Monday, May 28, 2012

Specialization and Spontaneous Order - more lessons for Obama

Perhaps it would have been more appropriate to have written this on July 4, rather than on Memorial Day. But you can’t argue with inspiration.

July 4 commemorates that date in the year of 1776, the date we pick to mark the Declaration of Independence and the launching of the grand and noble American experiment that is still playing out. It so happens that 1776 is also the year of publication of Adam Smith’s famous book, An Inquiry into the Nature and Causes of the Wealth of Nations, more commonly known simply as The Wealth of Nations.

It is not really an accident that these two works are so close in timing. They share a common intellectual tradition, the ideas of English liberalism that were ”in the air” – and had been around for at least a hundred years dating back at least to the works of John Locke and the other contributors to the English natural-law tradition. For the first time in human history all individuals are seen as possessing certain basic rights, simply by virtue of being human, the same rights regardless of their station in life. Ironically, for most of human history these rights were far from “self-evident.” But the American Revolution, and the essence of the Constitution that followed, was predicated upon them – the rights to life, liberty and property - even though amended by Benjamin Franklin to read “the pursuit of happiness.” What is the connection?

Adam Smith’s work affirmed that secure individual rights to property were absolutely necessary for a nation to prosper – a key to the wealth of nations – and thus to the pursuit of happiness.  And every infringement of that individual right, however small, is an impediment to the attainment of that ideal. There are two essential ideas in Smith’s work, that together fully explain the how this works.

The first is the idea that productivity is the result of a the division of labor – specialization, leading to an improvement in knowledge, skills, expertise, etc. that enhance production and lead to the introduction of new and improved methods and products. But this division of labor has to be organized. People have to decide what to do and how to do it, and their plans and actions needs to dovetail with those of many others upon whom they depend. How is this “proper” division of labor to be coordinated? As explained in my previous post, this is the function of the market process, that system of natural property rights that results in voluntary production and exchange on the basis of market-established prices that act as both incentives and signals to do the “right thing.” So, it is not from the benevolence of the butcher that we get our meat, but from his attention to his own self-interest in the pursuit of profit. He is led by an invisible hand to provide us with the meat that within his specialized ability to produce. Coordination is not organized, it emerges spontaneously – it is a spontaneous order.

The invisible hand and the division of labor together provide a basic understanding of how the market systems works – when it is allowed to work. It is not perfect. The world is not, and will never be, perfect. People make mistakes, lots of them. The pursuit of profits brings both profits and losses. But, overall, this is the best, the only, system that is consistent with national prosperity, with the escape from the poverty that was the common plight of most people in the world prior to the modern era, and is still the plight of billions.

Like the Declaration of Independence, Adam Smith’s Wealth of Nations, reads as fresh today as the day it was written A great thinker and communicator, Adam Smith’s message is one that all national leaders should take to heart, including those of the nation whose founding documents were based on it. 

Friday, May 25, 2012

Profit maximization 101.

From yesterday's WSJ op-ed by Professor Paul Rubin: "In justifying his attacks on Bain Capital, President Obama argues that 'profit maximization' might be an appropriate goal for a private-equity firm, but not for more general public policy. This argument ignores one of the most basic premises of economics."

Don't you have to know any basic economics to become a lawyer, never mind teach constitutional law at the University of Chicago?! I mean everyone should know basically how markets work in order to give us what we want. Shouldn't they?

As Adam Smith put it, we don't get the meat from the butcher because of his benevolence; but rather because he is intent on "maximizing" his profits, or, in other words, he does the best he knows how, to make his profits as big a possible within the constraints that he faces - including legal and moral constraints. It is not that he is greedy or uncaring. He may be, but he may be a wonderfully compassionate and generous individual. But deviating from his endeavor to maximize his profits may put him at a disadvantage to his competitors and leave us with less meat, from him. So while not intending our benefit, and intending only his own, he is led, by the invisible hand of the market, to provide us with what we want. Why? Because the market process works by making his interest coincide with ours. It is the only social mechanism that can do this, however imperfectly. It works by providing the butcher with incentives to be efficient in the provision of what we want when we want it, to use his special and particular knowledge and abilities in doing so, and to be alert to new opportunities to do so better, opportunities that he is in a special position to recognize and exploit. To repeat, by being successful he benefits not only himself but also all those whom he serves. His “greed” is kept in check by the completion or potential competition of those who would like to fill his place by promising to serve us better.

How else could his “greed” be kept in check? By regulation? On what basis? Who would decide how much profit is sufficient, reasonable? How do the regulators get this privileged knowledge? Why should we trust them? What incentive do they have to get it right? What good does it do to try and “shame” profit-earners into adopting some other goal? None, it will either be completely ineffective or produce more harm than good.

To require 
that businessmen should not strive to maximize profits, as President Obama seems to want to do,  betrays either a woeful ignorance of how things work, or a crass hypocrisy. Either way its not good and it tends to perpetuate the kind of economic illiteracy that has gotten us into so much trouble.

Wednesday, May 23, 2012

A Greek Tragedy?

Greece is fast approaching the wall. How ironic that NPR and the BBC see fit to report the news as though this is something that is caused  by Germany’s hard-nosed refusal to modify its demand for meaningful and credible fiscal reform. Interview with man-in-the-street who blames the Greek government and Germany, but mainly Germany. Ergo, its Germany. Sure, when I can’t pay my credit-card bill, that’s the credit-card company’s fault, right?

All the pundits I read suggest that Greece exiting the Euro-zone is a bad thing for everybody. I don't see it. Sure it’s bad for Greece and the Greeks - because it will mean a resort to unconstrained growth in domestic-currency-financed-government-spending, in other words, growth of government and a shrinking of the already shriveled private economy. And this will lead to inflation, the worst and most destructive of all taxes, which will lead sooner or later - probably not so later - to economic meltdown. By that time probably most of the Greek labor force will have emigrated.

But, it would be a good thing for the Euro-zone if it sent a clear message to the rest of the PIGS - the PIS - and maybe France too with its brand-new, rich, swanky, socialist president. A Euro-zone with one less deadbeat to support, and the rest in fear for their economic lives, why is that bad? The bond-holders take their knocks – what’s left to take. Some real belt-tightening occurs. Things would definitely get better after that. Of course, that’s a best-case scenario.

I don’t know the political details well enough to know what spurred Angela Merkel to hold fast, what vested interests, what real principles. Whatever it was, good for her!!

Saturday, May 12, 2012

The Financial Fiasco is not a Market Problem

Good piece by Holman Jenkins in today's WSJ:

Obama+Frank+Dodd=Market uncertainty and incentives to get too big to fail by accumulating risky assets. How ironic!

Mark-to-market is a dysfunctional regulation that is based on the fiction that the value of durable assets are accurately assessed at any point in time by the "market." At the bottom of this is a profound misunderstanding of the fundamental nature of "value." The value of any (financial) asset at any point in time depends on what those who pay money to buy it think will happen in the future. It is NOT some mystical, objective number that the application of esoteric, rocket-science type formula will reveal. Finance is categorically different from physics. Value depends on what people think will happen, and different people think different things will happen (sometimes exactly opposite of each other). Regulators are not in some privileged position. They are, if anything, less likely to be right than the "expert" traders, who have both a greater incentive and more detailed knowledge and experience to get it right. But, even they, the experts, will be wrong - often - that is the way the market works. Sometimes they win, sometimes they and their clients lose. Regulation, by making the financial environment more uncertain, creates a greater disparity of outcomes and encourages irresponsible behavior by trying to shield us from failure. Too big to fail is just too big!