do list. Eliminate birth controls; check. Eliminate effective education by teaching facts and eschewing judgment; check. Ship manufacturing jobs overseas; check. Import cheap labor from Mexico for all service industries; check. Make sure that this labor is here illegally so that it can be employed at wages far below minimum wage; check. Create an uncritical and fawning press; check. Undermine people’s faith in the western liberal ideals; check. Eliminate discussion of ideas from public discourse; check. Bury people in debt so that they have as few behavioral choices as possible; check. It just goes on and on…)
It is only on rare occasions that Malthus rule has proven unreliable. And those occasions have always been associated with material increases in the land amenable to farming, to new farming methods, or to new and more nutritionally effective foodstuffs. Since the discovery of the New World, Europe has seen at least two waves of cheap foodstuff from the discovery. The first wave was the foods from seed - potatoes, tomatoes, maize, peppers, and squash that were imported from the new world. The next was the wholesale importation of beef and grain from the Americas The third came with the mechanization of production using machines powered by oil.
It is not impossible that there might be more, but the gains will be marginal, not exponential as they were early on. The discovery of the New World increased the potential food supply by at least an order of magnitude. And the mechanization of food productiion along with the rise of new chemicals to aid in food production probably redoubled this. But already humans consume a substantial portion of the sun’s energy that the plant kingdom transforms into plant materials. And some portion is required to maintain soil fertility. We are not very far from the point at which the earth can be pressed no harder.
Unless humans figure out how to seed the great vast oceans with crops for energy and food; there is not much room before the planet’s food generating resources are pushed to a f theoretical limit. Recent food shortages around the globe suggest that once again the view of population dynamics hinted at by Smith and developed more thoroughly by Malthus will prove more accurate as long term views.
Smith goes on to argue how it is that relative shortages of food sharply drive up the rent of land while surplusses of food tend to drive down rent of land. It is probably at least partly in light of this fact that it has been for some centuries that land owners in European nations have insisted that all foodstuffs be grown locally. From a culinary point of view and from a sustainability point of view this is a good idea. But these are generally not the the primary motivations. Rather, it is beneficial to keep a kind of artificial limit on the supply. The French, however, in the case of bread are inclined to keep keep surplusses in order to keep prices low and to keep everyone’s head where it belongs.
Smith argues that a plot of land is capable of producing a great deal more food than a person who cultivates it is capable of consuming. It is an apt obeservation. It is certainly true in every developed western nation. But it is demonstrably false in certain other locations. Jared Diamond (writing more than two centuries later in Collapse) notes that in Rwanda at the time of the genocide, a typical person owned something like an acre of land. That land was intensely cultivated. And it produced very little more than was required to sustain the family who cultivated it intensely.
So Smith has established a condition that is a requirement for an industrial society: namely, that there be an amount of arable land that, when cultivated appropriately, provides a more than ample supply of food; and that this supply of food be ample over the whole range of nutritional qualities; and that the labor required to coax from the land this nutritional bounty be a relatively small fraction of the labor available within the population. He assumes that such a condition might occur in any country. Whether he was right in his own day is open to question. The condition certainly does not apply in a number of poor nations today, however, and the fact is vitally important when one sets out to understand the factors that sustain the high standards of living in the west. There are many but the two germane to the discussion are:
1) a level of population materially lower than what the land would support under the best available cultural practices
2) a level of fertility of the land, a level of technological development, and a level of auxiliary energy inputs that drives the cost of labor on a plot of land to be an almost inconsequential part of the cost of agricultural production.
These certainly are not sufficient conditions; but they are necessary ones if one is to create and sustain a vital industrial or post-industrial economy. Societies that fail to approach these conditions fail to establish industrialized societies with rich middle-classes.
In his section about rent on land Smith also talks about the extractive industries. It is useful to keep in mind that already in 1776 Europeans were using “copper from Japan” (p179) in their manufactures. The Peruvian silver mines had been in production for some time. And the Spanish had been trading Peruvian copper in China for goods that were then imported to Europe. Smith, in an earlier section on money, even complains that Spain’s silver and gold mines in the new world have driven down the value of precious metal currency so one needed to carry around more of the heavy coins in one’s pocket for the purchase of incidentals.
The point, of course, of talking about mines is that extractive industries tend to increase rent on land - at least while the extractive material is being extracted. Since Smith’s time it has become increasingly popular practice to strip land of its qualities of excess value before selling it in a retail marketplace. So in California, for instance, a land owner whose house is demolished by any unusual motions of his land is responsible for the damages. These hazards convey with the rights to build and occupy the land. And a homeower who has the misfortune of locating near open, wind-swept veins of asbestos on public lands or lands held by land speculators, bears the full burden of the carcinogenic consequences of inhaling the asbestos carried on the breeze from another’s property. But if oil or gold is discovered on the property it always belongs to someone else. Perhaps it belongs to the owner of the asbestos. The ways of the free-marketeers have complicated the issue of rent on land. Or they have simplified it; for one no longer has to worry about the corrosive effects of becoming rich by the same means as Jed Clampett and the ensuing social discomforts.
The issue of rent on land has been a central issue in the European study of economic theory because for one or two millenia there was a class of aristocracy who survived by rent derived from their land holdings. It was not that they were farmers, often. It was that they contracted with workers to work their land, claiming all the fruits of the labor, and paying them some portion of the crop.
When food was scarce - as it was with a kind of almost periodic regularity in Europe from the fall of Rome to the discovery of the new world and over a few periods after that - landowners would reap huge profits from their lands. And the serfs working the lands would enjoy some of the bounty. When food was plentiful, as when there had recently been a plague or a devastating war, food prices were generally depressed. Land owners did not receive much rent from the land. And the people who worked it barely survived.
A curious side effect of this arrangement is that bitter and protracted wars might decimate the populatiion, driving down food prices. So the aristocracy, if they understood this fact well, might be disinclined to wage expensive, bloody wars. It is worth noting that Napoleon was not such an aristocrat. And evidently such aristocrats had fallen into short supply by the time WWI came. European politics was driven by its merchant families, a number of whom grew very rich from the conflict.
One of the points Smith makes about the rent on land is that efficient manufacture of non-agricultural products and efficient trade in such products effectively raises rent on the land, for it increases the amount of stuff one might be able to buy with the materials produced on a farm. In his day merchants, bankers, and manufacturers did have a certain amount of political clout; but it was still the landed gentry who had the bulk of the political power. And this is a kind of argument they would be inclined to understand, approve of, and remember.
Scarcity
The issue of scarcity and excess value crops up a number of times in Wealth of Nations. He tells a story from days of exploration. While Columbus was collecting seeds of peppers, tomatoes and squash his shipmates were sowing seeds of their own and creating a conduit by which certain diseases would find there way back to the new world. In the process they engaged the natives who evidently had a generous nature on several fronts. They wore nuggets of gold in their hair. And when asked kindly, they would gladly give them over. It was as if these nuggets were little better than other bits of detritus one finds by the wayside. Part of the attraction of gold, evidently is universal. But the factor that makes it dear, reasons Smith, is its scarcity. To Columbus shipmates gold was both scarce and dear.
Scarcity drives up the price of agricultural good and it drives up the price of manufactured goods. There is, in fact, a sense in which scarcity is at the center of economic study. In a world of no scarcity of any sort, there is no meaningful economic activity. People have precisely what they want. They want precisely what they have. Everything is in balance. The idea is one that can be found in the philosophies of very old civilizations.
Lao Tze, a Chinese philosopher who was a contemporary of Confucius envisioned a perfect world. One lived in one’s pleasant little village. The village had a full complement of artisans and craftsmen. it had tree-lined streets, perhaps. And little shops. It produced all the things one needed from local supplies of resources. A person worked the land, engaged in arts, raised a family. In the morning one could hear the cock crowing in the next village; but one was never tempted to go there because everything was fine right here. It is a vision that eschews bounty and extreme scarcity alike; for bounty encourages wasteful and unsustainable ways.
This is a kind of medieval vision that is borne of a closed, static society. And it is a kind of vision that describes a great deal of human village life in several continents over many thousands of years. It is one that westerners have difficulty understanding since all of western culture - especially that developed over the last half millennium - is built on moving the bounds of the frontier. But it is a vision that might become helpful in the days when there is no more hope of achieving the satisfaction we crave by moving to the frontier.
Similarly, Siddhartha imagined that unhappiness arose from desire and disappointment. And his idea was to overcome desire. One might almost argue that the idea was to embrace scarcity. The old mystical practice of fasting is a kind of embodiment of this idea. Fasting can put one in a different mental space. And some people actually feel much better after a few days without food. So even the body’s own systems tend to reinforce the idea. In any case, Siddhartha’s idea is a kind of idea that one would find gaining popularity in places where the frontier had long since passed. Population levels had reached a kind of quasi-equilibrium. And serious dearths would always take a big toll.
Once again, this idea of overcoming want by sheer force of will is an idea that must necessarily be rejected in frontier societies; for such societies thrive on want. They thrive on the expansion of want, the expansion of territory, the expansion of productive capacity. But should there ever be a day when such expansion is beyond the capacity of the earth to support, scarcity will ensue. And western culture will find itself in need of a new way to deal with scarcity. Whether denying want - or whatever term one chooses to use for the Buddhist practice of driving dissatisfaction from the soul - proves a good way for westerners to deal with unavoidable scarcity remains to be ssen. It does not help one eat better; but it might, sometimes make one less dissatisfied with want when there exist no practical alternatives.
Smith’s understanding of scarcity seems just a little more robust than that of the free-marketeer; Smith understands that real scarcity can exist. And he understands that this causes the price of a good to increase. He understands that while the scarcity persists, the price will remain high. He understands that sometimes a high price succeeds in inducing a subsequent increase in supply; and sometimes it does not. When it does, the price of the good is driven down again. This situation happens from season to season with a number of agricultural commodities. And if it is not regulated to some degree, it can play havoc with food supply.
To the free-marketeer it’s just lines on a graph and equations. The equations say that shortage causes the price to go up; and that high price causes increase in supply; and that increased supply causes price to go down. And in a flash we are back where we started, as if nothing ever happened. By this clever analysis one could prove that any meaningful shortage was, in fact, nonexistent. For before it had any chance to have any material effect, the price would have gone up, the problem with supply would have been corrected, and the price would have fallen. QED.
But it’s the kind of facile argument one gets when one creates a flawed mathematical model of reality and then proceeds to confuse the very limited, simplified model with the reality it kinda represents. In many cases the physical conditions that cause shortages take time to correct if they can be corrected at all. In the world of agriculture, for instance, that time period can be one year. But sometimes unfavorable weather or diseases will affect some agricultural crop for some years. And in some cases resources become completely depleted and there is no more to be had at any cost. Such is the case for extinct species, for instance.
Fifteen years ago when the price of oil hovered around $20 per barrel, free-marketeers argued that the world could never run out of oil. If more were needed, the price would go up. And the oil would start to flow again - simple as that. Today the price hovers around $100 per barrel and exploration activities each year continue to find new reserves at a rate slower than existing reserves are depleted by oil ‘production’. So this particular shortage has, so far, failed to produce the amount of oil necessary to sustain supply at any price. Perhaps at $500 per barrel things will go better. Or at $2000 per barrel. Who can say? But at some point either the west will develop other primary sources of energy such as nuclear, solar and wind; or else the whole industrial society will come crashing down for lack of fuel.
The cost of believing the free-marketeer’s fictions here could be very high. With the amount of money so far committed to the illegal invasion of Iraq America could have built enough nuclear power generating capacity to obviate the need for all of the oil secured by the invasion. And we have not yet even begun to purchase the oil ‘secured’ by the invasion. So when we do purchase it, we will have paid for it two or three times over. If we judge it by its results, we might be led to believe that in contrast to Smith’s goal of creating economic goods the goal of the free-marketeer is to create and exploit scarcity in a systematic and destructive way.
National Interests
in economic terms a nation can be viewed as a kind of economic organism. It has an internal life that consists of trade. Nations with lively internal trade systems tend to generate wealth. Those with little internal trade tend not to do this so well. This is an idea one might take from the first half of Smith’s book. And it explains why the founders the the United States wished to control trade between states; it was so that states would not be allowed to erect barriers to trade by taxing trade. This idea, arguably, was derived from Smith’s work and was advocated by Alexander Hamilton. And it is for this reason that his face graces the $50 bill. But parts of Europe provided a fine counter example. There were fiefdoms that charged excise taxes for all goods that crossed their territories. And this played havoc with trade, especially when a good travelled long distances across land.
Just as living organisms exchange materials with the environment around them, so too nations exchange goods with other nations. And just as organisms erect barriers at their boundaries to gain some control over the flow of materials across the boundary, so too nations place controls on what crosses their boundaries.
There are limits to the analogy, however. One distinction is that if organisms systematically either allow the wrong things to cross the boundaries or prevent certain things from crossing boundaries, the organism dies a quick death. An organism that does it better takes its biological niche. Because this process had been going on a long time, organisms tend to do a reasonably good job of this regulative process while they inhabit regions with environmental conditions similar to the ones they evolved to exploit.
Something like this might be said of nations. It is not necessarily true that a nation must have external trade to surviv; but it is true that external trade can make for a happier place. Where the analogy really begins to break down is that ometimes nations adopt policies that are in the interests of one group but are highly to the detriment of the nation as a whole. Sometimes they adopt policies about trade that are, in the longer term, generally destructive. Adam Smith was interested in this question. And the second half of Wealth of Nations sets out to evaluate various instruments and how their deployment has affected a nation’s wealth, usually Britain’s.
Among the first questions he addresses is the quesion of protectionist policies. He argues that a nation ought to do most what it does best. And from there it ought to trade for the rest. In other words, Smith envisions nations specializing in economic activities in roughly the same way humans do. And he envisions them trading in the same way. Given a fairly well developed nation, one that has at least some healthy industries that manage to export effectively, Smith’s argument is difficult to puncture. And if one looks at the question in a purely abstract way as Smith does, there can hardly be any doubts.
For example, Smith talks about a treaty that liberalized trade with Portugal. The English pledged to lower tariffs on Port if the Portugese would lower tariffs on woolen goods. Now it doesn’t take a PhD economist to know that the English weather could never produce good port. Nor is it difficult to understand that the English had certain local advantages in the cultivation of wool and in the weaving of it into fabric. It would be pure folly to grant to a British firm the exclusive right to produce Port and to exclude the stuff made in Portugal. It is similarly true that, at least until the age of the container ship, it frequently made sense to finish manufactured goods near where the principle raw materials for the good were most abundant.
For some nations getting started has proven difficult. In some nations there simply is no industry of any sort. So where could one start? Well, if its people are not industrious, and if they are disinclined toward commerce, and if its stock of fertile land is pushed to the limit in supporting its population, then there is almost no hope at all. One cannot start with agriculture. One cannot start with trade. One cannot start with industry. There is nowhere to be found any surplus to be traded. The people of the land are permanently wed to poverty. Almost no amount of aid, almost no kind trade policy, almost no factor can change the situation.
If the nation can import the resources it needs from lands with surplus resources. And if its people are industrious and educated, there is some hope that investment can be made in manufacturing facilities. And that such investments might provide excess returns. Such was the case for Korea in the 1950’s through the 1990’s and such is the case for China in the 1970’s through the 2000’s. But where this transformation is occurring nations will be inclined to do what they can to protect their new investments. One does not transplant small nursery plants into the garden without adding some fertilizer to the soil and watering them in. One does not fail to give them protections from pests that might pick them off while they are young and vulnerable. Smith’s argument, then, might not apply when one is trying to establish new industries.
The Chinese, for example, simply took the huge profits their new industries were making and invested the proceeds in dollar-nominated securities, mostly US treasuries. The size of this influx of cash kept the value of the dollar artificially elevated. And it made Chinese goods seem artificially inexpensive to American consumers. It’s not clear how much of a competitive advantage the Chinese gained from this; but presumably the Chinese imagined it was bigger than the loss they might experience once the dollar tumbled after they withdrew their support.
What about the case where an established industry is dying in a rich nation because the same good can be manufactured less expensively in another nation? This is a more difficult question. At the highest level, the answer is relatively straightforward; the good that is produced most cheaply is produced most efficiently. Smith’s argument wins. But the consequence is not everywhere equally desirable. The stakeholders of a firm that closes up in one location and is replaced by a like firm where labor is a great deal cheaper all lose. The stockholders, the employees, the community. Its customers gain.
What would happen to a rich nation that outsourced all its manufacturing? So long as it could cling to all the associated service industries that add value to manufacturing - marketing, engineering, design, accounting, finance, distribution, and so on, there is some reasonable hope that these services would sustain a nation. Nobody has ever done the experiment. Furthermore, while there is some reason to place marketing near the customer, there is reason to move engineering and accounting near the manufacturer. So even the supply of service jobs is likely to move closer to manufacturing. Thus, while one can make a case by case argument for why everyone in a nation wins when one industry relocates to a land of cheap labor; one cannot make the case that it is perfectly alright for all to do so. Rich nations are so because they are productive.
It may be that Smith’s invisible hand will work its way in this case. What is likekly to happen is that, at some point, labor in the far east will grow less cheap in lands that have developed manufacturing bases. At some point the pressure to share the profits of an enterprise with the laborers who do the work begins to bubble up and force wages upward. It happens a little more slowly in in the Orient for social reasons. And it may take some time in China since a majority of the Chinese, arguably, are underemployed in agricultural endeavors. But if one were to project far enough into the future, one would expect labor rates there to go up. (Assuming an infinite supply of resources…) It is also likely that labor in the US will become less expensive. Certainly the minimum wage has fallen considerably in real terms since the liberalization of trade with China. And the recent drop of 30% in the value of the dollar suggests that some of its excess value is eroding.
Once most of the qualified slack labor in the world is used up, it will not be long thereafter that one will find a resurgence manufacturing businesses within the US. But in the mean time the question will be how far will the living standard of the American fall before the rising standard of living in the Orient provides a hard stop? It depends on whether Americans can remain materially more productive than the Chinese. And that, in turn, depends to some degree on how neglected the manufacturing base becomes before the turnaround.
Smith’s invisible hand teaches us what might happen in the long run. Its genrealities are sound. But it is not good at all at telling us how to get through the transition periods. So it’s useful, sometimes to think outside the box defined by Smith.
WHAT ABOUT SMITH”S INVISIBLE HAND?
At one point I had read most of the first two thirds of Adam Smith’s Wealth of Nations; I had carefully browsed large portions of the final third of the book; but I had not yet located Smith’s “invisible hand.” Neither chapter headings nor subchapter headings proved helpful in locating it. I was tempted to believe that Smith, himself, instead of viewing this unshakable tenet of capitalism as the central thesis of the book, veiwed it as an incidental point. In fact, if one reads the material of the book; one can just as easily see it as
1) making argments for other factors in the economic success of a nation or
2) making arguments that serve as some kind of exception to the rule of the invisible hand.
One can locate it near the bottom of page 351 in a chapter about restraints on imports. It appears in a long and passionate paragraph that would not seem out of place in John Galt’s speech in Atlas Shrugged. Smith argues that each person works as hard as she can, as cleverly as she can; that each smploys all the resources at her disposal in a free market economy. Every means to a better end is exploited out of self interest. Since one can extract no more effort and supply no more resources, this must be the best one can do. Sum together all the products of these extreme efforts, and voila.
It’s a pretty good argument.
There are, however, a number of minor problems with Smith’s idea as sensible as it sounds. Smith himself identified one of them when he talked about cartels. Smith hated cartels. But he argued earlier that:
People of the same trade seldom meet together .. but the conversation turns to a conspiracy against the public.
By Smith’s own reasoning people colluded voluntarily and this collusion created inefficient markets. This inefficiency diminished the wealth of a nation. But wait, Smith has just argued that people, in maximizing their own profit also maximize the wealth of a nation. Both of these cannot be true. If his words about cartels are true then it is not true that the fact that a person acting in his own interest axiomatically means he acts in the interest of all of those whom his acts affect. One cannot simultaneously argue that guilds are desstructive of wealth; that people will collude voluntarily, and that all the activities that maximize individual wealth maximize national wealth. It just cannot be so.
In a kind of strict, logical sense the invisible hand idea is not true at all. It is, perhaps, suggestive of something that is true. It might give us a good start in getting to something true, but the issues of cartels - a very common kind of economic activity, and one with profound economic ramafications - is completely ignored by it.
Another problem with the idea it does presume a higher levels of knowledge, and enlightenment, and motivation than are generally widely spread through the population. It also assumes a higher level of access to capital than many enterprises have enjoyed. People do work hard. And they make use of what resources they can. but it is frequently true that the smallest of enterprises dio not have the depth of intellectual resources to do this as well as larger enterprises sometimes might. For this reason it is sometimes true that changes in structure lead to gains in operating efficiency.
By the same virtue it is sometimes true that larger enterprises are formed for the purpose of making a quick buck. They enter a business, make a big mess, then go bust. Certain kinds of industrial scale farms, sometimes, may pay less attention to techniques that sustain soil fertility over many generations than do farmers with a multi-generational link to the land. In such cases small farmers might represent society’s durable interests better by not exploitatively working the land.
It is not axiomatic that all things that create profit are societal goods, either. Pollution is an example. So is carbon dioxide creation. These are side-effects of practices that increase returns on investment. When an enterprise creates an external cost, a cost to society, by virtue of its normal operation, that normal operation is not properly representing the interests of society. Its goods are priced as if the externality did not exist. But it does. So there is an element of deciept here.
Those who are concerned about China’s share of the manufacturing market might note that if there were global pressure on China to clean up the air pollution, and to pay her manufacturing workers a fair wage, and to give them reasonable working hours, many of the business advantages that the Chinese have that seem unfair to western businesses and workers would go away. The respiratory health of the Chinese would improve. And they would be able to enjoy a little leisure time and fewer would work themselves to death.
There are other side effectsto thinkng about the invisible hand in the wrong way. One of the bizarre temptations of Smith’s invisible hand idea is the argument that all that might be done to improve things has been done. If the invisible hand is true not because people behave in a certain kind of rational way, but simply because it is true, then one would be forced to conclude that things are the best they can possibly be because the invisible hand has made them that way.
The spirit of this idea is antithetical to the spirit of Smith’s invisible hand idea for it removes all motivation to improve and to drive more efficient operations. The invisible hand idea depends on the idea that anything that might be done to improve a business is done simply because a person ought to be motivated to do it. But that is not always the case. Sometimes it takes some time. How much time depends on a lot of factors like cost and technical feasibility and political consequences. And it requires that the person running the business does not believe in the invisible hand as a kind of mystical force that substitutes for their own good judgment and diligence. The free-marketeers veer dangerously close to this kind of thinking by assuring us that everything is fine, we don’t have to worry ( see also think) about any of this stuff; the experts will do that.)
There are a number of really h uge notable exceptions to the assumptions Smith makes in his invisible hand argument
1) Slavery.
It is certainly in the economic interest of slave owners to own slaves. The choice allows them to live as rich men, enjoying the rent on huge tracts of land. Smith’s argument says that the slave owner will likely do what he can to maximize the output of his enterprise. So he will keep his slaves well-fed but lean. And he will work them hard but fairly.
In a purely economic sense that is all well and good. But the invisible hand may not tell us that slavery is antithetical to the ideal of participatory government. It may not tell us that the economic idea that humans can be treated as chattel degrades the very idea of humanity. There are issues that impinge on economic practice that are bigger and more important than mere efficiency of production. When cheap stuff is the ulitmate goal of existence life has become unfathomably cheap.
2) Education.
My own father was removed from school in the ninth grade. His parents argued that he belonged down on the farm. And what he learned after ninth grade would be of no help to anyone. At some point my father decided otherwise. He took the GED, went to college and graduated, as he puts it “in the upper two-thirds of his class.” Not so great if one is highly ambitious, but good enough to land him a job teaching high school physics. This he did for something over thirty years. And he was pretty good at it.
This issue is one that has plagued children for a good long time; the tension between their own interests and that of their parents. It is frequently the case that parents, bearing no malice to their children, make terrible economic choices with regard to their childrens’ educations. It is an idea that J.S. Mill argues in On Liberty. There, he grants people a great deal of latitude to make bad choices about their own affairs. But children, he argues, are incapable of understanding the importance of education. And too frequently their parents are not much better at it. When parents withdraw their children from school they mistreat them because they simply misunderstand the importance of education.
In lands where it is traditional for children to take up the family business, the argument against higher education almost always wins. How is one to persuade a small, rural middle eastern family that knots carpets by hand and sends them westward that their six year old daughter must learn to solve differential equations or that their son must read Jane Eyre? What does that have to do with making a living in the carpet trade? But for each year their children are at school they lose not only the income from making carpets, but the ability to become highly skilled at the trade. If they are to be good at the trade they must quit school early. The Massai inhabit the extreme end of this spectrum: they allow only the children too dimwitted to herd cattle to waste their time in school.
Interestingly, the Masai, my grandparents, the middle eastern carpetmakers, and the free-marketeers are all making the same argument as Adam Smith: “Pull the little monsters out of school and set them to work milking my cows!” I guess they must be right! See also item 1)
3) Roads
Let us wave a magic wand that causes every car in the continental US to carry a little black box that bills the owner of every linear foot of private roadway in the US he traverses. This would make private road ownership possible without immediately snarling traffic with toll booths at ever stoplight. What next? Pricing. How is each foot of roadway to be priced? Let us say an average trip caused one to travel on roadways owned by six firms. How do we decide if a route is “the best route?” If we are in a hurry, we might choose the shortest route. But what if too many others find this the most convenient. It may not be the cheapest route. So we must calculate the cost of travel based on a handful of routing choices. And then decide on the best compromise between cost and convenience. Not a problem, I always carry a calculator, a road rate schedule, a notepad, and a pen with me for such occasions. And I love solving integer programming problems. But, I wonder, do people who do not have twelve of fifteen graduate credits of operations research enjoy the task so much as I do?
Next question is the issue of access. If roads are owned and operated by private companies what is to keep them from preventing certain parties from travelling on their roads. Suppose companies A and B are competitors. Now, suppose company B needs to drive on company A’s roads to maintain its own. Suppose further that company A covets B’s roads and wishes to get them as its own. How might it rationally behave. It would deny B access to its roads. B’s roads would deteriorate until A could get them at pennies on the dollar of their real value. And any drivers who needed to use company B’s roads, meanwhile have either moved to where there is a functional road system or are paying their mechanics huge repair bills. One might argue that public roads get bad, too. But the argument here is not just that a company may fail to act in its own enlightened self-interest, it is that one company could render another’s roads useless in order to gain a competitive advantage. The purposeful ruination of a competitor’s functional capital, in this case can be a rational choice. And the only way to forestall such a practice would be to legislate against it.
Were this nation’s system of highways designed by private firms and owned by them there is a high likelyhood that the roadways would be riddled with dysfunctional discontituities. Over and over again one would face a kind of “You can’t get there from here” problem.. Furthermore, if there were more than three or four days per year in which traffic was not parked bumper to bumper during rush hour the private enterprises who owned the roadways would imagine that the roads were over-capacity. They are not paid for efficient travel, only by car-mile.
The fact is that there are so many opportunities for private companies to make more money by making road travel more miserable, less functional, more costly and less amenable to the public interest that it is in the public interest to have roads be constructed and maintained by govermental agencies. The invisible hand, here would create havoc with roadways.
4) Sustainability
If one starts by assuming that the world is flat, that it exists as a kind of semi-infinite plane, and that as all the resources are used up at one location, one can simply move westward and get more, then sustainability is not a very important issue; you just keep moving until you locate the resources that are needed. In a material way this was the way the world looked to the British in Adam Smith’s day. North America was perhaps a hundred times as large as England. Australia was huge. And so was Africa. The amount of resources available seemed practically endless. And, in fact, they have lasted for nearly two and a half centuries.
As big as the resources seemed then, they must rightly seem small er to us now for three reasons.
a) we use far more of them per capita than did the people of Smith’s day
b) we have exhausted a fair portion of the resources already It would not be far from the truth to imagine that we have used up something approaching half the supply of a handful of resources such as copper and oil. There is very little anthracite left, bituminous coal is growing hard to find. And we are strip mining the much lower quality lignite. A recent price hike doubled the price of taconite, suggesting a tightening of supply in iron ore. And iron is a rather plentiful resource.
c) the global population today is more than ten times what it was in Smith’s day. And more people are using more resources. So the second half will take much less time to deplete than the first half of any resource.
These factors suggest that our current model of extraction as the primary source of raw materials is already outdated. Smith’s invisible hand says that when resource shortages start, prices will be driven up and things will take care of themselves. In the case of copper the cycle has started. Unoccupied homes in many neighborhoods are being stripped of copper wiring and piping by thieves. It is only a matter of time before we read stories about people who go on vacation and return to find their toilets don’t flush because the copper piping is gone. This is the new mining.
In the field of agriculture it is sometimes true that large businesses cultivate a huge plot of land, mistreat it for the purpose of making a quick buck and end up making it unfit for agricultural production.
In the field of finance since bank deregulation we find that the whole industry attempted to make easy money by speculating on the value of real estate. When real estate stopped going up in price they were ruined. That’s not a problem when the investors in the instruments understand the game they are playing; but they did not. This is where the invisible hand reaches into your retirement savings account and moves the whole bit into someone else’s account. To the extent that one clings to Adam Smith’s invisible hand argument like a religious tenet this is the effect of Smith’s argument. Smith, I think, would have been repulsed by it.
But the point is that all speculative bubbles, all of the businesses that derive excess profits from the “joining” phenomenon are unsustainable at the limit. And that means that when the joining rate falls below a certain level, the game is over and some of the players are out of money. Such games are decidedly not in everybody’s best interest. And to the extent that they derive excess profit in an unsustainable way they are both deceptive and destructive.
This is one of the perfect examples of the distinction between economic anarchy and economic liberty. Ecomomic liberty allows the pursuit of all constructive economic games. Economic anarchy allows also economically destructive games, ruinous games, not just on an individual level but on a national level.
There is still a question whether the mortgage security crisis will destabilize the US banking system. A number of large players have been on the brink for some time. The whole reason for the crisis is the change in banking regulations in 1996 that moved the system toward anarchy.
Because Adam Smith’s invisible hand is not concerned with the liberty to make speculative decisions that fail to actually generate wealth but is interested in decesiond that deal with with getting favorable outcomes and actually generating wealth, I think Smith might have been disinclined to use the invisible hand idea to argue for the wide deployment of unsustainable economic games. In the promotion of such games the free-marketeers have made bad use of the invisible hand idea
5) Question of Terms
The invisible hand is an equilibrium argument. That means that it is descriptive of something that markets tend to approach over a long enough period of time. But it is less helpful in telling us how long this takes or what we should expect to see on the way. As one prominent economist once quipped “In the long term we are all dead.”
The fact that it was a long-term argument has not made a great deal of difference over the term that it has been used. But if conditions change in a way that makes the excess resources of frontier disappear, then the surplusses that drive large-scale commerce may cease to exist, and the very energy that makes the transportation of goods so cheap might disappear as well. In other words, if the term is long enough, the very physical factors that make commerce possible might not exist.
So if one looks far enough out, there is a real possibility that the world will look much like a sixteenth century Afghan village or a twelfth century Lithuanian village. Or even a third century American Plains village once all the coal and oil is used up.
The fear is that that’s what would happen if the free-marketeers have their way with the electorate. At that point there won’t be very much use for Smith’s theories because commerce will be dead. The invisible hand idea will not be wrong, it will be irrelevant. Our hope, in setting out on this little diversion has been to help forestall such a bleak future.
6) Pollution and other Externalities
Let us suppose that You and I live in the Adam Smith Invisible Hand enclave of Freedom City. The city is build on uneven ground and I happen to live in an appartment that is higher in elevation than yours. Now, because this is a modern city our apartments are fitted with the modern fixtures such as flush toilets. But because there was no law requiring otherwise and because it was cheaper to do so, the builder plumbed the effluent of my bathroom so that it falls into the street. Much to your own inconvenience, because of the various spacial and temporal relationships at play, the matter I flush down my toilet lands in precisely the same spot that your milkman uses for deliveries of milk. And it coincidentally does so soon after the fresh milk is delivered. This set of coincidences makes your breakfast of cereal and milk simultaneously less appetizing and more hazardous than they might be if the world were arranged in some other way.
To westerners today such a construction may seem hyperbolic to the point of being absurd. But conditions not fundamentally much different from this reigned in all cities in the world until some point in the ninteenth century. Then Loui Pasteur lived and proved that microorganisms caused infectious diseases, sewers were built in Paris, Victor Hugo wrote Les Miserables, and the notion of the modern city changed forever. In the first few decades of the twentieth century virtually every western city and town undertook public works that collected and treated sewerage and that treated drinking water and made it sanitary and relatively safe to drink. Only in this last decade has more than half of the human population of the world gained access to pure, potable water. In the west, the creation of vast distriubution networks to collect and process sewerage and to distribute safe, potable drinking water alone added almost twenty years to the average life expectancy.
The free market did not do this. Nor could it.
The Invisible Hand Meets an Ignoble End
The problem with the city until the deployment of sewers and public water works was was that everybody’s shit was killing everyone else. And you couldn’t fix the problem with any certainty until you had systematically collected everyone’s shit and systematically provided everyone with clean drinking water. One person’s shit in the wrong place could ruin everything.
The invisible hand does not create good solutions for problems like this. It is capable of creating bottled water that costs half an hour of labor per drink - a hundred or a million times as much as potable tap water. With such a solution only the reasonably well-off can drink safely. And the shit is still rotting in street. We live longer, some of us; but we still live in shit. If we want to get the hell out of there for a little while on the weekend, we travel by taxi on a private road to a private park where all the trees have been painted orange and reek of grape Koolaid because such an arrangement brings in more revenue.
This is the world you get by slavish adherence to the free-marketteer’s cheap idea of the invisible hand: you live your life knee deep in shit and on your day off you pay an arm and a leg to go elsewhere and see smelly orange-painted trees. Let the buyer beware.
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04.01.08
Posted in News Commentary, Politics at 2:54 am by steve
The “subprime mortgage” fiasco is being treated as if it is some kind of exotic financial disease heretofore unknown to man. There seems to be a lot of “how could we have known?” going around. But if one looks beneath the specifics and gets to the generalities, one quickly realizes the fiasco is of a type that can be traced far back in history The specifics are different but the generalities are the same. The problem is one of speculation.
Speculation is a problem associated with the perceived value of a thing depending at least to some degree on the expectation that the real price of a good will be higher later on. This speculative force draws its sustaining force from new people entering the marketplace, usually because a good is appreciating at a remarkable rate of increase. The joining phenomenon brings new players into the system, driving up prices. Then, when there are no more people entering the marketplace, the scheme collapses. Who is hurt most depends on the specifics of the game, but it is frequently the last to join the frenzy. To understand this game we must look at some historical examples
Of Tulipmania and Ponzi Schemes
An early example of this was the seventeenth century Dutch “Tulipmania.” People would purchase new tulip cultivars, hold them, then resell them a little later, and realize a significant increase in price. The breadth and depth of the craze was profound. Early on many people made a fortune. The mania spread and expectations grew wiith the extent of the infection. There were cases in which people mortgaged their homes to purchase a single tulip bulb in order to ride the speculative frenzy to new heights. But by that time the fever had almost run its course. Soon the market collapsed for lack of fresh fuel. If everyone has morgaged their house to buy a single tulip bulb, where does the money come from for the next wave of investors to purchase bulbs at an even higher level? Eventually such a scheme must collapse. Tulipmania is a classic, if somewhat exaggerated, example of a speculative bubble.
To get a handle on things we need to define some rarely used terms. The first is non-speculative price. Or normal price. This is the price that a widely traded good would fetch on an open market when the expectation of speculative gain is identically zero. A person buys the item not for what they expect it will fetch later, but for what it is right now. They buy it soley for the normal utility it provides.
Suppose one goes to a Wal-Mart to buy a pair of sneakers. One pays no premium on the sneakers. It’s because one does not expect that at some point in the forseable future those sneakers will fetch far more than one pays for them. This is what we mean by normal price. One can define a normal price for most goods that are widely traded. For one-of-a kind items such as an original Van Gogh painting it is not so easy to do. But for homes, for cars, for sneakers, for commodity goods, for most things that are purchased partly or mostly for their utility, one can always estimate a normal price. And when a price exceeds this level it is, by definition a speculative price.
Some kinds of speculative pricing is sometimes justified. A tulip bulb can be had on the open market for something like half a dollar. This is the normal price. A new introduction might be priced at two or three times this price. Here, a buyer might pay an extra amount to be the first in the neighborhood to grow a particular tulip. So if one is in the tulip business, one might purchase a handful of new tulip bulbs for many tens of thousands of dollars, paying for the exclusive propagation and distribution rights for a season or two.
The distributor might pay hundreds or thousands of dollars per bulb. We might define this increment as speculative price. But at least here the value of the speculative price is secured by a cartel agreement. The nature of the speculation is different. The speculative value depends on limiting distribution, not on creating an unsustainable psychological game of chance.
It is a very different kind of speculation from the sort at work during tulipmania. It limits the losers to the bulb company - if it fails to sell as many new bulbs as it expects to sell - and the bulb company’s customers who pay more than they otherwise would for new tulip varieties. But these losses are losses based on clearly defined risks. The people who lose know the parameters of the game going in. They enter the game understanding and accepting the risks.
The tulipmania game is categorically different. The nature of the speculation derives from the creation of buzz. It derives from the expectation of excess gain that exists only by virtue of someone else later on joining the game because it provides excess profits. This hope of gaining excess profits by controlling ownership of an appreciatiing asset we will call greed. Tulipmania existed because of greed. And it was sustained byan ever increasing body of new members who joined not because they were interested in growing tulips but because they were interested in making a quick profit.
The purest form of the game was invented in the early twentieth century by a New York whiz-kid named Ponzi. Ponzi advertised accounts that would pay15 percent interest per annum. This is quite a huge return on investment; but if money is very shrewdly invested it is not impossible to get these kinds of returns. Warren Buffet has done it. Early investors in Ponzi’s scheme, in fact, realized the advertised gains. They told their friends, neighbors. and business contacts. And many of them joined in, too. The game continued in this way for a while, but the population of joiners was finite and, as it turns out, Ponzi was a great marketer by a lousy investor.
He was not investing the funds at all. Rather, he was using the deposits of new investors to pay interest to existing investors. The “interest” was a wholesale distribution of funds from new entrants to older ones. If an account pays 15 percent interest in such a game, the game is sustainable only so long as the pool of new participants grows at more than 15 percent per year. Once that no longer holds, the obligations to investors quickly dwarf the assets available to fulfil them. And the institution comes crashing down. It is a mathematical fact that this conditon cannot be fulfilled; therefore the scheme must fail.
What was brilliant about Ponzi’s scheme was that it achieved what tulipmania did without there existing any underlying asset. Tulipmania participants, at least, could argue that “the value of an asset is what it will bear on the open market, so if I mortgage my house to buy a tulip bulb, that must be the value of the bulb.” Precisely the same reasoning was heard on Wall Street just before the dotcom crash. It illustrates the difference between normal price and speculative price and the dangers of confusing the two.
But in Ponzi’s scheme there was no underlying asset. People were trading on trust. And if they had understood how Ponzi was creating 15 percent returns, most of his investors would have looked elsewhere. Ponzi’s scheme, then, is a compelling argument for two qualities in investment instruments:
1) Transparency. Ideally, every financial transaction that might potentially affect value is represented on the publicly available books. A recent article about Citibank suggested that up to half its assets were off-balancesheet. No wonder it is selling itself cheap to offshore sovereign funds.
2) Comprehensibility. Ideally, every person who invests has a pretty firm grasp of what it is, fundamentally, that causes an investment to create wealth. This understanding allows an investor to assess risk. Financial instruments that require a PhD in mathematics to comprehend deserve to be used only by investors who can employ PhD mathematicians to protect their interests in real time.
In the Ponzi scheme the whole of the value of the investment is secured by subsequent joiners. This means that the last people to join must necessarily lose most or all of their investment.
Of Leverage and Levitation
This brings us up to the market crash that led to the Great Depression. In the “roaring twenties” new industries such as steel, and oil had passed through infancy and adolescence and were in early middle ages and t were turning out huge amounts of cash. Railroads were in their late middle ages. and were still turning out healthy profits. With the possible exception of automobiles, there were not so many new industries in which to invest - not on the same scale, anyway. Consequently, the price of equities was driven above the normal price. Meanwhile, speculators saw that share prices had been going up steadily for a long time, and they chose to exploit that fact.
Anytime an asset has appreciated steadily for a decade or more, there is a temptation to believe that the trend is permanent. And speculators did just this. But the real money was to be made by borrowing money to buy stocks. If one borrowed money at five percent and one realized ten percent in the stock market, it was like getting free money. Rich individuals did this. So did banks. It seemed like a sure bet. And it might have been, so long as the price of the equities was a normal price.
The result of this was that the price of assets slowly began to rise abovr the normal price. After some time they departed significantly from the normal price. A significant portion of the price of an equity became speculative. And because the continued rise in this speculative value relied on ever-increasing amounts of money entering the system, it was, by definition, not sustainable. On “Black Friday” in 1929 the market collapsed.
In normal circumstances, if a person buys an equity and the equity loses half its value, then the equity stake loses half its value. But these were not normal circumstances. Many speculators, individuals and banks had borrowed money to puchase equities, on the assumption that the price of equities could only go up.
If a person had borrowed an amount equal to their personal assets in land and other fungible assets to buy stocks; and if the stocks they bought fell by half, they could sell their stock holdings and half their other assets to make good on the loan. But, in fact, many investors were leveraged more than this. And some investments fell by more than half. As a result, many investors were wiped out. Many banks went bust. And their depositors lost their deposits. The capital markets dried up. And unemployment reached 25 percent. It was hard times.
The basic system can be described in many terms. It was a normal sort of speculative bubble driven by greed and hope of easy money. It was a speculative game that relied on an ever increasing number of players to sustain the excess return of early entrants. It was a case in which a significant portion of the price of an asset was speculative in nature - it was based on the expectation of future appreciation. And the effects of a downturn were amplified by leverage. The fact that borrowed assets were used as instruments to purchase a speculative asset meant that smaller downturns resulted in more devastating losses.
The tulipmania speculators lost only their own houses. They did not lose, as well, the houses of everyone on the block. But leverage which allowed an institution to make excess gains using other people’s money to buy speclative assets, also destabilized the system. It both led to a kind of speculative frenzy, and it assured that the end of the speculative frenzy would be ruinous not only to those who chose to play but also to people who did not even know they were participating.
My Stodgy Bank
The lessons of the Great Depression were not lost on legislators of the ninteen thirties and forties. They passed legislation that isolated banks from other kinds of financial institutions. From the point of view of depositors; they should be able to correctly presume when they deposit money in a checking or savings account that it will always be there to use when they need to usel it. The bank is presumed by depositors to be a safe place to put money. When this condition does not hold, it is a swindle to bank customers and it is a blot against the reputation of the banking industry.
Banking simply cannot survive without this high level of trust. If it is both to sustain this trust and warrant it, banking institutions must simply never lose people’s deposits through speculative misfeasance or malfeasance. They simply cannot be allowed to play unduly risky games with the money - whether they are smart enough to understand those risks or not. This was the thinking that underlay the legislation. And, until 1996, this kind of organizational principle made banking secure for bank investors and depositors.
Consider a simple case; the home mortgage lender of the mid-fifties. It was a neighborhood bank. It lent mortgage money to home owners who put twenty percent down on their homes. It lent from a pool of capital that came primarily from local savings. And so if Mr Smith defaulted on his mortgage, Mrs Jones and several of her neighbors may not be able to withdraw their savings to spend on cars or college for the children.
Actually; reserve requirements made it hard for this to actually happen; but the threat was always there. Banks lent wisely, for the most part, because it was in the best interest of the institution, because it was in the best interest of the community, and because it was in the best interest of the bank’s officers. They took their fiduciary responsibilities personally. They also lent wisely because there was a body of law that would prevent practices that would lead to the unstable conditions of the 1920s.
But things changed. Banks began trading mortgages. This was good because some places had an excess of capital; large cities for example. And commercial or industrial institutions sometimes generated huge sums of cash. And some areas, such as bedroom communities, had large demand for debt. All other things being equal, the business of selling mortgages helps efficiently allocate financial resources.
But already, all things are not quite so equal. Already the practice of selling a mortgage comes with a problem; if the originating institution - be it a bank or a service company - has no stake whatsoever in the quality of the debt instrument and the creditworthiness of the debtor, the game is set up to encourage companies that manufacture and sell morgage debt insturments without making sure these instruments actually have any minimal level of quality. Furthermore; institutional safeguards alone are not always so powerful as are safeguards that include a risk to reputation as well.
Still, economic theory predicts that in the long term market forces might weed out those institutions that are the worst offenders; but this takes time to discover. And it requires that one price mortage securities in accordance with this lower expetation of creditworthiness. In other words; when one changes the rules of writing mortgage securities in a way that increases risk; the securities need to be valued in accordance with this fact. Perhaps in some recent cases this has not been the case.
What actually happened over the last decade or so was that even if an institution that wrote a loan did have some financial stake, if it was a publicly held company that originated a loan, the company could flourish so long as it increased its monthly loan-writing volume. Fees for originating new loans would paper over losses from bad loans. for some time. Then, when the whole thing went south, the officers would bail out, keep their houses and big bonuses, and the shareholders and creditors would be left holding the bag.
Unlike the olden days when a bank loan officer was part of the community from which the equity originated, loans came from nameless pools of money. Now, nobody who benefitted from this legal sort of Ponzi scheme had to look a depositor in the eye and say “sorry Mrs Jones, I behaved like an idiot with your money. Your retirement is cancelled.”
The behavior of knowingly writing bad loans is destructive; and it is reasonable to have laws that punish people who are responsible for it. But things got much worse. Morgage securities were bundled into huge pools of securities. Then they were “sliced up.” This meant that certain kinds of risk - geographical, for instance, might be spread evenly through a large number of portfolios. This certainly did decrease the amount of risk in any given portfolio. And that is good. But the practice did not eliminate all kinds of risk. For instance, mortgage securities depended upon increasing home prices for borrowers to keep making payments. This meant that the creditworthiness of the whole pool depended upon consistently rising home prices. The risk associated with the failure of this condition was essentially the same, regardless of how things were sliced and diced.
If home prices stopped going up. And if people were borrowed to the max against their home equity, they would have financial incentive to walk away. Seeing this day coming, Congress revised bankrupcy laws in the early 2000’s to make this eventuality less attractive to homeowners. But this did not change the workings of the financial machine that derived its value from lending money it did not have. It did not fix the problem of leverage. It did not change the expectation of the average Joe that his own home would accumulate value almost like magid indefinitely.
The Value of a Home
It’s hard to say precisely when today’s real estate boom took off. There is a kind of continuity to it that can be traced all the way back to the end of WWII. The parents of todays boomer generation began building sprawling suburbs at the end of the war. And the building trend has continued apace ever since. People have become ever more productive, and the amount of resources they can dedicate to buying a house, in real terms, has increased. At the same time, inflation has changed the value of a dollar. All of these factors have conspired to drive up the nominal price of a home.
There have been ups and downs. Boomtimes occurred when real interest rates dropped. Bust times occurred when interest rates rose or when significant economic retrenchment occorred. But for the most part, homes kept pace with inflation or did a little better over the stretch from 1950 to 1996.
There was a point in time in the early 1970’s in which the inflation rate was nearly seven percent and the interest rate on a long-term loan was five percent. If one believed that the inflation rate was not going to become lower, then the only rational behavior was to borrow as much money as one could, and invest in real estate. All other things being equal, the house would appreciate at the inflation rate but the loan value would appreciate at a lower rate. It was like printing money. Paul Volker, whom President Carter brought in to chair the Federal Reserve thought it was a dangerous game. He jacked up interest rates to almost userous levels and inside of four years he had killed inflation dead.
That put an end to the most abusive kind of manipulations. But, nonetheless, homes have appreciated in nominal value almost monotonically since the early ninteen fiftees. If they have not proven good real investments; at least they have proven to be good hedges against inflation.
What this means is that if one looks at the trend in nominal home prices, houses appear to be a good investment. And if one wishes to really take advantage of the fact, there are good ways to do so. One way is to borrow money and buy investment properties. So long as the properties appreciate at a nominal rate that is higher than the rate of the note, one makes money. And it is easy money because the gains come from using other peoples money. A variation on the theme is to buy properties that are run-down, restore them, and “flip” them. These games are not without their risks. And the risks in the game have limited the amount to which they were played. It is probably true that most of the excess returns caused by such behavior was offset by risk. Nor is it possible to pin much of the current crisis on this sort of speculation.
But most home buyers understand nominal price better than they understand the real value. We need to illustrate. At seven percent inflation, a good will cost twice as much in ten years as it does now. Every good will. Even a house. So if one “invests” $100,000 in a home today and sells the home for $200,000 in ten years, the $200,000 (ignoring taxes) will buy precisely what the $100,000 did a decade earlier. It will buy the same house, the same number of recent model cars, the same number of dishwashers, the same number of barrels of crude oil and so on.
There is no real gain on the home, just a nominal one. What has changed in value is not the value of the house but the value of the currency. This idea is not well dealt with in the tax code. And it is not well understood by most home buyers. And for this reason it is easy for a home buyer to imagine that gains on a home amount to much more than they actuallly do.
To the extent that this is true, it means that homeowners will be inclined to commit too much to buying a home. That is, they will factor in the future price and the nominal gains into their buying decision, misinterpreting nominal gains for real ones. Part of the purchase price, then, becomes speculative in nature. And the speculative hope is attached to a fictional gain. So long as the portion of people who buys homes employs this this speculative thinking in buying a home, and so long as the number of people in the market is roughly constant, there is not much harm in the game. The system reaches equilibrium at an inflated price, perhaps, But not much bad stuff happens after that. Not until some condition comes along that challenges the assumption. At that point the speculative spell is broken and homes trade again near their normal price.
So long as people buy a home for what it is - a shelter that delivers a suite of comforts and amentities - not for what it might fetch when it is sold, the price of a home remains at a normal level. But when people buy a home primarily as “an investment” part of the price of the home is speculative. There are places in the nation where, arguably, most of the value in the price of a home is non-speculative. And there are places where a good portion might be speculative.
It’s not so difficult to get a handle on it. Find out what people are paying in rent per square foot in an area; and find out what they are paying per square foot for homes. If there is a rough equivalence; or if the differences can easily be explained entirely by objective desireability factors, then homes are priced at their nominal value. If, however, home owners are paying three or four times as much per square foot, there is good reason to believe that a majority of the price of the home is speculative in nature.
There was a point in recent history when this muiltiple was something like two or three for parts of coastal California. Perhaps the same was true in some parts of the east coast. It was not hard to tell that we were approaching the crest of the wave when one read in 2005 in the Economist that a clever fellow had worked out that in real terms the price homes had reached levels unprecedented for over a century; and one could see cartoons in the New Yorker depicting adolescents on the beach in front of an elaborate sand-castle saying “let’s flip it before the tide comes in.” Sensible people saw this one coming. So what about the experts?
The New Derivative
One recent article describes the financial underpinnings of the crisis. A bank makes money by lending. The more it lends, the more it makes. If that were all there were to it, there would not be much mess to clean up. But what happened in this case was that financial institutions used instruments that they falsely assumed to be secure to acquire new assets. Now in the old days, the days between the Great Depression and 1996 these instruments were primarily deposits. They were monies in checking and savings accounts. Banks could make loans on the basis of these accounts. The dollars were in the vault. Some portion they would hold in reserve in case lots of depositors withdrew money at the same time. And the Federal Reserve would lend money on favorable terms to cover day-to-day shortfalls so that banks could always meet their obligations to depositors.
But when banking deregulation came along, the kinds of financial instruments banks could use to collateralize new loans increased. It was no longer, cash. It was also other kinds of securities. Among these securities was mortgage-backed securities. These were securities whose value ultimately depended on the value of homes. What this meant was that banks could, in effect, lend money they did not have. Rather, they were lending money that they would have, assuming home prices kept going up and people kept on paying their mortgages. But it was money they did not have when home prices stopped going up and people defaulted on the mortgages. The problem for the banks was that once home prices started to fall and defaults exceeded expectations they had lent money they imagined they had but they actually didn’t have. That’s a violation of a fundamental rule of banking. And if a bank fails to bridge the gap, it collapses.
The reason financial institution behaved this way was because it was profitable, so long as the securities they used as collateral were sound. But ultimately it amounted to taking on debt obligations that were secured by the assumed inevitable rise in price of some asset. And when that assumption no longer held, the game was over. Just like Black Friday.
One might imagine that the game could go on forever but there were physical limitations. In order to realize excess profits on the scheme, they had to keep on expanding the pool of mortgage holders. And so long as they could do this by writing mortgages to creditworthy customers, the game would continue. Once this pool was exhausted there were two alternatives. One was to stop the game and settle on “normal returns.” The other was to lend to people who were known not to be creditworthy and keep pusihing the envelope. The motivation to do the latter was big because everyone saw a way to make a quick buck from pushing the game along. And everyone who knew the risks imagined that they could be passed along to other players.
What we have just described is a kind of game that sensible people will understand cannot be sustained indefinitely. It gains its power to enrich by enlisting new people in the gaime. And when it collapses it is generally the latest joiners who are hurt the most. What we describe is an old game in new clothes. It is a game that exploits a long term trend in the value of an asset. It is a game that derives a significant portion of its its percieved value from that long term upward trend in the value of an asset. It is a game that exploits speculative pricing. It is a game that ultimately depends on an ever-expanding pool of players. It is a game in which gains, then, ultimately depend on unsustainable conditions. And it is a game that hurts a lot of people when it collapses.
This game is pretty much like the Ponzi scheme. Two of the reasons it was not properly recognized as one are lack of transparency and lack of comprehensibility. Investors in companies engaged in the practice of securitizing loans with shaky mortgage investments often did not understand the risks. Sometimes it was because the people who wrote subprime loans purposefully lent to uncreditworthy customers. And people who were paid to know and care were paid more not to know and not to care.
To a significant degree, too, the problem was invisible because large institutitions carried risky assets off balance sheet. A recent article mentioned that half of Citibank’s assets were “off balance sheet.” And one can bet that the half that were so were the risky ones. So transparency certainly was a problem. Enron should have been enough to teach us the lesson; but evidently it did not.
There is some evidence that even many people in the business did not really understand the nature of many of the financial instruments they were dealing with.. Some of the instruments were highly complex derivatives whose movement was understood only by PhD mathematicians. To people who used them, the instruments were black boxes - just like Ponzi’s accounts.
This makes rational valuation impossible. It also makes a rational market impossible. It is one thing to allow markets to create fnancial instruments that are abstract and esoteric and to use these instruments at the margins for the purpose of arbitrage, with the goal of achieving an efficient market. But it is something else entirely to have people who are oblivious to how they work deal in them every day. It’s kind of like the difference between having a small nuclear arsenal that is very carefully controlled by trained people and handing out nuclear weapons to anybody who shows up at the corner of High Street anb Main. One can find good arguments for the former; but it’s not so easy to find good arguments for the latter.
Meltdown
Banking deregulation, then, produced a huge supply of new money. And it produced a huge supply of esoteric instruments. The money first went into homes, causing them to double in price since 1996. Some homeowners borrowed against the increase in value of their homes to buy consumer goods. This did not tend to drive up the cost of consumer goods in nominal terms; so it was not considered inflationary. It may be, however, that such goods would have fallen more in price were money not quite so loose.
More recently, the flood of money has driven up commodity prices. The spin on Wall Street is that it is demand in China and India that is responsible for spiraling oil, copper, and iron prices. Gold is speculative. Wheat is driven by the rise in corn. Corn is driven by ethanol. Ethanol is driven by oil. But the fundamental fact is that once all homes and raw materials have doubled in price; it is not long before other things will as well. A 30 percent drop in the dollar’s value against other currencies suggests something like the same kind of rise in the price of imported goods. Once every good one can buy has doubled in price; it is a safe bet that the currency is worth half as much. So it is not impossible that some significant portion of the rise in prices of all of these goods is simply an artifact of money produced by the same mechanism that caused the crisis. The world was awash in liquidity for a decade and now we pay the price. In other words, inflation.
If this is true then by the time the thing is over, the dollar will be worht half of what it was in 2005. Maybe less. In nominal dollars, we might hope our homes will be worth what they were in 2005, but in real terms they will be worth half that. Or less. The people who will be screwed will be the poor sods who held paper. It will be the people who held bonds of any sort. As it was in the 1920’s the people who were net savers, the people who placed their trust in financial institutions to vouchsafe their life’s savings will be screwed. Nobody else can afford to pay; not the federal government, not the financial institutions who profited from the scheme, not the people who borrowed the money, not the banks who used bad loans to securitize worse ones.
This, of course, assumes that the Fed is capable of keeping the whole system from coming unravelled. With each bailout and each rescue the picture looks worse and worse. The amount of leverage in the system appears to be pretty big. We know this because a few tens of billions of non-performing debt threatens to destabilize a system that has trillions of dollars in assets. Back before banking deregulations the level of assets held in reserve against adverse conditions was much bigger than this. And as any person with a bit of sense might have predicted, this increased leverage would flood the market with excess liquidity and it would threaten to destabilize the system. It’s a no-brainer.
One is forced to the conclusion that either the people who advocated for deregulation and those who voted for it were idiots. Or they were scoundrels. There’s a good chance that it was mostly idiots led by scoundrels. One more crusade.
Blame
No analysis of disaster is complete without an accounting of blame. So who owns responsibility for the mess? We offer some opinions for consideration.
1) The American electorate at large for voting into power a group of politicians who somehow never heard of the Great Depression or at least failed completely to comprehend the forces that caused it. Americans might argue that we did not know what these politicians might do. But this is nonsense. They ran and won elections on the premise that they would slash taxes and deregulate everything. Also they would put people in jail who objected to bad policy by burning flags. These candidates appealed first to greed and jingoism in their campaigns. They appealed to our meaner animal instincts, not to our better judgment. What should we expect? Politicians gave us what we voted for.
2) People in major financial institutions who should have known better than to leverage speculative instruments. Again, most of the people were just trying to make a buck. But the small portion of people who actually understood what was going on should have been voicing concern. There was none. It is so bad that we must wonder whether the whole system is run by idiots or whether it is run by and for scoundrels. For it is inconceiveable that a fair portion of the people who saw what was going could not have understood the non-sustainable nature of the game. Were players at the highest levels totally incompetent? Or did they intend for a crisis to occur?
3) People in financial services sector who originated loans without the adequate safeguards against bad debt. This group was the ground troops. They bore responsibility for the crisis in approximately the way draftees into the Wehrmacht owned responsibility for WWII. Maybe it could not have happened without them. But they were pretty much doing what was expected of them by the society they were a part of.. And that’s the way societies work, pretty much.
4) Irresponsible borrowers. Yes. It is true. Some borrowers got loans without either the means or the intention of paying them off. There exist cases in Ohio and Florida in which mortgagees have stopped paying loans but refused to vacate homes until the holder of the loan can produce the appropriate proof off ownership. And in some cases this has gone on for years. Simillarly, there are those who misjudge their ability to pay. And there are those whose financial position deteriorates due to loss of a job or health problems. And, it would seem that the portion of borrowers who fall into this category was artificially inflated by the recent practices of group 3) working to sell loans originated by group 2). based on a policy that can be traced back to group 1) One can argue to what extent bad debtors are abusers of trust and to what extent they are victims. There is a mix here. . We hope that laws and law enforcement make good distinctions here; but it looks like who has the best lawyers in this game wins.
Who will pay?
1) The American electorate. The taxpayer. Some portion of the crisis is being handled by handing money from the federal government to the banking system. Or at least by loan guarantees. Thus, the taxpayer is underwriting the failures of financiall institutions. There is a sense of justice here, because we elected the guys who deregulated the banks. We are getting what we asked for.
2) Head honchos in financial institutions whose primary assets were secured by the value of stock abd stock options they held in their failed instittuions Again, there is a sense of justice here. But one wonders whether some of them ought to spend some time in jail.
3) The people who touted deregulation at any cost rightly ought to lose their intellectual credentials. People who advocated for a kind of economic anarchy preached by the neocons and the radical libertarians of the eighties and ninnties ought to be laughed out of town. Really, the village idiot ought to be listened to more carefully. For, at least, we know that the village idiot hopes, at most , to end up getting a free meal out of any exchange we might have; while the radical libertarian hopes for a contract whose clever terms allow him permanent rights to your house and car and retirement assets.
4) Irresponsible borrowers. Again, there is some sense of justice here.
Whether the pain will be distributed roughly according to blame is doubtful. More probable is that the pain will be felt most by who has the least political and economic power.
Speculative Questions
In any Ponzi scheme, the early players do well and the later players do poorly. Tulipmania, the Roaring Twenties, and the Dotcom boom all relied on simple normal greed. Malfeasance was not involved. Or it was not the primary force motivating the game. The outcome was an almost inevitable result of the general shape of the investing environment and of attitudes at the time. It followed naturally from the rules of the game. The consequence of this is that it is reasonable for governments to set up rules that make these sorts of instabilities rare. It is reasonable that they set up rules that require that if one enters a speculative game, one both knows it is so, and one understands the nature of the risks. It was not true for bank depositors in the twenties. The Fed is working to assure it is, however, true today.
There is an important distinction between “saving” and “investing.” It’s a fundamental distinction. And it is all but impossible to understand why, given a long history of speculative booms and busts a legislature of well-informed and well-intentioned people put an end to it by dissolving the distinction between “bank” and “brokerage.” The most generous thing one might say is that they were duped. Or they were blinded by a loyalty to an ideal that they really did not understand. I mean, if Adam Smith were alive today and saw the kinds of abuses done in the name of his “invisible hand,” he would turn over in his grave!
The fact that we can explain the whole of the legislative snafu in terms of simple greed and slavish adherence to bad policy is suggestive of the idea that nothing nefarious is going on behind the scenes. But it does not remove all doubt. For example, we mentioned the bill making it more difficult for consumers to walk away from bad debts that was passed by Congress ca.. 2005. Who sponsored that bill saw this coming.
And at about the same time there was an article about the fact that the Chinese were beginning to buy mortgage securities instead of US Treasuries because of their perception that the federal debt was growing too big to be sustainable. In Wall Street language, the credit rating agency within the Chinese government that decides how to rate debt downgraded the credit rating of the US government.
Since the Chinese purchase perhaps a quarter of the US Treasuries; such a policy change risks putting a crimp in the Republicrat bad habit of spending more and taxing less. To attract the same amount of money, the US treasury would have to offer significantly higher rates of interest. And that would drive up the costs of borrowing. Since interest on the national debt is the largest line item behind entitlements and military spending, a big swing in the cost of borrowing could either force tax hikes or iresult in nsolvency.
A third alternative to the treatment of national debt is inflation. Weimar Germany did it; why should we not do it, too? As we noted earlier, if one has a high rate of inflation - one that exceeds interest rate, the advantage goes to the borrower.
One might argue that the whole speculative bubble in home prices was an attempt to create money and defile the currency. One might argue that banking deregulation was designed precisely to allow the kinds of abuses that occurred, knowing they would occur. By doing so, it would create a huge wash of currency and this, in turn, would drive inflation. If one set out to do this, one would have to have a ready-made piece-wise explanation why every single good and service became more expensive in order that nobody suspected the actual cause, too much money.
Inflation is a simple way to transfer money from creditors to debtors. It is a swindle that drives down the cost of borrowing. And if the Federal Government set out to do just this in 1996, it would have been difficult to invent a better scheme.
But in the end, a nation’s creditors wise up. They will not lend if they cannot expect to be fairly paid. If the US government gets a reputation for playing financial games that allow it to weasel out of its debt obligations, its credit standing will erode. And it will need to pay a lot more for loans in the future. That’s not some esoteric threat. It means some combination of higher taxes and less in the way of government protections.
There are other questions one might ask. If we grant that the inflationary cycle was created intentionally, we might also ask whether the credit crisis was engineered as well. In retrospect, it is impossible to imagine how it might have turned out differently.
But if it was engineered, to what end? Recall that the Southwest Savings and Loan scandal ended with billions of dollars missing, presumably in offshore accounts of some of the BCCI principals. The point is that there might be much money to be made from failed or failing banks, if one understands how to play the game; and if one has friends who are bankers and high government officials in places like Saudi Arabia. There were rumors that certain members of the Bush family did farily well in that BCCI debacle, being well connected with some of the principals. To what extent does the family hold interests in the sovereign funds that are “rescuing” the likes of Citibank? Here some transparency might help.
Conclusion
The machinery that manufactured this crisis was put in place in 1996 when the a body of legislation deregulating banks allowed for the kinds of practices that led to the problem. That it would happen was known to Congress in 2005 when it passed legislation making bankrupcy for individuals more difficult and costly. Exactly how the situation might affect the financial system might not have been known; but fact that creditworthiness among consumer borrowers was going to hell in a handbasket was well known.
We know that loose credit practices must have begun soon after deregulation since home prices began to escalate sharply at that point. We know that the cycle was propelled by greed among borrowers and lenders alike and that the financial machinery employed was leverage. Mortgage securities were used by banks to securitize new loans, knowing that this entailed ever bigger risks should housing prices ever fail to appreciate. We know that this kind of game was sustainable only so long as new players entered the game. We know that it had to break down soon after it ran out of new blood. And we know that the means used by financial institutions to carry out these practices involved hiding assets off balance sheet. There was a lack of transparency. These qualities, the fiasco shared with any Ponzi scheme.
In response to the crisis there might be a temptation to outlaw certain kinds of speculative games; but we believe a small number of controls might suffice. One is to require by law a kind of transparency in financial transactions that would properly reveal the risks. And to enforce that law.
Another is to change the requirement for collateral against which mortgages might be written by financial institutions. Mortgage-backed securities might be allowed as a small portion of the portfolio; but certainly once the quantity rises above a third, minor fluctuations in the housing market risk ruining the institution.
It is still a good idea to distinguish between institutions whose chief purpose is to vouchsafe savings from those whose purpose is to allow investors and speculators to invest and speculate. If such institutions offer other financial services that do not involve risking their own capital or that of their depositors, that’s not a problem. But there is a problem when an institution holds deposits for customers and, in a far-flung subsidiary, makes huge speculative bets on the currency market or the price of homes or the price of gold or oil or other commodities or securities. Such bets, ultimately, risk losing depositors’ money or destabilizing an entire banking system.
There is something to be said for that stodgy bank.
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