Sunday, September 3, 2017

Jeff Friedman on James Buchanan and Libertarianism.

Jeff Friedman's new blog began with an attack on libertarians and James Buchanan.   The context was MacLean's book, Democracy in Chains.   Friedman argues that MacLean's work fails as a work of history.   He cites a variety of instances where she misrepresents libertarians.

However, his major criticism of her work is that it exhibits manicheanism.   Her opponents on the right must be entirely evil.   Friedman claims that libertarians, and Buchanan in particular, do the same.   They treat their opponents as wholly evil.   Friedman uses this to share his view that manicheanism is a serious problem of our time.    It is common, even typical, to impute base motives on political opponents.  This would be as opposed to considering their views being some sort of intellectual error that might be corrected through discussion.

Friedman identifies libertarian in a narrow way.   Perhaps it is best known as the position advocated by Nozick in Anarchy, State, and Utopia, but I describe it as Rand/Rothbard libetarianism.   In his premier blog post, Friedman asserts a key position--taxation as theft.    But more fundamentally, coercion is counted as an absolute wrong.   And that includes violations of property rights.  According to Friedman, libertarians are not reflective regarding property rights.   Libertarians just assume that private property rights must be inviolate.

Some of this discussion is all about claiming that MacLean just cannot believe that anyone could possibly believe such absurd notions and that explains her view that all the libertarians are being paid by rich people.   These rich people benefit from keeping government from taking their private property.

If, instead, "libertarian" is understood in a more inclusive way--including, for example, the view of James Buchanan, then all of this just falls apart.   Milton Friedman, F.A. Hayek, Ludwig Von Mises, and Buchanan all supported private property and market exchange because it is beneficial to just about everyone.    All of them believe that taxation is appropriate for some purposes.

In other words, none of them just assume that private property rights exist and their violation is evil coercion and none of them take the position that taxation is immoral and must be abolished.

While Buchanan's policy views are in many ways typical for a mainstream libertarian, his political philosophy is a bit unusual.  There are no property rights or market exchange in the Hobbesian state of nature, so it is the social contract that creates property rights and freedom for the more mundane contracts that allow for market exchange.    According to Buchanan, all must be willing to agree to the social contract that generates the constitutional order.    Buchanan favors private property rights and freedom of contract because it will benefit everyone and so it would be sensible for them to agree to it as part of the social contract.

But that doesn't mean that the agreed constitution would prohibit the government from imposing any regulation or collecting any taxes--it is just that everyone benefits from a system with private property and market exchange and with necessary taxation and regulation limited by constitutional rules.  

It is also important to understand that in Buchanan's view a sensible constitution will allow for regulation or taxation without a unanimous vote.   It is true, however, that 50% plus 1 is not essential.   Depending on the issue, it could be more or it even could be less.    Not every political decision will benefit everyone, but the system as a whole should be something that benefits everyone so that they are willing to agree to it.

Buchanan strongly believed that constitutional rules should be designed to protect against selfish voters, politicians, and bureaucrats.   While such rules may interfere with the ability of well meaning voters, politicians and bureaucrats to do good, he believed that it is sensible to protect against the threat of serious harm by political actors with venal motives.

Does public choice assume that all voters, politicians, and bureaucrats are self interested?   That is the near universal analytical assumption as best  I can tell.   What would happen if they were?   And does that pattern of activity fit the data?    It is no different from the economic approach to understanding markets.     What if firms all maximized profits?  What would happen if they did?   Does that fit the data?

My view, which I don't think is unusual in the "Virginia School," is that most people are mostly selfish.   Analysis based upon the assumption of selfishness will explain much of what happens in society, but not all.

A constitution that will work well if everyone is public spirited but fails in the face of selfishness is a disaster waiting to happen.   A constitution that will meet the test of selfish voters and ambitious politicians is not only a safeguard against disaster but will work tolerably well with real people.

My understanding of the market economic system is that it will work tolerable well, even if people are entirely selfish.   It is much better than a system of production and consumption that would only work if most people were mostly public spirited.   And a market system is better than the alternatives with real people, most of whom, are mostly, though not totally, selfish.    I agree with Buchanan that a proper constitution constrains voters, politicians and bureaucrats in a similar way, as best can be managed.

Wednesday, July 26, 2017

Is Democracy in Chains Good for Buchanan's Legacy?

     My impression of Nancy MacLean's Democracy in Chains is that it is primarily an attack on Charles Koch.   The Koch brothers are hardly an unusual target.   What is special about MacLean's "contribution" is that she uses James M. Buchanan as a club.    Yet another reason for the perfidy of the Koch's is that they are promoting and spreading the ideas of wicked Buchanan.   And what is wicked about Buchanan?   His ideas are at base little more than strategies to fight civil rights and maintain Jim Crow segregation.

      False, but....

      Does this book help or harm Buchanan's legacy?

       For those of us who would like to see Buchanan's body of work become more influential, I think the answer is that it helps.

     There is no such thing as bad publicity.   At least that is what P.T. Barnum said.

      Friedman and Hayek were subject to hatchet jobs.   Buchanan is joining the club of late libertarian Nobel-winning economists.  (Bringing the level of attention Buchanan's ideas receive to that of Friedman and Hayek is a good thing in my opinion.)

   That a left (far left?) historian trashes Buchanan can hardly hurt him on the right.   A leftist tries to paint him as a racist?   That is practically a badge of honor.

    Surely, the field of intellectual battle is on the center left.   And MacLean's careless errors makes her argument against Buchanan very weak.

    Her status as an award winning historian at an elite university is more damaging for the reputation of academic history than to Buchanan.   The more historians and humanities academics defend her--even claiming that making things up is good practice--the more they destroy their credibility.

    I realize that academics seeking Koch money for some kind of university center will see MacLean's book used against them.   Maybe it will be the motivation--filtered through leftist professors--for student protests.   I admit that these are costs.   But let faculty senates discredit themselves.   Let university presidents do their jobs.

    Is Buchanan some shadowy figure with a secret agenda?  Of course not.   His actual views can withstand honest scrutiny.

     Picking apart MacLean's book is necessary.   But don't get mad.   See the opportunity.

Tuesday, July 11, 2017

What James Buchanan Told Me....

Image result for james m. buchanan

... and everyone else in class.

     I took two classes with James M. Buchanan.   The first was in the late seventies at Virginia Tech and the second in the early eighties at George Mason.    He was also a member of my dissertation committee.

     Anyway, in class he explained that when he was in the Navy in WW2, he learned to follow instructions completely.   After the war, when he was at Chicago, he was given a complete bibliography of Public Finance and he took it to be the class reading list, and so he read it all.  (Well, maybe he didn't say he finished it all, but he was working at it when the instructor explained that it wasn't intended to be the reading list for his course.)

     Included on that list was a work by Knut Wicksell.   Wicksell is a quite famous monetary economist, but he also wrote a book on public finance.   Buchanan was especially taken by Wicksell's "A New Theory of Just Taxation."   He told us that his contributions to Public Choice were little more than an elaboration of Wicksell's approach.

      I think he was being more than a bit too modest, but he didn't mention John C. Calhoun or the Southern Agrarians as inspirations.   Looking at his early publications, sure enough, soon after graduate school in the late forties and early fifties  he appeared to be applying the Wicksellian insights.

     The Thomas Jefferson Center for Studies in Political Economy started in 1957.    Here is Buchanan's contemporary description of what it was about.

    Nothing there about protecting states' rights or the desirability of segregation.   I find it hard to see anything "between the lines."   There is just an express support for individual liberty and the free enterprise system.

     Nancy MacLean's Democracy in Chains is not consistent with the James Buchanan I met in the late seventies and I have seen nothing that suggests that the early Buchanan was much different.



NGDP Targeting and a Small Open Economy

IHS and the Mercatus Institute had meeting about monetary policy in San Diego on June 25th.   I was fortunate to attend.

Scott Sumner was interviewed by David Beckworth for Macro Musings.   I suppose we were the live audience.   (As I write, the interview isn't up yet.)

In the question and answer period, Sumner was asked whether it would be possible to test out Nominal GDP targeting in some smaller country--say Kenya--rather than hold out for the Fed or the ECB.  Sumner said that he was not sure that NGDP targeting is appropriate for a small open economy.   The problem is that they may be too specialized in producing a commodity with an unstable world price.

When I spoke to him later, he said that for countries in that situation it is probably better to stabilize nominal labor income.   Of course, Nominal GDP is hardly ideal even for a country like the U.S. either.   Changes in indirect business taxes, for example,  could create problems.   A stable growth path for something like total labor compensation might be better  for the U.S. too.

But I would like to explore the small open economy issue a bit more.   While I can imagine scenarios where shifts in commodity prices might cause problems, I think that the problem isn't really specialization in commodities with unstable world prices.

For example, suppose everyone in a country is a coffee farmer.   The country stabilizes the growth path of nominal GDP, so regardless of world coffee prices or local coffee production, nominal income from coffee sales grows at a stable rate.

How is this possible?   If world coffee prices rise, the value of the currency rises enough so that the domestic price of coffee remains the same.    Nominal incomes remain the same and imported goods become cheaper.

If, on the other hand, coffee prices fall, the value of the currency falls enough so that the domestic price of coffee is unchanged.  Nominal incomes are the same, but imported goods become  more expensive.

Complete specialization in producing a commodity with an unstable price looks like no problem--other than menu cost of all of the shops changing the prices of  imported consumer goods.

Now, lets add a bit more realism.   Who is operating the shops full of imported goods?   What about haircuts?   What about home construction?

If the world price of coffee rises, at first pass, the currency rises in value so that the domestic price of coffee is the same.    Nominal income for the coffee growers and nominal income in the nontraded sector is unchanged.   The imported goods in the shops are cheaper.   If the income and substitution effect for nontraded goods exactly offset, then that is all.   In other words, if the increase in the demand for nontraded goods due to the higher real incomes is equal to the decrease in quantity demanded due to their higher relative price compared to imports, then the distribution of nominal income and the allocation of resources remain unchanged.

However, if the income effect is greater than the substitution effect, the currency must rise more than in proportion to the world price of coffee so that the domestic price of coffee falls, reducing nominal income in the coffee sector.   The profitability of coffee falls a bit, freeing up resources to provide more nontraded goods.   If nothing else, somebody is going to have to handle the increased volume of the imported goods coming in.   Nominal income in the nontraded sector increases.

The less pleasant scenario for this nation of coffee growers is a decrease in the world price of coffee.   The currency falls in value and, at first pass, the domestic price of coffee is the same as is nominal income in the coffee sector.   Imported goods in the shops become more expensive.   If the income and substitution effects exactly offset, nominal incomes in the nontraded sector are unchanged, but real incomes fall just as they do for coffee growers.  There is inflation of consumer goods prices--particularly the imported ones.  If income effect is greater than the substitution effect, the currency will fall enough to raise the domestic price of coffee, making coffee growing more profitable, expanding the demand for labor and other resources no longer needed in the nontraded good sector.

The situation where the substitution effect is greater than the income effect is a bit inconsistent with the conventional terminology of "nontraded goods sector."    The analysis is no different from a situation where there are import competing industries.   If the world price of coffee rises, the currency rises, and the now cheaper imports result in lower demand and lower nominal incomes in the import competing sector.   The currency, therefore, must rise less than in proportion to the world price of coffee, such that domestic coffee prices and nominal incomes in the coffee sector rise an amount that offsets the decline in the prices of import competing goods and the resulting decrease in nominal income in that sector.   Profitability in the coffee sector rises drawing resources from the import competing sector into the production of coffee for export.  Of course, import prices are cheaper, making the effect on real incomes in the import competing sector somewhat ambiguous, but real income rises in aggregate because of the improved terms of trade.

If the world price of coffee falls, the currency decreases in value.   The demand for import competing products rises, resulting in higher prices and higher nominal incomes in that sector.   The decrease in the value of the currency is dampened then, so that there is a decrease in price and nominal income in the coffee sector that offsets the increase in spending and nominal income in the import competing sector.   The increased profitability of the import competing sector creates an incentive to pull resources away from coffee production to the production of goods for domestic consumption.   With the higher prices of imported goods, real incomes in the import competing sector are ambiguous, though aggregate real income falls with the less favorable terms of trade.

It is these considerations that suggest to me that nominal GDP targeting might well be appropriate for a small open economy specializing in the production of a commodity with an unstable world price.   What is Sumner's concern?

Consider a situation where our small open economy has a giant copper mine or maybe a giant diamond mine.    The product makes up approximately all exports and a substantial portion of GDP, but directly generates little employment.

If the world price of copper increases, then the value of the currency increases, the domestic price of copper is unchanged and imported goods are cheaper.    If the income effect is greater than the substitution effect for nontraded goods, then the price of copper rises somewhat less so that the domestic price of copper is less and so nominal income generated by copper falls, making it slightly less profitable to produce so that fewer workers are needed and they can be shifted to the nontraded sector where prices and nominal incomes rise.   Of course, with the assumption that there are very few copper miners anyway, and the other resources useful for copper mining might not be very useful in other endeavors, this adjustment in relative nominal incomes might provide what is superficially the correct signal and incentive to reallocate resources, but there just is not much reallocation possible.  There has just been a pointless inflation in the nontraded goods sector.

If the world price of copper falls, this problem is even more apparent.   The value of the currency decreases.  At first pass, the domestic price of copper is unchanged.   Imported goods are more expensive.   If the income effect is greater than the substitution effect, the value of the currency decreases by less, the domestic price of copper actually rises a bit, nominal income in the copper industry rises, and nominal income in the nontraded sector decreases.   This provides the signal and incentive to shift resources from the nontraded sector to copper production.   But if copper production generates few employment opportunities, the result is that there is really just a pointless deflation of prices and wages in the nontraded sector.   Compounding the pain in the nontraded sector, there is substantial consumer price inflation due to higher import prices.

Inflationary recession in most of the economy, while the copper mine earns more nominal profit.   If the copper mine were privately owned, this would be a political disaster.

If there are import competing industries, these problems are exacerbated.   With an increase in the world price of copper, the value of the currency rises, with nominal income rising in the copper sector while falling in the import competing sector.   While this provides a good signal and incentive to shift more resources to copper production, by assumption that happens to a minor degree.  Again, there is mostly just a pointless deflation of prices and wages in the import competing sector.

If the world price of copper falls, the currency falls in value. Prices and nominal income in the import competing sectors increase, while the domestic price of copper and nominal income in the copper industry decrease an offsetting amount.   While this provides the proper signal and incentive to shift resources from copper production to import competing industries, by assumption, there is little opportunity for such an adjustment.   The result is just an unnecessary inflation in prices and wages in the import competing sector.   Of course, rising import prices imply consumer price inflation anyway.

If there are other export industries along with copper, for example, fruit, an increase in the world price of copper and the resulting increase in the value of the currency will reduce domestic prices and nominal incomes in these other export industries.   While this would provide an appropriate signal and incentive to shift from the production fruit to copper, again, the possibility for such a reallocation of resources is limited by assumption.   With a decrease in the world price of copper, the reduction in the value of the currency will result in higher domestic prices and nominal incomes in other export industries.

Consider a scenario where the copper mine is on a distant offshore island.   The mining is done by a foreign multinational with expatriate workers from other parts of the world.   Leaving aside any income the government collects from this enterprise, does it make any sense to include the nominal output of this operation when determining an appropriate monetary policy for the mainland? It would seem more appropriate for monetary policy to stabilize nominal GDP for the mainland while ignoring what is happening in what is effectively a foreign industry.  

Sumner's suggestion that total labor compensation be stabilized would probably help solve the problem where an export generates a substantial part of GDP and little employment.    But more generally, the problems I see with nominal GDP targeting in this context involves the specificity or substitutability of resources in production of various goods.   My coffee example assumed labor and resources could be shifted between coffee and other products-nontraded, import-competing, or other exports.    My copper example assumed that this was nearly impossible.

I believe this is related to the notion of an optimal currency area.   The example of the copper producing island causing pointless disruption on the mainland makes this plain.  The island and mainland do not make an optimal currency area.   Regardless of its geographical location, however,, the same issues apply.   Regardless of the location of the copper mine, perhaps it is better to stabilize the growth path for nominal production for the rest of the economy (nominal GDP less final copper output.)

But nominal GDP targeting, does not, in general, result in problems when countries are specialized in the production of a commodity with an unstable price.   In the extreme, where all that is produced is such a good, it works quite well.   And it also works even better when resources can be shifted between the export sector, the nontraded sector, the import competing sector, and other export sectors.

Now, it might be that stabilizing the growth path of nominal labor compensation would do ever better.   But nominal GDP targeting would work better than stabilizing the exchange rate or consumer price inflation.

Saturday, July 8, 2017

Employer Power?

    I recently read a claim that employers have unfair bargaining power relative to employees.   The reason is that the employees need money right away while the employers don't need workers right away.   I have certainly heard such a claim before, but it recently struck me that it is silly.

     I certainly agree that many workers need a job right away.   And I also agree that many employers are unlikely to be desperate to fill a vacancy--particularly if an employer has many employees.
      Of course, this is not always true.    Not all workers are so desperate and some employers may be brought to a standstill without a key employee.

      But let us suppose that a currently unemployed worker accepts an unfairly low wage because he needs the money now and cannot hold out for a fair wage.   The employer would be willing to pay more, and if the employee just waited a bit, the employer would offer more.   But the employee cannot. He must eat.

      Now, the unemployed worker is employed.   Earning an unfairly low amount by assumption, but presumably no longer desperate.

      So now the unemployed worker can look for a new job.   He doesn't have to quit, become unemployed, and then look for a new job.   He can seek this new job while continuing to work.

       Now, the claim that the workers have nothing and need money right away no longer applies.   This worker can continue to work at his current pay until a better offer comes along.  

        Is this realistic?   Do firms actually hire the employees of other firms?   Do people accept a new job while they are currently working for an employer?   Or is that sort of thing quite rare, with employers generally hiring those who are unemployed and most employees only obtaining a new job if they have been laid off or fired from their previous job?

        There about 150 million people employed right now in the U.S. and there are about 7 million unemployed people.   Hires are over 5 million per month.   More people are hired in two months than are unemployed today.

       Quits are about 3 million per month.   That is 36 million per year.

       Do all of these people become unemployed?   Of course not.   For the most part, these are people who have been hired while they already have another job which they then quit.

       There are many reasons why someone might quit one job and take another, but a key reason is better pay and benefits.    Of course workers leave one employer and go to another that offers a better deal.   Of course employers will hire currently employed workers.   In fact, there is evidence that they discriminate in favor of the currently employed.

      If the desperation of unemployed workers to take anything was important to employers you would expect that they would be most anxious to hire the unemployed.   But they aren't.   That suggests that employers do not obtain a benefit from this sort of bargaining power.

      Layoffs and other discharges are about 1.6 million per month.   Almost certainly, they add to the pool of unemployed.   (In 2009, layoffs and discharges were almost 2.5 million per month.)   If it weren't for new hires, in 10 years, everyone would be unemployed!    But, more people are hired than lose their jobs.   That is why employment grows.    In the last decade or so, it rises about 200,000 each month because total hires are greater than total separations.

      The point of these figures is to understand that the labor market cannot be identified with people losing their jobs, being desperate to find work, and then employers finally hire the unemployed.   While that is part of the story, workers being hired away from one employer by another is very significant--more significant.

      The pace of new hires is very important.   In 2008 and 2009, new hires dropped significantly.   While there was plenty of hiring--3.5 million a month--that is a lot less than 5 million.     During the year or two when it was worst, something like 70 million people were hired.   But these days more than 100 million people would be hired over a similar period of time.   That makes a big difference.

      As mentioned above, layoffs jumped up too--close to the number of hires.   But the rest of the story is that quits dropped off tremendously, to less than 2 million per month.   Why?   Most likely because firms were hiring less, and that mostly means hiring fewer people away from other employers.  Current employees quit less often since there are fewer new, better job to take.

      When labor demand is strong and growing, wages rise from employees switching employers.   When labor demand is weak and there are few hires, then wages stagnate.

Entrepreneurial Goals

I suppose it is almost the definition of entrepreneurship that profit is sought and loss avoided.   As soon as time is considered, this transforms into maximizing the value of the firm--accepting losses now in exchange for anticipated profits in the future.  But the very logic of value maximization separates the individual entrepreneur from the firm.   Sacrificing profits now for future profits only makes sense if it is possible to sell the firm, or more plausibly, sell an interest in future profits.

However, there is no presumption that a specific individual will save any part, much less all, of his or her income so as to maximize the increase in wealth.   Yet the notion that such a motivation is central to "capitalism" is common.   Weber's Protestant ethic explained economic growth in northern Europe due to the supposed Calvinist view that earning money was a sign of God's favor but spending it on luxuries reflected a sinful worldliness.   This was in contrast to the supposed Catholic view that the whole point of earning money was to use it for something.  (I think this "Catholic" view is more sensible and theologically sound, as well as being more consistent with modern economic reasoning.)  
Even before, Marx more or less treated the income from profit as the same as saving and forecast eventual economic disaster because the growth of wealth will outstrip the investment, really industrialization, entailed by the inevitable development of the material productive forces.   Hegelian hocus pocus really doesn't fit in well with modern economic thought.

Still, it is certainly possible that entrepreneurs would save a substantial portion of their profit.   It seems that many entrepreneurs find their work enjoyable.   They are really too busy to enjoy anything like the consumption they could afford.   To the degree that effort and commitment are more likely to lead to success than a more dilatory approach, many of the most notable entrepreneurs will in fact have that characteristic.    "Why waste my time on lavish consumption activity when I can plow money back into business activity have some real fun!"  Some tycoons, including the President of the United States, have claimed that money is just a way of keeping score.   On this view, the goal is to raise one's standing on the Fortune 500 list--perhaps to reach the top and win the game of life by earning the greatest net worth.

Since earning profit and avoiding loss generates value, value that is typically much greater than what the entrepreneur earns, it would seem that the rest of society is getting something for nothing.   Fundamentally, if someone consumes income then resources must be devoted to produce the goods that are to be consumed.   If the income is never consumed, then the resources can continue to be used for other purposes.

However, this scenario involves the entrepreneur saving all of this additional income, so it isn't available for anyone's consumption in the present.   Presumably, it will be available for someone's consumption when the entrepreneur dies.   So, if an entrepreneur doesn't consume profit but reinvests for fun, and these investments remain profitable, consumption is moved to the future.  Leaving aside inheritance tax, whose future consumption can be increased is determined by the entrepreneur's bequest.

If the relevant comparison is to luxurious consumption by the entrepreneur now, it is difficult to see how this result is any worse.   Of course, some might argue that some of these profits should be taxed and the proceeds transferred so that others might consume more now.

Suppose, however, that that entrepreneur does not use these funds for direct investment, but simply saves them.   There is no longer some story about an entrepreneur using the funds to enjoy business activity, but still, net worth increases as would more passive investment income.    If financial markets function properly, any funds saved result in matching investment by some firm or other.   The greater future output generated by that investment allows for additional consumption for whomever the entrepreneur leaves a bequest.

Unlike the situation where the entrepreneur is directly investing saved profits, these other avenues for saving leave the possibility of some kind of breakdown in financial markets such that saving and investment do not match with full employment of resources.   "The" market interest rate might fail to fall enough to match "the" natural interest rate that coordinates saving and investment.

This sort of problem is always monetary broadly understood.   Saving might occur by accumulating money, and if prices and/or wages are sticky, real output and employment will decline.   In my view, an appropriate monetary regime avoids this perverse result.   And so, the entrepreneur who has no interest in consumption but solely wants to save profit to "win" by accumulating the most wealth only causes problems if there is a less than ideal monetary regime.

That our driven entrepreneur allows for added consumption in the future for whomever he makes his bequest points to an alternative motivation.   The entrepreneur might reduce consumption from what would be possible now with the intention of allowing for added future consumption for his descendants.   But rather than simply allowing his children to consume, I would like to consider another motivation.   The notion that his descendants will permanently earn sufficient capital income to maintain a high level of consumption forever.

While this seems reasonable enough on its face, I think this goal is better motivated by cultural factors that existed prior the modern market system.   As the market order came to dominate, the aristocrats inherited a system that had evolved such that they earned rental income from land.   There was no requirement that aristocrats do much to manage their land, much less become actively involved in business activities.   Aside from living a life of leisure while being doted upon by many personal servants, the only real duty was to participate in what can be broadly understood as governance.   The initial rationale of this system involved military service, and a norm of service as officers in modern armies was really a holdover.

While the time when this income must be rents from land is long past, the notion that one's children and grandchildren and so on can be set up to live in that fashion is a plausible motivation for saving.   So, the entrepreneur earns profits and consumes little immediately, mostly saving.   The point is to leave a sufficient bequest to provide for an adequate (high) income for ones children,   They will then pass on a similar bequest to their children, and so on.

This motivation, however, does not result in capital income being saved in perpetuity.  Once set up properly, the family must avoid dipping into principal (or capital,) but otherwise, the income is spent on consumption that may be lavish by the standards of many people but typical of the upper class.

The entrepreneur consumes less than he otherwise could and saves.   The amount saved is never intended to be consumed, but rather is to form a principal that will generate an income that is intended to be consumed.

This motivation does not require that the entrepreneur enjoy making money or have any particular interest in direct investment.   Still, any notion that this somehow results in too much saving is still less plausible.   The saving is transitional.   Considering the "cultural" factors, the notion that the traditional aristocracy had more income than they could use is pretty implausible.    Quite the contrary.     Even so, if this transitional saving did outstrip investment, any problem with maintaining employment would still be a consequence of an inadequate monetary regime.  

What would be the implication of a negative natural interest rate for entrepreneurs saving their profits?   Assuming that the real market interest rate matches this natural interest rate, then the entrepreneur making money to "keep" score, will provide a bequest to someone that allows for less real consumption than the entrepreneur could have enjoyed.   Of course, if the entrepreneur continues with direct investment, he may well earn more than the natural interest rate.    This is really only relevant with a more passive investment strategy.   If the nominal interest rate is positive, but the real interest rate is negative due to inflation, then I suppose some entrepreneurs would count their nominal gains as making progress in the game.   If the nominal interest rate is negative, however, simply holding onto wealth would be clearly counter-productive.

For the motivation of providing a bequest sufficient for one's descendants to earn a sufficient capital income, it would seem that a permanently negative natural interest rate would make it impossible.   In such a scenario, refraining from consumption now provides no benefit and would earn no reward.  Providing for one's children and more distant descendants would be possible, of course.   But without a positive real interest rate, eventually the wealth will be gone.   However, as is much more likely, the natural interest rate would only be transitionally negative and likely only for the shortest and safest assets.    


Saturday, April 1, 2017

Must Capitalist Economies Grow?

I ran across a claim that a "capitalist" economy must grow.

I believe that one of the key benefits of a market economy is creative destruction.   Entrepreneurship leads to innovation and growth. Profit and loss incentives motivate each firm to introduce new products and methods of production that create a system where larger amounts of better goods and services are produced.  Successful innovation generates greater profit.   Perhaps more important,  innovation by competitors can result in reduced profits and perhaps losses and even bankruptcy.   This creates a powerful incentive to innovate in order to "keep up with the competition."

A somewhat different consequence of profit and loss incentives is to allocate resources to produce whatever goods and services for which people are willing to pay the most.   Competition for resources results in resource prices that communicate opportunity costs--the value of the most important goods and services sacrificed by the use of those resources in production.   If buyers are willing to pay more for products than the opportunity cost of the resources used to produce them, then a firm profits.   If, on the other hand, people are willing to pay less for a product than the opportunity cost, any firm producing that product suffers losses--motivating it to produce less.  Profit and loss creates an incentive to produce more important things and avoid "wasting" resources in producing less important things.

But does any of this mean than capitalist economies must grow?

One "micro" argument would be that larger firms are always more efficient.  This would seem to imply that only one firm can survive competition.   During the competitive process, then, each firm is racing to be the biggest, and so most efficient, which will allow it to increase its lead and eventually "win" the competition by becoming a monopoly.  

I am not sure how seriously to take such an argument.   If a new production technique is introduced that exhibits economies of scale, and there were many firms using some prior approach with fewer such economies of scale, then something like the above process would occur.   Depending on the economies of scale and the demand for the product, it could be that the result is a natural monopoly--a single firm can produce the amount of the product demanded at the lowest cost.   But this is not necessarily true.     It is not always most efficient to produce output in a single giant plant.  It is more common to have many factories or plants even if they are all owned by a single firm.   Having many factories managed by a single firm is not necessarily more efficient than having multiple independent firms in competition.   Organizations have many problems, which generally are described as the cost of bureaucracy.  One key benefit of the market system is that it allows for large scale cooperation without a single massive bureaucracy.   There can instead be many, somewhat smaller, more manageable bureaucracies.

A second argument is "macro."   Here there is a behavioral assumption that is supposed to be a defining characteristic of capitalism.   Firms make profit.   While the owners of the firms consume something, this can be ignored as a practical matter.   The profits are all reinvested making the firm grow.   "Capital," understood as the value of the firm, increases.   "Capitalism" is an economic system that maximizes the growth of capital by maximizing profit.  The greater capital is intended to result in greater profit and so greater increases in capital.   Critics of capitalism claim that this system must eventually collapse.   I read Marx as making an argument along these lines.

I think there are some advocates of the market system who defend it with something like the first part of the argument.   They justify profit based upon how it is used.   Profit is justified because it is reinvested and that creates more growth (and maybe even "more jobs.")    I suppose for a leftist critic of capitalism, reading such claims by their opponents, gives them the impression that everyone agrees that capitalism entails constant growth in capital.   And if these advocates of capitalism focus on the benefits of more capital and justify profit on that ground, then this explains their opposition to policies that reduce profit--such as higher wages.

I think that most economists, including those who are very sympathetic to the market, really don't focus on how profits might be used.   As I mentioned in my first two paragraphs, the profits and losses both motivate innovation and also the allocation of resources to produce what particular goods and services people want to buy the most.   If anything, the assumption is that the entrepreneurs use this source of income to enjoy greater consumption of goods and services.   That is the reward they obtain for their successful innovation or reallocation of resources.    I think allowing entrepreneurs to obtain profit and suffer losses is desirable because the prospect of profit and losses motivates them to do desirable things--innovate and reallocate resources to produce what people want to buy most.

Of course, entrepreneurs may well save part of the income they earn.  Perhaps they will save a substantial portion of it.   Still, any identification of profit with saving and capital accumulation is simply not a key element of modern economics.   Instead, it is common to identify "capitalism" with a "market economy."   My basic framing of the economic problem includes consumption being the purpose of production.   So, as I consider capitalism, I don't start with profit and capital accumulation, must less with a "goal" of maximum aggregate profit and maximum accumulation of capital.  Rather, it is about people achieving their goals, with an emphasis on producing the goods and services they most want to consume.     Perhaps I have some slight idiosyncratic twist to my thinking on this, but I think it is pretty much consistent with mainstream economics.  In my view, this is just a restatement of the centrality of scarcity in economic thinking.

Starting with this notion that the purpose of production is consumption helps make sense of the view that saving is about reducing consumption in the present and increasing it in the future.   For an individual in a market system, to save is to spend less on consumer goods and services now than the income earned now, so that  more can be spent on consumer goods and services later than the income earned later.   Suppose someone works for many years and spends just part of their wage income on consumer goods and services.   The saving each year is income less  consumption.   This person's wealth, or net worth, grows with that saving over the years.   Eventually, this individual retires from work and no longer has any wage income.   However, they continue to purchase consumer goods and services out of their accumulated wealth.   Each year, wealth decreases due to dissaving.   That is, consumption greater than income.

Entrepreneurs earn profit, which is a form of income.   Unless they have some other source of income, they must use some of it to purchase consumer goods and services.  If they earn a very high income, then they can purchase lots of consumer goods and services.   However, like anyone else, they certainly can save.   Still, the basic framing here is that they save by spending less income from profit on consumer goods and services now in order to spend more than their income in the future.

Under most circumstances, both the worker saving for retirement or the entrepreneur saving profit and building a fortune can earn capital income on their wealth.   The worker might put savings in a bank and earn interest.   The entrepreneur might reinvest his saving in his own firm, purchase additional capital equipment, and earn additional profit.   This capital income reduces the amount the worker must save while working to have sufficient consumption when retired.   The already luxurious consumption an entrepreneur could afford now is compounded in the future by the additional income earned on accumulated wealth.

However, this doesn't mean that there is some kind of "system" that has the goal of maximizing aggregate profit with all of it being saved to accumulate as much wealth as possible to increase profit as much as possible.

In my view, the fundamental reason for capital income is productivity.   If fewer resources are used to produce consumer goods and services now, then those current resources can be used in ways that allow for additional production of consumer goods and services in the future that not only replace those sacrificed now, but exceed them.   Generally these techniques involve the use of various sorts of durable tools--machinery, equipment and the like.   More elaborate--more expensive and productive--tools can be used if more resources are available to produce them.

The capital income earned by the worker putting money in a bank for retirement or the entrepreneur reinvesting profit into his or her own enterprise captures part of this additional output as added income.   That it is desirable that people earn capital income is not based on some notion that they will always reinvest such income and accumulate even more wealth which also implies that more valuable and productive capital equipment will be produced and utilized.  Or rather, I don't think of it that way.   It is rather that the prospect of earning such income in the first place motivates people to save more than they otherwise would, resulting in more total output and income than would otherwise exist.

To me, and most all economists, growth is about increases in the production of goods and services.   It isn't about increases in aggregate profit or wealth or the capital stock.   Profit and loss generates powerful incentives for growth, however, nothing in the market system, that is  "capitalism," requires such growth.   If no one was interested in any new good or service or there were no better ways to produce the existing ones, then there would be no more innovation.   One of the key reasons why profit is desirable would no longer exist, though there would still be the second reason--producing the proper mix of existing goods and services in the already discovered most efficient ways.

Most economics is done in the context of a growing population.   This requires some net saving and investment so that a growing work force can utilize the same types and amounts of capital equipment and that there will be more consumer goods and services for the additional people to enjoy.   Such growth could occur with each person and generation enjoying unchanging consumption per capita.   A market system could coordinate that scenario.

If the population were to be constant or even shrink, the market system could coordinate that scenario too.  With a constant population, constant consumption and sufficient capital (tools and the like for each worker) could be maintained with no net saving or investment.   With a shrinking population, the market system could coordinate a shrinking capital stock through negative saving and investment-net dissaving and net disinvestment.   The output of consumer goods and services would shrink over time, reflecting the reality that there would be fewer people to enjoy them.

Or suppose people wanted to enjoy more leisure.  They might prefer shorter workdays, work weeks, longer annual vacations, or perhaps start work later or retire earlier.   If they valued this more than the goods and services that they would not be producing and could no longer afford, then the market system could coordinate that.   Better yet, in the context of creative destruction and growing productivity it is perfectly possible to take the benefits in reduced work time.   Further, a market system could coordinate a mixed result where more consumer goods and services are produced for people to enjoy along with additional leisure time to enjoy them.

If everyone wanted to consume all of their income, so that there was no net saving and no net investment, then wealth would not grow nor would the capital stock.   However, if creative destruction continued, the capital equipment might well improve, and substantially change as old capital goods wear out and are replaced.   Consumption could grow or leisure could expand without any increase in wealth or capital.   (The scenario of no net saving or investment and a growing population is more challenging.)

Nothing in a market system requires constant growth in output.  Nor does capitalism require that profits be saved and used to increase net worth and increase the capital stock.

A separate question is whether a practice of entrepreneurs always saving their profit so that profit always adds to net worth and the capital stock is harmful to the market system.   It is not necessary for capitalism to exist, though it is plainly consistent with capitalism if people behave this way.  What happens?  Does that practice, which some seem to think is an essential defining characteristic of capitalism, have some calamitous consequence?

More later.