[49] The last two decades in Japan help demonstrate what happens when prices don’t reset to fundamental values. More recently we can contrast the policy responses of Iceland and Ireland to the 2008 banking crisis. Iceland let its banks fail and all domestic prices reset, Ireland bailed out its banks with new taxpayer debt, trying to maintain the banks solvency. Three years later, Iceland is recovering; Ireland is still in dire straits.
[50] It's interesting to consider who this "Mr. Market" really is, since it seems very natural for us to want to personify this force of nature. Mr. Market is us, all of us together, behaving in different ways in order to survive, subject to the constraints of the physical world, the main constraint being scarce resources. We can see that this basic human impulse can never be defeated, as anti-market ideologues often suggest.
[51] As opposed to cost-benefit analysis, I believe an expected risk-return assessment based on the overriding assumption of loss aversion might offer a more effective method to evaluate policy proposals.
[52] First explained by economist Frédéric Bastiat in 1850 and recounted notably in Henry Hazlitt’s classic book, Economics in One Lesson.
[53] Whether public or private goods provision is more or less efficient should be an empirical question, not a rigid ideological position. In other words, we should test and study data that helps us compare the two and choose the best policies. Nevertheless, we should keep in mind that public and private goods are clearly defined and the burden of proof rests with the public sector as markets are the default position.
[54] This simple philosophical principle was the inspiration for the title of Milton and Rose Friedman's classic work, Free to Choose.
[55] Ideologues might object that this objective advocates prejudicial support for free market ideology, but this bias is less ideological than empirical and theoretical. Markets do for us what no bureaucracy or regulatory agency ever could by providing price-based market signals to all participants in the economy. This is a fairly uncontroversial view in economics, despite the financial meltdown and the failures of market finance.
[56] A social insurance state is not socialism per se, but the socialization of risk does impose certain social constraints on individual freedom. One example is that we cannot opt out of Social Security or Medicare and stop paying the requisite taxes.
[57] Social Security is a pay-as-you-go system that is guaranteed by the full faith and credit of the U.S. government. In other words, the Federal government is compelled to tax current and future incomes sufficiently to meet its Social Security obligations. Unlike a private retirement or pension plan that accumulates and reinvests savings over time, Social Security transfers funds from productive workers to Social Security recipients.
[58] You can observe in real time the accumulation of moral hazard costs and inadequate savings as they effect the budgetary items and liabilities of the U.S. government (i.e. the U.S. citizenry) at this website: http://www.usdebtclock.org/ Of course, the U.S. government can never go bankrupt and creates its own money for payment, so these liabilities will be paid in full. The question is whether these liabilities will maintain their real purchasing value.
[59] The private insurance market often solves this problem with reinsurance. Interesting fact: reinsurance is the industry that made Warren Buffett rich.
[60] Granted, this proposition is rather radical in that general equilibrium theory dismisses the possibility that prices in a market economy will not adjust to correct for such distortions and eventualities. Yet the mathematics of GE theory do not account for distributional dynamics, which is good reason to question its macroeconomic conclusions. I would argue that prices do correct in terms of unemployment and the sharp devaluation of capital assets. This would be the business cycle, which only begs the question of what will happen if Fed policy merely reinflates asset prices? Nevertheless, these propositions must be tested, but that requires different analytical tools and techniques. See agent-based computational economics.
[61] Some may mistakenly believe "ownership" was the failed strategy of the George W. Bush administration, but this strategy offered little to speak of beyond inflated home ownership. The ownership we need is over the productive resources of the economy, which means more widespread equity ownership of the public corporation and a reversal of the privatization of U.S. companies.
[62] TARP = Troubled Assets Relief Program.
[63] This means any investment will have to secure higher returns to compensate for the risk plus pay the tax. Investments that fall short of this hurdle rate will not be undertaken or will result in losses.
[64] If one is interested in assigning blame, I would recommend from the reading list, Reckless Endangerment, by Gretchen Morgenson.
[65] Regulatory capture refers to the ability of the industry or company being regulated to “capture” the bureaucratic regulator to relax the regulation. This ability is the product of lobbying, where private interests entice regulators to their point of view on policy with various forms of payoffs, both legal and illegal. For the Masters of the Universe on Wall Street, enticing a low-paid civil servant to one’s point of view has never been a difficult prospect.
[66] A put option is a financial derivative that establishes a floor for a security’s price. A “Greenspan put” meant that if the market fell to a certain level, the Fed would enter the market and provide reserves to prevent further deterioration. Thus, there was limited downside and unlimited upside to every trade. We can imagine how this distorts prudent risk-taking behavior.
[67] Quantitative easing (QE) is a central bank policy of directly buying bonds from the U.S. Treasury or government-backed mortgages, essentially injecting new funds into the financial system and providing a price floor under distressed financial assets.
[68] I don’t mean to suggest that risk precludes the more humanistic qualities of hope, altruism, and love. Rather it is the opposite, uncertainty is a necessary condition for us to hope. When faced with uncertainty and risk, loss is the downside, but hope is the upside.
[69] In other words, we are not free to do whatever we want, only that which does not deprive someone else of their rights. So we must prevent cheating. The social goal is not to enable me to get rich by impoverishing you. Remember, “heads I win, tails you lose,” is a natural and universal human instinct tempered only by a sense of moral justice and the enforcement of law.
[70] This does not presume that political or social goals and individual economic goals always coincide, but social goals are achieved through democratic politics and democratic politics relies on a competitive political market.
[71] Admittedly, this is overly simplistic but captures the basic outline of the business cycle. The crucial variable that has occupied macroeconomists is the downward inflexibility of wages and persistent unemployment leading to productive undercapacity.
[72] In Capitalism and Freedom, Milton Friedman’s wrote that “Fundamentally, there are only two ways to coordinating the economic activities of millions. One is central direction involving the use of coercion—the technique of the army and of the modern totalitarian state. The other is voluntary co-operation of individuals—the technique of the marketplace.” I side with the freedom of the market.
[73] I have summarized a critique of economic orthodoxy in the Appendix. The failures of all theories are found in the limitations or errors of their assumptions.
[74] Walter Russell Mead, “The Future Still Belongs to America,” The Wall Street Journal, July 2, 2011.
[75] Interest rates are expressly in nominal terms but if inflation is present, the effective real rate may be negative. For example, if the interest rate is 3% and the inflation rate is 5%, then the real rate is -2%. In this case one should borrow to the max and use the funds to buy appreciating real assets, like real estate, collectibles, or precious metals.
[76] See Emanuel Derman, Models. Behaving. Badly.
[77] My own attempt to contribute to agent-based modeling resulted in a simp
le model called CasinoWorld. (Chapter 10 in Agent-Based Methods in Economics and Finance.)
Common Cents Page 23