Friday, July 2, 2010

Responses to Journalist Questions

I received an inquiry from a journalist in Tehran, Iran, about several issues. This is my response.

1- The case, as it's usually presented, is that the globalized economy is a good thing that will secure jobs, allow us to remain competitive, and make the economic situation of a country better. Isn't there some wrong to that as we saw an economic crisis in US spread all over the globalized economies?

Free trade and free markets have been proven to be the greatest source for wealth creation, for raising standards of living and human development, and increasing liberty. When people engage in voluntary trade they are doing so because they expect it will make them better off. When trade is coercive or is restricted then people do not get what t hey want at the price they are willing and able to pay. Instead, they get lower quality goods at a higher price and often do not get what they want.

The recent global crisis occurred because of government intervention. Government interventions in the US housing market, regulations on capital flows and banking around the world all led to an attitude that failure is not possible – governments will bail out firms that fail. And, indeed, that is what occurred.
Now, be sure that not all economists agree on what the problem with the financial crisis was and is. It is often claimed by economists that there is essential agreement in the profession on almost everything. Well, if that was ever the case, it is not now. There are free market economists, Keynesian economists, Austrian economists, and even Marxists.

You can see the division among economists in the following remark by Paul Samuelson.
“And today we see how utterly mistaken was the Milton Friedman notion that a market system can regulate itself. We see how silly the Ronald Reagan slogan was that government is the problem, not the solution. This prevailing ideology of the last few decades has now been reversed. Everyone understands now, on the contrary, that there can be no solution without government.”

The market system is generally the most efficient allocation system—it best satisfies people’s wants and needs and raises their standards of living. Without anyone dictating what buyers and sellers do, the market determines a price for each traded good at which the quantities that people are willing and able to sell are equal to the quantities that people are willing and able to buy. Day in and day out, the market system induces people to employ their talents and resources where they have the highest value. People do not have to be fooled, cajoled, or forced to do their parts in the market system. Instead, they pursue their own self-interests and, in so doing, generate the most good for society.

Firms acquire resources and then organize and coordinate the resources to create and offer for sale various goods and services. The value that consumers place on these goods and services must be more than the value they place on the individual resources alone or else the firm will cease to exist. When a firm’s goods and services have more value than the opportunity cost of the resources used to create and sell the goods and services, then rivals will begin to compete with that firm. In other words, when economic profit is negative, the firm will cease to exist; when economic profit is positive, the sharks will attack. Rivals will enter and compete. People will get the goods and services they want at the lowest possible prices and resources will be used where their value is highest.

A free, competitive market is usually illustrated as a simple downward sloping demand curve and an upward sloping supply curve. The price and quantity at which the curves intersect represent the result of competition, the price that is the lowest possible and the quantity that people want and are able to pay for. This price and quantity result from resources being used where they are most valued. If another department store could match Nordstrom’s products and service but do so at a lower price, consumers would abandon Nordstrom and shop at the other store. This would drive Nordstrom’s profits down until they were at the normal or zero economic profit level. If iPods can be replaced with another company’s MP3 at lower prices and/or higher quality, then Apple’s profit will be driven to the normal level. Thus, the intersection of demand and supply is the point where consumers are currently happy with what they are getting and prices are as low as possible.

When competition is limited and entry restricted, then the picture changes. With total entry restrictions, the entire market is converted into a single firm, the monopolist (or a cartel of firms acting as a monopolist). The firm maximizes profit by restricting quantity and raising price. If government intervenes in the fre market price and or quantity is distorted from the competitive outcome and either "too much" or "too little " is produced and consumed. Resources are misallocated. Intervening or interfering with free competitive markets harms society.
But even so, it is argued, a free market causes too many problems. For instance ,if a free market is hit by a sudden reduction in demand caused by any number of things, such as speculative activities, unexpected resource changes, or some other crisis, the free market adjusts to the demand reduction by firms exiting business and price and quantity being reduced. The free market adjusts by price dropping until the demand and supply curves intersect again.

Here is the theoretical crux of the argument between free market economists and Keynesians – the speed with which the market adjusts to changes. Critics of the free market argue that the adjustment from the first equilibrium to the second takes too much time. Markets just take too long.

A slow adjustment of the market means resources will be unemployed and inventories will stock up on shelves for awhile. If demand decreases but price and quantity do not immediately follow, then a surplus will occur. If this market is wheat, then a surplus of wheat will exist; wheat will lie dying in the field. If this market is cars, then excess inventories of cars exist; cars will be piling up on dealer lots. But most importantly to market interventionists, if this market is the labor market, then there is a surplus of labor; unemployment rises.

John Maynard Keynes, the leading economist of the 1930s, captured this criticism of free markets with the following statement:"The long run is a misleading guide to current affairs. In the long run we are all dead." Tract on Monetary Reform (1923) Ch. 3.

Free market economists argue that intervening in free markets will make matters worse than just letting the free market adjust. Under this view, when something like the Great Depression occurred in 1930 or when the financial collapse in 2006-08 occurred, the free market response would be to do nothing - because in the long run the markets would solve the problem, the price of labor would fall, more firms would hire, people would return to work, and the economy would return to full employment.
Keynes said this was madness - in the depth of a recession, why not try to do something about it, rather than leave it to 'market forces'. In the long run the recession may end but the long run could be 10, 15 or more years. Keynes wanted to try and solve the depression now rather than wait for 10 or 15 years or however, long the 'longrun' was.

This viewpoint is the basis of many of the arguments between free market economists and the Keynesian or non-free market economists. "It simply takes too long for the market to work things out. People, central planners, and governments can do it better."

The counter to this argument is that while we might be dead in the long run, our children and grandchildren won’t be. So we should do what is best for the economy in the long run and that is leave markets alone. By intervening in free markets, inefficiencies arise that slow the growth of the economy and harm future generations. In the end, intervening in the functioning of free markets just makes the situation worse and creates additional problems.

There is more to the story than this. The Keynesian solution does not even help in the short run. The GreatDepression lasted 13 or so years; the great recession of 1921 lasted two years. The difference was that the Keynesian solution was tried in the Great Depression. In 1920, nothing was done; the free market adjusted. In 2008 the free market was interfered with in a huge way with bailout, takovers, cram downs, huge expansoins of the money supply and other Keynesian policies. How effective have those Keynesian policies been to date?

Ignoring the long run is impossible. People care what happens to their children and grandchildren and the long run to someone, say Pratt, is much longer than it is to me. As a good friend of mine states, I don't even buy green bananas any more. The intergenerational robbery that has gone on with the Keynesian policies is perhaps the theft of the century.

2- Some people feel that after communism collapse, free-market capitalism may be next. Do you think it is the case or capitalism adapt itself with the new conditions and sustain its life?

The long winded answer to question 1 should provide you my answer to this question. No, capitalism will not collapse or fail. What may fail is crony capitalism or big government capitalism. In other words, in those nations where a move toward greater economic freedom is made, success will follow. In other nations, where government is growing as a share of the economy, failure will result. Compare for instance the growth of the US economy to the growth of European economies. From the 1950s to the 1990s the US economy grew at about 3.5 percent per year while the European economies were half that. The projection of future growth for the US is at most 2 percent per year. Increasing government means decreasing economic growth. Comparing 3.5 percent per year growth to 1.5 per year growth means that the size of the economy will double in about 20 years versus about 50 years.

3- Before the recent crisis US was called the motor of the world economy? Do you think it is yet?

The US is still the driver in the world economy but the share of world GDP created by the US is declining. As US government continues to grow, the importance of the US dollar and the US economy will shrink.

4- What is your prediction of the world economy situation at 2050? Which country would be the biggest economy at 2050? Where would be the center of the world economy: the West or East?

There is no way I would venture to forecast the economic situation in 2050. I can tell you with certainty, that the nations that create and protect private property rights, that enhance and secure economic freedom, will be the successful nations. Those that allow government to grow beyond 15 to 20 % of GDP but with a private sector and some private property rights will grow very slowly or decline over time. Those without economic freedom and private property rights will collapse. As a stab in the forecast arena consider the following:

China will either recede into a shell with its totalitarian government without economic freedom or will emerge as a different country by 2050. It could be hugely successful or could return to dire straights. There is inevitably a clash between economic freedom and communist government. India will struggle but will continue to pull more people out of poverty than has ever been done in history. India’s economic freedom must continue increasing and secure private property rights must increase.

The European Union will disintegrate. Most European nations will flounder as their social welfare system grows and private sector output fails to pay for entitlements. It is likely that well before 2050 the European nations will dissolve into class and civil warfare.

The newly free nations of Europe and Asia will likely succeed as freedom and private property rights propel them. In Latin America, the jury is out. Those nations such as Venezuela will collapse. Chile is likely to continue growing. Some other nations may follow Chile’s success.

Accordingto "The Closing of the Muslim Mind" by Robert R. Reilly, unless
a revision in Islam can occur, economic freedom and private property rights -- the necessary conditions for eocnomic growth -- will not occur. According to Reilly, the Wahabi and Sunni nations will collapse without the oil revenues. I don't kow whether Shia and Sunni view matters significantly differently to allow success to Shia nations while Sunni decline. The Wahabi and Sunni nations now have wealth only because of oil. If nations are able to secure other sources of oil and turn to other sources of power, the oil producing nations that do not accept freedom and private property rights will fail. Similarly, without oil revenues and without enhancing private property rights and economic freedom, Russia is not likely to succeed. Another factor in old European nations and Russia is that demographics are against them. Without replacement population growth from within either the countries shrink or immigrants replace resident population.

1 comment:

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