The Great Experiment

Since early last fall, it's been my strong opinion that the real (and only) solution to the financial situation was to have the Fed pump huge amounts of liquidity into the system. Instead, we got TARP's and bailouts and stimulus packages and all kinds of stuff. The stock market continuously tanked in response to all those packages and the financial system continued to be mired in fear, uncertainty and doubt.

Finally, in early March, the Fed did just what I hoped they would:

"...the Bernanke Fed launched another shock-and-awe stimulus plan that will expand the Fed’s balance sheet another $1.2 trillion through the purchase of $300 billion in long-dated Treasuries, $750 billion in mortgage-backed securities (Fan/Fred), and another $100 billion in U.S. agency debt."

Sure enough, the stock market had its biggest rally in many months in response. Banks are looking healthier, the financial system is starting to look a bit more stable, and some economic indicators are starting to point to a recovery.

I'm really happy the Fed finally did this. Beyond the fact that I thought it would help, it's also a very interesting experiment. The second half of the experiment will take place in the future. The Fed created a huge amount of liquidity. Eventually, as the credit markets thaw completely and money velocity returns to normal levels, the Fed will need to mop up all that excess liquidity or the economy will drown in all that extra money. I'm hoping they have the resolve to do the right thing. I think they can, but not everybody agrees with me. If I'm wrong, we'll see quite an uptick in inflation, probably starting in the next several months.

But my curiosity will be sated either way.

Philosophy of Economics

In the study of Philosophy of Economics, I think that four names stand out on this subject: Karl Marx, John Rawls, Robert Nozick, and F.A. Hayek. They each have each put forth some very powerful ideas and represent (more or less) communism, socialism, libertarianism, and (sort of) conservatism respectively. While none of their ideas are perfect and in any case subject to preference, I think each should be studied and the strength and weakness of the arguments understood in order to participate in any debate about economic policy.

Much to my surprise, in a recent informal poll of friends and acquaintances, I've found that very few have heard of any of these other than Marx. While Marx is certainly the most important since his teachings were the instigation for the radical formation of governments in countries containing billions of people, each of the other philosophers' ideas are very important as well.

Here is a quick overview of each of their ideas:

Karl Marx
Marx argued that capitalism, like previous socioeconomic systems, will produce internal tensions which will lead to its destruction. Communism, the ultimate heaven of earth with riches for all, will rise from the ashes of capitalism. "From each according to his ability, to each according to his needs" is the slogan popularized by Marx to describe the basic working of communism from the workers point of view.

John Rawls
Rawls makes the case for redistributive justice and socialism in A Theory of Justice. He does this by asking how one might choose to design a fair economic system if we had no clue (he calls this a "veil of ignorance") as to our position in that system. We might be at top in terms of talent and opportunity or we might be at the bottom. If this were the case, he argues that we would design a system that would maximize the position of the worst off (known as "the difference principal") in case we ended up being the worst off, and that such a system would have a great deal of redistribution in order to be just.

Robert Nozick
Nozick's Anarchy, State, and Utopia (1974), which received a National Book Award, argues among other things that a distribution of goods is just if brought about by free exchange among consenting adults and from a just starting position, even if large inequalities subsequently emerge from the process. He also argues that the only just system of government is a minimalist government dedicated only to the protection of the population, though he argues for progressive taxation to fund that government. Nozick turned Marx's slogan around to become "from each as they choose, to each as they are chosen".

F.A. Hayek
He shared the 1974 Nobel Prize in Economics with ideological rival Gunnar Myrdal "for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena." He also wrote extensively on the distribution of information in an economic system and the relationship between that and liberty. He also wrote about evolution of human institutions that support economic activity ("the spontaneous order").

I find that when beginning a discussion about fairness and economics (a favorite topic of Left leaning friends and acquaintances), that a huge part of the effort ends up being dedicated to subtopics already thoroughly addressed by the economic philosophers I've mentioned above. I wish that instead of only teaching Marx in schools, that all four were taught. I think that everybody would then have a much better handle on the economic policy debates that are continually rehashed in the country.

Wages and Standard of Living

One constant refrain from socialists and statists is that capitalism is unfair because the rich are getting richer and the poor and getting poorer. Often cited in support of this statement is that wages of the middle and lower classes have been stagnant for decades, the implication being that the standard of living for those classes has also been stagnant. The obvious flaw in this reasoning is that stagnant (i.e., not getting richer) is not the same as getting poorer.

However, the more important flaw is subtle; stagnant wages do not necessarily imply a stagnant standard of living for the lower classes. There are several reasons that there is not a direct link between wages and standard of living.

First, nominal wages have not been stagnant at all - they're much higher than they were a few decades ago. What's meant when referring to stagnant wages is that they have been relatively stagnant when converted from nominal wages to real wages by comparing them to the inflation rate. The inflation rate is an average inflation rate across all goods and services. However, [T]he rich have faced a higher effective rate of inflation than the poor have. Examples:

• The price of fish eggs (caviar) has increased much more than the price of chicken eggs (not to mention chickens).
• The price of high end wines have gone through the roof, while two-buck chuck (Charles Shaw wines) provide far more value per real dollar (in my opinion) than has ever been available.
• Ferraris have really gotten expensive, but my Hyundai Elantra was amazingly cheap and good and there are even less expensive cars.

The inflation rate for the poor is lower than the official (average) inflation rate and therefore the poors' wages have not been stagnant with regards to purchases that poor people typically make. In other words, the poor can buy more than they used to. That's not stagnation, that's improvement in their standard of living.

Second, wages aren't the same thing as compensation. Compensation includes vacation, sick leave, health care, perks such as cars or meals, and other benefits in addition to wages. As Daniel Griswold elaborates, measures of real wages only are misleading:

A more accurate measure of earnings is “real hourly compensation,” which includes not only wages but benefits. The Bureau of Labor Statistics data on wages and benefits combined tell a more accurate and encouraging story about the well-being of the average American worker. Since 1973, average real hourly compensation for American workers has increased 45 percent, for an average annual growth rate of more than 1.1 percent. Figure 2 shows that real hourly compensation has not only climbed since 1973, but its rise has accelerated in the past decade along with America’s growing economic openness. The average American worker has not suffered from “stagnant” earnings in the past three decades but in fact has enjoyed real gains.

Third, while it should be obvious, many pundits seem to overlook that fact that the wage data from decades ago are for different people than the current wage data. The people who were in the bottom quintile of income back then have generally moved up to higher quintiles (see here and here for more information). Those are then replaced in the lowest quintile by immigrants, students, etc. who will then also attain higher incomes over time.

Next, standard of living is not directly dependent on income. That might seem like a surprising statement, but if you think about it, standard of living is mostly dependent on "outgo". It's your ability to spend, not your income that determines how well you can live. These days, many more of the poor get substantial assistance that's not considered income. For example, the vast majority of students have low incomes, but because of financial aid and parental help, they mostly live far better than their incomes would otherwise indicate. Other programs like the Earned Income Tax Credit and Food Stamps also help lower income families have higher outgo and therefore a better standard of living.

Also, median family size has fallen by about 3% per decade over the last few decades. So even a stagnant household wage would still mean that the typical person in the median family is better off.

The bottom line is that the poor from the past are, in general, significantly better off now and this is corroborated by the fact that poor households typically have numerous amenities that their counterparts from decades past did not have. If the current Administration and Congress don't blow it too badly, the trend of the poor having an ever better standard of living will probably continue.

America's Last Depression

So what's the difference between a recession and depression? They're both economic contractions, but there's no widely accepted set of economic indicators that separates one from the other. And why is it called "depression" which also has the definition, "gloom; ... sadness greater and more prolonged than that warranted by any objective reason..."

Perhaps the difference between recession and depression is mostly psychological. If we give up, then long term recession and stagnation may be inevitable. John Maynard Keynes said, "If the animal spirits are dimmed and the spontaneous optimism falters, leaving us to depend on nothing but a mathematical expectation, enterprise will fade and die." I'm not sure I completely agree with that, but I do think that the mathematical expectation drops precipitously if the "animal spirits are dimmed". If everybody is all depressed and doesn't work as hard, doesn't invest as much, and doesn't partake as much of the available goods and services, it puts the economy into a more or less permanent downward spiral.

From the mathematical expectation standpoint, we're nowhere near the great depression. We're only starting to approach the recession of the early 1980s.

But from a psychological depression standpoint, it seems to me that we've already shot by that recession and are headed to unknown depths. The diversity of gloom is impressive. It's not surprising that Republicans and the Right are depressed - they're out of power, out of (marketable) ideas, and out of luck and they know it. However, when people like Paul Krugman are also depressed, given that they control all the reins of power and should be ecstatic to be able to enact all of the programs they've been drooling over for decades, it shows an extraordinary breadth of despair.

With despair, despondency, and depression can come political instability. Political instability has led to some truly frightening scenarios in the past:

The sad truth is that democracy itself is often unstable. Intellectuals lose faith. Democracy is not flashy. It falls out of fashion. The intelligentsia feel scorned, unappreciated, and turn to new theories.

There are other pressures. Republics stand until the citizens begin to vote themselves largess from the public treasury. When the plunder begins, those plundered feel no loyalty to the nation—and the beneficiaries demand ever more, until few are left unplundered. Eventually everyone plunders everyone, the state serving as little more than an agency for collecting and dispensing largess. The economy falters. Inflation begins. Deficits mount.

It's remarkable how apropos the above excerpt is to the current situation given that it was written in 1983 as "the introduction to an anthology of science fiction stories" by writer Jerry Pournelle. Remarkably descriptive and predictive. I'm rather hoping that the next part of his introduction isn't predictive:

Something must be done. Strong measures are demanded, but nothing can be agreed to. [...]

Enter the strong man, who will save the state.

From the ancient Greeks to the Romans to the Germans, democracies with economic problems faltered and turned to the dictator. I have no doubt that eventually America's time will come when it turns to the dictator.

Is that time here already?