Monthly Archive: September 2015

The year was 1979 and the rock band Pink Floyd had just released their concept album The Wall.  Strains of Young Lust and Another Brick in the Wall filled the halls in my high school.  These are fine songs (who can argue with lyrics like “How can you have any pudding if you don’t eat your meat!”?) but the song that really spoke to me was Comfortably Numb.

It emotionally resonated with me because beneath its seemingly depressing façade was a defiant and cautionary tale of the price that’s ultimately paid by numbing the pain rather than rising up against it and fixing the root malady.

I’ve always kept that message, if not exactly that song, near and dear to my heart.  Bodily pain is the nervous system’s way of telling you something is wrong and numbing the body, except in the case of corrective action like surgery, is a foolish thing to do.  By masking those important signals, you are tricked into thinking things are fine until catastrophe hits and a serious problem has now become an insurmountable problem.  Tell most anyone in our wellness-conscious society and you’ll get a quick agreement – at least where the body is concerned.

The situation is quite different when it comes to the economic pain and, for reasons I can’t explain, very few people seem to know or care about the numbness that is killing our economy.  And what is this anesthesia that is causing the numbness – the policy of the Federal Reserve to keep interest rates, specifically the discount rate, at zero.

In order to understand how low interest rates is acting to numb the economy, I need to say a little about prices.

In an economy, prices serve three purposes:

• Terms of the exchange for completing a transaction
• Signal to the producer about the relative worth of a good or service as judged by the consumer
• Signal to the consumer about the relative worth of a good or service as judged by the producer

When you go to a store and wish to purchase a good the deciding factor is the price.  Measured relative to your want or need, the price determines whether the transaction is made and you leave the store with the item or the transaction remains unfulfilled and the good remains on the shelf.

Looked at locally, within the confines of a single consumer, the price simply serves to help determine the relative worth of the good to the consumer.  Taken globally, each successful transaction sends a message from the consumer to the producer that the relative worth of the good is favorable to the consumer.  Each failed transaction sends the opposite message, telling the producer that the good is valued too high.  The speed with which the good is purchased sends a message about whether the price is too low or too high.

Likewise, each price set by the producer sends a message to the consumer about how the producer judges the worth of the good against the producer’s outlay in its production.  If the producer can’t entice a consumer to buy the product for more than it cost the producer to make it then the message is sent that the producer should stop making the product.

In effect, the price system functions as the nervous system in the economy, sending messages to and fro between different parts of the body politic saying to either make more or less of a particular good.  Seen in this way, prices help regulate the economy so that the scarce resources available to society are best used – where best is judged by consumer demand.

When the Federal Reserve keeps interest rates low, it basically floods the economy with an anesthetic that interferes with the signals sent using the price system.  Businesses that should have received the message that they are not producing products desirable to society are instead receiving a mixed or muted message that tells them to try again.

By keeping interest rates too low, the Fed allows businesses that should have failed to remain on life support with what is essentially free money.  The idea that the Fed has is that it is compassionate to keep business going; that in order for the economy to grow, businesses need to succeed.

But why?  What’s wrong with failure as a message?  In the body, pain speaks volumes.  It tells the body not to do whatever caused the pain.  Learning from the pain is not the same as preventing it entirely, for without the pain no growth can occur.  How can our economy grow if we can’t learn what works and, more importantly, what doesn’t?

Maybe the Federal Reserve should analyze less, interfere with the economy for less often, and listen to some Pink Floyd instead.

In doing the research for the previous post on China and government held debt and the earlier one on energy usage and wealth creation, one country stood out – the country of Peru.  It stood out not because it topped any particular list but because of the great strides that Peru has taken over the last quarter century to reform it government and economy.  These reforms are reflected in the very low ratio of government held debt to GDP and in the relatively high efficiency with which it uses energy to create wealth.

During the 1980s, the situation in Peru was quite different.  Hyperinflation, which totaled in at an amazing 2,220,200% in the five year period from 1985 to 1990, was a crippling problem, social unrest lead to the rise of the Marxist Shining Path (Sendero Luminoso), and the population had little to no faith in the government, dubbing even their president as Alan ‘Crazy Horse’ Garcia.

During the 1990s, Peru elected Alberto Fujimori and his policies helped put the country on a stable trajectory and get its macroeconomic house in order.  But how exactly did he accomplish this transformation?  Well government is complicated and any success it enjoys has many creators but the Peruvian economist Hernando de Soto played a big role.

de Soto was born in the Peruvian city of Arequipa in 1941 but was moved to Switzerland in 1948 following a military coup and the self-exile of his father a diplomat.  When de Soto returned to Peru he found that the economic situation was appalling.  In reaction to this, he founded the Institute for Liberty and Democracy (ILD) whose influence helped to enact over four hundred laws and regulations enabling the poorer members of Peruvian society to benefit from the having access to capital.

de Soto is perhaps best known for his experiments with the ‘stopwatch’.  The idea behind his experiment is to determine how long it takes for a prospective entrepreneur to open a business.  In other words, de Soto hopes to quantify the transaction cost required to become a legitimate business owner who operates within the law and enjoys the corresponding privileges, including formal recording of the title of ownership and well-defined protection of assets under the rule of law.

What he found was depressing.  He tried to setup a small shirt factor and discovered that it would take 278 full days to get all of the permits needed and that, along the way, the would-be business man had to navigate a level of corruption where the bribe was the accepted currency.  NPR recently aired an engaging piece on de Soto’s efforts which premiered on their Planet Money regular feature.

As a result of his efforts, Peru has gone from the hyperinflationary times of the 1980s to a sustained average growth of approximately 6.6% for the last decade while simultaneously having a very low percentage of government-held debt to GDP around 20%.

Due to these successes, de Soto has been called upon by many foreign governments to help craft economic policies suited to the developing world.  As a self-styled ‘third-worlder’, de Soto maintains a fierce objection to the theses of many of the ‘western economists’ who publically maintain that there is too much capitalism in the world.  He has been powerfully critical of the general notion suggested by Thomas Piketty that capital causes friction between societal groups and that society should move away from such notions. de Soto convincingly asserts that Piketty engaged in rash guesswork when analyzing the situation in the developing world and that Piketty’s book Capital in the 21^st Century represents Eurocentrism at is most extreme.

The basic idea underlying de Soto’s analysis, is that there are really two types of economies in the world: legal and extra-legal.  The world’s elite enjoy the benefits of working within the legal system – benefits that include most especially the right to their property.  The rest of the world, some 5 to 6 billion, sits outside these protections.  This group finds itself in the precarious position where the only protections they enjoy are arbitrary ones conferred locally by some microeconomic or microlegal structure.  Go 2 miles in any direction and the protections vanish.  Step one toe out of line and the protections vanish.

This lack of access to true capital, defined by de Soto as the formal recognition of property rights and all the protections implied by such a recognition, is what holds the poor down.  He traces the self-immolation of Tarek al-Tayeb Mohamed Bouazizi, which led to the Arab Spring, to the expropriation of his property – that is to say by the arbitrary way in which this street vendor was robbed of his wares and his livelihood because he had no formal protection for his property rights.

While he cares most about the poor in the developing world and for ways to lift them out of the extra-legal economy and into the legal one, de Soto also has some criticism for the West.  He has sharp criticism for the lack of transparency in both Europe and the United States evident in the recent financial crisis.

I suppose de Soto see these tangled webs of toxic assets, credit default swaps, and derivatives as steps in the wrong direction; as ways in which the elite erode the property rights of many to enrich a few.  I think he’s absolutely correct.

The year was 1979.  Not a lot was known by the public about China, its people, its politics, or its economics.  Nixon’s historic visit to the mainland had only happened about 7 years earlier and it was still a common occurrence to hear China referred to as Red China.  On March 16^th of that year, the movie entitled The China Syndrome was released in theaters. The idea behind the movie was that negligence and corporate malfeasance at a nuclear plant led to a nuclear meltdown where the core metaphorically sinks through the earth all the way to China.  Eerily, a scant 12 days later, the accident at the Three Mile Island (TMI) plant in Dauphin County, Pennsylvania occurred.  Suddenly, it seemed, all our worst fears about nuclear power were realized and the word ‘China’ had suddenly taken on a sinister meaning independent of the nation in the Far East.

Now with the benefit of hindsight, we can see that the TMI disaster, while serious, was not the catastrophic event that we feared.  Even the far more serious nuclear accidents at Chernobyl and Fukushima-Daiichi have had little in the way of global impact.  Simple analysis of the size of the stored energy in these plants relative to the size of the planet suffices to show that.

However, we are witnessing a meltdown of the Chinese economy, and the impact of this event promises to have a global impact.  Curiously, there weren’t any prescient tales speaking the precarious nature of the Dragon’s economy released to theaters.  Not even a book that made it onto the best-seller list.

Just to set the stage, let’s consider for a moment where we were just a few short years ago, and what the popular wisdom was.  The common idea, spoken by pundit and plebian alike, was that the ‘Middle Kingdom’ was soon to be the dominant player on the world stage.  The reign of the US dollar as the reserve currency was drawing to a close and soon the Yuan Renminbi would be what all the cool countries used.

I was deeply skeptical because I have a long memory and remembered the depressing and relentless drum beat of the 1970s and 80s heralding the United States’ economic doom at the hands of Japan (footage from Johnny Dangerously).

By the early 1990s, it was clear that the strength of the Japanese economy had been exaggerated and its systemic weaknesses ignored.  By the turn of the century, the world started talking about Japan’s Lost Decade, and their economy has yet to recover from that slump, now roughly a quarter of a century later.

I can’t be certain why this cautionary tale was forgotten 10 years later, when economists were all agog with the ‘new economy’ engendered by the internet, and the dot com bubble came and went.  Nor why the message was lost again about 5 years later when almost everybody was considering flipping houses, and the sub-prime bubble grew and burst.

All that is certain is that the message got lost once more – drowned in incessant chatter about the new powerhouse on the world stage.  Never mind that China was following a ‘if you build it they will come’ strategy that piled up debt.  Never mind that China played with its currency and subsidized oil purchases to keep gasoline costs low.  Never mind that the Chinese government built entire cities in which no one lived.  All that mattered to the intelligentsia was that the Dragon of the East had figured out what we in the West couldn’t – how to get around the law that says there is no such thing as a free lunch.

Of course there were voices out there that said something was wrong, but they were in the minority and weren’t heeded then.  Now you can’t hear anything else but words of woe on China.

So how bad is it and for how long should we have known?  It isn’t clear how to answer either of those two questions.  By some measures, China is much better off than other countries.  Consider the following table that shows the ratio of Government Debt to GDP for select countries.  Compared to the US and Japan, China’s central government holds significantly less debt (source:  http://www.tradingeconomics.com/)

But, by other measures, China is in bad shape. According to Forbes Contributor Kenneth Rapoza, its total debt to GDP ratio is approximately 280%.  Is that bad, it’s hard to tell since the US’s total debt ratio is about 332%. What is needed to put debt into perspective is a measure debt to assets, something I am sure is hard to come by for China's economy. That said, it is likely that the ratio of China's total debt to its assets is much higher than that of the US. Further on, the same article has this to say about China’s growth in debt:

Perhaps the most telling point is that China itself feels that it is in trouble.  It took the unheard-of step of adjusting its currency three times in a short period of time this summer.  It also has been buying stock on its own exchange.

Will China fall?  It is hardly likely.  What is more likely is that its spend-now-and-pay-later expansion is coming to an end.  China will still be an economic giant, and that’s probably good; after all, it has an incredible comparative advantage just due to population size.  But it is very unlikely that it will ever dislodge the West from its pre-eminent position until it corrects its internal problems with liberty and human rights.  Unfortunately, that isn’t a movie plot that can sell.

In a recent article in the Washington Post, blogger Ana Swanson reported on a new study in the field of economics that found some revealing and, perhaps, surprising results.  The article, entitled, Why some billionaires are bad for growth, and others aren’t, summarizes the findings of two economists, Sutirtha Bagchi of Villanova University and Jan Svejnar of Columbia University. (Note: Bagchi and Svejnar published their findings in the Journal of Comparative Economics and a summary of their findings is available at the link.)

In their analysis, Bagchi and Svejnar, took Forbes magazine annual list ranking the world’s billionaires, normalized the raw data to account for country size (either by GDP or by population or somehow – Swanson wasn’t particularly clear on this point), and then correlated the result with economic conditions in the country as a whole.  According to Swanson, what the pair concluded was that as wealth inequality grew so did economic conditions for the general citizen worsen in the form of slower economic growth.

Also, the Bagchi and Svejnar correlated a percentage of the billionaires’ wealth to their political connections to the government.  This measure of cronyism is supposed to help shed light on the positive and negative mechanisms that cause concentrations of capitol to exist in a country and that lead to wealth inequality.  To illustrate this point, Swanson notes that the United Kingdom and Indonesia have similar Gini coefficients (I found them to be 38.1 and 38.0, respectively, in the World Bank Gini coefficient table) but that the business climate in these two countries are quite different.

The implication of this further analysis helps justify the title of the article – namely that not all concentrations of capitol come about for the same reasons and some billionaires are better than others.

In a nutshell, what Bagchi and Svejnar concluded were:

• Gini coefficient doesn’t tell the whole story determining national growth
• Cronyism is a drag on the economy
• Innovation isn’t a drag on the economy

Wow!  What a big surprise.  I would never have seen that coming.  Some billionaires actually deserve their fortunes because they enable rather than impede growth.  To be fair, Bagchi and Svejnar didn’t actually state that billionaires who earned their money without political connections helped economic growth, simply that they didn’t impede it.

There are really two points that are worth addressing.  The first one is on methodology.  The second is on economic and philosophical outlook.

The methodology employed in the study requires one take the data with a grain of salt.  For example, a few, simple queries of the Forbes list, Google, and the World Bank find the following data for Columbia and the United States.

The data in this table do support the idea that the larger percentage of billionaires in the population the slower the growth as the percentage of billionaire-held wealth in the US is almost 3 times higher than that in Columbia.  But that’s where the data stop making sense.  Bagchi and Svejnar determined that 84% of the billionaire-held wealth in Colombia is due to political ties with the government.  In other words, it is due to cronyism.  In contrast, they found that only 1% of the billionaire-held wealth in the US is due to cronyism.  Making the required adjustments, I found that ratio of Crony Wealth to GDP was 4.1% for Colombia versus 1.4% for the US and yet the Colombian GDP growth rate is double that of the US.  Paradoxically, the Gini coefficient, which measures income inequality and is supposed to not be a reliable indicator of the harm that concentrations of capitol have on an economy, seems to be much more correlated with the Bagchi-Svejnar conclusion than their measure of ‘politically-connected wealth inequality’.

Perhaps the way that they chose to classify billionaire-held wealth is the problem.  Well, I don’t have access to the original article so I can only quote what Swanson said

Now I’m not asserting that the Bagchi-Svejnar conclusions aren’t correct.  They may be for all I know.  I am asserting that there seem to be correlations that support some of their conclusions and others that don’t.  Causation is another thing entirely.

Now on to the second point on the economic philosophy behind this whole revelatory study.  Basically, these two economists claim to have discovered a data-driven conclusion that it matters how people get that wealth and how the government spends its money.  In other words, that the basic neo-Keynesian idea about money and spending is wrong.  That it is not enough for an economy to get money moving.  That is does matter if the work is productive.   That those who say “Go ahead and dig ditches even if you have to fill those ditches back up again.  All that matters is that we’ve kept busy.” are wrong.

Of course, Bagchi and Svejnar may not say it quite that way but the conclusion is inescapable.  For that matter, Ana Swanson may not say it that either but how else can one interpret the subtitle of her article ‘Not all inequality is created equal’!