by Joe Kernen
Which, come to think of it, is the same argument used by Progressives to explain their eagerness to redistribute wealth from haves to have-nots.
CDO. Noun. Abbreviation for collateralized debt obligation. An investment whose value is based on a package of other fixed-income mortgages, corporate bonds, and mortgage-backed securities, whose complicated nature has been blamed for much of the crisis of 2008. CDO risks and prices are calculated using a mathematical technique known as cupola modeling, a multivariate joint distribution defined on the n-dimensional unit cube [0,1]n such that every marginal distribution is uniform on the interval [0,1].
I don’t understand it either.
CEO. Noun. Abbreviation for chief executive officer, the highest-ranking manager in a corporation, agency, or organization, who reports to the institution’s board of directors. The Boss.
In 2009, the median CEO salary at America’s five hundred largest corporations was about $8 million. This, we are told by Progressives, is a sign of the worst excesses of capitalism: CEOs taking home more than three hundred times what the average worker does, up from forty times that number thirty years ago. This is, like most such arguments, half information taken out of context, seasoned with a lot of envy.
The reaction to these more-than-generous incomes is pretty overheated. America’s top five hundred CEOs earn more than Major League Baseball’s 750 players and the four hundred (or so) members of NBA teams combined, and they don’t offer nearly as much entertainment in return. However, there is less here than meets the eye. More than half of CEO compensation is in the form of stock and stock options, which means that the biggest reason they’re paid so much is that the companies they manage have increased in value, which is a bargain that most shareholders probably applaud. It’s also worth remembering that in 2009 the companies they manage generated more than $5 trillion in revenues, and their total pay is barely a rounding error.
This doesn’t, of course, mean that every CEO is worth what he or she is paid. Every year, some prove that they are clearly not up to the job, or even able to stay on the right side of the law. And it seems possible that lots of companies could get the job done just as well by someone willing to work for less (though I wouldn’t like to be the one to explain the decision to save a few million bucks to the board of directors of a hundred-billion-dollar company). But it does mean that attempts to legislate limits on CEO pay have about as much impact on a large company’s efficiency as removing the embossing from business cards, no matter how much better it makes everyone feel.
Competition. Noun. In economics, the contest between individuals and companies to sell more goods and services.
Blake’s feel for the rhythms of business may be a little erratic, but she understands competition. And she especially understands that winning—a race, a tennis match, a music competition—is a whole lot better than losing. The reason that competition is one of the basic principles of free-market economics starts from the same impulse but affects a lot more than a ten-year-old’s self-esteem.
Adam Smith, the granddaddy of all free-market thinkers, was also the first to draw the link between free competition and increasing prosperity, pointing out that competition is the engine that allocates resources to their highest-valued use: If any business is good for the public, Smith wrote, “the freer and more general the competition, it will always be the more so.” This has been taught to generations of introductory-economics students as the notion of perfect competition, which includes a number of, well, unlikely characteristics. For a business to qualify as perfectly competitive, it needs an infinite number of sellers (and consumers), no barriers to anyone wanting to enter the business, and no transaction or information costs—that is, when I want to shop for a widget, I can compare all the widgets instantaneously without stirring from my chair. In such a consumer’s Garden of Eden, all prices for widgets will eventually be only a tiny bit higher than the cost of making them.
To a lot of people the nonexistence of such perfectly competitive markets outside of introductory economics textbooks means that (a) free markets don’t really work as well as described; and (b) governments have to intervene to make sure that monopolies don’t grow where competition used to exist. Both ideas are favorites of Progressives. And both (surprise!) are wrong.
While perfect competition makes for neat equations, the fact is that even imperfect competition is pretty good. In fact, a little bit of competition is better than none, more competition is better than a little, and a lot of competition is better still. Monopolies (see below; actually businesses with some monopoly pricing power) will always emerge, as one firm or individual takes advantage of a superior idea or just plain luck. But in a free market, they don’t last, as other firms, attracted by the profits that a monopolist earns, enter the business. The only monopoly pricing power that lasts, in fact, is the sort that is created by the government. As always, the Progressives have it exactly backward: Competition doesn’t need government help; it generally only suffers from it.
Consumption. Noun. The purchase of goods and services by end users, i.e., consumers, rather than businesses or government.
You’d think that economics could agree on a definition of consumption, which is, after all, their primary subject. You’d be wrong. In addition to the definition above, a lot of economists (and policy makers) measure consumption as every economic transaction that isn’t either design, production, or selling. John Maynard Keynes, along with his many other dubious contributions, defined it as all income that isn’t saved or invested, which leads to the notion that if you borrow money and then spend it, you’ve increased consumption without increasing income. Come to think of it, this explains how the national debt got to be so large that it now has fourteen digits.
Eventually, consumption of goods and services and production of goods and services have to even out. However, eventually can be a long time, which is why both households and governments frequently find themselves so far behind the eight ball. Some economists argue that the best way to improve things is to tax consumption rather than income, but the governments that listen to them inevitably end up taxing both.
Creative destruction. Compound noun. The principle that, in a free market, innovation creates new businesses at the expense of old.
The idea that capitalist economies grow by killing off existing enterprises was not original to the Austrian economist Joseph Schumpeter, who named it the “perennial gale of creative destruction” in 1942. A century earlier, Karl Marx, of all people, was writing about the eternally disruptive nature of capitalism—a nature that didn’t bother Marx all that much but sure gives fits to a lot of other folks: not just Progressives who reflexively think that any sort of economic pain is a sign of market failure but also conservatives whose real allegiance is to a society organized along the most traditional lines.
It isn’t a very happy thought for your typical ten-year-old, either.
“It’s just not fair.”
“What isn’t fair, Blake?”
“The candy store, Dad.”
“What about the candy store?”
“It’s closing, and that means that no one is going to sell those good vanilla-and-chocolate lollipops anymore.”
It’s one thing that Blake has in common with the most reactionary and the most collectivist impulses: the desire to keep the forces of change at bay. The belief in some sort of “endangered businesses act” is understandable, at least for someone Blake’s age. Free market capitalism has been an unmatched engine of prosperity for centuries, but that doesn’t mean that it delivered that prosperity without any suffering along the way: Jobs vanish, companies and even entire industries disappear, and it speaks well for Blake’s compassion that she isn’t exactly cheering for it, even when it’s only a corner candy store.
When that compassion turns into policies that protect jobs and industries that aren’t going to survive on their own, however, the cost is economic decline. America had more than 100,000 harness makers in
1900, and more than 200,000 blacksmiths. Twenty years later, the country was a lot richer, but that doesn’t mean that a lot of formerly prosperous families weren’t suffering. Schumpeter made an analogy to evolution by natural selection—he called new “species” of business “industrial mutations,” in case anyone missed the point: Extinction was hard on the dinosaurs, but it was a godsend for the ancestors of all the mammals walking the earth today, including Blake.
Credit. Noun. The transfer of something valuable from one person or firm to another, when payment for it is delayed until a later date.
It’s not very hard to figure out how a word from the Latin root meaning “to trust or believe” ended up meaning both the recognition of an actor’s work in a movie or play and the amount of money a bank is willing to lend. Blake doesn’t quite get it:
“Dad?”
“Yes, Blake?”
“How does a credit card work?”
“When you use a credit card to buy something, you still have to pay for what you bought, but you do it later, instead of right now.”
“When I get extra credit for a project, is that later or right now?”
“There are lots of kinds of credit, Blake. What the two meanings have in common is acknowledging that something is owed.”
“Like when my name is in a concert program, they call it a credit?”
“Exactly: You are owed some recognition for playing the guitar. When you get extra credit, that recognizes that you did more than you needed to on a test. And when you buy something on credit, you’re recognizing that you owe the person you bought it from.”
“Too many meanings, Dad.”
Well, maybe. The credit that means buying today and paying tomorrow isn’t really unique to a free market—lots of unfree markets happily accept its benefits—but it does depend on trust: trust that someone will pay what is owed. Which is a lot easier than the other essential aspect of credit, which is understanding that a dollar tomorrow is worth less than one today.
“Blake, would you rather have a dollar right now, or tomorrow?
“Doesn’t matter.”
“How about a year from now?”
“Then I’d rather have it now.”
“What if I gave you a choice of a buck today, or two bucks a year from now?”
“I’d rather have the money today.”
“How about ten dollars?”
“Still rather have it now.”
Blake’s time value of money is a little steep. Eventually, though, even she will get the idea that if you make the cost of lending money too high, no one will borrow any. But you (or rather, your happy-golucky government) can also make the cost too low; when that happens, too many people borrow money, and not all of them will pay it back. “Trust or belief,” indeed.
Debt. Noun. An obligation to pay, at a later date, for assets acquired in the present; future purchasing power.
There are those who think that the ability to discount is at the core of modern capitalism, and the huge variety of debt instruments reflect this. From the simplest bank loan (fixed amount of money repaid at fixed rate of interest over fixed amount of time) to letters of credit (maximum amount fixed, but interest paid only on the money actually used) to corporate and government bonds, inflation-indexed debt, mezzanine obligations, syndicated loans—the list is endless. As are the zeros on the end of the debt currently owed by the United States to various creditors: more than $8 trillion. (It also owes more than $4 trillion to itself, in the form of future Social Security and the like.)
Debt is not always bad. If the only things people and businesses could buy were things for which they had cash on hand, there’d be a lot fewer factories, apartment buildings, commercial airplanes, and so on. Borrowing money against the future money-generating potential of an asset is a much better allocation of resources than saving it by burying it in the backyard (putting it in the bank is just lending it to someone else). However, the potential for, shall we say, overshooting the mark, seems obvious, and—to Blake—it is:
“Do you know what’s wrong with debt, Blake?”
“Well . . . you can start here [she places her hand about belt high], but before too long you’re here [her hand moves to just below her chin], and pretty soon here [hand above head; drowning noises].”
Depression, Great. Noun. The worldwide economic collapse that began in the United States in 1929, spread around the world, and caused an unprecedented loss of wealth, income, and productivity for an entire decade, with unemployment between 25 percent and 30 percent, crop prices falling by more than half, deflation, completely frozen credit, and untold misery. For many decades, almost everyone seemed to agree that the Depression was the result of unregulated markets gone wild and that it was cured (or at least made less bad) by the policies and jobs programs of the New Deal. Today it is pretty respectable to argue that the Depression was the result of misguided governmental intervention (such as increasing tariffs) and that the impact of the New Deal was, at best, nothing—and that it was possibly even harmful.
The only good thing about the Great Depression is that it has made all other economic crises—including the current one—seem like a mild head cold.
Derivatives. Plural noun. Agreements or contracts whose value is determined by the price of something else.
Futures, swaps, options . . . All derivatives are financial instruments that have no underlying value (how can they?), but that doesn’t mean they have no market value, though the mathematical formulas used to calculate those values make subatomic physics look easy (see CDO). There’s nothing intrinsically wrong with allowing people to gamble on the change in value of a stock or a piece of real estate (usually, actually a package of mortgages on different sorts of real estate), and a good case can be made that allowing people to bet that the value of one investment might not increase—the term is “hedging”—actually allows investors to insure themselves against bad outcomes (which is what insurance is for) and even makes even more information about pricing available—and the more information about how people value things, the more efficient the market.
Even so, derivative investments are not for the faint of heart. The fact that (a) hundreds of billions are wagered daily on contracts whose value moves in the opposite direction from the underlying investment; (b) some trades are derived from things that have no underlying market, like hurricane activity; and (c) some derivative contracts are worth hundreds or thousands of times as much as the underlying investment to which they are tied, means that small problems can turn into gigantic ones in the blink of an eye.
Efficiency. Noun. In economics, the degree to which allocation of resources results in the maximum production of goods and services. A system is efficient6 when markets are in equilibrium: enough supply and demand at every price point.
Since it is mathematically provable that a competitive market is also the most efficient, the kind of reflexive hostility to markets that are the hallmark of Progressivism requires either arguing that markets aren’t competitive or defining true efficiency not as the most goods and services at the lowest cost but as a socially desirable amount. Progressives do this by arguing that externalities like air pollution or discrimination against women need to be counted in the price of everything. Everyone who makes this argument also argues that he knows what that price is.
Externalities. Noun. In an economic transaction, costs or benefits that aren’t incorporated into the price.
Anytime you hear someone talking about externalities, you are in the presence of Progressives, and you should count the silver before they leave.
Fair trade. Noun. The belief that certain agricultural commodities need a minimum price, without which trade is, presumably, unfair to the farmers who produce them. No one has yet figured out how to establish such a price, much less make sure that it actually enriches farmers rather than the bureaucrats who decide whether a particular price is “fair.”7
Fiat money. Noun. Currency issued without any right to conver
t it to anything else.
Friedman, Milton. American economist (1912–2006) who was the twentieth century’s most prominent and effective advocate of free-market capitalism. Awarded the Nobel Memorial Prize in Economic Sciences in 1976. Author of dozens of books and articles, including 1980’s Free to Choose, written with his wife, Rose.
Milton Friedman casts a ridiculously large shadow over twentieth-century economics, in technical areas like consumer behavior and monetarism (the idea that the only really important economic responsibility of the government is to keep the supply of money growing at a constant rate), but wouldn’t be worth mentioning in this book if he hadn’t also been the most successful advocate for the free market since Adam Smith. In fact, he went a lot further, arguing, among other things, for abolishing virtually every governmental agency and even the requirement that doctors be licensed.
People love to do the old compare-and-contrast game with Friedman and John Maynard Keynes, but the real key to understanding the importance of both men is the Great Depression, which persuaded a whole lot of people that free markets had failed (sound familiar?). For decades, the Keynesian solution to the great unemployment of the 1930s had been for government to spur demand by spending money. Hidden in all of this was the germ of the worst Progressive myth: Since people don’t know best how and when to spend their own money, government employees need to do so on their behalf.
Friedman wasn’t having any of it. Almost single-handedly, he revived the idea that people do make the best decisions about their own wealth, that they “maximize utility” (which is usually defined as choosing the highest-valued alternative available) not just in the short term but over their entire lifetimes. If he hadn’t done anything else, this would have secured his position as the great free-market thinker of the era.