Monday, January 30, 2012

Can you spot the fake Keynesian?

As promised, I have assembled a team of informed Keynesians and left-wing econ fans to answer some general questions about modern economists. Mixed in with their answers are my own, using my understanding of left-wing economics to answer them from that perspective. I did not Google any of my answers or look at what someone else wrote first.

Before I get started, a special thank you to Joshua Zelinsky of Religion, Sets, and Politics who provided the questions used in this experiment. Thanks Joshua, you were a great help.

I used a random number generator to choose the order for the answers from my guests and I, and the order remains constant for each question. Instead of attributing each answer to writer A, B, C and D, I have labeled them as Al Pacino, Steve Buscemi, Christopher Walken and Robert De Niro because it's my blog and it's more fun that way.

The identities of each writer will be revealed in one week. Now on with it!

Question 1: Does government funding of scientific research do more good than harm?

I think that government funding for R&D is very important and, in most cases, relatively effective. It's important to take into consideration the role of the patent-granting activities of the government as the most potent tool for the advancement of scientific research and development, particularly in the pharmaceutical and medical science fields. Without the economic security granted by a patent, companies involved in the research and development of new technologies and advancements would have very little incentive to continue their work if they have no assurances of profit-maximization opportunities once they've developed or discovered something important. In my view, government funding of R&D and scientific and technological advancements in general should be a transcendent policy issue - everybody from every corner of the political and ideological arena should be able to recognize just how worthy of an investment this sort of spending is to the future of the country.

The government funding of science does more good than harm. Scientific research raises our collective good by investing in the intellectual capital of its people. In addition research by the government paves the way for private industry to profit from their discoveries. This is particularly true with Tempur-pedic fabric and nuclear technology.

It would depend upon the scientific research. Martial scientific research, like research in advanced weaponry, does little to improve our economy. War is ultimately a destructive force with net economic losses. Profit aligns with our values often enough to rely on it to drive economic growth a majority of the time, but the alignment isn’t seamless and it’s my opinion that a democratic society can decide to allocate resources for research in areas where start-up costs are too high for for-profit entrepreneurs to be attracted to it.

Scientific breakthroughs are public goods, and you subsidize public goods with positive externalities. That's econ 101, folks. Private companies need to justify research with short-term profits, and what happens if their funding shuts off in short order? How could you hope to have a massive project like the Collider - a machine the size of a racetrack - to satisfy curiosity and not make money? What about figuring out how nature works in general with no intended application? These are major market failures.

Question 2: What caused the current recession and what is the best thing the government can do to help us get out of it?

The current recession was causes by a toxic confluence of events precipitated by bad economic policy and a healthy dose of bad luck. The massive amounts of deregulation in the Reagan and Clinton years led to an environment on Wall Street in which poisonous mortgage-backed securities (subprime) and derivatives became the centerpiece of trading and investing behavior. Predatory and ill-advised mortgage lending made these securities toxic and the vile collusion between ratings agencies and financial institutions led to these investments being used for pensions and 401Ks and other such investment activities which subsequently tanked. Massive tax cuts, an unpaid for prescription drug benefit for Medicare and two incredibly expensive and unpaid for wars, in addition to the mess on Wall Street and the housing bubble, are the main causes of the current disastrous economy.

I propose that increased government spending in targeted, stimulative areas such as hiring tax credits, R&D, infrastructure programs, unemployment benefits, job training programs, education, and so on, will be the most effective ways to stimulate and jump start the economy. This need only last until full employment is reached. Full employment however is not 0% unemployment but there is a 4% to 6% level. Due to the leakages from MPS (marginal propensity to save) the government spending option provides a more direct, dollar-for-dollar boost to the economy at a time when neither consumers nor producers are in a position to do much in the way of growth-oriented economic activity.

The current recession was caused by lack of oversight and hubris: Oversight on the side of the major rating houses and hubris on the part of bankers. Bankers had to feed a demand for more and more mortgage backed securities, so they had to become creative with how they acquired them and bundled them together. This, combined with rating houses giving risky securities AAA ratings, was a recipe for disaster.

I honestly don’t know what happened - I have not studied the recession in great detail. But what I do know is that the state of our nation is nothing remotely close to what it was during the depression or other serious economic downturns. Whatever was or wasn’t done by the government (bailouts?) has likely either saved us, or their affects were negligible (nothing was harmed) and economic forces kept our machine oiled.

The recession was not caused by deregulation per say, existing protective laws were not relaxed. Instead it came from the stubborn refusal to adopt new regulations for new financial products. Derivatives and sub-prime loans entered the marketplace with no safety rail, and the economy went over the cliff.

We're already out of the recession now, but that doesn't mean the government can't still speed up the recovery with public works projects and putting more money in the hands of the impoverished through redistribution, who will spend more of it right away. Yes, you can let the wound heal on its own, but why not put some neosporin on it to speed up the process?

Question 3: How serious a problem is deadweight loss? What are the primary causes and what can be done to reduce it?

Dead weight loss is a serious problem. If you observe a graphic representation, you can see what is called the "welfare loss triangle" to get a nice visual sense of how and why this phenomenon exists. The primary causes of dead weight loss are taxes, price floors and price ceilings. In all three instances, government imposes policies that interfere and obstruct the natural machinations of markets where the markets would ordinarily adjust through the price mechanism of supply and demand, thus arriving at equilibrium levels through the invisible hand. When taxes are paid, not all of the taxes paid are collected by government due to leakages which result in dead weight loss. The same is true of price floors and ceilings; price floors cause an excess of supply and thus dead weight loss and price ceilings cause an excess of demand and result in dead weight loss as well.

I would say at this point in history dead weight loss is less of a problem than it has ever been. Major causes of deadweight loss are monopolies, cartels, and other supplies in collusion. The best way to combat it it is to maintain strong antitrust laws and keep a vigilant eye on mergers. Of particular interest at this point would be the cell phone providers in the US.

I can’t think of any consumer driven causes, but there are plenty of ways either suppliers or states can create deadweight loss. State tools include taxation, subsidies, price ceilings and floors, etc. Supplier tools include monopolistic/oligopolistic price gouging. I admit, I can’t remember a whole lot about the subject, but I might speculate the seriousness of deadweight loss is highly dependant on the volume of the loss and/or the subjective intrinsic/sentimental value of the consumer product. In the event where deadweight loss is undesirably high, the solution to correct it will depend on the cause. State driven deadweight loss requires legislation to correct. I’m unsure about the best way to correct supplier driven deadweight loss, but it might be to break up the monopoly.

Deadweight losses - where something is taxed and less of it is created - are not always a problem. That's the whole idea of Pigovian taxes - when you tax something, you get less of it - including tobacco use, soda consumption and other activities that have negative costs to society. It's true you see some marginal changes with taxes when you have elastic demands, but that just shows how serious the job of setting tax rates is.

Question 4: The leader of a small country in the developing world asks for your advice about monetary and fiscal policy. What do you say to them?

I would advise an aggressive mix of expansionary fiscal and monetary policies. Expansionary fiscal policies are either increasing government spending or cutting taxes. Since a developing nation is in similar conditions to what a nation like the U.S. would characterize as a "recession", I would advice going the route of increased government spending. Keynesian principles hold that deficit spending during a recession is the best and most effective way to stimulate economic growth. The reason is simply - government spending is most directly impactful on an economy because it does not have to be filtered through households and firms, where a decision has to be made in terms of what to spend, save or invest. Infrastructure spending and projects are great for stimulating an economy on two levels: the short-term increases in employment as people are needed to build, repair and plan these projects. And the long-term impacts are very important as a strong and modern infrastructure can very often be the vehicle of economic growth, such as the expansion of the interstate highway system in the mid 20th century and the advent of the Internet in the 1990s, each of which acted as tremendously important innovations and investments for the U.S. economy.

On the monetary side, I would also advocate an expansionary policy by increasing the money supply and thus lowering the interest rate. When the interest rates are low and credit is more readily available, firms and businesses can more easily invest and expand which will in turn increase employment and consumption. This will happen for the basic reason that as the money supply is increased, demand for money decreases and interest rates decrease accordingly. Interest rates are in essence the "price" of money and when money is cheap, firms and households can engage in larger amounts of economic activity.

Take a hard and brutal look at your country and decide what competitive advantage it might have over others in the region, and if transportation and infrastructure is in place, then the world. In addition, when allowing foreign companies to develop in country, require a percentage of their revenue to remain in country.

Monetary policy is not my area of expertise. I struggled in college to make the connections between interest rates and currency values, with trade and economic growth. Relative to developing nations and our past, our country has enjoyed a very long period of economic stability while employing state controls over the value of our currency and interest rates. But I may be confusing causality and correlation. I would argue that measures should be taken to stabilize currency, as opposed to letting it succumb to the whims of economic forces. Developing nations are much more vulnerable to instability and exploitation.

As for fiscal policy - developing nations tend to have fewer social institutions and stability. Good business depends on good relationships and a strong (don’t read as “big”) government that can enforce rules and agreements (no matter how few, libertarians.) Strong public investment in education is highly recommended.

I’ll go a step further and talk about trade policy as well. I would suggest free trading blocs with regional states at comparable stages of development. States that have opened trade with large Western nations get stuck producing (or rather just gathering) primary goods for export. While its an improvement from subsistence farming, it could be a dead end and unsustainable. Trade with regional partners strengthens political ties (reduces the chance of war, which is much more likely in developing nations) and diversifies markets.

I'm assuming we have a democracy, not an autocrat state, if we expect the advice to be heard. For monetary policy, have a central bank with a lot of government oversight to make sure monetary policy is being used appropriately, and put in safeguards to keep someone from running wild with the printing press like we saw in Zimbabwe. If the nation is small enough, why not have no monetary policy and adopt a foreign currency like the US dollar?

Fiscal policy needs to be tailored to the area. Do they have an AIDS problem? If so, thats going to require a lot of medical spending. Is there a lot of inequality to smooth out? I could give the boilerplate Keynesian prescription, but I'd have to know what I'm working with.

Question 5: Assume we discover an easy method of transportation to a planet with a far off alien species that is friendly and about the same technological level. Assuming small costs of transportation of goods to and from their civilization, what are the most likely economic consequences of such trade

According to Ricardo (and any other economist with a brain) engaging in free and fair trade will only benefit both trading partners. It will be imperative to first determing what we have an absolute advantage in and more importantly what we have a comparative advantage in; when I say "in" I mean in producing - what can we produce more efficiently than the aliens can or what can we produce at a lower opportunity cost in terms of other goods. If we specialize in that which we have those goods in which we enjoy a comparative advantage and the aliens do the same on their end, free trade between the two parties will benefit both. Real wages will rise and each trading partner will end up with more of all of the goods being traded than they would have if they'd chosen to keep all production and trade domestic. The only times I will even consider supporting protectionism or limitations on trade is in the case of "infant industry" or with respect to national security concerns.

Trade is good. If Gordon Gekko were a space trader he would have said the same thing. Trade will help out both countries, (sorry, planets) even if they are at the same technological level. The most likely consequence of such trade would be more specialization and lower prices on all goods involved.

We would easily see economic growth.

Depends if the general public can get over their irrational fears that "aliens are taking our jobs." The best case scenario is free trade with these beings, which will benefit both human and alien civilizations. There will be specific losers on both sides of space, like laborers who see their industry moving off-planet, but in total everyone will benefit. More "people" to cooperate with means more specialization and more gains from trade.

Question 6: Most would agree that as an economic theory, mercantilism suffered many flaws. If you had to identify a single biggest flaw what would it be and why?

The flaws in mercantilism relate very closely to my response to to the previous question. If government is too tightly restricting trade, consumers will have to pay higher prices for commodities that are expensively and ineeficiently produced domestically. The mercantilistic insistence on a "positive" trade balance is naive because it implies that there is something wrong with importing more than you export - there is not. The U.S. is uniquely positioned to lead in the information tech and information services sectors while other nations, such as China, are better suited to the manuifacturing of consumer goods. Mercantilism in short is an obnoxious and short-sighted repudiation of the reality of globalization. As I stated in the previous response, when trading terms are worked out fairly and intelligently, both partenrs end up with more of all goods being traded and the consumers and producers in both trading nations end up better off.

Anyone who has played a game of Settlers of Catan can tell you that it is harder to win if you don’t trade. However you define winning it is easier with trade. Whether winning involves; increased productivity, political stability, standard of living, or simply highest yield. In any case the greatest flaw of mercantilism would be that of its restrictive nature towards trade.

I hate following rules, so I will give you TWO major flaws: First, we probably suffered from EXCESSIVE deadweight loss under mercantalism - I realize that may seem redundant to some, but in a previous answer I argued that some deadweight loss may be regarded as negligible or tolerable.

Secondly, Mercantalism fostered jingoistic nationalism a driving factor for both wars and exploitative colonialism both of which were highly destructive.The best thing competing European countries did was open up trade between each other after WWII. I would argue that Western European Nations will never go to war with each other again *quickly sweeps sectarian-violence-in-Northern-Ireland under the carpet.*

I'd say confusing shiny rocks, be they gemstones, gold, silver or certificates that stand for them, with wealth. Wealth is in things like raw materials, manufactured goods, usable items and services. Mercantalists were willing to trade away those things to bring in more shiny rocks. They could indeed exchange these rocks for resources, but they chose to choke off incoming resources in lieu of more shiny rocks, thus making them poorer in the practical sense.

That's everything. Can you guess which one is actually a freshwater economics writer attempting to answer from a Keynesian perspective? That answer is available here, but please don't click until you have a candidate in mind. There are things in there that you can see but can't unsee.